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Chapter 1

INTRODUCTION

A business is an activity carried out with the intention of earning the profits. A person carrying out the business is interested in knowing basically two facts about his business (a) What is the result of operations of the business activity? In other words, whether the business has resulted into the profit or loss? Excess of revenue over the expenses will be in the form of profits whereas excess of expenditure over the revenue will be in the form of loss. Where the business stands in financial terms at any given point of time.

(b)

Providing the answers to the above questions is not possible unless the transactions relating to the business are recorded in a systematic manner. Here the process of accounting comes into the picture. According to American Institute of Certified Public Accountants, Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are of a financial character and interpreting the results thereof. The process of recording the business transactions in a defined set of records, which in technical words are called as Books of Accounts, is referred to as Book Keeping. Accounting refers to the process of analyzing and interpreting the information already recorded in the books of accounts with the ultimate intention of answering the above stated questions. This intention is satisfied by preparing what are called as Financial Statements. The financial statements prepared by the organization are basically in two forms(a) Profitability Statement, which is the answer to the first question i. e, what is the result of operations of the business activity. Thus, profitability statement indicates the amount of profit earned or the amount of loss incurred. Balance Sheet, which is the answer to the second question i.e. where the business stands in financial terms at any given point of time. Thus, balance sheet indicates the financial status of the business at any given point time in terms of its assets and liabilities.

(b)

Introduction

The nature of these financial statements is discussed in details in the following pages. Thus, the process of book keeping is more procedural and clerical in nature while the process of accounting is more managerial in nature. As such, the job of book keeping is entrusted to junior level employees, whereas the job of accounting needs more professional expertise. STREAMS OF ACCOUNTING The process of Accounting gets split into three streams 1. 2. 3. Financial Accounting Cost Accounting Management Accounting

Let us discuss the nature of these three streams of accounting in details. Financial Accounting Financial Accounting is the process .of systematic recording of the business transactions in the various books of accounts maintained by the organization with the ultimate intention of preparing the financial statements there from. These financial statements are basically in two forms. One, Profitability Statement which indicates the result of operations carried out by the organization during a given period of time and second Balance Sheet which indicates the state of affairs of the organization at any given point of time in terms of its assets and liabilities. This nature of Financial Accounting indicates following characteristic features of Financial Accounting (a) Financial Accounting considers those transactions which can be expressed in terms of money. All those transactions which can not be expressed in terms of money, howsoever important they may be from business point of view, find no place in financial accounting and hence in financial statements. E.g. Assuming that the business of an organization is such that it is likely to be injurious to the health of local community. As such, there is a strong opposition from the local community for the companys carrying on the business at that location. This opposition is something which can not be expressed in terms of money and hence finds no place in financial accounting and hence in financial statements though, it is affecting the business operations of the organization to a very great extent. Financial Accounting is referred to as Historical form of accounting. In other words, financial accounting is concerned with recording of transactions which have already taken place. No futuristic transactions and events, howsoever important and significant they may be from business point of view. find any place in financial accounting and hence in financial statements.

(b)

Management Accounting

(c)

In practical circumstances Financial Accounting is more or less a legal requirement. In case of certain organizations like Company form of organization, Banks, Insurance Companies etc., not only it is necessary to maintain the financial accounting records and prepare the financial statements there from, but it is obligatory to get these financial statements audited also by an independent Chartered Accountant. In some cases, there may not be direct legal requirement to prepare the financial statements, but indirectly it is necessary to prepare the financial statements. E.g. If a partnership firm wants to file its Income Tax Return as per the provisions of Income tax Act, 1961, preparation of financial statements is a must to ascertain the profits. Financial Accounting is meant for those people who are external to the organization. In other words, financial accounting is basically meant for those people who are not a part of decision-making process regarding the organization. This class of people may consist of the people like investors, customers, suppliers, banks, financial institutions etc. The information available from Financial Accounting, i.e. financial statement, is available at a delayed point of time. E.g. Balance Sheets as on 31st March 2002 is available after 31st March 2002 is over. The various legal provisions also allow sufficient time lag for the preparation of financial statements. For decision-making purposes, immediate availability of financial data is a prerequisite which is not satisfied by financial accounting. In this sense, financial accounting has the limitation. Further, as sufficient time is allowed for the preparation of financial statements, they are expected to be accurate. Financial Accounting discloses the financial performance and financial status of the business as a whole. It does not indicate the details about the individual department or job or process inside the organization, the information which is more significant from decision-making point of view. In this sense, financial accounting has the limitation. Financial statements are essentially interim reports and cannot be the final ones. E.g. In order to understand the correct profitability and correct position of the assets and liabilities of an organization, it will be necessary to stop the business operations, dispose off all the assets of the organization and liquidate all the liabilities. Obviously it is not feasible and practicable. In order to prepare the financial statements for a specific period, it may be necessary to cut off various transactions involving costs and incomes at the date of closing the accounts. This may involve personal judgements. Various policies and principles are required to be formulated and followed consistently for such cutting off of incomes and costs. As the going concern principle is followed while preparing the financial statements, the various assets and liabilities are shown at the historical prices which may not necessarily represent the current market prices or the liquidation prices. This may affect profitability

(d)

(e)

(f)

(g)

(h)

Introduction

also due to incorrect provision for depreciation on assets. This problem may be more critical during the periods of extreme inflation or depression. (i) The process of Financial Accounting gets largely affected due to the various accounting policies followed by the accountants. Even though, attempts are being made to bring in the uniformity in the various accounting policies followed by the accountants, still the accounting policies may differ from organization to organization. These accounting policies may differ basically in two fields :
l l

Valuation of Inventory Calculation of Depreciation

The effect of these different accounting polices is discussed in the following chapters. Cost Accounting Cost accounting is the process of classifying and recording of the expenditure in a systematic manner with the intention of ascertaining the cost of a cost centre with the intention of controlling the cost. The Institute of Cost and Management Accountants, London has defined Cost Accounting as 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 as well as the presentation of information for the purpose of managerial decision making. The above description of Cost Accounting reveals the following characteristic features of Cost Accounting (a) Cost Accounting views the organization from the angle of individual components of the organization like department or job or process etc. Cost Accounting is interested in ascertaining the profitability of these individual components of the organization. Cost Accounting is operated with basically three objectives l

(b)

Ascertainment of cost and profitability with the help of various principles, methods and techniques. Cost Control - This indicates the process of controlling the costs of operating the business. Presentation of information to enable the managerial decision-making.

(c)

Cost Accounting is meant for those people who are internal to the organization. In other words, Cost Accounting is meant for those people who are a part of decision-making process of the organization. The people who are external to the organization do not have any access to the cost accounting records. In fact the basic objective of cost accounting is to facilitate professional decision-making process on the part of managers.

Management Accounting

(d)

Cost Accounting is not a legal requirement. Maintenance of cost accounting records is not mandatory. However, maintenance of cost accounting records may be a legal requirement in some exceptional cases. Section 209 (1) (d) if the Companies Act, 1956, makes it mandatory for companies falling under certain class of industries to maintain cost accounting records and also get them audited from an independent Cost Accountant (which is technically referred to as Cost Audit). Cost Accounting does not necessarily restrict itself to the historical transactions or historical events. Future transactions or events may find the place in cost accounting. In fact, each and every transaction, whether past or future, which is likely to have an impact on the business is of concern to the cost accounting. As Cost Accounting is supposed to facilitate professional decision making on the part of manager, immediate availability of data is the prerequisite of cost accounting. As such, accuracy is not insisted upon by cost accounting to the extent of hundred percent.

(e)

(f)

Management Accounting Management Accounting is the process of analysis and interpretation of financial data collected with the help of financial accounting and cost accounting with the ultimate intention to draw certain conclusions therefrom in order to assist the management in the process of decisionmaking. Emergence of Management Accounting In the olden days, when size of business operations was small and the complexities involved in the same were limited, financial accounting was considered to be sufficient. Financial Accounting ultimately aims at preparing financial statements which are basically in two forms. (1) Profit and Loss statement which is a period statement and relates to a certain period, usually one year. This tells about the result of operations, either profit or loss, arising out of the conduct of business operations during that period. Balance Sheet which is a position statement and relates to a particular point of time. This tells about the various properties held by the business (termed as assets) and obligations accepted by the business (termed as liabilities) as on a particular date.

(2)

The preparation of these financial statements was considered to be sufficient to serve the requirements of all the interested parties, both outsiders as well as insiders. However, due to the increasing size and complexities of the business operations and specifically due to the segregation of ownership and management, only financial accounting was realised to be insufficient. This was specifically due to certain limitations of financial accounting.

Introduction

(a)

Financial accounting considers only those transactions which may be expressed in financial terms, either fully or at least partially. However, it ignores the fact that there may be other types of non-financial transactions which may have a bearing on business operations, e.g.. Prestige of business, credit standing of business, efficiency and loyalty of employees, efficiency and intensity of management etc. Financial accounting deals with recording of the past events and as such it is the postmortem record of business transactions. For taking correct decisions regarding the business, the management may need, not only the past details but also the future events, and future events are not the subject matter of financial accounting.

(b)

As such, financial accounting and preparation of financial statements therefrom is no longer considered to be sufficient for successful and smooth running of business. The analysis and interpretation of data available from financial accounting is also considered to be necessary which may not be directly available from financial accounting itself. Here comes into the picture Management Accounting. Management Accounting deals with, the analysis and interpretation of financial data with the ultimate intention to draw certain conclusions therefrom, in order to assist the management in the process of decision-making. To conclude, it may be said that the role of management accounting has emerged due to the shortcomings of financial accounting. Definition of Management Accounting The Institute of Chartered Accountants of England and Wales has defined management accounting as any from of accounting which enables a business to be conducted more efficiently. Management Accounting Team of Anglo-American Council on Productivity has described the term Management Accounting as the presentation of accounting information in such a way so as to assist management in the creation of policy and the day to day operation of an undertaking. American Accounting Association has defined the term Management Accounting as the application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist management in establishing plans for reasonable economic objectives and in the making of rational decisions with a view towards these objectives. The various definitions of the term Management Accounting reveal the following features of the same. (1) Management Accounting is a service function which is concerned with providing various information to the management to facilitate decision making and review of implementation of those decisions.

Management Accounting

(2)

Management Accounting uses not only the historical data but may also use the data based on projections and forecasts for the purpose of evaluation of various possible alternatives. Management Accounting assists the management in establishing the plans to attain the economic objectives and in taking proper decisions required to be taken for the attainment of these objectives. Management Accounting involves the application of various special techniques and concepts for the attainment of its objects. The techniques used in the process of management accounting are discussed in the following chapters.

(3)

(4)

Objects of Management Accounting The above discussions reveal that the Management Accountant is an invaluable aid to the management to discharge the basic functions of planning, execution and control. This is done by (1) (2) Making available accounting and other data to enable the management to plan effectively. Measuring the actual performance and reporting the same to the various levels of management to indicate the effectiveness of the organisational methods used. Computation of deviation of actual performance from the plans and standards set. Presenting to the management the operating and financial statements at reasonable intervals and interpreting the same to enable the management to take action/decisions regarding future policy and operations.

(3) (4)

Scope of Management Accounting After considering the various objectives the Management Accounting aims at, it can be noted that the scope of Management Accounting is much wider. It covers virtually every area and every aspect of business operations. However, to be more precise, the various areas covered by Management Accounting can be stated as below. (1) Accounting : It deals with recording, summarising and analysing various business transactions. The process of accounting may take basically two forms. (a) Financial Accounting : It deals with recording the business transaction which are financial in nature. It aims at the preparation of what is called financial statements which may be basically in two forms. Firstly, the Balance Sheet which tells about the state of affairs of the business in terms of the various assets and liabilities and Secondly, the profitability statement which tells about the result of operations of

Introduction

the business i.e. profit earned or loss incurred. The financial statements are mainly meant for the outsiders dealing with the business. (b) Cost Accounting : It deals with recording of income and expenditure, ascertainment of cost and profitability and the presentation of information derived therefrom for the purpose of managerial decision making. Thus, the cost accounting is basically meant for the management to enable it to take decisions.

(2)

Cost Control Procedures : It deals with the various steps involved in the process of controlling the cost. Thus, in turn it may deal with. (a) (b) (c) Establishment of plans or budgets for the future. Comparison of actual performance with the planned or budgeted performance. Computation of variations between the planned and actual performance.

(3)

Reporting : It deals with the presentation of cost data, statistical data or any other information to the various levels of management. It may be required for the purpose of decision making or for the purpose of fulfillment of various legal obligations. Taxation : It deals with the computation of income as per the law and filing the tax returns and making the tax payments. Audit : It deals with devising the internal control systems and internal audit system to cover the various operational areas of business. In many cases, it may also deal with the management audit which is the evaluation of the managerial performance. Methods and Services : It deals with providing the management services and the management information systems. It also deals with the various methods of reducing the cost and improve efficiency of accounting and other office operations and preparing and issuing the accounting and other operational manuals.

(4)

(5)

(6)

Disadvantages/Limitations of Management Accounting In spite of the various advantages available from the management accounting in the era of ever increasing complex business operations, it suffers from some limitations, (1) A very wide scope of management accounting is the limitation by itself. It attempts to operate in a wide range of areas and it is quite possible that it may not be able to make proper justification to all of them. In spite of the fact that the management accounting provides the various details required for qualitative decision making thus attempting to avoid the possibility of intuitive decision making, in many cases in practice, the decisions are based upon the intuition of the decision maker rather than the scientific data available therefor.

(2)

Management Accounting

(3)

The installation and operation of management accounting requires a very elaborate organisational structure and a large number of rules and regulations. It may make the management accounting system a costly proposition which can be implemented only by large scale organisations. Management Accounting system is still in the evolution stage and hence suffers from the various limitations which any system may face in the initial stages like the requirement of constant improvements of the techniques and uncertainty about the application of the system etc. The installation and operation of management accounting system may call for the radical changes in the entire organisational structure which may cause severe opposition and resistance from the existing personnel.

(4)

(5)

FINANCIAL ACCOUNTING AND COST ACCOUNTING COMPARED (a) Financial Accounting is concerned about the calculation of the profitability and state of affairs of the organization as a whole with the help of preparation of the financial statements. Financial Accounting takes into consideration only the historical data which may not be of any use from the cost control point of view. Cost Accounting may deal with the ascertainment of cost and calculation of profitability of the individual products, departments, branches and so on. Cost Accounting involves a much-detailed study of costs and profitability which takes into consideration not only historical data but also the future events and possibilities. As such, cost accounting proves to be better proposition from the cost control point of view. (b) Due to the various statutory regulations, maintenance of financial accounting records and preparation of financial statements therefrom is more or less a legal requirement. Maintenance of cost accounting records is not a legal requirement except in case of certain company form of organizations where maintenance of cost accounting records has been made compulsory as per the provisions of Section 209 (1) (d) of the Companies Act, 1956. (c) Financial Accounting primarily protects the interests of the outsiders dealing with the organization in various capacities like investors, suppliers, customers, banks, financial institutions, government authority etc. Cost Accounting is primarily meant for the management to enable the same to discharge various functions in a proper manner i.e. planning, execution, co-ordination and decisionmaking.

Introduction

This relationship between Cost Accounting and Financial Accounting can be better explained with the help of the following illustration which states the presentation of the profitability statement under both the sets accounting. (a) Financial Accounting Profit and Loss Account for the year ended on 31st march 1990. To, Material Cost To, Labour Cost To, Factory Expenses To, Gross Profit c/fd (40% of sales) 2,00,000 5,00,000 To, Administration Expenses To, Selling Expenses To, Net Profit (12% of sales) 90,000 50,000 60,000 2,00,000 (b) Cost Accounting Products Total Material Cost Labour Cost PRIME Cost Factory Expenses FACTORY Cost Administration Expenses Selling Expenses TOTAL COST Profit SALES Profit % on sales 1,50,000 1,00,000 2,50,000 50,000 3,00,000 90,000 50,000 4,40,000 60,000 5,00,000 12% A 20,000 15,000 35,000 20,000 55,000 40,000 15,000 1,10,000 (-) 10,000 1,00,000 B 50,000 30,000 80,000 10,000 90,000 20,000 20,000 1,30,000 20,000 1,50,000 13.33% C 80,000 55,000 1,35,000 20,000 1,55,000 30,000 15,000 2,00,000 50,000 2,50,000 20% 2,00,000 By Gross Profit C/f 2,00,000 5,00,000 1,50,000 1,00,000 50,000 By sales 5,00,000

10

Management Accounting

Financial Accounting and Management Accounting compared (a) For the purpose of extracting the data required for managerial decision-making, Management Accounting may use the information appearing in the financial statements. This information may be used as it is or it can be rearranged or regrouped if required. As such, financial accounting becomes a source of information for management accounting. Financial Accounting considers only the historical financial transactions and does not consider the non-financial transactions. As Management Accounting aims at enabling the management to take the decisions about the future, it may consider future data as well as non-financial factors. (c) As stated earlier, due to the various statutory regulations, maintenance of financial accounting records and preparation of financial statements therefrom is more or less a legal requirement. Moreover, the format in which the financial statements are required to be prepared is also standardized. Management Accounting is not at all a legal requirement. Management is free to install or not to install a management accounting system. Further, these systems have their own reporting formats. (d) As stated earlier, financial accounting primarily protects the interests of the outsiders dealing with organization in various capacities like investors, suppliers, customers, banks, financial institutions, government authorities etc. The reports generated by management accounting are meant for the use by management for effective decision-making. (e) As stated earlier, the financial statements which are generated as a result of financial accounting, report the financial performance of the organization as a whole. Reports generated by the management accounting may deal with the various parts of the organization. As such, management accounting reports may deal with the individual department or the individual product also. (f) The reports generated by financial accounting which are in the form of financial statements are available only after the relevant accounting period is over. E.g. Balance Sheet as on 31st March 2002 is available after 31st March 2002. As such, financial accounting data may not be available to the management for decision-making purposes. Moreover, as the financial accounting data is available after a time lag, the financial statements are required to be accurate.

(b)

Introduction

11

In case of management accounting, more emphasis is on making the data available to the management as quickly as possible to facilitate the effective decision-making. If upto-date information is not made available to the management for decision-making, management accounting will loose its utility. As such, accuracy is not the prerequisite of management accounting. Cost Accounting and Management Accounting compared Cost Accounting and Management Accounting are similar to each other in many respects. Both the streams of accounting primarily aim at the effective decision making on the part of management. Both the streams of accounting are on and average not a legal requirement. The various techniques which are used by management accounting viz. Marginal Costing, Budgetary Control, Standard Costing, Uniform Costing etc. are basically regarded as the advanced methods of Cost Accounting. As such Cost Accounting may be considered to be a part of Management Accounting. Management Accounting is an extension of managerial aspects of cost accounting with the ultimate intention to protect the interests of the business. Techniques of Management Accounting There may be various techniques with the help of which the basic functions of management accounting can be discharged. We will discuss the following techniques in details in the following chaptersl l l l

Marginal Costing (Break Even Analysis) Budgetary Control Standard Costing Uniform Costing

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Management Accounting

QUESTIONS 1. Explain the nature and characteristic features of Financial Accounting and Cost Accounting. How are they related to each other? What do you mean by Management Accounting? State the advantages and limitations of Management Accounting. How Management Accounting is related with other streams of accounting?

2.

Introduction

13

NOTES

14

Management Accounting

Chapter 2
BASICS OF FINANCIAL ACCOUNTING

As stated earlier, financial accounting is the process of recording the past financial business transactions and calculating the net result of these transactions, with the intention to communicate the same to the various persons dealing with the business in the external capacity. However, financial accounting is the technical process. Before we consider the technicalities of financial accounting, let us consider some of the fundamental issues relating to the financial accounting. ACCOUNTING PRINCIPLES In order to bring the uniformity in recording the business transactions, the accountants follow certain basic procedures universally. These are referred to as the Accounting Principles. The Accounting Principles can be classified in two categories a. b. Accounting Concepts Accounting Conventions

Accounting Concepts Accounting Concepts indicate those basic assumptions upon which the basic process of accounting is based. Following are the important Accounting Concepts : Business Entity Concept This accounting concept proposes that the business is assumed to be a distinct entity than the person who owns the business. The accounting process is carried out for the business and not for the person who owns the business. E.g. If there is a partnership concern carrying on the business in the name of M/s. XYZ & Co., where Mr. A and Mr. B are the equal partners, M/s. XYZ & Co. is supposed to be a separate entity from Mr. A and Mr. B. The financial statements prepared on the basis of accounting records are of M/s. XYZ & Co. and not of Mr. A or Mr. B individually. It should be noted in this connection that the business entity concept has nothing to do with the legal entity of the business. It applies to both corporate organization

Basics of Financial Accounting

15

(which by itself is a separate legal entity from the owners) as well as non-corporate organization (which is not a legal entity separate from the owners). Dual Aspect Concept This concept proposes that every business transaction has two aspects. However, basic relationship between assets and liabilities i.e. assets are equal to liabilities, remains the same. E.g. If Mr. A starts the business by introducing the capital of Rs. 50,000, the assets and liabilities structure will be as below Liabilities Capital Assets Cash

50,000

50,000

Now, if Mr. A uses the cash to purchase the material worth Rs. 40,000, the assets and liabilities structure will change as below Liabilities Capital Assets Cash Stock in Trade

50,000

10,000 40,000 50,000

50,000

If Mr. A sells the above material worth Rs. 40,000 for Rs. 45,000 on credit basis, the assets and liabilities structure will change as below Liabilities Capital Assets Cash Receivables

55,000

10,000 45,000 55,000

55,000 Going Concern Concept

This concept proposes that the business organization is going to be in existence for an indefinitely longer period of time and is not likely to close down the business in the shorter period of time. This affects the valuation of assets and liabilities. As such, the assets are disclosed in the Balance Sheet at cost less depreciation and not at the current market price. If the assets are to be disclosed in the Balance Sheet at correct value, the current market price will be most suitable. However, as the business is likely to exist for an indefinitely longer period of time and as the assets are not likely to be sold off in the market in the near future, the market price becomes immaterial. Accounting Period Concept Even if the Going Concern Concept proposes that the business is going to be in existence for an indefinitely longer period of time, in order to facilitate the preparation of financial statements on periodical basis, the indefinitely longer life span on the business is divided into shorter time 16
Management Accounting

segments, each one being in the form of Accounting Period. Profitability is computed for this accounting period (by preparing the profitability statement) and the finanial position is assesseed at the end of this accounting period (by preparing the balance sheet). It should be noted that the selection of accounting period may depend upon the various factors like characteristics of the business organization, tax considerations, statutory requirements etc. Cost Concept This concept proposes that the assets acquired by the organization are recorded at their cost of acquisition and this cost is considered for all the subsequent accounting purposes say charging of depreciation. This concept does not take into consideration current market prices of the various assets. Money Measurement Concept This concept proposes that only those transactions and facts find the place in accounting which can be expressed in terms of money. As such, all those transactions and facts which can not be expressed in terms of money (E.g. Morale and motivation of the workers, credibility of the business organization in the market etc.) do not find any place in accounting and that is why in financial statements, though they may be having direct or indirect bearing on the business. This concept imposes severe restrictions on the kind of information available from the financial statements. In fact, this is one of the major drawbacks of financial accounting and financial statements. Matching Concept This concept proposes that while calculating profit for the accounting period in a correct manner, the expenses and costs incurred during the period, whether paid or not, should be matched with the revenues generated during the period. E.g. If the accounting period ends on 31st March, the salaries for the month of March should be considered as cost for the year ending on 31st March, even if they are actually paid for in the month of April. Otherwise, calculation of the profits for the year ending on 31st March will go wrong as the income will be for 12 months while the expenses will be for 11 months only. Accounting Conventions Accounting Conventions indicate those customs and traditions that are followed by the accountants while preparing the financial statements. Following are the important Accounting Conventions. Convention of Conservation This convention is usually expressed as anticipate all the future losses and expenses, however do not consider the future incomes and profits unless they are actually realized. This convention generally applies to the valuation of current assets and as such, the current assets are valued
Basics of Financial Accounting

17

at cost or market price whichever is lower. The valuation of non-curret assets is done at cost (as per the cost concept). Convention of Materiality This convention proposes that, while accounting for the various transactions, only those transactions will be considered which have material impact on profitability or financial status of the organization and other insignificant transactions will be ignored. E.g. If the organization purchases some postal stamps, some of which remain unused at the end of the accounting period. According to matching concept, the cost of such non-used postal stamps should not be considered as the item of cost. However as its impact on the overall profitability is likely to be negligible, the cost of non-used postal stamps may be ignored treating the cost of purchases as the expenditure. Which transactions should be treated as material ones is a subjective concept and depends upon the judgment and knowledge of the accountant. Convention of Consistency This convention proposes that the accounting polices and procedures should be followed consistently on period-to-period basis so as to facilitiate the comparison of finanacial statements on period-to-period basis. If there is any change in the accounting policies and procedures, this fact coupled with its effect on profitabity should be disclosed explicitly while preparing the financial statements. SYSTEMS OF ACCOUNTING a. Cash System of Accounting In this system of accounting, expenses are considered to be the expenses only when they are paid for and the incomes are considered to be incomes only when they are actually received. This system of accounting is mainly used by the organizations established not for earning the profits. This system of accounting is considered to be defective in nature, as it may not represent the true picture of the profitability as well as of the state of affairs. b. Mercantile or Accrual System of Accounting In this system of accounting, expenses are considered as expenses during the period to which they pertain. Similarly, incomes are considered to be incomes during the period to which they pertain. When the expenses are actually paid for or when the incomes are actually received is not significant in case of Mercantile or Accrual system of accounting. This system of accounting is considered to be more ideal, generally preferred by the accountants. However, as the time of physical receipt of cash is immaterial in this system of accounting, Accrual System of Accounting may result into the unrealized profits being

18

Management Accounting

reflected in the books of accounts on which the organization may be required to pay the taxes also. It will not be out of place to mention here that, as per the provisions of Section 209 of the Companies Act, 1956, all the company form of organizations are legally required to follow Mercantile or Accrual system of accounting. Other organizations have a choice to select either of the systems of accounting. TYPES OF EXPENDITURE For the purpose of accounting, the amount of money that is paid for is classified in three ways a. Capital Expenditure Capital Expenditure indicates the amount of funds paid for acquiring the infrastructural properties required for doing the business that are technically referred to as Fixed Assets. Fixed Assets do not give the returns during the same period during which they are paid for. As such, benefits available from capital expenditure are long-term benefits. Hence, it will be wrong to consider the capital expenditure as expenses while calculating the profitability during a certain period. In technical words, capital expenditure never affects the Profitability Statement, except in case of Depreciation, which in simple words indicates that part of capital expenditure returns equivalent to which are received during the corresponding period. b. Revenue Expenditure Revenue Expenditure indicates the amount of funds paid during a certain period with the intention to receive the return during the same period. As such, the benefits available from revenue expenditure are received during the same period during which they are paid for. The entire amount of revenue expenditure affects the Profitability Statement. c. Deferred Revenue Expenditure Deferred Revenue Expenditure indicates the amount of funds paid which does not result into the acquisition of any fixed asset. However, at the same time benefits from this expenditure are not received during the same period during which they are paid for. The examples of Deferred Revenue Expenditure are a. b. c. Initial Advertisement Expenditure Research and Development Expenditure In case of company form of organization, Preliminary Expenses or Company Formation Expenses. 19

Basics of Financial Accounting

Principally, Deferred Revenue Expenditure is not transferred to Profitability Statement during the period during which they are paid for. As such, deferred revenue expenditure does not affect the profitability of the period during which it is paid for. It is transferred to Profitability Statement (in technical words written off to Profitability Statement) over the period over which benefits are received, by passing the adjustment entry. As such, deferred revenue expenditure affects the profitability only when they are written off to Profitability Statement. Till they are written off to Profitability Statement, they are shown on the Asset side of Balance Sheet. GLOSSARY OF TERMS USED IN FINANCIAL ACCOUNTING 1. Account Account is the record of all the transactions pertaining to a person, asset, liability, income or expenditure which have taken place during a specified period and shows the net effect of all these transactions finally. Debit Side Debit Side of the account is left hand side of the account. Credit Side Credit Side of the account is right hand side of the account. Voucher Voucher is any documentary evidence to justify that a particular transaction has taken place. The voucher can be internal voucher or external voucher. Entry Entry means the record of a financial transaction in the books of accounts. To debit To debit an account means to make the entry on debit side of the account. To credit To credit an account means to make the entry on credit side of the account. Journal Journal is the Book of Original Entry or the Book of Prime Entry where the financial transactions are recorded in the chronological order as and when they take place. Ledger Ledger is the book where the transactions of the similar nature are pooled together under one Ledger Account. Ledger or General Ledger as it is referred to in practical circumstances, maintains all types of accounts i.e. Personal, Real and Nominal. Whichever transactions are recorded in the Journal or Subsidiary Books in chronological order, the same transactions are posted in the Ledger, account wise.

2. 3. 4.

5. 6. 7. 8.

9.

10. Narration Narration is the summarized explanation or description of the financial transaction recorded in the books of accounts. 11. Casting Casting refers to totalling of the books of accounts.

12. Posting Posting refers to the process of transferring the transaction entered into the book or original entry or subsidiary book to the ledger account.

20

Management Accounting

13. Folio Folio refers to the page number of the book of original entry or the ledger. 14. Brought Forward When the balances in the ledger account or cash/bank book of the previous year or previous period are entered in the current years books of accounts, the balances are said to be Brought Forward. 15. Carried Forward When the balances in the ledger account or cash/bank book of the current year or current period are to be transferred to the next years books of accounts, the balances are said to be Carried Forward. 16. Assets All the properties owned by the business are collectively referred to as the assets of the business. 17. Liabilities All the amounts owed by the business to various providers of funds or services are collectively referred to as liabilities. 18. Capital Capital indicates the amount of funds invested by the owner of the business in the business. 19. Drawings Drawings indicates the amount of funds or goods withdrawn by the owner of the business for the personal use. 20. Debtor A Debtor is a customer who owes the money to the business for the goods or services supplied to him on credit basis. 21. Creditor A Creditor is a supplier to whom the business owes the money for the goods or services bought from him on credit basis. 22. Debit Note Debit Note is an intimation sent to a person dealing with the business that his account is being debited for the purpose indicated therein. 23. Credit Note Credit Note is an intimation sent to a person dealing with the business that his account is being credited for the purpose indicated therein. 24. Trade Discount Trade Discount is the discount received on purchases or discount allowed on sales which is an adjustment with the basic purchase or sales price. Trade discount is not accounted for in the books of accounts. Purchase value or sales value is accounted for net of trade discount. 25. Cash Discount Cash discount is the discount received from the suppliers or allowed to customers for making the early payment of dues. Cash discount is accounted for in the books of accounts. Cash discount received from the suppliers is revenue income and cash discount allowed to the customers is revenue expenditure.

Basics of Financial Accounting

21

26. Balance Sheet Balance Sheet is the summarized statement of what the business owns i.e. assets and what the business owes i.e. liabilities at any given point of time. 27. Bills Payable Bills Payable indicates the amount payable to the suppliers for which the negotiable instrument in the form of Bill of Exchange is given to the suppliers. 28. Bills Receivable Bills Receivable indicates the amount receivable from the customers for which the negotiable instrument in the form of Bill of Exchange is received from the customer. 29. Depreciation The term Depreciation applies to fixed assets like Land, Buildings, Machinery, Furniture, Vehicles etc. The term indicates reduction in the value of fixed assets which can arise either due to time factor or use factor or both. A detailed note on Depreciation Accounting is enclosed in the Annexure. DOUBLE ENTRY SYSTEM OF ACCOUNTING The basic presumption made by the Double Entry System of Accounting is that every business transaction has two elements i.e. when the business receives something, it has to pay something. Eg. If the business pays the telephone bill in cash, it gets the benefit of using the telephone, but at the same time cash goes out. Similarly, if goods are sold to the customer for cash, goods of the business go out, but it receives the corresponding amount of cash. Accordingly, if Double Entry System of Accounting is followed, every business transaction affects two accounts. One account is debited, while another account is credited by the similar amount. Thus, Double Entry System of Accounting follows the principle of every debit has a corresponding credit and hence, total of all debits has to be equal to the total of all credits. Double Entry System of Accounting proves to be advantageous due to certain reasons a. b. It takes into consideration both the aspects of each business transaction. Arithmetical accuracy of the accounting records can be verified by preparing the Trial Balance. c. The correct result of operations can be ascertained by preparing the final accounts periodically. Correct valuation of assets and liabilities is possible at any given point of time by preparing the Balance Sheet.

d.

TYPES OF ACCOUNTS The various accounts for the purpose of Financial Accounting get classified under the following categories

22

Management Accounting

1.

Personal Accounts - These are the accounts of persons with whom the organization deals in various capacities. In practical circumstances, personal accounts may consist of the following types of accounts Accounts of the suppliers Accounts of the customers Bank / Financial Institutions Capital Account

2.

Real Accounts These are the accounts of assets and liabilities. In practical circumstances, real accounts may consist of the following types of accounts Land Account Building Account Machinery Account Furniture Account Vehicles Account

Real Accounts may also consist of the accounts of some intangible assets like 3. Goodwill Account Patents and Trade Marks Account

Nominal Accounts These are the accounts of incomes or expenses. In practical circumstances, nominal accounts may consist of following types of accounts Salary Account Wages Account Printing & Stationary Account Insurance Account Telephone Expenses Account Interest paid or Received Account Commission paid or Received Account

RULES OF DOUBLE ENTRY BOOK KEEPING While entering into various financial transactions in the records maintained by the organization, following basic rules for accounting are followed a. b. c. In case of Personal Accounts Debit the Receiver, Credit the Giver In case of Real Accounts Debit What Comes in, Credit What Goes out In case of Nominal Accounts Debit all the expenses, Credit all the incomes

Basics of Financial Accounting

23

ANNEXURE Depreciation Accounting Depreciation can be defined as a permanent, continuous and gradual reduction in the book value of a fixed asset. Normally, all the fixed assets except land, depreciate in value rendering the asset useless after the end of certain specific period. Following may be stated as the main causes of depreciation. (1) Use factor : The fixed assets depreciate because they are used for the purpose they are meant for. It is applicable in case of tangible assets like machinery, furniture, office equipments etc. Time factor : The fixed assets depreciate due to the passage of time. Obsolescence : It is the reduction in the value of fixed assets, say a machine, due to its supersession at a date before it is completely worn out. It may take place due to new inventions, modifications or improvements.

(2) (3)

Need for Depreciation Accounting : According to the nature of fixed assets, these are those assets which may be used for the business purposes over a certain number of future accounting periods and the benefit received from them is spread over the said number of future accounting periods. According to the matching principle of accounting, the costs incurred during an accounting period are required to be matched with the benefits or revenues earned daring that period. Hence, it is necessary to distribute the cost of a fixed asset, less the scrap or salvage or realisable value, after the useful life of the fixed asset is over, in such a way so as to allocate it as equitably as possible to the periods during which the benefits are received from the use of fixed assets. This system or procedure is called depreciation accounting. Thus the depreciation accounting is necessary for two main purposes. (a) To ascertain due profits by correctly matching the various costs and expenses incurred with various incomes and revenues earned during various accounting periods. To represent the value of a fixed asset on the Balance Sheet at its unexpired cost i.e. at book value less depreciation. If depreciation is not provided, the asset may appear in the Balance Sheet at an overstated amount.

(b)

It may also be noted in this connection that the depreciation forms a part of cost for arriving at the profits which can be distributed to the owners of the business in the form of dividend. By providing the depreciation, the amount of distributable profits is reduced and retained in the business, which can be utilized for the replacement of the asset at the end of its economic life. 24
Management Accounting

Methods for Calculating Depreciation : There may be various methods available for calculating the amount of depreciation to be charged to Profit and Loss Account. Amount of depreciation is a function of various factors. (1) Time, (2) Usage, (3) Time and Usage, (4) Time and Cost of maintaining the fixed asset, (5) Provision of funds for replacing the assets. As such the various methods available for charging the depreciation can be described as below. (1) Straight Line Method :

According to this method, the amount of yearly depreciation is calculated as below. Cost of asset - Estimated scrap value Estimated life in years Eg. C = Cost of Asset. Estimated scrap value (At the end of life of the asset) Estimated life Rs. 1,10,000

Rs. 10,000 10 years

Rs. 1,10,000 - Rs. 10,000 Yearly depreciation = 10 years Rs. 10,000

The benefit of this method is that equal amount of depreciation is charged every year throughout the life of the asset, making the calculation of depreciation and cost comparison easy. The main drawback of this method is that the amount of depreciation in later years is high when the utility of the asset is reduced. (2) Written Down Value (Reducing Balance) Method :

According to this method, the depreciation is provided at a predetermined percentage, on the balance of cost of asset after deducting the depreciation previously charged (usually termed as written down value). Eg. Cost of asset Estimated scrap value Cost of asset subjected to depreciation Rate of depreciation Rs. Rs. Rs. 1,10,000 10,000 1,00,000 10%

Basics of Financial Accounting

25

The amount of depreciation is calculated as shown below. Year Balance Cost of Assets Rs. 1,00,000 90,000 81,000 72,900 65,610 Depreciation Rs. 10,000 9,000 8,100 7,290 6,561 Written Down Value - WDV Rs. 90,000 81,000 72,900 65,610 59,049

1 2 3 4 5

The rate of depreciation to be charged is calculated according to the following formula. D = where n = 1n R C

number of years Residual / Scrap Value Cost of the asset

R = C =

The main benefit of this method is that it recognizes the fact that in the initial years of life of the asset, the repairs and maintenance cost is less which goes on increasing gradually with the progressing life of asset. According to this method, the higher amount of depreciation in the initial years and a gradual decrease therein is counterbalanced by the lower amount of repairs and maintenance cost in the initial years and a gradual increase therein. It should be noted here that the written down value can never become zero. (3) Production Unit Method :

According to this method, depreciation is provided at a predetermined rate per unit which in turn is calculated on the basis of total number of units lo be produced during the life of the asset. Eg. Cost of the machine Estimated scrap value Estimated number of units to be produced Rate of depreciation per unit = = Rs. 2 Rs. 1,10,000 Rs. 10,000 50,000 Rs. 1,10,000 - Rs. 10,000 50,000 units

26

Management Accounting

If in a particular year, 7,000 units are produced, the depreciation to be charged will be : 7,000 units x Rs. 2 per unit = Rs. 14,000. This method gives more stress on usage factor rather than time factor. Higher the number of units produced, higher is the amount of depreciation and vice versa. (4) Production Hour Method :

This method is similar to the production unit method except that instead of number of units to be produced during the life of asset, number of hours for which the asset is expected to work are taken into consideration. Eg. Cost of the machine Estimated scrap value Estimated number of hours Rate of depreciation per hour = Rs. 1,10,000 Rs.10,000 25,000 Rs. 1,10,000 - Rs. 10,000 25,000 hours = Rs. 4

If in a particular year, the machine works for 2,500 hours, the depreciation to be charged will be : 2,500 hours x Rs. 4 per hour = Rs. 10,000 (5) Joint Factor Rate Method :

According to this method, the depreciation is provided partly at a fixed rate on time basis and partly at a variable rate on usage basis. Eg. Cost of the machine To be depreciated on time basis over life of the machine i.e. 10 year Estimated number of units to be produced Depreciation : (a) On time basis Rs. 50,000 10 years (b) On usage basis Rs. 50,000 50,000 units = Rs. 5,000 per year Rs. 1,00,000

Rs.

50,000 50,000

Re. 1 per unit

Basics of Financial Accounting

27

If in a particular year, the machine produces 6,000 units, the depreciation to be charged will be : Time basis Usage basis 6,000 units x Re. 1 Rs. 5,000 Rs. 6,000 Rs. 11,000 (6) Annuity Method :

This method assumes that the amount of capital invested in the fixed assets would have earned interest had it been invested otherwise. The depreciation to be charged under this method is a constant proportion of the aggregate of the cost of the asset depreciated and interest at the specific rate on written down value of the asset at the beginning of each period. Eg. Cost of the asset (c) Life of the asset (n) Rate of interest (r) Depreciation to be charged is calculated as below. D = 1Year Cxr 1 (1 + r)n -1 Cost/WDV Rs. 1 2 3 4 5 1,00,000 83,620 65,602 45,782 23,980 = 1Interest Rs. 10,000 8,362 6,560 4,578 2,400 1,00,000 x 0.10 1 (1.10)5 -1 Total Rs. 1,10,000 91,982 72,162 50,360 26,380 Depreciation Rs. 26,380 26,380 26,380 26,380 26,380 83,620 65,602 45,782 23,980 Nil WDV C/fd = Rs. 26,380 Rs. 1,00,000 5 years 10%

The amount of depreciation is very high under this method and covers the opportunity cost of non-investment of the capital anywhere else. (7) Sinking Fund Method :

Unlike any other method, this method attempts to make available funds equivalent to the original cost of asset, at the end of useful life of the asset. According to this method, depreciation to be charged is the fixed period charge which is invested at a compound rate and the amount of investmen with the compounded interest earned over the life of the asset equals to the original cost of the asset. 28
Management Accounting

Eg.

Cost of the asset (c) Life of the asset (n) Rate of interest (r)

Rs. 1,00,000 5 years 10%

Depreciation to be charged is calculated as below : D Year = Cxr (1 + r) - 1 Bal. B/fd Rs. 1 2 3 4 5 (8) 16,380 34,398 54,218 76,020 Interest Provision Rs. 1,638 3,440 5,422 7,600
n

1,00,000 x 0.10 (1.10)5 - 1 Annual Investment Rs. 16,380 16,380 16,380 16,380 16,380

Rs. 26,380 Annual Rs. 16,380 18,018 19,820 21,802 23,980 Bal.c/fd Rs. 16,380 34,398 54,218 76,020 1,00,000

Endowment Policy Method :

This method is similar to sinking fund method. Under this method, an insurance policy is taken out for the amount required to replace the asset at the end of life of the asset. The amount of depreciation to be charged is equal to the annual premium payable on the insurance policy, which is decided by the insurance company. (9) Revaluation Method :

According to this method, the asset is revalued periodically. The amount of depreciation for that period is the difference between the cost of the asset at the beginning of the period and the amount of revaluation at the end of the period. This method of charging the depreciation is extensively used for the assets like livestock, patterns etc. (10) Renewal Method : According to this method, the full cost of the asset is charged as depreciation during the period in which asset is renewed. No depreciation is charged in between the period. This method of charging can be used if the asset is of small value and is renewed frequently.

Basics of Financial Accounting

29

Practical considerations relating to depreciation 1. In spite of the fact that there are various methods available for calculating the depreciation, the final choice of the method depends upon the individual organization. It should be noted that Income Tax Act, 1961 which is a very important piece of legislation applicable to all types of business organizations, recognizes only one method for calculating the depreciation i.e. Written Down Value method. The rates at which the depreciation is to be calculated are also specified in the Income Tax Act, 1961. If the organization wants to calculate the depreciation on some different basis or at some different rates, it can do so for financial accounting purposes. However, for calculating the tax liability, the depreciation has to be calculated on Written Down Value basis and that too at the specified rates. The company form of organizations to whom the provision of Companies Act, 1956 apply are required to calculate the depreciation as per the provisions of Schedule XIV of the Companies Act, 1956. The salient features of Schedule XIV of the Companies Act, 1956 can be stated as below a. Schedule XIV of the Companies Act, 1956 provides that the company can calculate the depreciation by using either Written Down Value method or Straight Line method. The companies are given the choice to select between these two methods. The actual choice of the method may depend upon the effect on the profitability of the company. If the company wants to change the method of calculating the depreciation, it amounts to the change in accounting policy. Any change in the method of calculating the depreciation has to be effected with retrospective effect from the date of incorporation of the company. The company is required to disclose the fact of change in the method of calculating the depreciation while preparing its financial statements along with the effect of change in the method of calculating the depreciation. The rates at which the companies are required to calculate the depreciation are also specified in Schedule XIV. For this purpose, the fixed assets are classified in various categories. The broad categorization of the fixed assets is as below l l l l l

2.

b.

Buildings - Factory Building as well as Administration Buildings Plant and Machinery Furniture Vehicles Computer Installations

30

Management Accounting

The rates for calculation of depreciation are as below Nature of the Fixed Assets Buildings - Factory Buildings - Administrative Plant and Machinery Furniture Vehicles Computer Installations c. WDV 10% 5% 15% 10% 20% 40% SLM 3.63% 1.63% 4.75% 6.33% 9.5% 16.21%

If during the financial year, any addition has been made to any asset or any asset has been sold, the depreciation on such asset will be calculated on a pro rata basis from the date of such addition or upto the date on which such asset has been sold. There are some of the questions which are normally raised in respect of the nature of depreciation. (1) Is Depreciation a cost? Yes, depreciation is a cost because of the obvious reasons that it reduces the profitability and it is a charge against the profit. At the same time, it should also be noted that it is a non-cash cost as it is never paid or incurred in cash. (2) Does Depreciation generate funds for replacement of assets? If the depreciation is provided under the Sinking Fund Method or Endowment Policy Method, sufficient funds may be available, at the end of life of the asset, equivalent to the original cost of the asset. As such, it can be said that these two methods make available the funds equivalent to the original cost of the asset at the end of life of the asset. However these funds may not be sufficient to replace the asset due to the increased price of the same. Other methods of charging the depreciation do not directly generate the funds required for replacing the assets. The fact that the assets are depreciated to the extent of almost entire of the original cost of the same, does not indicate that the funds are available for the replacement purpose. However, depreciation may be viewed from one more angle. It is a charge to profits which reduces the profits which can be distributed among the shareholders by way of dividends, thus conserving the business funds in the business itself. This may be considered to be a very very indirect way of interpretation that the depreciation involves a source of funds.

Basics of Financial Accounting

31

QUESTIONS 1. What do you mean by various accounting principles? Explain the various accounting concepts and conventions used in the financial accounting. Distinguish between the following pairs of terms. 3. Cash Basis of Accounting and Accrual Basis of Accounting Revenue Expenditure and Capital Expenditure Written Down Value Method and Straight Line Method of Depreciation Depreciation as per Companies Act and Income Tax Act

2.

What do you mean by depreciation? What are the objectives for calculating the depreciation? Explain the various methods for calculating the depreciation. Write an essay on Depreciation.

4.

32

Management Accounting

NOTES

Basics of Financial Accounting

33

NOTES

34

Management Accounting

Chapter 3
PROCESS OF ACCOUNTING

JOURNALIZING Journalizing refers to the process of recording the business transaction in the Journal that is referred to as the Book of Original Entry or the Book of Prime Entry. The various transactions are entered in the journal in the chronological order, as and when the transactions take place. The Journal may look as stated below Journal Date a Particulars b Account (To be Debited) Dr. To, Account (To be Credited) Narration The Journal may be subdivided in the following five columns a. b. Date It refers to the date on which a particular transaction has taken place. Particulars It refers to titles of the account to be debited or credited. Title of the account to be debited starts from the extreme left and the abbreviation Dr. is written to the extreme right of the same column on the same line. Title of the account to be credited is entered on the next line preceded by the words To leaving some space from the extreme left. In the same column on the next line, brief description of the transaction is written which is referred to as Narration. The narration conventionally starts with the wording Being. L.F. This is the abbreviation of Ledger Folio. This column refers to the page number of the ledger. The nature of Ledger is discussed in the following paragraphs. Amount Debited The amount to be debited is stated in this column. Amount Credited The amount to be credited is stated in this column. L.F. c Debit Rs. d Credit Rs. e

c.

d. e.

Process of Accounting

35

Illustration Journalize the following transactions in the books of Mr. Amit Sen a. Mr. Sen commenced business with cash Rs. 10,000, Machinery Rs. 10,000, Buildings Rs. 30,000 and Furniture Rs. 15,000. Installed and paid for Neon Sign Board at a cost of Rs. 1,000 Mr. Sen borrowed Rs. 25,000 from his wife and the same were deposited by him in bank to open an account. Mr. Sen purchased goods for Rs. 7,000 for cash. Mr. Sen purchased goods worth Rs. 10,000 from Mr. Rao on credit @2% Cash Discount. Sold goods to Ramdas worth Rs. 15,000 against cash after allowing 5% Trade Discount. Paid Rs. 1,995 to Mr. Rajesh for purchases of goods after allowing 5% Cash Discount on the invoice. Sent a cheque of Rs. 1,000 to Chief Ministers Fund as Mr. Sens personal contribution. Placed an order for goods worth Rs. 2,000 with M/s Archana Traders. A personal table fan worth Rs. 450 brought in the office for office use.

b. c.

d. e. f. g. h. i. j.

Solution In the Books of Mr. Amit Sen Date Particulars Cash A/c Machinery A/c Building A/c Furniture A/c To, Capital A/c (Business started with cash, machinery, building and furniture) Advertisement A/c To, Cash A/c (Being paid for neon sign board installed) 1,000 1,000 L.F. Debit Rs. 10,000 10,000 30,000 15,000 65,000 Credit Rs.

36

Management Accounting

Date

Particulars Bank A/c To, Loan from Mrs. Sen A/c (Being the amount borrowed from Mrs. Sen to open account with the bank) Purchases A/c To, Cash A/c (Being paid for cash purchases) Purchases A/c To, Cash A/c To, Discount Received (Being purchases worth Rs. 10,000 after getting 2% cash discount) Cash A/c To, Sales (Sold goods worth Rs. 15,000 after allowing trade discount of 5%) Purchases A/c To, Cash A/c To, Discount Received (Paid Rs. 1,995 for goods purchased after getting 5% cash discount) Drawings A/c To, Bank A/c (Being donation paid to Chief Ministers Fund as Mr. Sens personal contribution) No Journal Entry will be passed, as the transaction is not a financial transaction. Furniture A/c To, Capital A/c (Being the personal table fan brought for office use)

L.F.

Debit Rs. 25,000

Credit Rs.

25,000

7,000 7,000

10,000 9,800 200

14,250 14,250

2,100 1,995 105

1,000 1,000

450 450

Process of Accounting

37

Compound Journal Entry If the similar transactions take place on the same day and the same account is either debited or credited, instead of passing different journal entries, it can be accounted for by passing a compound journal entry. It avoids duplication and makes the journal less bulky. Illustration Mr. A commenced the business with cash Rs. 10,000, Machinery worth Rs. 25,000 and the Computer worth Rs. 50,000. The transaction will be journalized as below Date 1.4.2002 Particulars Cash A/c Machinery A/c Computer A/c To, Capital A/c (Commenced business with cash, machinery and computer) L.F. Debit Rs. 10,000 25,000 50,000 85,000 Credit Rs.

SUBSIDIARY BOOKS If the volume of transactions is very large, recording all the transactions in the Journal may prove to be a voluminous job. Hence, the transactions of the similar nature may be entered into a separate Subsidiary Book and the net effect of the similar transactions may be transferred into the main records. In the practical circumstances, following subsidiary books are used very frequently a. Cash Book This records all the cash transactions i.e., Cash Receipts and Cash Payments. In some cases, Cash and Bank Book may be maintained which records Cash as well Bank Receipts and Cash as well as Bank Payments. The Cash and Bank Book may look as below
Date Particulars L.F. Cash Bank Date Particulars L.F. Cash Bank

b.

Purchases Register or Purchases Day Book This records all the credit purchases transactions. Date Name of the Supplier L.F. Invoice No. Amount

Note : L.F. stands for Ledger Folio Number which indicates the Page Number in the Creditors Ledger as the Control Ledger. The term Control Ledger is discussed in the following paragraphs.

38

Management Accounting

c.

Sales Register or Sales Day Book This records all the credit sales transactions. The Sales Register may look as stated below Date Name of the Customer L.F. Invoice No. Amount

Note : L.F. stands for Ledger Folio Number which indicates the Page Number in the Debtors Ledger as the Control Ledger. The term Control Ledger is discussed in the following paragraphs. d. Purchases Returns Register This records the transactions of return of goods to the suppliers from whom purchases were made on credit basis. The Purchases Return Register may look as stated below Date Name of the Supplier L.F. Debit Note No. Amount

Note : L.F. stands for Ledger Folio Number which indicates the Page Number in the Creditors Ledger as the Control Ledger. The term Control Ledger is discussed in the following paragraphs. The Debit Note stands for an intimation sent to the supplier at the time of returning the goods which informs the supplier that his account is being debited on account of goods returned to him. e. Sales Returns Register This records all the transactions of return of goods by the customers to whom sales were made on credit basis. The Sales Return Register may look as stated below Date Name of the Customer L.F. Credit Note No. Amount

Note : L.F. stands for Ledger Folio Number which indicates the Page Number in the Debtors Ledger as the Control Ledger. The term Control Ledger is discussed in the following paragraphs. The Credit Note stands for an intimation sent to the customer at the time of accepting the returned goods which informs the customer that his account is being credited on account of goods returned by him. f. Journal Proper This records all the residual transaction which cannot be entered into any other subsidiary book. The transactions which can be entered in the Journal proper are a. b. c. d. Opening Entries Closing Entries Rectification Entries Adjustment Entries

Process of Accounting

39

LEDGER POSTING If Journal or Subsidiary Books are the books which record of the transactions in the chronological order, Ledger is the book where the transactions of the similar nature are pooled together under one Ledger Account. Ledger or General Ledger as it is referred to in practical circumstances, maintains all types of accounts i.e. Personal, Real and Nominal. Whichever transactions are recorded in the Journal or Subsidiary Books in chronological order, the same transactions are posted in the Ledger, account wise. Thus, a ledger account can be defined as the record of all the transactions pertaining to a person, asset, liability, income or expenditure which have taken place during a specified period and shows the net effect of all these transactions finally. As such, the transactions are first entered into Journal or Subsidiary Book when they take place and from there they are transferred to Ledger and this process is called as Ledger Posting. The Ledger Account may be maintained in two ways Type I Dr. Date Particulars Folio Rs. Date Particulars Folio Rs. Cr.

Type II Date Particulars Folio Debit Credit Rs. Balance Rs.

Control Ledgers In practical circumstances, if the transactions of purchases and sales are very large, it may not be feasible to carry the accounts of all the suppliers and customers in the Main or General Ledger. In such cases, apart from the Main Ledger or General Ledger, the Control Ledgers can be maintained. Control Ledgers carry the individual accounts whereas the Main Ledger or General Ledger records the consolidated effect of the individual transactions. As such, the balance shown by the consolidated account in the Main Ledger or General Ledger has to tally with the balances in the individual ledger accounts maintained in the control ledger. In practical circumstances, control ledgers may be maintained for the following purposes a. b. c. Sundry Debtors Sundry Creditors Advances to Staff

40

Management Accounting

Balancing of Ledger Accounts To ascertain the net effect of all the transactions recorded in the Ledger Account, the account is required to be balanced. Balancing of Ledger Account involves the following steps a. b. c. Take the total of both sides of the Ledger Account. Calculate the difference between totals of both the sides. If the total of debit side is heavier, place the difference on the amount column of credit side by writing By Balance c/fd. If the total of credit side is heavier, place the difference on the amount column of debit side by writing the To Balance c/fd. If the balance appears on the credit side, the account will be considered to have Debit Balance. If the balance appears on the debit side, the account will be considered to have Credit Balance. After balance is placed on the appropriate side, ensure that totals of both the sides match with each other.

d.

Illustration Machinery Account Date Particulars Folio Rs. Date Particulars Depreciation Balance c/fd (Balancing figure) Folio Rs. 10,000 85,000 95,000

01.04.01 Balance b/fd 10.04.01 Bank

25,000 31.03.02 70,000 31.03.02 95,000

Steps explained a. Before considering the Balancing Figure, the total of debit side is Rs. 95,000 and the total of credit side is Rs. 10,000. As such, debit side is heavy. Difference between both the sides is Rs. 85,000. As the debit side is heavy, the difference of Rs. 85,000 is put on the credit side.

b. c.

Trial Balance Trial Balance is the summary of all the balances in all the accounts listed in the General Ledger and Cash / Bank Book of an organization at any given date. Tallying of the Trial Balance is the evidence of the fact that all the transactions have properly been posted in the General Ledger. As such, tallying of Trial Balance generally ensures the arithmetical accuracy of the process of Ledger Posing.

Process of Accounting

41

Format of Trial Balance Trial Balance as on 31st March 2002 Name of the Account Debit Credit

For the preparation of Trial Balance, all the accounts in the General Ledger need to be balanced to ascertain the Closing Balance. Similarly, Cash Book / Bank Book is also required to be balanced to ascertain the Closing Balance. Accounts having the Debit Balance are shown on the Debit Side whereas the accounts having the Credit Balance are shown on the Credit Side. Generally, accounts of the assets will have Debit Balance and hence will be shown on Debit Side. Generally, accounts of all liabilities will have Credit Balance and hence will be shown on Credit Side. Generally, accounts of all the Expenses will have Debit Balance and hence will be shown on Debit Side. Generally, accounts of all the Incomes will have Credit Balance and hence will be shown on Credit Side. PREPARATION OF FINAL ACCOUNTS FROM TRIAL BALANCE Preparation of the financial statements is the basic objective of financial accounting. These financial statements are basically in two forms a. Profitability Statement This financial statement is referred to as Profit and Loss Account in more technical language. The purpose of this financial statement is to disclose the result of operations of the business transactions during a given period of time. As such, by nature Profit & Loss Account is a period statement which relates to a specific duration of time. Hence, Profit and Loss Account is always referred to as Profit and Loss Account for the year ended on 31st March 2002. Balance Sheet The purpose of this financial statement is to disclose the financial status of the organization in terms of its assets and liabilities at any given point of time. Thus, in simple language, Balance Sheet is a listing of the assets and liabilities of an organization at any given point of time. Whichever sources are used by an organization for raising the required amount of funds create an obligation or liability for the organization and whichever ways the funds are used or applied by an organization create the properties or assets for the organization. Hence, in practical circumstances, the liabilities are referred to as Sources of Funds and the assets are referred to Application of Funds. As such, by nature Balance Sheet is a position statement in the sense it relates to a specific point of time or date. Hence, Balance Sheet is always referred to as Balance Sheet as on 31st March 2002.

b.

42

Management Accounting

PROFIT AND LOSS ACCOUNT As stated earlier, Profit and Loss Account is prepared to disclose the result of operation of the business transactions during a certain duration of time. In technical language, Profit and Loss Account may have following four components a. Manufacturing Account This part of Profit and Loss Account discloses the result of manufacturing operations carried out by the organization. The final result disclosed by the Manufacturing Account is the Cost of Production incurred by the organization. Following is the specimen of Manufacturing Account. Manufacturing Account for the year ended on 31st March 2002
Particulars Opening Stock Raw Material Work in Progress Amount Particulars Closing Stock Raw Material Work in Progress Amount

Purchases of Raw Material Carriage Inward Wages Paid Power and Fuel Consumable Stores Manufacturing Expenses Depreciation on Production Assets

Cost of Production (Transferred to Trading Account)

Total b.

Total

Trading Account This part of Profit and Loss Account discloses the result of trading operations carried out by the organization. The final result disclosed by the Trading Account is the Gross Profit earned by the organization. Following is the specimen of Trading Account.

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43

Trading Account for the year ended on 31st March 2002


Particulars Opening Stock Finished Goods Amount Particulars Sales (Net of Sales Returns) Amount

Cost of Production (Brought from Manufacturing A/c) Gross Profit

Closing Stock Finished Goods

Total

Total

c.

Profit and Loss Account This part of Profit and Loss Account discloses the final result of business transactions of the organization. The final result disclosed by the Profit and Loss Account is the Profit After Tax (PAT) earned by the organization. Following is the specimen of Profit and Loss Account. Profit & Loss Account for the year ended on 31st March 2002
Particulars Administrative Expenses Office Salaries Postage & Telephone Traveling & Conveyance Legal Charges Office Rent Depreciation Audit Fees Insurance Repairs & Renewals Amount Particulars Gross Profit b/fd Other Income Discount Received Commission Received Non-Trading Income Interest Received Rent Received Amount

Selling & Distribution Expenses Advertisement Carriage Outward Free Samples Bad Debts Sales Commission

Abnormal Income Profit on the sale of assets

44

Management Accounting

Particulars Financial Expenses Interest & Bank Charges Other Expenses Loss on the sale of assets Salary to Working Partners Interest on Capital Provision for Taxation Net Profit after Taxes (Transferred to Capital Account)

Amount

Particulars

Amount

Total d.

Total

Profit and Loss Appropriation Account This part of Profit and Loss Account, which is mainly applicable to company form of organization, discloses the manner in which the PAT earned by the organization is appropriated. The amount of profit not appropriated or retained is transferred to Reserves and Surplus in the Balance Sheet. Following is the specimen of Profit and Loss Appropriation Account.
Profit & Loss Appropriation Account for the year ended on 31st March 2002

Particulars Dividend Paid Transferred to Reserves Balance transferred to Balance Sheet

Amount

Particulars Profit After Tax b/fd Amount withdrawn from Reserves

Amount

Total

Total

BALANCE SHEET As stated earlier, the purpose of preparing the Balance Sheet is to disclose the financial status of the organization in terms of its assets and liabilities at any given point of time. As such, the Balance Sheet has two sides a. b. Liabilities Assets

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45

Liabilities Credit balances in all the Personal and Real Accounts appear on Liabilities side. Following items may appear on the liabilities side a. Capital Capital indicates the amount of funds contributed by the owners of the business to the requirement of funds of the business. As owner of the business is considered to be a separate entity than the business itself, any amount contributed by the owner is a liability for the business. Similarly, any amount of profit earned in the past which is not distributed to the owner also belongs to the owner and becomes a part of the capital. b. Long Term Liabilities This indicates the liabilities which are to be paid off over a longer span of time say 5 to 10 years. In practical circumstances, it may consist of long-term loan borrowed from banks or financial institutions. c. Current Liabilities This indicates the liabilities which are supposed to be paid off within a very short span of time say one year. In practical circumstances, it may consist of the flowing items 1. 2. Sundry Creditors Amounts payable to the suppliers of goods and/or services. Advances received from customers This amount may not be paid back to the customers. It gets adjusted with the final selling price. Till it is adjusted with the selling price, it appears as a current liability. Outstanding Expenses This amount indicates the expenses already incurred during the relevant period but not paid for. Income Received in Advance Liability for taxes

3. 4. 5. Assets

Debit balances in all the Personal and Real Accounts appear on Asset side. Following items may appear on the assets side a. Fixed Assets As stated earlier, fixed assets indicate the value of infrastructural properties acquired by the business where the benefits are likely to be received over a longer duration of time. Fixed assets are the assets which are not supposed to be sold, but they are supposed to be used to do the business to earn the profits. Some of the fixed assets which can be found in practical circumstances are Land, Building, Machinery, Furniture, Vehicles, and Computers etc. 46
Management Accounting

b.

Investments This indicates the amount of funds invested by the organization outside the business.

c.

Current Assets Current Assets are the assets which are likely to be converted in the form of cash or likely to be consumed during the normal operating cycle of the business within a very short span of time say one year. The purpose of holding the current assets is to sell the current assets or use them during the normal course of operations. Current assets change their form very frequently while doing the business. Some of the current assets which can be found in practical circumstances are Stock, Sundry Debtors, Cash & Bank Balances, Prepaid Expenses etc.

Following is the specimen of Balance Sheet. Balance Sheet as on 31st March 2002
Capital & Liabilities Capital Long Term Liabilities Loan from Bank Current Liabilities Sundry Creditors Advance from Customers Outstanding Expenses Income Received in Advance Amount Assets & Properties Fixed Assets Land Building Machinery Furniture Vehicles Computers Investments Current Assets Stock Sundry Debtors Cash Balance Bank Balance Prepaid Expenses Amount

Total

Total

Adjustments While preparing the final accounts from the Trial Balance, it should be remembered that the Trial Balance might not reflect all the transactions which have the impact on profitability for the relevant period or the state of affairs of the organization on a particular date. As such, before preparing the final accounts, the effect of such transactions needs to be considered. The same is done by passing the Adjustment Entries. Thus, the effect of Adjustment Entries is yet
Process of Accounting

47

to be reflected in the Trial Balance. As such, according to the Double Entry principles, the Adjustment Entries always have two effects. Following are some of the main adjustment entries made while preparing the final accounts from the Trial Balance. a. Closing Stock This indicates the amount of stock in hand on the date of Balance Sheet. The basic principle on which the closing stock is valued is at cost or market price whichever is less. Accordingly, the first effect of the closing stock is that it is shown on the credit side of Manufacturing and/or Trading Account and the second effect is that it is shown on Balance Sheet Asset side. The Journal Entry passed for this is Closing Stock A/c Dr. To, Trading Account b. Depreciation This indicates the reduction in the value of fixed assets due to wear and tear. As the basic cost of the fixed assets is not transferred to Profit and Loss Account, this adjustment is necessary to reflect the cost for the use of fixed asset during the year. Accordingly, the first effect of the adjustment for Depreciation is that the amount is debited to Profit & Loss Account reducing the profit or increasing the loss and the second effect is that the corresponding amount is reduced from the value of fixed asset in the Balance Sheet. In other words, the value of fixed assets in the Balance Sheet is net of depreciation. The Journal Entry passed for this is Depreciation A/c Dr. To, Fixed Asset A/c c. Outstanding Expenses This indicates the amount of expenses pertaining to the relevant period which are not paid during the said period. According to Matching Principle of Accounting, income for a certain period needs to be compared with the expenses for the same period, whether it is paid for or not. Accordingly, the first effect of this adjustment is that the corresponding amount of expenses are increased reducing the profit or increasing the loss and the second effect is that the corresponding amount is shown as Current Liability on the Balance Sheet liabilities side. The Journal Entry passed for this is Expenses A/c Dr. To, Outstanding Expenses A/c

48

Management Accounting

d.

Prepaid Expenses This indicates the amount of expenses pertaining to the next period which are paid in advance during the relevant period. According to Matching Principle of Accounting, income for a certain period needs to be compared with the expenses for the same period. Accordingly, the first effect of this adjustment is that the corresponding amount of expenses are reduced, thus increasing the profit or reducing the loss and the second effect is that the corresponding amount is shown as Current Asset on the Balance Sheet Asset side. The Journal Entry passed for this is Prepaid Expenses A/c Dr. To, Expenses A/c

e.

Accrued Income This indicates the amount of income for the current period which is not received during the current period. According to Matching Principle of Accounting, income for a certain period needs to be compared with the expenses for the same period. Accordingly, the first effect of this adjustment is that the corresponding amount of income is increased, thus increasing the profit or reducing the loss and the second effect is that the corresponding amount is shown as Current Asset on the Balance Sheet Asset side. The Journal Entry passed for this is Accrued Income A/c Dr. To, Income A/c

f.

Income Received in Advance This indicates the amount of income for the next period which is received during the current period. According to Matching Principle of Accounting, income for a certain period needs to be compared with the expenses for the same period. Accordingly, the first effect of this adjustment is that the corresponding amount of income is reduced, thus reducing the profit or increasing the loss and the second effect is that the corresponding amount is shown as Current Liability on the Balance Sheet Liabilities side. The Journal Entry passed for this is Income A/c Dr. To, Income received in advance A/c

g.

Bad Debts This indicates the unrecoverable amount from the customers on account of credit sales made to them. If the customer is not likely to pay the amount due from him, the same is written off as Bad Debts. Accordingly, the first effect of this adjustment is that the amount

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49

of Bad Debts is debited to Profit and Loss Account, thus reducing the profits or increasing the losses and the second effect is that the amount of Sundry Debtors is reduced. The Journal Entry passed for this is Bad Debts A/c Dr. To, Sundry Debtors h. Provision for Doubtful Debts Provision for doubtful debts is necessary due to the possibility that all the customers to whom the credit sales have been made may not pay the entire amount. Accordingly, the first effect of this adjustment is that the amount equivalent to the provision for doubtful debts is written off to Profit and Loss Account and the second effect is that the corresponding amount is reduced from the Sundry Debtors in the Balance Sheet. It should be noted that if the provision for bad and doubtful debts is to be maintained at a certain percentage of Sundry Debtors and if the provision to some extent has already been made in the books of account, the differential amount only needs to be debited to Profit and Loss Account. The Journal Entry passed for this is Profit and Loss Account Dr. To, Sundry Debtors A/c i. Provision for Discount on Debtors In some cases it is necessary to allow cash discount to the customers for making the early payment. As the amount of debtors who are likely to avail the cash discount is not known in advance, a provision is made in the books of account for the discount to be allowed to debtors. Accordingly, the first effect of this adjustment is that the amount equivalent to the provision for discount on debtors is written off to Profit and Loss Account and the second effect is that the corresponding amount is reduced from the Sundry Debtors in the Balance Sheet. The Journal Entry passed for this is Profit and Loss Account Dr. To, Sundry Debtors A/c j. Interest on Capital In order to calculate the profit earned by the organization properly, in some cases interest may be provided on the amount of capital introduced by the proprietor or partner in the business. It may not be out of place to mention here that in case of partnership firms, interest on capital is considered to be an allowable expenditure for calculating the tax liability as per the provisions of Income tax Act, 1961 if it is payable to the Working Partners at the rate which is not exceeding 12% p.a. Accordingly, the first effect of this

50

Management Accounting

adjustment is that the amount of Interest on Capital is debited to Profit and Loss Account, thus reducing the profits or increasing the losses and the second effect is that the corresponding amount is credited to the Capital Account of proprietor or partner. The Journal Entry passed for this is Interest on Capital A/c Dr. To, Capital A/c k. Drawings This represents the amount of cash or value of goods withdrawn by the proprietor or partner for personal use. If the amount is withdrawn in cash, the same may be entered in the books of account regularly and thus will be reflected in the Trial Balance. However, the value of goods withdrawn by the proprietor or partner may be required to be considered by way of adjustment. Accordingly, the first effect of this adjustment is that the amount of Sales will be increased, thus increasing the profits or reducing the loss and the second effect is that the corresponding amount will be debited to the Capital Account of the proprietor or partner. The Journal Entry passed for this is Drawing / Capital A/c Dr. To, Sales A/c l. Deferred Revenue Expenditure Written Off This represents that part of Deferred Revenue Expenditure, returns equivalent to which are received during the current period. Accordingly, the first effect of this adjustment is that the deferred revenue expenditure written off will be debited to Profit and Loss Account, thus reducing the profit or increasing the loss and the second effect is that the corresponding amount will be reduced from the Asset side of the Balance Sheet. The Journal Entry passed for this is Deferred Revenue Expenditure Written Off A/c Dr. To, Deferred Revenue Expenditure A/c It should be noted that Deferred Revenue Expenditure Written Off Account is a Nominal Account whereas Deferred Revenue Expenditure Account is a Real Account. m. Abnormal Loss due to fire etc. In some cases, the organization incurs the loss of stock due to some abnormal events like fire, earthquake etc. Accordingly, the first effect of this adjustment is that the Trading Account is credited with the cost of goods lost due to fire, earthquake etc. and the corresponding amount is debited to Profit and Loss Account as Loss due to Fire Account. The Journal Entry passed for this is
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51

Loss due to Fire Account Dr. To, Stock Destroyed Account In some cases, the stock held by the organization is insured with the Insurance Company. After the abnormal event like fire or earthquake takes places, the insurance company settles the claim, either in full or in part. The actual loss incurred by the organization is to the extent of difference between the cost of goods destroyed and the amount of claim settled by the insurance company. In such event, the amount of claim settled by the insurance company is debited to the Insurance Companys Account and only the net amount of loss is debited to Profit and Loss Account. The Journal Entry passed for this is Insurance Company A/c Dr. Loss due to Fire A/c Dr. To, Stock Destroyed A/c n. Goods Distributed as Free Samples This represents the value of goods distributed as free samples as a part of sales promotion effort of the organization. This is in the form of advertisement. Accordingly, the first effect of this adjustment is that the amount of goods distributed as free samples is debited to Profit and Loss Account, thus reducing the profits or increasing the losses and the second effect is that the amount of Sales is increased thus increasing the profit or reducing the loss. The Journal Entry passed for this is Advertisement A/c Dr. To, Sales A/c o. Goods sent on approval basis Goods sent to the customers on approval basis should not be treated as the sales till the goods are finally approved by the customers or the period as agreed upon by both the parties is over. This is due to the fact that the property in the goods is not transferred until the said period is over. If the amount of such goods sent on approval basis is treated as the sales, the effect of this entry needs to be reversed. At the same time, the closing stock needs to be increased by the cost of such goods sent on approval basis. p. Commission payable to the manager In some cases, commission is payable to the manager as a percentage of profit earned by the business. The calculation of this commission may be made in two ways
l

As a percentage of profit before charging such commission to Profit and Loss Account.
Management Accounting

52

As a percentage of profit after charging such commission to Profit and Loss Account.

In both the cases, the amount of profit needs to be calculated before the commission is calculated and then the amount of commission is calculated based upon the methods to be used for calculating the same. The journal Entry passed for this is Commission A/c Dr. To, Commission Payable A/c Illustration 1 From the following particulars in respect of M/s Pam Industries, Journalize the following transactions, post them to the ledger, prepare the trial balance and prepare the final accounts. Date March 2002 1 2 3 5 7 9 15 18 21 25 27 28 30 Started business with the capital of Rs. 50,000 Opened a Bank Account by paying Rs. 35,000 Purchased goods from Ajay on credit Rs. 20,000 Sold the goods to Vijay on credit Rs. 14,000 Paid Ajay by cheque Rs. 19,500 in full settlement Received Rs. 13,000 from Vijay in full settlement by cheque Purchased furniture of Rs. 10,000 and paid the amount by cheque Paid for traveling expenses in cash Rs. 3,000 Sold the goods to Vinod for cash Rs. 10,000 Goods purchased from Ashok against cash Rs. 8,000 Cash deposited in bank Rs. 5,000 Amount withdrawn by cheque for personal purpose Rs. 3,000 Paid salary in cash Rs. 2,000 Particulars

Adjustments a. b. c. Value of goods unsold on 31st March 2002, valued at cost, Rs. 17,000 Depreciate furniture @2% Telephone bill for the month of March 2002 not yet paid Rs. 1,500

Process of Accounting

53

Solution In the books of M/s Pam Industries


Date March 2002 1 Particulars Cash A/c Dr. To, Capital A/c (Capital introduced in the business) Bank A/c Dr. To, Cash A/c (Opened Bank Account) Purchases A/c Dr. To, Ajay A/c (Goods purchased on credit) Vijay A/c Dr. To, Sales A/c (Sold goods on credit) Ajay A/c Dr. To, Bank A/c To, Discount A/c (Paid Ajay in full settlement) Bank A/c Dr. Discount A/c Dr. To, Vijay A/c (Received from Vijay in full settlement) Furniture A/c Dr. To, Bank A/c (Furniture purchased against cheque) Traveling Expenses A/c Dr. To, Cash A/c (Paid for traveling expenses) Cash A/c Dr. To, Sales A/c (Sold goods for cash) Purchases A/c Dr. To, Cash A/c (Goods purchased for cash) Bank A/c Dr. To, Cash A/c (Cash deposited in bank) Drawings A/c Dr. To, Bank A/c (Withdrawn for personal purpose) Salary A/c Dr. To, Cash A/c (Paid salary in cash) L.F. Debit Rs. 50,000 50,000 35,000 35,000 20,000 20,000 14,000 14,000 20,000 19,500 500 13,000 1,000 14,000 10,000 10,000 3,000 3,000 10,000 10,000 8,000 8,000 5,000 5,000 3,000 3,000 2,000 2,000 Credit Rs.

15

18

21

25

27

28

30

54

Management Accounting

General Ledger of M/s Pam Industries for March 2002 Cash Account
Date 1 21 Particulars To Capital A/c To Sales Folio Rs. 50,000 10,000 Date 2 18 25 27 30 31 60,000 Particulars By Bank By Traveling Exp. By Purchases By Bank By Salary By Balance c/fd Folio Rs. 35,000 3,000 8,000 5,000 2,000 7,000 60,000

Bank Account
Date 1 9 27 Particulars To Cash A/c To Vijay To Cash Folio Rs. 35,000 13,000 5,000 53,000 Date 7 15 27 31 Particulars By Ajay By Furniture By Drawings By Balance c/fd Folio Rs. 19,500 10,000 3,000 20,500

53,000

Purchases Account
Date 3 25 Particulars To Ajay To Cash Folio Rs. 20,000 8,000 Date 31 Particulars By Trading A/c Folio Rs. 28,000

28,000

28,000

Sales Account
Date 31 Particulars To Trading A/c Folio Rs. 24,000 Date Particulars By Vijay By Cash 24,000 Folio Rs. 14,000 10,000 24,000

Traveling Expenses Account


Date 18 Particulars To Cash Folio Rs. 3,000 Date 31 Particulars By Profit & Loss A/c Folio Rs. 3,000

3,000

3,000

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55

Salary Account
Date 30 Particulars To Cash Folio Rs. 2,000 2,000 Date 31 Particulars By Profit & Loss A/c Folio Rs. 2,000 2,000

Telephone Expenses Account


Date Particulars 31
To Outstanding Exp.

Folio

Rs. 1,500 1,500

Date 31

Particulars By Profit & Loss A/c

Folio

Rs. 1,500 1,500

Discount Account
Date 9 Particulars To Vijay Folio Rs. 1,000 Date 7 Particulars By Ajay By Profit & Loss A/c 1,000 Folio Rs. 500 500 1,000

Depreciation Account
Date 31 Particulars To Furniture Folio Rs. 200 200 Date 31 Particulars By Profit & Loss A/c Folio Rs. 200 200

Ajay Account
Date 7 7 Particulars To Bank To Discount Folio Rs. 19,500 500 20,000 20,000 Date 3 Particulars By Purchases Folio Rs. 20,000

Vijay Account
Date 5 Particulars To Sales Folio Rs. 14,000 Date 9 9 14,000 Particulars By Bank By Discount Folio Rs. 13,000 1,000 14,000

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Management Accounting

Capital Account
Date 28 31 Particulars To Bank To Balance c/fd Folio Rs. 3,000 47,000 50,000 50,000 Date 1 Particulars By Cash Folio Rs. 50,000

Outstanding Expenses Account


Date 31 Particulars To Balance c/fd Folio Rs. 1,500 1,500 Date 31 Particulars By Telephone Exp. Folio Rs. 1,500 1,500

Furniture Account
Date 15 Particulars To Bank Folio Rs. 10,000 Date 31 31 10,000 Particulars By Depreciation By Balance c/fd Folio Rs. 200 9,800 10,000

Trial Balance as on 31st March 2002


Name of the Account Cash Bank Purchases Sales Traveling Expenses Salary Telephone Expenses Depreciation Discount Capital Furniture Outstanding Expenses 9,800 1,500 3,000 2,000 1,500 200 500 47,000 Debit 7,000 20,500 28,000 24,000 Credit

Total

72,500

72,500

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57

Trading Account for the year ended on 31st March 2002


Particulars Opening Stock Purchases Gross Profit c/fd Total Amount Nil 28,000 13,000 41,000 Total 41,000 Particulars Sales Closing Stock Amount 24,000 17,000

Profit & Loss Account for the year ended on 31st March 2002
Particulars Traveling Expenses Salary Telephone Expenses Discount Depreciation Amount 3,000 2,000 1,500 500 200 Particulars Gross Profit b/fd Amount 13,000

Profit carried to Capital Account

5,800

Total

13,000

Total

13,000

Balance Sheet as on 31st March 2002


Capital & Liabilities Capital Balance Add : Profit for year 47,000 5,800 Amount Assets & Properties Fixed Assets Furniture Less : Depreciation 10,000 200 Amount

52,800 Current Assets Current Liabilities Outstanding Expenses 1,500 Stock Cash Bank

9,800

17,000 7,000 20,500

Total

54,300

Total

54,300

58

Management Accounting

Illustration 2 From the following balances and information, prepare Trading and Profit & Loss Account of Mr. X for the year ended 31st March 1998 and a Balance Sheet as on that date. Particulars Xs Capital Account Plant and Machinery Depreciation on Plant and Machinery Repairs to Plant Wages Salaries Income Tax of Mr. X Cash in Hand and at Bank Land and Building Depreciation on Building Purchases Purchase returns Sales Bank Overdraft Accrued Income Salaries Outstanding Bills Receivable Provision for Bad Debts Bills Payable Bad Debts Discount on Purchases Debtors Creditors Opening Stock 7,400 70,820 Information 70,820 200 708 7,000 6,252 300 400 3,000 1,000 1,600 Dr. Rs. 3,600 400 520 5,400 2,100 100 400 14,900 500 25,000 300 49,800 760 Cr. Rs. 10,000

a. b. c. d.

Stock as on 31st March 1998 was Rs. 6,000 Write off further Rs. 600 for bad Debt and maintain a provision for bad Debts at 5% on Debtors. Goods costing Rs. 1,000 were sent to customer for Rs. 1,200 on 30th March 1998 on sale or return basis. This was recorded as actual sales. Rs. 240 paid as rent of the office were debited to Landlord Account and were included in the list of Debtors. 59

Process of Accounting

e. f.

General Manager is to be given commission at 10% of net profits after charging the commission of works manager and his own. Works manager is to be given commission at 12% of net profits before charging the commission of General Manager and his own.

Solution Trading Account for the year ended on 31st March 1998
Particulars Opening Stock Purchases Less : Returns 25,000 300 24,700 Closing Stock Wages Gross Profit c/fd 5,400 18,100 Add : Goods on approval 6,000 1,000 7,000 Amount 7,400 Particulars Sales Less : Goods on approval 49,800 1,200 48,600 Amount

Total

55,600

Total

55,600

Profit & Loss Account for the year ended on 31st March 1998 Particulars Salaries Depreciation on Plant Depreciation on Building Repairs to Plant Rent Bad Debts 200 Add : Additional Bad Debts 600 Add : Provision for Bad Debts 248 Less : Existing Provision 1000 48 1,800 1,200 12,000 18,808 Total 18,808 Amount 2,100 400 500 520 240 Particulars Gross Profit b/fd Discount Amount 18,100 708

Commission to Works Manager Commission to General Manager Profit transferred to Capital A/c Total

60

Management Accounting

Balance Sheet as on 31st March 1998 Capital & Liabilities Capital Balance Add : Profit for year Less : Income Tax 10,000 12,000 100 21,900 Current Liabilities Creditors Bills Payable Overdraft Outstanding Salaries Commission Payable 6,252 1,600 760 400 3,000 Current Assets Closing Stock (Including stock on Approval) Cash Debtors Less : Bad Debts Less : Goods on approval Less : Due from Landlord 7,000 600 1,200 240 4,960 Less: Provision for Bad Debt 248 Bills Receivables Accrued Income Total Working Notes : Rs. Profit before calculating the commission 15,000 33,912 Total 4,712 3,000 300 33,912 400 7,000 18,500 Amount Assets & Properties Fixed Assets Plant & Machinery Building 3,600 14,900 Amount

Commission payable to Works Manager @12% Commission payable to General Manager on Commission payable to General Manager @10% (Calculated as 13200 / 110 x 100) Illustration 3

1,800 13,200 1,200

The following Trial Balance is of Shri Om as on 31st March 1991. You are requested to prepare the Trading and Profit & Loss Account for the year ended 31st March 1991 and a Balance Sheet as on that date after making the necessary adjustments.

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61

Particulars Sundry Debtors Sundry Creditors Outstanding Liabilities for Expenses Wages Carriage Outwards Carriage Inwards General Expenses Cash Discount Bad Debts Motor Car Printing and Stationery Furniture and Fittings Advertisement Insurance Salesmans Commission Postage and Telephones Salaries Rates and Taxes Drawings Capital Account Purchases Sales Stock as on 1st April 1990 Cash at Bank Cash in Hand

Dr. Rs. 5,00,000

Cr. Rs.

2,00,000 55,000 1,00,000 1,10,000 50,000 70,000 20,000 10,000 2,40,000 15,000 1,10,000 85,000 45,000 87,500 57,500 1,60,000 25,000 20,000 14,43,000 15,50,000 19,87,500 2,50,000 60,000 10,500

36,30,500 The following adjustments are to be made a. b. Stock as on 31st March 1991 was valued at Rs. 7,25,000.

36,30,500

A provision for Bad and Doubtful Debts are to be made to the extent of 5% on Sundry Debtors.

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Management Accounting

c. d. e.

Depreciate Furniture & Fixture by 10% and Motor Car by 20%. Shri Om had withdrawn goods worth Rs. 25,000 during the year. Sales include goods worth Rs. 75,000 sent out to Santi & Company on approval and remaining unsold on 31st March 1991. The cost of the goods was Rs. 50,000. The salesman was entitled to a commission of 5% on total sales. Debtors include Rs. 25,000 bad debts. Printing and Stationery expenses of Rs. 55,000 relating to 1989-90 had not been provided in that year but were paid in this year by debiting outstanding liabilities. Purchases include purchases of furniture worth Rs. 50,000.

f. g. h.

i.

Solution Trading Account for the year ended on 31st March 1991
Particulars Opening Stock Purchases Less : Furniture purchased Wages Carriage Inwards Gross Profit c/fd Total 1550000 50000 15,00,000 Closing Stock 1,00,000 Add : Goods on approval 50,000 Goods withdrawn 8,12,500 27,12,500 Total 27,12,500 25,000 725000 50000 7,75,000 Amount Particulars 1987500 75000 19,12,500 Less : Goods on approval Amount

2,50,000 Sales

Process of Accounting

63

Profit & Loss Account for the year ended on 31st March 1991
Particulars Salaries Carriage Outwards Advertisement Insurance Salesmans Commission Postage & Telephones Rates & Taxes Bad Debts Add : Additional Bad Debts 10000 25000 55,000 70,000 20,000 15,000 64,000 55,000 Total 8,57,125 Total 8,57,125 Amount 1,10,000 85,000 Loss transferred to Capital A/c 45,000 95,625 57,500 25,000 44,625 Particulars Amount 8,12,500

1,60,000 Gross Profit b/fd

Add : Provision for Bad Debts 20000 General Expenses Cash Discount Printing & Stationery Depreciation Previous Year Expenses

Balance Sheet as on 31st March 1991


Capital & Liabilities Capital Balance Less : Loss for year Less : Drawings Less : Goods withdrawn Amount Assets & Properties Fixed Assets 14,43,000 Motor Car 44,625 Less : Depreciation 20,000 25,000 Furniture Add : Purchases 13,53,375 Less : Depreciation Current Liabilities Creditors Outstanding Commission 8,125 Current Assets 2,00,000 Closing Stock (Including stock on Approval) Cash at Bank Cash in Hand Debtors Less : Bad Debts Less : Goods on approval Less: Bad Debt Provision 500000 25000 75000 400000 20000 3,80,000 60,000 10,500 7,75,000 110000 50000 16000 1,44,000 240000 48000 1,92,000 Amount

Total

15,61,500

Total

15,61,500

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Management Accounting

Illustration 4 The following is the Trial Balance of Hari as at 31st December 1994 Particulars Haris Capital Account Stock as on 1st January 1994 Sales Returns Inwards Purchases Returns Outwards Carriage Inward Rent and taxes Salaries and Wages Sundry Debtors Sundry Creditors Bank Loan @14% Bank Interest Printing and Stationery Bank Balance Discount Earned Furniture and Fitting Discount Allowed General Expenses Insurance Postage and Telegram Cash Balance Travelling Expenses Drawings 5,000 1,800 11,450 1,300 2,330 380 870 30,000 5,11,330 The following adjustments are to be made a. Included among the Debtors is Rs. 3,000 due from Ram and included among the Creditors Rs. 1,000 due to him. 5,11,330 1,100 14,400 8,000 4,440 19,600 4,700 9,300 24,000 14,800 20,000 8,600 3,21,700 5,800 46,800 3,89,600 Dr. Rs. Cr. Rs. 76,690

Process of Accounting

65

b.

Provision for Bad and Doubtful Debts to be created at 5% and for Discount @2% on Sundry Debtors. Depreciation on Furniture and Fitting @10% should be written off. Personal purchases of Hari amounting to Rs. 600 had been recorded in the Purchases Day Book. Interest on Bank Loan shall be provided for the whole year. A quarter of the amount of Printing and Stationary expenses is to be carried forward to the next year. Credit Purchase Invoice amounting to Rs. 400 had been omitted from the book. Stock as on 31st December 1994 was Rs. 78,600.

c. d.

e. f.

g. h.

Prepare Trading and Profit & Loss Account for the year ended on 31st December, 1994 and the Balance Sheet as on that date.

Solution Trading Account for the year ended on 31st December, 1994
Particulars Opening Stock Purchases Less : Personal purchases Add : Unrecorded purchases Less : Returns Outwards 321700 600 400 5800 3,15,700 Closing Stock 78,600 Amount Particulars 389600 8600 3,81,000 Amount

46,800 Sales Less : Returns Inwards

Carriage Inwards

19,600

Gross Profit c/fd

77,500

Total

4,59,600

Total

4,59,600

66

Management Accounting

Profit & Loss Account for the year ended on 31st December 1994
Particulars Salaries and Wages Rent and Taxes Bank Interest Add : Outstanding Printing and Stationery Less : Prepaid Discount Allowed General Expenses Insurance Postage and Telegram Travelling Expenses Provision for Bad Debts Discount on Debtors Depreciation Profit transferred to Capital A/c 1100 1700 14400 3600 10,800 1,800 11,450 1,300 2,330 870 1,150 437 500 34,503 2,800 Amount Particulars Amount 77,500 4,440

9,300 Gross Profit b/fd 4,700 Discount Earned

Total

81,940

Total

81,940

Balance Sheet as on 31st December, 1994


Capital & Liabilities Capital Balance Add : Profit for year Less : Personal Purchases Less : Drawings Amount Assets & Properties Fixed Assets 76,690 Furniture & Fitting 34,503 Less : Depreciation 600 30,000 Current Assets Closing Stock 80,593 Prepaid Printing & Stationary Bank Balance Current Liabilities Creditors Add : Unrecorded Purchases Less : Due to Ram 14800 400 1000 14,200 Less: Bad Debt Provision Outstanding Interest 1,700 Less: Discount Bank Loan Total 20,000 1,16,493 Total 1,16,493 Cash in Hand Debtors Less: Due to Ram 24000 1000 23000 1150 21850 437 21,413 78,600 3,600 8,000 380 5000 500 4,500 Amount

Process of Accounting

67

Illustration 5 From the following trial balance and information, prepare Trading and Profit & Loss Account of Mr. Rishabh for the year ended 31st march 1999 and a Balance Sheet as on that date. Particulars Capital Drawings Land and Building Plant and Machinery Furniture Sales Returns outwards Debtors Loan from Gajanand on 1.7.98 @6% p.a. Purchases Returns Inward Carriage Sundry Expenses Printing and Stationery Insurance Expenses Provision for bad and doubtful Debts Provision for Discount on Debtors Bad Debts Profit of textile Department Stock of General Goods on 1st April, 1998 Salaries and wages Creditors Trade Expenses Stock of Textile Goods on 31st March, 1999 Cash at Bank Cash in Hand 800 8,000 4,600 1,280 21,300 18,500 12,000 400 10,000 80,000 5,000 10,000 600 500 1,000 1,000 380 18,400 30,000 12,000 90,000 20,000 5,000 1,40,000 4,000 Dr. Rs. Cr. Rs. 1,00,000

2,97,380

2,97,380

68

Management Accounting

Information a. b. Stock of General Goods on 31st March, 1999 valued at Rs. 27,300. Fire occurred on 23rd March, 1999 and Rs. 10,000 worth of general goods were destroyed. The insurance company accepted claim for Rs. 6,000 only and paid the claim money on 10th April, 1999. Bad Debts amounting to Rs. 400 are to be written off. Provision for bad and Doubtful Debts is to be made at 5% and for discount at 2%. Received Rs. 6,000 worth of goods on 27th March ,1999, but the invoice of purchase was not recorded in Purchase Book. Rishabh took away goods worth Rs. 2,000 for personal use but no record was made thereof. Charge depreciation at 2% on Land and Building, 20% on Plant and Machinery and 5% on Furniture. Insurance prepaid amounted to Rs. 200.

c.

d. e.

f.

g.

Solution Trading Account for the year ended on 31st March, 1999
Particulars Opening stock of General Goods Purchases Less : Return Outwards Add : Unrecorded Purchases 80000 4000 6000 82,000 Goods withdrawn Goods destroyed by fire Carriage 10,000 Closing Stock of General Goods Gross Profit c/fd 61,000 27,300 2,000 10,000 Amount Particulars 140000 5000 1,35,000 Amount

21,300 Sales Less : Return Inwards

Total

1,74,300

Total

1,74,300

Process of Accounting

69

Profit & Loss Account for the year ended on 31st March 1999
Particulars Salaries & Wages Sundry Expenses Printing & Stationery Insurance Less : Prepaid Bad Debts Add : Additional Bad Debts Trade Expenses Depreciation Loss by Fire Interest on Loan Profit carried to Capital A/c 1000 200 400 400 800 Discount on Debtors 800 Less : Existing 6,050 4,000 1,350 37,738 342 380 38 Amount Particulars Amount 61,000 10,000 900 1000 100

18,500 Gross Profit b/fd 600 Profit of Textile Department 500 Provision for Bad Debts 800 Less : Existing

Total

71,138

Total

71,138

Balance Sheet as on 31st March, 1999


Capital & Liabilities Capital Balance Less : Drawings Less : Goods withdrawn Add: Profit for year Loan from Gajanand Current Liabilities Creditors Add : Unrecorded Purchases Outstanding Interest on Loan 12000 6000 18,000 Current Assets Stock of General Goods Stock of Textile Goods 1,350 Sundry Debtors Less : Bad Debts Less : Bad Debts Provision Less : Discount Cash at Bank Cash in Hand Prepaid Insurance Receivable from Insurance Company Total 1,73,088 Total 18400 400 18000 900 17100 342 16,758 4,600 1,280 200 6,000 1,73,088 27,300 8,000 100000 12000 2000 37738 Amount Assets & Properties Fixed Assets Land & Building Less: Depreciation Plant & Machinery 1,23,738 Less : Depreciation Furniture 30,000 Less : Depreciation 90000 1800 20000 4000 5000 250 4,750 16,000 88,200 Amount

70

Management Accounting

Illustration 6 Hira and Manik are partners in a firm sharing profits and losses in equal proportion. Following is the Trial Balance as at 31st March, 1989. Debit Balances Plant & Machinery Opening Stock Purchases Land & Building Carriage Inwards Carriage Outwards Wages Sundry Debtors Salaries Furniture Trade Expenses Return Inwards Advertisement Suspense Discount Partners Drawings Hira Manik Bills Receivable Insurance Bad Debts Cash at Bank Total 3,000 2,000 20,000 1,200 1,000 5,000 3,97,750 Total 3,97,750 Rs. 50,000 30,000 80,000 85,000 1,700 2,500 16,000 50,000 12,000 18,000 6,000 950 12,500 900 Credit Balance Sales Discount Sundry Creditors Bills Payable Hiras Loan Account Capital Accounts Hira Manik 50,000 25,000 Rs. 2,40,000 2,000 20,000 10,750 50,000

You are required to prepare Trading and Profit & Loss Account of the firm for the year ended on 31st March 1989 and the Balance Sheet on that date after taking into consideration following adjustments a. b. Closing Stock Rs. 45,000. Depreciate Plant @10% and Furniture @20%. Appreciate Land and Building to Rs. 90,000. Bad Debts Reserve to be raised to 2.5% on Sundry Debtors.

c.

Process of Accounting

71

d. e.

Advertisement Suspense Account to be written off against revenue over five years. Partners Drawings are to bear interest @10% p.a. Amounts were withdrawn on 31st December, 1988. Annual charges for insurance Rs. 1,000. Balance represents amount paid in advance. Hira gave loan to the firm on 30th September, 1988 which carries the interest @6% p.a. Manik was to be allowed a salary of Rs. 250 per month. The partners agree to contribute 50% of the distributable profit to the National Defence Fund.

f. g. h. i.

Solution Trading Account for the year ended on 31st March, 1989
Particulars Opening Stock Purchases Carriage Inwards Wages Amount Particulars 240000 950 2,39,050 45,000 Amount

30,000 Sales 80,000 Less : Returns Inwards 1,700 Closing Stock 16,000

Gross Profit c/fd

1,56,350

Total

2,84,050

Total

2,84,050

Profit & Loss Account for the year ended on 31st March, 1989
Particulars Salaries Trade Expenses Carriage Outwards Insurance Less : prepaid Discount Bad Debts Bad Debts Reserve Advertisement Salary Payable to Manik Interest on Loan from Hira Depreciation Sub-Total 1200 200 1,000 900 1,000 Appreciation of Land & Building 1,250 2,500 3,000 1,500 8,600 40,250 5,000 Amount Particulars Amount 1,56,350 2,000 75 50

12,000 Gross Profit b/fd 6,000 Discount Received 2,500 Interest on Drawings Hira Manik

72

Management Accounting

Particulars Contribution to National Defence Fund Transferred to Capital Account Hira Manik Total

Amount 61,613

Particulars

Amount

30,806 30,806 1,63,475 Total 1,63,475

Balance Sheet as on 31st March, 1989


Capital & Liabilities Capital Hiras Capital Add : Profit for year Less : Drawings Less : Interest on Drawings 50000 30806 3000 75 Amount Assets & Properties Fixed Assets Land & Building Add : Appreciation Plant & Machinery 77,731 Less : Depreciation Furniture Less : Depreciation Maniks Capital Add : Profit for year Add : Salary Less : Drawings Less : Interest on Drawings 25000 30806 3000 2000 50 Current Assets Closing Stock Sundry Debtors 56,756 Less : Bad Debt Reserve Bills receivables Hiras Loan Account Current Liabilities Sundry Creditors Bills Payable Interest on Hiras Loan Account Contribution to National Defence Fund 20,000 Advertisement Suspense 10,750 Less : Transferred to revenue 1,500 61,613 12500 2500 10,000 50,000 Cash at Bank Prepaid Insurance 50000 1250 48,750 20,000 5,000 200 45,000 85000 5000 50000 5000 18000 3600 14,400 45,000 90,000 Amount

Total

2,78,350

Total

2,78,350

Illustration 7 Following is the Trial Balance of M/s. Pandit Brothers, a partnership firm, as on 31st March, 1992.

Process of Accounting

73

Particulars Capital Account H. Pandit Capital Account K. Pandit Drawings H. Pandit Drawings K. Pandit Buildings Furniture Purchases Sales Stock (1st April, 1991) Wages Rates and Taxes Office Expenses Salaries Sundry Debtors Sundry Creditors Cash in Hand Bank Overdraft Carriage Inwards

Dr. Rs.

Cr. Rs. 1,00,000 1,00,000

16,000 16,000 80,000 20,000 2,00,000 3,00,000 50,000 44,000 1,600 10,000 50,000 25,000 12,000 400 29,000 28,000

Total

5,41,000

5,41,000

Following further information relating to the firm is made available a. b. c. d. e. Stock at the end of the year on 31st march, 1992 was Rs. 1,14,500 There was a fire in the premises on 26th November, 1991 which damaged a portion of stock and the loss was estimated at Rs. 17,500. H. Pandit is in charge of purchases and is to be paid 2.5% commission on such purchases. A steel table purchased on 1st February, 1992 for Rs. 3,000 was debited to purchases account. K. Pandit who looks after all other business aspects except purchases is entitled to a commission of 5% on net profits after charging commission on purchases due to H. Pandit and commission payable to himself. Depreciation on Buildings @2.5% and on Furniture @10% Profits or losses are shared equally.
Management Accounting

f. g. 74

You are required to prepare Trading and Profit & Loss Account for the year ended on 31st March, 1992 and the Balance Sheet on that date. Solution Trading Account for the year ended on 31st March 1992
Particulars Opening Stock Purchases Less : Table Purchased Wages Carriage Inwards Commission on purchases Gross Profit c/fd 200000 3000 1,97,000 Closing Stock 44,000 28,000 Stock destroyed by fire 4,925 1,08,075 17,500 1,14,500 Amount Particulars Amount 3,00,000

50,000 Sales

Total

4,32,000

Total

4,32,000

Profit & Loss Account for the year ended on 31st March 1992
Particulars Salaries Rates and Taxes Office Expenses Stock destroyed by fire Depreciation Amount 1,600 10,000 17,500 4,050 83,150 Commission to K. Pandit 1,187 Particulars Amount 1,08,075

50,000 Gross Profit b/fd

Profit transferred to Capital Account H. Pandit K. Pandit 11,869 11,869

Total

1,08,075

Total

1,08,075

Process of Accounting

75

Balance Sheet as on 31st March, 1992


Capital & Liabilities Capital H. Pandit Capital Add : Profit for year Add: Commission Less : Drawings 100000 11869 4925 16000 Amount Assets & Properties Fixed Assets Building Less : Depreciation Furniture 1,00,794 Add : Purchases Less : Depreciation K. Pandit Capital Add : Profit for year Add: Commission Less : Drawings 100000 11869 1187 16000 Current Assets Closing Stock 97,056 Sundry Debtors Cash in Hand Current Liabilities Sundry Creditors Bank Overdraft 12,000 29,000 1,14,500 25,000 400 80000 2000 20000 3000 2050 20,950 78,000 Amount

Total

2,38,850

Total

2,38,850

Note Commission payable to K. Pandit is calculated as below (108075 83150) x 5 105 Illustration 8 The following is the Trial Balance of Shri Arihant as on 31st December 1999. Particulars Capital Drawings Opening Stock Purchases Freight on purchases Wages Sales Salaries 1,00,000 75,000 80,000 16,20,000 15,000 1,10,000 25,00,000 Dr. Rs. Cr. Rs. 14,00,000

76

Management Accounting

Particulars Travelling Expenses Miscellaneous Expenses Printing and Stationery Advertisement Expenses Postage and Telegram Discounts Bad Debts written off (after adjusting recovery of bad debts of Rs. 6,000 written off in 1997) Building Machinery Furniture Debtors Provision for Doubtful Debts Creditors Investments (12% Purchased on 1st October, 1999) Bank Balance

Dr. Rs. 23,000 35,000 27,000 25,000 13,000 7,600

Cr. Rs.

14,500

14,000 10,00,000 75,000 40,000 1,50,000 19,000 1,60,000 6,00,000 83,900

40,93,500 Adjustments a. b. c. Closing Stock Rs. 2,25,000.

40,93,500

Goods worth Rs. 5,000 were taken for personal use but no entry was made in the books. Machinery worth Rs. 35,000 purchased on 1st January, 1997 was wrongly written off against Profit & Loss Account. This asset is to be brought into account on 1st January, 1999 taking depreciation at 10% per annum on straight line basis upto 31st December, 1998. Depreciation Building at 2.5%, Machinery at 10% and Furniture at 10%. Provision for Doubtful Debts should be 6% on Debtors. The manager is entitled to a commission of 5% of net profits after charging his commission.

d. e. f.

Prepare Trading and Profit & Loss Account for the year ending 31st December, 1999 and a Balance Sheet as on that date.

Process of Accounting

77

Solution Trading Account for the year ended on 31st December, 1999
Particulars Opening Stock Purchases Freight on purchases Wages Gross Profit c/fd Total Amount 16,20,000 15,000 Goods withdrawn 1,10,000 Closing Stock 9,05,000 27,30,000 Total 27,30,000 2,25,000 5,000 Particulars Amount 25,00,000

80,000 Sales

Profit & Loss Account for the year ended on 31st December 1999
Particulars Salaries Travelling Expenses Miscellaneous Expenses Printing & Stationery Advertisement Expenses Postage and Telegram Discount Bad Debts Depreciation Sub-Total Commission to Manager Profit transferred to Capital A/c Amount Particulars Amount 9,05,000 6,000 9000 19000 10,000 18,000 14,500

1,00,000 Gross Profit b/fd 23,000 Bad Debts recovered 35,000 Provision for bad Debts 27,000 Less : Existing 25,000 Income from investments 13,000 Discount Received 7,600 20,000 40,000 2,90,600 31,567 6,31,333

Total

9,53,500

Total

9,53,500

78

Management Accounting

Balance Sheet as on 31st December, 1999


Capital & Liabilities Capital Balance b/fd Less : Drawings Less : Goods withdrawn Add : Profit for year Add : Machine capitalized 1400000 75000 5000 631333 28000 Amount Assets & Properties Fixed Assets Building Less : Depreciation Machinery Add : Capitalized 19,79,333 Less : Depreciation Furniture Less : Depreciation Current Liabilities Sundry Creditors Commission to Manager 1,60,000 Investments 31,567 Current Assets Closing Stock Debtors Less : Bad Debt Provision Bank Balance Investment Income outstanding 150000 9000 1,41,000 83,900 18,000 2,25,000 6,00,000 1000000 25000 75000 28000 11000 40000 4000 36,000 92,000 9,75,000 Amount

Total

21,70,900

Total

21,70,900

Note Value of machine purchased Rs. 35,000. Depreciation for 1997 and 1998 Rs. 7,000. Value of machine to be capitalized Rs. 28,000. Depreciation for 1999 on this machine Rs. 3,500.

Process of Accounting

79

Illustration 9 Following is the Trial Balance of K as on 31st March, 2000. Particulars Capital Drawings Opening Stock Purchases Freight on Purchases Wages (11 months up to 29th February, 2000) Sales Salaries Postage, Telegrams, Telephones Printing and Stationery Miscellaneous Expenses Creditors Investments Discount Received Debtors Bad Debts Provision for Bad Debts Building Machinery Furniture Commission on sales Interest on Investments Insurance (Year up to 31st July 2000) Bank Balance 24,000 1,50,000 34,45,000 34,45,000 3,00,000 5,00,000 40,000 45,000 12,000 2,50,000 15,000 8,000 1,00,000 15,000 1,40,000 12,000 18,000 30,000 3,00,000 60,000 75,000 15,95,000 25,000 66,000 23,10,000 Dr. Rs. Cr. Rs. 8,00,000

80

Management Accounting

Adjustments a. b. Closing Stock Rs. 2,25,000. Machinery worth Rs. 45,000 purchased on 1st October, 1999 was shown as purchases. Freight paid on the machinery was Rs. 5,000 which is included in the freight on purchases. Commission is payable on sales @2.5% on sales. Investments were sold at 10% profit, but the entire sale proceeds have been taken as sales. Write off Bad Debts Rs. 10,000 and create a provision for Doubtful Debts at 5% of Debtors. Depreciate building by 2.5% p.a. and Machinery and Furniture at 10% p.a.

c. d.

e.

f.

Prepare Trading and Profit & Loss Account for the year ended on 31st March, 2000 and the Balance Sheet on that date. Solution Trading Account for the year ended on 31st March 2000
Particulars Opening Stock Purchases Less: Machine Purchased Freight on Purchases Less : Freight on Machinery Wages Add : Outstanding 1595000 45000 25000 5000 66000 6000 72,000 20,000 15,50,000 Closing Stock 2,25,000 Amount Particulars 2310000 110000 22,00,000 Amount

75,000 Sales Less : Sale of Investments

Gross Profit c/fd Total

7,08,000 24,25,000 Total 24,25,000

Process of Accounting

81

Profit & Loss Account for the year ended on 31st March 2000
Particulars Salaries Postage, Telegrams, Telephones Printing and Stationery Miscellaneous Expenses Bad Debts Add : Additional Provision for Bad Debts Less : Existing Provision Commission on Sales Add : Outstanding Insurance Less : prepaid Depreciation Profit transferred to Capital A/c Total 15000 10000 12000 8000 45000 10000 24000 8000 16,000 64,000 3,81,000 7,45,000 Total 7,45,000 55,000 4,000 25,000 Amount Particulars Amount 7,08,000 15,000 12,000 10,000

1,40,000 Gross Profit b/fd 12,000 Discount Received 18,000 Interest on Investments 30,000 Profit on sale of Investments

Balance Sheet as on 31st March, 2000


Capital & Liabilities Capital Balance b/fd Add : Profit for year Less : Drawings 800000 381000 60000 Amount Assets & Properties Fixed Assets Building Less: Depreciation 11,21,000 Machinery Add : Purchased Less: Depreciation Furniture Current Liabilities Creditors Sales Commission outstanding Wages Outstanding 3,00,000 10,000 Current Assets 6,000 Closing Stock Debtors Less : Bad Debts Less : Bad Debts Provision Bank Balance Prepaid Insurance 250000 10000 240000 12000 2,28,000 1,50,000 8,000 2,25,000 Less : Depreciation 300000 7500 500000 50000 52500 40000 4000 36,000 4,97,500 2,92,500 Amount

Total

14,37,000

Total

14,37,000

82

Management Accounting

Illustration 10 From the following particulars extracted from the books of Ganguli, prepare Trading and Profit & Loss Account for the year ended on 31st March 1994 and Balance Sheet on that date after making the necessary adjustments. Debit Balances Opening Stock Sales Returns Purchases Carriage Inwards Rent Salaries Sundry Debtors Printing & Stationery Interest Paid Advertisement Cash at Bank Investments at 5% on 1.4.93 Furniture on 1.4.93 Discount Allowed General Expenses Audit Fees Fire Insurance Premium Travelling Expenses Postage & Telegrams Cash on Hand Deposits @10% on 1.4.93 Drawings Rs. 23,400 4,300 1,21,550 9,300 2,850 4,650 12,000 1,700 450 5,600 4,000 2,500 900 3,770 1,960 350 300 1,165 435 190 15,000 5,000 Credit Balance Capital Sales Purchases Returns Sundry Creditors Loan from Bank @12% Interest Received Discount Received Rs. 54,050 1,44,800 2,900 7,400 10,000 725 1,495

Total Adjustments a.

2,21,370

Total

2,21,370

Value of stock as on 31st March, 1994 is Rs. 39,300. This includes goods returned by customers on 31st March, 1994 of the value of Rs. 1,500 for which on entry has been passed in the books. 83

Process of Accounting

b. c. d.

Purchases include furniture purchased on 1st January 1994 for Rs. 1,000. Depreciation should be provided on furniture @10% p.a. Bank Loan as on 1st April, 1993 was Rs. 5,000. An amount of Rs. 5,000 was borrowed on 31st March, 1994. Sundry Debtors include Rs. 2,000 due from Robert and Sundry Creditors include Rs. 1,000 due to him. Interest paid includes Rs. 300 paid on the Bank Loan. Interest received represents Rs. 100 from the Sundry Debtors and the balance on investments and deposits. Provide for interest payable on Bank Loan and for interest receivable on investments and deposits. Make a provision for doubtful debts @5% on the balance under Sundry Debtors. No such provision is necessary for the deposits.

e.

f. g.

h.

i.

Solution Trading Account for the year ended on 31st March 1994
Particulars Opening Stock Purchases Less : Purchase Returns Less : Furniture Purchased Carriage Inwards Gross Profit c/fd 121550 2900 1000 1,17,650 9,300 27,950 Closing Stock 39,300 Amount Particulars 144800 1500 4300 1,39,000 Amount

23,400 Sales Less : Goods returned Less : Sales Returns

Total

1,78,300

Total

1,78,300

84

Management Accounting

Profit & Loss Account for the year ended on 31st March 1994
Particulars Salaries Rent Printing & Stationery Interest paid Add : Interest on Bank Loan Advertisement Discount Allowed General Expenses Audit Fees Fire Insurance Premium Travelling Expenses Postage & Telegrams Depreciation Reserve for Bad Debts Profit transferred to Capital A/c 450 300 750 5,600 3,770 1,960 350 300 1,165 435 115 475 7,050 Amount Particulars 725 1000 1,725 1,495 Amount 27,950

4,650 Gross Profit b/fd 2,850 Interest Received 1,700 Add : Receivable Discount received

Total

31,170

Total

31,170

Balance Sheet as on 31st March, 1994


Capital & Liabilities Capital Balance Less: Drawings Add : Profit for year 54050 5000 7050 Amount Assets & Properties Fixed Assets Furniture Add : Purchases 56,100 Less : Depreciation Investments Loan from Bank 10,000 Current Assets Closing Stock Current Liabilities Sundry Creditors Less : Due to Roberts Outstanding Interest 7400 1000 Sundry Debtors Less : Due to Roberts 6,400 Less : Goods returned 300 Less : Bad Debts reserve Cash on Hand Cash at Bank Deposits Interest Receivable 12000 1000 1500 475 9,025 190 4,000 15,000 1,000 39,300 900 1000 115 1,785 2,500 Amount

Total

72,800

Total

72,800

Process of Accounting

85

QUESTIONS 1. 2. If the Trial Balance does not agree, what steps will you take to ensure that it tallies? What do you mean by Final Accounts? Explain in brief the structure of Profitability Statement and Balance Sheet. What are the various components of Profit and Loss Account ? Explain the purpose of each component. How would you deal with the following while preparing the final accounts a. b. c. d. e. f. Goods lost by fire Goods distributed as free samples Goods sent on approval basis Bad Debts and Provision for Bad Debts Interest on Capital Prepaid Expenses and Outstanding Expenses

3.

4.

86

Management Accounting

PROBLEMS Q.1. The following is the Trial Balance of Shri Paras as on 31st March 1991. You are requested to prepare the Final Accounts after giving effect to the adjustments. Particulars Sundry Creditors Sundry Debtors Capital Account Drawings Insurance General Expenses Salaries Patents Machinery Freehold Land Building Stock on 1st April 1990 Carriage on Purchases Carriage on Sales Fuel and Power Wages Returns Outwards Returns Inwards Sales Purchases Cash at Bank Cash in Hand 4,06,750 26,300 5,400 17,65,800 The following adjustments are to be made a. b. Stock as on 31st March, 1991 was valued at Rs. 68,000. A provision for Bad and Doubtful Debts is to be made to the extent of 5% on Sundry Debtors. Depreciate Machinery @10% and Patents @20%. 17,65,800 6,800 9,87,800 52,450 6,000 30,000 1,50,000 75,000 2,00,000 1,00,000 3,00,000 57,600 20,400 32,000 47,300 1,04,800 5,000 1,45,000 7,10,000 Dr. Rs. Cr. Rs. 63,000

c.

Process of Accounting

87

d. e. f.

Wages include a sum of Rs. 20,000 spent on erection of a cycle shed for employees and customers. Salaries for the month of March 1991 amounting to Rs. 15,000 were unpaid. Insurance includes a premium of Rs. 1,700 on a policy, expiring on 30th September, 1991.

Q.2. Mr. A, a Shopkeeper had prepared the following trial balance from his ledger as on 31st March 1989. Particulars Purchases Sales Cash in Hand Cash in Bank Stock of Goods on 1st April, 1988 Mr. As Capital Drawings Salaries Postage and Telephone Salesmen Commission Insurance Advertising Furniture Printing and Stationery Motor Car Bad Debts Cash Discount General Expenses Carriage Inwards Carriage Outwards Wages Creditors Debtors Dr. Rs. 6,20,000 8,30,000 4,200 24,000 1,00,000 5,77,200 8,000 64,000 23,000 70,000 18,000 34,000 44,000 6,000 96,000 4,000 8,000 60,000 20,000 44,000 40,000 80,000 2,00,000 14,87,200 14,87,200 Cr. Rs.

You are requested to prepare Trading and Profit & Loss Account for the year ended 31st March, 1989 and Balance Sheet as on that date. You are also given the following further information

88

Management Accounting

a. b. c. d. e. f. g. h. i.

Cost of goods in stock as on 31st March, 1989 Rs. 1,45,000 Mr. A had withdrawn goods worth Rs. 5,000 during the year. Purchases include purchase of furniture worth Rs. 10,000. Debtors include Rs. 5,000 Bad Debts. Creditors include a balance of Rs. 4,000 to the credit of Mr. B in respect of which it has been decided and settled with the party to pay only Rs. 1,000. Sales include goods worth Rs. 15,000 sent to Ram & Co. on approval and remaining unsold as on 31st March 1989 and the cost of goods was Rs. 10,000. Provision for bad debts is to be created at 5% on Sundry Debtors. Depreciate furniture by 15% and Motor Car by 20% The salesmen are entitled to a commission of 10% on total sales.

Q.3. From the following balances extracted from the books of Mr. Yellow, prepare Trading and Profit & Loss Account for the year ended 31st December, 1990 and a Balance Sheet as on that date. Particulars Purchases Mr. Yellows Capital Account Computer at cost Cash at Bank Cash on Hand Sundry Creditors Bills Payable Account Furniture & Fittings Account at cost Rent Discount Received Bills Receivables Account Trade Charges Sundry Debtors Sales Returns Outwards Drawings Account Rent Due Discount Wages Salaries Returns Inwards Dr. Rs. 71,280 18,380 4,000 2,836 13,000 10,220 1,540 12,540 22,000 6,720 920 34,156 60,720 11,432 5,200 320 540 1,800 16,780 1,000 1,77,692 1,77,692 Cr. Rs. 60,000

Process of Accounting

89

Adjustments a. b. c. d. e. f. g. h. i. j. k. Closing Stock on 31st December, 1990 was valued at cost Rs. 25,000 (Market Value Rs. 16,200) Rs. 6,000 paid to Mr. Red against Bill Payable were debited by mistake to Mr. Greens Account and included in the list of Sundry Debtors. Travelling expenses paid to sales representative Rs. 5,000 for the month of December 1990 were debited to his personal account and included in the list of Sundry Debtors. Depreciation on furniture & fittings shall be provided at 10% per annum. Provide for doubtful debts at 5% on Sundry Debtors. Goods costing Rs. 1,500 used by the proprietor. Salaries include Rs. 12,000 paid to sales representative who is further entitled to a commission of 5% on net sales. Stationary charges Rs. 1,200 due on 31st December, 1990. Purchases include opening stock valued at Rs. 7,000 (cost price) Sales representative further entitled to an extra commission of 5% on net profit after charging his extra commission. No depreciation need to be provided for computer as it had been purchased on 31st December, 1990 and not put to use.

Q.4. From the following trial balance of Hari and additional information, prepare Trading and Profit & Loss Account for the year ended 31st March, 1995 and a Balance Sheet as on that date. Particulars Capital Furniture Purchases Debtors Interest Earned Salaries Sales Purchase returns Wages Rent Sales Returns Bad Debts written off 20,000 15,000 10,000 7,000 30,000 3,21,000 5,000 20,000 1,50,000 2,00,000 4,000 Dr. Rs. Cr. Rs. 1,00,000

90

Management Accounting

Particulars Creditors Drawings Provision for Bad Debts Printing and Stationery Insurance Opening Stock Office Expenses Provision for Depreciation

Dr. Rs. 24,000

Cr. Rs. 1,20,000 6,000

8,000 12,000 50,000 12,000 2,000 5,58,000 5,58,000

Additional Information a. b. c. Depreciation furniture by 10% on original cost. A provision for Doubtful Debts is to be created to the extent of 5% on Sundry Debtors. Salaries for the month of March 1995 amounting to Rs. 3,000 were unpaid which must be provided for. However, salaries include Rs. 2,000 paid in advance. Insurance amounting to Rs. 2,000 is prepaid. Provide for outstanding office expenses Rs. 8,000. Stock used for private purpose Rs. 6,000. Closing Stock in Trade Rs. 60,000

d. e. f. g.

Q.5. The following is the Trial Balance of Shri Arihant as on 31st December, 1999. Particulars Capital Drawings Opening Stock Purchases Freight on purchases Wages Sales Salaries 1,00,000 75,000 80,000 16,20,000 15,000 1,10,000 25,00,000 Dr. Rs. Cr. Rs. 14,00,000

Process of Accounting

91

Particulars Travelling Expenses Miscellaneous Expenses Printing and Stationery Advertisement Expenses Postage and Telegram Discounts Bad Debts written off (after adjusting recovery of bad debts of Rs. 6,000 written off in 1997) Building Machinery Furniture Debtors Provision for Doubtful Debts Creditors Investments (12% Purchased on 1 October 1999) Bank Balance
st

Dr. Rs. 23,000 35,000 27,000 25,000 13,000 7,600 14,000 10,00,000 75,000 40,000 1,50,000

Cr. Rs.

14,500

19,000 1,60,000 6,00,000 83,900

40,93,500 Adjustments a. b. c. Closing Stock Rs. 2,25,000.

40,93,500

Goods worth Rs. 5,000 were taken for personal use but no entry was made in the books. Machinery worth Rs. 35,000 purchased on 1st January, 1997 was wrongly written off against Profit & Loss Account. This asset is to be brought into account on 1st January 1999 taking depreciation at 10% per annum on straight line basis upto 31st December, 1998. Depreciation on Building at 2.5%, Machinery at 10% and Furniture at 10%. Provision for Doubtful Debts should be 6% on Debtors. The Manager is entitled to a commission of 5% of net profits after charging his commission.

d. e. f.

Prepare Trading and Profit & Loss Account for the year ending 31st December, 1999 and a Balance Sheet as on that date. Q.6. From the following information, you are required to prepare Trading Account, Profit & Loss Account and Balance Sheet as on 31st December, 1999 for SANPAT Co.

92

Management Accounting

Particulars Sundry Debtors Bills Receivables Goodwill Land & Building Plant & Machinery Furniture Motors Telephone Bills Opening Stock Wages Advertisement Royalty Power & Fuel Legal Charges Audit Fees Lighting Salaries Repairs Purchases Rent Cash in Hand Depreciation Fund Outstanding Taxes Bills Payable Sundry Creditors Bank Overdraft Capital General Reserves Bank Loan Provident Fund Purchases Returned Sales Bank Loan Outstanding Interest

Dr. Rs. 40,000 18,500 40,500 1,10,000 40,000 40,200 50,800 11,200 18,700 2,000 11,700 12,000 12,800 1,200 4,090 2,000 3,500 110 22,000 1,700 78,000

Cr. Rs.

8,000 1,800 2,200 4,700 3,200 1,50,000 38,000 1,00,000 40,000 1,000 1,20,500 50,400 1,200 5,21,000 5,21,000

Process of Accounting

93

Adjustments a. b. c. d. e. f. g. Interest on Capital 10%. Closing Stock Rs. 75,000. Goods costing Rs. 8,000 lost by fire and insurance company admitted a claim of Rs. 6,500. Depreciation on Motors 10%, Furniture 20%, Plant & Machinery 5%. Provide RDD 10% on Debtors. Outstanding Wages Rs. 1,000. Prepaid Telephone Bill Rs. 1,200.

Q.7. Following Trial Balance was taken out on 31st March, 1996 from the books of Mr. Raman. You are required to prepare Trading and Profit & Loss Account for the year ended 31st March, 1996 and Balance Sheet as at that date, after making the necessary adjustments. Debit Balances Wages & Salaries Drawings Purchases Sales Returns Office Furniture Buildings Office Expenses Advertisement Opening Stock Rent and Taxes Commission Bills receivables Travelling Expenses Trade Expenses Bad Debts Sundry Debtors Cash in Hand Investments Fuel & Power (Factory) Total Rs. 6,000 2,000 18,000 300 4,000 12,000 800 500 5,000 400 200 800 250 350 190 11,000 1,800 2,000 1,060 66,650 Total 66,650 Credit Balances Sales-Cash Sales-Credit Capital Discount earned Purchases Returns Provision for Bad Debts Sundry Creditors Bank Overdraft Income from Investments Rs. 8,000 18,000 34,000 340 460 1,500 2,800 1,300 250

94

Management Accounting

Adjustments a. b. c. d. e. f. Depreciation to be provided on Building and Furniture @10%. Rent outstanding was Rs. 120. Provision for Doubtful Debts to be maintained at 5%. Interest accrued but not received was Rs. 50. Goods of the value of Rs. 100 were given away as free samples. Closing Stock was valued at Rs. 8,200.

Q.8. From the following Trial Balance and adjustments, prepare Trading and Profit & Loss Account for the year ending 31st December 1997 and Balance Sheet as on that date. Debit Balances Salaries Bad Debts Opening Stock Purchases Wages Commission Paid Carriage Outwards Octroi Machinery Additions on 1.7.97 Bank Goodwill Cash Sundry Debtors Legal & Professional Fees 25000 12500 37,500 22,500 25,000 15,000 52,500 2,500 Rs. 16,500 1,500 12,500 87,500 5,000 250 2,500 7,000 Credit Balances Commission Received Sales Interest Received Provision for Bad Debts Capital Loan taken on 1.10.97 @12% p.a. Rs. 1,250 1,70,000 2,250 1,750 1,00,000 12,500

Total Adjustments 1. 2. 3.

2,87,750

Total

2,87,750

Closing stock was valued at cost Rs. 37,500. Outstanding salaries amounted to Rs. 1,500. Commission received but not earned Rs. 250.

Process of Accounting

95

Q.9. From the following Trial Balance and adjustments, prepare Trading and Profit & Loss Account for the year ending 31st December, 1997 and Balance Sheet as on that date. Debit Balances Opening Stock Wages Carriage Salaries Bad Debts Purchases Return Inwards Plant & Machinery Furniture as on 1st January, 1997 Furniture purchased 1.7.1997 Investments Patent Rights Cash in Hand Cash at Bank Sundry Debtors Bills Receivables Postage and Telegrams Rs. 25,000 5,000 1,000 3,800 700 1,10,000 2,000 35,000 20,000 5,000 27,500 3,500 750 13,250 40,000 10,000 200 Credit Balances Rent Received Commission Received Miscellaneous Income Bad Debts recovered RDD Sales Return Outwards Bills Payable Capital Creditors Rs. 1,500 750 250 1,000 700 2,00,000 1,000 7,500 70,000 20,000

Total Adjustments 1. 2. 3. 4. 5.

3,02,700

Total

3,02,700

Write off Bad Debts Rs. 500 and create 5% RDD on Debtors. Salaries Outstanding Rs. 200. Unearned commission Rs. 50. Plant & Machinery and Furniture to be depreciated @10% p.a. Closing Stock Rs. 10,000.

Q.10. Melon and Lemon are partners sharing profits equally. From the following Trial Balance and the additional information, prepare Trading and Profit & Loss Account for the year ending 30th June, 1982 and Balance Sheet on that date.

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Management Accounting

Debit Balances Drawings - Melon - Lemon Land & Building Machinery Salaries Motor Car Trade Expenses Carriage Inward Royalties Purchases Return Inwards Debtors Discounts Insurance Stock on 1.7.81 Advertisement Cash at Bank

Rs. 2,000 3,500 36,000 18,000 3,700 10,500 1,900 400 1,800 45,300 2,500 24,600 1,000 1,200 23,800 3,000 2,900

Credit Balances Capital - Melon - Lemon Sales Returns Bad Debts Reserve Creditors Commission Bank Loan taken 0n 1.1.82

Rs. 35,000 25,000 95,500 1,300 800 3,000 1,500 20,000

Total Additional Information a.

1,82,100

Total

1,82,100

Stock on 30th June, 1982 was worth Rs. 36,000 at cost while its market value was Rs. 39,000 Goods worth Rs. 4,000 taken by Lemon for personal use were not entered in the books of accounts. Of the debtors, Rs. 600 were bad and should be written off and reserve for doubtful debts should be maintained at 5%. 5% interest is to be allowed on capital. Provide for interest on bank loan @10% per annum. Insurance is paid for the year ending 31st December, 1982.

b.

c. d. e. f.

Process of Accounting

97

Q.11. From the Trial Balance of M/s. Hocus and Pocus, you are required to prepare Trading and Profit & Loss Account for the year ending 31st December 1982 and the Balance Sheet as on that date after taking into account the additional information. Partners share the profits and losses equally. Debit Balances Drawings Hocus Drawings Pocus Stock as on 1.1.82 Bills Receivables Purchases Returns Inwards Plant and Machinery Furniture Sundry Debtors Cash in Hand and at Bank Salaries Wages Rent and Taxes Insurance Printing and Stationary General Expenses Power and Fuel Rs. 14,450 15,000 2,00,000 25,000 2,75,000 5,000 1,00,000 45,000 1,20,000 77,550 12,000 19,000 11,500 3,000 2,000 6,500 4,500 Credit Balances Capital Hocus Capital Pocus Sales Bills Payable Return Outwards Sundry Creditors Rs. 1,80,000 1,50,000 4,00,000 61,000 4,500 1,40,000

Total Additional Information. a. b. c. d. e. f. g.

9,35,500

Total

9,35,500

Stock as on 31st December, 1982 was Rs. 1,60,000. It is discovered that sales effected on 31st December, 1982 of the value of Rs. 2,000 has not been recorded in the books. Stock worth Rs. 3,000 uninsured has been destroyed by fire. Depreciate Plant & Machinery by 20% and Furniture by 5% Provide for bad and doubtful debts Rs. 6,000. Outstanding Expenses Salaries Rs. 2,500, Wages Rs. 1,000. Prepaid insurance Rs. 500.

98

Management Accounting

Q.12. The Accountant of M/s. Kasturi Agencies extracted the following Trial Balance as on 31st March, 1987. Particulars Capital Drawings Buildings Furniture Motor Van Bank Loan at 12% Interest Interest paid on above Sales Purchases Stock as on 1.4.86 Stock as on 31.3.87 Establishment Expenses Freight Inwards Freight Outwards Commission Received Sundry Debtors Bank Balance Sundry Creditors 2,28,500 28,100 20,500 10,000 2.68,500 15,000 2,000 1,000 7,500 75,000 25,000 32,000 15,000 7,500 25,000 15,000 400 1,00,000 Dr. Rs. Cr. Rs. 1,00,000 18,000

The Accountant located the following errors but is unable to proceed further any more. a. b. c. A totalling error in bank column of payment side of cash book whereby the column was undercast by Rs. 500. Interest on Bank loan paid for the quarter ending 31st December, 1986, Rs. 450, was omitted to be posted in the ledger. There was no further payment of interest. You are required to set right the Trial Balance and prepare the Trading and Profit and Loss Account for the year ended on 31st March, 1987 and the Balance Sheet on that date, after carrying out the following 1. Depreciation is to be provided on the assets as follows :
l l l

Buildings 2.5% p.a. Furniture 10% p.a. Motor Van 10% p.a.

2.

Balance of interest due on the loan is also to be provided for. 99

Process of Accounting

NOTES

100

Management Accounting

Chapter 4
BANK RECONCILIATION STATEMENT

If the account is opened in a bank in the name of business, the bank periodically gives the bank passbook or the bank statement. The bank passbook or the bank statement is the extract of the account in the name of business as it appears in the books of the bank. Similarly, in the books of business also, it maintains the bank book which is the extract of bank transactions as it appears in the book of business. As both the bank book in the books of business and bank passbook as per the books of bank record the same transactions, the balance as per bank book should match with the balance as per passbook. However, in reality, the said balances may not match with each other. These balances may not match with each due to the following reasons 1. Cheques issued but not debited - The business might have issued some cheques which are not yet presented in the bank for clearing. As such, the balance as per bank pass book may be higher. Cheques deposited but not cleared - The business might have deposited some cheques in the bank account, but the bank might not have received the payment for the same and hence the amount is not yet credited to the bank account. As such, balance as per bank book may be higher. Other Reasons There may be a possibility that certain items may appear only in the passbook without any corresponding effect of the same in the bank book. This may be possible due to following reasons a. The bank debits periodical bank charges and bank interest to the account. These amounts appear only in the bank passbook. The business organization makes the entry of the same on the receipt of intimation from the bank. Till the entry is passed in the bank book, the bank book may show higher balance than the passbook. If the cheques deposited by the business organization get dishonoured, bank immediately debits the same amount to the account. The business organization makes the entry of the same on the receipt of intimation from the bank. Till the entry is passed in the bank book, the bank book may show higher balance than the passbook. 101

2.

3.

b.

Bank Reconciliation Statement

c.

In some cases, some of the customers of the business organization may make the payment directly in the bank account of the business organization. The business organization makes the entry of the same on the receipt of intimation from the bank. Till the entry is passed in the bank book, the bank book may show lower balance than the passbook. In some cases, the business organization may give the standing instructions to the bank to make the recurring payments like rent, electricity bills, telephone bills etc. as and when they become due for payment. Accordingly, the bank might have paid these amounts and on payment, they are debited to the account. The business organization makes the entry of the same on the receipt of intimation from the bank. Till the entry is passed in the bank book, the bank book may show higher balance than the passbook. In some cases, the bank is given the responsibility of collecting the investment income or the principal amount of investment or the bills of exchanges on the date of maturity. Accordingly, the bank collects the same and credits the same to the account. The business organization makes the entry of the same on the receipt of intimation from the bank. Till the entry is passed in the bank book, the bank book may show lower balance than the passbook. There may be some clerical error on the part of bank when certain amounts may be wrongly debited or credited by the bank to the account. The business organization makes the entry of the same on the receipt of intimation from the bank. Till the entry is passed in the bank book, the bank book may show lower or higher balance than the passbook depending upon the nature of error on the part of bank.

d.

e.

f.

Bank Reconciliation Statement is the statement prepared to explain the reasons as to why the bank balance as per passbook and bank balance as per bankbook does not match. Preparation of Bank Reconciliation Statement The bank reconciliation starts with the Closing Bank Balance as per Bank Book and by making the additions and subtractions therefrom, the Bank Balance as per the Bank Statement or Pass Book is arrived at. Alternatively, the bank reconciliation statement may start with Balance as per the Bank Statement or Pass Book and by making the additions and subtractions therefrom, the Bank Balance as per the Bank Book may be arrived at. For preparing the bank reconciliation statement, entries on the payment side of Bank Book are compared with the withdrawal column of the Pass Book or Bank Statement and the entries on the receipts side of Bank Book are compared with the deposits column of Bank Statement or Pass Book. If entries on the payment side or receipt side of the Bank Book appear on the withdrawal or deposit column of Bank Statement or Pass Book respectively, bank reconciliation statement

102

Management Accounting

does not get affected. Bank reconciliation statement is affected due to those amounts which appear on the payment side of Bank Book but are not there in the withdrawals column of Bank Statement or Pass Book or amounts which appear on the receipts side of Bank Book but are not there in the deposits column of Bank Statement or Pass Book. Following is the specimen of bank reconciliation statement Bank Reconciliation Statement as on Bank Balance as per Bank Book Add : a. Cheques issued but not presented b. Amount credited in Pass Book but not in Bank Book c. Deposits made in the account directly d. Wrong credits given by bank Sub-Total Less : a. Cheques deposited but not cleared b. Interest/Bank Charges debited by bank c. Direct payments made by bank not entered in Bank Book d. Cheques dishonoured not recorded in Bank Book e. Wrong debits given by bank Sub-Total Bank Balance as per Bank Statement or Pass Book Following points should be remembered a. If the bank reconciliation statement is prepared by starting with Bank Balance as per Bank Statement or Pass Book, amounts added in the above specimen need to be subtracted and the amounts subtracted in the above specimen need to be added. b. If the bank has given the overdraft facility, generally the Bank Book will show closing balance as credit balance. If the bank reconciliation statement is prepared starting with bank balance as per Bank Book, amounts added in the above specimen need to be subtracted and the amounts subtracted in the above specimen need to be added. If the bank reconciliation statement prepared discloses the amounts for which the entries have not been made in the Bank book, those entries should be made in the books of accounts and the balance as per the Bank book should be modified accordingly. 103

c.

Bank Reconciliation Statement

d.

After all the entries as disclosed by the bank reconciliation statement are passed in the books of account, there will be mainly two amounts appearing in the final bank reconciliation statement viz. cheques issued but not presented for payment and cheques deposited but not cleared. In some abnormal circumstances, the final bank reconciliation statement may have the amounts which are wrongly debited or credited by the bank erroneously for which the bank needs to pass rectification entries subsequently. For the purpose of preparation of Trial Balance, bank balance as per Bank Book will be considered and not the balance as per Bank Statement or Pass Book.

e.

Illustration Following are the entries recorded in the Bank Column of the Cash Book of Mr. X for the month ending 31st March 1997. Cash Book (Bank Column only) Date 15.3.97 20.3.97 22.3.97 31.3.97 Particulars To Cash To Roy To Kapoor To Balance c/fd Rs. 36000 24000 10000 7640 Date 01.3.97 04.03.97 06.3.97 15.3.97 20.3.97 Total 77640 Particulars By Balance b/fd By John By Krishnan By Kailash By Joshi Total Rs. 40000 2000 400 240 35000 77640

On 31st March, 1997, Mr. X received the Bank Statement. On perusal of the statement, Mr. X ascertained the following information a. b. c. d. e. f. g. Cheques deposited but not cleared by bank Rs. 10,000 Interest on securities collected by the bank but not recorded in cash book Rs. 1,080 Credit transfers not recorded in the cash book Rs. 200 Dividend collected by the bank directly but not recorded in the cash book Rs. 1,000 Cheques issued but not presented for payment Rs. 37,400 Interest debited by the bank but not recorded in the cash book Rs. 1,000 Bank Charges not recorded in the cash book Rs. 340

From the above information you are asked to prepare a Bank reconciliation statement to ascertain the balance as per Bank Statement.

104

Management Accounting

Solution Bank Reconciliation Statement as on 31st March, 1997 Bank Balance as per Cash Book (Overdraft) Add : a. Cheques deposited but not cleared b. Interest debited by bank not recorded in Cash Book c. Bank Charges debited by bank not recorded in Cash Book Sub-Total Less : a. Cheques issued but not presented b. Interest on securities collected by bank not Recorded on cash book c. Credit transfer not recorded in cash book d. Dividend collected by bank not recorded in Cash Book Bank Balance as per Bank Statement (Overdraft) Illustration From the following extracts of the cash book (bank column) and bank pass book of Mr.X, prepare the bank reconciliation statement for the month ending on 31st March, 1997. Cash Book (Bank Column only) Date 01.3.97 03.3.97 05.3.97 16.3.97 21.3.97 24.3.97 28.3.97 29.3.97 31.3.97 Particulars To Balance b/fd To A To B To C To Interest To D To E To F To G Total Rs. 8,680 1,200 1,620 600 700 1,200 3,500 2,200 2.800 22,500 Total 22,500 Date 02.3.97 03.3.97 08.3.97 12.3.97 21.3.97 24.3.97 28.3.97 31.3.97 Particulars By Salaries & Wages By Interest on Loan By Bank Charges By X By Y By Z By Drawings By Balance c/fd Rs. 3,250 80 5 1,500 200 1,350 800 15,315 1,000 39,680 20,700 1,080 200 37,400 340 11,340 18,980 10,000 1,000 7,640

Bank Reconciliation Statement

105

Extracts of Pass Book of Mr. X In the books of Bank of India, Karve Road Branch, Pune Date 01.4.97 02.4.97 02.4.97 03.4.97 04.4.97 05.4.97 05.4.97 06.4.97 06.4.97 07.4.97 07.4.97 Solution Bank Reconciliation Statement as on 31st March 1997 Bank Balance as per Bank Book Add : Cheques issued but not presented Mr. Z Mr. Y Sub-Total Less : Cheques deposited but not cleared Mr. E Mr. D Mr. F Mr. G Sub-Total Bank Balance as per Bank Statement or Pass Book 7,165 3,500 1,200 2,200 2,800 9,700 1,350 200 1,550 16,865 15,315 Particulars Balance b/fd To Z By E By D To Insurance Premium To M By Cash By F To Y By G To Interest 500 200 2,800 700 1,200 1,000 2,200 1,350 3,500 1,200 Withdrawals Deposits Dr/Cr Cr Cr Cr Cr Cr Cr Cr Cr Cr Cr Cr Balance 7,165 5,815 9,315 10,515 9,815 8,615 9,615 11,815 11,615 14,415 13,915

106

Management Accounting

Illustration Following particulars are extracted from the books of accounts of Mr. Bose for the month ending 31st March, 1989. a. b. c. Bank balance as per cash book Rs. 7,000. Cheques issued but presented after 31st March, 1989 Rs. 1,000. Three cheques were issued for Rs. 500, Rs. 1,000 and Rs. 1,500 respectively, but the cheque for Rs. 1,000 was presented on 3rd April, 1989. Cheques issued but not recorded in the cash book Rs. 750. Cheques deposited but credited after 31st March, 1989 Rs. 250. Three cheques were deposited for Rs. 1,000, Rs. 1,200 and Rs. 1,600 respectively, but the cheque for Rs. 1,600 was credited on 2nd April. Cheques deposited into the bank but not recorded in the cash book Rs. 1,000. Debit side of the cash book was overcast by Rs. 500. Credit side of the cash book was undercast by Rs. 800. Bank interest credited for Rs. 150 and debited for interest Rs. 50 not recorded in the cash book. Dividend collected by the bank not recorded in the cash book Rs. 1,000. A debtor directly deposited into bank but not recorded in the cash book Rs. 500. Rs. 1,000 in respect of dishonoured cheques appeared in the pass book but not in the cash book. Bank met a Bill Payable of the firm Rs. 1,500 on 30th March, 1989 under an advice to the firm on 2nd April, 1989. Banks charges for a cheque book Rs. 5 were entered in the cash book twice. A cheque for Rs. 50 drawn by Mr. Mukherjee had been charged to Mr. Boses account in error in March, 1989.

d. e. f.

g. h. i. j.

k. l. m.

n.

o. p.

Prepare the bank reconciliation statement as on 31st March, 1989 before and after making the necessary adjustments in the cash book.

Bank Reconciliation Statement

107

Solution Bank Reconciliation Statement as on 31st March, 1989 (Before making adjustments in the cash book) Bank Balance as per Bank Book Add : a. Cheques issued but not presented b. Cheques issued but not presented c. Cheques deposited but not recorded in cash book d. Bank Interest credited not credited in cash book e. Dividend collected not entered in cash book f. Deposits made in bank not entered in cash book Sub-Total Less : a. Cheques deposited but not cleared b. Cheques issued but nor recorded in cash book c. Cheques deposited but not cleared d. Debit side of cash book overcast e. Credit side of cash book undercast f. Bank Interest debited not debited in cash book g. Bill paid by bank not entered in cash book h. Cheques dishonoured not recorded in cash book i. Cheque wrongly debited by bank Sub-Total Bank Balance as per Bank Statement or Pass Book Cash Book (Bank Column only) Particulars To Balance b/fd To Cheques deposited To Interest Received Account To Dividend Received Account To Debtors To Bank Charges (debited twice) Rs. 7,000 1,000 150 1,000 500 5 Particulars By Cheques issued By Debit side overcast By Credit side undercast By Bank Charges By Debtors (Dishonoured cheques) By Creditors By Balance c/fd Total 9,655 Total Rs. 750 500 800 50 1,000 1,500 5,055 9,655 250 750 1,600 500 800 50 1,500 1,000 50 6,500 5,155 g. Bank charges recorded twice in cash book 1,000 1,000 1,000 150 1,000 500 5 4,655 11,655 7,000

108

Management Accounting

Bank Reconciliation Statement as on 31st March, 1989 (After making adjustments in the cash book) Bank Balance as per Bank Book Add : a. Cheques issued but not presented Sub-Total Less : a. Cheques deposited but not cleared b. Wrong debits given by bank for cheque Sub-Total Bank Balance as per Bank Statement or Pass Book Illustration From the following particulars, prepare the bank reconciliation statement for Mr. S.Sarkar as on 31st December, 1985 before and after making necessary adjustments in the cash book. a. b. c. d. e. f. g. h. i. j. k. Bank Balance as per cash book Rs. 610 (Credit). Cheques issued but not presented Rs. 3,000. Cheques deposited but not cleared Rs. 2,500. A cheque drawn for Rs. 100 has been incorrectly entered as Rs. 10 in the cash book. A debtor directly deposited into Sarkars bank account but not recorded in the cash book Rs. 1,000. Payment side of the cash book was undercast by Rs. 500. A cheque for Rs. 5,000 drawn by Mr. Banerjee has been charged to Sarkars account in error. Bank paid a Bill Payable for Rs. 1,450 but it was recorded in the cash book as Rs. 1,540. The receipt column of cash book was overcast by Rs. 1,000. Discount allowed Rs. 410 has been entered through mistake with the cheque in the bank column of the cash book. Pursuant to instructions dated 30th December, 1985, asking the banker to transfer Rs. 10,000 to fixed deposit account and entry for this was made in the cash book but the bank acted in January 1986. The bank debited the account with Rs. 500 being the amount of cheque received from a customer and returned unpaid but not entered in the cash book. Cheques amounting to Rs. 300 though actually banked were not entered in the cash book. 5,155 1,850 50 1,900 5,055 2,000 7,055

l. m.

Bank Reconciliation Statement

109

Solution Bank Reconciliation Statement as on 31st December, 1985 (Before making adjustments in the cash book) Bank Balance as per Cash Book (Overdraft) Add : a. Cheques deposited but not cleared b. Cheque for Rs. 100, entered as Rs. 10 c. Payment side of cash book undercast d. Wrong debit in pass book for Mr. Banerjees Cheque e. Receipt column of cash book overcast f. Discount allowed treated as receipt of cheque in the cash book g. Cheque dishonoured Sub-Total Less : a. Cheques issued but not presented b. Amount deposited by debtor in bank account c. Bill Paid for Rs. 1,450 entered as Rs. 1,540 d. Cheques deposited but not entered in cash book c. Transfer to fixed deposit Bank Balance as per Bank Statement Cash Book (Bank Column only) Particulars To Debtor To Creditor To Fixed Deposit Account To Debtors Rs. 1,000 90 10,000 300 Particulars By Balance b/fd By Creditor By Payment side undercast By Receipt side overcast By Discount By Debtors By Balance c/fd Total 11,390 Total Rs. 610 90 500 1,000 410 500 8,280 11,390
Management Accounting

610 2,500 90 500 5,000 1,000

410 500 10,000 10,610 3,000 1,000 90 300 10,000 14,390 3,780

110

Bank Reconciliation Statement as on 31st December, 1985 (After making adjustments in the cash book) Bank Balance as per Bank Book Add : a. Cheques issued but not presented Sub-Total Less : a. Cheques deposited but not cleared b. Wrong debits given by bank for cheque Sub-Total Bank Balance as per Bank Statement or Pass Book Illustration Following are the cash book and pass book of Mr. X for the month of April, 2002. Cash Book (Bank Column only) Date 01.4.02 04.4.02 08.4.02 13.4.02 18.4.02 21.4.02 25.4.02 30.4.02 Particulars To balance b/fd To Sales A/c To P A/c To M A/c To Kamal A/c To Furniture A/c To Sales A/c To F A/c Rs. 12,500 8,000 1,500 3,400 4,600 1,200 3,800 3,000 Date Particulars Rs. 4,000 3,200 6,000 2,500 5,000 7,500 3780 8,280 3,000 11,280

01.4.02 By Salaries (C.No. 183) 06.4.02 By Purchases (C.No. 184) 11.4.02 By Machinery (C.No. 185)

15.4.02 By Omprakash (C.No. 186) 1,000 19.4.02 By Drawings (C.No. 187) 23.4.02 By K A/c (C.No. 188) 27.4.02 By S A/c (C.No. 189) 30.4.02 By Printing (C.No. 190) 30.4.02 By Balance c/fd 800 2,000 1,000 500 19,500 38,000

38,000

Bank Reconciliation Statement

111

Pass Book Date 01.4.02 02.4.02 06.4.02 06.4.02 10.4.02 16.4.02 17.4.02 20.4.02 24.4.02 28.4.02 28.4.02 30.4.02 30.4.02 30.4.02 Particulars By Balance b/fd To Cheque By Cheque To Cheque By Cheque By Cheque To Cheque By Cheque By Cheque To Cheque To Cheque By Interest By Deposit (K.Sen) To Charges 10 185 189 6,000 1,000 100 3,000 187 800 4,600 3,800 184 3,200 1,500 3,400 183 4,000 8,000 C.No. Withdrawals Deposits Dr/Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Balance 12,500 8,500 16,500 13,300 14,800 18,200 17,400 22,000 25,800 19,800 18,800 18,900 21,900 21,890

You are required to prepare a Bank Reconciliation Statement as on 30th April 2002. Solution Bank Reconciliation Statement as on 30th April, 2002 Bank Balance as per Cash Book Add : a. Cheques issued but not presented (Rs. 1,000 + Rs. 2,000 + Rs. 500) b. Deposited by K.Sen c. Interest credited by bank, not in cash book 3,500 3,000 100 6,600 Sub-Total Less : a. Cheques deposited but not cleared (Rs. 1,200 + Rs. 3,000) b. Bank Charges debited by bank Sub-Total Bank Balance as per Bank Statement or Pass Book 4,200 10 4,210 21,890 26,100 19,500

112

Management Accounting

Illustration Fun Fare Limited have a current account with National Bank Limited. The following is the extract from the Banks books of account for the last week of June, 1988. Particulars Balance b/fd Gopal Brothers Madhu Industries N Traders Ram Gopal Sons Gopal Brothers Ourselves Dividend Warrants Incidental Charges Interest on Loan Lal Chand It is understood that a. b. c. Cheque no. 214 drawn in favour of T.W.Traders for Rs. 2,100 was not yet presented to the bank. Advice regarding the incidental charges, interest on loan and dividend warrants reached Fun Fare Limited only in July. Cheque favouring Lal Chand was towards rent for the month of June. 217 10 900 1,000 215 216 4,100 2,400 500 213 7,200 7,500 212 4,000 5,000 C.No. Withdrawals Deposits Dr/Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Balance 21,000 17,000 22,000 14,800 22,300 18,200 15,800 16,300 16,290 15,390 14,390

From the above data you are required to prepare a cash book (bank column only) of Fun Fare Limited and a bank reconciliation statement in their books at the end of the month. Solution : Cash Book (Bank Column only) Date 30.6.88 Particulars To Balance b/fd To Madhu Industries To Ram Gopal Rs. 21,000 5,000 7,500 Date Particulars Rs. 4,000 7,200 2,100 4,100 2,400 1,000 12,700 33,500

30.6.88 By Gopal Brothers By N Traders By T W Traders By Gopal Brothers By Cash By Rent By Balance c/fd

33,500

Bank Reconciliation Statement

113

Bank Reconciliation Statement as on 30th April, 2002 Bank Balance as per Cash Book Add : a. Cheques issued but not presented b. Dividend collected by bank, not in cash book 2,100 500 2,600 Sub-Total Less : a. Incidental charges debited by bank b. Interest on Loan debited by bank Sub-Total Bank Balance as per Bank Statement or Pass Book 10 900 910 14,390 15,300 12,700

QUESTIONS 1. What do you mean by Bank Reconciliation Statement ? What are the reasons for difference between the balance shown by cash book and the one shown by the pass book? What are the different causes of discrepancy between bank balance as per cash book and pass book ? What is Bank Reconciliation Statement ? Why is it prepared ?

2.

3.

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Management Accounting

PROBLEMS Q. 1 The Bank account of Mukesh was balanced on 31st March, 1992. It showed an overdraft of Rs. 5,000. The Bank Statement of Mukesh showed a credit balance of Rs. 76,750. Prepare a Bank reconciliation statement taking the following information into account a. b. c. Cheques issued but not presented for payment till 31st March, 1992 Rs. 12,000. Cheques deposited but not collected by bank till 31st March, 1992 Rs. 20,000. Interest on term loan Rs. 10,000 debited by bank on 31st March, 1992 but not accounted in Mukeshs books. Bank charges Rs. 250 was debited by bank but accounted in the books of Mukesh on 4th April, 1992. An amount of Rs. 1,00,000 representing collection of Mukeshs cheques was wrongly credited to the personal account of Mukesh by the bank in their bank statement.

d.

e.

Q. 2 From the following particulars, prepare a Bank Reconciliation Statement as on 31st December, 1993. a. On 31st December, 1993, the cash book of a firm showed a bank balance of Rs. 6,000 (Debit Balance). Cheques had been issued for Rs. 5,000, out of which cheque worth Rs. 4,000 only were presented for payment. Cheques worth Rs. 1,400 were deposited in the bank on 28th December, 1993 but had not been credited by the bank. In addition to this, one cheques for Rs. 500 was entered in the cash book on 30th December, 1993 but was banked on 3rd January, 1994. A cheque from Susan for Rs. 400 was deposited in the bank on 26th December, 1993 but was dishonoured and the advice was received on 3rd January, 1994. Passbook showed bank charges of Rs. 20 debited by the bank. One of the debtors deposited a sum of Rs. 500 in the bank account of the firm on 20th December, 1993 but the intimation in this respect was received from the bank on 2nd January, 1994. Bank Passbook showed a credit balance of Rs. 5,180 on 31st December, 1993.

b.

c.

d.

e. f.

g.

Bank Reconciliation Statement

115

Q. 3 On 31st May, 1994, the cash book of ABC Ltd. showed a bank overdraft of Rs. 1,234. On an examination of the cash book and bank pass book, the following information was gathered a. Two cheques received from P and Q for Rs. 234 and Rs. 456 respectively were deposited with the bank on 30th May, 1994, but they were cleared only on 1st June 1994. A cheque for Rs. 345 issued on 26th May, 1994 was presented to the bank for payment on 3rd June, 1994. A cheque for Rs. 567 deposited by a customer in the companys account with bank directly on 25th May, 1994. Rs. 5,678 being proceeds of a bill collected on 30th May, 1994 did not appear in the cash book. A bill payable for Rs. 5,789 was duly paid off on 31st May, 1994 according to the instructions of the company, entry of which was made in the cash book on 1st June, 1994. Interest on overdraft Rs. 111 appears in the pass book.

b.

c.

d. e.

f.

Q. 4 On 31st January, 1988, my cash book showed a bank overdraft of Rs. 12,500. On comparing it with the pass book, following differences were located a. Cash and cheques amounting Rs. 1,340 were sent to bank on 27th January, but cheques worth Rs. 230 were credited on 2nd February and one cheque for Rs. 45 was returned by them as dishonoured on 4th February. During the month of January, I issued cheques worth Rs. 1,760 to my creditors. Out of these, cheques worth Rs. 1,370 were presented for payment on 5th February. According to my standing orders, the bankers have paid during the month of January the following d. e. f. g. Life insurance premium Rs. 170 Driving license fee Rs.40

b. c.

My bankers have collected Rs. 150 as dividend on the shares. My bankers have given me wrong credit for Rs. 150. A bill receivable for Rs. 100 discounted with the bank in December, 1987 has been dishonoured on 31st January, 1988. Interest charged by the bank Rs. 125.

Prepare a bank reconciliation statement on 31st January, 1988.

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Management Accounting

Q. 5 From the following particulars, find out adjusted bank balance as per cash book and prepare thereafter bank reconciliation statement as on 31st December, 1995 of Raja Brothers Particulars Bank Overdraft as per Cash Book Cheques deposited as per bank statement but not entered in cash book Cheques recorded for collection but not sent to the bank Credit side of bank column cast short Bank charges recorded twice in the cash book Customers cheques returned as per bank statement only Cheques issued but dishonoured on technical grounds Bills collected by bank directly Cheques received entered twice in cash book Rs. 80,000 3,000 10,000 1,000 100 4,000 3,000 20,000 5,000

Q. 6 The cash book of a firm showed an overdraft of Rs. 30,000 on 31st March, 1999. A comparison of the entries in cash book and pass book revealed that a. On 22nd March, 1999, cheques totaling Rs. 6,000 were sent to bankers for collection. Out of these, a cheques for Rs. 1,000 was wrongly recorded on the credit side of the cash book and cheques amounting to Rs. 300 could not be collected by bank before 1st April, 1999. A cheque for Rs. 4,000 was issued to a supplier on 28th March, 1999. The cheque was presented to bank on 4th April, 1999. There were debits of Rs. 2,600 in the pass book for interest on overdraft and bank charges, but the same had not been recorded in the cash book. A cheque for Rs. 1,000 was issued to a creditor on 27th March 1999, but by mistake the same was not recorded in the cash book. The cheque was however duly encashed on 31st March, 1999. As per standing instructions, the banker collected dividend of Rs. 500 on behalf of the firm and credited the same to its account by 31st March, 1999. The fact was however intimated to the firm on 3rd April, 1999.

b.

c.

d.

e.

You are required to prepare a bank reconciliation statement as on 31st March, 1999.

Bank Reconciliation Statement

117

Q. 7 On 31st March, 1998, Mehtas Pass Book showed a debit balance of Rs. 6,350. From the following information, prepare a Bank Reconciliation Statement as on that date 1. Out of total cheques of Rs. 6,000 deposited into the bank in March. 1998, one cheque of Rs. 500 was collected on 28th March, 1998 and another cheque of Rs. 1,000 was collected on 3rd April, 1998. The bank had paid a premium of Rs. 300 on 17th March for which there was no entry made in the cash book. The total of debit side bank column of cash book was undercast by Rs. 100. Amount withdrawn from the bank on 26th March Rs. 200 was not recorded in the cash book at all. During March, cheques issued amounted to Rs. 2,000 of which cheques for Rs. 1,500 were presented to the bank on 2nd April 1998.

2. 3. 4.

5.

Q. 8 D. Diwakars Pass Book shows a balance of Rs. 5000 (Credit) on 30th June, 1998. His cash book shows a different balance. On an examination, it is found that a. b. No record has been made in the cash book for dishonour of a cheque for Rs. 100. Cash and cheques amounting to Rs. 700 were paid into the bank on 29th June, 1998 and the same had not been entered in the pass book. Bank charges of Rs. 15 have not been entered in the cash book. Cheques amounting to Rs. 1,800 issued by P. Prabhakar and paid into the bank on 28th June, 1998 had not been credited.

c. d.

Prepare a bank reconciliation statement as on 30th June, 1998. Q. 9 On 30th September 1998, cash book of a firm showed a bank balance of Rs. 7,500. From the following information, prepare a bank reconciliation statement showing the balance as per pass book a. Cheques amounting to Rs. 1,200 were paid on 28th September, 1998 had not been credited by the bank. One cheque for Rs. 375 was entered in the cash book on 28th September, 1998 but was banked on 3rd October, 1998. Cheques issued for Rs. 900 had not yet been presented for payment at the bank.

b.

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Management Accounting

c.

A cheque for Rs. 200 paid on 26th September, 1998 was dishonoured but the advice was received only on 3rd October, 1998. Bank charges of Rs. 15 were debited in the pass book by the bank. There was an entry in the pass book for the receipt of Rs. 600 collected by the bank as interest.

d. e.

Q. 10 From the following particulars, ascertain the balance by means of a statement that would appear in the pass book of Mr. S.Gavaskar as on 31st December 1998. a. b. c. d. e. f. Overdraft as per Cash Book Rs. 4,558. Interest on overdraft for six months ending 31st December, 1998 Rs. 120. Bank charges debited in the pass book Rs. 24. Cheques drawn but not cashed by the customers prior to 31st December, 1998 Rs. 1,326. Cheques paid into the bank but not cleared before 31st December, 1998 Rs. 2,412. A Bill Receivable originally discounted with the bank in November 1998 is dishonoured Rs. 800.

Q. 11 From the following particulars, ascertain the balance that would appear in the cash book of Mr. M. Ranganathan as on 31st December, 1998 a. b. Overdraft balance as per Pass Book Rs. 24,240. Cheques amounting to Rs. 8,200 were paid into the bank on 28th December, 1998 out of which only Rs. 600 was credited by the bank in the pass book till 31st December, 1998. Cheques for Rs. 5,400 were issued on 28th December, 1998 out of which only one cheque for Rs. 800 was presented for payment. There is a debit of Rs. 200 for interest and Rs. 50 for bank charges in the pass book which have not been entered in the cash book. Rs. 400 debited to bank account in the cash book has been omitted to be banked. There was a wrong debit of Rs. 600 in the pass book.

c.

d.

e. f.

Bank Reconciliation Statement

119

Q. 12 On 30th June, 1990, the pass book of Sunil & Co. showed a balance of Rs. 9,800 as cash at bank a. Prior to that date, they had issued cheques amounting to Rs. 3,500, of which, cheques amounting to Rs. 1,900 have so far been presented for payment. Out of the cheques for Rs. 2,000 paid by him into the bank before that date, only cheques for Rs. 1,200 were credited in the pass book. He had also received a cheque for Rs. 680 which although entered in the cash book had been omitted to be paid into bank. The bank had collected dividend directly and credited them.

b.

c.

d.

Q. 13 From the following particulars, prepare a Bank Reconciliation Statement as on 28th February, 1989. Thiru Pandiyan had an overdraft balance of Rs. 80,500 as shown by the bank columns of the cash book. Cheques amounting to Rs. 10,000 had been paid into the bank on 24th February, 1989 but of these only Rs. 7,500 were credited in the pass book. He had issued cheques amounting to Rs. 25,000, of which Rs. 20,000 worth only seem to have been presented. The bank has debited in the pass book Rs. 750 for interest. A cheque for Rs. 600 which was debited in the bank column in the cash book has been omitted to have been presented. An entry appears in the pass book for Rs. 3,000 for a direct deposit by a customer of Thiru Pandiyan. Q. 14 On 31st March 1991 the cash book of Mr. X showed a bank balance of Rs. 14,850. While verifying with the pass book, the following facts were noted a. Cheques sent in for collection before 31st March, 1991 and not credited by bank amounted to Rs. 845. Cheques issued before 31st March, 1991 but not presented for payment amounted to Rs. 885. The banker has debited a sum of Rs. 100 towards the bank charges and credited Rs. 250 for interest received and Rs. 1,000 for dividend collected. The banker has given a wrong credit for Rs. 250. Mr. Y has paid into the bank a sum of Rs. 300 on 28th March, 1991 which has not been entered in the cash book. A cheque for Rs. 200 sent for collection returned dishonoured has not been entered in the cash book.

b. c.

d. e.

f.

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Management Accounting

Q. 15 Find out the balance as per pass book from the following particulars a. b. c. d. e. Bank overdraft as per cash book on 30th April, 1992 was Rs. 2,000. Cheque issued but not presented for payment Rs. 1,350. Cheques deposited but not yet collected by the banker Rs. 500. Bank charges Rs. 80 debited by the bank not yet entered in the cash book. Interest on investments collected by the bankers and credited in the pass book amounted to Rs. 905.

Q. 16 From the following particulars, ascertain the balance that would appear in the cash book of B as on 31st December, 1998, before and after making necessary adjustments a. b. c. d. e. f. Overdraft as per pass book as on 31st December 1998 Rs. 13,880. Interest on overdraft for six months ending 31st December 1998 not yet entered in the cash book Rs. 240. Bank charges for the above period not yet entered in the cash book Rs. 60. Cheques drawn but not encashed by customers before 31st December, 1998 Rs. 3,300. Cheques paid into the bank but not cleared before 31st December, 1998 Rs. 4,340. A Bill Receivable, discounted with the bank in November, dishonoured on 31st December, 1998 Rs. 1,000.

Q. 17 From the following particulars taken on 31st December, 1989, you are required to prepare a bank reconciliation statement to reconcile the bank balance shown in the cash book with that shown in the pass book a. b. c. d. e. f. Balance as per pass book on 31st December, 1989 Rs. 1,027 (Credit). Four cheques drawn on 31st December but not cleared till January Rs. 1,144. Interest on overdraft not entered in the cash book Rs. 51. Three cheques received on 30th December, 1989 and entered in the bank column of cash book but not lodged in bank for collection till 3rd January, Rs. 5,280. Cost of cheque book Rs. 5 entered twice erroneously in cash book in November. A Bill Receivable for Rs. 250 on 29th December, 1989 was passed to the bank for collection on 28th December, 1989 and was entered in the cash book forthwith, whereas the proceeds were credited in the pass book only in January following. 121

Bank Reconciliation Statement

g.

Chamber of Commerce subscription Rs. 10 paid by bank on 1st December, 1989 had not been entered in the cash book. Bank Charges of Rs. 5 had been debited in the pass book twice erroneously.

h.

Q. 18 On 30th June, 1981, the pass book of M/s Thin and Short showed a balance of Rs. 2,000 at the bank. They had sent cheques amounting to Rs. 10,000 to the bank before 30th June, 1981 but it appears from the pass book that cheques worth Rs. 9,000 had been credited before that date. Similarly, out of the cheques for Rs. 5,000 issued during the month of June, cheques for Rs. 4,000 were presented and paid in July. The pass book showed the following payments a. b. Rs. 320 as premium according to standing instructions. Rs. 2,000 against a promissory note as per the instructions.

The pass book showed that the bank had collected Rs. 1,800 as interest on Government Securities. The bank had charged as interest Rs. 50 and incidental expenses Rs. 20. There was no entry in the cash book for the payment of interest etc. A bill sent for collection was returned dishonoured on 29th June amounting to Rs. 600. Prepare the Bank Reconciliation Statement as on 30th June, 1981. Q. 19 From the following particulars, prepare a bank reconciliation statement showing the balance as per pass book on 31st March, 1989. a. Cheques for Rs. 7,900 was paid into bank in March, 1989 but were credited only in April, 1989. Cheques for Rs. 11,000 were issued in March, 1989 but were cashed in April, 1989 only. A cheque for Rs. 1,000 which was received from a customer was entered in the bank column of the cash book in March, 1989 but the same was paid into the bank in April, 1989 only. The pass book shows a credit of Rs. 2,500 for interest and a debit of Rs. 500 for bank charges. The bank balance as per cash book was Rs. 1,80,000 on 31st March, 1989.

b. c.

d.

e.

122

Management Accounting

Q. 20 From the following particulars, prepare a bank reconciliation statement as at 31st December, 1991. a. b. c. d. e. f. As on 31st December, 1991, bank overdraft as per cash book Rs. 2,49,900. Interest debited in the bank pass book only Rs. 27,870. Cheques issued but not presented for payment Rs. 66,000. Draft deposited in the bank but not yet credited in the pass book Rs. 13,500. Dividend collected by the bank Rs. 42,500 has not yet been entered in the cash book. A direct payment into the bank by a customer Rs. 16,000 has not been recorded in the cash book. Bank column on the debit side of the cash book has been undercast by Rs. 3,500.

g.

Q. 21 From the following particulars, prepare a bank reconciliation statement showing the balance as per cash book as on 31st December, 1997. The following cheques were paid into the bank in December 1997 but were credited by the bank in January, 1998. Premnath Rs. 350 Shaym Lal Rs. 250 Ram Lal Rs. 200

The following cheques were issued by the firm in December, 1997 but were presented for payment in January, 1998. Suresh Rs. 400 Ramesh Rs. 450

A cheque for Rs. 100 which was received from a customer was entered in the bank column of cash book in December, 1997 but was omitted to be banked in the month of December, 1997. The pass book shows a credit of Rs. 100 for interest and a debit of Rs. 20 for bank charges. The bank balance as per pass book was Rs. 6,200 as on 31st December, 1997. Q. 22 According to the cash book of Gopi, there was a balance of Rs. 44,500 standing to his credit on 30th June, 1996. On investigation you find that 1. Cheques amounting to Rs. 60,000 issued to creditors have not been presented for payment till that date.

Bank Reconciliation Statement

123

2.

Cheques paid into bank amounting to Rs. 1,05,000 out of which cheques amounting to Rs. 55,000 only collected by the bank up to 30th June, 1996. A dividend of Rs. 4,000 and rent amounting to Rs. 6,000 received by the bank and entered in the pass book but not recorded in the cash book. Insurance premium (up to 31st December, 1996) paid by the bank Rs. 2,700 not entered in the cash book. The payment side of the cash book had been undercast by Rs. 50. Bank charges Rs. 50 shown in the pass book had not been entered in the cash book. A bill payable for Rs. 2,000 has been paid by the bank but is not entered in the cash book and bill receivable for Rs. 6,000 has been discounted with the bank at a cost of Rs. 100 which has also not been recorded in the cash book.

3.

4.

5. 6. 7.

You are required a. b. to make appropriate adjustments in the cash book. To prepare a statement reconciling it with the bank pass book.

Q. 23 From the following extracts of the cash book (bank column) and bank pass book of Mr.X, prepare the bank reconciliation statement for the month ending on 31st March, 1997. Cash Book (Bank Column only) Date 01.3.97 03.3.97 05.3.97 16.3.97 21.3.97 24.3.97 Particulars To Balance b/fd To D To A To M To N To R Rs. 1,000 750 250 800 2,500 1,700 Date 02.3.97 03.03.97 08.3.97 12.3.97 21.3.97 24.3.97 28.3.97 31.3.97 Total 7,000 Particulars By Drawings By K By Rent By P By S By H By Wages & Salaries By Balance c/fd Total Rs. 500 700 450 650 330 900 770 2,700 7,000

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Management Accounting

Extracts of Pass Book of Mr. X In the books of Bank of Baroda, Pune Date 01.4.97 02.4.97 02.4.97 04.4.97 04.4.97 05.4.97 07.4.97 09.4.97 11.4.97 11.4.97 Particulars Balance b/fd P N C Pal M S H Sen Bose 470 330 900 300 350 500 800 650 2,500 Withdrawals Deposits Dr/Cr Cr Cr Cr. Cr. Cr. Cr. Cr. Cr. Cr. Cr. Balance 1,280 630 3,130 2,780 3,280 4,080 3,750 2,850 3,150 3,620

Prepare a Bank Reconciliation Statement as on 31st March, 1997. Q. 24 On 31st December, 1982, the bank column of the cash book of P shows a debit balance of Rs. 922. On examination of cash book and statement, you find that a. Cheques amounting to Rs. 1,260 issued before 31st December and entered in the cash book were not presented for payment till that date. Cheques amounting to Rs. 500 entered in the cash book as sent to the bank on 31st December were entered in the bank statement after that date. A cheque from a debtor for Rs. 146 had been dishonoured prior to 31st December but no record appeared in the cash book. A dividend warrant for Rs. 76 was paid direct to the bank and nothing appeared in the cash book. Bank interest and charges amounting to Rs. 84 were not entered in the cash book but appeared in the bank statement. There was no entry in the cash book for a club membership subscrption Rs. 20 paid by bankers order in November, 1982. Bank charges for a cheque book received by P Rs. 2 were entered in the cash book twice. 125

b. c.

d.

e.

f.

g.

Bank Reconciliation Statement

h.

A cheque for Rs. 54 drawn by Q had been charged to Ps account in error.

Make appropriate adjustment in the cash book to bring down the correct balance and prepare a bank reconciliation statement reconciling the corrected cash book balance with the balance as per bank statement. Q. 25 When Sweetex Limited received its bank statement for the period ended 30th June, 1984, this did not agree with the balance shown in the cash book of Rs. 2,972 in the companys favour. An examination of the cash book and bank statement disclosed the following a. A deposit of Rs. 492 paid on 29th June 1984 had not been collected by the bank until 1st July, 1984. Bank charges amounting to Rs. 17 had not been entered in the cash book. A debit of Rs. 42 appeared in the bank statement for an unpaid cheque which had been returned marked out of date. The cheque had been re-dated by the customer of Sweetex Limited and paid into the bank again on 3rd July, 1984. A standing order for payment of an annual subscription amounting to Rs. 10 had not been entered in the cash book. On 25th June, 1984, managing director had given the cashier a cheque for Rs. 100 to pay into his personal account at the bank. The cashier had paid the same into companys account by mistake. On 27th June, two customers of Sweetex Limited had paid direct to the companys bank account Rs. 499 and Rs. 157 respectively for the payment of goods supplied. The advices were not received by the company until 1st July and were not entered in the cash book until that date. On 30th March, 1984, the company had entered into a hire purchase agreement to pay by bankers order a sum of Rs. 26 on the 10th day of each month, commencing April. No entries had been made in the cash book. A cheque for Rs. 364 received from Mr. B and paid into the bank had been entered twice in the cash book. Cheques issued amounting to Rs. 4,672 had not been presented to the bank for payment until 30th June, 1984.

b. c.

d.

e.

f.

g.

h.

i.

126

Management Accounting

j.

A customer of the company who received a cash discount 2.5% on his account of Rs. 200 paid the company a cheque on 10th June. The cashier in error entered the gross amount in the bank column of the cash book.

After making the adjustments required by the foregoing, the bank statement reconciled with the balance in the cash book. You are required 1. to show the necessary adjustments in the cash book of Sweetex Limited bringing down the correct balance on 30th June, 1984. to prepare a Bank Reconciliation Statement

2.

Bank Reconciliation Statement

127

NOTES

128

Management Accounting

Chapter 5
RECTIFICATION OF ERRORS

The errors in accounting can be classified into the following main groups a. Errors of Omission These errors refer to a situation where a transaction is totally omitted to be recorded in the subsidiary book or partially omitted while posting from subsidiary books to the ledger. Errors of Commission These errors refer to wrong posting or totalling errors, calculation errors or errors in carrying forward etc. Following are the examples of errors of commission
l l l l l

b.

Posting of wrong amounts Posting to wrong side of account Posting to wrong account Wrong totalling of subsidiary books or ledger accounts Errors while carrying forward figures from one page to another page

c.

Errors of Principle These errors refer to wrong classification of income or expenditure. Following are the examples of errors of principle
l l l l

Purchases of fixed assets recorded in the Purchases Register Revenue expenditure treated as capital expenditure Capital receipt treated as revenue income Revenue receipt treated as capital receipt

d.

Compensating Error These errors refer to a situation where excess or less debits in one or more accounts are compensated by equal amount of excess or less credits in one or more accounts. Due to these errors arithmetical accuracy of the Trial Balance does not get affected.

Rectification of Errors

129

EFFECT OF ERRORS ON TRIAL BALANCE Tallying of Trial Balance is the primary indication about the arithmetical accuracy of the books of account. However, it cannot be the conclusive evidence of the total accuracy of the books of accounts maintained. This is due to the fact that certain errors as stated above do not affect the trial balance. As such, locating the errors requires a lot of skills, particularly when they do not affect the agreement of trial balance. Errors affecting Trial Balance Following errors may affect the agreement of Trial Balance a. Wrong totalling of subsidiary books If the total of any subsidiary books is taken wrongly but the posting to the individual accounts is made correctly, it will affect the agreement of trial balance. Eg. Total of Purchase Register for the month of March is taken as Rs. 1,50,000 instead of Rs. 1,55,000. Posting to the individual accounts of suppliers total to the correct amount of Rs. 1,55,000, but the Purchases Account is debited by Rs. 1,50,000, the trial balance will not agree. Posting on the wrong side of an account If a transaction is posted on the wrong side of the account, the trial balance will not agree. Eg. A payment of Rs. 10,000 made to M/s. Pam Industries is posted on the credit side of M/s. Pam Industries Account, the trial balance will not agree. Omission of posting an amount in the ledger If an amount is entered in the journal or subsidiary book but not posted in the ledger, the trial balance will not agree. Eg. A cash payment of Rs. 1,500 for the conveyance expenses has been entered in the cash book but is not debited to Conveyance Account, the trial balance will not agree. Posting of wrong amount If an amount is wrongly posted to an account, the trial balance will not agree. Eg. A cash payment of Rs. 1,500 for the conveyance expenses has been correctly entered in the cash book, but while posting the same to the Conveyance Account, it is posted as Rs. 150, the trial balance will not agree. Error in balancing If an error has been committed while calculating the closing balance of cash book or a ledger account, the trial balance will not agree.

b.

c.

d.

e.

Errors not affecting the Trial Balance Following types of errors may not affect the agreement of Trial Balance. a. Errors of Principle If the revenue expenditure is treated as capital expenditure or if revenue receipt is treated as capital receipt or if capital expenditure is treated as revenue expenditure or if capital receipt is treated as revenue receipt, it will not affect the agreement

130

Management Accounting

of trial balance. Eg. An amount of Rs. 10,000 paid for maintenance of machinery. Instead of posting this amount to Machinery Maintenance Account, it is debited to Machinery Account, the trial balance will still agree but it will not show a true and fair view. b. Errors of Omission If a transaction is totally omitted while making the entries in the books of accounts, it will not affect the agreement of trial balance. Eg. A bill for the purchase of material worth Rs. 15,000 has been received, but it is not entered in the Purchase Register at all, the trial balance will still agree but it will not show a true and fair view. Errors of Commission If an amount is posted to the correct side of a wrong account, it will not affect the agreement of trial balance. Eg. A payment is Rs. 25,000 made to Mr. Salim is debited to the account of Mr. Sham, the trial balance will still agree but it will not show a true and fair view. Recording of wrong amount in the books of prime entry or subsidiary books If a transaction is wrongly entered in the book of prime entry or the subsidiary book and then correctly posted to the correct account, it will not affect the agreement of trial balance. Eg. Stationary worth Rs. 4,500 has been purchased but it is entered as Rs. 4,700 in the cash book, the trial balance will still agree but it will not show a true and fair view. Compensating Errors If one type of error is compensated by the error of the opposite nature, it will not affect the agreement of trial balance. Eg. While balancing the traveling expenses account, the closing debit balance is taken as Rs. 1,40,000 instead of Rs. 1,50,000. Similarly, while balancing the sales account, the closing credit balance is taken as Rs. 28,90,000 instead of Rs. 29,00,000. The trial balance will still agree but it will not show a true and fair view.

c.

d.

e.

Steps in locating the errors If the errors result into the disagreement of trial balance, following steps should be taken to locate the errors. a. b. Total of all the subsidiary books and cash book should be checked carefully. Similarly, the total of trial balance should be checked carefully. It should be ensured that all the opening balances have been correctly brought forward in the current years books of account. It should be ensured that all the ledger accounts have been properly balanced and the balances of all the ledger accounts have been reflected in the Trial Balance. If an amount of Rs. 24,000 is debited to a certain account instead of crediting the same to the same account, the difference between the debit side and credit side of trial balance 131

c.

d.

Rectification of Errors

will be Rs. 48,000. As such, the difference in trial balance should be halved to locate such errors. e. If the difference in the trial balance is divisible by 9 without any reminder, it may indicate the transposition or transplacement of the amounts. Eg. If the cash payment of Rs. 176 is posted as Rs. 167, the difference in the trial balance will be divisible by 9. The trial balance of the current year can be compared with the trial balance of the previous year to locate certain highlighting error.

f.

How to rectify the errors The errors should be rectified by any one of the following methods I. In some cases, if the trial balance does not agree but the books have to be closed, the difference is placed to a Suspense Account and the trial balance is tallied. If the credit side of the trial balance is heavy by Rs. 50,000 and same amount is placed on the debit side of Suspense Account. Subsequently, attempts are made to locate the errors and the rectification entries are routed through the Suspense Account. After all the errors have been located, the balance in Suspense Account will become zero. It should be remembered that the Suspense Account is operated till the errors are located and finally the balance in Suspense Account has to become zero. Further, only the errors affecting the agreement of trial balance are routed through the Suspense Account.

Illustration A merchant while balancing his books of account finds that, the trial balance shows excess credit of Rs. 1,700. Being required to prepare the final accounts, he places the difference to a newly opened Suspense Account which he carries forward. In the next accounting year, the following errors are discovered a. Goods bought from Narayan amounting to Rs. 5,000 had been posted to the credit of Narayan as Rs. 5,500. An item of Rs. 1,000 entered in the sales returns book was posted to the debit of Pandey who had returned the goods. Sundry items of furniture sold for Rs. 26,000 had been entered in the sales book. Ignore depreciation and profit or loss on the sale. Discount amounting to Rs. 200 from a creditor had been duly entered in the creditors account, but not posted to discount account.

b.

c.

d.

Draft journal entries necessary for rectifying the abovementioned errors. Prepare the Suspense Account and show the ultimate effect of the errors on the last years profit by preparing the Profit and Loss Adjustment Account.

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Solution a. Goods bought from Narayan had been posted to the credit of Narayan Account by Rs. 5,500 instead of Rs. 5,000. As such, Narayan Account has been credited more by Rs. 500. As such, this excess credit needs to be reversed by passing following entry Narayan A/c. Dr. 500 To, Suspense A/c. 500 b. Goods supplied to Pandey worth Rs. 1,000 should have appeared on the debit side of Pandeys account. Instead of that the entry has been made on the credit side of Pandeys account. This excess credit needs to be reversed by passing the following entry To Suspense A/c. Dr. 2,000 Pandey A/c. 2,000 c. As the amount of furniture sold has been entered in the sales book, sales account has been wrongly credited. This wrong credit needs to be reversed by debiting sales account. The journal entry to be passed is Sales A/c. Dr. 26,000 To Furniture A/c. 26,000 d. Discount received from the creditor has been entered in the creditors account but discount account has not been credited. As such, the error will be rectified by passing the following entry Suspense A/c. Dr. 200 To Discount Received A/c. 200 Suspense Account
Date 1 1 Particulars To Balance b/fd To Discount Recd. A/c. To Balance c/fd Folio Rs. 1,700 200 600 Date 1 1 Particulars By Narayan A/c. By Pandey A/c. Folio Rs. 500

2,000 2,500

2,500 II.

The errors which affect two accounts and which do not affect the agreement of trial balance may be rectified by passing the rectification entries. The basic principle for rectifying the errors by this means suggests the following steps to be taken a. What is the wrong entry passed ?

Rectification of Errors

133

b. c.

What should be the correct entry to be passed ? Nullify the wrong effect by reversing the same and reinstate the correct by passing the rectification entry.

Illustration Pass necessary journal entries to rectify the following errors a. An amount of Rs. 200 withdrawn by the proprietor for his personal use has been debited to trade expenses account. A purchase of goods from Nathan amounting to Rs. 300 has been wrongly entered through the sales book. A credit sale of Rs. 100 to Santhanam has been wrongly passed through the purchase book. Rs. 150 received from Malhotra have been credited to Mehrotra. Rs. 375 paid on account of salary to the cashier Dhawan stands debited to his personal account. A contractors bill for the extension of premises amounting to Rs. 2,750 has been debited to building repairs account. On 25th June, goods of the value of Rs. 500 were returned by Akashdeep and were taken into stock but the returns were entered in the books under date 3rd July i.e. after the expiration of the financial year on 30th June. A bill of Rs. 200 for old office furniture sold to Sethi was entered in the sales daybook. The periodical total of the sales book was cast short by Rs. 100. An amount of Rs. 80 received on account of interest was credited to commission account.

b.

c. d. e.

f. g.

h. i. j.

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Solution a Wrong Entry Correct Entry Rectification Entry b Wrong Entry Correct Entry Rectification Entry Trade Expenses A/c To Cash A/c Drawings A/c To Cash A/c Drawings A/c To Trade Expenses A/c Nathan A/c To Sales A/c Purchases A/c To Nathan A/c Sales A/c Purchases A/c To Nathan A/c Purchases A/c To Santhanam A/c Santhanam A/c To Sales A/c Santhanam A/c To, Purchases A/c To Sales A/c Cash A/c To Mehrotra A/c Cash A/c To Malhotra A/c Mehrotra A/c To Malhotra A/c Dhawan A/c To Cash A/c Salary A/c To Cash A/c Salary A/c To Dhawan A/c Building Repairs A/c To Cash A/c Building A/c To Cash A/c Building A/c To Building Repairs A/c No entry passed 200 200 200 200 200 200 300 300 300 300 300 300 600 100 100 100 100 200 100 100 150 150 150 150 150 150 375 375 375 375 375 375 2,750 2,750 2,750 2,750 2,750 2,750

Wrong Entry Correct Entry Rectification Entry

Wrong Entry Correct Entry Rectification Entry

Wrong Entry Correct Entry Rectification Entry

Wrong Entry Correct Entry Rectification Entry

Wrong Entry

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135

Correct Entry Rectification Entry h Wrong Entry Correct Entry Rectification Entry i Wrong Entry Correct Entry Rectification Entry j Wrong Entry Correct Entry Rectification Entry

Sales returns A/c To Akashdeep A/c Sales returns A/c To Akashdeep A/c XYZ A/c To Sales A/c XYZ A/c To Furniture A/c Sales A/c To Furniture A/c No entry passed Suspense A/c To Sales A/c Suspense A/c To Sales A/c Cash A/c To Commission A/c Cash A/c To Interest A/c Commission A/c To Interest A/c

500 500 500 500 200 200 200 200 200 200

100 100 100 100 80 80 80 80 80 80

QUESTIONS 1. It is said that tallying of Trial Balance is not the conclusive proof of accuracy of the books of account. Why ? What are errors in financial accounting ? What are the different types of errors ? What do you mean by Suspense Account? How is it operated in financial accounting? Can the balance of Suspense Account appear in the Trial Balance in ideal situations? What are errors in financial accounting? Do all the errors affect the Trial Balance? State the errors that affect the Trial Balance and the errors that do not affect the Trial Balance.

2. 3.

4.

PROBLEMS Q.1 Ganesh drew a Trial Balance of his operations for the year ended 31st March 1992. There was a difference in the Trial Balance which he closed with a Suspense Account. On a scrutiny by the Auditors, the following errors were found a. Purchases day book for the month of April 1991, was undercast by Rs. 1,000.

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Management Accounting

b. c. d. e.

Sales day book of October 1991 was overcast by Rs. 10,000. A furniture purchased for Rs. 8,100 was entered in the Furniture Account as Rs. 810. A bill for Rs. 10,000 drawn by Ganesh was not entered in the Bills Receivable Book. A machinery purchased for Rs. 10,000 was entered in the purchase day book.

Pass necessary journal entries to rectify the same and ascertain the difference in the Trial Balance that was shown under the Suspense Account in respect of the above items.

Q.2 A bookkeeper while preparing his Trial Balance finds that the debit exceeds by Rs. 7,250. Being required to prepare the final accounts, he places the difference to a Suspense Account. In the next year, the following mistakes were discovered a. A sale of Rs. 4,000 has been passed through the Purchase daybook. The entry in customers account has been correctly recorded. Goods worth Rs. 2,500 taken away by the proprietor for his use has been debited to Repairs Account. A bill receivable for Rs. 1,300 received from Krishna has been dishonoured on maturity but no entry passed. Salary Rs. 650 paid to a clerk has been debited in his Personal Account. A purchase of Rs. 750 from Raghubir has been debited to his account. Purchase Account has been correctly debited. A sum of Rs. 2,250 written off as depreciation on furniture has not been debited to Depreciation Account.

b.

c.

d. e.

f.

Draft the Journal Entries for rectifying the above mistakes and prepare Suspense Account.

Q.3 The accountant of X prepared the Trial Balance for the year ended 31st March 1996. But there was a difference and the accountant put the difference in Suspense Account. Rectify the following errors found and prepare the Suspense Account. a. b. The total of the Returns Outward book, Rs. 420 has not been posted in the ledger. A purchase of Rs. 350 from Y has been entered in the sale book. However, Ys account has been correctly entered. 137

Rectification of Errors

c. d. e.

A sale of Rs. 390 to Z has been credited to his account as Rs. 290. Old furniture sold for Rs. 5,400 has been entered as Rs. 4,500 in sales account. Goods taken by proprietor, Rs. 500 have not been entered in the books at all.

Q.4 A bookkeeper finds the difference in the Trial Balance amounting to Rs. 1,000 and puts it in the Suspense Account. Later on he detects the following errors a. b. c. d. Purchased goods from Ravi but entered into Sales Book. Received one bill for Rs. 25,000 from Arun but recorded in Bills Payable Book. An item of Rs. 3,500 relating to prepaid rent account was omitted to be brought forward. An item of Rs. 2,000 in respect of purchase returns, had been wrongly entered in the purchase book. Rs. 25,000 paid to Hari against our acceptance were debited to Harish Account. Bills received from Janaki for repairs done to radio Rs. 2,500 and radio supplied for Rs. 45,000 were entered in the Purchase Book as Rs. 46,000.

e. f.

Give rectifying journal entries with full narration and prepare Suspense Account.

Q.5 There is a difference in the Trial Balance of Shri Om. Subsequently, the following errors were found to have been committed. Pass journal entries to rectify them and ascertain the difference in the Trial Balance. a. b. c. d. A sale of Rs. 2,000 to Shanti & Co. was credited to their account. The Returns Inward Book had been cast Rs. 1,000 short. A sale of Rs. 10,000 had been passed through the Purchase Day Book. The customers account, had, however been correctly debited. Rs. 3,750 paid for wages to workmen for making showcases had been charged to Wages Account. A purchase of Rs. 6,710 had been posted to the debit of the creditors account as Rs. 6,170. The creditor was Paras & Co.

e.

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Management Accounting

Q. 6 There was difference in the Trial Balance of Shri Arihant which was put to newly opened Suspense Account. Subsequently, the following mistakes were discovered. Pass journal entries to rectify them and ascertain the difference in the Trial Balance. a. b. Materials costing Rs. 700 in the erection of machinery and the wages paid for amounting to Rs. 400 were included in the Purchase Account and Wages Account respectively. Goods sold under credit terms Rs. 16,900 to Mohan were recorded properly in the Sales Book but were debited to his account as Rs. 19,600 and carriage outward freight paid Rs. 700 chargeable from him were posted to Sales Expenses Account. Sales Returns by Yogesh Rs. 2,300 were correctly recorded in the Sales Returns Book from where they were debited to Yogesh Account by Rs. 3,200. Old furniture originally purchased for Rs. 1,800 written down to Rs. 1,100 was sold for cash Rs. 1,700 and was credited to Furniture Account. Machinery purchased on credit Rs. 17,000 was recorded in Purchase Book and transport charges for the machine Rs. 1,200 were debited to Trade Expenses Account.

c.

d.

e.

Q.7 Give journal entries to rectify the following errors a. b. c. d. e. Rs. 2,500 paid for the purchase of a radio set for the personal use of the proprietor debited to general expenses account. Rs. 1,300, the amount of sale of old machinery, has been posted to sales account. A sum of Rs. 160 paid by way of rent has been debited to landlords personal account. Rs. 245 cost of repairing the floor of room has been charged to buildings account. A payment of Rs. 250 made to Harish Brothers for cash purchase of goods from him stands debited to his account.

Q.8 Rectify the following errors by passing necessary journal entries a. b. Goods taken by the proprietor Rs. 1,500 for gift to his daughter were not recorded at all. Rs. 1,500 received from Praveen against debts previously written off as bad debts have been credited to his personal account. 139

Rectification of Errors

c. d.

Received interest Rs. 150 posted to loan account. A cheque received from Amar, a debtor, for Rs. 2,000 was directly received by the proprietor who deposited it into his personal bank account.

Q.9 While preparing the final accounts for the year ended 31st March 1995, Mr. Smart could not get his Trial Balance agreed. He transferred the difference to Suspense Account and prepared the final accounts. In April 1995, following errors were discovered in the books of accounts for the year 1994-95 a. b. The sales book for January 1995 was undercast by Rs. 1,000. Entertainment expenses Rs.150 incurred on 5th January 1995 were omitted to be posted from cash book to the ledger. Discount column on the receipt side of the cash book for February 1995 was added as Rs. 2,230 instead of Rs. 2,130. A purchase from Mr. Sumer for Rs. 8,200 on 3rd March 1995 was correctly recorded in the purchase book. But the supplier was wrongly debited for the purchase.

c.

d.

Pass the necessary journal entries to rectify the above-mentioned errors without affecting the profit for the year 1995-96. Also prepare Suspense Account and Profit & Loss Adjustment Account. Assume that all the errors have been located.

Q.10 An accountant could not tally the Trial Balance. The difference was temporarily placed to Suspense Account for preparing the final accounts. The following errors were discovered later on a. b. The sales book was undercast by Rs. 350. Entertainment expenses Rs. 95 though correctly entered in the cash book were omitted to be posted in the ledger. Commission of Rs. 25 paid was posted twice, once to discount account and again to commission account. A sales of Rs. 139 to Ramnath, though correctly entered in the sales book was posted wrongly to his account as Rs. 193.

c.

d.

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Management Accounting

You are required to pass the necessary journal entries in the books of the next accounting year so as not to affect the profit of that year.

Q.11 The Trial Balance of N Ltd. does not tally. In order to give it a semblance of agreement, the accountant of the company transfers the difference to a newly opened Suspense Account. Later on, he discovers the following errors a. An item of Rs. 5,850 paid for purchase of a new typewriter for the accounts department has been wrongly passed through the purchases book. An item of Rs. 780 in the sales book has been posted as Rs. 960 in the customers account. An addition in the returns inward book has been cast Rs. 240 short. An item of Rs. 450 appearing in the discount column on the credit side of the cash book has been posted to the credit side of the concerned personal account as Rs. 540. A bill of exchange for Rs. 2,650 accepted by R & Co. and later discounted with the bank has been returned by the bank as dishonoured. On dishonour, the amount of the bill has been debited to sales account.

b.

c. d.

e.

Give journal entries to rectify the above mentioned errors and also show the Suspense Account.

Q.12 Pass journal entries to rectify the following errors a. A purchase amounting to Rs. 1,000 made for a staff member was recorded in the purchases book. Wages paid to workers for installing machinery, Rs. 750 were debited to wages account. A dishonoured bill receivable for Rs. 5,000 returned by the bank with whom it was discounted was credited to bank and debited to bills receivable account. A sum of Rs. 1,000 drawn by the proprietor for his personal use was debited to traveling expenses account.

b. c.

d.

Rectification of Errors

141

Q.13 Pass journal entries to rectify the following errors a. b. c. d. e. A sum of Rs. 100 paid to Suresh was debited to Subhash. A credit sale of Rs. 587 was recorded in the sales book as Rs. 857. Goods sold to Prem for Rs. 170 were returned by him, but no entry was passed in the books. A bill receivable for Rs. 2,000 accepted by Vimal was recorded in bills payable book. Repairs of furniture amounting to Rs. 500 were debited to furniture account.

Q.14 Pass journal entries to rectify the following errors and prepare Suspense Account. a. b. c. d. e. Rs. 1,080 received from Mohan was posted to the debit of his account. Rs. 200 being purchase returns were posted to the debit of purchases account. Rs. 400 received as discount was posted to the debit of discount account. Rs. 1,148 paid for repairs of motor car was debited to motor car account as Rs. 148. Rs. 400 paid to Suresh was debited to Satish.

Assume that there are no other errors.

Q.15 On 28th February 1999, the Trial Balance of X did not agree. X put the difference in a newly opened Suspense Account. Subsequently, following errors were located a. b. The returns inward book for January 1999 had been cast Rs. 1,000 short. A purchase of Rs. 1,671 had been posted to the debit of the creditors account as Rs. 1,617. The creditor is Panna & Co. A sale of Rs. 2,000 to Singhi & Co. was credited to the account of the customer. A sale of Rs. 4,000 has been passed through the purchase book. The customers account has however been correctly debited. While carrying forward the total of sales book from one page to the next, the amount was written as Rs. 1,76,658 instead of Rs. 1,67,568.

c. d.

e.

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Management Accounting

Pass journal entries to rectify the above-mentioned errors. Also prepare the Suspense Account assuming that all the errors have been located.

Q.16 An accountant prepared a Trial Balance on 31st January 2000, which revealed a difference in the books of account. He put the difference in a newly opened Suspense Account. During February 2000, he detected the following errors a. b. The total of the returns outward book, Rs. 4,200 had not been posted in the ledger. A purchase of Rs. 3,500 from Y had not been entered in the purchase book. However, Ys account had been correctly credited with the amount. A sale of Rs. 3,900 to Z had been credited to his account as Rs. 2,900. Furniture sold for Rs. 5,400 had been entered as Rs. 4,500 in the sales book. Goods worth Rs. 500 taken by the proprietor for personal use had not been recorded at all. Wages paid for an installation of machinery Rs. 1,000 had been debited to wages account.

c. d. e.

f.

Pass journal entries to rectify the abovementioned errors and prepare Suspense Account assuming that all the errors have been located.

Q.17 Give journal entries to rectify or adjust the following in the books of both the head office and the branch. a. Goods costing Rs. 16,000 purchased by branch, but payment made by head office. The head office has debited the amount to its own purchase account. Branch paid Rs. 30,000 as salary to a visiting head office official. The branch has debited the amount to salaries account. Depreciation, Rs. 50,000 in respect of branch assets whose accounts are kept in the head office books is to be recorded by both the parties. Expenses Rs. 70,000 to be charged to the branch for work done on its behalf by the head office.

b.

c.

d.

Rectification of Errors

143

Q.18 On finding a difference between two sides of the Trial Balance, the accountant transferred the excess debit of Rs. 770 to a suspense account. Subsequently, the following errors were detected. Give journal entries to rectify the errors and show the suspense account. 1. 2. 3. 4. 5. 6. 7. 8. 9. Repairs to machinery Rs. 2,000 were debited to Machinery Account. A sale of Rs. 900 to Patel was recorded in the Purchases Book. The total of the Returns Inwards Book Rs. 400 was not posted. A purchase of Rs. 590 from Sathe was posted to his account as Rs. 950. The bank column of the receipt side of the cash book was undercast by Rs. 110. A cash sale of Rs. 200 to Ramesh was entered both in the cashbook and sales book. A credit purchase of Rs. 300 from Satish was omitted to be recorded. Cash Rs. 150 paid to Brijmohan was posted twice to his account. A credit balance of Rs. 450 to Malasinghs account was carried forward as Rs. 540 on the debit side.

10. The name of Vinod, a creditor, to whom we owed Rs. 500 was omitted from the list of sundry creditors. Q.19 Rectify the following errors 1. 2. 3. Carriage on machinery is debited to Carriage Account Rs. 100. Goods purchased from Sahani Rs. 531 was debited to his account as Rs. 351. A television purchased for the workers canteen in the factory for Rs. 25,000 was debited to Factory Expenses. An amount of Rs. 15,000 paid for the construction of a new hall in the building was debited to Repairs Account. The total of the Sales Book for the month of February was cast short by Rs. 10. A credit sale of Rs. 575 to Mahendra was debited to Mohinders Account. A sum of Rs. 500 paid to Poonawalla for salary was debited to his personal account. A credit sale of Rs. 1,000 to Rashid was correctly entered in the Sales Book but was posted to the credit of his account in the ledger as Rs. 100. Goods sold to Devidas Rs. 590 was recorded in the Sales Book as Rs. 950.

4.

5. 6. 7. 8.

9.

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NOTES

Rectification of Errors

145

NOTES

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Management Accounting

Chapter 6
COST ACCOUNTANCY
[BASIC CONCEPTS AND PRINCIPLES]

INTRODUCTION : The Institute of Cost and Management Accountants, London has defined the Cost Accountancy as 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 as well as presentation of information for the purpose of managerial decision making.. The analysis of the above definition reveals the following facts. (1) Cost Accountancy is a science, art and practice of a Cost Accountant. Science indicates the possession and the application of relevant systematic knowledge. Art indicates the skill and ability of the Cost Accountant. Practice indicates a continuous effort on the part of the Cost Accountant. The terms costing and cost accounting should not be confused. Costing indicates the process of ascertaining the costs which can be done arithmetically also. Cost accounting indicates the process of recording the costs in a formal and systematic manner with the intention of preparing statistical data therefrom to ascertain the cost. The objects of Cost Accountancy can be threefold. (a) Ascertainment of cost and profitability with the help of various principles, methods and techniques. Cost control This indicates the process of controlling the costs of operating the business. This process, in turn, involves the following stages. To plan the operations (which can be done by the establishment of budgets and standards), execute the plans, measuring the actual performance, comparison of planned and actual performance, computing the variations between planned and actual performance and taking the decisions to maintain favourable variations or to remove unfavourable variations.

(2)

(3)

(b)

Cost Accountancy [Basic Concepts and Principles]

147

(c)

Presentation of information to enable managerial decision making. Unless and until the results of any study or action are presented correctly to the person who takes the decision in respect of the same, the study has no meaning.

CONCEPT OF COST CENTRE : Cost Centre is defined as a location, person, or item of equipment (or a group of these) in or connected with an undertaking, in relation to which costs may be ascertained and used for the purpose of cost control. Correct identification of a cost centre is pre-requisite for the successful implementation of cost accounting process as the costs are ascertained and controlled with respect to the cost centres. Similarly, correct identification of cost centre facilitates the fixation of responsibility in a correct manner. Eg. A person in-charge of a cost centre may be held responsible for the proper functioning and cost control in relation to that cost centre. As cost centres facilitate this control function, in many cases, they are termed as Responsibility Centres. There may not be any fixed principle for deciding the number and size of cost centres. It depends upon the nature and size of organisation, expenditure involved, requirements of management from cost control point of view and so on. However, following pattern of classification may be followed to decide the cost centres. (1) Impersonal and Personal Cost Centres : An impersonal cost centre consists of location or item of equipment (or group of these). Eg. A region of sales, a branch, a department, a grinding machine and so on. A personal cost centre consists of a person or a group of persons. Eg. Finance Manager, Sales Manager, Works Manager and so on. (2) Production and Service Cost Centres : Production cost centre is the one where the production activity is carried on. Eg. Machine shop, Paint shop, Assembly shop and so on. Service cost centre is the one which assists the production activity. Eg. Store Dept., Internal Transport Dept., Labour Office, Maintenance Dept., Accounts/Costing Dept., and so on. CONCEPT OF COST : The term cost indicates the amount of expenditure (actual or notional) incurred on or attributable to, a given thing. The term cost can be viewed from various angles.

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(1)

Direct Cost and Indirect Cost : Direct Cost indicates that cost which can be identified with the individual cost centre. It consists of direct material cost, direct labour cost and direct expenses. It is also termed as Prime Cost. Indirect Cost indicates that cost which cannot be identified with the individual cost centre. It consists of indirect material cost, indirect labour cost and indirect expenses. It is also termed as overheads. As it is not possible to identify these costs with individual cost centres, such identification is done in the indirect way by following the process of allocation, apportionment and absorption. (It is discussed in details in the following chapters).

(2)

Fixed, Variable and Semi-variable/Semi-fixed Cost : Fixed cost indicates that portion of total cost which remains constant at all the levels of production, irrespective of any change in the later. As the volume of production increases, per unit fixed cost may reduce, but not the total fixed cost. Variable cost indicates that portion of the total cost which varies directly with the level of production. Higher the volume of production, higher the variable cost and vice versa, though per unit variable cost remains constant at all the levels of production. Semi-variable or semi-fixed cost indicates that portion of the total cost which are partly fixed and partly variable in relation to the volume of production.

(3)

Controllable Cost and Uncontrollable Cost : Controllable cost indicates that cost which can be controlled by a specific number of person(s) in the organisation. Eg. A person in charge of a responsibility centre may be in the position to control the costs in relation to that responsibility centre. Uncontrollable cost indicates that cost which cannot be controlled by a specific number of person(s) in the organisation. Eg. The costs relating to one responsibility centre cannot be controlled by a person who is in-charge of another responsibility centre. It should be noted here that a clear-cut distinction between controllable and uncontrollable costs may not be possible. The cost which is controllable for one person may not be controllable by another one. In fact, no cost is completely uncontrollable. The degree of controllability varies in relation to a particular individual and a level of management. In a very broad sense, it can be said that the variable costs are controllable at the lower level of management while fixed costs are controllable at the top level of management.

Cost Accountancy [Basic Concepts and Principles]

149

(4)

Normal Cost and Abnormal Cost : Normal Cost indicates that cost which is normally incurred at a certain level of output under normal circumstances. Abnormal cost indicates that cost which is normally not incurred at a certain level of output under normal circumstances.

SPECIAL TYPES OF COST : (a) Opportunity Cost : In very simple language, opportunity cost is the cost of opportunity foregone. The resource like men, material, machine, money etc. may be having various alternative uses each one having some specific yield or return. However, if they are used in one particular way, they cannot be used in any other way. Opportunity cost refers to the return or yield which is not available if the resources are used in any specific manner. Eg. Mr. A has Rs. 1,00,000 to invest. He is having two options open. (i) (ii) Keep the same with some Bank in Fixed Deposit and get the interest of 10% p.a. Invest the money in the business and get the return on investment of 12%. If Mr. A decides to invest the money in business, he cannot get the interest on Fixed Deposit from Bank. As such, opportunity cost of investing the money in the business is in the form of lost interest on Fixed Deposits with the Bank. It should be noted that the opportunity cost itself finds no place in the accounting process. However, it is required to be considered in the decision making process, for the comparison purpose. The returns available from a proposal should be more than the cost of opportunity lost, then and then only the proposal can be accepted. (b) Differential Cost : Differential cost indicates increased or decreased cost due to the increased or decreased volume of operations. While assessing the acceptability of a proposed change, the differential costs are compared with differential revenues, and so long as differential revenues are more than the differential costs, the proposed change may be accepted. (c) Sunk Cost : Sunk cost indicates historical cost which is incurred in past. This type of cost is normally not relevant in the decision-making process. Eg. While deciding about the replacement of a machine, the depreciated book value of the machine may not be relevant being in the form of sunk cost.

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Management Accounting

INSTALLATION OF COSTING SYSTEM : At the outset, it should be noted that if it is decided to install a costing system in an organisation there may not be any standard type of costing system applicable. The details of costing system may be required to be worked out in such a way that they satisfy the individual requirements of the organisation. Following factors will have to be considered before installing a costing system. (a) Nature of the Product : Before installing the costing system, the nature of product in respect of which the system is to be installed will have to be studied. If the product is material intensive, more stress may be necessary on inventory control procedures, if the product is labour intensive, more stress may be necessary on control procedures and so on. (b) Nature of the Organisation : The nature of the organisation may be required to be studied from the various angles. (1) (2) (3) Size and layout of the factory. Organisational structure of the organisation. The procedures presently followed in the respect of accounting of material cost, labour cost and overheads. Management requirements from the cost control point of view.

(4) (c)

Manufacturing Process : Before installing the costing system, the technical process involved in the manufacturing of the product will have to be studied. This may involve the study from the stage of designing of the product, the quantity, quality and mix of the materials used, the degree of automation involved, the production control techniques implemented, the degree of complexities involved in the production process and so on.

(d)

Simplicity and Cost : The costing system to be installed should be simple to understand and easy to operate. The costing system should be economic in terms of cost of installing and operating the system, and the results obtained therefrom should justify the cost.

Cost Accountancy [Basic Concepts and Principles]

151

(e)

Reporting systems : The costing system should be designed in such a way that it generates proper reports in a proper way to facilitate cost control decisions from the managements side. The reporting system should be based upon the principle of Management by Exception. Forms and records required to be maintained to facilitate correct reporting should be designed in such a way that it involves minimum clerical work and minimum cost.

Some problems may arise while installing a costing system in an organisation. However, they are faced mainly where the system is not properly planned, executed and communicated. These problems are definitely not of the costing principles as such and can easily be overcome by having systematic planning and communication procedures. The problems which are usually faced while installing a costing system can be stated as below. (1) The costing system may not be suitable considering the nature of product and nature of business. The employees and the executives may resist the installation of the costing system feeling that it is meant for pointing out their drawbacks. This arises only out of ignorance and suspicion. Lack of cost consciousness among the various levels of management. The cost involved in installing a costing system may be too high. Laxity on the part of various employees to complete the forms of cost office and to forward them to the cost office.

(2)

(3) (4) (5)

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Management Accounting

QUESTIONS 1. Explain the nature of Cost Accounting. Explain the factors which need to be considered for installing a costing system for a medium sized engineering organisation. 2. Write short notes on a) b) Cost Centre Opportunity Cost

Cost Accountancy [Basic Concepts and Principles]

153

NOTES

154

Management Accounting

Chapter 7
ELEMENTS OF COSTS

In case of a typical manufacturing type of operation, the activity may consist of conversion of raw material in the form of finished goods with the help of labour and other services and selling the finished goods in the market to earn the profits. In order to interpret the term cost correctly and to ascertain the cost with respect to the centres, the cost attached with the manufacturing process may be subdivided into what is known as Elements of Cost. Broadly there can be three elements of costs. (A) Material : This is the cost of commodities and materials used by the organization. It can be direct or indirect. Direct Material indicates that material which can be identified with the individual cost centre and which becomes an integral part of the finished goods. It basically consists of all raw materials, either purchased from ourside or manufactured in house. Indirect Material indicates that material which cannot be identified with the individual cost centre. This material assists the manufacturing process and does not become an integral part of finished goods. The examples of this type of material may be consumable stores, cotton waste, oils and lubricants, stationery material etc. (B) Labour : This is the cost of remuneration paid to the employees of the organisation. It can be direct or indirect. Direct Labour Cost indicates that labour cost which can be identified with the individual cost centre and is incurred for those employees who are engaged in the manufacturing process. Indirect Labour Cost indicates that labour cost which cannot be identified with the individual cost centre and is incurred for those employees who are not engaged in the manufacturing process but only assist in the same. The examples of this type of cost are wages paid to foreman/storekeeper, salary of works manager, Accounts/Personnel department salaries etc.
Elements of Costs

155

(C) Expenses : This is the cost of services provided to the organisation (and the notional cost of assets owned). It can be direct or indirect. Direct Expenses are those expenses, which can be identified with the individual cost centres. The examples of these expenses are hire charges of machinery/ equipments required for a particular job, cost of defective work for a particular job etc. Indirect Expenses are those expenses, which cannot be identified with the individual cost centres. The examples of these expenses are rent, telephone expenses, insurance, lighting etc. The above elements of cost can be shown as below. Cost Material Direct Indirect Direct Labour Indirect Direct Expenses Indirect

The aggregate of Direct Material Cost, Direct Labour Cost and Direct Expenses is termed as Prime Cost. The aggregate of Indirect Material Cost, Indirect Labour Cost and Indirect Expenses is termed as Overheads. Overheads : As discussed above, the aggregate of Indirect Material cost, Indirect Labour cost and Indirect Expenses is termed as Overheads. For the proper interpretation and presentation of cost, the term overheads may be further classified as below. (a) (b) (c) (a) Factory Overheads (Also termed as production/works/manufacturing overheads.) Office and Administration Overheads. Selling and Distribution Overheads. Factory Overheads : These overheads consist of all overhead costs incurred from the stage of procurement of material till the stage of production of finished goods. They include :
l

Indirect Material such as consumable stores, cotton waste, oil and lubricants etc.

156

Management Accounting

Indirect Labour Cost such as wages paid to foreman/storekeeper, works managers salary etc. Indirect Expenses such as carriage inward cost, cost of factory lighting/power expenses, rent/insurance/repairs for factory building/machinery, depreciation on factory building or machinery etc.

(b)

Office and Administration Overheads : These overheads consist of all overhead costs incurred for the overall administration of the organization. They include :
l l

Indirect Material such as stationery items, office supplies etc. Indirect Labour cost such as salaries paid to Accounts and Administration staff, Directors remuneration etc. Indirect Expenses such as postage/telephone, rent/insurance/repairs/depreciation on office building, general lighting, legal/audit charges, bank charges etc.

(c)

Selling and distribution Overheads : These overheads consist of all overhead costs insured from the stage of final manufacturing of finished goods till the stage of sale of goods in the market and collection of dues from the customers. They include :
l l

Indirect Material such as packing material, samples etc. Indirect Labour like salaries paid to sales personnel, commission paid to sales manager etc. Indirect Expenses like carriage outwards, warehouse charges, advertisement, bad debts, repairs and running of distribution van, discount offered to customers etc.

Elements of Costs

157

The above classification of overheads can be shown as below : Indirect Material Factory Indirect Labour Indirect Expense Indirect Material Overheads Office/Administration Indirect Labour Indirect Expense Indirect Material Selling & Distribution Indirect Labour Indirect Expense Cost Sheet/Cost Statement : The various elements/components of the cost as discussed above can be presented in the form of a statement, popularly known as Cost Sheet or Cost Statement. The cost sheet may be prepared separately for each cost centre and may have the columns like cost per unit or cost of previous period etc. A Proforma cost sheet is shown below : Direct Material Cost Direct Labour cost Direct Expenses PRIME COST Add : Factory Overheads FACTORY/WORKS COST Add : Office and Administration Overheads TOTAL COST Add : Selling and Distribution Overheads COST OF SALES Add : Profit SALES
Management Accounting

158

The above relationship among the various elements of costs can be explained in a better way with the help of following diagram. PROFIT SELLING & DISTRIBUTION OVERHEADS ADMINISTRATION OVEREHEADS FACTORY OVERHEADS DIRECT EXPENSES PRIME COST DIRECT LABOUR DIRECT MATERIAL Note : The difference between sales and factory/works cost is termed as Gross Profit and the difference between sales and cost of sales is termed as Net Profit or Operating Profit. As such, the difference between Gross Profit and Office and Administration Overheads and Selling and Distribution may be different from the Net Profit or Operating Profit. This Net Profit may be different from the net Profit as disclosed by the financial statement in the form of Profit and Loss Account. This is due to the fact that the Profit and Loss Account considers the various non-operating incomes/expenses or incomes/expenses of purely financial nature (as discussed below) while they may be ignored by the cost statement. (a) Non-operating/Financial Incomes : These represent incomes which arise not as a part of regular operations of the organisation. Eg. Profit on the sale of assets/investment, dividend received, windfall income etc. Due to these, the operating profit as per cost statement may be less than profit as per Profit and Loss Account. (b) Non-operating/Financial Expenses : These represent expenses which arise not as a part of regular operations of the organisation. Such expenses may be in the form of those incurred as a result of policy.
Elements of Costs

COST OF SALES

FACTORY COST

TOTAL COST

SALES 159

Eg. loss on the sale of assets/investment, good-will/ preliminary expenses written off, provision for Income Tax, Interest paid, Dividend paid etc. Due to these, the operating profit as per cost statement may be more than profit as per Profit and Loss Account. As such cost structure may also be presented as below. Sales Less : Factory/Works Cost Gross Profit Less : Office and Administration Overheads Selling and Distribution Overheads Operating Profit Less : Add : Non-Operating/Financial Expenses Non-Operating/Financial Income Net Profit (As per Profit and Loss Account) It goes without saying that if an organisation maintains cost records and financial records separately, there may be a need to reconcile the profits as disclosed by the cost records and the profit as disclosed by the financial records. ILLUSTRATIVE PROBLEMS (1) From the following list of balances, prepare a statement showing Cost of Sales, Gross Profit, Operating Expenses, Operating Profit and Net Profit. Rs. Sales Purchases Sales Returns Salaries : Office Selling Rent and Taxes : Office Selling Stationery and Postage Depreciation Advertising Selling expenses Travelling expenses 160 40,350 22,950 2,700 1,350 4,050 3,850 13,950 4,700 2,350 3,000
Management Accounting

7,80,000 4,83,375 30,000 63,300

Opening Stock Sundry Expenses : Office Selling Closing Stock Dividend on shares Profit and sale of shares Loss on sale of shares Solution : COST STATEMENT (A) Sales Gross Sales Less : Sales Returns Net Sales (B) Prime Cost (Material consumed) Opening Stock Add : Purchases 16,500 8,250

1,14,375

24,750 1,47,750 13,500 4,500 6,000

Rs. 7,80,000 30,000

Rs.

7,50,000

1,14,375 4,83,375 5,97,750

Less : Closing stock

1,47,750 4,50,000

(C) Gross Profit (i.e. A-B) (D) (a) Office and Administration Overheads Salaries Rent and Taxes Stationery and Postage Depreciation Travelling Expenses Sundry Expenses 40,350 2,700 3,850 13,950 3,000 16,500 80,350

3,00,000

Elements of Costs

161

(b) Selling and Distribution Overheads Salaries Rent and Taxes Advertising Selling Expenses Sundry Expenses 22,950 1,350 4,700 2,350 8,250 39,600 (E) (F) Operating Profit (i.e. C-D) (a) Less : Non-operating Expenses Dividend on shares Loss on sale of shares 13,500 6,000 19,500 1,60,550 (b) Add : Non-operating Income Profit on sale of shares (G) Net Profit Notes : (a) From the available details, it appears that the above activity is a trading activity. As such there will be no factory overheads and prime cost will consist of only material cost. In want of sufficient information, depreciation and travelling expenses are treated as office and administration overheads. Dividend on shares may indicate the non-operating income also. However, in want of sufficient information, it is treated as dividend paid by the company i.e. a part of nonoperating expenses. From the books of accounts of M/s. Aryan Enterprises, the following details have been extracted for the year ending March, 1994. Rs. Stock of Materials Opening Closing Materials purchased during the year Direct Wages paid Indirect Wages 162 1,88,000 2,00,000 8,32,000 2,38,400 16,000
Management Accounting

1,19,950 1,80,050

4,500 1,65,050

(b)

(c)

(2)

Salaries to administrative staff Freights Inward Outward Cash Discounts allowed Bad Debts written off Repairs to Plant & Machinery Rent, Rates and Taxes Travelling Expenses Salesmens Salaries and Commission Depreciation Plant & Machinery Furniture Directors Fees Electricity Charges (Factory) Fuel (for boiler) General Charges Managers Salary Factory Office

40,000 32,000 20,000 14,000 18,800 42,400 12,000 6,400 12,400 33,600 28,400 2,400 24,000 48,000 64,000 24,800 48,000

The managers time is shared between the factory and the office in the ratio of 20:80. From the above details, you are required to prepare :a. b. c. d. e. f. Prime Cost Factory Overheads Factory Cost Administration Overheads Selling Overheads Total Cost

Solution : COST SHEET Direct Materials Cost Opening Stock Add : Purchases Less : Closing Stock Rs. 1,88,000 8,32,000 2,00,000 8,20,000 Add : Freight Inward 32,000 Rs.

Elements of Costs

163

Rs.

Rs. 8,52,000

Direct Wages PRIME COST Factory Overheads Indirect wages Repairs to Plant & Machinery Rent, Rates and Taxes Depreciation Plant & Machinery Electricity Charges Fuel for boiler Managers Salary 16,000 42,400 12,000 28,400 48,000 64,000 9,600

2,38,400 10,90,400

2,20,400 FACTORY COST Administration Overheads Salaries Rent, Rates and Taxes Travelling Expenses Depreciation Furniture Directors Fees General Charges Managers Salary 40,000 6,400 12,400 2,400 24,000 24,800 38,400 1,48,400 OFFICE COST Selling Overheads Freight Outward Cash Discount allowed Bad Debts written off Salesmens Salary & Commission 20,000 14,000 18,800 33,600 86,400 TOTAL COST 15,45,600 14,59,200 13,10,800

164

Management Accounting

(3)

An advertising agency has received an enquiry for which you are supposed to submit the quotation. Bill of Materials prepared by the Production Department for the job states the following requirement of material : 10 reams @ Rs. 1800 per ream Rs. 5,000 Rs. 3,000

Paper Ink & Other printing material Other consumables

Some photography is required for the job. The agency does not have a photographer as an employee. It decides to hire a professional photographer who is to be paid professional fees of Rs. 10,000. Estimated job card prepared by the Production Department specifies that services of the following employees will be required for the execution of the job. Monthly remuneration payable to these employees as indicated by the Personnel Department is also given. Artist Copywriter Client Servicing 80 hours. Paid Rs. 12,000 p.m. 75 hours. Paid Rs. 10,000 p.m. 30 hours. Paid Rs. 9,000 p.m.

You can assume that a month consists of 25 working days and one working day consists of 6 working hours. An amount of Rs. 4,000 will be required for the cost of primary packing material. Production overheads are likely to be 40% of direct cost while selling and administration overheads are likely to be 25% of production cost. The agency expects the profit of 10% on basic quotation price. COST SHEET Rs. Direct Materials Cost Paper Ink & Other printing material Other Consumables Primary Packing Material 18,000 5,000 3,000 4,000 30,000 Direct Labour Cost Artist Copywriter Client Servicing 6,400 5,000 1,800 13,200 Rs.

Elements of Costs

165

Direct Expenses Photography Charges DIRECT COST Production Overheads PRODUCTION COST Selling & Administration Overheads TOTAL COST Profit QUOTATION PRICE 10,000 53,200 21,280 74,480 18,620 93,100 10,344 1,03,444

(4)

Pune Equipments Ltd. manufactured and sold 1,000 refrigerators in year ending 31 December, 1984. The Trading and Profit & Loss Account is as below: Trading and P&L Account for the year ending 31.12.84.

To, Cost of material To, Direct wages To, Manufacturing Cost To, Gross Profit

80,000 1,20,000 50,000 1,50,000 4,00,000

By, Sales

4,00,000

4,00,000 By, Gross Profit 1,50,000

To, Mgn. & Staff Salary To, Rent, Rates etc. To, Selling Expenses To, General Expenses To, Income Tax To, Net Profit

60,000 10,000 30,000 20,000 5,000 25,000 1,50,000

1,50,000

For the year ending 31.12.85, it is estimated that : 1. 2. 3. 4. 5. 6. 166 Output and sales will be 1,200 refrigerators. Prices of the materials will rise by 20% on the previous years level. Wages will rise by 5%. Manufacturing cost will rise in proportion to combined costs of materials and wages. Selling cost per unit will remain unchanged. Other expenses will remain unaffected by the rise in output.
Management Accounting

You are required to prepare a cost statement showing the price at which each refrigerator should be marked so as to show profit of 10% on the selling price. Solution : Cost Statement for the Year Ending 31.12.85 (Base - 1,200 Refrigerators) Per Unit Rs. Material Cost Direct Wages Prime Cost Manufacturing Cost (25% of Prime Cost) Factory Cost Management & Staff Salary Rent/Taxes and General Expenses Selling Expenses Cost of Sales Profit (1/9th of Total Cost) Sales Note : (1) Material Cost and Direct Cost increases both due to increase in volume and increase in prices. Calculation of manufacturing cost percentage Present Materials Cost Present Direct Wages Present Prime Cost Present Manufacturing Cost Rs. 80,000 96.00 126.00 222.00 55.50 277.50 50.00 25.00 30.00 382.50 42.50 425,00 Total Rs. 1,15,200 1,51,200 2,66,400 66.600 3,33,000 60,000 30,000 36,000 4,59,000 51,000 5,10,000

(2)

Rs. 1,20,000 Rs. 2,00,000 Rs. 50,000

Manufacturing Cost is 25% of Prime Cost. (3) Expenditure in the form of income tax will be ignored being non-operating expenditure.

Elements of Costs

167

(5)

The standard production for a particular work order is 20 units per day and piece rate wages is 60 paise per unit if daily production is 20 units or more. The rate is 50 paise per unit if production is less than 20 units. Cost of material is 30 paise per unit. It is proposed to charge factory overhead under one of the following methods. (i) (ii) 100% on labour cost. 80% on prime cost.

Tabulate the above data in the form of a suitable statement and indicate in the factory cost per unit, under each of the above methods if the daily production is (a) 15 units (b) 20 units (c) 25 units.

Solution : COST SHEET (a) No. of units produced per day (b) Material cost (Rs) (c) Labour cost (Rs) (d) Prime cost i.e. b+c Alternative I (a) No. of units produced per day (b) Prime Cost (Rs) (c) Factory overheads (Rs) (d) Total factory cost i.e. b+c (e) Factory cost per unit i.e. d/a (Rs) Note : According to Alternative I, Factory Overheads are charged @ 100% on Labour Cost. According to Alternative II, Factory Overheads are charged. @ 80% on Prime Cost. 15 12.00 7.50 19.50 1.30 20 18.00 12.00 30.00 1.50 25 22.50 15.00 37.50 1.50 15 4.50 7.50 12.00 20 6.00 12.00 18.00 25 7.50 15.00 22.50

Alternative II 15 12.00 9.60 21.60 1.44 20 18.00 14.40 32.40 1.62 25 22.50 18.00 40.50 1.62

168

Management Accounting

(6)

X Ltd. manufactures four brands of toys A, B, C and D. If the Company limits the manufacture to just one brand, the monthly production will beA - 50000 Units C - 150000 Units B - 100000 Units D - 300000 Units

You are given the following set of information, from which you are requested to find out the profit or loss made on each brand showing clearly, the following elements. (a) Direct cost (b) Works cost (c) Total cost Brands A Monthly Production (units) Direct Wages (Rs.) Direct Material Cost (Rs.) Selling Price Per Unit (Rs.) 6,750 15,000 50,000 20 B 18,000 27,500 92,500 15 C 40,500 37,500 1,27,500 10 D 94,500 1,05,000 3,80,000 8

Factory overhead expenditure for the month was Rs. 1,62,000. Selling and distribution cost should be assumed @ 20% of works cost. Factory overhead expenses should be allocated to each brand on the basis of the units which could have been produced in a month when a single brand production was in operation.

Solution : From the information given, it is observed that One unit of B is equivalent to 2 units of A. One unit of C is equivalent to 3 units of A One unit of D is equivalent to 6 units of A Expressing the actual production in terms of unit equivalents of product A Product A Product B Product C Product D 6,750 9,000 13,500 15,750 45,000 units. units equivalent of A units equivalent of A units equivalent of A

Elements of Costs

169

The factory overheads of Rs. 1,62,000 are to be distributed over 45,000 equivalent units of product A. As such rate of factory overheads for one unit of Product A will be Rs. 1,62,000 45,000 units = Rs. 3.60/per unit

As such, per unit factory overheads for other products will be Product B - Rs. 3.60/2 = Rs. 1.80/ per unit. Product C - Rs. 3.60/3 = Rs. 1.20/ per unit. Product D - Rs. 3.60/6 = Rs. 0.60/ per unit. On this basis, the cost sheet for each product can be worked out as below. A (a) Direct Material Cost (b) Direct Wages (c) Total Direct Cost i.e. a+b (d) Factory Overheads (e) Works cost i.e. c+d (f) Selling/Distribution overheads 50,000 15,000 65,000 24,300 89,300 17,860 1,07,160 6,750 20 1,35,000 27,840 B 92,500 27,500 1,20,000 32,400 1,52,400 30,480 1,82,880 18,000 15 2,70,000 87,120 C 1,27,500 37,500 1,65,000 48,600 2,13,600 42,720 2,56,320 40,500 10 4,05,000 1,48,680 D 3,80,000 1,05,000 4,85,000 56,700 5,41,700 1,08,340 6,50,040 94,500 8 7,56,000 1,05,960

(g) Cost of Sales e+f (h) Units Sold/Produced (i) (j) Units Selling Price - Rs. Total Sales Rs.

(k) Profit i.e. j-g (7)

A manufacturing company has an installed capacity of 1,20,000 units per annum. The cost structure of the product manufactured is as under Variable Cost (Per unit) Materials Labour (subject to a minimum of Rs. 56,000 per month) Overheads Rs. 8 Rs. 3 Rs. 8

1.

2.

Fixed overheads Rs. 1,04,000 per annum

170

Management Accounting

3.

Semi variable overheads Rs. 48,000 per annum at 60% capacity which increase by Rs. 6,000 per annum for increase of every 10% of the capacity utilization or any part thereof.

The capacity utilisation for the next year is estimated at 60% for 2 months, 75% for 6 months and 80% for the balance part of the year. If the company is planning to have a profit of 25% on the selling price, calculate the estimated selling price for each unit of production. Assume that there is no opening or closing stock. Solution : Capacity Utilisation Months No. of units 60% 2 6000 75% 6 7500 80% 4 8000

Hence, total number of units will be 6000 x 2 months + 7500 units x 6 months + 8000 units x 4 months = 89,000 units Total Materials (Rs.) Labour Overheads Semi-variable Overheads Fixed Overheads Cost of Production Per Unit Cost of Production i.e. 18,69,000/89,000 = Rs. 21 As profit is 25% on the selling price, selling price will be Rs. 28 per unit. (8) AB & Co. manufactures two types of pens P and Q. The cost data for the year ended 30th September, 1990 is as follows Rs. Rs. Rs. Rs. It is further ascertained that : a. b. c. Direct Materials in type P cost twice as much direct materials in type Q. Direct wages for type Q were 60% of those for type P. Production overheads were of same rate for both types. 4,00,000 2,24,000 96,000 7,20,000 96,000 112,000 36,000 8,000 360,000 360,000 135,000 30,000 256,000 256,000 96,000 20,000 7,12,000 7,28,000 2,67,000 58,000 1,04,000 18,69,000

Direct Materials Direct Wages Production Overheads

Elements of Costs

171

d. e. f.

Administration overhead for each was 200% of direct labour. Selling costs were 50 paise per pen for both types. Production during the year Type P Type Q 40,000 1,20,000 units units

g.

Sales during the year Type P Type Q 36,000 1,00,000 units units

h.

Selling prices were Rs. 14 per pen for type P and Rs. 10 per pen for type Q.

Prepare a statement showing per unit cost of production, profit and total sales value and profit separately for two types of pens P and Q. Solution : Cost Statement for the year ended on 30th September, 1990 Particulars Direct Material Direct Wages Production Overheads Administration Overheads a. b. c. d. e. f. g. h. i. j. Cost of Production Production (Units) Per Unit Cost of Production (Rs.) (Being a/b) Sales (Units) Cost of Sales (Being d x c) Selling Cost Total Cost (Being e + f) Per Unit Selling Price (Rs.) Sales (Being d x f) Profit P 1,60,000 80,000 24,000 1,60,000 4,24,000 40,000 10.60 36,000 3,81,600 18,000 3,99,600 14.00 5,04,000 1,04,400 Q 2,40,000 1,44,000 72,000 2,88,000 7,44,000 1,20,000 6.20 1,00,000 6,20,000 50,000 6,70,000 10.00 10,00,000 3,30,000

172

Management Accounting

Working Notes : a. Direct Materials Let per unit direct materials cost of Q be Rs. X. Hence, per unit direct materials cost of P will be 2X Total Direct Materials Cost will be 40,000 units x 2X + 1,20,000 units x X = 4,00,000. Solving for X, we get X = Rs. 2 Hence, Direct Materials Cost for P will be Rs. 1,60,000 and Direct Materials Cost for Q will be Rs. 2,40,000. b. Direct Wages Let rate of labour be Rs. X for P Hence, rate of labour for Q will be 0.6X for Q Total Direct Wages will be 40,000 units x X + 1,20,000 units x 0.6X = 2,24,000 Solving for X, we get X = 2 Hence, Direct Wages Cost for P will be Rs. 80,000 and Direct Wages Cost for Q will be Rs. 1,44,000. (9) A company presently sells an equipment for Rs. 35,000. Increase in prices of labour and material are anticipated to the extent of 15% and 10% respectively in the forthcoming year. Material cost represents 40% of cost of sales and labour cost 30% of cost of sales. The remaining relate to overheads. If the existing selling price is retained, despite the increase in labour and material prices, the company would face a 20% decrease in the existing amount of profit on the equipment.

You are required to arrive at a selling price so as to give the same percentage of profit on increased cost of sales, as before. Prepare a statement of profit/loss per unit showing the new selling price and cost per unit in support of your answer. Solution : Let cost of sales per unit be Rs. X. Then per unit profit will be 35000 X. Per unit cost structure will be as below Material Cost Labour Cost Overheads 0.4X 0.3X 0.3X

After the price increase, per unit cost structures will change as below Material Cost Labour Cost Overheads
Elements of Costs

0.44X 0.345X 0.3X 173

However, after the price increase and existing selling price remaining the same, the profit per unit will come down by 20%. Hence, the following equation will emerge 35,000 (0.44X + 0.345X + 0.3X) = 0.8 (35,000 X) Solving for X, we get X = 24,561. Hence, the existing per unit cost of sales is Rs. 24,561. As such, following is the per unit cost structure with the existing prices and after the price increase, Existing Materials Cost Labour Cost Overheads Cost of Sales Profit Selling Price 9,825 7,368 7,368 24,561 10,439 35,000 Future 10,808 8,473 7,368 26,649 8,351 35,000

Existing profit on cost of sales works out as 10,439 24,561 If the same profit percentage is to be maintained after the cost increase, the new selling price will be 26,649 + 42.5% of 26,649 = Rs. 37,975. (10) A firm has purchased a plant for manufacturing a new product, the cost data for which is given below. Estimated Annual Sales Estimated Costs Material Direct Labour Overheads Administrative Expenses Selling Expenses Rs. 4.00 per unit Rs. 0.60 per unit. Rs. 24,000 per year. Rs. 28,800 per year. 15% of sales. 24,000 units. X 100 = 42.5%

Calculate the selling price if profit per unit is Rs. 1.02. 174
Management Accounting

Solution : Let the selling price be Rs. X Hence, total sales will be Rs. 24000X The cost sheet will be as below Material Cost Direct Labour Overheads Administrative Expenses Selling Expenses 15% of sales Profit Hence, 24000X = 96000 + 14400 + 24000 + 28800 + 3600X + 24480 24000X = 187680 + 3600X 20400X = 187680 X = 9.20 Hence, selling price will be Rs. 9.20 Re. 1.02 per unit 24000 x Rs. 4.00 24000 x Rs. 0.60 96,000 14,400 24,000 28,800 3,600X 24,480

QUESTIONS 1. What do you mean by Elements of Cost? Explain in details. Draw a standard format of cost sheet for a machine tool manufacturing company. Assume suitable data. How the cost is classified into various elements for presenting the same in the form of a cost sheet. Prepare a standard format of cost sheet for a furniture making unit. Assume suitable data.

2.

Elements of Costs

175

PROBLEMS (1) The following figures relates to the trading activities of Hind Traders for the year ended 30.6.79. Prepare a statement showing net operating income. Rs. Sales Purchases Opening Stock Closing Stock Sales Returns Interest on Debentures Advertising Travelling 5,20,000 3,22,250 76,250 98,500 20,000 15,300 4,700 2,000 Office Salaries Rent Stationery & Postage Depreciation Other charges Provision for Tax Rs. 27,000 2,700 2,500 9,300 16,500 40,000

(2)

From the following list of balances, prepare a statement showing net operating income. Rs. Sales Purchases Sales Returns Purchases Returns Opening Stock Closing Stock Rent Received Profit on sale of asset Office Expenses Manufacturing Expenses Selling Expenses Depreciation Interest on Loan Income Tax 5,40,000 1,60,000 40,000 10,000 50,000 60,000 1,50,000 1,00,000 25,000 30,000 10,000 13,000 2,000 150

176

Management Accounting

(3)

A Ltd. is a company which is engaged in the business of executing the various jobs as per the customer requirements. It has received one job from one of the customers for which it is required to submit the quotation. The Production Manager of the company has worked out the following details of the cost in respect of the said job Rs. 40,000 Rs. 50,000 Rs. 5,000 Rs. 4,000 400 Labour Hours @ Rs. 30 per hour 20% of Direct Material 15% of Prime Cost 100 Man-hours @ Rs. 50 per hour 15% of Factory Cost 10% of Total Cost

Raw Materials Bought Out Components Primary Packing Material Consumable Stores Direct Workers Royalty Payable Other Factory Overheads Support from administrative staff Other administration overheads Selling Overheads

What selling price should be quoted by the Company if it intends to earn a profit of 20% on selling price? (4) Honesty Engineering Works has a machining shop in which it manufactures two Auto Parts P1 and P2 out of forgings F1 and F2. For the quarter ending December 1993, following cost data are available 1,50,000 2,00,000 1,53,000 12,000 15,000 16,000 8,000 50,000 68,000 64,400 75,000 8,11,400

Consumption of Raw Materials - F1 - F2 Wages and Salaries Stores and Spares Repairs and Maintenance Power Insurance Depreciation Factory Overheads Administration Overheads Distribution Overheads Total Cost

Elements of Costs

177

You are given further information a. Production and Sales of P1 and P2 were as under P1 Production (Pieces) Sale of above pieces (Rs.) b. 6,000 4,80,000 P2 4,000 5,20,000

Direct wages paid were Rs. 36,000 incase of P1 and Rs. 32,000 for P2. This is used for apportioning Wages and Salaries and Factory Overheads. Following machine hours were utilized in production of these products P1 550 P2 450

c.

d.

Stores & Spares, Repairs & Maintenance, Power, Insurance and Depreciation are charged to cost of both the products on the basis of machine hours used. Administration Ovcrheads are apportioned on the basis of respective conversion costs while Distribution Overheads on the basis of their sales realizations. All the production was sold out.

e. f.

Required Prepare cost sheets of both the products and work out profit earned of each of them. (5) The cost of manufacturing 5,000 units of a commodity comprises Material Rs. 20,000, Wages Rs. 25,000, Chargeable Expenses Rs. 400. Fixed Overheads Rs. 16,000, Variable Overheads Rs. 4,000. For manufacturing every 1,000 extra units of the commodity, the cost of production increases as follows. 1. 2. 3. 4. 5. Materials : Proportionately. Wages : 10% less than proportionately. Chargeable Expenses : No extra cost. Fixed Overheads : Rs. 200 extra. Variable Overheads : 25% less than proportionately.

Calculate the estimated cost of producing 8,000 units of the commodity and show by how much it would differ if a flat rate of factory overhead were charged.

(6)

The following is the profit and loss account of a manufacturing company for the year 1987-88 (figures in lakhs).

178

Management Accounting

Rs. Materials Wages Factory overheads Gross Profit c/d 48 36 24 12 Sales Closing Stock of finished goods Work in Progress (at cost) Materials Labour Works Expenses 120 Administration Expenses Goodwill and Preliminary Expenses written at Net Profit 2 5 13 6 Gross Profit b/d Interest Received 3.00 1.80 1.20

Rs. 96 18

6 120 12 1

13

During the year 6000 units were manufactured and 4800 units were sold. The costing records show that works expenses have been charged @ Rs. 300 per article,and administration expenses @ Rs. 150 per article. The costing books show a profit of Rs. 12 lakhs. Prepare cost sheet and show the reconciliation (7) A firm manufactured and sold 500 units during the year ended on 31st March, 2001. The summarised Trading and Profit & Loss Account is as below : Rs. 40,000 60,000 25,000 75,000 2,00,000 Management Expenses Rent General Expenses Selling Expenses Net Profit 30,000 5,000 10,000 15,000 15,000 75,000 75,000 Gross Profit 2,00,000 75,000 Particulars Sales Rs. 2,00,000

Particulars Material Consumed Direct Labour Manufacturing Cost Gross Profit

Elements of Costs

179

For the year 2001-2002, the estimates are : a. b. c. d. e. f. Output and sales will be 600 units. Material prices will increase by 20% over the previous year. Direct Labour rate will rise by 5%. Manufacturing expenses will increase in proportion to prime cost. There will be no change in selling expenses per unit. Rise in output will not affect other expenses.

Prepare a statement showing the price in such a way that profit will be 20% on selling price. (8) Following costs were incurred in producing 800 MT of M.S. Rods Materials Labour Processing Charges Total Cost 2,80,000 1,00,000 1,00,000 4,80,000

Of the total output, 10% was defective and had to be sold after a discount of 10% off the normal price. The scrap arising out of the production realized a sum of Rs. 8,760. The sale price is calculated to yield 15% profit on sales. You are required to find out the normal price as well as the discounted price of per MT of M.S. Rods. (9) In a factory, the methods mentioned below are adopted for the allocation of office and selling overheads. (a) (b) (c) (d) Advertisement and Sales Promotion - On Factory Cost figures. Credit and Collection Expenses - On Sales figures. Direct Selling Costs - On Sales figures. Other items - On Factory Cost figures.

The factory deals with five different types of products viz. B, C, D, E and F. The following information has been collected from its books.

180

Management Accounting

Particulars

B Rs.

C Rs. 48,000 36,000 1,65,000

D Rs. 66,000 57,000 2,62,500

E Rs. 33,000 24,000 1,09,500

F Rs. 40,500 34,500 1,60,500

Direct Materials Direct Wages Sales

24,000 27,000 1,12,500

Factory overhead charges are 80% of direct wages. Office and sales expenses are : Rs. Direct Selling Costs Other Items Credit and Collection Expenses Advertisement and Sales Promotion 81,000 53,280 8,100 79,920

Prepare a statement showing the costs incurred and the profit earned in respect of each product. (Calculations may be made to the nearest rupee).

Elements of Costs

181

NOTES

182

Management Accounting

Chapter 8
MATERIAL COST

Material cost is the first and probably the most important element of cost. In case of some specific types of industries, say cement, sugar, chemicals, iron and steel etc., the materials cost forms a very significant portion of the overall cost of production. The term material refers to all commodities which are consumed in the production process. The materials which can be consumed in the production process can be basically classified as: (i) (ii) Direct Materials Indirect Materials

The meaning of both these terms has already been discussed. The basic objective of cost accounting i.e. ascertainment of cost and control of cost is equally applicable to material cost as well. The ascertainment of material cost is made from basically two documents i.e. the invoice of the supplier of material and material requisition slip specifying material issued from stores department to production department. However, a whole lot of organisational procedures are also involved in the process, which affect the material cost, either directly or indirectly. E.g. Purchases from improper source of supply may be expensive, non-availability of material in time may result into hold ups and so on. As such, a proper study of the various procedures involved in case of the movement of materials and a proper control thereon enables an organisation to exercise the control on a sizeable manufacturing cost. The movement of material may involve the following stages. (a) (b) (c) Procurement of materials. Storing the material till it is required for consumption. Issue of the material for consumption.

(A) Procurement of Materials : Though the practices may differ from organisation to organisation, normally, the process of purchasing the materials involves the following stages.
Material Cost

183

(1)

Purchase Requisition : It is an indication given to the purchases department to purchase certain material. It is issued either by storekeeper (in respect of material required for regular production purposes) or by production department (in respect of special materials required). Following particulars must appear in purchase requisition. (i) Material to be purchased : It should be clearly specified. To make it more specific, in addition to the description of the material required, code number should also be specified. When it is required : Unless the material is required for regular production purposes (when the storekeeper himself will place the purchase requisition as soon as it reaches the ordering level), purchase requisition should mention the last date by which the material is required. Ideally, the material should be purchased whenever the market for the same is favourable.

(ii)

(iii) How much to be purchased : Purchase requisition should state the quantity of the material required. Before deciding the quantity of material to be purchased, the principle which should be kept in mind is that there should not be any overstocking or understocking of materials as both these situations involve costs. Overstocking may have following consequences : - Blocking of working capital. - Risk of deterioration of quality and obsolescence. - More storage facilities. - Additional Insurance Cost. - More material handling and upkeeping. - Risk of breakage/pilferage etc. Understocking may have following consequences : - Production hold ups, resulting into disturbed delivery schedules. - Frantic eleventh hour purchases which may result into unfavourable prices and quality. - Payment for idle time to workers. Before deciding the quantity to be purchased, consideration will have to be given to the following factors also : (i) Quantity already ordered.

184

Management Accounting

(ii) Quantity reserved. There may be the case that a particular quantity, though in hand, might have been reserved for a particular job which is not available for other purposes. In such cases, this quantity is such, as if it is not in stock. (iii) Funds availability - Amounts which are kept aside for drawing up purchase budget should be considered. The purchase requisition should be signed by Head of the Department drawing the same. A standard form of Purchase Requisition is as shown below : PURCHASE REQUISITION To : Purchase Department From : Department No. Date Please purchase the material stated below.
Sr. No. Description Code No. Quantity Required Quantity on hand Remarks

: :

Signed by : Storekeeper

Approved by

For the use of Purchase Department only


Date P.O. No. Name of Supplier Delivery Date Remarks

Signed : Purchase Manager

(2)

Selection of Source of Supply : For this purpose, the purchase department may call for the quotations from the prospective suppliers of a certain type of material. In practice, following types of quotations may be called for : (a) Single Tender : It is addressed to only one selected source when there is only one source of supply available. 185

Material Cost

(b)

Limited Tender : It is addressed to a limited number of suppliers known to be reliable sources on the basis of data maintained by the purchase department. Open Tender : It is open to all who can supply specified quality and quantity of the required material. Tenders are called by giving advertisements in the newspapers, journals etc. Global Tender : Anybody from any part of the world can respond to these tenders.

(c)

(d)

To discourage unreliable and unwanted sources from quoting, some tender deposit may be insisted upon. Comparative Statements : After receiving the tenders as stated above, a comparison has to be made among the various available sources so that the best possible source can be selected. All the offers are tabulated in a comparative statement. The authority which is authorised to accept the tender should be specified. The criteria for selecting the final source of supply may depend upon the terms of offer which can be compared in respect of price offered, quality, other terms (like Sales Tax, Octroi, Freight etc.), terms of delivery, terms of payment, guarantee offered by the supplier, goodwill of the supplier etc. Lowest quotation may not necessarily be the best quotation. (3) Purchase Order : The contractual obligation between the supplier and purchaser starts from purchase order. It is drawn in favour of the supplier by the purchase department. It may specify a number of facts. Material to be supplied (Description as well as code numbers and quality). Quantity to be supplied. Price and other terms (e.g. excise duty, sales tax, octroi, insurance, packing and transportation etc.). Cash and trade discount. Instructions in respect of delivery. Guarantee clause. Liquidated damages clause. Escalation clause. Inspection clause. Method of settlement of disputes. Details in respect of letters of credit, import licence etc. Details in respect of interest payable in the event of late payment of dues.

186

Management Accounting

Ideally, purchase orders should be serially numbered. Normally, four or five copies of Purchase Orders are drawn, to be distributed as below : One to Supplier. One to User Department. One to Stores Department. One to Accounts/Costing Department. One with Purchase Department.

A standard form of Purchase Order is as shown below : PURCHASE ORDER No. Date Requisition No. Date Please supply the following material on such terms and conditions as stated therein.
Description Code No. Quantity Rate Rs. Value Rs. Delivery Date Remarks

Delivery : Goods to be delivered at Extra as applicable Excise Duty Sales Tax Packing Charges Insurance Terms of payment For (Purchasing Company)

Purchase Manager

Material Cost

187

(4)

Receipt and Inspection : After material is received from the supplier, the quantity received actually, is compared with quantity ordered. Variations, if any, are taken up with the supplier again. Excess material received may be dealt with in any of the following ways : Accept all the material received. Accept the material ordered and return the excess to the supplier.Before accepting, material may be subjected to inspection. The extent of inspection may vary from material to material.

(5)

Checking invoice and accounting for purchases : The suppliers invoice received for the supply of material is subjected to scrutiny before a voucher is passed for the same for making the entry in the books of accounts. For this purpose, the suppliers invoice may be compared alongwith the following documents. (a) (b) (c) Purchase Order. Goods Received Note. Inspection Report.

If the quantity and/or rate as per purchase order and invoice match with each other, the invoice of the supplier is passed for making the entry in the books of accounts. If the quantity and/or rate as per purchase order and invoice differ from each other, the difference is adjusted by raising a debit or credit note in favour of the supplier. (B) Storing and Issue of Material : After the material is received, inspected and approved, the process of storing comes into operation which deals with storing the material in good condition till it is required for use by production departments and issuing the same whenever required. As far as the movement of the material from the stores point of view is concerned, there can be basically four types of movements. (1) (2) (3) (4) (1) Receipt of material. Issue of material Return of material from Production Department to Stores Department. Transfer of material. Receipt of Material :Usually the receipt of material is accompanied by delivery challan given by the supplier. On receipt of the material, quantity received is checked with the quantity ordered by the Stores Department. The received material may be inspected, before acceptance either by separate inspection department or by Stores

188

Management Accounting

Department itself. A document known as Goods Received Note or Goods Received Report (GRN or GRR) is prepared to record the details of the material received. The usual form in which GRN or GRR is prepared is as below : GOODS RECEIVED NOTE No. Date
S. No. Description Code Qty. Recd. Qty. Accepted Qty. Rejected Remarks

Prepared by

Received by

Inspected by

Store Keeper

It may be prepared in quadruplicate to be distributed as follows. One copy to Purchases Department for comparing with purchases order and approving the invoice of the supplier. One copy to Accounts Department for making the payment of suppliers invoice. One copy to Costing Department for pricing and entering in stores record. One copy to be retained by Stores Department.

Ideally, GRN/GRR should be serially numbered in order to locate the material which is physically received but for which invoice is not received. Discrepancies in material receipts : The material physically received when compared with material ordered as per the purchase order may reveal certain discrepancies which may take any of the following forms. (1) (2) (3) Quantity received in excess. Quantity received in short. Quantity received of different quality.

Excess quantity received may be retained and accepted, if required, with the approval of the purchase department. Alternatively, if it is not accepted, it may be returned to the supplier with Goods Returned Note. The usual form in which Goods Returned Note is prepared is as below:

Material Cost

189

GOODS RETURNED NOTE To : No. Date : Following material supplied by you vide your D.C. No.____________ and Invoice No.____________against our Purchase Order No. ______________is being returned to you for the reasons stated below: Description Quantity Reasons

Signature

Usually, three copies of Goods Returned Note are prepared to be distributed as below : One copy to the Supplier. One copy to the Purchase Department. One copy to be retained by the Stores Department.

Excess Quantity Accepted : If excess quantity is already billed in the invoice, it will be approved and paid. If not, either the supplier may be asked to give a supplementary invoice or credit note may be issued to the supplier for amending the amount. Excess Quantity Returned : If excess quantity is already billed in the invoice, debit note may be issued to the supplier for amending the amount. In case the quantity received is short, purchase department may take up the case with the supplier or carrier or insurer as per the terms of purchases. If quantity short supplied is billed in the invoice, invoice is suitably amended and debit note is issued to the supplier. If quantity received is of different quality and is rejected in inspection, it can either be retained or returned. It may be retained by accepting some mutually decided concessional price. The variation in prices may be adjusted by issuing either the credit note or debit note in favour of the supplier. (2) Issue of Material : Here, the issue of material refers to issue of material from stores department to production department. The material should not be issued from the stores unless a proper authority in writing is produced before the stores department. Usually, this authority is in the form of Material Requisition Note or Material Requisition Slip.
Management Accounting

190

The normal contents of this note/slip are : Number and date (Ideally, they should be serially numbered). Department demanding the material. Description and code of material demanded. Quantity of material demanded. Signature of authority approving the demand. Signature of the person receiving the material.

Normally one note/slip is prepared for requisitioning a single item of material. The usual form in which it is prepared is as below : MATERIAL REQUISITION NOTE Production/Job Order No. Bill of Materials No. No. Date : Department : Description Code Qty. Unit Cost (for costing Dept. only) Rate per unit Amount Rs.

Authorised by

Issued by

Received by

Entered and Valued by

Normally, it is prepared in three copies.Two copies to Stores Department which in its turn passes one copy to Costing Department for pricing while second copy is retained by the Stores Department. One copy is for demanding department. (3) Return of material : There can be some situations, when material once issued to production departments is returned back to the stores. It can happen in the following circumstances. (a) (b) Material issued in excess of requirement. Scrap or defective work arising out of the production processes.

Under these circumstances, a document in the form of Materials Returned Note is prepared, which is to record return of unused materials. The usual form in which this document is prepared is as below :

Material Cost

191

MATERIALS RETURNED NOTE Production/Job Order No. Bill of Materials No. No. Date : Department : Description Code Qty. Unit Cost (for costing Dept. only) Rate per unit Amount Rs.

Authorised by

Received by

Posted by

As far as the valuation of the returned material is concerned, it may be treated as the fresh receipt of the material or alternatively, it may be treated as the negative(minus) issues. (4) Transfer of Materials :In some situations, considering the urgency for the requirement of the material, it may be necessary to transfer the material from one production/job order to another. Such transfer of material is usually accompanied by preparing a document in the form of Material Transfer Note. The usual form in which this document is prepared is as below :

MATERIAL TRANSFER NOTE No. Date : FromDept. Production/Job Order No. Description Code No. Qty. To..Dept. Production/Job Order No. Cost (for costing Dept. only) Rate per unit Amount Rs.

Authorised by

Received by

Entered by

192

Management Accounting

Transfer of materials does not result into any fresh issue of material. However, material transfer notes will have to be valued and considered in order to compute the material cost as per the job orders and production orders. PROPER CONDUCT OF STORAGE FUNCTION As discussed earlier, proper conduct of storage function requires that material should be properly stored in good condition till it is required for use by production departments and should be issued whenever required. This proper conduct is ensured by what is known as Perpetual Inventory System. The aims of the perpetual inventory system are two fold. (1) Recording receipts and issues in such a way so as to know at any time, the stock in hand, in quantity and/or value, without the need of physical counting. This aim is achieved by maintaining what is called as Bin Card and Stores Ledger. Continuous verification of physical stock at regular intervals.

(2)

Bin Card It is only a quantitative record of receipts, issues and closing balance of an item of material. Separate bin card is maintained for each item of material. The usual form in which a bin card is maintained is as below. BIN CARD Description Code No. Location/Unit Date Document No. Receipt Issue Maximum level Minimum level Recorder level Balance Remarks

Entries in receipts column are made on the basis of Goods Received Note or Material Returned Note. Entries in issues column are made on the basis of Material Requisition Note. After every entry of either receipts or issues, the balance quantity is calculated and recorded so that the balance can be known at any point of time. The levels indicated on bin card enable the stores department to keep a watch on balance and replace the material as soon as it reaches the reorder level.
Material Cost

193

Ideally, bin card should be placed alongwith the material. But it may not be possible in all the cases, then bin cards are placed at a centrally located place but within stores department only. Stores Ledger Like Bin Card, it is maintained to record all receipts and issue transactions of material but with the exception that it records not only the quantities received or issued or in stock but also the financial expressions of the same. The usual form in which the stores ledger is maintained is as following : STORES LEDGER Description Code No. Location/Unit Date Document No. Receipts Qty. Rate Rs. Issues Maximum level Minimum level Recorder level Balance Rs. Remark

Qty. Rate Rs. Qty. Rate

By summing up the amounts appearing in the issues column of stores ledger, one can get the cost of material issued to Production Department which forms the Material Cost. As in case of bin card, separate store ledger sheets are maintained in case of each item of material. The stores ledger sheets are maintained either in loose form or in bound book form. Bin Card Vs. Stores Ledger : If the stores ledger is having all the information mentioned in a bin card plus some additional information is also available, the next question which arises is why is it necessary to maintain both bin card and stores ledger simultaneously as it will be only duplication of work. In the situations of computerized inventory accounting system, maintenance of bin card and sotres ledger simultaneously can be avoided. However, in the situations of manual inventory accounting system, it will be ideal to maintain bin card and stores ledger simultaneously due to the following reasons. (1) Bin card is maintained by stores department while stores ledger is maintained by costing department.

194

Management Accounting

(2) (3)

Bin card is not an accounting record but only a quantity record and as such is not concerned with the financial implications of stores transactions. Maintenance of stores ledger provides a second check on maintenance of bin cards.

Reconciliation of Bin Card and Stores Ledger : As the source documents for the entries in Bin Card and Stores Ledger are the same, the closing balances disclosed by both of them should match with each other. But in practice, they may not match due to the following reasons. (1) (2) (3) (4) Arithmetical error in calculating balance. Non-posting of certain document in either of these documents. Posting on wrong bin card or stores ledger sheet. Treating receipts transaction as issue transaction or vice versa.

If the closing balance as per bin card and stores ledger is not matching, the very purpose of maintaining these two documents simultaneously will be defeated. As such, it is necessary to reconcile both balances at regular intervals by keeping all the postings upto date. If the balances as on a particular day are not matching, all the previous transactions should be checked to locate differences. Valuation of Material Movements : As discussed above, the stores ledger considers not only the movement of material in terms of quantity but also in terms of its financial implications. As such, it is necessary that all the possible movements of material are valued properly and are expressed in terms of money. We will consider this problem under the following heads. (a) (b) (c) (a) Valuation of receipts. Valuation of issues. Valuation of returns from production department to stores department. Valuation of receipts : Valuation of receipts is relatively an easy task, as the invoice or bill received from the supplier of the material is available as a starting point. Following propositions should be considered for this purpose. (1) The price as billed by the supplier will be the valuation of the receipts. The trade discount is deducted from the basic price and all other amounts as billed by the supplier are added viz. Excise Duty, Sales Tax, Octroi Duty, Transport/Insurance charges etc. There are different opinions in respect of the treatment of cash discount. One opinion says that cash discount should be ignored being purely of financial nature while valuing the receipts, while another opinion says that it should be considered while valuing the receipt of the material. 195

Material Cost

(2)

In some cases, more than one item of material are included in one single bill and some costs are jointly incurred for all the items of material. Such joint costs may be distributed on the basis of basic price of the material. In case of the imported material, the cost of the material consists of basic price (which may be stated in foreign currency and should be converted in Indian Rupees), Customs Duty, Clearing Charges, Transport Charges, Octroi Duty etc. In some cases, the point of receipt of imported material and the point of making the payment of invoice amount may be different. As such, rate of foreign currency may be different at the time of payment of customs duty and at the time of payment of invoice amount. In such cases, the rate of exchange existing at the time of making the payment of invoice amount should be considered for valuing basic cost of material imported.

(3)

Illustration : The particulars relating to 1,200 kgs. of a certain raw material purchased by a company during June, were as below. (a) Lot prices quoted by suppliers and accepted by the company for placing the purchase order. Lot upto 1000 kgs. Between 1000 - 1500 kgs. Between 1500 - 2000 kgs (b) (c) (d) (e) (f) (g) (h) Trade Discount 20%. Additional charge for containers @ Rs. 10 per drum of 25 kgs. Credit allowed on return of containers @ Rs. 8 per drum. Sales Tax at 10% on raw material and 5% on drums. Total freight paid by the purchaser Rs. 240, Insurance at 2.5% (on net invoice value) paid by the purchaser. Stores Overheads applied at 5% on total purchase cost of material. The entire quantity was received and issued to production : The containers are returned .in due course. Draw up a suitable statement to show : (a) (b) Total cost of material purchased. Unit cost of material issued to production. @ Rs. 22 per kg. @ Rs. 20 per kg. @ Rs. 18 per kg.

For Supplies to Factory

196

Management Accounting

Solution : (a) Statement showing cost of purchases Basic Cost 1,200 kgs x Rs. 20/kg. Less : Trade Discount @ 20% Rs. 24,000 4,800 19,200.00 Container Cost : 48 Drums x Rs. 10 /Drum 480.00 19,680.00 Sales Tax : 10% on Rs. 19,200 5% on Rs. 480 1,920.00 24.00 1,944.00 21,624.00 Other charges Insurance 2.5% on Rs. 21,624.00 Freight 540.60 240.00 22,404.60 Less : Credit for drums returned Rs. 8 per Drum x 48 Drums TOTAL COST Add : Stores Overheads 5% 384.00 22,020.60 1,101.03 23,121,63 (b) Unit cost for valuation of issues Rs. 23,121.63. 1,200 kgs. Illustration : The particulars related to the import of Sealing Ring made by AB & Co. during December 85 are given below. (a) (b) Sealing Ring 1,000 pieces invoiced @ 2 CIF, Bombay Port. Customs Duty was paid @ 100% on invoice value (which was converted to Indian Currency by adopting an Exchange Rate of Rs. 17.20 per ) 197 = Rs. 19.268/kg. Rs.

Material Cost

(c) (d)

Clearing charges : Rs. 1,800 for the entire consignment Freight charges : Rs. 1,400 for transporting the consignments from Bombay Port to Factory premises.

It was found on inspection that 100 pieces of the above material were broken and therefore rejected. There is no scrap value for the rejected part. No refund of the broken material would be admissible as per the terms of contract. The management decided to treat 60 pieces as normal loss and the rest 40 pieces as abnormal loss. The entire quantity of 900 pieces was issued to production. Calculate : (a) (b) Total cost of material. Unit cost of material issued to production.

Also state briefly how the value of 100 pieces rejected in inspection will be treated in costs. Solution : Total Cost of Material (1) Invoice Price UK - 1,000 pieces x 2 = 2,000 - 2,000 x Rs. 17.2 per UK (2) (3) (4) Customs Duty @ 100% Clearing Charges Freight charges Total Cost 34,400 34,400 1,800 1,400 72,000 Rs.

As loss of 40 pieces is considered as abnormal loss, it will be transferred to Costing Profit and Loss Account. Abnormal Loss = Rs. 72,000 1,000 pieces X 40 pieces

= Rs. 2,880 Balance of the cost (i.e. Rs. 72,000 - Rs. 2,880 = Rs. 69,120)Includes cost of units treated as normal loss i.e. 60 pieces. This cost will be borne by good pieces.

198

Management Accounting

Rs. 69,120 Unit cost of good pieces = 900 pieces = Rs. 76.80

(b)

Valuation of Issues : This is a more complex process than the valuation of the receipts. It is because of the reason that the material may be issued out of the various lots which might have been purchased at various prices. As such, a problem may arise as to which of the receipt prices should be used to value the material requisition notes. Various methods may be used for this purpose, main methods of which may be discussed as below. (a) First In First Out (FIFO)Under this method, the price of the earliest available lot is considered first and if that lot is exhausted, the price of the next available lot is considered. It should be remembered that the physical issue of the material may not be made out of the said lots, though it is presumed that it is made out of these lots as stated above.

Illustration : Following transactions have taken place in respect of a material during March 1990. Date : 1 5 7 9 19 22 25 30 Opening Balance 500 units @ Rs. 6 per unit. Purchased 100 units @ Rs. 7 per unit. Issued 400 units. Purchased 300 units @ Rs. 8 per unit. Issued 250 units. Issued 50 units. Purchased 300 units @ Rs. 7.50 per unit. Issued 250 units.

Prepare the Stores Ledger assuming that the issues are valued on FIFO basis.

Material Cost

199

Stores Ledger Description/Code No. Unit Location Date Particulars Qty. RECEIPTS Rate Rs. Rs. Qty. ISSUES Rate Rs. Rs. Qty. Maximum level Minimum level Re-order level BALANCE Rate Rs. 6 Rs.

1 5

Op. Bal. GRN No. 100 7 700

500 500 100

3,000

MRN No.

400

2,400 100 100

} }

6 7 6 7 6 7 8 3700 3,700 1300

GRN No.

300

2,400

100 100 300 100

}
}

19 22 25

MRN No. MRN No. GRN No. 300 7.5 2,250

100 50 50

}
}

6 7 8 8 400 200 200 300 8 8 7.5 3850 1,600 1700 250 8 2,000

30

MRN No.

200 50

8 7.5 1975 250 7.5 1,875

Value of closing stock is Rs. 1,875 which considers latest available market price of the material. The advantages of this method are as below : (a) (b) (c) It is simple to operate. It considers the valuation of closing stock at the current market prices. It can be conveniently applied if transactions are not too many and the prices of the material are fairly steady.

200

Management Accounting

The objections raised against this method are as below : (a) (b) Calculations become complicated if the lots are received frequently and at varying prices. Costs may be wrongly presented if the price of different lots of material are used for pricing issues to various batches of production. In case of varying prices, the pricing of issues does not consider current market prices. Last In First Out (LIFO) : Under this method, the price of the latest available lot is considered first and if that lot is exhausted, the price of the lot prior to that is considered. Here also, it should be remembered, that the physical issue of the material may not be made out of the said lots, though it is presumed that it is made out of the lots as stated above. Illustration : Following transactions have taken place in respect of a material during March 1990. Date: 1 5 7 9 19 22 25 30 Opening Balance 500 units @ Rs. 6 per unit. Purchased 100 units @ Rs. 7 per unit. Issued 400 units. Purchased 300 units @ Rs. 8 per unit. Issued 250 units. Issued 50 units. Purchased 300 units @ Rs. 7.50 per unit. Issued 250 units.

(c) (b)

Prepare the stores ledger assuming that the issues are valued on LIFO basis.

Material Cost

201

Stores Ledger Description/Code No. Unit Location Date Particulars Qty. RECEIPTS Rate Rs. Rs. Qty. ISSUES Rate Rs. Rs. Qty. Maximum level Minimum level Re-order level BALANCE Rate Rs. 6 Rs.

1 5

Op. Bal. GRN No. 100 7 700

500 500 100

3,000 3,700

} }
6 7 6

MRN No.

100 300

7 6

2,500 200

1,200

9 19

GRN No. MRN No.

300

2,400 250 8

200 300 2,000 200 50

} } } }
6 8 6 8 6

3,600 1,600

22 25

MRN No. GRN No. 300 7.5 2,250

50

400 200 200 300

1,200 3,450

30

MRN No.

250

7.5

1,875 200 50

} } } }
6 7.5 6 7.5

1,575

Value of closing stock is Rs. 1,575 which consists of 200 units valued at Rs. 6 per unit which happens to be the earliest available price of the material i.e. price of the opening balance available. The advantages of this method are as below : (a) (b) It is simple to operate. The cost of materials issued considers fairly recent and current prices. The prices quoted on this cost fairly represent its real cost. It can be conveniently applied if transactions are not too many and prices of the material are fairly steady.

(c)

202

Management Accounting

The objections raised against this method are as below : (a) (b) Calculations become complicated if the lots are received frequently and at varying prices. Costs may be wrongly presented if the price of different lots of material are used for pricing issues to various batches of production. In case of falling prices in the market, this method may give wrong results.

(c)

(C) Average Price Method : Both the above methods i.e. FIFO and LIFO, consider the exact or actual cost for valuing the issue of material. However these methods may prove to be disadvantageous if the transactions are too many and are at varying prices. In such cases, instead of considering the exact or actual cost, average cost may be considered to lessen the effect of variation in prices, either upward or downward. E.g. Assume a situation as below : Mar. 1 Mar. 15 Received Received 1500 units @ Rs. 10 1600 units @ Rs. 30 - Rs. 15,000 - Rs. 48,000

On March 20, 1800 units were issued to production. If FIFO method is followed to price the issues, the issues will be valued as below. 1500 units @ Rs. 10 per unit 300 units @ Rs. 30 per unit Rs. 15,000 Rs. 9,000 Rs. 24,000 The issues will be considerably under-valued and closing stock will be considerably over valued, as compared to the current market prices. If LIFO method is followed to price the issues, the issues will be valued as below. 1600 unite @ Rs. 30 per unit 200 units @ Rs. 10 per unit Rs. 48,000 Rs. 2,000 Rs. 50,000 The closing stock will be considerably under valued as compared to the current prices. To lessen the effect of such drastic price variation, both on the valuation of issues as well as of closing stock, instead of considering the actual/exact price of Rs. 10 per unit or Rs. 30 per unit, average price may be taken into consideration. There are mainly two ways in which average prices may be considered.

Material Cost

203

(1)

Simple Average Method :Under this method, the simple average of the prices of the lots available for making the issues is considered for pricing the issues. After the receipt of new lot, a new average price is worked out. It should be remembered in this connection that, for deciding the possible lots out of which the issues could have been made, the method of First In First Out is followed.

Illustration : Following transactions have taken place in respect of a material during March 1990. Date : 1 5 7 9 19 22 25 30 Opening Balance 500 units @ Rs. 6 per unit Purchased 100 units @ Rs. 7 per unit. Issued 400 units. Purchased 300 units @ Rs. 8 per unit. Issued 250 units. Issued 50 units. Purchased 300 units @ Rs. 7.50 per unit. Issued 250 units.

Prepare the stores ledger assuming that the issues are valued on Simple Average basis. Stores Ledger Description/Code No. Unit Location Date Particulars Qty. 1 5 7 9 19 22 25 30 Op. Bal. GRN No. MRN No. GRN No. MRN No. MRN No. GRN No. MRN No. 300 7.5 2,250 250 7.30 300 8 2,400 250 50 7 7 100 7 700 400 6.5 RECEIPTS Rate Rs. Rs. Qty. ISSUES Rate Rs. Rs. Qty. 500 600 2,600 200 500 1,750 250 350 200 500 1,825 250 Maximum level Minimum level Re-order level BALANCE Rate Rs. 6 Rs. 3,000 3,700 1,100 3,500 1,750 1,400 3,650 1,825

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Management Accounting

This method is suitable if the material is received in uniform quantity.If the material quantity of each lot varies widely, this method may lead to wrong results. (2) Weighted Average Method :As stated above, the simple average method of valuation of issues may lead to wrong results, if the quantity of each lot of material received varies widely. Eg. Assume the following situation. Mar. 1 Received 100 units @ Rs. 10 Mar. 10 Received 5,000 units @ Rs. 30 Rs. 1,000 Rs. 1,50,000 Rs. 1,51.000 On March 20, 4800 units were issued to production. As both the lots are possible lots for making the issue, the average of prices of both the lots will be taken into account if simple average method is considered. Hence, per unit issue price will be Rs. 10 + Rs. 30 2 i.e. Rs. 20

As such, the issue quantity will be priced at : 4,800 units x Rs.20 i.e. Rs. 96,000, which will be incorrect, as considering the quantity of issue, the price of the material received on March 10 should get more weightage. To overcome this drawback of simple average method, weighted average method may be used which considers not only the price of each lot but also the quantity of the same. Though this method involves considerable amount of clerical work, in practice, this method proves to be very useful in the event of varying prices and quantities. In practice, the calculation of weighted average rate proves to be very simple. The products of quantity and price divided by the total quantity of all lots, just before the issue, gives the unit price in respect of the subsequent issues. Illustration : Following transactions have taken place in respect of a material during March 1990. Date : 1 5 7 9 19 22 Opening Balance 500 units @ Rs. 6 per unit Purchased 100 units @ Rs. 7 per unit. Issued 400 units. Purchased 300 units @ Rs. 8 per unit. Issued 250 units. Issued 50 units.

Material Cost

205

25 30

Purchased 300 units @ Rs. 7.50 per unit. Issued 250 units.

Prepare the Store Ledger assuming that the issues are valued on Weighted Average Basis. Stores Ledger Description/Code No. Unit Location Date Particulars Qty. 1 5 7 9 19 22 25 30 (d) Op. Bal. GRN No. MRN No. GRN No. MRN No. MRN No. GRN No. MRN No. 300 7.5 2,250 250 7.41 300 8 2,400 250 50 7.27 7.27 100 7 700 400 6.16 RECEIPTS Rate Rs. Rs. Qty. ISSUES Rate Rs. Rs. Qty. 500 600 2,467 200 500 1,817 250 363 200 500 1,851 250 Maximum level Minimum level Re-order level BALANCE Rate Rs. 6.00 6.16 6.16 7.27 7.27 7.27 7.41 7.41 Rs. 3,000 3,700 1,233 3,633 1,816 1,453 3,703 1,852

Highest In First Out :This method assumes that the stock should always be shown at the minimum value and hence the issues should always be valued at the highest value of receipts. E.g. Assume a situation as follows. Mar. 1 Purchased 100 units @ Rs. 12 Mar. 5 Purchased 125 units @ Rs. 18 Mar. 10 Purchased 75 units @ Rs. 15 On March 20, 120 units are issued to production and they will be valued at Rs. 18 per unit being the highest price. This method is not very popular. It always overvalues the issues and undervalues the closing stock. This method may be useful in case of the organisations dealing with monopoly products which is a rare possibility.

206

Management Accounting

(e)

Market Price : Under this method, market price is considered to be the base for pricing the issues. In this case, market price may be treated as latest purchase price, realisable price or replacement price. This method is used mainly in respect of obsolete stock items or non-moving stock items. The defect in respect of this method is that the price concessions obtained in respect of bulk purchases are not reflected in cost of material.

(f)

Specific Price : If the material is purchased against a specific job or production order, the issue of material is priced at actual purchase price. This method can be adopted if purchase prices are fairly stable.

(g)

Standard Price : This is the normal or ideal price which will be paid in the normal circumstances, based on the basis of estimated market conditions, transportation costs and normal quantity of purchases. Any issue of material will be priced at standard prices irrespective of actual prices. This enables the simplification of accounting system with reduced clerical work and also enables to decide the efficiency of purchase department,

(c)

Valuation of Returns : This indicates the material returned by production departments to stores department The way in which returned material may be valued can be as below : (a) At the same price at which issued : The original price of issue will be a base for valuing the returns for which original material requisition note will be the base. (b) At the current price of issues : The method which is followed for valuing the issue on the same date is considered for valuing the returns. This will avoid the clerical efforts, but at the same time the track of original issue of material cant be maintained.

Treatment of shortages : In some cases, the physical verification of stock may reveal that the physical stock is less than the stock as per stores ledger. For proper accounting, the shortage has to be treated as an issue so that the book stock can be brought down to the level of physical stock. The

Material Cost

207

valuation of this shortage is done as if it is an issue of material. The treatment given to the valuation of shortages in Cost Accounts depends upon the nature of the shortage i.e. Normal Shortage or Abnormal Shortage. Inventory Control : The object of inventory control is to reduce the investment in inventory without affecting the efficiency in the area of production and sales. It should be remembered that the object is not only to reduce the investment in inventory. If that would have been the object, no organisation would have maintained inventory of any kind, thereby making the investment in inventory as Nil. However, that is not the ultimate object as it is likely to affect the production and sales function adversely. E.g. If sufficient stock of raw material is not available, the production activity is likely to be interrupted. If sufficient stock of finished goods is not available, it may not be possible for the organisation to serve the customers properly and they may shift to the competitors. The object of inventory control is to avoid the situation of over investment as well as under investment. The level of inventories should be maintained at the optimum level. Techniques of Inventory control (1) Economic Order Quantity : It indicates that quantity which is fixed in such a way that the total variable cost of managing the inventory can be minimised. Such cost basically consists of two parts. First, Ordering Cost (which in turn consists the costs associated with the administrative efforts connected with preparation of purchase requisitions, purchase enquiries, comparative statements and handling of more number of bills and receipts) Second, Carrying Cost i.e. the cost of carrying or holding the inventory (which in turn consists of the cost like godown rent, handling and upkeep expenses, insurance, opportunity cost of capital blocked i.e. interest etc.) There is a reverse relationship between these two types of costs i.e. If the purchase quantity increases, ordering cost may get reduced but the carrying cost increases and vice versa. A balance is to be struck between these two factors and it is possible at Economic Order Quantity where the total variable cost of managing the inventory is minimum. It is possible to fix the Economic Order Quantity with the help of mathematical formula. The following assumptions may be made for this purpose. Let Q be Economic Order Quantity. A be Annual Requirement of material in units. O be cost of placing an order (which is assumed to remain constant irrespective of size of order.) C be cost of carrying one unit per year.
Management Accounting

208

Now, if A is the annual requirement and Q is the size of one order, the total number of orders will be A/Q and the total ordering cost will be - A/Q x O Similarly, if the size of one order is Q and if it is assumed that the inventory is reduced at a constant rate from order quantity to zero when it is repurchased, the average inventory will be Q/2 and the cost of carrying one unit per year being C, the total carrying cost will be Q/2 X C. Thus, Total Cost = Ordering Cost + Carrying Cost = A Q X O + Q 2 XC

The intention is that the value of Q should be such that the total cost should be minimum. Hence, taking the first derivative of the equation with respect to Q and setting the result to zero, do dq Q = = AO ( 1 Q2 ) + C 2 Where = O OR

2xAXO C

Q = Economic Order Quantity A = Annual Requirement in Units O = Cost of Placing an Order C = Cost of Carrying One Unit Per Year Illustration : A manufacturer uses 200 units of a component every month and he buys them entirely from outside supplier. The order placing and receiving cost is Rs. 100 and annual carrying cost is Rs. 12. From this set of data, calculate Economic Order Quantity. Solution : EOQ =

2xAxO C

2 x 2400 x 100 12 200 units 209

=
Material Cost

In some cases, the carrying cost may be expressed as an annual percentage of the unit cost of purchases, in which case, the calculation of Economic Order Quantity takes the following form. EOQ =

2xAxO Cxi

where

Annual Requirement in units Cost of placing an order Unit purchase price Carrying cost expressed as a percentage of unit purchase price.

O = C i = =

Illustration : From the Following data, work out the EOQ of a particular component. Annual Demand Ordering Cost Price per Unit : 5000 Units : Rs. 60 per Order : Rs. 100

Inventory carrying Cost : 15% on average inventory, Solution : EOQ =

2 x 5000 x 60 15% of 100

= 200 units The total cost of managing inventory will be Ordering Cost - 5000 200 Carrying Cost 200 2 X 60 i.e. 25 X 60 Rs. 1,500

X 15% of 100

Rs. 1,500 Rs. 3,000

(Based on average inventory)

Now, the next question is whether the purchases in Economic Order Quantity really reduce the total cost of managing inventory to the minimum, We can verify this, by trial and error method, by considering the above results.

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Management Accounting

Order Quantity

No. of Orders A/Q Rs. 100 50 25 20 5 4 2

Ordering Cost A/Q x O Rs. 6,000 3,000 1,500 1,200 300 240 120

Carrying Cost Q/2 x Ci Rs. 375 750 1,500 1,875 7,500 9,375 18,750

Total Cost

50 100 200 250 1,000 1,250 2,500

6,375 3,750 3,000 3,075 7,800 9,615 18,870

It can be observed from the above, that the order size of 200 units proves to be the most economic one in terms of minimum total cost. If the purchases are made in any other way, the same may not necessarily result into minimum total cost. Illustration : Kapil Motors purchase 9,000 motor spare parts for its annual requirements, ordering onemonth usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15 and the carrying charges are 15% of the average inventory per year. You have been asked to suggest a more economical purchasing policy for the company. What advice would you offer and how much would it save the company per year. Solution : Present Policy : Number of Orders = = Annual Requirement Order size 9000 750 Ordering Cost Carrying Cost = = = = 12 ...(1) X Carrying cost in %

12 X 15 = 180 Order Size 2 750 2 X Cost Price

X 15% of Rs. 20 ...(2) ...(3)

= Total Cost i.e. 1 + 2


Material Cost

375 X 3 = 1,125 = 180 + 1125 = 1305

211

Proposed Policy : To purchase in Economic Order Quantity EOQ =

2xAxO Cxi

2 x 9000 x 15 15% of 20 = 300 units

Now, the revised total cost will be Number of Orders Ordering Cost Carrying Cost = = = = Total Cost i.e. 4 + 5 = 9000 300 = 30 ...(4) ...(5)

30 x 15 = 450 300 2 X 15% of 20

150 X 3 = 450 450 + 450 = 900 ...(6)

Thus, purchases in Economic Order Quantity will result into the yearly saving of Rs. 405 (i.e. Rs. 1305 - Rs. 900) (2) Fixation of Inventory Levels : Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. However, the following propositions should be remembered. (i) Only the fixation of inventory levels does not facilitate the inventory control. There has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time. The various levels fixed are not fixed on a permanent basis and are subject to revision regularly.

(ii)

The various levels which can be fixed are as below. (1) Maximum Level : It indicates the level above which the actual stock should not exceed. If it exceeds, it may involve unnecessary blocking of funds in inventory. While fixing this level, following factors are considered.

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Management Accounting

(i) (ii)

Maximum usage. Lead time.

(iii) Storage facilities available, cost of storage and insurance etc. (iv) (v) (vi) Prices for the material. Availability of funds. Nature of material e.g. If a certain type of material is subject to Government regulations in respect of import of goods etc., maximum level may be fixed at a higher level.

(vii) Economic Order Quantity. (2) Minimum Level : It indicates the level below which the actual stock should not reduce. If it reduces, it may involve the risk of non-availability of material whenever it is required. While fixing this level, following factors are considered. (i) (ii) (3) Lead time. Rate of consumption.

Re-order Level: It indicates that level of material stock at which it is necessarily to take the steps for procurement of further lots of material. This is the level falling in between the two extremes of maximum level and minimum level and is fixed in such a way that the requirements of production are met properly till the new lot of material is received.

(4)

Danger Level : This is the level fixed below minimum level. If the stock reaches this level, it indicates the need to take urgent action in respect of getting the supply. At this stage, the company may not be able to make the purchases in a systematic manner but may have to make rush purchases which may involve higher purchases cost.

Calculation of various Levels : The various levels can be decided by using the following mathematical expressions. (1) (2) Re-order Level : Maximum Lead Time x Maximum Usage. Maximum Level : Reorder Level + Reorder Quantity - (Minimum Usage X Minimum Lead Time).

Material Cost

213

(3) (4) (5)

Minimum Level : Reorder Level - (Normal Usage x Normal Lead Time.) Average Level : Maximum Level + Minimum Level. Danger Level : Normal Usage x Leadtime for emergency purchases.

Note : It should be noted that the expression of the Reorder Quantity in the calculation of Maximum Level indicates Economic Order Quantity. Illustration : Two components X and Y are used as follows. Normal usage Minimum usage Maximum usage Reorder quantity 50 units per week each. 20 units per week each. 75 units per week each. X - 400 units Y - 600 units Recorder period X - 4 to 6 weeks Y-2 to 4 weeks Calculate for each component : a. b. c. d. Reorder level Minimum level Maximum level Average stock level.

Solution : (1) Reorder Level : Maximum Lead time x Maximum Usage X = 6 weeks x 75 units = 450 units Y = 4 weeks x 75 units = 300 units. (2) Minimum Level : Reorder Level (Normal Usage x Normal Leadtime) X = 450 units (50 units X 5 weeks) = 200 units. Y = 300 units (50 units x 3 weeks) = 150 units

214

Management Accounting

(3)

Maximum Level : Reorder Level + Reorder Quantity - (Minimum Usage x Minimum Leadtime) X = 450 units + 400 units - (25 units x 4 weeks) = 750 units. Y = 300 units + 600 units - (25 units x 2 weeks) = 850 units.

(4)

Average Stock Level : Minimum Level + Maximum Level 2 200 units + 750 units X = 2 Y = 150 units + 850 units 2

= 475 units

= 500 units

As stated above, the expression of the Reorder Quantity in the calculation of Maximum level indicates Economic Order Quantity. Hence, in some cases, it may be necessary to decide the Economic Order Quantity before fixing the inventory levels. Illustration : Shriram Enterprises manufactures a special product ZED The following particulars are collected for the year 1986. (a) (b) (c) (d) (e) (f) (g) Monthly demand of ZED - 1000 units. Cost of placing an Order - Rs. 100. Annual carrying cost per unit - Rs. 15. Normal Usage 50 units per week. Minimum Usage 25 units per week. Maximum Usage 75 units per week. Re-order period 4 to 6 weeks.

Compute from the above: (1) (2) (3) (4) (5) Re-order Quantity. Re-order Level. Minimum Level. Maximum Level. Average Stock Level. 215

Material Cost

Solution : (1) Reorder Quantity :

2xAxO C

where

A = Annual Requirement O = Ordering cost per cost C = Carrying cost per unit per year EOQ =

2 x 12000 x 100 15

= 400 units (2) Reorder Level : Maximum Lead Time x Maximum Usage. 6 weeks X 75 units = 450 units (3) Minimum Level : Reorder Level - (Normal Usage x Normal Lead Time) 450 units - (50 units X 5 weeks) = 200 units (4) Maximum Level : Reorder Level + Reorder Quantity (Minimum Usage X Minimum Leadtime) 450 units + 400 units - ( 25 units X 4 Weeks) = 750 units. (5) Average Stock Level : Minimum Level + Minimum Level 2 200 units + 750 units 2 There may be one more way in which the various inventory levels may be fixed and for this determination of the safety stock (also called as minimum stock or buffer stock) is essential. Safety stock is that level of stock below which the actual should not be allowed to fall. The safety stock may be calculated as 216
Management Accounting

= 475 units

(Maximum Usage X Maximum Leadtime) less (Normal Usage X Normal Leadtime) According to this method, the various inventory levels as discussed above may be fixed as below. (1) Minimum Level : It is equal to safety stock. (2) Maximum Level : It can be calculated as - Safety Stock + EOQ. (3) Reorder Level : It can be calculated as : Safety Stock + (Normal Usage x Normal Leadtime) (4) Average Stock Level : It can be calculated as Minimum Level + Maximum Level 2 = Safety Stock + Safety stock + EOQ 2 Safety Stock + EOQ 2

Illustration : You have been asked to calculate the following levels for Part No. 007 from the information given thereunder: (a) (c) (e) Re-ordering level, Minimum level, Average level. (b) Maximum level (d) Danger level,

The ordering quantity is to be calculated from the following data : (i) (ii) Total cost of purchasing relating to the order Rs. 20. Number of units to be purchased during the year 5,000

(iii) Purchase price per unit including transportation costs Rs. 50.

Material Cost

217

(iv)

Annual cost of storage of one unit Rs. 5. Lead Times : Average Maximum Minimum Maximum for emergency purchases Rate of consumption:Average Maximum .. 15 units per day .. 20 units per day ... 10 days .. 15 days .. 6 days ... 4 days

Solution : Working Notes : (a) Calculation of Safety Stock : (Maximum Usage x Maximum Leadtime) - (Normal Usage x Normal Leadtime) = = = (b) (20 units x 15 days) - (15 days x 10 days) 300 units - 150 units 150 units.

Calculation of EOQ :

A O C = = = Hence, EOQ =

2xAxO C

where

Annual requirement Ordering cost per order Carrying cost per unit per year.

2 X 500 X 20 5

= (1)

200 units.

Reordering Level : It can be calculated as Safety Stock + (Normal Usage x Normal Leadtime) = 150 units + (15 units X 10 days) = 150 units + 150 units = 300 units.

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Management Accounting

(2)

Maximum Level : It can be calculated as Safety Stock + EOQ = 150 units + 200 units = 350 units.

(3)

Minimum Level : It is equal to Safety Stock = 150 units.

(4)

Danger Level : Normal Usage X Leadtime for emergency purchases = 15 units X 4 days = 60 units.

(5)

Average Stock Level : It can be calculated as Safety Stock + EOQ 2 200 2 units = 250 units

= 150 units + (3)

Inventory Turnover : Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below : Value of material consumed Average inventory held where

Value of material consumed can be calculated as : Opening Stock + Purchases - Closing Stock. Average inventory held can be calculated as : Opening Stock + Closing Stock 2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio.

Material Cost

219

Illustration : From the following data for the year ended 31st December, 1986, calculate the inventory turnover ratio of the two items and put forward your comments on them. Material A Rs. Opening Stock 1.1.86 Purchases during the year Closing Stock 31.12.86 Solution : Inventory turnover ratio = Value of material consumed Average Inventory held Material A Inventory Turnover = 56,000 8,000 = 7 Material A Inventory Turnover Period = 365 7 = 52 days Material B 25,000 10,000 2.5 Material B 365 2.5 146 days 10,000 52,000 6,000 Material B Rs. 9,000 27,000 11,000

A high inventory turnover ratio or low inventory turnover period indicates that maximum material can be consumed by holding minimum amount of inventory of the same, thus indicating fast moving items. Thus high inventory turnover ratio or lower inventory turnover period will always be preferred. Thus, knowledge of inventory turnover ratio or inventory turn over period in case of various types of material will enable to reduce the blocked up capital in undesirable types of stocks and will enable the organisation to exercise proper inventory control. (4) ABC Analysis :

This technique assumes the basic principle of Vital Few Trivial Many while considering the inventory structure of any organisation and is popularly known as Always Better Control. It is an analytical method of inventory control which aims at concentrating efforts in those areas where attention is required most. It is usually observed that, in practice, only a few number of items of inventory prove to be more important in terms of amount of investment in inventory or 220
Management Accounting

value of consumption, while a very large number of items of inventory account for a very meager amount of investment in inventory or value of consumption. This technique classifies the various inventory items according to their importance. E.g. A Class consists of only a small percentage of total number of items handled but are most important in nature. B Class items include relatively less important items. C Class items consist of a very large number of items which are less important. The importance of the various items may be decided on the basis of following factors. (i) (ii) Amount of investment in inventory. Value of material consumption.

(iii) Critical nature of inventory items. An example of ABC Analysis can be given as below. Class No. of items % of total No. of items 6 30 64 100 Value/ Consumption Rs. 5,60,000 1,60,000 80,000 8,00,000 % of Total Value/ Consumption

A B C

300 1500 3200 5000

70 20 10 100

In order to exercise proper inventory control, A Class items are watched very closely and control is exercised right from initial stages of estimating the requirements, fixing minimum level/leadtimes, following proper purchase/ storage procedures etc. Whereas in case of C Class of items, only those inventory control measures may be implemented which are comparatively simple, elaborate and inexpensive in nature. Advantage of ABC Analysis : (a) A close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall material consumption and due to this the costs associated with inventions may be reduced. The investment in inventory can be regulated in a proper manner and optimum utilisation of the available funds can be assured. A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio.However it should be noted that the success of ABC analysis depends mainly upon correct categorisation of inventory items and hence should be handled by only experienced and trained personnel.

(b)

(c)

Material Cost

221

(5)

Bill of Materials :

In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purposes whenever it is required. This aim can be achieved by preparing what is normally called as Bill of Materials. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department. The form in which the bill of material is usually prepared is as below : BILL OF MATERIALS No. Date of Issue Production/Job Order No.

Department authorised
S. No. Description of Material Code No. Qty. For Department Use only Material Requisition No. Date Quantity demanded Remarks

The functions of bill of materials are as below : (1) Bill of material gives an indication about the orders to be executed to all the persons concerned. Bill of material gives an indication about the materials to be purchased by the Purchases Department if the same is not available with the stores. Bill of material may serve as a base for the Production Department for placing the material requisitions ships. Costing/Accounts Department maybe able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as a base for quoting the price for the job or production order.

(2)

(3)

(4)

222

Management Accounting

(6)

Perpetual Inventory System : As discussed earlier, in order to exercise proper inventory control, perpetual inventory system may be implemented. It aims basically at two facts. (1) Maintenance of Bin Cards and Stores Ledger in order to know about the stock in quantity and value at any point of time. Continuous verification of physical stock to ensure that the physical balance and the book balance tallies.

(2)

The continuous stock taking may be advantageous from the following angles : (1) Physical balances and book balances can be compared and adjusted without waiting for the entire stocktaking to be done at the year-end Further, it is not necessary to close down the factory for Annual stocktaking. The figures of stock can be readily available for the purpose of periodic Profit and Loss Account. Discrepancies can be located and adjusted in time. Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material. A systematic maintenance of perpetual inventory system enables to locate and slow and non-moving items and to take remedial action for the same. Stock details are available correctly for getting the insurance of stock.

(2)

(3) (4)

(5)

(6)

ILLUSTRATIVE PROBLEMS (1) The following informative is extracted from the Stores ledger in respect of Material X Opening Stock Purchases Jan. 1 Jan. 20 Issues Jan. 22 Jan. 23 60 for Job W 16 60 for Job W 17 100 @ Re. 1 per unit 100 @ Rs. 2 per unit Nil

Complete the receipts and issues valuation by adopting the First In First Out, Last In First Out and Weighted Average method. Tabulate the values allocated to Job W 16 and 17 and the closing stock under the methods aforesaid.

Material Cost

223

Solution : (a) Valuation of receipts : (For all methods) Jan. 1 Jan. 20 100 x 1.00 100 x 2.00 200 units Weighted Average Rate = = = Rs. 100 Rs. 200 Rs. 300 Rs. 300 200 units (b) Valuation of Issues/Closing Stock = Rs. 1.50/Unit

(1) Issues FIFO Date Jan. 22-W16 Jan.23-W17 Qty. Unit 60 40 20 Rate Rs. 1.00 1.00 2.00 Amt. Rs. 60.00 40.00 40.00 140.00 160.00 Qty. Unit 60 40 20 LIFO Rate Rs. 2.00 2.0 1.00 Amt. Rs. 120.00 80.00 20.00 220.00 80.00 Weighted Average Qty. Unit 60 60 Rate Rs. 1.50 1.50 Amt. Rs. 90.00 90.00 180.00 80 1.50 120.00

(2)

Closing Stock

80

2.00

80

1.00

(c)

Values allocated to individual jobs W 16 Rs. FIFO LIFO Weighted Average 60 120 90 W 17 Rs. 80 100 90

(2)

From the records of an oil distributing company, the following summarised information is available for the month of March 1986. Sales for the month - Rs. 19,25,000 Opening Stock as on 1-3-86 - 1,25,000 Litres @ Rs. 6.50 litre Purchases (including freight and insurance) March 5 -1,50,000 litres @ Rs. 7.10 litre

224

Management Accounting

March 27 - 1,00,000 litres @ Rs. 7.00 litre. Closing stock as on 31-3-86 - 1,30,000 litres General Administrative expenses for the month Rs. 45,000 On the basis of the above information, work out the following using FIFO and LIFO methods of inventory valuation assuming pricing of issues is being done at the end of the month (after all receipts during the month). (a) (b) (c) Value of Closing Stock as on 31-3-86 Cost of goods sold during March 86 Profit or Loss for March 86.

Solution : (a) (1) Value of Closing Stock FIFO :

Under this method, the value of closing stock will constitute the value of latest available lot for consumption, earlier lots assumed to have been consumed. As such, value of closing stock will be: Purchased on 27-3-86 Purchased on 5-3-86 1,00,000 Its. x Rs. 7.00 30,000 Its. x Rs. 7.10 = = Rs. 7,00,000 Rs. 2,13,000 Rs. 9,13.000 (2) LIFO :

Under this method, the value of closing stock will constitute the value of earliest available lot for consumption, latest lots assumed to have been consumed. As such, value of closing stock will be : Opening Stock on Purchased on 1-3-86 1,25,000 Its. x Rs. 6.50 5-3-86 5,000 Its. x Rs. 7.10 = = Rs. 8,12,500 Rs. 35,500 Rs. 8,48,000

Material Cost

225

(b)

Cost of goods sold during March 1986 FIFO Rs. LIFO Rs. 8,12,500 17,65,000 25,77,500 8,48,000 17,29,500

Opening Stock 1,25,000 Its. x Rs. 6.50 Purchases

8,12,500 17,65,000 25,77.500

Less : Closing Stock (as per a above)

9,13,000 16,64,500

The value of purchases is calculated as below : Purchased on Purchased on 5-3-86 1,50,000 X Rs. 7.10 27-3-86 1,00,000 X Rs. 7.00 = = Rs. 10,65,000 Rs. 7.00,000 Rs. 17,65,000 (c) Profit or Loss for March 1986 FIFO Rs. (1) Sales Total Cost Cost of goods sold Administrative Expenses 16,64,500 45,000 17,09,500 (2) (3) Profit (1 - 2) 2,15,500 17,29,500 45,000 17,74,500 1,50,500 19,25,000 LIFO Rs. 19,25,000

A company uses annually 50,000 units of an item each costing Rs.1.20. Each older costs Rs. 45 and inventory carrying costs 15% of the annual average inventory value. Find EOQ If the company operates 250 days a year, the procurement time is 10 days, and safety stock is 500 units, find reorder level, maximum, minimum and average inventory.

(a) (b)

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Management Accounting

Solution : (a) Economic Order Quantity

2 X A X O Ci

2 X 50,000 X 45 15% of 1.20 5,000 units

= (b) (1)

Reorder Level :

Safety Stock + (Normal Usage x Normal Leadtime) = 500 units + (200 units x 10 days) = (2) Maximum Level : Safety stock + EOQ = 500 units + 5,000 units = 5,500 units (3) Minimum Level It is equal to safety stock i.e. 500 units (4) Average Level Safety Stock + EOQ 2 5000 units 2 2,500 units

= = (4)

500 units + 3000 units

M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is fairly constant at 6,250 per month. The valve costs Rs. 1.50 per unit when purchased in quantities and inventory carrying cost is 20%. The average inventory investment on annual basis. The cost to place an order and to process the delivery is Rs. 18. It takes 45 days to receive from the date of an order and minimum stock of 3,250 valves is desired. You are required to determine -

Material Cost

227

a. b. c.

The most economical order quantity and the number of orders in year. The reorder level The most economic order quantity if valve costs Rs. 4.50 each instead of Rs. 1.50 each.

Solution : (a) Economic Order Quantity :

EOQ

= =

2xAxO Ci = 3,000 units

2 x 75,000 x 18 20% of 1.50

Number of Orders : Annual Consumption EOQ = (b) 75,000 units 3,000 units = 25

Reorder Level : Safety stock + (Normal Usage x Normal Leadtime) = = 3,250 units + (6,250 units x 1.5 months) 12,625 units

(c)

Revised EOQ (If unit cost is Rs. 4.50 instead of Rs. 1.50) EOQ = =

2xAxO Ci

2 x 75,000 x 18 20% of 4.50 1,732 units

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Management Accounting

(5)

The Purchase Department of your Organisation has received an offer of quantity discounts on its orders of materials as under : Price Per Tonne 1,200 1,180 1,160 1,140 1,120 Tonnes Less than 500 500 and less than 1000 1000 and less than 2000 2000 and less than 3000 3000 and above.

The annual requirement for the material is 5000 tonnes. The delivery cost per order is Rs. 1,200 and the stock holding cost is estimated at 20% of material cost per annum. You are required to advice the Purchase Department the most economic purchase level. Solution : As the price discount varies with lot size, EOQ will have to be decided by Trial and Error Method. Lot Size (Units) Q Price per Tonne-Rs. P Purchase Cost for 5,000 Tonnes Rs. 3 60,00,000 60,00,000 59,00,000 59,00,000 58,00,000 58,00,000 57,00,000 57,00,000 56,00,000 56,00,000 5000 X 1200 Q 4 60,000 24,000 12,000 9,600 6,000 4,800 3,000 2,400 2,000 1,500 2 5 12,000 30,000 59,000 73,750 1,16,000 1,45,000 2,28,000 2,85,000 3,36,000 4,48,000 6(3+4+5) 60,72,000 60,54,000 59,71,000 59,83,350 59,22,000 59,49,800 59,31,000 59,87,400 59,38,000 60,49,500 Ordering Cost Q X P X 20% Carrying Cost Total Cost Rs.

1 100 250 500 625 1,000 1,250 2,000 2,500 3,000 4,000

2 1200 1200 1180 1180 1160 1160 1140 1140 1120 1120

Material Cost

229

It will be observed, that if the purchases are made in the lot size of 1,000 units it proves to be most economical. (6) (a) A company needs 24,000 units of raw materials which costs Rs. 20 per unit and ordering cost is expected to be Rs. 100 per order. The company maintains safety stock of 1 months requirements to meet emergency. The holding cost of carrying inventory is supposed to be 10% per unit of average inventory. Find out : 1. 2. 3. 4. (b) Economic lot size. Ordering cost Holding cost Total cost

The supplier of raw material has agreed to supply the goods at a discount of 5% in price on a lot size of 4,000 units. Find whether the concession price should be availed.

Solution : (a) (1) Economic Lot Size

2xAxO Ci

2 x 24,000 x 100 10% of 20

= (2)

1,550 units (Approx.)

Ordering Cost Annual Requirement EOQ = 24,000 1550 X 100 = Rs. 1,548 (Approx.) X Ordering cost per order

(3)

Holding Cost : As the company maintains safety stock of one months requirement, the average inventory held at any point of time will not only be EOQ/2 but safety stock + EOQ/2. Assuming that the usage of raw material is steady throughout the year i.e. 2,000 units per month, holding cost will be :

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Management Accounting

(Safety Stock + EOQ/2) / Carrying cost per unit per year = = = (4) (2,000 units + 1,550 units 2 ) X 10% of Rs. 20

2,775 units X Rs. 2 Rs. 5,550

Total cost : Cost of material 24,000 x 20 Ordering Cost Holding Cost Total Cost = = = = Rs. 4,80,000 Rs. 1,548 Rs. 5,550 Rs. 4,87,098

(b) (1)

Revised Total Cost : (with 5% discount) Ordering Cost :

As order size is going to be 4,000 units, total 6 orders will be placed. Hence total ordering cost will be 6 orders x Rs. 100 per order i.e. Rs. 600 (2) Holding Cost :

The holding cost will be as below : (Safety Stock + Order Size 2 4000 units 2 ) x 10% of Rs. 19 ) x Carrying cost per unit per year

= = (3)

(2,000 units + Rs. 7,600 Total Cost :

Total Cost of material - 24,000 x 19 Ordering Cost Holding Cost Total Cost

= = = =

Rs. 4,56,000 Rs. 600 Rs. 7,600 Rs. 4,64,200

Material Cost

231

Conclusion : If purchased in Economic Lot Size, total cost (including material cost) is Rs. 4,87,098. If purchased in Lot Size of 4,000 units with 5% discount, total cost (including material cost) is Rs. 4,64,200. As purchases in Lot Size of 4,000 units result in the saving of Rs. 22,898 (i.e. Rs. 4,87,098 Rs. 4,64,200) that alternative will be preferred.

QUESTIONS 1. Explain the various steps in which a raw material moves in a manufacturing organization till it gets consumed in the production. Give the format of various documents which are prepared in the process. Write a detailed essay on a) b) c) Valuation of Receipts Valuation of Issues Valuation of Returns

2.

232

Management Accounting

PROBLEMS (1) The following is the record of receipts and issues of certain material in a factory during the week ending May 1979. Opening balances 100 tons at Rs. 10 per ton. Issued 60 tons. Received 120 tons at Rs. 10 per ton Issues - 50 tons (Stock verifier reported shortage of 2 tons) Received back from order 20 tons (originally issued at Rs. 9.90) Issued 80 tons. Received 44 tons at Rs. 10.20 per ton. Issued 66 tons. Received 44 tons at Rs. 10.20 per ton. Issued 66 tons. From the above particulars prepare stores ledger separately under e method charging issues at weighted and simple average method. (2) Following transactions appeared in a specified material during month of August 1980. Date 1 4 5 12 13 19 25 30 31 Particular Opening balance Purchased Issued Issued Purchased Issued Issued Purchased Issued Quantity (Tons) 100 50 30 40 30 40 30 40 30 28 25 Rate per ton 24 26

The stock verifier noticed shortage in stock on 26th August of 5 tons and on 29th August of 4 tons. Write up stores ledger by charging issues by FIFO and by weighted average methods. (3) The following is the history of the receipt and issue of materials in a factory during February 1980,

Material Cost

233

Feb. 1 2 4 8 13 14 16 20 24 25 26 27 28

Opening balance -500 tons at Rs. 25 Issued 70 tons Issued 100 tons Issued 80 tons Received from vendor 200 tons at Rs. 24.50 Refund of surplus from a work order 15 tons at Rs. 24 Issued 180 long Received from vendor 240 tons at Rs. 24.40 Issued 304 tons Received from vendor 320 tons at Rs. 24.30 Issued 112 tons Refund of surplus from a work order 12 tons at Rs. 24.50 Received from vendor 100 tons at Rs. 25

Issues are to be priced on the principle of LIFO and simple average method. The stock verifier of the factory noted that on the 15th he had found a shortage of 5 tons and on 27th another shortage of 8 tons. Write out complete stores ledger account in respect of the material. (4) A cloth manufacturer commenced the business on 1.1.82. Textile materials used include two types - M & N. During 6 months ending on 30.6.82, transactions were as follows : Date M 4.1.82 6.1.82 7.1.82 12.1.82 18.3.82 28.3.82 16.4.82 22.4.82 26.5.82 1.6.82 2.6.82 8.6.82 1000 17.50 1300 800 9.50 1580 3000 16 2860 2300 12 1420 1000 1600 Purchased (Mtrs.) N Rates per Mt. 10 15 700 1200 Issued (Mtrs.) M N

234

Management Accounting

You are required to prepare stores ledger account for M type of material by charging issues by LIFO method and N type of material by charging the issues on weighted average method. (5) The stores ledger account of material C in the books of Saurabh and Sweta Ltd. revealed following transactions for September 1984, Sept. 1 5 8 Opening stock 200 kgs at Rs. 7.50 per kg. Received from supplier 400 kgs at Rs. 7.75 per kg GRN 448 Issued to Production Dept. 240 kgs SR No. 883

10 Received from supplier 500 kgs at Rs. 7.90 per kg. GRN 45 12 Issued to Production Dept. 160 kgs SR No. 897 15 Issued to Production Dept. 400 kgs SR No. 912 16 Received from supplier 250 kgs at Rs. 8.00 per kg GRN 469 19 Received from supplier 600 kgs at Rs. 8.25 per kg GRN 561 21 Issued to Production Dept. 350 kgs SR No. 946 24 Issued to Production Dept. 260 kgs SR No. 959 27 Issued to Production Dept. 340 kgs SR No. 974 You are required to price the issues and draw out the closing balance in the stores ledger account under the pricing method in which the material costs charged to production would be closely related to current prices. (6) Record the following transactions in a store ledger and show the cost of consumption and closing stock by using FIFO method of pricing issues. For the month of January 1985 : Jan. 1 Opening Stock 300 units at Rs. 9.70 per unit 3 Purchases 250 units at Rs. 9.80 per unit 15 Purchases 300 units at Rs. 10.50 per unit 25 Purchases 150 units at Rs. 10.30 per unit Jan. 11 Issues 20 Issues 29 Issues 400 units 210 units 100 units

Material Cost

235

(7)

Prepare a stores ledger account on the basis of FIFO method. Jan. 1 3 4 6 Opening stock Purchased Purchased Issued 250 units 100 units 200 units 400 units 400 units 150 units 100 units 100 units 200 units 300 units @ Re. 1 each @ Rs. 1.25 each @ Rs. 1.20 each @ Re. 1 each @ Rs. 1.05 each @ Rs. 1.05 each

10 Purchased 12 Issued 13 Issued 16 Purchased 22 Purchased 31 Issued (8)

The following is a summary of the receipts and issues of a material in a factory during a month. 1st Opening Balance 500 units at Rs. 25 per unit. 3rd Issued 70 units. 4th Issued 100 units. 8th Issued 80 units. 13th Receipts 200 units at Rs. 24.50 per unit (Supplier) 14th Returned to stores 15 units at Rs. 24 per unit. 16th Issued 180 units. 20th Receipts 240 units at Rs. 24.75 per unit (Supplier) 24th Issued 304 units. 25th Receipts 320 units at Rs. 24.50 per unit (Supplier) 26th Issued 112 units. 27th Returned to stores 12 units at Rs. 24.50 per unit 28th Received from supplier 100 units at Rs. 25 per unit. Stock verification revealed that on 15th there was a shortage of 5 units and another on 27th of 8 units. Prepare Stores Ledger Account on the basis of FIFO basis.

236

Management Accounting

(9)

Following is an extract of receipts and issues for the month of January 1989 of a manufacturing company. Date 2 4 6 10 15 19 22 25 30 Purchased Purchased Issued Purchased Issued Issued Issued Purchased Issued 8,000 units 1,000 units 4,000 units 12,000 units 8,000 units 2,000 units 4,000 units 9,000 units 6,000 units @ Rs. 2.75 @ Rs. 3 @ Rs. 2 @ Rs. 2.50

Draw up store Ledger Account by LIFO method showing balance as on 31.1.89 (10) The transactions in connection with the materials are as follows : Days Unit 1st 2nd 3rd 4th 5th 6th 40 20 50 Receipts Rate per unit Rs. 15.00 16.50 14.30 Issues (Units)

30 20 40

Calculate the cost of material issued under FIFO method and Weighted Average method of issue of materials. (11) From the following details of stores receipts and issues of Material EXE in a manufacturing unit, prepare the stock ledger using Weighted Average method of valuing the issues. Nov. 1 Opening Stock 2,000 units (S) Rs. 5.00 each Nov. 3 Issued 1,500 units to production Nov. 4 Received 4,500 units @ Rs. 6.00 each Nov. 8 Issued 1,600 units to production. Nov. 9 Returned to stores 100 units by production department (from the issues of Nov. 3) Nov. 16 Received 2,400 units @ Rs. 6.50 each
Material Cost

237

Nov. 19 Returned to supplier 200 units out of the quantity received on Nov. 4Nov. 20 Received 1,000 units @ Rs. 7 each. Nov. 24 Issued to production 2,100 units Nov. 27 Received 1,200 units @ Rs. 7.50 each Nov. 29 Issued to Production 2,800 units (Use rates upto two decimal places) (12) The following are the transactions in respect of purchases and issues of components forming part of an assembly of a product manufactured by a firm which requires, to update its cost of production very often for bidding tenders and finalising cost plus contracts. Date 1986 January February 5 11 1 18 26 March 8 17 28 Quantity (in Nos.) 1,000 2,000 1,500 2,400 1,000 1,000 1,500 2,000 Particulars

Purchased @ Rs. 1.20 each Issued Purchased @ Rs. 1.30 each Issued Issued Purchased @ Rs. 1.40 each Purchased @ Rs. 1.30 each Issued.

The stock on 1st January 1986 was 5,000 Nos. valued at Rs. 1.10 each. State the method you would adopt in pricing the issues of components giving reasons. What value would you place on stocks as on 31st March which happens to be the financial year end and how would you treat the difference in value, if any, on the stock account. (13) The following are the extract from the transactions on the bin card of Job No. 12-3-89 for March 1987 Date 2 6 8 12 15 18 28 On order 50 Receipt 40 50 30 Rate 25.00 28.00 24.00 26.00 Issue 20 30 50 Balance 40 20 70 40 70 70 20

238

Management Accounting

Find out the pricing of material issue under LIFO, FIFO and simple average method. (14) XYZ Ltd. requires 20,000 units of product A per annum. The purchase price is Rs. 4 per unit. The inventory carrying cost is 20% per annum and the cost of ordering is Rs. 100 per order. Advise the company, on how many times they should order in a year, so as to minimise the cost of product A? (15) A Manufacturer buys certain essential spares from outside suppliers at Rs. 40 per set. Total annual requirements are 45000 sets. The annual cost of investment in inventory is 10% and costs like rent, stationery, insurance, taxes etc. per unit per year work to Re. 1, cost of placing an order is Rs. 5. Calculate the Economic Order Quantity. (16) Following information relating to a type of raw material is available. Annual Demand Unit Price Ordering cost per order Storage cost Interest Rate Lead Time 2,400 units Rs. 2.40 Rs. 4.00 27% p.a. 10% p.a. Half month

Calculate Economic Order Quantity and total annual inventory cost in respect of the particular raw material. (17) From the particulars given below, you are required to compute. (a) (b) (c) (d) (e) Economic Order Quantity Maximum Level Minimum Level Re-ordering Level Average stock Level (i) (ii) (iii) (iv) Quantity required annually 3,000 units @ Rs. 5 per unit. Interest and cost of storing 10%. Cost of placing an order Rs. 30 per order. Consumption per week Normal 60 units Maximum 70 units Minimum 50 units. (v) Lead time (in weeks) Normal 5 Maximum 6 Minimum 4

Material Cost

239

(18) The Stock-Ledger Account for material X in a manufacturing concern reveals the following data for the quarter ended September 30, 1989. Receipts Quantity Units July 1 Balance b/d 1.600 July July August August August September September September 9 13 5 17 24 11 27 29 3,000 3,600 2,500 2.00 2.20 2.40 2.50 1,200 900 1,800 2,100 700 2,556 1,917 4,122 4,971 1,656 Price Rs. Quantity Units Issues Amount Rs.

Physical verification on September 30, 1989 revealed an actual stock of 3,800 units. You are required to : (a) (b) Indicate the method of princing employed in the above. Complete the above account by making entries you would consider necessary including adjustments, if any, and giving explanations for such sdjustments.

(19) Following information is available in respect of two components A and B. Particulars Normal Usage Minimum Usage Maximum Usage Lead Time Annual Consumption Ordering cost per order Carrying cost per unit per year Calculate for each component. Units Units Units Week Units Rs. Rs. A 50 25 75 4-6 9,000 45 9 B 50 25 75 2-4 6,250 100 5

240

Management Accounting

(i) (ii)

Re-order level Minimum level

(iii) Maximum level (iv) Average level

(20) P. Ltd. uses three types of materials, A, B and C for production of X, the final product. The relevant monthly data for the components are as given below : A Normal Usage (Units) Minimum Usage (Units) Maximum Usage (Units) Re-older Quantity (Units) Re-order period (Months) Calculate for each component. (1) (2) (3) (4) Re-order Level Minimum Level Maximum Level Average stock Level 200 100 300 750 2 to 3 B 150 100 250 900 3 to 4 C 180 90 270 720 2 to 3

(21) The following data are available from the records of M/s. Naveen Industries Ltd. using two types of materials A and B for the manufacture of their product. A Normal Usage (Units per month) Minimum Usage (Units per month) Maximum Usage (Units per month) Reorder Quantity (Units) Reorder Period (Months) Compute for each type of material, the following levels. (1) (2) (3) (4) Reorder Level Minimum Level Maximum Level Average Stock Level 250 100 350 900 2 to 3 B 200 200 400 1000 3 to 4

Material Cost

241

(22) Following details are available in respect of a material. (i) (ii) Ordering cost per order Rs. 45 Annual consumption 9,000 units

(iii) Carrying cost per unit per year Rs. 9 (iv) Lead Times Average - 10 days Minimum 6 days Maximum 15 days Maximum for emergency purchases 4 days (v) Rate of consumption - Average 15 units per day Maximum 20 units per day Calculate : (i) (ii) Reordering Level Maximum Level

(iii) Minimum Level (iv) Average Level

(23) Certain purchased part of which annual requirements are 8000 units, involves ordering cost equal to Rs. 12.50 per order, cost per piece Re. 1 and the annual carrying cost 20%. In addition, average daily usage is 32 units (based on 250 operating days per year), lead time is 10 days and safety stock has been calculated to be 100 units. Calculate : (a) (b) (24) (i) Economic Order Quantity Reorder point XYZ Company buys in the lot of 500 boxes which is a 3 months supply. The cost per box is Rs. 125 and the ordering cost is Rs. 150. The inventory carrying cost is estimated at 20% of unit value. What is the total annual cost of the existing inventory policy? How much money could be saved by employing the economic order quantity?

(ii)

(25) To decided to buy an item, the following data is given. Annual Demand 600 units Ordering Cost - Rs. 400 Holding Cost - 40%

242

Management Accounting

Cost per unit - Rs. 15 Discount 10% if the order quantity is 500 What should be the decision? Justify your answer. (26) A manufacturer requires 10 lakhs components for use during the next year which is assumed to consist of 250 working days. The cost of storing one component for one year is Rs. 4 and the cost of placing order is Rs. 32. There must always be a safety stock equal to two working days usage and the lead time from the supplier, which has been guaranteed, will be 5 working days throughout the year. Assuming usage takes place steadily throughout the working days, delivery takes place at the end of the day and orders are placed at the end of working day, you are required to calculate. (i) (ii) Economic Order Quantity. Reorder point.

(27) Anil Company buys its annual requirement of 36,000 units in six instalments. Each unit costs Re. 1 and the ordering cost is Rs. 25. The inventory carrying cost is estimated at 20% of the unit value. Find the total cost of the existing inventory policy. How much money can be saved by using Economic Order Quantity? (28) A Company, for one of the A class items, placed 6 orders each of size 200 in a year. Given ordering cost Rs. 600, holding cost 40%, cost per unit Rs. 40, find out the loss to the Company by not operating scientific inventory policy. What are your recommendations for the future? (29) A manufacturer has to supply his customers 600 units of his product per year. Shortages are not allowed and the inventory carrying cost amounts to Rs. 0.60 per unit per year. The set up cost per run is Rs.80. Find (a) (b) (c) The Economic Order Quantity The minimum average yearly cost. The optimum number of orders per year.

(30) A purchase manager has decided to place order for minimum quantity of 500 numbers of a particular item in order to get a discount of 10%. From the records, it was found that in the last year, 8 orders each of size 200 number have been placed. Given Ordering cost Rs. 500 per order, Inventory carrying cost 40% of the inventory value and cost per unit Rs. 400, is the purchase manager justified in his decision. What is the effect of his decision on the company?

Material Cost

243

(31) A publishing house purchases 2000 units of a particular item per year at a unit cost of Rs. 20, the ordering cost per order is Rs. 50 and the inventory carrying cost is 25%. Find the optimal order quantity and minimum total cost including purchase cost. If a 3% discount is offered by the supplier for purchase in lots of 1000 or more, should the publishing house accept the proposal? (32) Calculate for each Component A and B the following (a) (b) (c) (d) Reorder Level Maximum Level Minimum Level Average stock Level 300 units per week each. 450 units per week each 150 units per week each

Normal Usage Maximum Usage Minimum Usage Reorder Quantity

- A - 2,400 units B - 3,600 units

Reorder Period

A - 4 to 6 weeks B - 2 to 4 weeks

244

Management Accounting

NOTES

Material Cost

245

NOTES

246

Management Accounting

Chapter 9
LABOUR COST

Labour Cost is another important element of cost in the manufacturing cost. It is important element of cost eventhough the production is material intensive. The basic factor which gives rise to the labour cost is the remuneration paid to workers. However, the objective of cost accounting (i.e. cost ascertainment with respect to the individual cost centre and cost control) can not be fulfilled properly unless and until the functions performed by the related departments are properly considered. These functions can be stated as below : (1) Personnel Department : This ensures the availability of correct workers to perform the jobs which are best suited for them. This is done by selecting them properly and training them properly. This department may also be involved with maintenance of records of job classification/ wage rates payable to workers, preparation of wages sheet and procedural aspects of wage payment. Time Keeping Department : This is concerned with recording of workers time. This is not only for the purpose of wage calculations but also for the purpose of cost analysis and apportionment of cost over various jobs. The main functions performed by this department are time keeping and time booking. Cost Accounting Department : This department accumulates and classifies cost data with respect to labour cost from the analysis of wages sheet and presents the reports to management to facilitate the control over labour cost.

(2)

(3)

The starting point for ascertaining the labour cost is in the form of Time Keeping and Time Booking. Time Keeping : This is the process of recording attendance time of the workers. It is the responsibility of Time Keeping Department which may function as separate department in some cases or else may function as the part of Personnel Department. Attendance time recording may be necessary as the payment of wages may depend on the attendance. Even when the payment of wages does not depend on time attended, say in case piece rate payment, the recording of time attended may be necessary from the following angles.

Labour Cost

247

(1) (2)

To Maintain discipline. Though the regular wages may not depend upon the time attended, in some cases, the other payments like overtime wages, dearness allowance etc. may be linked with the attendance. The fringe benefits like Pension, Gratuity on retirement. Provident Fund etc. may depend on the continuity of service which will be available only if time attended is recorded properly. Attendance records may be required for research and other purposes.

(3)

(4)

Methods of Time Keeping : For the purpose of time keeping, various methods may be followed, though the selection of the method may depend upon nature of organization and policy of management. Main such methods may be stated as below: (1) Hand-Written Method : Under this method, names of the workers are recorded in the attendance register with provision of various columns for various days. The attendance of the worker may be recorded either by calling out his name or by physical check. Alternatively, the workers themselves may sign in the attendance register. This method, though simple, has become outdated. This method can also result in malpractices with the collusion between workers and time keeping/ personnel department. Also recording of late coming, overtime, short leave etc. may involve more clerical work and may be subject to errors. (2) Token or Disc Method : Under this method, each worker is allotted an identification number and a disc or token bearing that number. Immediately before the scheduled opening time, all the tokens/ discs will be placed at the factory gate. Every incoming worker will take out his token and drop it in a separate box or hang it on a separate board. The tokens/discs not removed will indicate that the said worker is absent. Similar procedure is followed while the workers leave the factory. In addition to the physical handling of tokens/ discs, it will be required to record the attendance time separately. Though it is an improved method, as compared to manual/handwritten method, it is also subject to errors.mistakes and frauds. Further care should be taken to see that a worker does not remove the disc/token of his absent fellow in addition to his own.

248

Management Accounting

(3)

Time Recording Clock Method : Under this method, every worker is alloted individual ticket number and a clock card which bears that ticket number. The cards are placed on two racks on either side of the time recording clock denoting separately In rack and Out rack. At the opening time, all the cards are placed in Out rack. On arrival, worker takes out his own card, puts it in the slot available on the time clock recorder which punches the time on that card, and places the card in In rack. All the cards, left in the Out rack indicate absent workers. At the time of departure, he removes the card from In rack, gets it punched and places it in Out rack. Though, this method involves heavy capital outlay initially, it has certain advantages also. (1) It is economical in the sense it avoids clerical work: involved in manual/handwritten method. It is clean, safe and quick and has printed records to avoid disputes. Chances of fraudulent entries being made can be avoided.

(2) (3)

Time Booking : The ultimate aim of costing is to decide the cost of each cost centre. As such, recording of time attended is not sufficient. Equally important is to record the time spent for individual cost centres. This process is in the form of time booking. The methods followed for this purpose, may be considered as below : (a) Daily time sheets :

Under this method, each worker is provided with a daily time sheet on which time spent by him on various jobs/work orders is expected to be mentioned. If the worker works on various jobs in a particular day, the daily time sheets move along with the worker. The entries on the same may be made by the worker himself or by the foreman. This method may be conveniently used if the worker works on various jobs of short duration. Say in case of maintenance jobs. This method is disadvantageous in the sense that it involves considerable paper work. The form in which the daily time sheets may be prepared is as below :

Labour Cost

249

DAILY TIME SHEET Name of Employee Employee No. Job No. Dept. Time Record ON OFF Date : Time taken

Checked by (b) Weekly Time Sheets :

Cost office reference

Under this method also; one sheet is alloted to each worker but instead of recording the work done for a day only, record of time for all the jobs during the week is made. These types of time sheets are useful for intermittent types of jobs like building or construction work. It involves comparatively less paper work. The form in which weekly time sheets may be prepared is as below. WEEKLY TIME SHEET Name of Employee Employee No. Day Job No. On Time Off Time taken Standard Rate Amount Week ending on...

TOTAL Checked by Cost office reference

250

Management Accounting

(c)

Job Card :

Under this method, the details of time are recorded with reference to the jobs or production/ work orders undertaken by the workers rather than with reference to individual workers, and this facilitates the computation of labour cost with reference to jobs or production/work orders. There may be two ways in which job card may be maintained. (1) According to first method, each job or production/work order is alloted a number. When a worker takes up a job, the time of starting and finishing the job is entered on the card meant for that worker. The summary of this card states the total time taken by that worker for that job. In order to compute the total time booked for the job as a whole, all cards of all the workers with respect to that job are required to be analysed. The form in which this card may be prepared is as below. JOB CARD Name of Employee Employee No. Day ON FRI SAT SUN MON TUE WED Time OFF Time Taken Standard Rate Rs. Amount Rs. Job No.

Checked by (2)

Cost office reference

According to this method, a job card is prepared for each job production/work order accepted by the organization for execution. It describes the various operations/stages involved in the execution of the job. Time taken by the various workers to complete the job is entered on the card. This provides the information about the time taken by various workers to complete a particular job.

Labour Cost

251

The form in which this card may be prepared is as below. JOB CARD WITH OPERATIONS Job No. Job Description Operation Employee No. ON OFF Time taken Rate Amount Drawing No.

Cutting 1 2 Drilling 1 2 Grinding 1 2 Painting 1 2 Assembly 1 2 3 TOTAL

Checked by Reconciliation of time attended and time booked

Cost office reference

If a combined time and job card is maintained, the problem of reconciliation will be relatively simple as both the details will be available on the same card. In other cases, at the end of the wage period or at a shorter interval also, the total time attended has to be compared with the time booked on job cards on the various jobs. If the time booked as per the job cards, is less than the attendance time, this indicates the idle time during which the worker has not done any work, though he was present in the factory.

252

Management Accounting

Methods of remunerating the workers : Remuneration to workers indicate the reward for labour and services. The remuneration may be paid in monetary terms (which in turn may be in direct form or indirect form) or nonmonetary terms. The remuneration paid in the monetary form may be by way of basic wages or salaries and other allowances and may be paid either on time basis or on work basis. However, payment of only basic wages or salaries may not be sufficient enough to induce the workers to work efficiently, hence they may be remunerated in the form of some incentives. In case of remuneration in non-monetary form, the workers may not receive anything in the from money but they may get facilities which induce them to stay with the organization. It may be in the form of the provision of health or welfare or recreational facilities, provision of working conditions and so on. We will discuss these methods of remuneration under the following heads. (1) (2) (3) Remuneration on Time Basis i.e. Time Rate System. Remuneration on Work Basis i.e. Payment by Results. Incentive/Bonus Systems. (a) (b) (4) Individual Incentive Systems Group Incentive Systems.

Indirect monetary remuneration (a) (b) Profit sharing Co-partnership

(5)

Non-monetary incentives

Principles of a good wage payment system : (1) As a general rule, if the efficiency of the workers can be measured in the objective terms, the wages receivable by a worker should be in conformity with his efficiency. Otherwise an efficient worker is likely to be demotivated from working efficiently. At the same time, the standards fixed to measure the efficiency of a worker should be normal which can be attained by a normal worker under normal conditions. The wage payment system should be clearly defined and communicated to the workers leaving no scope for any ambiguity. At the same time, a good wage payment system should be simple to understand and easy to operate. No upper limit should be imposed on the wages which can be earned by an efficient worker.

(2)

(3)

Labour Cost

253

(4)

A good wage payment system will not punish the workers for the matters beyond the control of the workers. E.g. Workers should not be punished in terms of reduced wages due to the circumstances like machinery break down or power failures etc. A good wage payment system should be reasonably permanent in nature. Frequent changes in the same should be avoided. If any changes are proposed to be made in system of wages payment, they should not be thrust upon the workers by force, but should be implemented by having mutual discussions with and due approval from the workers. Wage payment system should be properly tied up with quality control procedures to ensure that the workers are paid only for good and quality production. The basic objective of the wage payment system should be to get maximum cooperation from the workers, improve the morale and productivity of the workers and to minimize the cost of supervision and labour turnover. The wage payment system should take into consideration the external obligations to which the organization may be subjected to. These obligations may be in the form of various statutes like Minimum Wage Act and the agreement entered into with the workers and so on. Time Rate System :

(5)

(6)

(7)

(8)

(A)

Under this, a worker is paid on the basis of time attended by him. He is paid at a specific rate irrespective of the production achieved by him. The pay rate may be fixed on daily basis, weekly basis or monthly basis. This type of remuneration system is helpful in the following circumstances. (a) If the output of the worker is beyond his control e.g. His speed depends upon speed of a machine or speed of other workers. If the output cant be measured or standard time cant be fixed e.g. Maintenance work. If close supervision is possible. If quality, accuracy and precision in work is of prime importance e.g. Artist, Ad-agency person.

(b) (c) (d)

The time rate system of remunerating the workers is useful due to the following features : (a) (b) (c) (d) 254 Useful for highly efficient and highly inefficient workers. Easy for calculations. Easy to understand for the worker. Assurance of minimum wages.
Management Accounting

The time rate system has one most important disadvantage attached to it that the efficiency of the worker is disregarded while paying remuneration to him. To avoid this difficulty, some variations as discussed below can be applied in practice. (i) High Wage Plan :

Under this system, timely wage rate of the workers may be fixed at such a level which is higher as compared to wages paid to workers in the same industry or locality. Suitable working conditions are provided. Correspondingly, a high standard of efficiency is expected from the workers. Those who are not able to come up to the standard, are taken off the scheme. (ii) Differential Time Rate :

Under this method, different hourly rates are fixed for different levels of efficiency. Up to a certain level of efficiency, normal day rate is applicable which gradually increases as efficiency increases. This can be illustrated as below : Up to 80% efficiency 80% to 90% efficiency 90% to 100% efficiency 101% to 125% efficiency (B) Payments by results : : : : : Re. 1.00 per hour (Normal Rate) Rs. 1.25 per hour Rs. 1.40 per hour Rs. 1.50 per hour

Under this system, workers are paid according to the production achieved by them. In many cases, time attended is not material. These methods can be reclassified as below. (a) Straight Piece Rate System :

Under this method, each job, production or unit of production is termed as a piece and the rate of payment is fixed per piece. The worker is paid on the basis of production achieved irrespective of the time taken for its performance. Thus, the earnings of the worker can be computed as : Wages = No. of units produced x Piece Rate per unit This method can be suitably applied if the production is of standard or repetitive nature. It cant be applied if the production cant be measured in suitable units. It can be seen that the crux of this method is to decide the time required to complete a piece. The fixation of this time should be done in such a way that within that much time, a normal worker can complete the piece. This can be done either on the basis of previous experience or on the basis of time and motion study.

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255

(b)

Piece Rate With Guaranteed Time Rate :

Under the straight piece rate system, the remuneration of a worker depends upon the production achieved. If the production is less due to some factors beyond his control, he is likely to be penalised. To remove this difficulty, it may be decided that he will be paid on time rate if his piece rate earnings fall below time rate earnings, so that the worker is assured of minimum earnings on time basis. However, if this guaranteed time rate payment is too high, the incentive to increase output to get piece rate payment is less. (c) Differential Piece Rate System :

Under this system, higher rewards are guaranteed to more efficient workers. The piece rates are fixed in such a way that normal piece rate is paid for work performed within and upto the standard level of efficiency. If efficiency exceeds the standard, payment at higher piece rate is made. This can be illustrated as below : Up to 83% efficiency Up to 100% efficiency Above 100% efficiency Normal Piece Rate. 10% above normal piece rate. 30% above normal piece rate.

This method offers more inducement to the workers to work more efficiently and earn higher wages. But it is complicated to understand and expensive to operate. Following systems use this principle of differential piece rates. (1) Taylor Differential Piece Rate System :

This was introduced by F.W. Taylor. It provides two piece rates, a low piece rate for output below standard and a high piece rate for output above standard and does not provide for any guaranteed time rate payment. Eg. If standard output is 10 units and piece rate is Re.l per unit, the total wages are : (i) If actual hourly output is 8 units i.e. below standard, the piece rate is say 80% of normal piece rate i.e. Re. 0.80. Hence total wages are 8 units x Re. 0.80 = Rs.6.40. If actual hourly output is 12 units i.e. above standard, the piece rate is say 120% of normal piece rate i.e. Rs. l.20.

(ii)

Hence, total wages are 12 units x Rs.l.20 = Rs. 14.40. The basic defect with this system is that eventhough the efficiency of the worker is below standard even marginally, he is punished heavily and even though the efficiency of the worker is above standard even marginally, he is benefited to a very great extent.

256

Management Accounting

(2)

Merrick Differential Piece-rate System :

To remove the defect existing in case of Taylors System which heavily punishes the worker who produces below standard, the Merrick System provides for three piece rates Eg. Efficiency Up to 83% Up to 100% Above 100% Piece rate Normal 110% of normal piece rate 130% of normal piece rate

It should be noted that under this method also, no guaranteed time rate payment is provided. Illustration : The following particulars relate to a company. Piece Rate M N O 6 paise per unit. Production of the workers 125 units per day 80 units per day 150 units per day

Standard production per day 120 units. Calculate the wages of the workers on the basis of Merricks Differential piece rate system, when basic piece rate is guaranteed below the standard and workers get 108% of the basic piece rate between 100% and 120% of the basic piece rate above 120% efficiency. Solution : Calculation of total wages : (a) Worker M : Actual production 125 units i.e. 104% efficiency. Applicable piece rate - 108% of normal i:e. 6.48 paise per unit. Total wages : 125 units x 6.48 paise = 810 paise i.e. Rs. 8.10 (b) Worker N : Actual production 80 units i.e. below the standard. Applicable piece rate : basic piece rate i.e. 6 paise per unit Total wages : 80 units x 6 paise = 480 paise i.e. Rs. 4.80

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257

(c)

Worker O : Actual production 150 units i.e. 125% efficiency. Applicable piece rate - 120% of normal i.e. 7.20 paise per unit. Total wages 150 units x 7.20 paise = 1080 paise i.e. Rs. 10.80

(3)

Gantt Task Bonus System :

This system is a combination of time rate and piece rate and provides for minimum time rate payment. A high task or standard is set. The wage structure may be fixed as below. Output below standard Output at standard Output above standard (C) Minimum time rate payment. Time wages plus some increase in wage rates. High piece rate for entire output.

Individual Incentive Systems :

In case of time rate systems, the losses due to inefficiency of workers or benefits due to efficiency of workers are suffered or enjoyed by the employer alone. Similarly in case of piecerate systems, the losses due to inefficiency of workers or benefits due to efficiency of workers are suffered or enjoyed by the worker alone. (The employer may be indirectly affected in the form of increased or decreased per unit overheads.) The incentive systems differ from both these systems in such a way that the financial advantages arising out of the efficiency of workers are enjoyed by both employer as well as workers. There are various systems by which the incentive may be paid to workers. We will consider following main systems. (a) Halsey Premium System :

Under this system, if the actual time taken is equal to or more than standard time, worker is paid at the time rate. If actual time is less than standard time, the worker, in addition to time wages for hours actually worked, gets a bonus payment. The bonus is equivalent to the wages for the time saved in the decided percentage to be shared with the employer The percentage allowed to worker may vary from 30% to 70% (usually 50%). The total wages payable to the worker under this system, can be computed as below. AH X HR Where AH SH HR + (SH - AH) X HR 2 Actual hours Standard hours Hourly rate Assuming 50% - 50% sharing

258

Management Accounting

(b)

Halsey - Weir Premium System :

This system is a deviation of Halsey Premium System only with the exception that the ratio of sharing between the worker and the employer is fixed as 1/3 : 2/3. The computation of total wages is the same as in case of Halsey Premium System, except the change in this ratio. (c) Rowan Premium System :

Under this system also, guaranteed time rate payment is made. The amount of bonus paid is a percentage of hourly rate which is in proportion to the time saved. The total wages payable to the workers under this system can be computed as below : AH X HR Where AH SH HR + SH - AH SH Actual Hours Standard Hours Hourly Rate X AH X HR

Comparative study of Halsey and Rowan System : Comparative study of total wages under both these systems reveals that if time saved is less than 50% of the standard time. Rowan system assures more wages than those under Halsey system. But if time saved exceeds 50% of the standard time, Halsey system proves to be more beneficial. In Rowan System a less efficient worker gets the same bonus as a more efficient worker. As such Rowan System may be implemented in case of loose fixation of standards. The fall in bonus as time saved increases, offsets the damage done by loose standards. Illustration : The following are the particulars given to yon. Standard time Time rate .. 10 hours. .. Re. 1 per hour.

Prepare a comparative table under Halsey Premium System and Rowan Premium System, if time taken is 9 hours, 8 hours, 6 hours, 5 hours 4 hours and 3 hours. Also calculate the amount of total wages and labour cost per hour under two methods. What conclusions do you draw from the table.

Labour Cost

259

Solution : Hours taken Halsey Premium system Wages = Actual Hours x Hourly rate + 1/2 (Time Saved x Hourly rate) Rowan Premium system. Wages = Actual Hours x Hourly rate + Time Saved/Time Allowed Actual Hours x Hourly rate Wages = 9 x 1 + 1/10 x 9 x 1 = Rs. 9.90 Wages = 8 x 1+ 2/10 x 8 x 1 = Rs. 9.60 Wages = 6 x 1 + 4/10 (6 x 1) = Rs. 8.40 Wages = 4 x 1 + 6/10 (4 x 1) = 6.40 Wages = 3 x 1 + 7/10 (3 x 1) = Rs. 5.10

(a) (b) (c) (d) (e)

9 8 6 4 3

Wages = 9x1+1/2 (I x 1) = Rs. 9.50 Wages = 8x1+1/2 (2 x 1) = Rs. 9 Wages = 6x1+1/2 (4 x 1) = Rs. 8 Wages = 4 x 1 1/2 (6 x 1) = Rs. 7.00 Wages = 3 X l+ 1/2 (7 x 1) = Rs. 6.50

Conclusion : It can be concluded from the above table that so long as time saved is less than 50% of standard time, the total wages are more under Rowan Premium system than under Halsey Premium System. If the time saved is more than 50% of standard time, Halsey system proves to be more beneficial in terms of the total wages. The other systems for making the payment of premium can be briefly described as below. (a) Barth Premium System :

Under this system, the wages payable to the workers are computed as below. Wages = Hourly Rate x

Standard Hours x Actual Hours

Eg. Standard Hours are 10 Actual hours are 8 Hourly rate is Rs. 2 per hour. Total wages will be 2x

10x8

= Rs. 17.89

260

Management Accounting

It should be noted that this system does not provide for any guaranteed time wages. This system is suitable for beginners or apprentices. (b) Emersonss Efficiency Bonus System :

Under this system the wages payable to the workers are computed as below. Wages = Actual Hours x Hourly Rate + Bonus Percentage x Actual -Hours x Hourly rate. For calculating bonus percentage, following directions are provided. Efficiency (1) Below 66.2/3 % Bonus No bonus is payable. Only the guaranteed time wages are payable. (2) 66.2/3% to 100% In Addition to time wages, bonus is paid at different percentages increasing rapidly to 20% at 100% efficiency. In addition to time wages and bonus @ 20%, 1% bonus for each 1% increase in efficiency beyond 100% is paid. Eg. 101 % efficiency - 21 % Bonus 110 % efficiency 120 % efficiency - 30 % Bonus - 40 % Bonus & so on.

(3) Above 100 %

The efficiency percentage can be calculated as below. (1) On time basis : Standard Hours Actual Hours (2) On output basis : Actual output Standard output x 100 x 100

Eg. Standard Hours are 10 Actual Hours are 8 Hourly Rate is Rs. 2 per hour.

Labour Cost

261

Efficiency percentage will be as below. Standard Hours Actual Hours X 100 = 10 8 X 100 = 125%

Bonus percentage will be 45% Total Wages = 8 x 2+ 45% of 8 x 2 = 16 + 45% of 16 = 16 + 7.20 = Rs. 23.20 It can be seen that the abovestated system is similar to that of piece rate with guaranteed time rate. This system may be suitable for non efficient workers for improving their efficiency. (c) Bedaux Point System :

Under this system, the standard time is divided into standard minutes, each standard minute identified as Bedaux Point or B. The wages payable to the worker are computed as below. Wages = Actual Hours x Hourly Rate + 75 % of BS x Hourly Rate 60

Where BS indicates the number of Bs saved i.e. the difference between Bs earned and standard Bs allowed for the job. Eg. Standard points for a job - 400 points in 8 hours. Hourly Rate - Rs. 3 per hour. Wages = = = = 8x3+ 75% of (450 - 400) x 3 60

24 + 75% of 2.50 24 + 1.875 Rs. 25.875.

It should be noted that a very accurate system of work study is required for this system. It is difficult to understand and involves a lot of clerical efforts.

262

Management Accounting

(d)

Accelerating Premium System :

Under this system, incentive increases at a fast rate with the increase in output. Total wages payable to the worker are computed as below. Y = 0.8 X2 where Y = Earnings X = Efficiency.

i.e. If efficiency is 140%, the earnings will be : 0.8 x 140 x 140 100 100 x 1.568 of basic wages i.e.

100% wages, 56.8% bonus. Eg. Standard hours are 10 Actual Hours are 8 Hourly rate is Rs. 2 per hour. Efficiency percentage will be

10/8 x 100 = 125% Earnings = 0.8 x = 1.25 Earnings will be 125% of basic wages i.e 100% basic wages, 25% bonus. 8x2 25% of Rs. 16 = 16 =4 = 20 125 125 x 100 100

Basic, wages Bonus Total Wages

This system is very difficult to understand. (e) Baum Differential Plan :

This is a combination of Taylors differential piece rate system and Halsey system and is also known as Milwaukee Plan.

Labour Cost

263

(f)

Diemer System :

This is a combination of Halsey System and Gantt system. (D) Group Incentive System :

In many cases, the output of the individual workers cannot be measured though the output of a group of workers can be measured. In such cases, the individual time rates or in some specified proportion depending upon the skill of the workers or equally, can be applied. (E) Indirect Monetary Remuneration :

This may take the following two forms. (a) Profit Sharing : According to this method, the workers, are entitled to share in profits earned by an organisation, in addition to the regular wages, at a specified percentage. The legal provisions in this regard are enacted by way of Payment of Bonus Act, 1965. According to the provisions of this Act, all the employees drawing a monthly remuneration of Rs. 2,500 or less are entitled to a bonus at the minimum rate of 8.33% of wages of the subject to the maximum ceiling of 20 % of the wages. It should be noted that the statutory requirement of the payment of bonus does not depend on the profit earned necessarily, as the bonus is payable eventhough there are no profits. It is also worth noting that the statutory requirement of payment of bonus is the specific percentage of the wages or salaries paid to the workers and hence remains unaffected by any changes, either upwards or downward, in the profits earned by the organisation. (b) Co-partnership : According to this method, the workers are granted ownership rights in the operations of the organisation by which the workers are in the position to control the affairs of the organisation. In corporate organisations, it may be in the form of offering the shares of the company to the workers or granting of loans to the workers to buy companys shares, according to which the workers get the voting rights to control the affairs of the company. The workers get dividend on the shares as bonus. With the help of this method, the morale of the workers is increased. However, certain objections are raised against this method. First, the increase in earnings is too small. Second, the shareholding of the workers is too small to control the affairs of the company. Third, the workers are not rewarded according to the individual efficiency.

264

Management Accounting

(F)

Non-monetary Incentives :

The intention of these incentives is to attract better workers, retain the existing workers, encourage loyalty, reduce labour turnover, provide better working conditions to workers and so on. Various benefits as stated below may be granted to the workers, either free or at reduced rates, remaining amount being contributed by the workers. (1) (2) (3) (4) (5) Health and safety services. Education and training to workers and their children. Canteen facility. Pension, superannuation fund etc. Loans at reduced rate of interest.

IMPORTANT TERMS IN CASE OF LABOUR COST : (A) Labour Turnover :

In every business organisation, the process of employees leaving the organisation and new workers being recruited is a normal feature. Labour Turnover indicates this change in labour force showing a highly increasing trend or highly decreasing trend. Labour turnover showing sharp increasing trend may involve the reduction in labour productivity and increasing costs. Too low a labour turnover trend may be due to inefficient workers who would not like to leave the organisation. Causes of labour turnover : The causes of labour turnover can be broadly classified as below : (a) Avoidable causes : (1) (2) (3) (4) (5) (b) Dissatisfaction with job. Dissatisfaction with remuneration. Dissatisfaction with working conditions. Dissatisfaction with hours of work. Relationship with supervisors and workers.

Unavoidable causes : (1) (2) (3) Betterment/Personal. Illness or accident. Move from locality. 265

Labour Cost

(4) (5) (6) (7) (8)

Discharge. Marriage. Retirement. Death. National service.

Costs of labour turnover The cost of labour turnover may be classified under two headings. (a) Preventive Costs : These refer to all the costs which may be incurred by the organisation to keep workers happy and discourage them from leaving the job. This, in turn, may include the costs like : (1) (2) Cost of Personnel Administration - To maintain good relations with the workers. Cost of medical services- To keep the workers and their families in healthy condition, as healthy workers are assets for the organisation who contribute towards higher efficiency and productivity. Costs of welfare activities - To give facilities like transport, canteen etc. Other incentive schemes like pension, provident fund, superannuation fund, Bonus etc.

(3) (4)

(b)

Replacement Costs : These refer to the costs incurred for recruitment and training of new workers and the resulting losses, wastages and reduced productivity due to the inefficiency and inexperience of new workers. This in its turn may include the costs like(1) (2) (3) (4) (5) (6) Inefficiency of new workers. Cost of selection and placement. Training costs. Loss of output due to delay in getting new workers Increased spoilage and defectives. Cost of tools and machine breakages.

266

Management Accounting

Measurement of labour turnover : There are three methods for measuring the labour turnover. (1) Separation Method Under this method, it is computed as : No. of Separations in a period Average no. of workers (2) Replacement Method Under this method, it is computed as No. of Replacements in a period Average no. of workers. (3) Flux Method Under this method, it is computed as No. of separations + No. of replacement Average no. of workers Illustration : From the following data given by Personnel Department, calculate the labour turnover rate by applying : (a) (b) (c) Separation Method Replacement Method Flux Method No. of workers on pay-roll - At the beginning of the month - At the end of the month 900 1,100 X 100 X 100 X 100

During the month, 10 workers left, 40 persons were discharged and 150 workers were recruited. Of these 25 workers are recruited in the vacancies of those leaving while the rest were for an expansion scheme.

Labour Cost

267

Solution : Calculation of Labour Turnover (1) Separation Method No. of separations in a period Average No. of workers = 50 X 100 = 5 1000 X 100

Monthly Turnover Rate : 5% Annual Turnover Rate : 5 X (2) Replacement Method : No. of replacements in a period Average No. of workers = 25 1000 X 100 = 2.5% X 100 365 30 = 60.83%

Monthly turnover Rate : 2.5% 365 Annual Turnover Rate : 2.5 X 30 = 30.42%

(3)

Flux Method : No. of separations + No. of replacements Average No. of workers = 50 +25 1,000 Monthly Turnover Rate : 7.5% 365 Annual Turnover Rate : 7.5 X 30 = 91.25% = 100 = 7.5% X 100

268

Management Accounting

Working Notes : Average number of workers is calculated as No. of workers at beginning + No. of worker at end 2 = = (B) 900 + 1,100 2 1,000

Idle Time :

It indicates the time for which wages are paid to the workers but during which no production is obtained. To exercise proper control on idle time, causes of the same should be analysed properly and studied from its controllability point of view. The causes of idle time can be analysed as below : (a) Productive causes : These can be further classified as : (i) (ii) Due to machine breakdown. Power failures.

(iii) Waiting for tools, work or raw materials. (iv) Waiting for instructions.

These causes are supposed to be controllable causes and can be controlled if planned properly. (b) Administrative causes : Some idle time may be caused due to administrative decisions. E.g. the organisation is having excess machine capacity or during the depression period, it is not having sufficient work to be performed, but it has decided not to get rid of trained workers temporarily. As such cost of idle time is accepted. (c) Economic causes : Economic causes may be of seasonal nature, cyclical nature or industrial nature. E.g. if the product manufactured is of a seasonal nature, for other periods of the year, the capacity may remain unused, unless some other product to take care of slack season is introduced. In case it is not possible to make alternate use of such idle capacity, some

Labour Cost

269

idle time is unavoidable. In case of cyclical causes, the causes are similar to seasonal fluctuations but these causes are beyond the control of management. Treatment of idle time cost : If Idle time payment is normal and controllable, it should be classified as overheads. If it is possible to allocate the same to some department, it should be allocated and absorbed in the production department cost. If idle time is normal and uncontrollable, the labour rates should be suitably modified. E.g. if time attended is 8 hours but time booked is only 7.5 hours and labour cost is Rs. 1.5 per hour, the hourly labour rate should be computed as 8 hours X Rs. 1.5 7.5 hours If idle time payment is uncontrollable and abnormal, it should not be considered as a part of manufacturing cost but should be written off to Costing Profit and Loss Account. (C) Internal Control Problems in Labour Cost : i.e. Rs. 1.60

In todays world, labour is one of the most important factors of production, and contributing to a very great extent to the cost of production. As such, it will be the intention of every organisation to have proper control on the labour cost. The implementation of various Internal Control Procedures indicate the following of all those methods and procedures which ensures fluent and smooth running of the operations of the organisation and also of achieving protection of assets, prevention of errors and frauds, proper recording of information whenever necessary. The cost of labour may be high due to the various reasons stated below : (1) (2) (3) (4) (5) (6) (7) Excess staffing - Having more staff than the requirement. Lack of experienced and efficient personnel. Excessive remuneration pattern - Settlement of the wage rates or piece rates on higher side which may not be justified on the basis of efficiency of workers. Clerical errors or fraudulent practices taking place in the area of time keeping, computation of wages payable, procedure for payment of wages to the workers etc. Idle time or unusual overtime wages. Increase of spoilage due to lack of proper supervision and inspection. High labour turnover.

After locating the reasons for increasing labour costs, attempts can be made to keep the same in control after following various internal control measures as discussed below.

270

Management Accounting

(1)

To avoide the problem of excess staffing, the employment of the workers should be made only after the receipt of labour placement requisition from the concerned department. After the receipt of this requisition, it should be seen, whether it is possible to meet the requirement of said department with the help of existing staff only or at least by transferring the existing excess staff in other departments. Before proceeding with the actual process of selection of the staff, care should be taken to decide in advance about the nature of work which may be assigned to the individual employee. To ensure that correct personnel is employed to work in the correct places, care should be taken to analyse the requirements of the job and then to select the personnel which suits these requirements. This process may be in the form of job evaluation. Selection of the proper personnel may not be enough. To train the selected personnel to extract maximum of their efficiency is equally necessary.

(2)

(3)

The problem of setting the excessive rate structure in the form of higher time rate or piece rates or bonus rates may be avoided by setting the standards in the most scientific manner. For this purpose, the techniques like time and motion study, work study etc. may be implemented. To avoid the clerical errors or fraudulent practices in the areas of wage sheet preparation or wage payments, proper internal check procedures may be implemented, so that the work of one person is properly checked by another person. For this, following steps may be taken : (a) Time recording clock should be installed, wherever possible. Proper supervision is required to ensure that one person punches his own card only. The terms of remuneration should be set and made known to the workers in very very clear terms. Proper internal checks should be executed while preparing the wages sheets. Cashier should not be allowed to handle the wages sheets and the person preparing the sheets should not be allowed to prepare wage packets. Personnel officer/manager should check and authorize the wages sheets. The wages should be paid to workers after they are properly identified. The wages should not be paid to any other person, unless proper authorization letter is produced in exceptional circumstances. Distribution of wages should be made in all the departments at a time so as to avoid the possibility of one person being present at two places.

(4)

(b)

(c)

(d)

(e)

Labour Cost

271

(5)

Existence of idle time should be properly analyzed according to controllability. The causes of controllable idle time should be attempted to be avoided. If it is necessary to work overtime, it should be properly authorized and should be paid and accounted for properly. Care should be taken to see that proper returns are obtained for making overtime wages payment.

(6)

If the labour cost is higher due to spoilage of work which in turn may be due to lack of proper supervision or inspection, it is a cost which can very will be controlled by having proper supervision or inspection. The causes of labour turnover should be analysed according to normality. All the avoidable causes of labour turnover should be paid proper attention. Higher trend of labour turnover adds to the costs in two ways mainly. It reduces the labour productivity and at the same time, increases the costs. If the workers have the grievances which are of avoidable nature, say dissatisfaction with remuneration or other benefits or working hours or working conditions or job itself or relations with the fellow workers or the supervisors, attempts can be made to avoid those causes of labour turnover.

(7)

ILLUSTRATIVE PROBLEMS (1) The standard hours for job X is 100 hours. The job can be completed by A in 60 hours, by B in 70 hours and by C in 95 hours. The bonus system applicable to the job is as follows : % of time saved to time allowed Saving upto 10% Saving from 11% to 20% Saving from 21% to 40% Saving from 41% to 100% Bonus 10% of time saved 15% of time saved 20% of time saved 25% of time saved.

Rate of pay per hour is Rs.1 Calculate the total earnings of each worker and also the rate of earnings per hour.

272

Management Accounting

Solution : A (1) (2) (3) (4) (5) Standard Hours Actual Hours Hours Saved % Hours saved Applicable bonus rate (% of wages for time saved) (6) (7) Hourly Rate (Rs.) Basic wages (Rs.) - 2 x 6 i.e. Actual Hours x Hourly rate (8) Wages for time saved (Rs.) - 3 x 6 i.e. Hours Saved x Hourly Rate (9) Bonus (Rs.) - 8 x 5 i.e. Wages for time saved x Bonus Rate (10) Total - (Rs.) 7+ 9 Note : It is assumed that the amount of bonus is not decided on rates of bonus on cumulative basis. (2) During one week X makes 200 units. He receives wages for a guaranteed 44 hours per week at a rate of Rs. 1.50 per hour. Estimated time to produce one unit is 15 minutes. Time allowed is increased by 20% allowance on estimated time, under incentive scheme. Calculate earnings as per : (i) (ii) Time rate Piece rate 8 68 6 76 0.5 95.5 40 30 5 60 70 95 20% 1 20% 1 10% 1 100 60 40 40% B 100 70 30 30% C 100 95 5 5%

(iii) Rowan scheme (iv) Halsey scheme

Solution : (i) Time Rate : No. of Hours X Hourly Rate = 44 Hours x Rs. 1.50 = Rs. 66

Labour Cost

273

(ii)

Piece Rate : Hourly Rate Units produced X Units per hour = 200 units X Rs. 1.50 4 units = Rs. 75

(iii) Rowan Scheme : Actual Hours X Hourly Rate + Time Saved Time Allowed 16 Hours 60 Hrs X Actual Hours X Hourly rate

44 Hours x Rs. 1.50 +

X 44 Hours X Rs. 1.50

= =

Rs. 66 + Rs. 17.60 Rs. 83.60

(iv) Halsey Scheme : Actual Hours X Hourly Rate + 1/2 (Time Saved X Hourly Rate) = = = 44 Hours X Rs. 1.50 + 1/2 (16 Hours X Rs. 1.50) Rs. 66 + Rs. 12 Rs. 78

Working Notes : For incentive scheme, time allowed is increased by 20% of estimated time Estimated time is 15 minutes per unit For incentive scheme, time allowed will be -

15 minutes + 20% = 18 minutes Time allowed for 200 units will be 18 minutes X 60 minutes Actual time taken is 44 Hours. Hence, time saved will be 16 hours ( i.e. 60 hours - 44 hours) 274
Management Accounting

200 units = 60 Hours

It is assumed that the allowance of 20% is available only in case of incentive systems and not in case of time rate or piece rate systems. (3) In a factory under bonus system, bonus hours are credited to the employee in the proportion of time taken which time saved bears to time allowed. Jobs are carried forward from one week to another. No overtime is worked and payment is made in full for all units worked on, including those subsequently rejected. From the following information, you are required to calculate for each employee. (1) (2) (3) Bonus hours and amount of bonus earned. Total wages cost. Wage cost of each unit (good) produced. A Rs. 5 2,500 2H 36M 52H 100 units B Rs. 8 2,200 3H 75H 40 units C Rs. 7.5 3,600 1H 30M 48H 400 units

Employee Basic wage rate per hour Units issued for production Time allowed for 100 units Time taken Rejections Solution :

The description of the bonus system indicates that it is Rowan system of incentive payment. A (1) (2) (3) (4) (5) (6) (7) Time allowed for 100 units Units issued for production Time allowed for actual production Time taken Time saved i.e. 3-4 Hourly basic wage rate (Rs.) Basic wages i.e. 4 x 6 (Rs.) Time taken x Hourly rate (8) Bonus earned : (Rs.) Time X taken (9) rate Hourly X Time allowed 52 312 600 40 400 Time saved 260 600 360 156 min. 2,500 65 hours 52 hours 13 hours 5 B 180 min. 2,200 66 hours 75 hours 8 C 90 min. 3,600 54 hours 48 hours 6 hours 7.5

Total wages i.e. 7 + 8 (Rs.)

Labour Cost

275

A (10) Rejections (units) (11) Good units i.e. 2-10 (12) Wages per good unit i.e. 9/11 (4) 100 2,400 Re. 0.13

B 40 2,160 Re. 0.28

C 400 3,200 Re. 0.125

From the following particular, you are required to work out the earnings of a worker under. (a) (b) (c) (d) Straight Piece Rate Differential Piece Rate Halsey Premium Scheme (50% Sharing) Rowan Premium Scheme 48 Rs. 7.50 Rs. 3.00 20 minutes 120 pieces 150 pieces 80% of piece rate when output below normal and 120% of piece rate when output above normal.

Weekly working hours Hourly wage rate Piece Rate per unit Normal time taken per piece Normal output per week Actual output for the week Differential piece rate

Solution : (a) Straight Piece Rate : Actual output x piece rate per unit = = (b) 150 pieces x Rs. 3 Rs. 450

Differential Piece Rate : Actual output is more than normal output. Hence, piece rate will be 120% of normal piece rate. Applicable piece rate 120% of Rs. 3 i.e. Rs. 3.60 Wages = Actual output x Applicable piece rate per unit = 150 piece x Rs.3.60 = Rs. 540

276

Management Accounting

(c)

Halsey Premium Scheme : Actual Hours X Hourly Rate + (Time Saved x Hourly Rate) 2 2 hours X Rs. 7.50 2

= = = (d)

48 hours X Rs. 7.50 + Rs. 360 + Rs. 15/2 Rs. 367.50

Rowan Premium Scheme : Actual Hours x Hourly Rate + Time Saved Time Allowed 2 hours = = = 48 hours X Rs.7.5 + 50 hours Rs. 360 + Rs. 14.40 Rs. 374.40 X 48 hours x Rs. 7.50 X Actual Hours X Hourly Rate

Note : Time saved is calculated as below : Normal time per piece Pieces per hour Pieces produced Hours allowed for pieces produced i.e. 150/3 Actual hours taken Hours saved (5) 48 2 20 minutes 3 150 50

In an engineering workshop, 15 persons work in a group. If the weekly production of the group exceeds 120 units per hour (which is standard), each man gets a bonus in addition to his hourly earnings. Bonus regulation - Each workers share should be 1/2 of the percentage in excess of standard production. The bonus shall be payable at this percentage of wage rate Rs.1.50 per hour. There is no relationship between individual workers hourly rate and bonus rate.

Labour Cost

277

The following is a weekly output : Day Monday Tuesday Wednesday Thursday Friday Saturday Hours worked 150 160 145 155 170 160 940 Compute a. b. The rate and amount of bonus for the week. Total earnings of David who worked 40 hours during the week and his basic wage was Rs. 1.20 per hour and that of Abdulla who worked for 48 hours and his basic wage was Rs. 1.25 per hour. Output in units 24,700 25,500 17,060 18,050 28,900 21,150 1,35,360

Solution : (a) Actual Production for the week Standard production i.e. 940 x 120 Excess Production 22,560 Excess production percentage = 1,12,800 Bonus percentage for the group = 1/2 of 20% = 10% Bonus Rate : 10% of Rs. 1.50 = Re. 0.15 per hour X 100 = 20% 1,35,360 units 1,12,800 units 22,560 units

278

Management Accounting

(b)

(1) Total Earnings of David : Basic wages - 40 hours x Rs. 1.20 hours Bonus - 40 hours x Re. 0.15/hour Rs. 48.00 Rs. 6.00 Rs. 54.00

(2)

Total Earnings of Abdulla : Basic wages - 48 hours x Rs. 1.25/hour Bonus - 48 hours x Rs. 0.15/hour Rs. 60.00 Rs. 7.20 Rs. 67.20

(6)

Two fitters, a labourer and a boy, undertake a job on piece rate basis for Rs. 1,290. The time spent by each of them is 220 ordinary working hours. The rates of pay on time rate basis are Rs. 1.50 per hour for each of the two fitters. Re. 1 per hour for the labourer and Re. 0.50 per hour for the boy. Calculate : (a) The amount of piece-work premium and the share of each worker, when the piece work premium is divided proportionately to the wages paid. The selling price of the above job on the basis of following data - Cost of Direct Materials is Rs. 2,010, works overhead at 20% of Prime Cost, selling overhead at 10% of works cost and Profit at 25% of cost of sales.

(b)

Solution : (A) (1) wages payable on time basis Fitter Labourer Boy Basic Wages (2) (3) (4) Price of the job Premium received i.e. b - a Share of each worker Fitters Rs. 300 Rs. 990 X Rs. 660 Rs. 200.00 220 hrs. x 2 x Rs. 1.50 220 hrs. x Re. 1 220 hrs. x Re. 0.50 = Rs. 660 = Rs. 220 = Rs. 110 = Rs. 990 Rs. 1,290 Rs. 300

Labour Cost

279

Labourer

Rs. 300 Rs. 990 Rs. 300 Rs. 990

Rs. 220

- Rs. 66.67

Boy

Rs. 110

- Rs. 33.33 Rs. 300.00

(b)

Fixation of selling price : Cost of Direct Material Cost of Labour Prime Cost Works Overheads (20% of Prime Cost) Works Cost Selling Overheads (10% of works cost) Cost of Sales Profit (25% on cost of sale) Selling Price Rs. 396.00 Rs. 4,356.00 Rs. 1,089.00 Rs. 5,445.00 Rs. 660.00 Rs. 3,960.00 Rs. 2,010.00 Rs. 1,290.00 Rs. 3,300.00

(7)

A worker, whose daily work wages is Rs. 2.50 an hour, received production bonus under the Rowan scheme. He carried out the following works in a 48 hours week. Job 1 Job 2 Job 3 Job 4 1,500 items at 4 hours per 1000 1,800 items at 3 hours per 1000 9,000 items at 6 hours per 1000 1,500 items for which no Standard time was fixed and it was arranged that the worker would be paid a bonus of 25%. Actual time taken on the job was 4 hours. 2,000 items at 8 hours per 1000, each item was estimated to be half finished.

Job 5

Job No. 2 was carried out on a machine running at 90% efficiency and an extra allowance of 1/9th of actual time was given to compensate the worker.

280

Management Accounting

4 hours were lost due to power cut. Calculate the earnings of the worker, clearly stating your assumptions for the treatment given by you for the hours last due to power cut. Solution : (a) Calculation of time allowed Job 1 Job 2 Job 3 Job 4 Job 5 6 hours 6 hours 54 hours 5 hours 8 hours 79 hours (b) Time taken (Except idle time) (c) (d) Time saved 35 hours 44 hours

Total wages (As per Rowan system) Time saved Time taken X Hourly rate + Time allowed 35 hours 79 hours X Time taken X Hourly Rate

44 hours X Rs. 2.50 +

X 44 hours X Rs. 2.50

= = (e)

Rs. 110 + Rs. 48.73 Rs. 158.73

Idle time wages (At hourly rate) 4 hours X Rs. 2.50 = Rs. 10

(f)

Total earnings - i.e. d + e Rs.158.73 + Rs. 10.00 = Rs.168.73

Labour Cost

281

Note : (1) The idle time is not treated for computing time taken. For idle hours, the worker will get the wages at normal hourly rate. Time allowed for Job 2, Job 4 and Job 5 is calculated as below : (a) Job 2 : Time taken for 1,800 units Add :Extra allowance 1/9 Time allowed (b) Job 4 : Time taken for 1500 units Add : Allowance @ 25 Time allowed (c) Job 5 : Time taken for 2000 Each item half finished Equivalent finished units Time for equivalent finished units QUESTIONS 1. Explain the various steps in the process of identifying the direct labour cost with the individual cost center. What do you mean by idle time. Explain in details the cost accounting treatment of idle time. Explain the term Labour Turnover. What are the causes responsible for labour turnover? Explain the costs of labour turnover. How the Labour turnover is measured? 1,000 8 hours 16 hours 4 hours 1 hour 5 hours 5.40 hour 0.60 hour 0.60 hour

(2)

2.

3.

282

Management Accounting

PROBLEMS (1) During the first week of March, 1984 the workman Mr. Saurabh manufactured 300 articles. He receives wage for a guaranteed 48 hours week at the rate of Rs. 4/- per hour. The estimated time to produce one article is 10 minutes and under incentive scheme the time allowed is increased by 20%. Calculate his gross wages according to : (a) (b) (c) Piece work with guaranteed weekly wage. Rowan premium bonus and Halsey premium bonus 50% to workman.

(2)

Calculate total monthly remuneration of three workers A, B and C from the following data. (a) (b) Standard production per month per worker 1,000 units. Actual production during the month A - 850 units, B - 750 units, C - 950 units. (c) (d) Piece rate is Re. 0.10 per unit. Additional production bonus is Rs. 10 for each percentage of actual production exceeding 80% over standard. (Example 79% Nil, 80% - Rs. 10, 81% - Rs. 20 and so on) (e) Dearness allowance fixed Rs. 60 per month.

(3)

Following are the particulars as regards a worker who worked on jobs No. 122 and 133. Job No. 122 133 Time allowed 26 hours 26 hours Time taken 20 hours 30 hours

His normal and basic rate of wages was Rs. 28 per day of 8 hours and the dearness allowance was Rs. 42 per week of 48 hours. Calculate the amount payable to him by showing your workings on the following basis. (a) (b) (c) Time basis. Halsey Incentive Plan basis (Bonus at 50% of time saved) Rowan Incentive Plan basis.

Labour Cost

283

(4)

Standard time fixed for a job is 40 hours and time rate is Rs. 4 per hour. You are required to prepare a comparative table under Halsey Plan 50 - 50 and Rowan Plan, if actual time taken is 36 hours, 32 hours, 24 hours, 16 hours and 12 hours. The table should clearly show (a) Bonus payable, (b) Total earnings, (c) Effective rate of earnings per hour.

(5)

Calculate the earnings of a workman under Halsey Premium Plan and Rowan Premium Plan for executing a piece of work in 60 hours as against 75 hours allowed. His hourly rate is 25 paise and under Halsey system, he is to be paid bonus at 50% of time saved. In addition, he gets a dearness allowance for Re. 1 per day of 8 hours worked.

(6)

From the following information, calculate the earnings of A, B and C under Halsey and Rowan premium bonus plans. A Standard time in hours per 100 units Wages per unit of output Wage rate per hour Actual hours taken Actual no. of units produced 35 Rs. 2 Rs. 7 50 200 B 40 Rs. 3 Rs. 8 48 150 C 42 Rs. 4 Rs. 10 46 125

(7)

The firm employs 5 workers at an hourly rate of Rs. 2.00. During the week they worked for 4 days for a total period of 40 hours each and completed a job for which standard time was 48 hours for each worker. Calculate the labour cost under the Halsey Method and Rowan Method of incentive Plan Payments.

(8)

Compute the total time wages and total earnings of a worker, the rate earned per hour and the bonus per hour in respect of three workers X,Y, and Z under the Halsey-Weir bonus plans. The following are the particulars supplied. Standard Time Hourly Rate of Wages : 20 hours. : Re. 1.00 per hour.

Time Taken X = 16 hours, Y = 12 hours and Z = 10 hours.

284

Management Accounting

(9)

The three workers Govind, Ram and Shyam produced 80, 100 and 120 pieces of a product X on a particular day in May 1987 in a factory. The time allowed for 10 units of Product X is 1 hour and their hourly rate is Rs. 4. Calculate for each of these three workers the following : (a) (b) Earnings for the day Effective rate of earnings per hour under (i) (ii) (iii) Straight piece Rate Halsey Premium Bonus (50% sharing) Rowan Premium Bonus methods of Labour Remuneration

(10) A worker takes 6 hours to complete a job under a scheme of payment by results. The standard time allowed for the job is 9 hours. His wage rate is Rs. 1.50 per hour. Material cost of the job is Rs. 16 and the overheads are recovered at 150% of the total direct wages. Calculate the factory cost of the job under - (a) Rowan and (b) Halsey scheme of incentive payments.

(11) In an engineering concern, the employees are paid incentive bonus in addition to their normal wages at hourly rates. Incentive bonus is calculated in proportion of time taken to time allowed, of the time saved. The following details are made available in respect of employees X, Y and Z for a particular week. X Normal Wages (Rs. per hour) Completed units of production Time Allowed (per 100 units) Actual time taken (hours) You are required to work out for each employee (a) The amount of bonus earned. (b) The total amount of wages received. (c) The total wages cost per 100 units of output. 4.00 6000 0.8 hr. 42 Y 5.00 3000 1.5 hrs. 40 Z 6.00 4800 1 hr. 48

Labour Cost

285

(12) A workman whose basic rate of pay under Rowan plan of premium bonus is Rs. 2 per hour. In addition, he receives a cost of living bonus of Rs. 33 per week of 66 hours on actual hours worked. During a week, he does the following jobs. (i) Job A for which 30 hours are allowed in 20 hours. (ii) Job B for which 36 hours are allowed in 20 hours. During this week, his waiting time was 4 hours. Calculate his earnings and amount to be charged to each job.

(13) An operator engaged on a machine, receives an ordinary day rate of Rs. 1.60 per day of 8 hours. The standard output has been fixed at 80 pieces per hour (time as fixed for premium bonus.) On a certain day, the output of a worker on this machine is 800 pieces. Find the labour cost per 100 pieces and the wages that should have been actually earned by the workman under the following (a) If a bonus of Re. 0.23 is paid per 100 of extra output. (b) If paid on straight piece work basis at the standard rate. (c) If Halsey Premium System is adopted.

(14) In a manufacturing concern, 20 workmen work in a group. The concern follows a group incentive bonus system whereby each workman belonging to the group is paid a bonus on the excess output over the hourly production standard of 250 pieces, in addition to his normal wages at hourly rate. The excess of production over the standard is expressed as a percentage and two thirds of this percentage is considered to be the share of the workman and is applied to the normal hourly rate of Rs. 6.00 (Considered only for purpose of computation of bonus.) The output data for a week are stated below. Days Monday Tuesday Wednesday Thursday Friday Saturday Manhours worked 160 172 164 168 160 160 984 Output (in pieces) 48,000 53,000 40,000 52,000 46,000 42,000 2,81,000

286

Management Accounting

You are required to (a) Work out the amount of bonus for the week and the average rate of which each workman is to be paid the same. Compute the total wages including bonus payable to Ram Jadhav who worked for 48 hours at an hourly rate of Rs. 2.50 and to Francis Williams who worked for 52 hours at an hourly rate of Rs. 3.00.

(b)

(15) Following data for the month of October 1990 is available for a company. No. of workers on payroll on 1st October, 90 - 1450 No. of workers on payroll on 31st October 90 - 1550 During the month 10 workers left the company, 70 persons were discharged and 200 workers were recruited. Of these workers, 40 workers were recruited in the vacancies of those who had left and the remaining were recruited for an expansion programme. Calculate the labour turnover rate by using (i) (ii) Separation Method Replacement Method

(iii) Flux Melhod

Labour Cost

287

NOTES

288

Management Accounting

Chapter 1 0
OVERHEAD COST

It has already been discussed that the term cost can be basically classified as Direct Cost and Indirect Cost. Direct Cost indicates all those costs which can be identified with the individual cost centre and indirect cost indicates all those costs which cannot be identified with the individual cost centre. The total of indirect costs are termed as overheads. There may be various ways in which the overheads may be classified. (1) Elementwise Classification : As the cost can be basically classified as per the Elements of Cost i.e. Material Cost, Labour Cost and Expenses, the indirect cost i.e. overheads may be classified as per the elements of cost. This classification of overheads takes the form of : (a) (b) (c) Indirect Material Indirect Labour Indirect Expenses.

The meaning and the type of expenses included in this classification have already been discussed in the chapter on Cost Sheet. (2) Functionwise Classification : Under this classification, the overheads are classified according to the functions they perform. This classification of overheads takes the form of : (a) (b) (c) Factory Overheads (also termed as production or works or manufacturing overheads) Administration Overheads. Selling and Distribution Overheads.The meaning and the type of expenses included in this classification have already been discussed in the chapter on Cost Sheet.

(3)

Variabilitywise Classification : (i) Fixed overheads : These overheads indicate the costs which remain unaffected by variations in volume of output. E.g. Rent, Insurance on building, salary to

Overhead Cost

289

administrative staff etc. Per unit cost of overheads may reduce as the volume of output increases but the total overheads remain constant. (ii) Variable overheads : These overheads indicate the costs which vary directly in proportion to volume of output. E.g. Consumable stores, nuts/bolts, loose tools etc. Per unit cost of overheads remains the same but total overheads may increase or decrease as per volume of output.

(iii) Semi-variable overheads : These overheads indicate those which are neither fixed nor variable in nature. These may remain fixed at certain levels of activity while may vary proportionately at other levels of activity. E.g. maintenance cost, power, electricity, supervision cost etc. (4) Controllabilitywise Classification : Under this classification, the overheads are classified according to their controllable nature. This classification takes the form of : (a) (b) (5) Controllable overheads. Uncontrollable overheads.This classification has already been discussed.

Normalitywise Classification : Under this classification, the overheads are classified according to the fact as to whether the overheads are normally incurred at a certain level of output under normal circumstances. This classification takes the form of : (a) (b) Normal overheads. Abnormal overheads.

This classification has already been discussed. It should be noted in this connection, that the above classification refers to the classification of same amount of overheads in different forms to suit the individual requirements. E.g. For the purpose of preparing the cost statement, overheads may be classified according to functions while for the purpose of marginal costing applications, overheads may be classified according to variability. Procedure for Charging the Overheads : The basic aim of costing is to find out the cost of each cost centre. The cost of each cost centre can be either the direct cost or the indirect cost. The direct cost can be identified with the individual cost centre and hence poses no difficulties. To charge the indirect costs i.e. overheads to the individual cost centres is the major problem. For this, the following procedure may be followed.

290

Management Accounting

(A)

Allocation/Primary Apportionment :

There can be some overheads which are incurred for the company as a whole, i.e. for all the departments. i.e. Production as well as Service departments. To identify the common costs with the individual departments is the first stage problem. This can be solved in two ways. (1) If at all it is possible to identify some overheads with the individual departments they should be identified by following the procedure of allocation of overheads. E.g. Wages paid to the maintenance department workers can be obtained from wages sheet and can be allocated to maintenance department. Similarly, cost of indirect material can be allocated to individual departments by pricing material requisition slips. (2) It may not be possible in all the cases to allocate the overheads, i.e. in case of common expenses for the entire factory. In this case, they can be apportioned among the various departments on some suitable basis, i.e. to all production as well as service departments. This process is in the form of Primary apportionment or distribution of overheads. The selection of the base on which overheads are or should be apportioned depends on the following principles : (a) Service or use basis : If the benefit obtained by various departments from the overheads can be measured, overheads can be apportioned on that basis. Survey basis : If amount of services rendered cant be measured, survey basis may be applied. E.g. If it can be noted that a supervisor is giving 60% of his services to department A and 40 % to department B, his wages can be apportioned on that basis. Ability to pay basis : In this case, the apportionment may depend upon the factors like total sales/profitability. It may not be fair in some cases as most efficient departments may have to bear higher amounts of overheads, though actual overheads of that department may be lower than those of other departments.

(b)

(c)

The usual bases which can be selected for Primary Apportionment may be as below : Item of expenditure (1) (2) (3) (4) (5) (6) Canteen expenses/Staff Supervision Rent/Taxes Power General Lighting Depreciation Supervision Base Number of workers. Area HP/KWh Number of light points/area Value of assets Number of Employees/wages paid

Overhead Cost

291

(7) (8)

Telephone expenses Fire Insurance.

Number of telephone calls made Value of stocks held/value of Assets.

Illustration : The Omega Co, is having four departments. A, B, and C are production departments and D is a servicing department. The actual costs for a period are as follows. Rs. Rent Repairs Depreciation Light Supervision Insurance Employees Insurance (Employers liability) Power 2,000 1,200 900 200 3,000 1,000 300 1,800

The following data are also available in respect of departments. Dept. A Area sq. ft. Number of workers Total wages (Rs.) Value of plant (Rs.) Value of stock (Rs.) 150 24 8,000 24,000 15,000 Dept. B 110 16 6,000 18,000 9,000 Dept. C 90 12 4,000 12,000 6,000 Dept. D 50 8 2,000 6,000

Apportion the cost to the various departments on the most equitable method.

292

Management Accounting

Solution : Apportionment of Overheads Particulars Base Total Rs. Dept. A Rs. 750 480 360 75 1,200 500 120 720 4,205 Dept. B Rs. 550 360 270 55 800 300 80 540 2,955 Dept. C Rs. 450 240 180 45 600 200 60 360 2,135 Dept. D Rs. 250 120 90 25 400 40 180 1,105

Rent Repairs Depreciation Light Supervision Insurance Employees Insurance (Employers Liabilities) Power

Area sq. ft. Total wages Value of Plant Area sq. ft. No. of workers Value of stock No. of workers Value of Plant

2,000 1,200 900 200 3,000 1,000 300 1,800 10,400

Notes : It is assumed that the insurance is payable only on stock. Had it been assumed that it is payable on stock as well as plant, the base would have been the combined value of stock and plant. For the apportionment of power cost, Kwh/HP rating would have been an ideal base. As relevant data is not available, it is apportioned on the basis of value of plant. Repairs are apportioned on the basis of total wages assuming that repair charges consist of mainly labour charges. (3) Secondary Apportionment : With the process of primary apportionment or distribution, the loading of overheads for all the departments i.e. production as well as service departments can be obtained. Next step is to transfer the overheads of non-production departments to production departments, as the various cost centres move through the production departments only. This is in the form of Secondary apportionment or distribution of overheads.

Overhead Cost

293

The usual bases which can be selected for the secondary apportionment may be as below : (1) (2) (3) (4) (5) (6) (7) Maintenance Dept. - Number of hours worked. Stores Dept. - Number of requisitions. Purchase Dept. - Number of Purchase orders Building Service Dept. - Area Welfare/ Canteen and other facilities - Number of employees. Personnel or Time keeping Dept. - Number of employees. Internal Transport - Weight/value of goods moved.

While apportioning the overheads of non-production departments to production departments, the problem will be there if non-production departments are rendering the services inter-se. There can be two ways to handle the situation like this (A) Ignore the services given by one service department to another. The defects involved with this method are very obvious. Illustration : Following figures are extracted from the accounts of M/s. Vasant Works for the month of July 1983. Production Depts. P1 P2 Indirect Material Indirect Wages Power and Light Supervision Charges Rent and Taxes Insurance on assets Rs. 3,000 Rs. 2,200 Rs. Rs. 500 60 280 324 140 312 Service Depts. S1 S2 S3 170 296 350 160 190 218

Depreciation at 12% p.a. on capital value of assets to be considered. From the above information and the following departmental data, prepare overhead recovery rates for the production departments PI and P2 on the basis of direct labour hours. The expenses of service departments should be apportioned straight to the production depts. with the information that SI is tool room, S2 is maintenance dept. and S3 is stores dept.

294

Management Accounting

Departmental Data : Area (sq. ft.) Capital Value of Assets (Ps.) Kilowatt Hours Number of employees Direct Labour Hours Number of requisitions

P1 400 8000 4000 150 5000 1000

P2 200 4000 3000 100 5000 300

S1 100 7000 1000 75

S2 200 5000 1000 100

S3 100 6000 1000 125

Solution : Statement showing apportionment of overheads Items Base P1 Rs. 280 324 1200 600 200 16 80 2700 Dept. S1 Dept. S2 Dept. S3 Labour Hours Labour Hours No. of requisitions 600 700 1000 5,000 P2 Rs. 140 312 900 400 100 8 40 1900 600 700 300 3,500 S1 Rs. 170 296 300 300 50 14 70 1200 (-)1200 (-)1400 (-)1300 S2 Rs. 350 190 300 400 100 10 50 1400 S3 Rs. 160 218 300 500 50 12 60 1300

Indirect Material Indirect wages Power & Light Supervision Rent & Taxes Insurance on Assets Depreciation

Allocation Allocation Kilowatt Hrs No. of employees Area Value of assets Value of assets

(B) If it is decided to consider the services rendered by one service department to another, the first problem will be to decide the percentage in which services are given by service departments inter-se. After such percentage is decided, the secondary apportionment can be made by either of the following methods. (i) Simultaneous Equation Method : Under this method the amount of overheads of each production department can be obtained by solving simultaneous equations.

Overhead Cost

295

(ii)

Repeated Distribution Method : Under this method service dept. overheads are distributed to other departments, production as well as service, on agreed percentage and this process is repeated till the figures of service departments are exhausted or are too small to consider further apportionment.

Illustration : A company has 3 production depts. and 2 service depts. and for a period departmental distribution summary has the following totals. Production Depts. Service Depts. A ..Rs. 800 1 ....Rs. 234 B Rs. 700 2.. Rs. 300 C. Rs. 500

The expenses of service depts. are charged out on a percentage basis as : A Service Dept. 1 Service Dept. 2 20% 40% B 40% 20% C 30% 20% 1 20% 2 10%

You are required to show the apportionment of overheads. Solution : (a) Simultaneous Equation Method : Let x y x = = = = = total overheads of Dept. 1 total overheads of Dept. 2 234+ 2/10 y 300 1/10 x 2340 + 2y 3000 + x ...(1) ...(2)

and y 10 x

and 10 y =

Rearranging equation 2 and multiplying equation I by 5 10y = 11700 - 50x 3000 + x 14700 49x 14700 300 300 + 1/10 x 300 + 1/10 x 300 330 ...(4) ...(3)

10y = Adding 0 = 49 x x = =

However, Y = Y Y = =

296

Management Accounting

Total overheads can be apportioned on the basis of agreed percentages to production departments as below. Total Rs. As per Primary appointment Dept. 1 (90% of Rs. 300) Dept. 2 (80% of Rs. 330) 2,000 270 264 2534 (b) Repeated Distribution Method : Dept. A Rs. As per Primary appointment Dept. 1 Dept. 2 Dept. 1 Dept. 2 800 47 129 13 3 992 (3) Absorption : The process of secondary apportionment of overheads, ensures the loading of overheads to production departments. Now the next stage is that each job or product should get the loading of the overheads while it is moving through the production department and this process is in the form of Absorption or Recovery of overheads. There can be a number of methods for absorbing the overheads but the ultimate selection of method has to be made after considering various factors like type of industry, nature of products, manufacturing process, requirements and policy of management, cost of operating the system etc. The various methods which can be considered for deciding the rates of overhead absorption are as below : (1) Direct Materials Cost Percentage Rate : This is calculated as : Amount of overheads to be absorbed Direct Materials cost X 100 Dept. B Rs. 700 94 65 26 1 886 Dept. C Rs. 500 70 64 20 2 656 Dept. 1 Rs. 234 (-) 234 65 (-) 65 Dept. 2 Rs. 300 23 (-) 323 6 (-) 6 Dept. A Rs. 800 60 132 992 Dept. B Rs. 700 120 66 886 Dept. C Rs. 500 90 66 656

Overhead Cost

297

E.g. If production overheads to be absorbed are Rs. 25,000/and Direct materials cost is Rs. 50,000, the absorption rate will be : 25,000 50,000 X 100 i.e. 50%

Now if the direct materials cost of a job is Rs. 500, it will be getting the loading of overheads to the extent of 50% of direct materials cost, i.e. Rs. 250. This method is useful if materials cost forms a major part of production cost and is normally used if materials costs are stable and equipments used remain unchanged. This method leads to unsatisfactory results due to following reasons. (i) There can be some situations where material prices vary without any change in the amount of over heads, in which case, this method may show wrong results. If this method is used, a job using expensive material may get high loading of overheads as compared to a job using cheap material, which may not be fair.

(ii)

(2)

Direct Wages Percentage Rate : This is calculated as : Amount of overheads to be absorbed Direct wages cost X 100

E.g. If the production overheads to be absorbed are Rs. 10,000 and direct wages cost is Rs. 40,000, the absorption rate will be : 10,000 40,000 Now if the direct wages cost of a job is Rs. 400, it will be getting the loading of overheads to the extent of 25% of direct wages cost, i.e. Rs. 100. This method is useful if labour cost forms a major part of production cost and also if the work performed by all the workers is uniform, ratio of skilled and unskilled workers is constant and labour rates do not fluctuate widely. The problem with this method is that there is very little relationship between direct wages and overhead expenses. It may give wrong results if the workers vary in ability. X 100 i.e. 25%

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Management Accounting

(3)

Prime Cost Percentage Rate : This is calculated as : Amount of overheads to be absorbed Prime Cost E.g. if the production overheads to be absorbed are Rs. 16,000 and prime cost is Rs. 80,000, the absorption rate will be : 16,000 80,000 Now if the prime cost of a job is Rs. 250, it will be getting the loading of overheads to the extent of 20% of prime cost, i.e. Rs. 50. This method is useful in this sense that it considers both the materials cost as well as labour cost. X 100 i.e. 20% X 100

(4)

Labour Hour Rate : This is calculated as : Amount of overheads to be absorbed Labour hours required for production. E.g. if production overheads to be absorbed are Rs. 50,000 and labour hours worked are 100,000, the absorption rate will be : Rs. 50,000 100,000 Now, if a job requires 20 labour hours to complete it, the loading of overheads to the same will be Re. 0.50 per labour hour i.e. Rs. 10/-. This method is useful if labour is the most important element of cost. However, additional records are required to be kept for time booking per job. Further, if machinery forms a dominant portion in production cost, this method may lead to wrong results. i.e. Re. 0.50 per labour hour.

Overhead Cost

299

(5)

Machine Hour Rate : This is calculated as : Amount of overheads to be absorbed Number of Machine Hours E.g. if production overheads to be absorbed are Rs. 20,000 and machine hours worked as 5000, the absorption rate will be Rs, 20,000 5,000 i. e. Rs. 4 per machine hour.

Now if a job requires 25 machine hours to complete, the loading of overheads to the same will be Rs. 4 per machine hour, i.e. Rs. 100. If the machine use accounts for a large element of cost in the overall production cost, then this method can be used conveniently. This rate can be considered to be useful and ideal especially in the days of high mechanisation and automation. While computing the machine hour rate, it is necessary to consider the various overheads required to be incurred for running a machine or group of machines treating the same as distinct cost centres. Illustration : Following information relates to activities of a production dept. of a factory for a certain period. Direct Materials used Direct wages Direct Labour hours worked (Including 20,000 hrs. of Machine operations) Overheads chargeable to the dept. For order No. 156 carried out in dept. relevant figures were. Direct Materials used Direct wages Direct labour hours (Including 800 machine hours) Calculate the overheads chargeable to Order No. 156 by 5 cost rates. 820 Rs. 200 Rs. 165 24,000 Rs. 5,000 Rs. 4,000 Rs. 6,000

300

Management Accounting

Solution : Calculation of overhead absorption rate (a) Direct Material Cost percentage : Amount of overheads Direct Material Cost = (b) Rs. 5,000 Rs. 4,000 X 100

X 100 = 125%

Direct Labour Cost percentage : Amount of overheads Direct Labour Cost Rs. 5,000 = Rs. 6,000 X 100 X 100 = 83 1/3%

(c)

Prime Cost percentage : Amount of overheads Prime Cost = Rs. 5,000 Rs. 10,000 X 100 = 50% X 100

(d)

Labour Hour Rate : Amount of overheads Direct Labour Hours = Rs. 5,000 24,000 = Re. 0. 2083 / Labour Hour.

(e)

Machine Hour Rate Amount of overheads Machine Hours = Rs. 5,000 20,000 = Rs 0.25 / Machine Hour.

Overhead Cost

301

The overheads chargeable to Order No. 156 and the total cost of the same can be calculated as below : Material Rs. (a) (b) Direct Material Cost percentage Direct Labour Cost percentage (c) (d) (e) Prime Cost percentage Labour Hour Rate Machine Hour Rate 200.00 200.00 200.00 200.00 165.00 165.00 165.00 165.00 137.50 182.50 170.83 200.00 502.50 547.50 535.83 565.00 200.00 165.00 250.00 615.00 Labour Rs. Overheads Rs. Total Rs.

Illustration : Compute the machine hour rate from the following data. Cost of the machine Installation charges Estimated scrap value after the expiry of life (15 years) Rent and Rates for the shop per month General lighting for the shop per month Insurance charges for the machine per annum Repairs and Maintenance expenses per month Power consumption 10 Units per hour. Estimated working hours per annum 2,200 (This includes setting up time of 200 hours) Rate of power per 100 Units Shop supervisors salary per month Rs. Rs. 20 600 Rs. 1,00,000 Rs. Rs. Rs. Rs. Rs. Rs. 10,000 5,000 200 300 960 1,000

The machine occupies 1/4 of the total area of the shop. The supervisor is expected to devote 1/5 of the total time for the supervision of the machine.

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Management Accounting

Calculation of Machine Hour Rate : (a) Standing Charges Depreciation Rent and Rates General lighting Insurance Charges Repairs and Maintenance Shop Supervisors salary Annual standing charges Annual Machine Hours (Excluding setting up time) Hourly standing charges (b) Running charges : Power Expenses Rate of power 20 paise per unit. Power consumption - 10 units per hour. Hourly power expenses (c) Machine Hour Rate i.e. a + b Rs. 2.00 Rs. 13.45 Rs. 7,000.00 600.00 900.00 960.00 12,000.00 1,440.00 22,900.00 2000 Rs. 11.45

Working Notes : (1) It is assumed that during the setting up time, the machine will not be used for the intended purpose and hence the said time is ignored for the calculation of machine hour rate. It is assumed that the depreciation is charged on straight-line basis. Hence, it is calculated as : Cost of Machine + Installation charges Estimated scrap value Estimated life of machine = (3) Rs. 100,000 + Rs. 10,000 Rs 5000 15 years = Rs. 7,000 p.a.

(2)

It is assumed that the Repairs and Maintenance expenses are incurred only for the machine.

Overhead Cost

303

Actual V/s. Predetermined Overhead Absorption Rates The overhead absorption rates can be considered on actual basis or predetermined basis. For computing the absorption rates on actual basis, the actual data for the previous period is considered, i. e. Actual overheads, actual direct materials/wages cost, actual prime cost, actual labour hours worked, actual machine hours worked etc. However, the actual overhead absorption rates have certain limitations. (1) The actual details are available only after the end of actual accounting period and required details may not be available either for proper control of overheads or for price fixation. If the production is of seasonal nature, overhead absorption rates will not be constant monthwise and comparison of production costs monthwise will be difficult.

(2)

As such, it is customary to consider predetermined overheads absorption rates instead of actual overhead absorption rates. By predetermined rates it is meant that instead of considering actual data in respect of Direct Materials/Wages/Prime Cost or Labour/Machine Hours, estimations are made in respect of the same and predetermined overhead absorption rate is applied whenever computations are to be made in respect of product cost of a job. Under Absorption or Over Absorption of Overheads If the organization follows the policy of considering predetermined overhead absorption rates, it may face the problem of under or over absorption of overheads if the actual overheads to be absorbed or the bases for the absorption, i.e. Materials/ Wages/ Prime cost or Labour/Machine Hours etc. vary from the assumption. E.g. A Company considers the overhead absorption rate as a direct materials cost percentage rate. It is decided that predetermined overhead absorption rate should be considered for the forthcoming year 1989. As such, the predetermined overhead rate was estimated on the basis of following details. i.e. Estimated amount of overheads Estimated Direct Materials cost i.e. Rs. 10,000 Rs. 50,000 X 100 i.e. 20% X 100

Now, on this basis all the jobs moving through that department during 1989 will be getting the loading of overheads @ 20% of Direct Materials Costs. After the year 1989 ended, the actual details are computed and it is found out that whereas Direct Materials cost was as estimated, i.e. Rs. 50,000, the actual amount of overheads was reduced to Rs. 9,000. As such, the rate at which the overheads should have been absorbed, should have been

304

Management Accounting

Rs. 9,000 Rs. 50,000

X 100, i.e. 18% and not 20%

as originally considered

Such situation gives rise to the under absorption or over absorption of overheads. The situation of under absorption arises if the overheads absorbed are less than the actual overheads. The situation of over absorption arises if the overheads absorbed are more than the actual overheads. E.g. Period Overheads Absorbed Rs. 7,500 10,000 Actual Overheads Rs. 9,000 8,000 Remarks

I II Causes :

Underabsorption Overabsorption.

Under absorption of overheads may take place due to the reasons like. Actual overheads being more than the estimated overheads or Actual output or hours worked being less than those as estimated.

Over absorption of overheads may take place due to the reasons like Actual overheads being less than the estimated overheads OR Actual output or hours worked being more than those as estimated.

Treatment of Under or Over Absorbed Overheads : The overheads which are under or over absorbed may be treated in either of the following ways (1) Use of supplementary rate : If the amount of under or over absorbed overheads is considerably significant, the cost of the cost centres may be adjusted by means of the use of supplementary overhead absorption rate. This method of treating the over or under absorption of overheads is most important where the cost is considered as a base for quoting selling prices, E.g. Cost plus contracts. E.g. The predetermined overhead absorption rate, for the forthcoming period of months, was decided as below. Amount of overheads Total labour Hours = Rs. 50,000 25,000 = Rs. 2 / Labour Hour.

Overhead Cost

305

A mid term review of 6 monthly operations revealed that whereas the total labour hours during the period were 12,500, the amount of overheads incurred was Rs. 30,000. The overheads actually absorbed will be 12,500 hours x Rs. 2 i.e. Rs. 25,000. Considering the same trend of amount of overheads, the total annual overheads are likely to be Rs. 60,000, out of which Rs. 25,000 are already absorbed. As such, for the remaining 6 months, the overhead absorption rate may be calculated as : Revised amount of overheads Number of Labour Hours = = (2) Rs. 60,000 Rs. 25,000 12,500 Rs. 35,000 12,500 = Rs. 2.80 / Labour Hour.

Carrying over to remaining period : In case of seasonal types of organization, the overheads under or over absorbed during a certain period may be carried over to the remaining part of the accounting period with the hope that they may be compensated during the remaining period of time. Writing off to Costing Profit and Loss Account : In case of the under or over absorption of the overheads arising out of the abnormal circumstances, they are written off to Costing Profit and Loss Account.

(3)

Illustration : The budgeted working conditions of a cost centre are as follows : Normal working per week No. of machines Normal weekly loss of hours on maintenance etc. No. of weeks worked per year Estimated annual overheads Estimated direct wage rate Actual result in respect of a 4 week period are : Wages incurred Overheads incurred Machine hours produced Rs. 9,000 Rs. 10,200 2,000 42 hours 14 5 hours per machine 48 Rs. 1,24,320 Rs. 4 per hour.

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Management Accounting

You are required to calculate : (a) (b) The overhead rate per machine hour The amount of under or overabsorption of wages and overheads.

Solution : (a) Normal working hours per year (For all 14 machines) Hours lost on maintenance 42 weekly hours per machine x 14 machines x 48 weeks = 28,224 machine hours. 5 hours per week x 14 machines x 48 weeks = 3,360 machine hours. 24,864 machine hours. Rs. 1,24,320 Rs. 5 2000 machine hours x Rs. 5 = Rs. 10,000 Rs. 10,200

(b)

(c) (d) (e) (f) (g) (h)

Effective machine hours i.e., a - b Estimated annual overheads Machine hour rate i.e., d / c Overheads absorbed Overheads actually incurred Overheads underabsorbed i.e., g - f

Rs. 200

WAGES (a) (b) (c) (d) (e) (f) Labour hours for 4 weeks For 14 machines Estimated direct wage rate Estimated direct wages for4 weeks i.e., b x c Wages actually incurred Wages overabsorbed i.e., d-e 42 hours x 4 week = 168 hours 168 hours x 14 machines = 2,352 hours Rs. 4 per hour Rs. 9,408 Rs. 9,000 Rs. 408

Control Over Overheads : As the basic intention of cost accounting is to exercise the control over the costs and as the overheads is a part of cost, cost accounting procedures attempt to control the overheads also. For this purpose, the following propositions should be remembered : (1) The success of procedures to control the overheads largely depends upon the correct classification of the overheads. This classification can be done from the various angles.

Overhead Cost

307

(a)

Functionwise : This takes the form of classification in the form of factory overheads, administration overheads and selling and distribution overheads. Variabilitywise : This takes the form of classification in the form of fixed overheads, variable overheads and semi-fixed or semi variable overheads. Normalitywise : This takes the form of classification in the form of normal overheads and abnormal overheads.

(b)

(c)

Fixed overheads normally arise as a result of policy and are largely uncontrollable at the lower level of management. They can be controlled at the top level of management. However, the variable overheads can be controlled at the lower or middle level of management as well. Most of the administration overheads are fixed in nature and can be controlled mainly at top management level. However, the factory overheads can be controlled at lower or middle management level also. (2) After the correct classification of overheads, use may be made of following two techniques with the intention to exercise proper control over overheads. (a) (b) Budgetary control Standard costing

Both these techniques are discussed in details in the following chapters. However, both these techniques necessarily involve the following stages in the process of implementation. (i) Planning : This lays down the course of action to be taken in future. In case of budgetary control, it is in the form of the budgets and in case of standard costing, it is in the form of the standard cost. (ii) Implementation of plan : This indicates actual steps to execute the plan. For this, downward communication may be necessary from top management level to lower management level.

(iii) Measuring actual performance, comparison with plans and computing variances : Measurement of actual performance may be in terms of actual costs or actual output. Actual costs and actual output is compared with the planned performance and variations, if any are calculated. (iv) Analysis of variances and decision making : Variations between actual performance and planned performance is required to be analysed as to the causes and proper corrective actions are required to be taken to remove unfavourable variations or maintain favourable variations. 308
Management Accounting

(3)

Classification of overheads as fixed and variable, facilitates the preparation of flexible budgets which provides proper base for comparison in the form of budgeted overheads for any level of activity actually attained. Flexible budgets may be treated as an improved method to control the overheads.

ILLUSTRATIVE PROBLEMS (1) Meera Industries Limited is a single product organization having a manufacturing capacity of 6,000 units per week of 48 hours. The output data vis-a-vis different elements of cost for three consecutive weeks are given below : Units Produced Direct Material Rs. 4,800 5,600 7,200 Direct Labour Rs. 6,000 7,000 9,000 Total factory overheads (Variable and Fixed) Rs. 37,200 38,400 40,800

2,400 2,800 3,600

As a cost Accountant, you are asked by the company to work out the selling price assuming level of 4,000 units per week and a profit of 20% on selling price. Solution : It can be observed that an increase in production by 400 units increases the total factory overheads by Rs. 1,200 indicating that per unit variable overheads are Rs. 3. Hence, at the activity level of 2,400 units, the total variable overheads are Rs. 7,200 i.e. 2400 units x Rs.3 per unit, out of total overheads of Rs. 37,200. Hence, the balance amount represents fixed overheads. It should be noted that the direct material cost and direct labour cost represents the variable cost of production. At 2,400 units, per unit cost is as below : Direct material - Rs. 4800 / 2400 units = Rs. 2 / per unit. Direct Labour - Rs. 6000 / 2400 units = Rs. 2.5 per unit The cost sheet for the production of 4000 units can be worked out as below :

Overhead Cost

309

Cost Sheet - 4000 units Per Unit Rs. Direct Material Cost Direct Labour Cost Variable Overheads Fixed Overheads Total Cost Add : Profit i.e. 20% of selling price of Or 25% of total cost Sales (2) 3.75 18.75 15,000 75,000 2.00 2.50 3.00 7.50 15.00 Total Rs. 8,000 10,000 12,000 30,000 60,000

XYZ Ltd., a manufacturing company, having an extensive marketing net work throughout the country, sells its products through four zonal sales offices viz. A,B,C and D. The budgeted expenditure for the year are given below : Rs.

Sales Managers salary Expenses relating to Sales Managers office Travelling salesmens salaries Travelling Expenses Advertisement Godown Rent-Zone A B C D 15,000 25,200 9,800 18,000

1,20,000 80,000 3,20,000 36,000 30,000

68,000 Insurance on inventories Commission on sales @ 5% on sales 20,000 6,00,000

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Management Accounting

The following further particulars are also available : A Sales (Rs. in lakhs) No. of salesmen Total mileage covered Allocation of Advertisement Average stock (Rs. in lakhs) 36 5 6000 30% 6 B 48 6 14000 30% 8 C 16 2 4500 20% 4 D 20 3 5500 20% 2

Based on the above details, compute zonewise selling overheads, as a percentage to sales. Solution : Calculation of Sales Overheads - Zone wise
Items Base Total Rs.
1. Sales Managers Salary 2. Expenses of Sales Managers office 3. Travelling salesmens Salaries 4. Travelling Expenses 5. Advertisement 6. Godown Rent 7. Insurance on inventories 8. Sales Commission Total Overheads Sales in Lakhs Rs. Overheads as % of sales 12,74,000 120 10.62% 3,77,200 36 10.48% 4,99,000 1,71,867 48 10.40% 16 10.74% 2,25,933 20 11.30% Sales Sales No. of Salesman Mileage covered Allocation Allocation Average stock Sales 1,20,000 80,000 3,20,000 36,000 30,000 68,000 20,000 6,00,000

A Rs.
36,000 24,000 1,00,000 7,200 9,000 15,000 6,000 1,80,000

B Rs.
48,000 32,000 1,20,000 16,800 9,000 25,200 8,000 2,40,000

C Rs.
16,000 10,667 40,000 5,400 6,000 9,800 4,000 80,000

D Rs.
20,000 13,333 60,000 6,600 6,000 18,000 2,000 1,00,000

(3)

The following yearly charges are incurred in respect of a machine where work is done by means of 5 machines of exactly same type. (1) (2) (3) (4) (5) Rent and Rates Depreciation on each machine Repairs & maintenance of 5 machines Power consumed (as per meter at 5 paise per unit) Electric charges for the shop Rs. Rs. Rs. Rs. Rs. 4,800 500 1,000 3,000 450

Overhead Cost

311

(6)

Two attendants looking after 5 machines and are paid Rs. 700 per year each Rs. Rs. Rs. 1,400 3,000 450

(7) (8)

Supervision One supervisor looking after 5 machines and paid Sundry supplies for the shop

The machine uses 10 units of power per hour. Calculate the machine hour rate. Solution : Calculation of Machine Hour Rate Rs. (a) Standing charges : Rent and Rates Depreciation Repairs and Maintenance Electricity charges Attendants salary Supervisors Salary Sundry Supplies Annual standing charges Annual Machine Working Hours Hourly Standing Charges (b) Running charges : Power charges - Rate of power - 5 paise per unit Power consumption - 10 units per hour Hourly power expenses (c) Machine Hour Rate i.e. a + b Working Notes : Number of machine working hours are calculated as below : (a) (b) (c) Total power cost for the shop Power cost relating to the machine Rate of power - 5 paise per unit - Rs. - Rs. 3.000 600 Rs. 0.50 Rs. 2.77 960 500 200 90 280 600 90 2,720 1,200 Rs. 2.27

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Management Accounting

(d)

Total power consumption in units Rs. 600 = 12.000 units Paise 5 Rate of power consumption - 10 units per hour

(e) (f)

If total units consumed are 12.000 and if rate of power consumption is 10 units per hour, it means that the machine must have worked for 1,200 hours.

(4)

From the following data, work out the predetermined machine hour rates for departments A and B of a factory. Preliminary Estimates of Expenses Total Rs. Dept. A Rs. 3,000 2,000 10,000 Dept. B Rs. 5,000 3,000 20,000

Power Spare Parts Consumable Stores Depreciation on Machinery Insurance on Machinery Indirect Labour Building Maintenance

15,000 8,000 5,000 30,000 3,000 40,000 7,000

The final estimates are to be prepared on the basis of above figures after taking into consideration the following factors : (1) (2) (3) An increase of 10% in the price of spare parts. An increase of 20% in the consumption of spare parts for Department B only. Increase in the straightline method of depreciation from 10% on the original value of machinery to 12%. 15% general increase in wage rates.

(4)

The following information is available Dept. A Estimated Direct Labour Hours Ratio of K W Rating Estimated Machine Hours Floor Space (sq. ft.) 80,000 3 25,000 15,000 Dept. B 1,20,000 2 30,000 20,000

Overhead Cost

313

Solution : Calculation of machine hour rate Expenses Base Total Rs. 15,000 9,900 5,000 Dept. A Dept. B Rs. Rs. 9,000 3,300 2,000 6,000 6,600 3,000

Power Spare Parts Consumable stores Depreciation on Machinery

KW Rating Allocation and adjustment for Final Estimates Allocation Allocation and adjustments for Final Estimates

36,000 3,000

12,000 1,000

24,000 2,000

Insurance on Machinery Indirect Labour

Ratio of depreciation Direct Labour Hours and adjustment for Final Estimates

46,000 7,000 1,21,900

18,400 3,000 48,700 25,000 1.948

27,600 4,000 73,200 30,000 2.44

Building Maintenance

Floor space

Estimated Machine Hours Machine Hour Rate Working Notes : (1) Spare Part Cost Original Estimate + Extra consumption Total 8,000 1,000 9,000 + 10% Price Increase 900 9,900 (5) Rs.

Dept A 3,000 3,000 300 3,300

Dept B 5,000 1,000 6,000 600 6,600

The factory overhead costs of four production departments of a company engaged in executing job orders, for an accounting year, are as follows : Depts. A B C D Rs. 19,300 4,200 4,000 2,000

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Management Accounting

Overhead has been applied as under Dept A - Rs. 1.50 per machine hour for 14,000 hours Dept B - Rs. 1.30 per Direct Labour Hour for 3,000 hours Dept C - 80% of Direct Labour cost of Rs. 6,000 Dept D - Rs. 2 per piece for 950 pieces. Find out the amount of departmentwise under or over absorbed factory overheads. Solution : (a) Factory Overheads absorbed Dept. A B C D (b) Rs. 21,000 3,900 4,800 1,900 Base Rs. 1.50 per Machine Hour for 14,000 hours Rs. 1.30 per Direct Labour Hour for 3,000 hours 80% of Direct Labour cost of Rs. 6,000 Rs. 2 per piece for 950 pieces

Calculation of under or over absorption Dept. Overheads Incurred Rs. 19,300 4,200 4,000 2,000 29,500 Overheads Absorbed Rs. 21,000 3,900 4,800 1,900 31,600 Over Absorption Rs. 1,700 800 2,500 Under Absorption Rs. 300 100 400 Rs. 2,100

A B C D

Net Over absorption (6)

In a factory, annual average charges for direct wages amount to Rs. 4,80,000. Following are some of the expenses incurred in factory. a. b. Works Managers salary Rs. 50,000 Factory Rent Rs. 36,000. The total area is 45,000 Sq. Ft. out of which shop is in 40,000 Sq. Ft. Wages of Peons and Sweepers Rs. 7,000 Other factory overheads Rs. 53,000

c. d.

Overhead Cost

315

A work order is executed in a shops part occupying an area of 6,000 Sq. Ft. and costs Rs. 10,000 in wages. If the total wages for all work orders executed in the shop amount to Rs. 1,60,000, calculate the total amount of factory overheads charges to be allocated to this work order. Solution : Factory Rent Rs. 36,000 40,000 Sq. ft. Rent of shop Rs. 32,000 i.e., Rs. 36,000 X 45,000 Sq. ft.

Rent for that area of shop where work order is executed. i.e. Rs. 32,000 X 6,000 Sq. ft. 40,000 Sq. ft. = Rs. 4,800

Apportionment of rent to work order on the basis of wages Rs. 10,000 Rs. 160,000 X Rs. 4,800 = Rs. 300

Other factory overheads Rs. Works Managers Salary Factory Rent (Balance) Wages of Peons /Sweepers Others 50,000 4,000 7,000 53,000 1,14,000 Apportionment of overheads to works order on the basis of wages Rs. 10,000 Rs. 4,80,000 X Rs. 1,14,000 = Rs. 2,375

Factory overheads chargeable to the work order Rent Factory overheads Rs. Rs. Rs. 300 2,375 2.675

316

Management Accounting

(7)

Superclass Co. Ltd. has three production departments X, Y and Z and two service Departments A and B. The following estimated figures for a certain period have been made available. Rs. Rent and Rates Lighting and Electricity Indirect wages Power Depreciation of machinery Other expenses and sundries 10,000 1,200 3,000 3,000 20,000 20,000

The following further details are also available. Total Floor space (Sq. Mts.) Light Points (Nos.) Direct wages (Rs.) Horsepower of machines Cost of Machinery (Rs.) Working Hours 10,000 120 20,000 300 1,00,000 X 2,000 20 6,000 120 24,000 4,670 Y 2,500 30 4,000 60 32,000 3,020 Z 3,000 40 6,000 100 40,000 3,050 A 2,000 20 3,000 20 2,000 B 500 10 1,000 2,000

The expenses of the service departments are to be allocated as follows. X A B 20% 40% Y 30% 20% Z 40% 30% A 10% B 10% -

You are required to calculate the overhead absorption rate per hour in respect of the three production departments. What will the total cost of an article with material cost of Rs. 50 and direct labour cost of Rs. 40 which passes through X, Y and Z for 2, 3 and 4 hours respectively.

Overhead Cost

317

Solution : Primary Apportionment of Overheads Expenses Base X Rs. 2000 200 900 1200 4800 6000 15100 Secondary Apportionment of Overheads Result of Primary Apportionment X - Rs. 15,100 A - Rs. 9,250 Let X = Y = X = Y = 10 X = 10 Y = Y - Rs. 14,400 B - Rs. 3,150 Z - Rs. 19,300 Y Rs. 2500 300 600 600 6400 4000 14400 Z Rs. 3000 400 900 1000 8000 6000 19300 A Rs. 2000 200 450 200 400 3000 3000 9250 B Rs. 500 100 150 400 1000 1000 3150

Rent & Rates Lighting & Electricity Indirect wages Power Depreciation Other expenses Direct wages (Only Service Depts.)

Floor space Light points Direct wages HP of machines Cost of machines Direct wages Allocation

Total overheads of Dept. A Total overheads of Dept. B 9,250 + Y/10 3,150 + X/10 92,500 + Y 31,500 + X ...(1) ...(2)

Multiplying equation 1 by 10 and rearranging : -10 Y = 10 Y Adding, 0 99X X Y = = = = = 9,25,000 - 100 X 31,500 + X 9,56,500 - 99X 9,56,500 9,662 4,116 ...(3) ...(4)

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Management Accounting

Total overheads can be apportioned to production departments at agreed percentages to calculate the overhead absorption rate as below : Total Rs. As per Primary apportionment Dept A 90% of Rs. 9662 Dept B 90% of Rs. 4116 48,800 8,696 3,704 61,200 Working Hours Labour Hour Rate Rs. Calculation of Total Cost Rs. Direct Material Cost Direct Labour Cost Overheads Dept X - 2 Hrs x Rs. 4/ Hour Dept Y - 3 Hrs x Rs. 6/ Hour Dept 2 - 4 Hrs x Rs. 8/ Hour = = = Rs. Rs. Rs. 8 18 32 58 178 (8) The expenses of a machine cost centre for a particular month are as under. (i) (ii) Power Maintenance and Repairs Rs. Rs. Rs. Rs. Rs. 50,000 10,000 2,000 6,000 40,000 80 40 X Rs. 15,100 1,933 1,647 18,680 4,670 4.00 Y Rs. 14,400 2,898 822 18,120 3,020 6.00 Z Rs. 19,300 3,865 1,235 24,400 3,050 8.00

(iii) Machine operators wages (iv) (v) Supervision Depreciation

Overhead Cost

319

Other particulars are given below : Products A B C D Rate of Production 30 Units per hour 10 Units per hour 6 Units per hour 4 Units per hour Production Units 1,800 500 300 260

The entire production was to be offered to Government on Cost Plus 20% basis. Material Costs per unit are A - Rs. 40, B - Rs. 60, C - Rs. 100 and D - Rs. 300 Prepare a statement showing product wise cost and offer price. Solution : Total Cost of Machine Centre Rs. Power Maintenance and Repairs Machine operators wages Supervision Depreciation 50,000 10,000 2,000 6,000 40,000 1,08,000 On the basis of rate of production and number of units produced of each product, number of machine hours used can be calculated as below : Product Rate of Production Production (Units) 1,800 500 300 260 Machine Hours used 60 50 50 65 225 Machines Hour Rate = Rs. 1,08,000 225 Machine Hour = Rs. 480 Machine Hour

A B C D

30 Units per hour 10 Units per hour 6 Units per hour 4 Units per hour

320

Management Accounting

Calculation of per unit total cost and offer price Product Material Cost Machine Cost Machine Machine Hours Hour Rate 3 Rs. 1/30 1/10 1/6 4 Rs. 480 480 480 480 Total Cost Profit 20% of Total Cost 7 Rs. 11.20 21.60 36.00 84.00 Offer Price

Total Machine Cost 5 Rs. 16.00 48.00 80.00 120.00

2 Rs. 40.00 60.00 100.00 300.00

6(2+5) Rs. 56.00 108.00 180.00 420.00

8 Rs. 67.20 129.60 216.00 504.00

A B C D

Overhead Cost

321

QUESTIONS 1. Discuss the factors which would create unabsorbed factory overheads and overabsorbed factory overheads. Mention the broad principles on which overhead expenses are generally apportioned. Upon what basis would you apportion the following expenses to individual cost centres in an engineering unit? (a) (b) (c) (d) 3. Rent Power Fire Insurance Premium Lighting

2.

Explain the term underabsorption and overabsorption of overheads. Explain any three methods of absorbing production overheads into the cost of production. Distinguish between actual and predetermined rates for absorption of factory overheads. Cite the major problems involved in using actual rates and discuss how predetermined rates eliminate this problem. How do you deal with under or over absorption of overheads? Mention the various items that go into (a) (b) (c) (d) Manufacturing overheads. Administration overheads. Selling overheads. Distribution overheads.

4.

5.

6.

What basis would you recommend for the apportionment of the following items of expenses to production departments, giving justification for the suggested one. (a) (b) (c) (d) (e) (f) Internal Transport. Air-Conditioning. General Factory Maintenance. Stores. Rent. Labour office.

7.

What is meant by apportionment of overheads? What can be considered as a good base for apportioning the following overheads with reference to a Diesel Engine Manufacturing Company?

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Management Accounting

(i) (ii)

Internal Transport Time Keeping expenses

(iii) Shop supervision (iv) Power, lighting and other utilities

Short Notes : (a) (b) (c) (d) (e) Machine Hour Rate Control of overheads Underabsorption and overabsorption of overheads Treatment of over- absorption of overheads Primary and Secondary apportionment of overheads

PROBLEMS (1) A certain type of factory produces a uniform type of article and has a capacity to produce 1,500 units per week of 48 hours. Following data shows different elements of costs for 3 weeks of 48 hours each when output has changed from one week to another. Units Produced Direct Material Rs. 400 500 800 800 1,000 1,600 Direct Labour Rs. 1,600 2,000 3,200 Factory Overheads (Fixed & Variable) Rs. 3,800 4,000 4,600

You are asked to find out selling price per unit when weekly output is 1,000 units and a profit of 8.33% on selling price will be made.

(2)

A factory is having three production departments A, B and C and two service departmentsBoiler House and Pump Room. The Boiler House has to depend upon the Pump Room for the supply of water and the Pump room in its turn is dependent on the boiler house for supply of steam power for driving the pump. The expenses incurred by the production departments during a period are A Rs. 8,00,000, B Rs. 7,00,000 and C - Rs. 5,00,000. The expenses for boiler house is Rs. 2,34,000 and the pump room is Rs. 3,00,000. The expenses of the boiler house and pump room are apportioned to the production departments on the following basis.

Overhead Cost

323

A Expenses of BH Expenses of PR 20% 40%

B 40% 20%

C 30% 20%

BH 20%

PR 10% -

Show clearly as to how the expenses of boiler house and pump room would be apportioned to A, B and C departments. Use an Algebrical equation.

(3)

The overheads distribution summary for the month of September 1980 disclosed following overheads expenses for departments mentioned below : Production Depts. A B Rs. 12,543 C Rs. 4,547 Service Depts. D Rs. 4,000 E Rs. 2,600

Overheads

Rs. 7,810

Expenses of service departments D and E are apportioned as follows. A D E 30% 10% B 40% 20% C 20% 50% D 20% E 10% -

You are required to find out the total cost of each production dept. by charging the respective costs of service depts. by simultaneous equations method.

(4)

The primary distribution of expenses disclosed the following details in respect of production departments PI, P2 and P3 and Service Departments S1 and S2 Dept. P1 6.300 P2 7,400 P3 2,800 S1 4,500 S2 2,000

Overheads (Rs.)

The services given by S1 and S2 are as follows. Dept. S1 S2 P1 40% 30% P2 30% 30% P3 20% 20% S1 20% S2 10% -

Find out the overheads to production Departments by using simultaneous equations method. (5) A company has three production cost centres A, B and C and two service cost centres X and Y. Costs allocated to service cost centres are required to be apportioned to the

324

Management Accounting

production centres to find out cost of production of different products. It is found that benefit of service cost centres is also received by each other along with the production cost centres. Overhead costs as allocated to the five cost centres and estimates of benefits of service cost centres received by each of them are as under Cost Centres Overhead Costs as allocated Rs. Estimates of benefits received from service centres % X A B C X Y Required Work out final overhead costs of each of the production departments including apportioned cost of service centres using a. b. (6) Continuous Distribution Method Simultaneous Equations Method The following particulars related to the production department of a factory for the month of June 1985. Rs. Material Used Direct Wages Direct Labour Hours Worked Hours of Machine operation Overhead charges allocated to the department 90,000 80,000 72,000 20,000 25,000 80,000 40,000 20,000 20,000 10,000 20 30 40 10 Y 20 25 50 5 -

Cost data of a particular work order carried out in the above department during June 1985 are given below. Rs. Material Used Direct wages Labour hours booked Machine hours booked 8,000 6,250 3,300 2,400

Overhead Cost

325

What would be the factory cost of the work order under the following methods of charging overheads? (i) (ii) Direct Labour Cost Rate Machine Hour Rate

(iii) Direct Labour Hour Rate (7) The following information is extracted from the budget of A Ltd. for 1985. Factory Overheads Direct Labour cost Direct Labour hours Machine hours .. .. .. .. Rs. Rs. 62,000 1,00,000 1,55,000 50,000

The following details are available for job 195 Direct Material Cost Direct Labour Cost Direct Labour hours Machine hours Rs. 45 Rs. 50 40 30

You are required to work out the overhead application rates and ascertain the cost of job 195 by using the following methods of overheads absorption. (1) Direct Labour Hours Rate, (2) Direct Labour Cost, (3) Machine Hour Rate (8) Atlas Engineering Ltd. accepts a variety of jobs which require both manual and machine operations. The budgeted Profit and Loss Account for the period 1996-97 is as follows : (Rs. in Lakhs) Sales Cost : Direct Materials Direct Labour Prime Cost Production Overhead Production Cost Other Overheads Profit 10 5 15 30 45 15 60 15 75

326

Management Accounting

Other budgeted data Labour Hours for the period Machine Hours for the period No. of jobs for the period 2,500 1,500 300

An enquiry has been received recently from a customer and the production department has prepared the following estimate of the prime cost required for the job Direct Material Direct Labour Prime Cost Labour Hours required Machine Hours required You are required to a. Calculate by different methods, six overhead absorption rates for absorption of production overhead and comment on the suitability of each. Calculate the production overhead cost of the order based on each of the above rates. Give your recommendation to the company. A company has two production departments and two service departments. The data relating to a period are as under : Production Depts. PD1 PD2 Direct Materials (Rs.) Direct Wages (Rs.) Overheads (Rs.) Power requirement at normal capacity operation (kwh) Actual power consumption during the period (Kwh) 13000 23000 10250 10000 20000 35000 12500 17500 80000 95000 80000 40000 50000 50000 Service Depts. SD1 SD2 10000 20000 30000 20000 10000 20000 2,500 2,000 4,500 = 80 = 50

b. c. (9)

The power requirement of these departments are met by a power generation plant. The said plant incurred an expenditure, which is not included above, of Rs. 1,21,875 out of which a sum of Rs. 84,375 is variable and the rest fixed.

Overhead Cost

327

After apportionment of power generation plant costs to four departments, the service department overheads are to be redistributed on the following bases : PD1 SD1 SD2 You are required to : a. b. c. Apportion the power generation plant costs to the four departments. Re-apportion service department cost to the production departments. Calculate the overhead rates per direct labour hour of production departments, given that the direct wages rates of PD1 and PD2 are Rs.- 5 and Rs. 4 respectively. 50% 60% PD2 40% 20% SD1 20% SD2 10%

(10) Following information is extracted from the cost records of Hilton Ltd. which specialises in the manufacture of automobile spares. The parts are manufactured in Department A and assembled in Department B. Total Direct Labour hours worked Machine Hours worked Machine Horse Power Book Value of Machines (Rs.) Floor Space (Sq.Ft.) Direct Material Direct Labour Factory Rent Supervision Depreciation on Machines Power Repairs to Machines Indirect Labour 80,000 30,000 400 50,000 20,000 65,000 90,000 15,000 6,000 5,000 4,000 2,000 4,000 Dept. A 30,000 25,000 353 40,000 10,000 50,000 40,000 2,500 1,600 2,000 Dept. B 50,000 5,000 47 10,000 10,000 15,000 50,000 3,500 400 2,000

The prime cost of batch B-401 has been booked as under Total Materials Labour 3,200 7,500 Dept. A 2,700 3,000 Dept. B 500 4,500

328

Management Accounting

Direct Labour hours worked on Batch B-401 were 2,500 in Department A and 5,000 in Department B. Machine hours worked on this batch were 1,250 in Department A and 600 in Department B. Allocate overhead expenditure and calculate the cost of each unit in Batch B401 which consists of 1,000 units. (11) Strongman Ltd. has three production departments A,B and C and two service departments X and Y. The data available for the month of March 1991 concerning the organization Rs. Rent Municipal Taxes Electricity Indirect wages Power Depreciation on Machinery Canteen Expenses Other Labour related costs Following particulars are also available Total Floor Space (Sq. Mts.) Light Points (Nos.) Direct Wages (Rs.) HP of Machines Cost of Machines (Rs.) Working Hours 5,000 240 40,000 150 20,0000 A 1,000 40 12,000 60 48,000 2,335 B 1,250 60 8,000 30 64,000 1,510 C 1500 80 12,000 50 80,000 1,525 X 1,000 40 6,000 10 4,000 Y 250 20 2,000 4,000 15,000 5,000 2,400 6,000 6,000 40,000 30,000 10,000

The expenses of Service Departments are to be allocated in following manner A X Y 20% 40% B 30% 20% C 40% 30% X 10% Y 10%

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

Overhead Cost

329

(12) A company has 3 production departments A, B and C and two service departments X and Y. The following data are extracted from the records of the company for a particular given period. Rs. Rent and Taxes General Lighting Indirect Wages Power Depreciation on Machinery Sundries Additional data departmentwise Total Direct Wages (Rs.) HP of Machines Cost of Machines (Rs. in Lakhs) Floor Space (Sq.Mts.) Lighting Points (Nos.) Production Hours 50000 150 12.50 10000 60 A 15000 60 3.00 2000 10 6226 B 10000 30 4.00 2500 15 4028 C 15000 50 5.00 3000 20 4066 X 7500 10 0.25 2000 10 Y 2500 0.25 500 5 25,000 3,000 7,500 7,500 50,000 50,000

Sundries can be apportioned on the basis of Direct Wages. Service Departments expenses allocation A X Y You are required to a. b. Compute the overhead rate of production departments using repeated distribution method. Determine the total cost of a product whose direct material cost and direct labour cost are Rs. 150 and Rs. 150 respectively and which would consume 4 hours, 5 hours and 3 hours in departments A, B and C respectively. 20% 40% B 30% 20% C 40% 30% X 10% Y 10%

(13) Universal Ltd. has four production departments A, B, C and D and two service departments viz. Transport and Power Supply.

330

Management Accounting

Particulars of expenses of the respective departments are as follows : A B C D Transport Power Supply Rs. Rs. Rs. Rs. Rs. Rs. 2,000 1,800 1,600 1,400 1,100 760

The service departments expenses are charged out on a percentage basis as given below : A Transport Power 10% 30% B 30% 20% C 20% 30% D 20% 10% Transport 10% Power 20% -

Using the above information, apportion the service department overheads to various production departments using a. b. Simultaneous Equations Method Repeated Distribution Method

(14) A shop has 2 newly purchased machines, each occupying equal area of space. One is 4 - spindle drilling machine and the other is 6-spindle drilling machine costing Rs. 80,000 and Rs. 1,00,000 respectively. Following are the expenses for one year : a. b. c. d. Rent Rates and Taxes Lighting and heating power expenses - 4 spindle machine - 6 spindle machine e. f. Administration expenses Running and Maintenance Rs. 10,000 Rs. 15,000 Rs. 38,000 Rs. 80,000 Rs. 40,000 Rs. 17,000 Rs. 12,600

The life of each machine is 10 years without any salvage value. Each machine works for 45 hours a week for 50 weeks in a year. 250 hours per machine are used for repairs. Running and repairs expenses are shared between two machines on the basis of power expenses. You are required to prepare statement showing computation of Machine Hour Rate.

Overhead Cost

331

(15) Calculate the machine hour rate in respect of machine No. 179 from the following particulars : Cost of machine Estimated Life Estimated scrap value Estimated working hours per annum Estimated hours required for maintenance Setting up time (Hours) Power 20 units @ Rs.0.17 per unit Repairs and maintenance per annum No. of operators (looking after also 3 other machines) Wages per operator per month Chemical required for operating the machine Overheads chargeable to the machine Insurance premium -1% p.a. on the cost of machine. Rs. 1500/2 Rs. 150/Rs. 100/- p.m. Rs. 200/- p.m. Rs. 20,000 15,000 hours Rs. 500/2200 100 (included in above) 100 (included in above)

(16) You are required to calculate the composite machine hour rate from the following particulars in respect of a jig boring machine whose scrap value is Rs. 50,000 after its working life of 10 years. 1. 2. 3. 4. 5. 6. 7. 8. Cost of the machine - Rs. 2,00,000 Importation charges & Customs duty etc.- Rs. 50,000 Working hours per year - 2,000 Repairs & Maintenance charges - 50% of depreciation charge. Lubricating oil - Rs. 20 per working day of 8 hours Consumable stores - Rs. 500 per month of 25 working days. Power 10 units per working hour at Re. 0.30 per unit Wages of the operator - Rs. 1,000 per month of 25 working days.

332

Management Accounting

(17) From the particulars furnished below, compute a machine hour rate : Name of the Equipment - Single spindle Automat Date of purchase Cost Estimated Life Depreciation Insurance Repairs Consumable stores Rent Superintendence (l/5th for the machine) 1.4.1983 Rs. 75,000 10 years 15% on original cost Rs. 4,000 p.a. Rs.1,800 p.a. Rs. 1,500 p.a. Rs. 2,400 p.a. Rs. 2,500 p.a.

The machine can work for 200 hours in a month and had actually worked for 80% of the normal working hours. Cost of oils and greases consumed per hour is Rs.4.50,

(18) A dept. is having 3 machines. The figures indicate the departmental expense of these machines. Calculate the machine hour rate from the data below : Depreciation of machines Rent Repairs to machines Insurance of machines Indirect wages Power Lighting Misc. Expenses Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs 12,000 2,880 4,000 800 6,000 6,000 800 4,200 36,680

Overhead Cost

333

Other information : M/c1 Direct wages Rs. Power units No. of workers Light points Space occupied (Sq. Ft.) Cost of machine Rs. Hours worked 1,200 30,000 4 8 400 3,00,000 200 M/c2 2,400 10,000 8 24 800 1,20,000 300 M/c3 2,400 20,000 8 48 800 1,80,000 300

(19) Following particulars relate to a machine : Rs. Purchase Price of machine Installation Expenses Rent per Quarter General Lighting for the total area Supervisors salary Insurance premium Estimated repairs Estimated consumable stores Power 2 units per hour @ Rs. 50 per 100 units The estimated life of the machine is 10 years and the estimated scrap value is Rs. 20,000. The machine is expected to run 20,000 hours in its life time. The machine occupies 25% of the total area. The supervisor devotes l/6th of his time for the machine. You are required to work out machine hour rate. 80,000 20,000 3,000 200 6,000 600 1,000 800 per month per quarter per annum per annum per annum

(20) From the following particulars, calculate the machine hour rate of machine installed in a Department. Cost of Machine Estimated scrap value after the expiry of its life (15 years) Rs. 16,000

Rs. 1,000

334

Management Accounting

Estimated working hours of the machine per year Monthly salary of a foreman engaged in supervision of this machine and other two identical machines. Repails and Maintenance of the machine Insurance premium for the machine

2,000

Rs. 1,500 Rs. 2,400 per year Rs. 120 per year

Departmental rent and rates are Rs. 1,200 per year. The space occupied by the machine is l/6th of the floor space of the department. Power consumption of the machine is 2 units per hour @ 10 paise per unit.

(21) A machine costing Rs. 20,000 is expected to work for 10 years and at the end of which the scrap value is estimated Rs. 2,000, installation charges amount to Rs. 200. repairs over 10 years life is expected Rs. l,800 and the machine is expected to run for 2.190 hours in a year. Its power consumption would be 15 units per hour at Rs. 5 per 100 units. The machine occupies l/4th of the area of the department and has two points out of ten for lighting. The foreman has to devote l/3rd of his time for this machine. The rent for the department is Rs. 300 p.m. and charges for lighting Rs. 80 p.m. The foreman is paid salary Rs. 960 p.m. Find out the hourly rate assuming insurance is 1% per annum and expenses on oil etc. Rs. 9 per month.

(22) Following data is available relating to a company for a certain month. Territory I Selling Expenses (Rs.) Distribution Costs (Rs.) No. of units sold Sales (Rs.) 7,600 4,000 16,000 76,000 II 4,200 1,800 6,000 28,000 III 6,240 2,000 10,000 52,000

The company adopts sales basis and quantity basis for application of selling and distribution costs respectively. Compute (a) (b) The territorywise overhead recovery rates separately for Selling and Distribution costs. The amounts of selling and distribution cost chargeable to a consignment of 2,000 units of a product, sold in each territory at Rs. 4.50 per unit. 335

Overhead Cost

(23) A machine is purchased for cash at Rs. 9,200. Its working life is estimated to be 18,000 hours after which its scrap value is estimated at Rs. 200. It is assumed from the past experience that a. b. c. d. The machine will work for 1,800 hours annually. The repair charges will be Rs. 1,080 during the whole period for life of the machine. The power consumption will be 5 units per hour at 6 paise per unit. Other annual standing charges are estimated to be 1. 2. 3. 4. 5 Rent of department (machine l/5th) Light (12 points in the department, 2 points engaged in the machine) Foremans salary (l/4th of his time is occupied in the machine) Insurance premium for machine Cotton Waste 780 288 6000 36 60

Find out the machine hour rate on the basis of above data for allocation of the works expenses to all jobs for which the machine is used.

(24) The following particulars relate to a new machine purchased. Purchase Price of the machine Installation Expenses Rent per Quarter General Lighting for the total area Foremans Salary Insurance Premium for the machine Estimated repair for the machine Estimated Consumable Stores Rs. 4,00,000 Rs. 1,00,000 Rs. Rs. Rs. Rs. Rs. Rs. 15,000 1,000 p.m. 30,000 p.a. 3,000 p.a. 5,000 p.a. 4,000 p.a.

The estimated life of the machine is 10 years and the estimated value at the end of 10 years is Rs. 1,00,000. The machine is expected to run 20,000 hours in its life time. The machine occupies 25% of the total area. The foreman devotes l/6th of his time for the machine. Calculate the machine hour rate for the machine.

336

Management Accounting

(25) A manufacturing unit has added a new machine to its fleet of five existing machines. The total cost of purchase and installation of the machine is Rs. 7,50,000. The machine has an estimated life of 15 years and is expected to realise Rs. 30,000 as scrap at the end of its working life. Other relevant data are as follows : a. Budgeted working hours are 2,400 based on 8 hours per day for 300 days. This includes 400 hours for plant maintenance. Electricity used by the machine is units per hour at a cost of Rs. 2 per unit. No current is drawn during maintenance. The machine requires special oil for heating which is replaced once in every month at a cost of Rs. 2,500 on each occasion. Estimated cost of maintenance of the machine is 500 per week of 6 working days. 3 operators control the operations of the entire battery of six machines and the average wages per person amounts to Rs. 450 per week plus 40% fringe benefits. Departmental and general overheads allocated to the operation during the last year were Rs. 60,000. During the current year it is estimated that there will be an increase of 12.5% of this amount. No incremental overhead is envisaged for the installation of the new machine.

b.

c.

d. e.

f.

You are required to compute the machine hour rate for the recovery of the running cost of the machine. (26) The following annual charges are incurred in respect of a machine in a shop where manual labour is almost nil and where work is done by means of five machines of exactly similar type and specification. (a) (b) (c) (d) (e) (f) Rent and Taxes (Proportionate to the floor space occupied) for the shop - Rs. 4,803. Depreciation on each machine - Rs. 500. Repairs and maintenance for five machines - Rs. 1,000 Power consumed @ 6.25 paise per unit for the shop Rs. 3,750. Electric charges for light in the shop - Rs. 540. Attendants - There are two attendants for the five machines and they are each paid Rs. 60 per month. Supervision - There is one supervisor in the shop for the five machines and he is paid Rs. 250 per month. 337

(g)

Overhead Cost

(h) (i)

Sundry supplies such as lubricants, jute and cotton waste etc. for the shop - Rs. 494. Hire Purchase - Instalment payable for the machine (including Rs. 300/- as interest) Rs. 1,200. The machine uses 10 units of power per hour. Calculate the machine hour rate for the year.

(j)

(27) In a manufactring concern ABC Ltd., die machine shop has 8 identical machines manned by 6 operators. The machines cannot be worked without an operator wholly engaged on them. The total cost of the machines are Rs. 8,00,000. Following information relates to a six monthly period ended 30th June, 1990. Normal available hours per month Absenteeism (without pay) hours per month. Leave (with pay) hours per month Normal idle time (unavoidable) hours per month Average rate of wages per day of 8 hours Production hours Power and Fuel consumption Supervision and Indirect Labour Electricity The following particulars are on a yearly basis. Repairs and Maintenance 3% of value of machines Insurance Depreciation Other factory expenses Allocated General Management Expenses Rs. 63,670 Rs. 42,000 10% of original cost. Rs. 12,000 10 Rs. 20 15% on wages Rs. 9,000 Rs. 3,300 Rs. 1,200 18 20 208

You are required to work out a comprehensive machine hour rate for the machine shop.

338

Management Accounting

(28) In a factory, the following particulars have been extracted for the quarter ending 30th June, 2001 in respect of Production Department P1, P2 and P3 and service Departments S1 and S2. Compute the departmental overhead rate for each of the production departments, assuming that overheads are absorbed as a percentage of direct wages. Particulars Direct Wages (Rs.) Direct Material (Rs.) No. of Workers Power (KWHrs.) Asset Value Light Points Area in Sq. Fts. Expenses for the period were Power Lighting Stores overheads Staff Welfare Depreciation Rent General Overheads Rs. Rs. Rs. Rs. Rs. Rs. Rs. 1,100 200 800 3,000 36,000 550 12,000 P1 30000 15000 150 6000 60000 10 150 P2 45000 30000 225 4500 40000 16 250 P3 60000 30000 225 3000 30000 4 50 S1 15000 22000 75 1500 10000 6 50 S2 30000 22000 75 1500 10000 4 50

Apportion general overheads in the proportion of direct wages. Apportion the expenses of S1 according to direct wages and those of S2 in the ratio of 5 : 3: 2 to the production departments. (29) A Ltd. has 3 production departments A, B and C and 2 service departments D and E. The following are the figures of the company. Rs. Rent and Rates General lighting Indirect wages Power Depreciation of Machinery Sundry Expenses 5,000/600/1,500/1,500/10,000/10,000/-

Overhead Cost

339

The following further details are available : A Floor Space (Sq.Ft) Light points Direct wages (Rs.) Value of Machinery (Rs.) H.P. of Machines 2000 10 3000 60,000 60 B 2500 15 2000 80,000 30 C 3000 20 3000 1,00,000 50 D 2000 10 1500 5,000 10 E 500 5 500 5,000

Sundry expenses are apportioted on the basis of direct wages The expenses of D and E are allocated as under : A D E 20% 40% B 30% 20% C 40% 30% D 10% E 10% -

Find the rate per hour if the working hours are as under : A B C Department Department Department 6226 4028 4066

(30) In a light engineering factory, the following particulars have been collected for the three monthly period ended 31.12.80. Compute the departmental overhead rates for each of the production departments assuming that the overheads are recovered as a percentage of direct wages. Production Dept. A Direct wages Direct materials Staff Electricity Light points Asset value Area occupied Rs. Rs. Nos. Kwh. Nos. Rs. Sq.Ft. 2,000 1,000 100 4,000 10 60,000 150 B 3,000 2,000 150 3,000 16 40,000 250 C 4,000 2,000 150 2,000 4 30,000 50 Service Dept. D 1,000 1,500 50 1,000 6 10,000 50 E 2,000 1,500 50 1,000 4 10,000 50

340

Management Accounting

The expenses for the period were : Motive power Lighting power Stores overhead Amenities to staff Depreciation Repairs and Maintenance General overheads Rent and Taxes Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. 550 100 400 1,500 15,000 3,000 6,000 275

Apportion the expenses of service dept. E proportionate to direct wages and that of service dept. D in the ratio of 5 : 3 : 2 to depts A, B and C respectively.

Overhead Cost

341

NOTES

342

Management Accounting

Chapter 1 1
MARGINAL COSTING

In the conventional system of cost ascertainment, the direct cost may be identified with the individual cost center. However, the indirect costs i.e. the overheads are identified with the individual cost center on the most equitable basis. This results into some problems in the process of managerial decision-making. a. The above process does not take into consideration the behaviour of cost. All the costs in the practical circumstances do not behave in the same manner. Some of the costs tend to remain constant despite the changes in the level of activity or volume of operations. These types of costs are comparatively irrelevant in the managerial decision-making. The above process results into the under absorption or over absorption of overheads.

b.

The said limitations have given rise to a managerial decision making technique that basically tries to classify the costs based upon the behaviour of cost. The technique is referred to as Marginal Costing. The basic proposition made by this technique is that the costs should be classified on the basis of behaviour of the costs. From this angle, the costs can be viewed as fixed costs and variable costs, Fixed Cost is the cost that tends to remain constant irrespective of the level of activity or volume of operations. Fixed Cost tends to vary with time rather than with level of activity. Basic characteristic feature of fixed cost is that this cost in terms of amount may remain constant at all the levels of activities, however per unit fixed cost goes on decreasing with the increasing level of activity and vice-a-versa. Variable Cost is the cost that varies in direct proportion with the level of activity or volume of operations. Basic characteristic feature of variable cost is that variable cost in terms of amount may increase or decrease with the changing level of activity or volume of operations. However, per unit variable cost remains constant. In practical circumstances, some costs may not be entirely fixed or entirely variable. They are technically in the form of semi-fixed costs or semi-variable costs. For the purpose of marginal costing, the semi-fixed costs or semi-variable costs are required to be classified in the individual

Marginal Costing

343

components of fixed cost and variable cost. For segregating the semi-fixed or semi-variable cost into the individual components of fixed cost and variable cost, various techniques or methods may be available viz.
l l l l l

Comparison by period or level of activity Range or High and Low method Analytical method Scattergraph method Lease Square method

Based upon the above discussions, let us make some calculations for a manufacturing organization manufacturing and selling a single product, operating at various levels of activities. Level of Activity Units Per Unit Selling Price Rs. Total Sales Rs. Variable Cost Rs. Fixed Cost Rs. Total Cost Rs. Per Unit Variable Cost Rs. Per Unit Fixed Cost Rs. Per Unit Total Cost Rs. 1000 100 1,00,000 60,000 30,000 90,000 6 3 9 1500 100 1,50,000 90,000 30,000 1,20,000 6 2 8 2000 100 2,00,000 1,20,000 30,000 1,50,000 6 1.5 7.5

It can be observed from the above calculations that if the fixed cost is included in the calculation of total cost, per unit total cost becomes non-comparable with the changes in the level of activity in one cost-period to another cost-period. To avoid this non-comparability, it is necessary to eliminate the fixed costs while determining the total cost. As such, the technique of Marginal Costing proposes that fixed cost tends to remain stagnant at least over a shorter period of time and hence should be ignored in the entire decision making process. As such, marginal costing considers only the variable cost as the relevant cost in the decision making process. The Concept Marginal Cost is defined as the amount at any given volume of output by which the aggregate costs are changed if the volume of output is increased or decreased by one unit. The aggregate cost consists of both fixed cost and variable cost. As in the short run, fixed costs remain constant irrespective of changes in the volume, aggregate costs may increase or decrease

344

Management Accounting

with the changes in volume, specifically due to variable cost. As such, in simple words, marginal cost indicates Per Unit Variable Cost. Marginal Costing is defined as the ascertainment, by differentiating between fixed and variable costs, of the marginal costs and of the effect on profit of changes in volume and type of output. Basic assumptions made by Marginal Costing The entire technique of Marginal Costing is based upon the following assumptions. a. Variable Cost varies in direct proportion with the level of activity. However, per unit variable cost remains constant at all the levels of activities. Per unit selling price remains constant at all the levels of activities. Whatever is produced by the organization is sold off. In other words, there are no variations due to the stock.

b. c.

Features of Marginal Costing 1. The product costs are classified as fixed costs and variable costs. Semi-variable costs are also classified in their individual components of fixed cost and variable cost. Only variable costs are considered while computing the product costs. The closing stock of finished goods and semi-finished goods is valued after considering variable costs only. Fixed costs are written off during the period of incurrence and hence do not find the place in product cost determination or inventory valuation. Prices of the product are based on variable costs only. Profitability of the products or departments is decided in terms of marginal contribution.

2.

3.

4. 5.

Marginal Costing and Cost-Volume-Profit Relationship The definition of the term Marginal Costing requires the computation ofa. b. a. Marginal Cost Cost-Volume Profit Relationship Determination of Marginal Cost As stated earlier, the marginal cost is the additional cost for manufacturing one additional unit, which is nothing else but the variable cost per unit. Thus the marginal cost or variable cost includes the direct cost plus the variable overheads. Fixed overheads get clubbed with the fixed cost.

Marginal Costing

345

b.

Cost Volume-Profit Relationship : The intention of every business activity is to earn the profit and to maximize the profit. Determination of the profits depends upon the interplay between the following factors and there exists a close relationship among these factors : (1) (2) (3) Selling price per unit and total sales amount. Total cost which in its turn may be in the form of variable cost or fixed cost. Volume of sales

Cost-Volume-Profit Analysis aims at studying the relationships existing among these factors and its impact on the amount of profits. The relationships existing among these factors may be basically presented in two forms. (a) (b) In statement or report form In graphical form, the graphs or charts taking the form of break even chart, contribution break even chart or profit chart.

Form of operating statement : Under the marginal costing technique, the operating statement takes the form as specified below. (a) In case of a single product company Rs. Sales Less : Marginal cost Direct Material Cost Direct Labour Cost Direct Expenses Variable Overheads x x x x x Contribution Less : Fixed costs Profit x x x x

346

Management Accounting

(b)

In case of a multi product company Product A Rs. Sales Less : Marginal cost Direct Material cost Direct Labour cost Direct Expenses Variable Overheads Contribution Less : Fixed costs Profit x x x x x x x x x x x x x x x x x x x x x x x Product B Rs. x Product C Rs. x Total Rs. x

Basic concepts in Marginal Costing : (1) Basic equation of Marginal Costing : The basic intention of the business is to earn the profit which is the excess of sales over the total costs. Profit = Sales - Total Cost However, total cost can be either fixed cost or variable cost. As such the basic equation takes the following forms. Profit = Sales - (Variable Cost + Fixed Cost) Profit = Sales - Variable cost - Fixed cost Profit + Fixed cost = Sales - Variable cost. This is the basic equation of marginal costing. Both the expressions of Sales - Variable Cost and Profit + Fixed cost are technically termed as contribution. Sales - Variable Cost = Contribution = Fixed Cost + Profit Contribution - Fixed cost = Profit

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347

(2)

Contribution : As discussed earlier, the term contribution can be expressed in two ways basically : (a) (b) Sales - Variable Cost Fixed cost + Profit

As in the short period, fixed costs are ineffective due to their stagnant nature, variable cost becomes the most important cost in deciding the profitability. As such, the situation which generates higher contribution is treated as profitable situation. Further, the term contribution, plays an important role in a situation where there are more than one products and the profits on individual products cannot be ascertained due to the problems of apportionment of fixed costs to different products. This is due to the fact that the fixed costs are ignored by marginal costing. (3) Profit Volume (P/V) Ratio : This ratio indicates the contribution earned with respect to one rupee of sales. As such, it is expressed as Contribution Sales X 100

As in the short run, fixed cost remains the same, if there is any change in profits, that is only due to change in contribution. Hence P/V ratio may also be expressed as : Change in Profits Change in Sales X 100

E.g. Sales price is Rs. 10 per unit, variable cost is Rs.6 per unit, and fixed costs are Rs.300, we observe that for 100 and 150 units, P/V Ratio works out as : 100 Units Rs. Sales Variable cost Contribution Fixed cost Profit 1,000 600 400 300 100 150 Units Rs. 1,500 900 600 300 300

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Management Accounting

Hence, P/V Ratio is Contribution Sales X 100 = 400 1,000 i.e. 100 X 100 = 600 1,500 40% X 100

OR Increase in Profits Increase in Sales X

40% 200 i.e. 500

X 100 = 40%

The fundamental property of P/V Ratio is that it remains constant at all the levels of activities, provided per unit sales price and variable cost remains constant. It should be noted that P/V Ratio remains unaffected by any variation in fixed costs though overall profits may change due to this variation. A high P/V Ratio indicates that a slight increase in sales without corresponding increase in fixed costs will result in higher profits and vice-versa. This is a pointer to increased sales promotion efforts to increase sales volume. A low P/V Ratio indicates low profitability so that efforts can be made to increase the profits by increasing selling price or by reducing variable cost. Overall profitability may also be increased by concentrating more on products having high P/V Ratio. Note : The basic expression of P/V Ratio i.e.Contribution/Sales may lead to other useful conclusion as (a) (b) Sales x P/V Ratio = Contribution Contribution P/V Ratio (4) = Sales

Break Even Point (BEP) : This is a situation of no profit no loss. It means that at this stage, contribution is just enough to cover the fixed costs i.e. Contribution = Fixed Cost. It also means that contribution generated by all sales beyond Break Even Point will directly result into profits. As such, it will be intention of every business to reach the Break Even Point, as early as possible. The Break Even Point may be expressed in two ways. (a) In terms of quantity Fixed Costs Contribution per unit

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349

(b) (5)

In term of amount

Fixed Costs P/V Ratio

Margin of Safety : These are the sales beyond Break even point. A business will like to have a high margin of safety because this is the amount of sales which generates profits. As such, the soundness of the business is indicated by the margin of safety. A high margin of safety indicates that the Break Even Point is much below the actual sales and even if there is reduction in sales, business will be still in profits. A low margin of safety accompanied by high fixed cost and high P/V Ratio indicates that efforts are required to be made for reducing the fixed cost or increasing sales volume. A low margin of safety accompanied by a law P/V Ratio indicates that efforts are required to be made for reducing the variable cost or increasing the selling price. Margin of safety may be expressed as below : Margin of Safety = = Sales - Break Even Sales Sales Fixed cost P/V Ratio

Margin of Safety

Sales x P/V Ratio - Fixed Cost P/V Ratio

Contribution - Fixed Cost P/V Ratio Profit

P/V Ratio

Margin of safety may be expressed as a ratio or as a percentage. E.g. If actual sales are Rs.l,00,000 and Break Even Sales are Rs.60,000, Margin of Safety will be Sales - Break Even Sales Sales i.e. i.e. 1,00,000 - 60,000 1,00,000 40% of Sales X 100 = X 100 40,000 1,00,000 = X 100

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Management Accounting

Illustrations : (1) Following details are available : Sales Rs. Period I Period II 39,000 43,000 Total Cost Rs. 34,800 37,600

Calculate variable cost, fixed cost and contribution for each period. Solution : As Sales - Total Cost = Profit, we know as below : Sales Rs. Period I Period II As P/V Ratio = = Increase in Profits Increase in Sales 5,400 - 4,200 43,000 - 39,000 X 100 = 39,000 43,000 X 100 1,200 4,000 X 100 = 30% Total Cost Rs. 34,800 37,600 Profit Rs. 4,200 5,400

As Sales x P/V Ratio = Contribution,For period I, Contribution = 39,000 x 30% = 11,700 For period II, Contribution = 43,000 x 30% = 12,900 As Sales - Contribution = Variable Cost, For period I, Variable Cost = 39,000 - 11,700 = 27,300 For period II, Variable Cost = 43,000 - 12,900 = 30,100 As Contribution - Profit = Fixed Cost, For period I, Fixed Cost = 11,700- 4,200 = 7,500 For period II. Fixed Cost = 12,900 - 5,400 = 7,500 To summarise, Period I Rs. Contribution Variable cost Fixed cost
Marginal Costing

Period II Rs. 12,900 30,100 7,500 351

11,700 27,300 7,500

(2)

Following details arc available : Sales Rs. Period I Period II 2,00,000 3,00,000 Profit Rs. 20,000 40,000

Find out Break even Sales Solution : We know that P/V Ratio = Increase in Profits Increase in Sales P/v Ratio = 20,000 100,000 Profit P/V Ratio For period I, Margin of Safety is = 20,000 20% = 1,00,000 X 100 = 20% X 100

Margin of safety

As Break Even Sales = Sales - Margin of Safety. Considering Period I, Break Even Sales = = (3) 2,00,000 - 1,00,000 1,00,000

Following details are available: Actual Sales Rs. 20,000

Break Even Sales Rs. 10,000 Fixed Cost Rs. 5,000

Find out the profit at actual sales, Solution : At break Even Point, Contribution = Fixed Cost At Break Even Point, sales are Rs. 10,000 and contribution Rs. 5,000

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Management Accounting

However we know that, P/V Ratio = Contribution Sales X 100 = 5,000 10,000 X 100= 50%

We also know that. Sales x P/V Ratio = Contribution, At actual sales of Rs. 20,000 Contribution = = 20,000 x 50% 5,000

We know that Contribution - Fixed cost = Profit Profit = = (4) 10,000 - 5,000 5,000

Following details are available: Break Even Sales Fixed cost Profit Rs. Rs. Rs. 20,000 10,000 5,000

Find out the margin of safety. Solution : At Break Even Point, Fixed Cost = Contribution When sales are Rs. 20,000, Contribution is Rs. 10,000

However, we know that Contribution Sales P/V Ratio We also know that, Margin of safety = Profit P/V Ratio 5,000 50% 353 = 10,000 X 100 = 10,000 20,000 P/V ratio

X 100 = 50%

Marginal Costing

(5)

Find, out the Break Even Point and Profit if sales are Rs. 50,00,000 and P/V Ratio is 50% and Margin of safety is 40%.

Solution : Sales are Rs. 50,00,000 and Margin of safety is 40% of sales, hence margin of safety is Rs. 20,00,000. As Break Even Sales = Sales Margin of Safety. BEP = Rs. 50,00,000 - Rs. 20,00,000 = Rs. 30,00,000 We know that, Margin of Safety = Profit P/V Ratio

Margin of Safety x P/V Ratio = Profit As Margin of Safety is Rs. 20,00,000 and P/V Ratio is 50%, Profit = 20,00,000 x 50% = 10,00,000 GRAPHICAL PRESENTATION OF COST-VOLUME-PROFIT RELATIONSHIPS As discussed earlier, the Cost-Volume-Profit relationships may be expressed in the form of visual aids like graphs and charts. There may be various ways in which these charts and graphs can be prepared depending upon the purpose for which they are prepared. We will discuss three of these ways. (1) Simple Break Even Chart It can be prepared as below. Y

TS TC

COST/REVENUE

BEP

LOSS MOS FC X

VOLUME

}
SL

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Management Accounting

TS TC BEP SL FS MOS Angle a

= = = = = = =

Total Sales Line Total Cost Line Break Even Point Selected Level of Activity Fixed Cost Margin of Safety Angle of Incidence.

Note : It will be observed from the above chart, that the angle formed by total sales line and total cost line is termed as Angle of Incidence. As the difference between total sales and total cost is in the form of profits, higher the angle of incidence better will be the situation. The limitation of Simple Break Even Chart is that contribution cannot be shown separately. As such, the following type of Break Even Chart may be prepared i.e. Contribution Break Even Chart. (2) Contribution Break Even Chart : This is a chart where the contribution is shown more clearly and specifically than in a simple break even chart. It can be prepared as below. Y TS TC COST/REVENUE a BEP FC VC

MOS

VC SL X

VOLUME

TS TC BEP SL C

= = = = =

Total Sales Line Total Cost Line Break Even Point Selected Level of Activity Contribution

}
PC VC MOS Angle a = = = =

Fixed Cost Variable Cost Margin Of Safety Angle of Incidence.

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355

(3)

Profit Graph : In case of this type of break even chart, horizontal axis represents sales volume and vertical axis represents profit or loss. The diagonal line represents contribution. The point where the contribution line cuts horizontal axis indicates sales at the Break Even Point indicating that at this point, there is no profit or no loss. PL BEP

P SALES

} FC
PL FC P = = =

Profit Line Fixed Cost Profit Area

L BEP

= =

Loss Area Break Even Point

PRACTICAL APPLICATIONS OF MARGINAL COSTING : The technique of marginal costing can be profitably employed in the following situations. (1) Evaluation of Performance : The performance of various segments of a business, say a department or a product or a branch and so on, can be evaluated with the help of marginal costing and the evaluation of the performance will be based upon the contribution generating capacity of these segments. If the fixed costs are apportioned over these segments on any basis whatsoever, it will be ignored while evaluating the performance.

356

Management Accounting

Illustration : Following details are available in respect of 3 products. Products B Rs. 1,50,000

A Rs. Sales Total Cost Variable Cost Fixed cost (Apportioned on the basis of sales) Total Cost Profit (Loss) 20,000 1,10,000 (10,000) 90,000 1,00,000

C Rs. 2,50,000

1,00,000

1,50,000

30,000 1,30,000 20,000

50,000 2,00,000 50,000

As product A is incurring the losses, it is decided to close down its production. Advise the management, Solution : It will not be advisable to close down the production of product A, because it is generating the positive contribution (i.e. Rs. 1,00,000 - Rs. 90,000 = Rs. 10,000) Closing down of product A will mean loss of contribution generated by it, fixed cost still remaining the same. Assuming that the production of product A is closed down, what will be the effect on profitability? Let us verify by applying marginal costing principles. Product B Rs. Sales Variable Cost Contribution 1,50,000 1,00,000 50,000 Product C Rs. 2,50,000 1,50,000 1,00,000 Total Rs. 4,00,000 2,50,000 1,50,000 1,00,000 50,000

Fixed costs Profits

It means that existing total profits of Rs. 60,000 will reduce to Rs. 50,000 which will affect profitability adversely.

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357

(2)

Profit Planning : Marginal costing, through the calculations of P/V Ratio, enables the management to plan the activities in such a way that the profits can be maximised or to maintain a specific level of profits. As such, this technique helps the planning of profits.

Illustration : (1) M/s. C and P Ltd. Produces and sells industrial containers and packing cases. Due to competition, the company proposes to reduce the selling price. If the present level of profit is to be maintained, indicate the number of units to be sold if the proposed reduction in price is (a) 10% and (b) 15%. The following information is available: Rs. (1) (2) (3) Present Sales (30,000 Units) Variable Cost (30,000 Units) Fixed Cost 3,60,000 1,40,000 5,00,000 (4) Net Profit 1,00,000 Rs. 6,00,000

Solution : The present cost structure can be stated as below: Per Unit Rs. Sales Variable Cost Contribution Fixed Cost Net Profit 20 12 8 Total Rs. 6,00,000 3,60,000 2,40,000 1,40,000 1,00,000

If the price is reduced by 10% or 15%, the per unit cost structure is going to change as below : Present Rs. Sales Variable Cost Contribution 20 12 8 10% Price Reduction Rs. 18 12 6 15% Price Reduction Rs. 17 12 5

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Management Accounting

If the present level of profits is to be maintained i.e. Rs. 1,00,000, the revised total contribution which the sales will have to generate with reduced per unit contribution will be Expected Profit + Fixed Cost, and the number of units which will have to be sold will be : Expected Profit + Fixed Cost Revised per unit contribution As such, the number of units which will have to be sold in the above cases of price reduction will be 10% Price Reduction Rs. 1,00,000 + Rs. 1,40,000 Rs. 6 = = (2) Rs. 2,40,000 Rs. 6 40,000 Units = = 15% Price Reduction Rs. 1,00,000 + Rs. 1,40,000 Rs. 5 Rs. 2,40,000 Rs. 5 48,000 Units

Per Unit cost structure of a single product manufacturing company is as below : Selling Price Direct Material Direct Labour Variable overheads Rs. Rs. Rs. Rs. 100 60 10 10

Number of Units sold in the year are 5,035. As per the agreement with the employees union, there will be an increase of 10% in Direct wages. Work out (a) How many more units have to be sold next year to maintain same quantum of profits. By what percentage the selling price has to be raised to maintain same P/V Ratio?

(b)

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359

Solution : The present profitability structure is as below : (i) (ii) Total number of units sold Per unit cost structure Selling price Variable cost Direct Material Direct Labour Variable Overheads Rs. 60 Rs. 10 Rs. 10 Rs. 80 Contribution per unit (iii) Total Contribution Rs. 20 Rs. 1,00,700 Rs. 100 5,035

In the next year, the per unit Direct Labour Cost will be more by 10% i.e. Rs. 11 per unit which will reduce the per unit contribution to Rs. 19. Alternative (a) : If the same quantum of profits is to be maintained, same amount of contribution will have to be generated with reduced per unit contribution. As such, number of units required to be sold will be : = Amount of contribution Revised per unit contribution Rs. 1,00,700 Rs. 19 5.300 Units

= =

Hence, the company will have to sell 265 units more (i.e. 5,300 Units - 5,035 Units) to maintain same quantum of profits. Alternative (b) : At present, when selling price is Rs. 100, contribution is Rs. 20 meaning that per unit variable cost is Rs. 80. In future, the variable cost is likely to be Rs. 81 per unit instead of Rs. 80. Accordingly, the selling price will also be required to be increased if it is intended that the same P/V Ratio should be maintained. 360
Management Accounting

The new selling price will be : Rs. 81 Rs. 80 X 100 = Rs. 101.25

As such, the selling price has to be raised by 1.25% to maintain the same P/V Ratio. The profitability structure will be Selling Price Variable Cost Contribution P/V Ratio Rs. 101.25 Rs. 81.00 Rs. 20.25 = Contribution per unit Selling Price per unit 20.25 101.25 (3) Fixation of Selling Price : The technique of marginal costing may be applied in the area of price fixation in such a way that prices fixed should cover atleast the variable cost. As in the short run, the fixed cost is a stagnant cost, it can be ignored, though it can not be ignored in the long run because of the simple fact, that it is a cost. In the short run, the prices fixed above the variable cost may generate some positive contribution which may help in the recovery of fixed cost. However, if the fixed cost is ignored in the long run, it may put the business into serious troubles as the business will never be able to earn the profits. In this connection, following propositions should be kept in mind. (a) In some exceptional circumstances viz. during the phase of depression, serious competition in the market, to introduce the new product in the market by keeping the price as low as possible in the initial stages, to dispose off the product which may deteriorate in quality etc., it may be necessary to fix the selling price even below the variable cost, however it is a deliberate decision taken by the management. The above principle is equally applicable while fixing the export price as well. The export price over and above the variable cost will result into increased amounts of profits if the fixed costs can be taken care of by the inland sales and if the home market is not likely to get affected by the export price fixed. However, if certain specific costs, either fixed or variable, are required to be incurred specifically for the execution of the export order, they will have to be recovered while fixing the export price as if it is a part of the variable cost. 361 X 100 = 20% X 100

(b)

Marginal Costing

Illustration : (1) The operating statement of a company is as follows : Rs. Sales (80,000 Units @ Rs. 15) Costs Variable Materials Labour Overheads 2,40,000 3,20,000 1,60,000 7,20,000 Fixed Total Costs Profit 3,20,000 10,40,000 1,60,000 12,00,000

The plant capacity is 1,00,000 units. A customer from U.S.A. is desirous of baying 20,000 units at a net price of Rs. 10 each unit. Advice the company whether or not offer should be accepted? Will your advice be different if the customer is a local one? Solution : At present, variable cost per unit is Rs. 9 i.e. Rs. 7,20,000 80,000 units So long as the export price is more than Rs. 9, it is going to generate additional contribution which is going to increase the profits, as the fixed costs are already covered by the local sales. As the export price offered is Rs. 10 i.e., Re. 1 more than the variable cost per unit, the company should accept the offer. The advice will be the same even it the customer is a local one, provided the price discrimination, i.e. Rs. 15 per unit for 80,000 units and Rs. 10/- per unit for 20,000 units is not going to adversely affect the current market for 80,000 units at the current price of Rs. 15. If the company accepts the export offer of Rs. 10 per unit, the revised profitability structure will be as below: Rs. Sales : 80,000 units @ Rs. 15 20,000 units @ Rs. 10 12,00,000 2,00,000 14,00,000

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Management Accounting

Costs

Variable 1,00,000 units @ Rs. 9 Fixed Total costs 9,00,000 3,20,000 12,20,000 1,80,000

Profit

The revised amount of profit will be more by Rs. 20,000 as compared to the existing amount of profits. Hence, the export order should be accepted by the company. (4) Make or buy decision : If the management is facing problem to decide whether a component or a product should be manufactured in house which can be purchased from an outside source as well, the technique of marginal costing may render useful assistance. E.g. The following cost data is made available in respect of two components A and B. Component A Rs. per unit If manufactured Variable Cost Fixed Cost 30 25 55 If purchased 40 30 20 50 25 Component B Rs. per unit

If the above data is viewed from total cost point of view, without considering the classification of cost like fixed or variable, it may be concluded that the purchase proposition may be profitable for both the components A and B. However, the conclusion may be misleading as the total cost in case of component A, if purchased, is not going to be only Rs. 40 per unit, but it is going to be Rs. 65 (i.e. Rs. 40 purchase price per unit plus Rs. 25 fixed cost per unit) which being more than present total cost, manufacturing proposition will be beneficial. On the other hand, in case of component B, total cost, if purchased, is going to be Rs. 45/- per unit (i.e. Rs. 25 purchase price per unit plus Rs. 20 fixed cost per unit) which being less than present total cost, buying proposition will be beneficial. The above conclusions may be simplified in the following way : If Purchases Price < Variable Cost, go in for purchase proposition. If Purchase Price > Variable Cost, go in for manufacturing proposition.

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363

Before taking any make or buy decision only on the basis of marginal cost analysis, following points should also be taken into consideration. (1) If buying proposition is beneficial in case of a component or product, the final decision to buy may depend on other factors also viz. whether the supplier is reliable one, whether the supplier can assure required quality, whether the supplier can assure uninterrupted supply etc. If it is decided to buy a component or a product which was being manufactured till now, the manufacturing capacity released should be profitably used for some other purposes. If it is decided to manufacture a companent which was being purchased till now, there may be two possibilities. One, production capacity used for same component or product may be diverted to manufacture another component or product. In this case, the loss of contribution of that another component or product should be considered as a part of cost. Second, if additional production facilities are required to be acquired for the manufacturing proposition, the additional fixed costs attached with the manufacturing proposition should be considered.

(2)

(5)

Optimising product mix : Product mix refers to the proportion in which various products of a company can be sold. If a concern is dealing in a number of products, a problem which usually arises is to decide a mix or proportion in which the sales of the various products should be made so that the profits can be maximized. Such a problem can be solved by studying the contributions generated by the various products individually and by selecting that mix which generates the maximum total contribution.

Illustration : Following information has been made available from the cost records of Universal Automobiles Ltd. manufacturing spare parts Direct Materials per unit X Rs. 8 Y Rs. 6 Direct wages X Y 24 hours @ 25 paise per hour. 16 hours @ 25 paise per hour.

Variable overheads - 150% of wages Fixed overheads - Rs. 750 Selling price X Y 364 Rs. 25 Rs. 20
Management Accounting

The Directors want to be acquainted with the desirability of adopting any one of the following alternative sales mixes in the budget for the next period. (a) (b) (c) (d) 250 units of X and 250 units of Y 400 units of Y only 400 units of X and 100 units of Y 150 units of X and 350 units of Y

State which of the alternatives you would recommend to management. Solution : Productwise Profitability Structure Product X Rs. (1) (2) Selling Price per unit Variable cost per unit Direct Material Direct Wages Variable Overheads 8 6 9 23 (3) Contribution per unit 2 6 4 6 16 4 25 Product Y Rs. 20

Evaluation of various alternative sales mixes as per Total Contribution Alternative Product X Rs. 250 x 2 = 500 400 x 2 = 800 150 x 2 = 300 Product Y Rs. 250 x 4 = 1,000 400 x 4 = 1,600 100 x 4 = 400 350 x 4 = 1,400 Total Rs. 1,500 1,600 1,200 1,700

a. b. c. d.

Fixed overheads are going to be the same in all these alternatives. As such, the alternative which generates maximum contribution is the maximum profitable one.As alternative d i.e. 150 units of X and 350 mills of Y generates maximum of contribution, it will be recommended to the management.

Marginal Costing

365

(6)

Cost control : Marginal costing is necessarily a technique of cost classification and cost presentation. The segregation of total costs as fixed costs and variable costs itself facilitates the cost control. Variable costs are the controllable costs at the lower level of management whereas fixed costs can be controlled only on the top level of management and that too, to a limited extent only. Classification of costs as fixed costs and variable costs enables the management to concentrate on the controllable costs. At the same time, the fixed costs are not completely ignored. The only thing is that they are collected and reported separately as an amount deducted from total contribution. As such, the fixed costs can also be controlled as they can be programmed and estimated in advance.

(7)

Flexible Budget Preparation : Marginal costing technique and more particularly the classification of costs as fixed and variable, facilitates the preparation of flexible budgets which is discussed in details in the chapter Budgetary Control.

PROBLEM OF KEY FACTOR : Under the marginal costing technique, profitability is measured in terms of the contribution and the products generating maximum contribution or having maximum P/V Ratio are treated as the maximum profitable products. As the intention of every business is to maximize the profits, the company will concentrate maximum on the products having highest P/V Ratio and will thus maximize the profits. However, in practice, there may be some factors which may come into play which may restrict the companys intention or capability to maximize the profits E.g. In case of the products having highest P/V Ratio, market may be limited, or in case of a maximum profitable product, raw material may not be available. These factors are in the form of Key Factor or Limiting Factor or Scarce Factor. A key factor is defined as the factor which, at a particular point of time or over a period, will limit the volume of output. The key factor may be in various forms viz. sales/market, material, labour, machine availability and so on. In order to evaluate the profitability of a product under key factor situations, the contribution per unit of key factor is the basic criteria. A product generating maximum contribution per unit of key factor is the maximum profitable product.

366

Management Accounting

Illustration : From the following details, which product would be recommended if time is the key factor. Product A Direct Material per unit Direct Labour @ Rs. 2 per hour Variable Overheads (% of labour cost) Selling Price per unit Solution : Product A (1) (2) Selling Price Unit Rs. Variable Cost per unit Rs. Direct Material Direct Labour Variable Overheads 24 20 40 84 (3) (4) (5) Contribution per unit Rs. Number of labour hours Contribution per labour hour Rs. 66 10 6.6 14 30 90 134 66 15 4.4 150 Product B 200 Rs. 24 Rs. 20 200% Rs. 150 Product B Rs. 14 Rs. 30 300% Rs. 200

As labour hours is the key factor and contribution per labour hour is more in case of product A, it will be recommended for production. Multiplicity of Key Factors In practice, more than one key factors may come into play and any decision regarding product mix ascertainment or profitability ascertainment will have to be decided on the basis of consideration of multiplicity of key factors. The situation of multiplicity of key factors is a more complex situation, the solutions to which may be found in the more advanced techniques like linear programming.

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367

Illustration : Following data is available to decide the product mix. A Raw material per unit Labour Hours required (Rate Rs. 1 per hour) Selling price per unit Rs. Maximum production Possible Units 6,000 4,000 3,000 125 100 200 10 kgs 15 B 6 kgs 25 C 15 kgs. 20

1,00,000 kgs of raw material is available at Rs. 10 per kg. Maximum production hours are 1,84,000 with a facility for a further 15,000 hours on overtime basis at twice the normal wage rate. Solution : Product A (1) (2) Selling Price per units Rs. Variable cost Material Labour 100 15 115 (3) (4) (5) Contribution per unit Rs. Contribution per Kg of Raw material - Rs. Contribution per labour hrs Rs. 10 1.00 0.66 60 25 85 15 2.50 0.60 150 20 170 30 2.00 1.50 125 Product B 100 Product C 200

Considering the contribution per kg of raw material as well as per labour hour, the rankings among the various products will be as below. I II III Product C Product B Product A

Hence, the available raw material and labour hours will be used for the manufacture of Product C and Product B respectively.

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Management Accounting

Product C B

Units 3,000 4,000

Raw Material Kgs. 45,000 24,000 69,000

Labour Hours No. 60,000 1,00,000 1,60,000

Hence, the balance of raw material and labour hours available for manufacturing of Product A will be as below. Raw Material - Kgs. 31,000 kgs. (i.e. 1,00,000 kgs - 69,000 kgs)

Labour Hours - 24,000 (i.e. 1,84,000 - 1,60,000) Plus 15,000 extra hours by paying double the normal wage rate. If extra labour hours are used for the manufacture of product A by paying double the normal wage rate, the cost structure of product A will be as below : (1) (2) Selling Price per unit Variable cost per unit Material Labour Rs. Rs. Rs. (3) Contribution per unit 100 30 130 Rs. 125

(-) Rs. 5

As there cannot be the positive contribution generated, it will not be advisable to use the labour hours which require the payment of wages at double the normal wage rate. As such, product A will be manufactured by utilising the labour hours which require the payment of wages at the normal wage rate only i.e. 24,000 hours with the help of which 1,600 units of A (24,000 Hours/ 15 Hours per unit) can be manufactured. As such, the final product mix will be as below. Product A Product B Product C 1,600 Units 4,000 Units 3,000 Units

Note : One alternate solution is possible to solve the problem of key factors. If the labour hours which require the payment of wages at double the normal wage rate can be utilised for the manufacture of Product C, its cost structure will be as below.

Marginal Costing

369

(1) (2)

Selling Price Per Unit Variable cost per unit Material Labour

Rs. 200

Rs. 150 Rs. 40

Rs. 190 (3) Contribution per unit Rs. 10

As such, apparently it may be possible to utilise the labour hours carrying double the normal wage rate for manufacturing product C and utilise the released labour hours carrying the normal wage rate for manufacturing Product A (i.e. 15,000 hours) In this case, the final product mix will be as below. Product A Product B Product C 2,600 Units 4,000 Units 3,000 Units

The calculation of total contribution generated under both those alternatives is as below. Alternative I Product No. of Units Contribution Per Unit Rs. 10 15 30 Total Contribution Rs. 16,000 60,000 90,000 1,66,000 Alternative II Product No. of Units Contribution Per Unit Rs. 10 15 30 10 Total Contribution Rs. 26,000 60,000 67,500 7,500 1,61,000 As in the second alternative, the total contribution generated is less than the one generated in the first alternative, the second alternative can not be accepted. As such, it will be advisable for the company not to utilise the labour hours requiring the payment of wages at double the normal wage rate. 370
Management Accounting

A B C

1,600 4,000 3,000

A B C C

2,600 4,000 2,250 750

LIMITATIONS OF MARGINAL COSTING (1) The classification of total cost as variable cost and fixed cost is difficult. No cost can be completely variable or completely fixed. In some cases, the cost which is considered to be variable, may not be variable in practical terms E.g. Direct Labour Cost. Under normal situations this cost is treated as variable cost. However, in India, considering the tremendous legal backing the workers are having, the direct labour cost may not be variable in nature. As such, it may be necessary to consider the direct labour cost as a part of fixed cost. Under the marginal costing, the fixed costs are eliminated for the valuation of inventory of finished goods and semi-finished goods, inspite of the fact that they might have been actually incurred. As such, it is not correct to eliminate the fixed costs. Further, such an elimination affects the profitability adversely. In the age of increased automation and technological development, the component of fixed costs in the overall cost structure may be sizeable. Any technique like marginal costing which ignores the fixed costs altogether, may not be proper under these circumstances as a major portion of cost is not taken care of. Marginal costing technique does not provide any standard for the evaluation of performance. In that sense, the techniques of budgetory control and standard costing may be considered to be better techniques from cost control point of view. Fixation of selling price on marginal cost basis may be useful for short term only. Here also, an undue importance given to only variable cost may result into taking on heavy business with low margin which in turn may increase the fixed costs. As such, over the long run, the prices should be decided on total cost basis only. Fixation of selling price on the marginal cost basis in the long run may be dangerous. Moreover, consideration of fixed costs may be necessary in price fixation under certain circumstances like cost plus contracts unless a very high percentage over the marginal cost is considered to take care of both fixed costs as well as profit margin. Marginal costing does not take into consideration the fixed overheads, as such the problem of under or over absorption of fixed overheads can be avoided. But the problem of under or over absorption of variable overheads cannot be avoided. Marginal costing can be used for assessment of profitability only in the short run. However, in the long run, one has to consider the fixed costs also in order to assess the profitability. Moreover, interpretation of the term short run is a subjective concept. For how long the decision can be taken on the basis of marginal costing principles cannot be decided in the objective manner.

(2)

(3)

(4)

(5)

(6)

(7)

Marginal Costing

371

ILLUSTRATIVE PROBLEMS (1) Profit and sales for the year 1984 are as follows. Profit Rs. 18,000, Sales Rs. 2,40,000. In 1985, the sales increased by Rs. 40,000 and the profit naturally increased by Rs. 8,000. You are required to calculate. (1) (2) (3) P/V Ratio Sales required to achieve a profit of Rs. 1,00,000. Sales at Break even Point.

Solution : We know that P/V Ratio = Increase in Profits Increase in Sales P/V Ratio = 8,000 40,000 We also know that Sales x P/V Ratio = Contribution and Contribution - Profit = Fixed Cost. Applying this to the information available for the year 1984 2,40,000 x 20% = Rs. 48,000 is the contribution and 48,000 - 18,000 = Rs .30,000 is the fixed cost If the company wants to achieve the profit of Rs. 1,00,000 the total contribution which will have to be generated will be Expected Profit + Fixed cost i.e. Rs. 1,00,000 + Rs. 30,000 i.e. Rs. 1,30,000 We know that Sales = Contribution P/V Ratio As such sales required to achieve a profit of Rs. 1,00,000 will be Expected Profit + Fixed Cost P/V Ratio X 100 = 20% ...(a) X 100

372

Management Accounting

1,00,000 + 30,000 20%

= We know that Break Even Point

1,30,000 20%

Rs. 6,50,000

...(b)

Fixed Cost P/V Ratio

Sales at Break Even Point

30,000 20% (c)

= Rs. 1,50,000 (2)

The Directors of Sports Material Manufacturing Co. gives the following information. Sales - (1,00,000 Units) Variable Costs Fixed Costs (a) (b) - Rs. - Rs. - Rs. 1,00,000 40,000 50,000

Find out P/V Ratio, Break Even Point and Margin of Safety. Evaluate the effects on P/V Ratio, Break Even Point and Margin of safety of the following (i) (ii) (iii) (iv) 20% increase in physical sales volume. 10% increase in fixed costs. 5% decrease in variable costs. 10% increase in selling price.

Solution : (A) Present profitability structure is as below. Sales - 1,00,000 Units Per Unit (Rs.) Sales Variable Costs Contribution Fixed Costs Profit 1.00 0.40 0.60 Total (Rs.) 1,00,000 40,000 60,000 50,000 10,000

Marginal Costing

373

(1)

P/V Ratio Contribution Sales X 100 = 60,000 1,00,000 X 100 = 60%

(2)

Break Even Point Fixed Cost P/V Ratio = 50,000 60% = Rs. 83,333

(3)

Margin of Safety Profit P/V Ratio = 10,000 60% = Rs. 16,667

(B) Effect of 20% increase in Physical Sales Volume. Revised Profitability structure will be as below. Sales 1,20,000 Units Per Unit (Rs.) Sales Variable Costs Contribution Fixed Costs Profit (1) P/V Ratio Contribution Sales (2) Break Even Point Fixed Cost P/V Ratio (3) Margin of Safety Profit P/V Ratio = 22,000 60% = Rs. 36,667 = 50,000 60% = Rs. 83,333 X 100 = 72,000 1,20,000 X 100 = 60% 1.00 0.40 0.60 Total (Rs.) 1,20,000 48,000 72,000 50,000 22,000

374

Management Accounting

(C) Effect of 10% increase in fixed costs. Revised profitability structure will be as below : Sales 1,00,000 Units Per Unit (Rs.) Sales Variable Costs Contribution Fixed Costs Profit (1) P/V Ratio Contribution Sales (2) X 100 = 60,000 1,00,000 X 100 = 60% 1.00 0.40 0.60 Total Rs. 1,00,000 40,000 60,000 55,000 5,000

Break Even Point Fixed Cost P/V Ratio = 55,000 60% = Rs. 91,667

(3)

Margin of Safety Profit P/V Ratio = 5,000 60% = Rs. 8,333

(D) Effect of 5% decrease in variable costs. Revised profitability structure will be as below. Sales 1,00,000 Units Per Unit (Rs.) Sales Variable Costs Contribution Fixed Costs Profit (1) P/V Ratio Contribution Sales X 100 = 62,000 1,00,000 X 100 = 62% 1.00 0.38 0.62 Total (Rs.) 1,00,000 38,000 62,000 50,000 12,000

Marginal Costing

375

(2)

Break Even Point Fixed Cost P/V Ratio = 50,000 62% = Rs. 80,645

(3)

Margin of Safety Profit P/V Ratio = 12,000 62% = Rs. 19,355

(E) Effect of 10% increase in selling price. Revised Profitability structure will be as below. Sales 1,00,000 Units Per Unit (Rs.) Sales Variable Costs Contribution Fixed Costs Profit (1) P/V Ratio Contribution Sales (2) X 100 = 70,000 1,10,000 X 100 = 63.64% 1.10 0.40 0.70 Total (Rs.) 1,10,000 40,000 70,000 50,000 20,000

Break Even Point Fixed Cost P/V Ratio = 50,000 63.64% = Rs. 78,567

(3)

Margin of Safety Profit P/V Ratio = 20,000 63.64% = Rs. 31,426

Note : The difference between Sales and Break Even Point is not matching with Margin of Safety, due to the rounding off differences. (3) From the following figures find out the break even volume. Selling Price per tonne Variable Cost per tonne Fixed Expenses Rs. 69.50 Rs. 35.50 Rs. 18,02,000

376

Management Accounting

If this volume represents 40% capacity, what is the additional profit for an added production of 40% capacity, the selling price of which is 10% lower for 20% capacity production and 15% lower, than the existing price, for the other 20% capacity. Solution : Selling Price per Unit Variable cost per Unit Contribution per Unit Break Even Point (in terms of quantity) = = = Rs. 69.5 Rs. 35.5 Rs. 34.0 Fixed Cost Contribution per Unit Rs. 18,02,000 Rs. 34 53,000 Units

Additional production of 53,000 units is envisaged, which can be classified in two parts for convenience purposes. Part I Selling Price per Unit Variable Cost per Unit Contribution per Unit Number of Units Total Contribution Rs. Rs. 62.55 Rs. 35.50 Rs. 27.05 26,500 7,16,825.00 Part II 59.075 35.500 23.575 26,500 6,24,737.50

As the fixed cost is already covered till the break even point, the contribution beyond the break even point will directly result into profit. Hence, additional profit will be Rs. 7,16,825.00 + Rs. 6,24,137.50 = Rs. 13,41,562.50. (4) The Quality Product Ltd. manufacture and markets a single product Following data is available. Rs. Per Unit Material Conversion (Variable) Dealers Margin Selling Price Fixed Cost - Rs. 5,00,000 Present Sales - 90,000 Units Capacity Utilisation - 60%
Marginal Costing

16 12 4 40

377

There is acute competition. Extra efforts are necessary to sell. Suggestions have been made for increasing sales. (a) (b) By reducing sales price by 5%. By increasing dealers margin by 25% over the existing rate.

Which of these two suggestions would you recommend if the company desires to maintain present profits. Give reasons. Solution : The present profitability statement will be as below, when 90,000 units are being sold. Per Unit (Rs.) (a) (b) Sales Variable Costs Material Conversion Dealers Margin 16 12 4 32 (c) (d) (e) Contribution a b Fixed cost Profit c d 8 14,40,000 10,80,000 3,60,000 28,80,000 7,20,000 5,00,000 2,20,000 40 Total (Rs.) 36,00,000

Alternative I To reduce selling price by 5%. In this alternative the profitability structure will be revised as below. Selling Price per Unit Variable Cost per Unit Contribution per Unit Rs. 38 Rs. 32 Rs. 06

If the company wishes to maintain the same profits, the total contribution which the sales will have to generate with the reduced amount of per unit contribution will be Expected Profits + Fixed Cost. And total number of units to be sold will be No. of Units to be sold = Expected Profit + Fixed Cost Revised contribution per Unit 2,20,000 + 5,00,000 6 1,20,000 Units

= =

378

Management Accounting

Alternative II To increase the dealers margin by 25%. In this alternative, the variable cost will be more by Rs. 1 and the profitability structure will be revised as below. Selling Price per Unit Variable cost per Unit Contribution per Unit Rs. 40 Rs. 33 Rs. 07

If the company wishes to maintain the same profits, the total contribution which the sales will have to generate with the reduced amount of per unit contribution will be Expected Profits + Fixed Cost. And total number of units to be sold will be No. of Units to be sold = Expected Profit + Fixed Cost Revised contribution per unit 2,20,000 + 5,00,000 7 1,02,857 Units

Acute competition in the market is the basic problem area. As such, the company will like to accept the alternative where less number of units will be required to be sold, the profits remaining the same under both the alternatives. As Alternative II requires 1,02,857 Units to be sold vis-a-vis 1,20,000 units required to be sold under Alternative I, the company will prefer Alternative II. Note : It is assumed that both the alternatives are exclusive alternatives i.e. Even when selling price is reduced by 5%, the dealers margin is unaffected and vice versa. (5) Frazer Ltd. manufactures and sells a product, the selling price and raw material cost of which have remained unchanged during the past two years. The following are the relevant data: Year 1 100 Rs. 20,000 Rs. 10,000 Rs. 3,000 Rs. 5,000 Rs. 2,000 Year 2 150 ? ? ? Rs. 5,700 Rs. 2,550

Particulars Quantity sold (Kgs.) Sales Value Raw Material Direct Wages Factory Overheads Profit

Marginal Costing

379

During year 2, direct wage rates increased by 50% but there was a saving of Rs. 300 in fixed factory overheads. Required : What quantity in Kgs. the company should have produced and sold in year 2 in order to maintain the same amount of net profit per Kg. as it earned during the year 1? Solution : The Profitability statement for both the years is as below Year 1 Quantity Sold (Kgs.) Sales (Rs.) Variable Cost Raw Material Direct Wages Variable Factory Overheads Total Variable Cost Contribution Fixed Cost Profit Profit per Kg. (Rs.) 10,000 3,000 2,000 15,000 5,000 3,000 2,000 20 15,000 6,750 3,000 24,750 5,250 2,700 2,550 17 100 20,000 Year 2 150 30,000

Per Unit Variable Cost in Year 2 works out to Rs. 165 i.e. Rs. 24,750 / 150 Kgs. Let us assume that the quantity to be sold in Year 2 is X Kgs. Hence, the profitability statement will be 200X - 165X - 2700 = 20X Solving for X, we get the value of X to be 180 Kgs. Hence, the company should have produced and sold 180 Kgs. in year 2 in order to maintain the same amount of net profit per Kg. as it earned during Year 1. Working Note Factory Overheads in Year 1 were Rs. 5,000 which became Rs. 5,700 in Year 2 with the information that there was a saving of Rs. 300 in fixed factory overheads. Assuming that there was no saving, the factory overheads would have been Rs. 6,000 in Year 2. Hence, the data would have been as below -

380

Management Accounting

Year 1 Quantity Sold (Kgs.) Factory Overheads (Rs.) 100 5,000

Year 2 150 6,000

For the increased quantity of 50 Kgs. the overheads would have increased by Rs. 1,000. It means that the variable factory overheads are Rs. 20 per unit. (6) Garden Products Limited manufacture the Rainpour garden pour. The accounts of the company for the year 1981 are expected to reveal a profit of Rs. 14,00,000 from the manufacture of Rainpour after charging fixed costs of Rs. 10,00,000. The Rainpour is sold for Rs.50 per unit and has a variable unit cost of Rs. 20. Market sensitivity tests suggest the following responses to price changes. Alternatives A B C Selling Price Reduced by 5% 7% 10% Quantity sold increased by 10% 20% 25%

Evaluate these alternatives and state which, on profitability consideration, should be adopted for the forthcoming year, assuming cost structure unchanged from 1981. Solution : At present, the expected profit is Rs. 14,00,000 after recovering the fixed cost of Rs. 10,00,000. Hence, the total expected contribution is Rs. 24,00,000 i.e. Rs. 14,00,000 + Rs. 10,00,000. Per Unit cost structure is as below. Selling Price Variable Cost Rs. 50 Rs. 20

Contribution Rs. 30 If total contribution is Rs. 24,00,000 and per unit contribution is Rs. 30, it means that the presently expected sales in terms of quantity are 80,000 units.

Marginal Costing

381

In the light of above, the results of the various alternatives can be calculated as below.
Alternatives Price Per Unit 1 Revised Selling Per Unit 2 Revised contribution Per Unit 3 Revised sold Quantity 4 Revised total contribution 5(3x4)

A B C

47.50 46.50 45.00

27.50 26.50 25.00

88,000 96,000 100,000

24,20,000 25,44,000 25,00,000

As profitability is the criteria on which the various alternatives are to be evaluated, Alternative B will be selected, as it generates maximum contribution, fixed cost remaining the same under all the alternatives. (7) Shri Kiron manufactures Lighters. He sells his product at Rs. 20 each and makes profit of Rs. 5 on each lighter. He worked 50% of his machinery capacity at 50,000 lighters. The cost of each lighter is as under. Rs. Direct Material Wages Works Overheads Sales Expenses 6 2 5 (50% fixed) 2 (25% variable)

His anticipation for the next year is that the cost will go up as under. Fixed Charges Direct Labour Material 10% 20% 5%

There will not be any change in selling price. There is an additional order for 20,000 lighters in the next year. What is the lowest rate he can quote so that he can earn the same profit as the current year?

382

Management Accounting

Solution : The profitability statement in the current year is as below : Sales 50,000 Units Per Unit (Rs.) (A) Sales (B) Variable Costs Direct Material Wages Works overheads Sales Expenses 6.00 2.00 2.50 0.50 11.00 (C) Contribution (A B) (D) Fixed Costs Works Overheads Sales Expenses 2.50 1.50 1,25,000 75,000 2,00,000 (E) Profits (C D) 2,50,000 9.00 3,00,000 1,00,000 1,25,000 25,000 5,50,000 4,50,000 20.00 Total (Rs.) 10,00,000

In the next year, material cost will increase by 5% i.e., by 30 paise and direct labour cost will increase by 20% i.e., by 40 paise. As such, the total variable cost will increase by 70 paise. Hence, the total variable cost will be Rs. 11.70 per unit. The revised profitability structure for 50,000 unit will be : Selling price per unit Variable cost per unit Contribution per unit Total contribution Rs. 20.00 Rs. 11.70 Rs. 8.30 Rs. 4,15,000

In the next year, fixed charges will increase by 10% i.e., total fixed charges of Rs. 2,00,000 in this year will become Rs. 2,20,000. As we know that Contribution - Fixed Charges = Profit, the profit generate by 50,000 units will be Rs. 4,15,000 Rs. 2,20,000 = Rs. 1,95,000

Marginal Costing

383

If in the next year, the company wants to earn the same total profits as in the current year i.e. Rs. 2,50,000 there will be a shortfall of Rs. 55,000 i.e., Rs. 2,50,000 - Rs. 1,95,000 and the shortfall will have to be recovered by additional 20,000 units proposed to be sold in the next year. Hence, over and above the variable cost, each of these additional units will have to recover the profit of : Rs. 55,000 20,000 units = Rs. 2.75 per Unit

Hence, the lowest rate which can be quoted will be : Expected variable cost per unit in the next year + Expected profit per unit in the next year i.e., Rs. 11.70 + Rs. 2.75 = Rs. 14.45 per unit (8) Following details are available in respect of a single product manufacturing company operating at 75% capacity. Units Sold Selling Price Per Unit Material Cost Labour hours required Labour hour rate Variable expenses Fixed cost 15,000 Rs. 12.5 Rs. 3 per Unit 2 per unit Re. 1 per hour 200% of labour cost Rs. 20,000

The company has received an offer to export 8,000 units. Due to the Government backing, the material will be available at a price lower by 25% than the existing price. An additional expenditure of Rs. 10,000 will have to be incurred for execution of this export order. But an export incentive is available from the Government which will be equivalent to 25% of the export price. What minimum price should be charged if it is intended that per unit exported should earn a clear margin of Rs. 2 and the profits from inland sales remaining the same. Ignore the benefits available as per the provisions of Income Tax Act, 1961 and the time required to receive the export incentive in cash since the date of actual export. Assume that Selling price in inland market cannot be increased.

384

Management Accounting

Solution : Present cost structure is as below: Sales -15,000 Units Per Unit (Rs.) (A) (B) Selling price Variable Costs Material Cost Labour Cost Variable Expenses 3.00 2.00 4.00 9.00 (C) (D) (E) Contribution (A - B) Fixed Cost Profit (C D) 3.50 45,000 30,000 60,000 1,35,000 52,500 20,000 32,500 12.50 Total (Rs.) 1,87,500

When sales are 15,000 Units, capacity utilisation is 75%. It means that maximum 20,000 units can be sold both in inland or export market. The export order received is for 8,000 units. Now, the company has two alternatives. Alternative I : Alternative II : Accept the export order only for 5,000 units which can be manufactured. Accept the export order for 8,000 units by reducing the inland sales by 3,000 units. Only 5,000 Units to be exported.

Alternative I :

The amounts which export price will have to cover are as below: Per Unit (Rs.) Material Cost Labour Cost Variable Expenses Additional Expenditure (Rs. 10,000 distributed over 5,000 units) Expected margin 2.00 2.00 12.25 The above amount can be covered either by way of export price of the export incentive which is 25% of export price. If we assume export price to be Rs. x, the following relationship is established.
Marginal Costing

2.25 2.00 4.00

385

x i.e. i.e. i.e.

+ 25% of x +

x x 4 5x 4 x

= = = =

12.25 12.25 12.25 9.80

Hence, export price should be minimum Rs. 9.80. Alternative II : 8,000 units to be exported, inland sales being only 12,000 units.If 8,000 units are to be exported, inland sales will be less by 3,000 units, which will result in the loss of contribution of Rs. 10,500 (i.e. 13000 units x Rs. 3.50 per unit) This loss of contribution also will have to be covered by the units to be exported, as the selling price in the inland market can not be increased. As such per unit amount to be covered by export price is as below: Rs. 12.25 (As calculated in Alternative 1) plus Rs. 10,500 8,000 units = Rs. 12.25 + Rs. 1.3125 = Rs. 13.5625 This amount can be covered either by way of export price or by export incentive, which is 25% of export price. Assuming export price to be Rs. x, x + 25% of x x+ x 4 5x 4 x = = 13.5625 13.5625 = Rs. 1.3125

= 13.5625 = 10.85

Hence export price should be minimum Rs. 10.85

386

Management Accounting

(9)

A Ltd. operating at 75% level of activity produces and sells two products X and Y. The cost sheets of these two products are as under : Product X 3,000 115 Product Y 2,000 95

Particulars Units produced and sold Selling Price Per Unit (Rs.) Cost : Direct Materials Direct Labour Factory Overheads (40% fixed) Administration & Selling Overheads (60% fixed) Total Cost Per Unit

10 20 25

20 20 15

40 95

25 80

Factory overheads are absorbed on the basis of machine hour rate which is the limiting factor. The machine hour rate is Rs. 10 per hour. The company receives an offer from Japan for the purchase of Product X at a price of Rs. 87.50 per unit. Alternatively, the company has another offer from Bangkok for the purchase of Product Y at a price of Rs. 77.50 per unit. In both the cases, a special packing charge of Rs. 2.50 per unit has to be borne by the company. The company can accept either of the two export orders by utilising the balance of 25% of its capacity. Advise the company with the detailed workings as to which proposal should be accepted and prepare a statement showing the overall profitability of the company after incorporating the export proposal suggested by you. Solution : The existing profitability structure as per marginal costing works out as below Product X Selling Price Variable Cost Direct Materials Direct Labour Factory Overheads Administration & Selling Overheads 10 20 15 16 61 Contribution 54 20 20 9 10 59 36 115 Product Y 95

Marginal Costing

387

Hence, Total Contribution Product X - 3000 Units x Rs. 54 per unit = Product Y - 2000 Units x Rs. 36 per unit = Rs. 1,62,000 Rs. 72,000 Rs. 2,34, 000 Fixed Cost can be calculated as below: Product X - 3000 Units x Rs. 34 per unit = Product Y - 2000 Units x Rs. 21 per unit = Rs. 1,02,000 Rs. 42,000 Rs. 1,44,000 Hence, profit i.e. Contribution - Fixed Cost Rs. 90,000. As Factory Overheads as absorbed on the basis of machine hour rate and as machine hour rate is Rs. 10, Product X takes 2.5 hours and Product Y takes 1.5 hours. Hence, the total number of hours consumed by the existing level of activity can be calculated as below: Product X - 3000 Units x 2.5 hours per unit = Product Y - 2000 Units x 1.5 hours per unit = 7,500 hours 3,000 hours 10,500 hours As 10,500 hours are equivalent to 75% level of activity, balance number of hours available for the execution of the export order are 3,500 which is equivalent to balance 25% level of activity. With the balance number of hours available, the maximum number of units which can be manufactured for export order work out as below: Product X - 3,500 hours / 2.5 hours per unit = 1,400 units Product Y - 3,500 hours / 1.5 hours per unit = 2,333 units The contribution generated by the units to be exported can be worked out as below : Product X Selling Price (Net of packing charge) Variable Cost Contribution 85 61 24 Product Y 75 59 16

Total contribution generated by executing the export order can be worked out as below: Product X - 1400 Units x Rs. 24 per unit = Rs. 33,600 Product Y - 2333 Units x Rs. 16 per unit = Rs. 37,328

388

Management Accounting

As the contribution generated by exporting Product Y is higher, it will be profitable to export Product Y. Hence, the total profitability works out as below: Existing Profits Contribution generated by exports Total Profits Rs. 90,000 Rs. 37,328 Rs. 1,27,328

(10) A Ltd. manufactures three different products and the following information has been collected from the books of account. S Sales Mix Selling Price Variable Cost Total Fixed costs Total Sales 35% Rs. 30 Rs. 15 Rs. 1,80,000 Rs. 6,00,000 Product T 35% Rs. 40 Rs. 20 Y 30% Rs. 20 Rs. 12

The company has currently under discussion a proposal to discontinue the manufacture of product Y and replace it with product M, when the following results are anticipated: S Sales Mix Selling Price Variable Cost Total Fixed Cost Total Sales 50% Rs. 30 Rs. 15 Rs. 1,80,000 Rs. 6,40,000 Product T 25% Rs. 40 Rs. 20 M 25% Rs. 30 Rs. 15

Will you advice the company to changeover to production of M? Give reasons for your answer. Solution : PRESENT PROFITABILITY STRUCTURE : S Rs. (1) (2) (3) (4) (5) (6) Sales Selling Price per Unit Variable Cost per Unit Contribution per Unit Units Sold (1/2) Total Contribution (4X5) = Rs. 2,82,000 2,10,000 30 15 15 7,000 1,05,000 Product T Rs. 2,10,000 40 20 20 5,250 1,05,000 Y Rs. 1,80,000 20 12 8 9,000 72,000

Marginal Costing

389

PROPOSED PROFITABILITY STRUCTURE : S Rs. (1) (2) (3) (4) (5) (6) Sales Selling Price per Unit Variable cost per Unit Contribution per Unit Units Sold (1/2) Total contribution (4X5) = Rs. 3,20,000 3,20,000 30 15 15 10,667 1,60,005 Product T Rs. 1,60,000 40 20 20 4,000 80,000 M Rs. 1,60,000 30 15 15 5,333 79,995

As the total contribution in the proposed alternative i.e. to change over to production of M is likely to be more than in the present situation, the company should change over to production of M. (11) The budgeted results of A Co. Ltd. include Product A B C Sales Value (Rs.) 50,000 80,000 1,20,000 P/V Ratio (%) 50 40 30

Fixed overheads for the period were Rs. 1,00,000. The Directors are worried about the results of the company. They have requested you to prepare a statement showing the amount of loss expected and recommend a change in the sales of each product or in total mix which will eliminate the expected loss. Solution : We know that (1) (2) Sales x P/V Ratio = Contribution Contribution - Fixed Cost = Profit Product A B C Sales Value (Rs.) 50,000 80,000 1,20,000 2,50,000 Less Fixed Cost Profit P/V Ratio 50% 40% 30% Contribution 25,000 32,000 36,000 93,000 1,00,000 (-) 7,000

390

Management Accounting

Hence, the expected loss is Rs. 7,000. To eliminate the expected loss, the sales of individual products may be increased, depending upon the P/V Ratio. The additional sales required to be achieved will be calculated as Loss to be eliminated P/V Ratio Hence, additional sales will be as below : Product A - 7,000/50% = Rs. 14,000. Product B - 7.000/40% = Rs. 17,500. Product C - 7,000/30% = Rs. 23,333. As an alternative, the overall sales may also be increased to eliminate the expected loss as stated below: At present, overall P/V Ratio is Contribution Sales X 100 = 93,000 2,50,000 X 100 = 37.2%

To cover the expected loss, the additional sales which will be required to be made will be Expected Loss Overall P/V Ratio = 7,000 37.2 % = Rs. 18,817

These additional sales may be increased in the existing proportion only i.e. 50,000 : 80,000 : 1,20,000. Hence, the productwise additional sales and the contribution generated by these additional sales will be as below : Product A B C Additional Sales Rs. 3,763 6,021 9,033 18,817 (12) A Ltd. been producing a standard mix as below : Product X 15,000 units. Product Y and Z 10,000 units. P/V Ratio 50% 40% 30% Contribution Rs. 1,882 2,408 2,710 7,000

Marginal Costing

391

The total variable costs amount to Rs. 2,09,000 and the variable cost ratio among the products is 1 : 1.5 : 1.75 respectively per unit The fixed, charges amount to Rs. 2 per unit. Selling prices are Rs. 6.40 for X, Rs. 7.60 for Y and Rs. 10.70 for Z. It is desired to change the mix as below : Product X Y Z Which mix should be recommended? Solution : The variable cost ratio among products X, Y and Z is I : 1.5: 1.75 respectively per unit. If all the products are expressed in terms of Product X, it can be as below : Product X Product Y Product Z 15,000 units 15,000 units (10,000 x 1.5) Mix 1 18,000 12,000 7,000 Mix 2 15,000 6,000 13,000 Mix 3 22,000 8,000 8,000

- 17,500 units (10,000 x 1.75) 47,500 Units

Total Variable cost is Rs. 2,09,000. Hence, per unit variable cost will be as below: Product X Product X Product Z Rs. 2,09,000 47,500 Rs. 4.40 X 1.5 = = Rs. 6.60 Rs. 7.70 Product Y Rs. 7.60 6.60 1.00 Product Z Rs. 10.70 7.70 3.00 = Rs. 4.40

Rs. 4.40 X 1.75

Product X Rs. Selling Price Less : Variable Cost Contribution 6.40 4.40 2.00

392

Management Accounting

The total contribution generated by various alternative mixes will be as below : MIX 1 X Y Z 18,000 x 2 12,000 x 1 7,000 x 3 Rs. 36,000 12,000 21,000 69,000 Mix 2 X Y Z 15,000 x 2 6,000 x 1 13,000 x 3 30,000 6,000 39,000 75,000 Mix 3 X Y Z 22,000 x 2 8,000 x 1 8,000 x 3 44,000 8,000 24,000 76,000 As Mix 3 generates maximum contribution, it will be recommended. Fixed cost will be ignored, as it will be same under all the circumstances. (13) A firm can produce three different products from the same raw material using the same production facilities. The requisite labour is available in plenty at Rs.8 per hour for all the products. The supply of raw material which is imported at Rs.8 per Kg. is limited to 10,400 Kgs. for the budget period. The variable overheads are RS.5.60 per hour. The fixed overheads are Rs. 50,000. The selling commission is 10% on sales. a. From the following information, you are required to suggest the most suitable sales mix which will maximise the firms's profits. Also determine the profit that will be earned at that level : Market Demand Units 8,000 6,000 5,000 Selling Price Per unit (Rs.) 30 40 50 Labour Hours Per Unit (Rs.) 1 2 1.5 Raw Material Per Unit (Kgs.) 0.7 0.4 1.5

Product x y z b.

Assume, in the above situation, if additional 4,500 Kgs of raw material is made available for production, should the firm go in for further production, if it will result in 393

Marginal Costing

the additional fixed overheads of Rs.20,000 and 25% increase in the rates per hour for labour and variable overheads ? Solution : The profitability statement is as below : X Selling Price per unit (Net of commission) Variable Cost per unit Raw Material Direct Labour Variable Overheads Total Variable Cost Contribution per unit Contribution per Kg. of Raw Material 27.00 Y 36.00 Z 45.00

5.60 8.00 5.60 19.20 7.80 11.14

3.20 16.00 11.20 30.40 5.60 14.00

12.00 12.00 8.40 32.40 12.60 8.40

As availability of raw material is the key factor, the order of preference among the products will be Y, X and Z. 6,000 units of Y consume 2,400 Kgs. of material. Balance left for X and Z are 8,000 Kgs. 8,000 units of X consume 5,600 Kgs. of material. Balance left for Z are 2,400 Kgs. With 2,400 Kgs. of material, maximum possible production for Z will be 1,600 units i.e. 2,400 / 1.5 Hence, the most suitable sales mix and said sales mix will be Product No. of Units Contribution Per Unit Rs. 5.60 7.80 12.60 Total Contribution Rs. 33,600 62,400 20,160 1,16,160 50,000 66,160

Y X Z Less : Fixed Cost Profit

6,000 8,000 1,600

394

Management Accounting

If additional 4,500 Kgs. of raw material is made available, the additional 3,000 units of Z can be sold. However, the profitability per unit of Z will be different as below : Selling Price Variable Cost Direct Material Direct Labour Variable Overheads Total Variable Cost Contribution 12.00 15.00 10.50 37.50 7.50 45.00

Total Contribution generated by these 3,000 units will be Rs. 22,500 i.e. 3,000 units x Rs. 7.50 per unit. As the fixed overheads are also likely to increase by Rs. 20,000, the additional 3,000 units will generate positive contribution of Rs. 2,500. Hence, it is advisible to go for further production with the additional raw material available. (14) The following particulars are obtained from the records of a factory manufacturing Products A and B. Product A (Per unit) Selling Price Material Cost at Rs. 10 per Kg. Wages @ Rs. 3 per hour Variable overheads Total fixed costs : Rs. 5,000 State which of the product is better to be produced and why in the following cases: (a) (b) (c) (d) (e) If total sales in units is key factor If total sales in value is key factor If law material is in short supply If labour hours is the Limiting factor If raw material available is 2,000 kgs. and maximum sales of each product is 500 units, advice about the sales mix. 100 20 30 10 Product B (Per Unit) 200 50 60 20

Marginal Costing

395

Solution : Product A Per Unit Rs. (1) (2) Selling Price Variable cost : Material Wages Variable Overheads 20 30 10 60 (3) (4) (5) Contribution (1 - 2) P/V ratio (3/1) Material consumption (6) Contribution per kg. of material (3/5) Labour Hours (a) Contribution per labour hour (3/6) If total sales in units is the key factor, Product B will be better as its per unit contribution is more. If total sales in value is the key factor, Product A will be better as its P/V Ratio is more. If raw material is in short supply, Product A will be better as its contribution per Kg. of material is more. If labour hours is the limiting factor, Product A will be better as its contribution per labour hour is more. If total available raw material is 2,000 Kgs., it will first utilised to manufacture Product A as its contribution per Kg. of material is more. However the maximum sales potential of Product A is restricted to 500 units which consumes 1,000 Kgs. of material (i.e. 500 units x 2 Kgs. per unit). Remaining material of 1,000 Kgs. can be used for the manufacture of Product B, with the help of which only 200 units of Product B can be manufactured i.e., 1,000 Kgs 5 Kgs. per Unit = 200 Units 10 4 20 3.5 40 40% 2 Kgs. 20 50 60 20 130 70 35% 5 Kgs. 14 100 Product B Per Unit Rs. 200

(b)

(c)

(d)

(e)

396

Management Accounting

Hence, the desirable product mix will be 500 units of Product A 200 units of Product B (15) Small-Tools Factory has a plant capacity adequate to provide 19,800 hours of machine use. The plant can produce all A type tools or all B type tools or a mixture of the two types. The following information is relevant. Per Type Selling Price Rs. Variable Cost Rs. Hours required to produce A 10 8 3 B 15 12 4

Market conditions are such that no more than 4,000 A type tools and 3,000 B type tools can be sold in a year. Annual fixed costs are Rs. 9,900. Compute the product mix that will maximize the net income to the company and find that maximum net income. Solution : It is a situation of multiplicity of key factors, first key factor being availability of machine hours and second one being market conditions. The contribution per machine hour can be computed as below : A Selling Price Per unit Rs. Variable cost per mat Rs. Contribution per unit Rs. 10 8 2 3 0.66 II B 15 12 3 4 0.75 I

Machine hours required per unit Contribution per machine your Rs.

Ranking when machine hours availability is key factor

As such, tool B will be produced to the maximum possible extent i.e. 3,000 units and the balance machine hours should be utilised for the production of tool A.

Marginal Costing

397

The net income can be worked out as below: Tool Units Machine hours required 12,000 7,800 19,800 Less : Annual fixed costs Net Profit Contribution per unit Rs. 3 2 Total contribution Rs. 9,000 5,200 14,200 9,900 4,300

B A

3,000 2,600

(16) An umbrella manufacturer makes an average net profit of Rs. 2.50 per piece on a selling price of Rs. 14.30 by producing and selling 6,000 pieces or 60% of the potential capacity. His cost of sales is as follows: Direct material Direct wages Works overheads Sales overheads Per Unit Rs. 3.50 Rs. 1.25 Rs. 6.25 (50% fixed) Rs. 0. 80 (25% varying)

During the current year, he intends to produce the same number but anticipates that his fixed expenses will go up by 10% while rate of direct labour and direct material will increase by 8% and 6% respectively. But he has no option of increasing the selling price. Under this situation he obtains an offer for a further 20% of capacity. What minimum price will you recommend for acceptance to ensure the manufacturer an overall profit of Rs. 16,730? Solution : Profitability structure Previous year Per Unit Rs. (1) (2) Selling Price Variable Cost Direct Material Direct Wages Works Overhead Sales Overheads 3.50 1.25 3.125 0.20 8.075 21,000 7,500 18,750 1,200 48,450 3.71 1.35 3.125 0.20 8.385 22,260 8,100 18,750 1,200 50,310 14.30 Total Rs. 85,800 Per Unit Rs. 14.30 Current Year Total Rs. 85,800

398

Management Accounting

Previous year Per Unit Total Rs. Rs. (3) (4) Contribution (1 2) Fixed Cost Works Overheads Sales Overheads 3.125 0.60 3.725 (5) Profit (3 4) 2.50 18,750 3,600 22,350 15,000 6.225 37,350

Current Year Per Unit Total Rs. Rs. 5.915 35,490

20,625 3,960 24,585 10,905

From the above, it can be seen that the present sales of 6,000 units will generate a total profit (after recovering the fixed cost) of Rs. 10,905. If it is intended that the overall profit should be Rs. 16,730, there will be a shortfall of Rs. 5,825 which will have to be covered by the additional 2.000 units to be sold. As such, every additional unit to be sold will have to generate a clear margin of Rs. 2.9125 i.e., Rs. 5,825/2,000 units. Hence the minimum price to be recommended will be Revised per unit variable cost + Expected per unit margin i.e., Rs. 8.385 + Rs. 2.9125 i.e., Rs. 11.2975 (17) The cost profile of a company, manufacturing only one product, is as under : Rs. Direct Material Direct Labour Variable factory overheads 5.60 1.50 0.40 7.50 Fixed factory overhead is budgeted at Rs. 3,30,000 for an annual sales of 4,00,000 units.Selling, Distribution and Administration costs are budgeted at Rs. 1,80,000. Capital employed is Rs. 4,50,000 in fixed assets and 50% of sales in current assets. Determine a selling price for the product to yield 20% return on capital employed. Solution : Let us assume that the selling price per unit is Rs. X. Hence, total sales will be Rs. 4,00,000 X.

Marginal Costing

399

The total amounts to be covered by this amount of sales will be Rs. Variable Cost - 4,00,000 x 750 Fixed Factory overheads Selling Distribution and Administration cost Profit 30,00,000 3,30,000 1,80,000 90,000 + 40,000 x 36,00,000 + 40,000 x Note : Profit is calculated as below : Expected yield - 20% of capital employed where Capital employed = = = Hence, Profit = = Thus, 4,00,000 x = 36,00,000 + 40,000 x = 3,60,000 x = 36,00,000 x = Rs. 10 Hence the selling price for the product should be Rs. 10 per unit. (18) V Ltd. produces two products P and Q. The draft budget for the next month is as under. P Budgeted Production and sales (Units) Selling Price Rs / Unit Total Costs Rs / Unit Machine Hours / Unit Maximum Sales Potential (Units) 40,000 25 20 2 60,000 Q 80,000 50 40 1 100,000 4,50,000 + 50% of sales 4,50,000 + 50% of 4,00,000 x 4,50,000 + 2,00,000 x 20% (4,50,000 + 2,00,000 x) 90,000 + 40,000 x

The fixed expenses are estimated at Rs. 9,60,000 per month. The company absorbs fixed overheads on the basis of machine hours which are fully utilised by the budgeted production and cannot be further increased.

400

Management Accounting

When the budget was discussed, the Managing Director stated that the product mix should be altered to yield optimum profit. The Marketing Director suggested that he could introduce Product C, each unit of which will take 1.5 machine hours. However, a processing vat involving a capital outlay of Rs. 2,00,000 is to be installed for the processing of product C. The additional fixed overheads relating to the processing vat was estimated to be Rs. 60,000 per month. The variable cost of Product C was estimated of Rs. 21 per unit. Required (i) (ii) Calculate the profit as per draft budget for the next month. Revise the product mix based on data given for P and Q to yield optimum profit.

(iii) The company decides to discontinue either product P or Q whichever is giving lower profit and proposes to substitute product C instead. Fix the selling price of Product C in such a way so as to yield 15% return on additional capital employed besides maintaining the same overall profits as envisaged in (ii) above. Solution : At present, the utilisation of the machine hours is as below. Product P - 40,000 units x 2 Product Q - 80,000 units x 1 = = 80,000 Hrs. 80,000 Hrs. 1,60,000 Hrs. Fixed Expenses are Rs. 9,60,000 per month and are absorbed on the basis of utilisation of machine hours. Hence, Machine Hour Rate = Rs. 9,60,000 1,60,000 Hrs. = Rs. 6/Hr.

As such, the fixed overheads absorbed by the product (which must have been included in the total cost.) are as below : Product P - 2 Hrs. x Rs. 6 = Rs. 12 Product Q - 1 Hr. x Rs. 6 = Rs. 6

Marginal Costing

401

Hence, the cost structure of the products can be amended as below : Product P Rs. Selling Price / Unit Less : Variable cost Fixed Cost Total Cost Profit (1) 8 12 20 5 Rs. 25 34 6 40 10 Product Q Rs. Rs. 50

Profit as per draft budget for the next month are (a) Sales - P - 40,000 Unit x Rs. 25/ Unit Q - 80,000 Units x Rs. 50/ Unit Rs. 10,00,000 Rs. 40,00,000 Rs. 50,00.000 (b) Variable Cost - P - 40,000 Units x Rs. 8/ Unit Q - 80,000 Units x Rs. 34/ Unit Rs. 3,20,000 Rs. 27,20,000 Rs. 30,40.000 (c) (d) (e) Contribution a b Fixed Expenses Profit c d Rs. 19,60,000 Rs. 9,60,000 Rs. 10,00,000

(2)

Revised Product Mix to yield Optimum Profit. The machine hours are available in limited quantity and hence are the key factor of production. The revised cost structure of the products is as under. Prod. P Selling Price - Rs./ Unit Variable Cost - Rs./ Unit Contribution Rs./ Unit Machine Hours/ Unit Contribution Rs./ Machine Hour 25 8 17 2 8.5 Prod Q. 50 34 16 1 16

As the contribution per unit of key factor i.e. Machine Hour is more in case of Product Q, the available machine hours will be utilised for the manufacture of Product Q subject to its maximum sales potential.

402

Management Accounting

Thus, the revised product mix will be: Product Product Q Product P Machine Hours 1,00,000 Units x 1 Hr. = 1,00,000 1,60,000 Hrs. 1,00,000 Hrs. = 60,000 Machine Hours/Unit 1 2 Units 1,00,000 30,000

The revised profitability will be (a) Sales - Q 1,00,000 Units x Rs. 50/ Unit - P 30,000 Units x Rs. 25/ Unit Rs. 50,00,000 Rs. 7,50,000 Rs. 57,50,000 (b) Variable Cost - Q 1,00,000 Units X Rs. 34/ Unit P 30,000 Units x Rs. 8/ Unit Rs. 34,00,000 Rs. 2,40,000 Rs. 36,40,000 (c) (d) (e) (3) Contribution a-b Fixed Expenses Profit c-d Calculation of Selling Price of Product C : Rs. 21,10,000 Rs. 9,60,000 Rs. 11,50,000

The various amounts to be covered by the sales of product C are as below: Variable cost - 40,000 Units x Rs. 21/ Unit Fixed Expenses to be absorbed 40,000 Units x Rs. 6/ Machine Hour x 1.5 Hrs/ Unit Additional fixed overheads Yield on capital employed 15% on Rs. 2,00,000 Deficit of Profit Rs. 30,000 Rs. 1,50,000 Rs. 14,40,000 Hence, the per unit selling price will beRs. 14,40,000 40,000 units = Rs. 36/ Unit Rs. 3,60,000 Rs. 60,000 Rs. 8,40,000

Marginal Costing

403

Notes : (1) As availability of machine hours is the key factor and the contribution per machine hour is less in case of Product P, it will be discontinued. Production of Product Q will be continued subject to its maximum sales potential. As such, 1,00,000 units of product Q will be produced and sold, thus leaving 60,000 machine hours for the production and sales of product C. As one unit of product C consumes 1.5 Machine Hours, maximum 40,000 units of product C can be produced and sold i.e., 60,000 Machine Hours 1.5 Machine Hrs./Unit (2) It is assumed that Product Q will continue to absorb the fixed expenses at the current rate of absorption. Hence, the profit generated by product Q will be as below: (a) (b) (c) (d) Sales - 1,00,000 Units x Rs.50/ Unit Rs. 50,00,000 Variable Cost - 1,00,000 Units x Rs. 34/ Unit Rs. 34,00,000 Contribution - a-b Rs. 16,00,000 Fixed Expenses absorbed 1,00,000 units x Rs. 6/ Machine Hr. Rs. 6,00,000 (e) Profit c-d Rs. 10,00,000 As the profit is desired to be maintained at Rs. 11,50,000 the deficit should be covered by the sales of product C (3) As the fixed overhead relating to the processing vat will be incurred specifically due to Product C, it will be as if the variable cost of Product C.

404

Management Accounting

QUESTIONS 1. What do you understand by the terms Break Even Point, Contribution and Margin of Safety? Explain your answer by drawing a chart with assumed figures. How does Break Even Analysis help in business decisions? Describe the importance of the following terms in relation to marginal costing. (a) (b) (c) 4. Break Even Point Profit Volume Ratio Margin of Safety

2. 3.

Explain what is meant by Break Even Analysis? Discuss (a) (b) The assumptions that are involved in this technique The various uses of this technique.

5.

Explain any four circumstances in which the technique of marginal costing will help the management in taking decisions. What are the limitations of this technique? The rate of earning profit mainly depends upon the magnitude of the angle of incidence projected on break even chart.- Explain as to whether this statement is correct. What measures can be adopted to increase the magnitude of angle of incidence. Write a critical note about uses, applications, advantages and limitations of Marginal Costing technique. The work of separating the overheads into fixed and variable costs is purely academic, but practically very difficult and as such the technique of Marginal Costing is of very little use in managerial decisions. How will yon make out a case for introducing the technique of Marginal Costing when encountered with the above argument? Discuss the most important areas of managerial decisions opened up by the application of marginal costing technique.

6.

7.

8.

9.

10. Write Short Notes on (a) (b) (c) (d) (e) (f) Profit Volume RatioContribution Break Even Point Margin of Safety Marginal Costing Importance of Break Even analysis -

Marginal Costing

405

PROBLEMS (1) Following information is made available to you about a company for two periods. Period. (I) (II) Find out (a) (b) (c) (d) (e) (2) Profit Volume Ratio Break Even Point for sales Profit when sales are Rs. 1,00,000 Sales required to earn a profit of Rs. 20,000 Safety Margin in period II Sales (Rs) 1,20,000 1,40,000 Profit (Rs) 9,000 13,000

The sales turnover and profits during two periods are as under. Period I - Sales Rs. 20 Lakhs, Profit Rs. 2 Lakhs Period II - Sales Rs. 30 Lakhs, Profit Rs. 4 Lakhs Calculate: (1) (2) P/V Ratio The sales required to earn the profit of Rs. 5 Lakhs

(3)

Following figures relate to a company manufacturing a varied range of products : Total Sales Year ended 31st Dec., 1987 Year ended 31st Dec., 1988 22,23,000 24,51,000 Total Cost 19,83,600 21,43,200

Assuming stability in price with variable costs carefully controlled to reflect predetermined relationship and an unvarying figure for fixed costs, calculate : (a) (b) (c) (d) (e) The profit volume ratio to reflect the rates of growth for profits and sales. Fixed Costs. Fixed Cost as % to Sales. Break even point Margin of safety for the year 1987 and year 1988.

406

Management Accounting

(4)

Gee Ltd. has two factories producing an identical product and realising the same selling price net i.e. Rs.60 per unit. The costs in the two factories can be summarised as follows. Factory A Capacity (Units) (Rs.) Variable Cost per unit (Rs.) Fixed Costs per annum (Rs.) 1,00,000 20 20,00,000 Factory B 1,50,000 15 45,00,00

The demand for the product is 2,00,000 units. State how much should be produced at each factory. (5) Calculate the Break Even Point in units and in rupees and also arrive at Margin of Safety ratio from the following information. Estimated sales (1,00,000 Units) Variable Cost Fixed Cost Rs. 12,00,000 Rs. 4,00,000 Rs.16,00,000 Net Profit (6) From the following data relating to a company, calculate : (1) (2) Break Even Sales Sales required to earn a profit of Rs.6,000 per period Period Total Sales Rs. 1 2 (7) (a) 42,500 39,200 Total Costs Rs. 38,700 36,852 Rs. 4,00,000 Rs. 20,00,000

A company budgets a production of 5,00,000 units at a variable cost of Rs. 20 each. The fixed costs are Rs. 20,00,000. The selling price is fixed to yield 25% profit on cost. Calculate (i) Break Even Point (ii) P/V Ratio

(b)

If the selling price is reduced by 20% find (i) (ii) The effect of the price reduction on the break even point and the P/V Ratio The number of units required to be sold at the reduced selling price to obtain an increase of 20% on the budgeted profit.

Marginal Costing

407

(8)

(1)

The following figures for profit and sales are obtained from the account of XYZ Co. Ltd. Year 1985 1986 Calculate (a) (b) (c) (d) P/V Ratio Fixed Cost Break Even Sales Sales to earn a profit of Rs. 5.000 Sales (Rs.) 20,000 30,000 Profit (Rs.) 2,000 4,000

(2)

Calculate all the above figures, if the company has a fixed overhead of Rs. 1,000 in addition to the expenses considered above.

(9)

The following data are obtained from the records of a company. First Year Rs. Sales Profit Calculate : (a) (b) (c) (d) (e) P/V Ratio Break Even Point Profit or loss when sales amount to Rs. 50,000 Sales required to earn a profit of Rs. 19,000 Sales position if company sustained a loss of Rs. 19,000 80,000 10,000 Second Year Rs. 90,000 14,000

(10) The following figures relating to the performance of a company for Year I and Year II are available. Assuming that the ratio of variable costs to sales and the fixed costs are the same for both the years, ascertain a. b. c. d. Profit Volume Ratio Amount of the fixed costs Break Even Point Budgeted profit for Year III if the budgeted sales are Rs. 1 Crore. Year I Year II Total Sales Rs. 70 Lakhs Rs. 90 Lakhs Total Costs Rs. 58 Lakhs Rs. 66 Lakhs

408

Management Accounting

(11) S Ltd. furnishes you the following information relating to the half year ending 30th June 1980. Rs. Fixed Expenses Sales Value Profit 50,000 2,00,000 50,000

During the second half of the year, the company has projected a loss of Rs. 10,000. Calculate (1) The P/V Ratio, Break Even Point and Margin of safety for six months-ending 30th June 1980. Expected sales volume for the second half of the year assuming that selling price and fixed expenses remain unchanged in the second half year also. The break even point and margin of safety for the whole year 1980.

(2)

(3)

(12) PQ Limited has been offered a choice to buy a machine between A and B. You are required to compute : (a) (b) (c) Break Even Point for each of the machines. The level of sales at which both machines earn equal profits. The range of sales at which one is more profitable than the others.

The relevant data is given below : Machines A Annual output in units Fixed Cost (Rs.) Profit at above level of production (Rs.) 10,000 30,000 30,000 B 10,000 16,000 24,000

The market price of the product, is expected to be Rs.10 pet Unit (13) The following is the basic cost of a firm ABC. (1) (i) (ii) (iii) Fixed Operating Cost Rs. 2,500 Sales Price (Per Unit) Rs. 10 Variable Cost (Per Unit) Rs. 5 Determine BEP in units and rupees

Marginal Costing

409

(2) (3)

If fixed operating cost increases to Rs. 3,000, what will be the new BEP ( in Units)? If sale price increases to Rs. 12.50 and the variable operating cost to Rs.7.50, what would be the impact on BEP?

(14) A Ltd. manufactures & sells four types of products under the brand names -P, Q, R and S. Sales mix in value comprises. 33.33%, 41.66%,16.66% and 8.33% of P, Q, R and S respectively. The total budgeted sales (100%) are Rs. 60,000 per month. Operating Costs are Variable Costs Product P Product Q Product R Product S 60% of selling price 68% of selling price 80% of selling price 40% of selling price

Fixed Costs : Rs. 14,700 per month Calculate the BEP for the products on an overall basis i.e. in total (15) Following information is presented by the costing department to the management accountant of the company. 1. 2. 3. Contribution Rs. 10,000 Fixed Cost Rs. 5,000 P/V Ratio 1/3

The Management Accountant is asked to find out the margin of safety if P/V Ratio is brought down to 1/2. (16) A company produces and sells 100 units of A at Rs. 20. Marginal cost per unit is Rs. 12 and the fixed costs are Rs. 300 per month. It is proposed to reduce the price by 20%. Find out the additional sales required to earn the same amount of profits as before. (17) A ball pen manufacturer has developed a new ball pen with unique features. His development executive has suggested three possible retail price viz. Rs.15 for super star, Rs.10 for deluxe and Rs. 7.50 for economy model. His marketing manager opines that the whole sellers and retailers have to be given at least 30% discount. The estimated fixed cost would be around Rs.70,000 and the variable cost per unit would be Rs. 3.50 (a) (b) Calculate breakeven point for each model of ball pen. How much should the manufacturer sell in order to make a profit of Rs. 21,000? Work out for each model of ball pen.

410

Management Accounting

(18) ABC Pvt. Ltd. manufactures and sells a standard product at fixed selling price. The budgeted figures for 1986-87 are as under. Production and sales Variable cost Fixed Cost Profit Margin 2,00,000 Units. Rs. 56 Per Unit Rs. 48,00,000 33.33% of selling price.

You are required to determine sales at break even both in terms of quantity and value for the budget year 1986-87 at the above selling price. (19) The Laila Shoe Company sells five different styles of ladies chappals with identical purchase cost and selling price. The company is trying to find out the profitability of opening another store which will have the following expenses and revenues. Per Pair (Rs) Selling Price Variable cost Salesmens commission Total Variable Cost Annual Fixed expenses are : Rent Salaries Advertising Other fixed expenses Rs. 60,000 Rs. 2,00,000 Rs. 80,000 Rs. 20,000 Rs. 3,60,000 Required : a. Calculate the annual break even point in units and in value. Also determine the profit or loss if 35,000 pairs of chappals are sold. The sales commissions are proposed to be discontinued, but instead a fixed amount of Rs. 90,000 is to be incurred in fixed salaries. A reduction in selling price of 5% is also proposed. What will be the break even point in units ? It is proposed to pay the stores manager 50 paise per pair as further commission. The selling price is also proposed to be increased by 5%. What would be the break even point in units? 30.00 19.50 1.50 21.00

b.

c.

Marginal Costing

411

d.

Refer to the original data. If the stores manager were to be paid 30 paise commission on each pair of chappal sold in excess of the break even point, what would be the stores net profit if 50,000 pairs were sold ?

(20) Speedy Airline can carry a maximum of 10,000 passengers per month on one of its routes at a fare of Rs. 85. Variable costs are Rs. 10 per passenger and fixed costs are Rs. 3,00,000 p.m. calculate (1) (2) (3) (4) Break Even quantity Break Even sales Break Even Percentage of capacity. Suppose that the management sets a profit target of Rs. 2,00,000

What would be the required profit before taxes to achieve this profit target, if the corporate tax rate of the company is 46%. (21) Three firms X, Y and Z manufacture the same product. The selling price is Rs.8 per unit of the product equal for all the firms. The fixed costs for the firms X, Y and Z respectively are Rs. 80,000 Rs. 2,00,000 and Rs. 3,30,000 while the variable costs per unit are Rs. 6, Rs. 4 and Rs. 3 (a) (b) (c) Determine the break even point for all the firms in units. How much profits are earned by the firms if each of them sells 80,000 units? What will be the impact percentagewise .on profits if sales increase by 20%.

(22) Merry Manufacturers Ltd. has supplied you the following information in respect of one of its products. Rs. Total Fixed costs Total Variable Costs Total Sales Units Sold 18,000 30,000 60,000 20,000

Find out (a) Contribution per unit (b) Break Even Point (c) Margin of Safety (d) Profit (e) Volume of sales to earn a profit of Rs. 24,000.

412

Management Accounting

(23) From the following information relating to Quick Standards Ltd., you are required to find out - (a) Contribution (b) BEP in units (c) Margin of Safety (d) Profits. Rs. Total fixed costs Total variable costs Total sales Units sold 4,500 7,500 15,000 5,000 (Units)

Also calculate the volume of sales to earn a profit of Rs. 6,000 (24) Bindra Ltd. is running its plant at present at 50% of capacity. The management has supplied you the following details. Cost of production per unit Rs. Direct Material Direct Labour Variable Overheads Fixed Overheads (fully absorbed) 4 2 6 4 16 Production per month Total cost of products Sales Price 40,000 Units 40,000 Units x Rs. 16 = Rs. 6,40,000 40,000 Units x Rs. 14 = Rs. 5,60,000 Loss Rs. 80,000

An exporter offers to purchase 10,000 units per month @ Rs. 13 per unit and the company is hesitating in accepting the offer due to the fear that it will increase its already large operating losses. Advice whether the company should accept or decline this offer. (25) Mega Corporation manufactures and sells three products to the automobile industry. All the products must pass through a machining process, the capacity of which is limited to 20,000 hours per annum, both by equipment design and government regulation.

Marginal Costing

413

Following additional information is available. Product X Selling Price Rs./Unit Variable cost Rs./Unit Machining requirements hrs/Unit Maximum possible sales units 1,900 700 3 10,000 Product Y 2,400 1,200 2 2,000 Product Z 4,000 2,800 1 1,000

Required - A statement showing the best possible production mix which would provide the maximum profits for Mega Corporation, together with supporting workings. (26) (a) A companys turnover in a year was Rs. 50,00,000, its profit was Rs. 500,000 and its P/V Ratio was 40% What is the break even point? A factory furnishes the following figures. August 84 Output (Units) Total Cost (Rs.) 50,000 6,70,000 September 84 55,000 7,10,000

(b)

What is the amount of fixed expenses per month? (27) (a) Calculate the Break Even Point from the following data. (i) (ii) (iii) (b) Sales Price per unit Rs. 10 Variable cost per unit Rs. 6 Fixed overheads Rs.20,000

Calculate the revised Break Even Point if (i) (ii) (iii) (iv) (v) (vi) Sales price is increased to R.11 per unit Sales price is reduced to Rs.9 per unit Variable cost increased to Rs.7 per unit Variable cost reduced to Rs.5 per unit Fixed overheads rise to Rs.25,000 Fixed overheads fall to Rs.15,000

(28) The Modern Machine Co. Ltd. places before yon the following figures Sales (Rs.) 1974 1975 2,00,000 1,80,000 Profit (Rs.) 10,000 2,000

414

Management Accounting

You are required to (a) (b) (c) Calculate profit or loss when sales amount to Rs. 1,50,000 and Rs-3,00,000. Calculate Profit Volume Ratio. Determine sales at Break Even Point.

(29) The selling price of a product is Rs.40 which yields a margin of 20%. The total fixed expenditure are Rs. 10,000 a month. What should be the level of sales to yield an annual profit of Rs.20,000? (30) The following is the annual profit plan of XYZ Company. (1) (2) Budgeted sales (2,00,000) units @ Rs. 25) Budgeted Costs Direct Material Direct Labour Factory Overheads Administrative Expenses Distribution Expenses Fixed Variable 9,00,000 10,00,000 3,00,000 1,00,000 3,00,000 26,00,000 44,00,000 6,00,000

50,00,000

7,00,000 6,00,000 5,00,000 18,00,000

Budgeted Profit Production capacity - 2,40,000 Units. (A) (a) (b) (c) Determine the break even point in rupees.

Would you accept an export order for 60,000 units @ Rs. 20 per unit and why? Briefly enumrate the basic assumptions underlying break even analysis.

(B) Compute BEP in the following independent situations if (i) (ii) (iii) a 10% increase is effected in fixed costs a 10% increase is effected in variable costs a 10% increase in fixed costs and 5% decrease in-variable costs is effected.

(31) You are the company Accountant of Machine Manufacturing Ltd. which was incorporated in February 1979. The company has started production from 1st January 1980. It was proposed that the company will produce and sell 8,000 units in the first year of its operations. Estimated costs of production are given below.

Marginal Costing

415

Raw Materials Direct Labour Other variable costs Fixed costs (1) (2)

Rs. 20 per unit Rs. 10 per unit 200% of direct labour Rs.1,50,000

The company fixed a target to earn a profit of Rs. 1,50,000 in the first year. Further, the company expects that annual fixed costs will increase by Rs. 1,00,000 in the second year of operations. The marketing manager has planned to spend a sum of Rs. 80,000 on promotion and advertising in the second year, keeping in view the target of the company to earn a profit of Rs. 2,50,000 in the second year of operations. It is expected that direct material, direct labour and other variable costs will not change in the second year. The company wishes to sell the product in the second year at a price of Rs.75 per unit.

(3)

Advice the company about the following : (a) (b) Selling price for the first year. Sales turnover ( in Units) for the second year.

(32) The Asian Industries specialise in the manufacture of small capacity of Motors. The cost structure of a motor is as under. Material Labour Rs. 50 Rs. 80

Variable Overheads 75% of labour cost. Fixed overheads of the company amount to Rs. 2.40 lakhs per annum. The sale price of the motor is Rs. 230 each. (a) (b) (c) Determine the number of motors that have to be manufactured and sold in a year to break even. How many motors have to be made and sold to make a profit of Rs.1 lakh per year? If the sale price is reduced by Rs. 15, how many motors will have to be sold to break even?

(33) Repographics Ltd. manufactures a document reproducing machine which has the variable cost structure as follows : Material Labour Overheads Rs. 40 Rs. 10 Rs. 4

Selling price per unit is Rs. 90

416

Management Accounting

Sales during the current year are expected to be Rs. 13,50,000 and fixed overheads Rs. 1,40,000. Under a wage agreement, an increase of 10% is payable to all direct workers from the beginning of the forthcoming year, whilst material costs are expected to increase by 7.5%, variable overheads by 5% and fixed overhead costs by 3%. You are required to calculate : a. b. The new selling price if the current Profit Volume Ratio is to be maintained. The quantity to be sold during the forthcoming year to yield the same amount of profit as the current year, assuming the selling price to remain at Rs. 90.

(34) Cookwell Ltd.manufactures pressure cookers the selling price of which is Rs. 300 per unit. Currently the capacity utilisation is 60% with a sales turnover of Rs. 18 lakhs. The company proposes to reduce the selling price by 20% but desires to maintain the same profit position by increasing the output. Assuming that the increased output could be made and sold, determine the level at which the company should operate, to achieve the desired objective. The following further data are available. (a) (b) (c) Variable cost per unit Rs.60 Semi variable cost (including a variable element of R1. 10 per unit) Rs. 1,80,000 Fixed cost Rs. 3,00,000 will remain constant Upto 80% level. Beyond this, an additional of Rs. 60,000 will be incurred.

(35) The MYZ Co. has the following budget for the year 1986-87. Rs. Sales (1,00,000 Units a Rs.20) Variable Cost Contribution Fixed cost Net Profit From the above set of information find out, (a) The adjusted profits for 1986-87 if the following two sets of changes are introduced and also suggest which plan should be implemented. 20,00,000 10.00,000 10,00,000 4,00,000 6,00,000

Marginal Costing

417

Plan A Increase in Price Decrease in Volume Increase in variable cost Increase in fixed cost (b) 20% 25% 10% 5%

Plan B Decrease in Price Increase in Volume Decrease in Variable cost Decrease in fixed cost 20% 25% 10% 5%

The P/V Ratio and break even points under the two plans referred above.

(36) A review made by the top management of Sweat and Struggle Ltd. which makes only one product, of the result of the first quarter of the year revealed the following details : Sales in units Loss in Rs. 10,000 10,000

Fixed Cost (For the year Rs.1,20,000) in Rs. 30,000 Variable cost per unit in Rs. 8

The Finance Manager who feels perturbed suggests that the company should at least break even in the second quarter with a drive for increased sales. Towards this, the company should introduce a better packing which will increase the cost by Re. 0.50 per unit. The sales manager has an alternative proposal. For the second quarter, additional sales promotion expenses can be increased to the extent of Rs. 5,000 and a profit of Rs. 5,000 can be aimed with increased sales. The production manager feels otherwise. To improve the demand, the selling price per unit has to be reduced by 3%. As a result, the sales volume can be increased to attain a profit level of Rs. 4,000 for the quarter. The Managing Director asks you as a Cost Accountant to evaluate these three proposals and calculate the additional sales volume that would be required in each case, in order to help him take a decision. (37) Following is the summarised Trading account of a manufacturing concern which makes two products X and Y.

418

Management Accounting

Summarised Trading Account for the four months to 30th April 1984 X Rs. Sales Less : Cost of Sales (a) Direct costs Labour Material 3,000 1,500 4,500 5,500 Indirect costs (a) Variable Expenses 2,000 3,500 (b) Fixed Expenses Common to both X and Y Net Profit (a) (b) 1,250 2,250 1,250 (-)250 2,500 2,000 1,000 1,000 3,000 4,500 1,000 1,000 2,000 2,000 6,500 7,500 10,000 Y Rs. 4,000 Total Rs. 14,000

These costs tend to vary in direct proportion to physical output. These costs tend to remain constant irrespective of physical outputs of X and Y. It has been the practice of the concern to allocate these costs equally between X and Y.

The following proposals have been made by the Board of Directors for your consideration as financial advisor. (1) (2) (3) Discontinue Product Y. As an alternative to (1), reduce the price of Y by 20%. (It is estimated that the demand then will increase by 40%.) Double the price of X (It is estimated that the demand then will reduce by three fifths.) You are required to recommend the proposal to be taken after evaluating each of these three proposals.

Marginal Costing

419

(38) A Multi-Product company has the following costs and output data for the last year. Product X Sales Mix (in value) Selling Price per unit Variable cost per unit Total Fixed cost Total Sales 40% Rs. 20 Rs. 10 Rs. 1,50,000 Rs. 5,00,000 Product Y 35% Rs. 25 Rs. 15 Product Z 25% Rs. 30 Rs. 18

The company proposes to replace Product Z by Product S. Estimated cost and output data are Product X Sales Mix (in value) Selling Price per Unit Variable cost per Unit Total fixed cost Total Sales 50% Rs. 20 Rs.10 Rs. 1,50,000 Rs. 5,00,000 Product Y 30% Rs. 25 Rs. 15 Product S 20% Rs. 28 Rs. 14

Analyse the proposed change and suggest what decision the company should take. Also state the break even point for the company as a whole in the two situations. (39) A manufacturer has planned his level of production at 50% of his plant capacity of 30,000 units. At 50% of the capacity, his expenses are as follows. (a) (b) (c) (d) Direct Labour Rs.11,160 Direct Material Rs. 8,280 Variable and other manufacturing expenses Rs. 3,960 Total fixed expenses regardless production Rs. 6,000

The home selling price is Rs.2.00 per unit. Now, the manufacturer receives a trade enquiry from overseas for 6,000 units at a price of Rs. 1.45 per unit If you were the manufacturer, would yon accept or reject the offer? Support your statement with suitable cost and profit details. (40) A manufacturer sells his product at Rs.5 each variable costs are Rs.2 per unit and the fixed costs amount to Rs.60,000. (a) (b) (c) (d) Calculate the break even point What would be the profit if he sells 30,000 units? What would be the BEP if he spends Rs.3,000 on advertisement? How much should the manufacturer sell to make a profit of Rs.30,000 assuming he spends Rs.3,000 on advertisement?
Management Accounting

420

(41) Texemat Private Limited has been manufacturing track suits for athletes currently, its output is around 70% of its rated capacity of 19,000 units per annum. One exporter has approved the sample and has offered to buy 5000 units at a special price of Rs. 150 per suit. At present, the company has been selling the track suit @ Rs.210.The standard cost per unit is as under. . Cost Items (a) (b) (c) (d) (a) (b) Cloth and other materials Labour Fixed cost Administrative variable cost Total Cost Should the company accept the offer? What would be your advice if the exporter offers to buy 10,000 units instead of 5000 units? Rs. 82 25 42 11 160

(42) The variable cost structure of a product manufactured by a company during the current year is as under Rs. Material Labour 0verheads Per Unit 120 30 12

The selling price per unit is Rs. 270 and the fixed cost and sales during the current year are Rs. 14 Lakhs and Rs. 40.50 Lakhs respectively. During the forthcoming year, the direct workers will be entitled to a wage increase of 10% from the beginning of the year and the materials cost, variable overhead and fixed overhead are expected to increase by 7.5%, 5% and 3% respectively. The following are required to be computed a. b. New selling price in the forthcoming year if the current P/V ratio is to be maintained. Number of units that would be required to be sold during the forthcoming year so as to yield the same amount of profit in the current year, assuming that the selling price per unit will not be increased.

Marginal Costing

421

(43) A company currently operating at 80% capacity has the following particulars. Rs. Sales Direct Materials Direct Labour Variable Overheads Fixed Overheads 32,00,000 10,00,000 4,00,000 2,00,000 13,00,000

An export order has been received that would utilise half the capacity of the factory. The order cannot be split i.e. it has either to be taken in full and executed at 10% below the normal domestic prices or rejected totally. The alternatives available to the management are : a. b. c. Reject the order and continue with the domestic sales only (as at present) or Accept the order, split capacity between overseas and domestic sales and turn away excess domestic demand or Increase capacity so as to accept the export order and maintain the present domestic sales by i) ii) buying an equipment that will increase the capacity by 10%. This will result in an increase of Rs. 1,00,000 in fixed costs and work overtime to meet the balance of required capacity. In that case, labour will be paid at one and half times the normal wage rate.

Prepare a comparative statement of profitability and sugget the best alternative. (44) A company produces a single product which is sold by it presently in the domestic market at Rs. 75 per unit. The present production and sales is 40,000 units per month representing 50% of the capacity available. The cost data of the product was as under Variable cost per unit Rs. 50 Fixed costs per month Rs. 10 Lakhs To improve the profitability, the management has 3 proposals on hand as under a. to accept an export supply order for 30,000 units per month at a reduced price of Rs. 60 per month, incurring additional variable costs of Rs. 5 per unit towards the export packing, duties etc. to increase the domestic market sales by selling to a domestic chain stores 30,000 units at Rs. 55 per unit retaining the existing sales at existing price

b.

422

Management Accounting

c.

to reduce the selling price for the increased domestic sales as advised by the sales department as under Reduce selling price per unit by Rs. 5 8 11 Increase in sales expected (units) 10,000 30,000 35,000

Prepare a table to present the results of the above proposals and give your comments and advice on the proposals. (45) A company producing a single product sells it at Rs. 50 per unit. Unit variable cost is Rs. 35 and fixed cost amounts to Rs. 12 Lakhs per annum. With this data, you are required to calculate the following, treating each independent of the other a. b. c. d. P/V Ratio and the Break Even Point New Break Even Sales if variable cort increase by Rs. 3 per unit, without increase in the selling price. Increase in sales required if profits are to be increased by Rs. 2.40 lakhs Percentage increase/decrease in sales volume to offset
l l

An increase of Rs. 3 in the variable cost per unit A 10% increase in selling price without affecting existing profits quantum

e.

Quantum of advertisement expenditure permissible to increase sales by Rs. 1.20 Lakhs without affecting profits quantum.

(46) A manufacturer of fountain pens selling in the market at Rs.100 per dozen makes an average net profit of 20% on sales by producing 50,000 dozen per annum against a capacity of 75,000 dozens. His cost sheet for 1984 was as under. Cost per dozen in Rs. Direct Materials Direct Wages Works overheads (50% of this is variable) Sales overheads (25% of this is variable) 4 10 36 30

In 1985, he anticipates his fixed costs to increase by 6%, cost of direct materials by 5%, and labour (with whom an agreement has been concluded) by 10%. Market enquiries revealed that the selling price of the product and quantity will remain unchanged in 1985.
Marginal Costing

423

An inquiry has been received for the supply of 10,000 dozens to a customer. What could be the lowest quotation, if the business wants to make a minimum profit of Rs. 8 lakhs in 1985? Give detailed workings. (47) The following figures relate to the current years position in an engineering industry operating at 70% capacity level. Break Even Point P/V Ratio Margin of Safety Rs.80 Crores 40% Rs 20 crores

The board at its last meeting have taken a decision to increase the output to 98% capacity level with the following modifications. (i) (ii) Reduction in selling price by 5% Increase in fixed cost by Rs.8 crores (Including depreciation on additions but excluding interest burden.).

(iii) Reduction in variable cost by 5% of sales. (iv) Additional finance for capital expenditure and working capital Rs.20 crores. (a) You are required to determine the revised sales figure necessary to yield the existing quantum of profits plus additional profit of Rs.4 crores on account of increased activity and 20% Interest burden on fresh capital inputs. Also determine the revised (i) (ii) Break Even point P/V Ratio

(b)

(iii) Margin of safety. (48) The following data are obtained from the records of a factoryRs. Sales 4,000 Units @ Rs.25 each Materials consumed Variable Overheads Labour overheads Fixed overheads 40,000 10,000 20,000 18,000 88,000 Net Profit 12,000 Rs. 1,00,000

424

Management Accounting

Calculate : (1) (2) (3) (4) (5) The number of units by selling which the company will neither loose or gain anything. P/V Ratio and Margin of Safety at present level. The extra units which should be sold to obtain the present profit if it is proposed to reduce the selling price by (a) 20% and (b) 25%. The selling to be fixed price to bring down its break even point to 500 units under present condition. The sales required to earn profit of Rs.60,000 at the present selling price of Rs.25 per unit,

(49) You are given the following data pertaining to a factory. Present (1986) Sales (in Units) Fixed cost (in Rs.) Loss (in Rs.) Profit (in Rs.) 10,000 25,000 5,000 5,000 Forecast (1987) 15,000 25,000

For the above working purposes, variable cost of sales has been taken at Rs.7 per unit upto 15000 units and it shall be Rs.8 per unit beyond 15,000 units. You are required to state as to (1) (2) (3) (4) What percentage of increase in sales is required to cover additional 50 paise per unit towards extra packing cost in 1987 for achieving the additional sales target? What percentage of increase in sales is required to maintain budgeted profit with a price reduction of 25 paise per unit? What percentage of increase in sales is required to meet additional publicity expenses of Rs. 2,000 and also maintain the targeted profits? What is the maximum increase in fixed cost (additional depreciation) per period to justify the proposal for buying a new machine which will reduce variable cost of sales by Rs. 2 per unit at all levels? Sales to remain at 10,000 units and the targeted profit to be achieved. (The above situations have to be considered independently of each other.) (50) The anticipated sales of Electronic Corporation Ltd. is Rs. 4,00,000 and unit sales price of product is Rs.20 each. The cost of direct material is Rs.9 each and the labour cost is Rs.3 each and other variable expenses are Rs.3 per unit. The company is earning a net profit of 5% and to improve the profitability, following propositions were discussed in the Executive Committee Meeting,

Marginal Costing

425

(a)

The present administration set up is on the regional basis and it was felt that centralisation will reduce the fixed cost by Rs. 12,000. The production manager has agreed that he will try to Work on a cost reduction programme which will reduce the cost by Re.1 per unit but there will be little impact on the quality which will be negligible to the customer.

(b)

The sales manager opposed the two proposals and suggests that it may be possible to increase the number of units sold by 20% provided the selling price is reduced by 5%. Alternatively, if the selling price is increased by 10%, the sales number of units will be reduced by 5%. As the Accountant of the company, discuss in detail the various pros and cons of the proposals and also put forward any other proposal to improve the situation. (51) Zed Ltd. reported the following figures for 1983 and 1984. 1983 Sales Total Cost Rs. 50,00,000 Rs. 45,00,000 1984 Rs. 60,00,000 Rs. 52,00,000

The company anticipated that in 1985. (i) (ii) Variable cost rates, on the average, would record an increase of 10% over the 1984 levels. Sales would record an increase of 20% over the 1984 level in volume.

(iii) Selling prices on the average would be increased by 5%. (iv) (v) In addition, another Rs.10 Lakhs of sale (1984 level) would be made to Government at a special discount of 10% thereof. Fixed costs would increase by Rs. 3,00,000.

Ascertain the expected profit/loss in 1985. If the increase in fixed costs mentioned above arises only if sales to Government is made, would you recommend the sale to be made? What is the P/V Ratio for 1985, at normal sales? Give workings. (52) Two business AB Ltd. and CD Ltd. sell same type of product in the same type of market. Their budgeted profit and loss account for the year 1984 is as follows :

426

Management Accounting

AB Ltd. Rs. Sales Cost Fixed Variable 15,000 1,20,000 1,35,000 Net Profit You are required to (a) (b) Calculate the Break Even Point of each business. 15,000 Rs. 1,50,000 35,000 1,00,000 Rs.

CD Ltd. Rs. 1,50,000

1,35,000 15,000

State winch business is likely to earn greater profits in condition of(i) (ii) Heavy demand for the product Low demand for the product

(53) In a factory producing two different kinds of articles, key factor is the availability of labour. From the following information for the factory for 1986. show which product is more profitable. Product A cost per Unit Rs. Material Labour 6 hrs @ Rs. 0.50 3 hrs @ Rs. 0.50 Overheads - Fixed (50% of labour) - Variable 5.00 3.00 1.50 1.50 11.00 Selling Price Profit Total Production per month (Units) Maximum capacity per month Maximum capacity of product B 14.00 3.00 500 4,800 hours 1,000 Units Product B Cost per Unit Rs. 5.00 1.50 0.75 1.50 8.75 11.00 2.25 600

Marginal Costing

427

(54) (a)

The following particulars are extracted from the records of a company. Product A per Unit Product B per Unit Rs. 1.20 3 kgs. Rs. 15 Rs. 10 Rs. 6

Sales Consumption of material Material Cost Direct Wages Cost Direct Expenses Machine hours used 3 : 2 Overhead Expenses Fixed Variable

Rs. 1.00 2 kgs Rs. 10 Rs. 15 Rs. 5

Rs. 5 Rs. 15

Rs. 10 Rs. 20

Direct Wages per hour is Rs.5. Comment on profitability of each product (both use the same raw material) When (i) (ii) Total Sales Potential is limited. Raw Material is in short supply.

(iii) Production capacity ( in terms of machine hours) is the limiting factor. (b) Assuming raw material is the key factor, availability of which is 10,000 kgs. and maximum sales potential of each product being 3,500 units, find out the product mix which will yield the maximum profit.

(55) The following particulars are available from a manufacturing unit A Units Sold Sales Material Cost Labour Cost Variable Expenses Fixed overheads. 80,000 Rs. 40,000 Rs. 20,000 Rs. 6,000 Rs. 4,000 Rs. 7,000 B 80,000 Rs. 80,000 Rs. 30,000 Rs. 10,000 Rs. 4,000 Rs. 10,000 C 2,00,000 Rs. 50,000 Rs. 25,000 Rs. 8,000 Rs. 5,000 Rs. 5,000

The key factor of production is an imported raw material and the consumption of the material in product A is 400 litres. Product B is 1,000 litres and Product C is 600 litres. The sales manager gives an assurance that it is possible for him to sell whatever produced. The management of the company has decided to close down one product line and

428

Management Accounting

concentrate on two lines to increase the profitability of the company. As the company Accountant, prepare a report to the Directors recommending the closure of one of the lines which is not more profitable. (56) Ambika Condiments bring out 2 products SUCHI and RUCHI which are popular in the market. The management has the option to alter the sales mix of the 2 products from the following combinations Option I II III IV SUCHI (units) 800 1,600 1,100 RUCHI (units) 600 1,300 500

The per unit production cost/sales data are SUCHI (units) Direct Materials (Rs.) Direct Labour (hours) Selling Price (Rs.) 25 10 75 RUCHI (units) 30 12 90

Variable factory overheads are 100% of direct labour cost for both products. Labour rate is Rs. 2 per hour. Common fixed overheads for both products Rs. 10,000. You are required to a. b. Prepare a marginal cost statement for the two products. Evaluate options and identify the most profitable sales mix.

(57) From the following particulars, find the most profitable product mix and prepare a statement of profitability of that product mix. Product A Units budgeted to be produced and sold Selling Price per unit (Rs.) Requirement per unit : Direct Materials (Kgs) Direct Labour (Hours) Variable Overheads (Rs.) Fixed Overheads (Rs.) Maximum possible units of sales
Marginal Costing

Product B 3,000 55 3 3 13 10 5,000

Product C 1,200 50 4 2 8 10 1,500 429

1,800 60 5 4 7 10 4,000

Cost of material per Kg is Rs. 4 and labour hour rate is Rs. 2. All the three products are produced from the same direct material using the same types of machines and labour. Direct labour which is the key factor is limited to 18,600 hours. (58) The Skyrock Ltd. produces and sells three types of products P, Q, and R. The management committee has decided to discontinue the production of Q since there is not much profit in it. From the following set of information, find out the profitability of the products and give your short comments on the decision of the management. Product Selling Price Per unit Rs. 300 275 305 Dept. A Variable Overheads Fixed overheads 150% 200% Direct Material Per unit Rs. 60 30 70 Dept. B 120% 240% Direct Wages Per unit Dept. A Dept. B Rs. Rs. 20 20 12 15 20 10 Dept. C 200% 150%

Dept. C Rs. 10 10 20

P Q R

The absorption rate of overheads on the Direct Wages are

(59) You had asked your accountant to prepare fair budgets based on different economic forecasts. After doing part A the work, he fell sick. Incomplete workings done by him were as under. Economic Forecast Variable Cost (Rs. 000) Depressed 40 Average 60 Good 90 Excellent 140

There are fixed costs of Rs.72,000 and P/V Ratio is 60%. Calculate. (a) (b) (c) The profit or loss at each of the four levels. The break even point in sales value and The sales value at which a profit of Rs .15000 would be made.

(60) Following is the abridged Profit and Loss Account of W Ltd. for 1987 (Rs. in Lakhs) Sales (10 Lakhs Units @ Rs. 2.50 Per unit) Less : Variable Cost Contribution Less : Fixed Costs Loss: 25.00 16.00 9.00 9.20 (-) 0.20
Management Accounting

430

S. Ltd. approaches W Ltd. which has spare capacity and offers to purchase 2 lakh units from W Ltd. If W Ltd. accepts this offer, it will save Rs. 0.25 per unit in sales commission. Existing scales will continue as above. What is the price per unit on this special offer that W Ltd. must charge in order that an Overall profit of Rs. 50,000 can be earned on total sales. (61) The profit of a company works out to 12.5% on capital employed in 1986. The details are as follows. Rs. 000s Sales Direct Material Direct Labour Variable overheads Capital Employed (a) 500 250 100 40 400

Forecast for 1987 indicates sales will increase by 10%, selling price will go up by 4% and cost elements will go down by 2%. Assuming no change in the capital employed, calculate the return on capital employed. The new sales manager who has joined the company recently estimates for the next year a profit of about 23% on capital employed, provided the volume of sales is increased by 10% and simultaneously there is an increase in selling price of 4% and an overall cost reduction in all elements of cost by 2%. Find out by computing in details the cost and profit for the next year. Whether the proposal of sales manager can be adopted?

(b)

(62) A multi product company has the following costs and output data for the last year. Products Y 35% 25 15

X Sales Mix Selling Price Variable cost per unit Total Fixed cost Rs. 1,50,000 Total Sales Rs. 5,00,000 40% Rs. 20 Rs. 10

Z 25% 30 18

The company proposes to replace Product Z by product S. Estimated cost and output data are :

Marginal Costing

431

X Sales Mix Selling Price Variable cost per unit Total Fixed cost Rs 1,50,000 Total Sales Rs. 5,00,000 50% Rs. 20 Rs. 10

Products Y 30% 25 15

S 20% 28 14

Analyse the proposed change and suggest what decision the company should take. (63) The following set of information is presented to you by your client AB Ltd. (1) (2) (3) (4) (5) (6) Direct Materials ( per unit ) X-Rs. 20 Y- Rs.l8. Direct Wages (per unit) X - Rs.6 Y- Rs. 4 Fixed expenses during the period are expected to be Rs. 1,600 Variable expenses are allocated to products @ 100% of Direct Wages. Sales Price (Per Unit) X - Rs.40 Y- Rs.30 Proposed Sales mixes (i) (ii) (iii) 100 Units of X and 200 units of Y 150 Units of X and 150 Units of Y 200 Units of X and 100 Units of Y

As a Cost Accountant, you are requested to present to the management of AB Ltd. the following. (a) (b) (c) The unit marginal cost and unit contribution. The total contribution and resultant profit from each of the above sales mixes, The proposed sales mixes to earn a profit of Rs.300 and Rs.600 with the total sales of X and Y being 300 units.

(64) An enthusiastic marketing manager suggests to his managing director that if only he is permitted to reduce the selling price of a product by 20%, he would be able to achieve a 30% increase in sales volume. The Managing Director, finding that the sales volume exceeds in percentage the extent of required reduction in price, gives the clearance. You are given the following information. Present selling price per unit Present volume of sales Total variable costs Total fixed costs Rs. 7.50 2,00,000 Nos. Rs. 10,50,000 Rs. 3,60,000

432

Management Accounting

Assuming no changes in the cost in the continuing period, (i) Examine the consequences of the Managing Directors decision assuming that 30% increase in sales is realised. At what volume of sales can the present quantum of profits be achieved after effecting the price reduction.

(ii)

(65) SV Ltd. has budgeted the manufacture of 30,000 units of its only product A for the next quarter. The capacity of the factory has not been fully utilised. The variable cost per unit of product A is as under : Rs. Direct Material Direct Wages (Rs.4 per hour) Factory variable overheads Selling variable overheads 48.00 36.80 27.60 18.00

Product A is sold at Rs.200 per unit. Fixed overheads for the quarter are Rs. 15,00,000. At present, the company manufactures component P one unit of which is used in each unit of Product A. The cost of this component is already included in the cost structure of Product A as aforesaid. Anyhow, the cost per batch of 1000 units of component P is separately supplied as under. Rs. Direct Material Direct Wages Factory variable overheads Fixed overheads apportioned to the component 6,000 4,800 3,600 3,600 18,000 It is proposed to utilise the spare capacity by manufacture of 1,500 units of product B for export. The details are as under : Export selling price Direct Material cost Direct labour Rs. 228 per unit Rs. 80 per unit 16 hours per unit

Variable expenses applicable to this product - Rs. 20 per unit. Factory variable overheads have to be charged, calculated on the basis of Direct Labour Hour Rate applicable to Product A. It has to be noted that component P is not used in the manufacture of product B.

Marginal Costing

433

You are required to (i) (ii) Present a statement showing the profit as originally envisaged in the budget. State whether component P should be manufactured or bought from the market if this can be procured at a price of Rs. 16 per unit.

(iii) Calculate the contribution on account of accepting the export order of product B. (66) A small scale manufacturer produces an article at the operated capacity of 10,000 units while the normal capacity of his plant is 14,000 units. Working at a profit margin of 20% on sales realisation, he has formulated his Budget as under 10,000 Rs. Sales Realisation Variable overheads Semi- Variable overheads Fixed overheads 2,00,000 50,000 20,000 40,000 14,000 Rs. 2,80,000 70,000 22,000 40,000

He gets an order for a quantity equivalent to 20% of the operated capacity and even on this additional production, profit margin is desired at the same percentage on sales realisation as for production to operated capacity. Assuming prime cost is constant per unit of production, what should be the minimum price to realise this objective? (67) The executives of B Co., a small manufacturer of one product are developing the annual profit plan. They have just reviewed the First Cut at the annual income statement and are concerned with the Rs. 1,10,000 indicated profit on a sales volume of 20,000 units. The fixed cost structure of Rs.9,90,000 appears to be high and they have some doubts about departing from the unit sale price of Rs.100. There is a general agreement that the Profit target should be Rs. 2,20,000. This case deals with several tentative alternatives suggested during the meeting of the executives committee that just reviewed the tentative profit plan. You are required to compute (a) (b) The budgeted break even point in rupees and in units and the number of units that would have to be sold to earn the target profit? You are also required to respond directly to each of the following two alternatives under consideration by the management. Consider each independent of the other and state any assumptions that you would like to make.

Alternative 1 - A sale price increase of 15% is contemplated, the sales executive estimates that this will cause a drop in units that can be sold by 15%. What would be the new breakeven point in Rs. and in units? What would be the new profit figure? How many units would have to be sold to earn the target profit?

434

Management Accounting

Alternative 2 - A decrease in fixed costs of Rs-55,000 and a decrease of variable costs of 6% are contemplated. What would be the new BEP in Rs. How many units must be sold to earn the target profit. (68) Stoner company uses three different components (Materials) in manufacturing its primary product. Stoner manufactures two of the components and purchases one (designated as component 1) from outside suppliers. The company is currently developing the annual profit plan. Sales are highly seasonal, component 2 cannot be acquired from outsiders, however component 3 can be purchased. The three components have critical specifications. The annual profit plan provided data for the following computations. Component 3 Unit Cost (at 12,000 units) Rs. Material (Direct) Labour (Direct) Fixed overheads (apportioned) Annual machine rental (Special machine used only for component 3) Variable factory overhead Average storage cost per year (fixed) Total Average inventory level 500 units. The Purchase Manager investigated outside suppliers and found one that would sign a one year contract to deliver 12,000 quality units as needed during the year at Rs.5.20 per unit. Serious consideration is being given to this alternative. Should Stoner make or buy component 3? Explain the relevant factors influencing your decision. (69) From the following data, which product would you recommend to be manufactured in the factory when(1) Time is the key factor. (2) (3) (4) Raw material is in short supply. Sales potential in units is a limiting factor. Sales potential in value is a limiting factor. Per unit of Product A Rs. Direct Material (Rs. 2 per Kg.) Direct Labour (Rs. 1 per Hour) Variable Overheads Selling Price
Marginal Costing

1.40 2.20 0.40 0.50 1.00 0.40 5.90

Per unit of Product B Rs. 14 3 6 110

24 2 4 100

435

NOTES

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Chapter 1 2
BUDGETARY CONTROL

INTRODUCTION : Budget and Budgetary control : The term Budget is defined as a financial and/or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. The analysis of this definition reveals the following characteristics of the budget. (1) (2) (3) (4) It may be prepared in terms of quantity or money or both. It is prepared for a fixed or set period of time. It is prepared before the defined period of time commences. It spells out the objects to be attained and the policies to be pursued to achieve that objective.

The term 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 the basis for its revision. The analysis of this definition reveals the following facts about budgetary control. (1) (2) (3) It deals with the establishment of the budgets.. It deals with the comparison of budgeted results with the actual results. It deals with computation of the variations and the actions to be taken for maintaining the favourable variations, removing the adverse variation or revising the Budgets themselves.

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ADVANTAGES OF BUDGETARY CONTROL : (1) It is a powerful tool available to the management for the purpose of cost control and maximization of profits through the same. It enables the management to utilize the available resources in the most profitable manner. A budget sets the plan of action. Plans in respect of various functional areas of operations are expressed in the form of the budgets. As such, the Budgetary Control systems acts as a means of declaration of the policies of the management. It acts a means of communication. The plans and objects laid down by top level management are communicated to middle level and lower level management by way of the budgets. As such, each and every person working in the organisation is aware of his duties and responsibilities in relation to those of the others. This maximizes the utilization of resources. It acts as a means of improving the co-ordination. The budgets prepared in the various functional areas of operations are prepared in such a way that the efforts are co-ordinated in the direction of achievement of common and defined objective. It develops the team spirit and help of various people can be sought to solve the common problem. The comparison between the budgeted results and the actual results may reveal the areas where there are adverse variations which may be identified as weak areas or delicate areas. As such, efforts can be made to remove these adverse variations, keeping aside the areas where there are no variations. This enables the concentration of efforts of the management on a smaller portion of activities which facilitates Management by exception. Budgetary control system enables the delegation of authority and makes possible the principles of Responsibility Accounting. It is a powerful tool available to the management for Performance Appraisal. The executives responsible for those functions where there is favourable variation may be rewarded, whereas the executives responsible for those functions where there is adverse variation may be punished. In this sense, budgetary control system provides a basis for establishment of the incentive systems.

(2)

(3)

(4)

(5)

(6)

(7)

Pre-requisites for the implementation of Budgetary Control If the organization decides to install the Budgetary Control system as a cost control technique, it will have to comply with the following preliminaries.

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(1)

Deciding the Budget Centre : A Budget Centre is that section of the organization with respect to which the budgets will be prepared. A Budget centre may be in the form of a product or a department or a branch of the company and so on. Budget centre should be clearly defined and established as the budgets will be prepared with respect to each and every Budget Centre.

(2)

Deciding the Budget Period : A Budget Period is that period of time for which the budget will be prepared and operated. The selection of the Budget Period should be made very carefully- Too long a budget period makes the correct estimation more difficult while too short a budget period may prove to be more costly. The selection of Budget Period may depend upon the nature of operations and the purpose of preparing the budgets. As such, in case of industries like the ones engaged in generation and distribution of electricity, transport operations etc. where capital expenditure is too high, budgets may be prepared even for a period of 5 to 10 years, while in case of industries like the ones engaged in manufacturing of motor vehicles or radios etc., where the customer demand may change more frequently, the budget period may be shorter. Similarly, a sales budget may be prepared for a period of 5 years, whereas the short term cash budget may be prepared on weekly or even daily basis.

(3)

Establishment of Accounting Records : There should be an efficient and proper system of accounting so that the information and data as required for the efficient implementation of the Budgetary Control system will be available in time.

(4)

Organization for Budgetary Control : A properly prepared organization chart may make the duties and responsibilities of each level of executive very clear to himself. The budgetary control organization will be headed by a senior executive in the form of budget controller or budget officer. In small or medium sized organizations, he himself will be involved in all types of works involved with the budgetary control system. However, in case of large organizations, be may have a budget committee under him which may consist of Chief Executive, budget officer himself and heads of main departments. The role of budget committee may be only advisory and its decision may become binding only if accepted by the Chief Executive. The functions performed by the budget committee can be broadly stated as below. (a) To receive and scrutirize the functional budgets.

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439

(b) (c) (d) (e)

To revise the functional budgets, if necessary. To approve the revised budgets. To receive the budget reports and comparative statements. To locate the responsibilities and recommend the corrective and remedial action.

The usual and normal organization for the budgetary control may be expressed by way of the following organization chart. Chief Executive Budget Officer Budget committee Production Manager (5) Personnel Manager Finance Manager Purchase Manager Sales Manager

Preparation of a budget mannual : A budget mannual is a document setting out the responsibilities of the persons engaged in and the forms and procedures required for the budgetary control. A budget manual enables the standardization of the methods and procedures in relation to the budgetary control. It should be well written, indexed and divided into the sections. It may be in bound book form or loose leaf form. A budget mannual may contain the following particulars. (a) Introduction of principles and objectives of budgetary control and the definitions and brief explanations. Duties and responsibilities of the various executives and the organization chart. Functions and duties of budget officer and budget committee. Scope of the budget and areas to be covered, whether budget will be a fixed budget or flexible budget. Accounts codes, budget center codes and other codes operated. The forms of reports and statements to be used. The last date for submission of budgets. Budget diagrams.

(b) (c) (d)

(e) (f) (g) (h)

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(6)

Determination of Budget Key Factor : A budget key factor is that the impact of which should be assessed first before other functional budgets are prepared to ensure that other functional budgets are capable of fulfillment. The key factor may take various forms Eg.Sales, Raw material, Labour, Production capacity, availability of funds and Government restrictions. Once the key factor is established, the budget with respect to that function will be prepared first and the other budgets will be prepared to conform to that Eg. If sales is the key factor, the sales manager will prepare and submit sales forecast first. The production manager will then decide whether it is possible to produce the quantity to meet sales demand. In case of the situations where there are more than one key factors, the importance of key factors themselves will be assessed first. The problem of multiplicity of key factors may be solved with the help of techniques like linear programming, operations research etc.

TYPES OF BUDGETS : There can be basically four areas in which management can function and the types of budgets can be studied with respect to these functional areas of management viz. Sales/Marketing, production, personnel and finance. (A) Sales/Marketing :

The budgets in this area may be of following types. (I) Sales Budget : It is a forecast of total sales expressed in terms of quantity and or money. It is inevitably the interplay between two factors i.e. sales quantity and selling price. Sales quantity may be forecasted after taking into consideration various factors. (1) Analysis of Past Trend : Analysis of the past trend over the last 5-10 years, may reveal the long term trends, seasonal trends and the cyclical trends. With the help of this trend analysis, the future trend can be established. For this purpose, reference can be made to the reports published by trade organizations and Government publications. Reports by Salesmen : Being in the actual field, probably the sales staff may be best able to estimate the quantity which can be sold in the market. Before using this estimate as an official sales forecast, necessary adjustments may be made for error of judgment or to avoid the possibility of overestimation on the part of the salesmen. Market Research and Market Survey : This is a very specialized technique available to assess which of the companys products can be sold, in which market,

(2)

(3)

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441

in what quantity and at what selling price. Such an analysis will facilitate the preparation of sales forecast areawise, productwise, salesmenwise and channel of distribution wise. (4) General Economic Conditions : General Trade and Business conditions affect the sales forecast of the company. They may be in the form of competition from other companies, supply condition for material and labour, trade conditions of the customers of the company and so on. Selling price at which products of the company can be sold may depend upon various factors viz. (1) (2) (3) (4) Cost price of the product Selling price charged by the competitors. Expected amount of profits. Advertisement and other sales promotion efforts carried out by the company.

If the company envisages to sell higher quantity than the past sales or the existing production capacity, and if some capital investment proposal is involved to increase the production, then the feasibility of the proposal and the availability of funds may also be required to be considered. If the sales forecast is less than the past sales but the top management insists upon a certain amount of additional profits, then the possibility of increasing the selling price or selling efforts and reduction in the cost price may be required to be considered. (II) Selling and Distribution Cost Budget : It shows the selling and distribution cost for selling the quantities considered in sales budget. The sales manager, the distribution manager, the advertising manager and the finance manager will be the persons involved in the preparation of this budget. This budget may be prepared on the principles of flexible budgeting (as discussed later in this chapter) for each head of selling and distribution costs, on the basis of volume of sales to be achieved. (III) Advertising Cost Budget : This cost is closely associated with sales. The intention of incurring this cost is to increase the sales. However, the result of incurring this cost i.e. increased sales may not be immediate and even if there is increase in sales, it is difficult to measure the portion of increased sales which is due to advertising cost. As such, normally, advertising cost budget is established in the form of a fixed amount for a specific period.

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The various ways in which the amount of budgeted advertising cost can be decided are as below : (1) Percentage of Sales or Profits : Here the advertising cost may be decided as a fixed percentage of sales or profits. However, the past data may not be suitable in view of recent business situations. Funds Available : Here the advertising cost depends upon the capability of the company to spend on advertising. This may be a hypothetical method and may not necessarily consider the relationship between advertising cost and benefits there from. Competitors Policy : Here the advertising cost may depend upon the amount which the competitors are spending on advertising. This method may pose some difficulty as the amount spent by competitors may not be known and it may be wrong to assume that the company may be able to derive the same benefits from advertising as the competitors derive.

(2)

(3)

(B)

Production :

The budgets in this area may be of following types : (I) Production Budget : It is a forecast of production for the budget period. It may be prepared from two angles. (i) (ii) Production Budget in terms of Quantity. Production Budget in terms of money i.e. the production Cost Budget further classified under each element of cost such as Direct Material Cost, Direct Labour Cost and Overheads Cost.

The material cost can be estimated by preparing the materials budget which indicates the estimated quantities as well as costs of various materials required for carrying out production as per production budget. The labour cost can be estimated by preparing Direct Labour Cost budget which indicates the direct labour requirements required to produce the quantity as specified in the production budget. For the purpose of this budget, labour requirement in terms of number of workers of different grades will be decided first. Afterwards, the rates of pay and allowances will be considered to decide the labour cost. The production overheads can be estimated by preparing production overhead budget which indicates all items of production overheads classified as fixed, variable and semi-variable. The process of allocation and apportionment can be followed to decide the loading of overheads to each budget centre. Following factors will have to be considered before preparing the production budget in terms of quantity.
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443

(1)

Coordination with Sales Forecast : Before the quantity to be produced is decided, it will be necessary to confirm whether it is possible to sell the quantity which is produced during the budget period. If it is not possible to sell whatever can be produced, inspite of all the sales promotion efforts, then the production budget should be adjusted to conform to the sales forecast. If the expected sales exceed existing production capacity, possibility of overtime working or extra shift working should be considered. Production Capacity : Production Budget estimates the quantity to be produced. If it is not possible to produce the quantity with the existing capacity available, it will be necessary to increase the capacity by incurring additonal capital expenditure. Consideration of Stocks : Whatever is to be sold need not be produced necessarilly. The quantity to be produced, after giving due consideration to the sales forecast, may depend upon the opening and closing stock of finished goods. The quantity to be produced during the budget period may be decided as Estimated Closing stock of finished goods. Add : Quantity to be sold, Less : Opening Stock of Finished Goods.

(2)

(3)

(4)

Management Policy : Sometimes, the policy decisions taken by the management are required to be considered before setting the production budget Eg. It will have to be considered whether certain components are decided to be produced instead of purchasing or vice versa.

(II)

Purchases Budget : It is a forecast of quantity and value of materials, direct or indirect, required to be purchased during the budget period. It is needless to state that the purchases budget is closely connected to the production budget. Following factors are required to be considered before setting the purchases budget, (1) (2) (3) (4) (5) (6) Orders already placed for the purchases of materials. Material already purchased but reserved for some specific purposes. Opening and closing stocks. Storing facilities and economic order quantity. Availability of funds. Prices of the materials.

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(C)

Personnel :

In this functional area, the budget to be prepared takes the form of a personnel budget, which indicates the requirement of personnel or labour force, either direct or indirect, to conform to the sales forecast and the production budget. The labour requirement may be decided in terms of number and grade of workers, number of labour hours, rupee value etc. Consideration is also required to be made of the overtime working or shift working. This budget may also indicate the training plans for new workers. (D) Finance :

The most important budget which is prepared under this functional area is the cash budget. It is an estimate of the expected cash receipts and cash payments during the budget period. Thus by preparing the cash budget, it is possible to predict whether at any point of time, there is likely to be excess or shortage of cash. If the shortage of cash is estimated, it may be required to arrange the cash from some other source. If the excess of cash is estimated, it may be possible to explore the investment opportunities. Before preparing the cash budget, following principles should be kept in mind. (i) The period for which cash budget is prepared should be selected very carefully. There is no fixed rule as to the period to be covered by the cash budget. It may vary from company to company depending upon the individual requirements. As a general rule, the period covered by the cash budget should neither be too long or too short. If it is too long, it is possible that the estimate will not be accurate. If it is too short, the factors which are beyond the control of management will not be given due consideration. The items which should appear in the cash budget, should be carefully decided. Naturally, all those items which do not involve cash flow will not be considered while preparing the cash budget. Eg. As the cost of depreciation does not involve any cash outflow, it does not affect the cash budget, though the amount of depreciation affects the determination of tax liability which involves cash outflow. A cash budget may be prepared in any of the following three methods. (1) Receipts and Payments Method : This method is useful for short term estimations. It lists the various estimated sources of cash receipts on one hand and the various estimated applications of cash on the other. While preparing the cash budget by this method, the various items appearing on the same may be classified under the following two categories : (i) Operating Cash Flows : These are the items of cash flow which arise as a result of regular operations of the business.

(ii)

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445

(ii)

Non operating Cash Flows : These are the items of cash flow which arise as the result of other operations of the business.

The standard items which may appear on the cash budget prepared by this method may be stated as below : Cash Inflow Operating : Cash sales Collection from debtors Interest/Dividend received Cash Outflow Operating : Payment to creditors Cash Purchases of raw materials Wages/Salaries Various kinds of overheads. (To the extent they are actually paid) Non-operating Redemption of shares/debentures. Loan Installments Purchases of Fixed Assets Interest Taxes Dividends.

Non-operating Issue of shares/debentures Receipt of loans/borrowings Sales of Fixed Assets Sales of Investments

Thus, finally cash budget appears in the form of opening cash balance, to which various estimated cash receipts are added, the estimated cash payments being deducted from this sum to arrive at the closing cash balance. (2) Balance Sheet Method : This method is useful for long term estimates. According to this method, the budgeted Balance Sheet is prepared for the following budget period, after considering the various terms viz. Capital, Long Term Liabilities, Current liabilities, Fixed Assets, Current Assets, but except cash. After both the sides of Balance Sheet are balanced, the balancing figure indicates the estimated cash balance in hand at the end of that period. This method does not consider the expenses and assumes the regular pattern of inflow and outflow of cash. Further, it indicates the cash requirement only at the end of budget period, any excess or shortage of cash during the budget period are not considered. Adjusted Profits/Losses Method : This method also is useful for long term estimates. According to this method, the cash budget is prepared in the following way to show the estimated cash balance at the end of the budget period.

(3)

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Management Accounting

Opening cash balance. Add : Profit before depreciation, provisions and other non-cash expenses. Add : Decrease in Current Assets or Increase in Current Liabilities. Add : Capital Receipts. Add : Receipt of loans/borrowings Less : Capital Expenditure Less : Repayment of loan installments Less : Payment of dividends/taxes Less : Increase in Current Assets or Decrease in Current Liabilities In other words, cash budget prepared as per this method is in the form of cash flow statement. (E) Miscellaneous Budgets : In addition to the various budgets as described above, which can be prepared in prime functional areas of marketing, production, personnel and finance, some other types of budgets may also be prepared. (I) Overheads Cost Budget : It indicates the various types of overheads to be incurred during the budget period. For the correct establishment of overheads cost budget, it will be necessary to classify the various overheads. In order to exercise proper control on the overheads, it will be necessary to analyse the overheads as fixed, variable and semi-variable. The semi-variable overheads are further required to be split into fixed and variable elements. (II) Capital Expenditure Budget : It is the plan of proposed investment in the fixed assets. It is closely related to the sales budget, production budget and cash budget. As such, capital expenditure budget should be properly coordinated with other functional budgets. The capital expenditure may be required to be incurred for the replacement purposes or expansion purposes. The requirements of capital expenditure may be basically received from the various functional executives viz. production manager, sales manager, finance manager and so on. If the investment in fixed assets is considered to be economically and financially feasible, then the arrangement is required to be made for the acquisition of the same. If the cash budget reveals the excess funds available, it may not be necessary to arrange the funds for acquiring the fixed assets from outside source. However, if no excess cash balance is available, then it may be necessary to borrow the funds from some outside source.

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447

(F)

Master Budget :

After all the functional budgets are prepared individually and are properly coordinated with each other, the master budget can be prepared by incorporating all the functional budgets. The ultimate incorporation of all the functional budgets takes the form of budgeted Profit and Loss Account and the Budgeted Balance Sheet. It may involve the presentation of current years budgeted figures as well as those of the previous year showing clearly why there is a change. FIXED AND FLEXIBLE BUDGETS : Any budget in any functional area of operation can be established as a fixed budget or a flexible budget. A fixed budget is established for a specific level of activity and is not adjusted to the actual level of activity attained at the time of comparison between the budgeted and actual results. Naturally, fixed budget is established only for a short period of time where the budgeted level of activity is expected to be attained to the maximum possible extent. Fixed budgets are more suitable for fixed expenses i.e. the expenses which have no relation with the level of activity. The fixed budgets do not indicate that they cannot be changed at all. A fixed budget can be revised if the actual level of activity is likely to differ widely from the budgeted level of activity. The fixed budget cannot be used as a effective tool of cost control while computing the variations between the budgeted result and the actual result, the variance cannot be explained properly and it is not possible to say whether the variance is due to the changes in the level of activity or due to the efficiency or inefficiency of the executive responsible for the execution of the budget. A flexible budget is designed to change with the fluctuations in the level of activity and provides a basis for comparison for any level of activity actually attained. A flexible budget is more elastic, and practical. It can be properly used as an effective tool for evaluation of performance and cost control. It explains the variations between the budgeted results and actual results stating the variations which are due to changes in the level of activity (which is beyond the control of operating executive) and which are due to the operational efficiency or inefficiency (for which the operating executive is responsible.) For the purpose of establishment of the flexible budgets, it is necessary to classify the costs as fixed costs, variable costs and semi-variable costs. The fixed costs remain the same at all the levels of activity whereas the variable costs change directly in proportion to the level of activity. So far as the semi-variable costs are concerned, each item of cost is examined and classified into its fixed and variable elements and a trend is established regarding the nature and behavior of each item of cost. ILLUSTRATIVE PROBLEMS (1) An estimate shows that there is a market for 10,00,000 units of an electric bell. Two big companies producing this electric bell will probably divide 80% of the market. Among
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448

other companies, producing the bell, Ghatanad Ltd. should get 15% of the total market. 60% of the Ghatanad sales will probably be evenly divided between the first and last calendar quarters, with twice as many sales being made in the second quarter as in the third. The bell sells for Rs.30 an unit, with the manufacturing cost as follows. The cost is worked out with reference to normal working capacity for the production which is 1,50,000 bells a year. Direct Materials Cost Direct Labour Cost Variable overheads cost Fixed overhead cost Rs. Rs. Rs. Rs. 15.00 7.50 2.50 1,00,000

Prepare a sales budget for the year showing cost of production and gross profit by calendar quarters. Assume no change in the inventory levels during the year. Solution : SALES BUDGET Particulars (A) Sales - Units Rs. (B) Cost of Production Direct Materials Rs. Direct Labour Rs. Variable Overheads Rs. Fixed Overhead Rs. 6,75,000 3,37,500 1,12,500 25,000 11,50,000 (c) Gross Profit i.e. A - B 2,00,000 6,00,000 3,00,000 1,00,000 25,000 10,25,000 1,75,000 3,00,000 1,50,000 50,000 25,000 5,25,000 75,000 6,75,000 3,37,500 1,12,500 25,000 11,50,000 2,00,000 22,50,000 11,25,000 3,75,000 1,00,000 38,50,000 6,50,000 Qtr. I 45,000 13,50,000 Qtr. II 40,000 12,00,000 Qtr. III 20,000 6,00,000 Qtr. IV 45,000 13,50,000 Total 1,50,000 45,00,000

Note : It is assumed that the fixed overheads are apportioned evenly over the various quarters. (2) XYZ Ltd. manufactures product C and G. During January, it expects to sell 5,000 Kgs of C and 20,000 Kgs of G at Rs. 20 and Rs. 10 each respectively.

Direct materials A, B and E are mixed in equal proportion to produce product C. Materials D, B and E are mixed in the proportion of 5:3:2 to produce product G. There is no loss of weight in the production.

Budgetary Control

449

Actual and budgeted inventories in quantities and costs for the month are as follows : Opening Inventory Kgs. Material A B D E Product C G 1,500 1,000 10,000 5,000 1,000 5,000 Desired Closing Inventory Kgs. 1,000 2,000 3,000 6,000 500 6,000 Anticipated Cost per kg. 5.50 5.00 1.00 3.50

You are required to prepare (i) the production budget (ii) the materials purchase budget, indicating the expenditure on raw materials for January. Solution : (A) Production Budget : January 1987 Product C Anticipated Sales - kgs. Desired closing stock - kgs 5,000 500 5,500 Less : Opening stock kgs. Production during month kgs. (B) Materials Purchase Budget - January 1987 A (a) Requirement for production (As per production Budget) For product C - kgs For product G - kgs. Total requirement - kgs. Desired closing stock - kgs Sub total a +b kgs Opening stock kgs To be purchased during month kgs. c - d Anticipated cost per kg. Rs. Anticipated cost of purchases Rs. B D E 1,000 4,500 Product G 20,000 6,000 26,000 5,000 21,000

(b) (c) (d) (e) (f) (g)

1,500 1,500 1,000 2,500 1,500 1,000 5.50 5,500

1,500 6,300 7,800 2,000 9,800 1,000 8,800 5.00 44,000

10,500 10,500 3,000 13,500 10,000 3,500 1.00 3,500

1,500 4,200 5,700 6,000 11,700 5,000 6,700 3.50 23,450

450

Management Accounting

(3)

Lookahead Ltd. produces and sells a single product. Sales budget for the calender year 1987 by quarter is as under Quarter I II III IV No. of units to be sold 12,000 15,000 16,500 18,000

The year 1987 is expected to open with an inventory of 4,000 units of finished product and close with an inventory of 6,500 units. Production is customarily scheduled to provide for two third of the current quarter s sales demand plus one third of the following quarters demand. Thus production anticipates sales volume by about one month. The standard cost details for one unit of the product is as below Direct Materials 10 Ibs @50 paise per Ib. Direct Labour 1 hour 30 minutes @Rs. 4 per hour. Variable Overheads 1 hour 30 minutes @Re. 1 per hour. Fixed Overheads 1 hour 30 minutes @Rs. 2 per hour, based on a budgeted production volume of 90,000 direct labour hours for the year. a. Prepare a production budget for 1987, by quarters, showing the number of units to be produced and the total costs of direct material, direct labour, variable overheads and fixed overheads. If the budgeted selling price per unit is Rs. 17, what would be the budgeted profit for the year as a whole ? in which quarter of the year is the company expected to break even ?

b. c.

Solution : a. Production Budget We know that Opening Stock + Production - Sales = Closing Stock Hence we know that Closing Stock + Sales - Opening Stock = Production

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Q1 Opening Stock Production Sales Closing Stock 4000 13000 12000 5000

Q2 5000 15500 15000 5500

Q3 5500 17000 16500 6000

Q4 6000 18500 18000 6500

Hence, the total production for all the quarters will be 64,000 units. b. Production Cost Budget Direct Materials Direct Labour Variable Overheads Total Variable Cost Fixed Cost Total Cost 64000 units x Rs. 5 96000 hours x Rs. 4 96000 hours x Re. 1 = = = Rs. 3,20,000 3,84,000 96,000 8,00,000 1,80,000 9,80,000

Total Variable Cost for 64000 units is Rs. 8,00,000. Hence, per unit variable cost is Rs. 12.50. c. Calculation of Profit Sales 61500 units @Rs. 17 per unit Variable Cost of units sold 61500 units @Rs. 12.50 per unit Contribution Less : Fixed Cost Profit d. Break Even Point Per Unit Selling Price is Rs. 17 and Per Unit Varaible Cost is Rs. 12.50. Hence, Per Unit Contribution Rs. 4.50. As Fixed Cost is Rs. 1,80,000, Break Even Point in units will be 180000 / 4.50 = 40000 units. This target is achieved by the company in Quarter 3, hence the company is expected to break even in Quarter Three. (4) A single product company estimated its sales for the next year quarterwise as under 7,68,750 2,76,750 1,80,000 96,750 10,45,500

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Management Accounting

Quarter I II III IV

Sales units 30,000 37,500 41,250 45,000

The opening stock of the finished goods is 10,000 units and the company expects to maintain the closing stock of finished goods at 16,250 units at the end of the year. The production pattern in each quarter is based on 80% of the sales of the current quarter and 20% of the sales of the next quarter. The opening stock of raw materials in the begining of the year is 10,000 Kgs. and the closing stock at the end of the year is required to be maintained at 5,000 Kgs. Each unit of finished output requires 2 Kgs. of raw material. The company proposes to purchase the entire annual requirement of raw materials in the first three quarters in the proportion and at the prices given below Quarter Purchases of raw materials % of total annual requirement in quantity I II III 30% 50% 20% 2 3 4 Price per Kg. Rs.

The value of the opening stock of raw materials in the beginning of the year is Rs. 20,000. You are required to present the following for the next year, quarterwise a. b. c. Production Budget in units. Raw Materials consumption budget in quantity. Raw Materials purchase budget in quantity and value.

Solution : a. Production Budget We know that Opening Stock + Production - Sales = Closing Stock Hence we know that Closing Stock + Sales - Opening Stock = Production

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Q1 Opening Stock Production Sales Closing Stock 10000 31500 30000 11500

Q2 11500 38250 37500 12250

Q3 12250 42000 41250 13000

Q4 13000 48250 45000 16250

Hence, the total production for all the quarters will be 1,60,000 units. b. Raw Materials Consumption Budget Production Budget is 1,60,000 units. Each unit of the final product requires 2 Kgs. of raw material. Hence, the raw material consumption budget in quantity will be 3,20,000 Kgs. c. Raw Materials Purchase Budget Total quantity of raw materials to be purchased will be Closing Stock + Consumption - Opening Stock 5000 + 320000 - 10000 = 315000 The quarterwise purchases will be as below Q1 30% of 315000 Kgs. i.e 94500 Kgs. @Rs. 2 per Kg. Q2 50% of 315000 Kgs. i.e. 157500 Kgs. @Rs. 3 per Kg. Q3 20% of 315000 Kgs. i.e. 63000 Kgs. @Rs. 4 per Kg. = = = 1,89,000 4,72,500 2,52,000 9,13,500 Hence, total purchase budget in terms of value is Rs. 9,13,500. (5) A private Limited company is formed to take over a running business. It has decided to raise Rs.55 Lakhs by issue of Equity shares and the balance of the capital required in the first six months is to be financed by a financial institution against an issue for Rs.5 Lakhs 8% Debentures (Interest payable annually) in its favour. Initial outlay consists of Freehold premises Plant & Machinery Stock Vehicle & Other items Rs. Rs. Rs. Rs. 25 10 6 5 Lakhs Lakhs Lakhs Lakhs

Payments on the above items are to be made in the month of incorporation. Sales during the first 6 months ending on 30th June are estimated as under.

454

Management Accounting

January February March

Rs. Rs. Rs.

14 15 18.50

Lakhs Lakhs Lakhs

April May June

Rs. Rs. Rs.

25 26.50 28

Lakhs Lakhs Lakhs

Lag in payment

- Debtors 2 months - Creditors 1 month

Other information : (1) (2) (3) (4) (5) (6) Preliminary expenses Rs.50,000 (Payable in February) General Expenses Rs.50,000 p.m.(Payable at the end of each month) Monthly wages (payable on 1st day of next month) Rs. 80,000 p.m. for first 3 months and Rs. 95,000 p.m. there after. Gross Profit rate is expected to be 20% on sales. The shares and debentures are to be issued on 1st January. The stock levels throughout is to be the same as the outlay. Prepare cash budget for the 6 months ended 30th June. Solution : Cash Budget (For 6 month sending 30th June) Jan. (A) Cash Inflow Issue of shares Issue of Debentures Collection from Debtors (B) Cash Outflow Fixed Assets Stock (Initial) Preliminary Expenses Sundry Creditors General Expenses Wages (C) Net cash Inflows (A-B) Opening Balance + Surplus for the month Closing Balance 55.00 5.00 60.00 40.00 6.00 0.50 46.50 Feb. 0.50 10.40 0.50 0.80 12.20 Mar. 14.00 14.00 11.20 0.50 0.80 12.50 1.50 1.30 1.50 2.80 Apr. 15.00 15.00 14.00 0.50 0.80 15.30 (0.30) 2.80 (0.30) 2.50 (Rs. in Lakhs) May Jun 18.50 18.50 19.05 0.50 0.95 20.50 (2.00) 2.50 (2.00) 0.50 25.00 25.00 20.25 0.50 0.95 21.70 3.30 0.50 3.30 3.80

13.50 (12.20) 13.50 13.50 (12.20) 13.50 1.30

Budgetary Control

455

Working Notes : (1) (2) It is assumed that the company is incorporated in January. Assuming that the company is carrying on manufacturing operations, the purchase say for the month of January are computed as below. Sales for January Less Gross profit @ 20% Cost of goods Less wages for January Purchases (6) 14.00 2.80 11.20 0.80 10.40

A newly started company Green Co. Ltd. wishes to prepare cash budget from January. Prepare a cash budget for the first 6 months from the following estimated revenue and expenditure. Month Total Sales Rs. Jan. Feb. Mar. Apr. May June 20,000 22,000 24,000 26,000 28,000 30,000 Material Wages Overheads Production Selling & Distribution Rs. Rs. 3,200 3,300 3,300 3,400 3,500 3,600 800 900 800 900 900 1000

Rs. 20,000 14,000 14,000 12,000 12,000 16,000

Rs. 4,000 4,400 4,600 4,600 4,800 4,800

Cash balance on 1st January was Rs.10,000. A new machine is to be installed at Rs.30,000 on credit, to be repaid by two equal installments in March and April. Sales commission @ 5% on total sales is to be paid within the month following actual sales. Rs. 10,000 being the amount of second call may be received in March. Share premium amounting to Rs. 2,000 is also obtainable with 2nd call. Period of credit allowed by suppliers period of credit allowed to customers Delay in payment of overheads Delay in payment of wages Assume cash sales to be 50% of total sales. 2 month 1 month 1 month 1/2 month

456

Management Accounting

Solution : Cash Budget of Green Co. Ltd. Jan. (A) Cash Inflows Cash sales Collection from debtors Share Capital (2nd call) Share Premium Feb. Mar. 12,000 11,000 10,000 2,000 35,000 Apr. 13,000 12,000 25,000 May Jun.

10,000 11,000 - 10,000 -

14,000 15,000 13,000 14,000 -

10,000 21,000 (B) Cash Outflows Sundry Creditors Wages For current month For last month Production Overheads Selling & Distribution Overheads Instalment for Machine purchased Sales commission 2,000 (C) Net Cash Inflows or outflows (A-B) Opening cash balance + Surplus for month Closing cash balance (7) 1,000 9,200 800 2,000 2,200 2,000 3,200

27,000 29,000

20,000 2,300 2,200 3,300

14,000 2,300 2,300 3,300

14,000 12,000 2,400 2,300 3,400 2,400 2,400 3,500

900

800

900

900

15,000 1,100 44,800

15,000 1,200 38,900

1,300

1,400

24,300 22,600

8,000 11,800 10,000 18,000 8,000 11,800 18,000 29,800

(-) 9800 (-) 13,900 29,800 20,000 20,000 6,100

2,700 6,100 2,700

6,400 8,800 6,400

(-) 9,800 (-) 13,900

8,800 15,200

Prepare a cash budget for the quarter ended 30th September 1987 based on the following information Cash at Bank on 1st July 1987 Salaries and wages estimated monthly Interest Payable August 1987 Rs. Rs. Rs. 25,000 10,000 5,000

Budgetary Control

457

June Rs. Estimated Cash sales Credit Sales Purchases Other Expenses (Payable in same month) 1,00,000 1,60,000 -

July Rs. 1,40,000 80,000 1,70,000 20,000

August Rs. 1,52,000 1,40,000 2,40,000 22,000

September Rs. 1,21,000 1,20,000 1,80,000 21,000

Credit sales are collected 50% in the month of sales are made and 50% in the month following. Collection from credit sales are subject to 5% discount if payment is received in the month of sales and 2.5% if payment is received in the following month. Creditors are paid either on a prompt or 30 days basis. It is estimated that 10% of the creditors are in the prompt category. Solution : Cash Budget (For Quarter ending September 1987) July Rs. (A) Cash Inflows Cash Sales Collection from Debtors Last month Current month 1,40,000 48,750 38,000 2,26,750 (B) Cash Outflows Sundry Creditors Prompt Basis Others Salaries & wages Other Expenses Interest August Rs. 1,52,000 39,000 66,500 2,57,500 September Rs. 1,21,000 68,250 57,000 2,46,250

17,000 1,44,000 10,000 20,000 1,91,000

24,000 1,53,000 10,000 22,000 5,000 2,14,000 43,500 60,750 43,500 1,04,250

18,000 2,16,000 10,000 21,000 2,65,000 (18,750) 1,04,250 (18,750) 85,500

(C) Net Cash Inflow (A-B) Opening Balance + Surplus for the month Closing Balance

35,750 25,000 35,750 60,750

458

Management Accounting

Working Notes : It is assumed that salaries and wages are paid in the same month. (8) From the following information you are required to prepare a cash budget for six months from January 1987 to June 1987, Month by month, showing also the cash credit facility available from the Bank. Opening overdrawn balance is Rs. 1,50,000.
Sales Materials Purchases Rs. Rs. Rs. Wages Prod. Expenses Rs. Selling & Dist. Expenses Rs. Adm. Expases Rs.

Month

January February March April May June

1,44,000 1,94,000 1,72,000 1,77,200 2,05,000 2,17,400

50,000 62,000 51,000 61,200 74,000 77,600

20,000 24,200 21,200 50,000 44,000 46,000

12,000 12,600 12,000 13,000 16,000 16,400

8,000 10,000 11,000 13,400 17,000 18,000

3,000 3,400 4,000 4,400 5,000 5,000

Following further information is available. (1) Out of total sales, 50% are cash sales and balance 50% is received in the month following month of sale. Payment for purchase of assets is to be made Rs.16,000 in February, Rs. 25,000 in March and Rs. 50,000 in April. Proceeds from sales of scrap are to be received in May, amounting to Rs.6,000. Dividend of Rs. 90,000 is to be paid in June. Sales commission is to be paid at 3% of total sales in same month in which sales are made. Suppliers for materials are paid in the month following the month of purchases of materials. Cash credit facility granted is Rs. 2,00,000. Wages are paid in the same month. Creditors of Production, Selling & Distribution and Administration expenses are given one months credit period.

(2)

(3) (4) (5)

(6) (7) (8) (9)

Budgetary Control

459

Solution :
Jan. 87 (A) Cash Inflows Cash sales Collection from debtors Sales of scrap 72,000 72,000 (B) Cash Outflows Creditors for Materials Wages Production Expenses Sales & Dist. Expenses Admin Expenes Purchases of Assets Dividend Sales Commission 20,000 4,320 24,320 (c) Net Cash inflows or outflows (A-B) Opening over drafting +Surplus/Deficit for the month Closing overdrawing 47,680 1,50,000 47,680 1,02,320 49,980 1,02,320 49,980 52,340 43,640 52,340 (-)8,716 8,700 54,950 (-) 43,322 17,416 (-) 37,534 54,950 (-) 43,322 5,788 97,000 72,000 1,69,000 50,000 24,200 12,000 8,000 3,000 16,000 5,820 1,19,020 86,000 97,000 88,600 86,000 1,02,500 88,600 6,000 1,97,100 61,200 44,000 13,000 13,400 4,400 6,150 1,42,150 1,08,700 1,02,500 2,11,200 74,000 46,000 16,000 17,000 5,000 90,000 6,522 2,54,522 Feb. 87 Mar. 87 Apr. 87 May 87 Jun. 87

1,83,000 1,74,600 62,000 21,200 12,600 10,000 3,400 25,000 5,160 51,000 50,000 12,000 11,000 4,000 50,000 5,316

1,39,360 1,83,316

43,640 (-) 8,716 8,700

17,416 (-) 37,534

Note : Eventhough, the Cash Credit Facility is granted to the extent of Rs.2,00,000, the company is not likely to utilise it fully. At the end of June 1987, the overdrawn balance is likely to be only Rs.5,788. (9) ABC Co. Ltd. wishes to arrange overdraft facilities with its bankers during the period April to June 1987 when it will be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, indicating the extent of the bank facility the company will require at the end of each month.

460

Management Accounting

Month February March April May June Additional Information : (1)

Sales Rs. 1,80,000 1,92,000 1,08,000 1.74,000 1,26,000

Purchases Rs. 1,24,800 1,44,000 2,43,000 2,46,000 2,68,000

Wages Rs. 12,000 14,000 11,000 10,000 15,000

All Sales are Credit Sales 50% of Credit Sales are realised in the month following the sales and the remaining 50% in the Second month following. Creditors are paid in the month following the month of purchases. Cash at Bank of 1.4.87 (Estimated) Rs.25,000.

(2) (3)

Solution : Cash Budget of ABC Co. Ltd. Apr. 87 (A) Cash Inflows Sundry Debtors First 50% Second 50% 96,000 90,000 1,86,000 (B) Cash Outflows Sundry Creditors Wages 1,44,000 11,000 1,55,000 (C) Net Cash Inflows or outflows (A-B) (D) Estimated Cash Surplus or shortage Opening Cash Balance + Surplus/Deficit for the month Closing cash balance 25,000 31,000 56,000 56,000 (-) l,03,000 (-) 47,000 (-) 47,000 (-) l,20,000 (-) 1,67,000 31,000 (-) l,03,000 (-) l,20,000 2,43,000 10,000 2,53,000 2,46,000 15,000 2,61,000 54,000 96,000 1,50,000 87,000 54,000 1,41,000 May 87 June 87

Budgetary Control

461

Note : It can be seen that the company will be required to arrange for the bank finance of Rs. 47,000 at the end of May 1987 and an additional amount of Rs.1,20,000 at the end of June 1987. (10) The manager of a Repairs and Maintenance Department has submitted the following budget estimates that are to be used to construct a flexible budget to be used during the coming budget year. Details of cost Planned at 6000 direct repairs hours 30,000 40,200 13,200 Planned at 9000 direct repairs hours 30,000 60,300 16,800

Employee Salaries Indirect Repair Materials Miscellaneous Costs a.

Prepare a flexible budget for the department up to activity level of 10,000 repair hours (use increment of 1000). What would be the budget allowance at 8,500 repair hours?

b.

Solution : 8500 Hours Employee Salaries Indirect Repair Materials Miscellaneous Costs 30,000 56,950 16,200 1,03,150 Working Notes : From the analysis of the costs, it is observed that a. Employee salaries is a fixed cost as they remain constant for both 6000 repair hours and 9000 repair hours. Indirect repair materials is a variable cost as it proportionately increases from 6000 hours to 9000 hours. Miscellaneous costs is a semi-variable cost. This cost neither remained constant nor increased proportionately the activity level of 6000 hours to 9000 hours. The cost increased by Rs. 3,600 for the increase of 3000 hours. means that the variable portion of this cost is Rs. 1.20 hour. Hence, out of total miscellaneous cost of Rs. 13,200 for 6000 hours, Rs. 7,200 is variable portion and balance 6,000 is the fixed portion.
Management Accounting

10000 Hours 30,000 67,000 18,000 1,15, 000

b.

c.

462

(11) Viveka Elementary School has a total of 150 students consisting of 5 sections with 30 students per section. The school plans for a picnic around the city during the week end to places such as the zoo, the amusement park, the planetarium etc. A private transport operator has come forward to lease out the buses for taking the students. Each bus will have a maximum capacity of 50 (excluding 2 seats reserved for the teacher accompanying the students). The school will employ 2 teachers for each bus paying them an allowance of Rs. 50 per teacher. It will also lease out the required number of buses. The following are the other cost estimates Cost per student Rs. Breakfast Lunch Tea Entrance fee at zoo Rent Rs. 650 per bus. Special permit fee Rs. 50 per bus. Block entrance fee of the planetarium Rs. 250. Prizes to the students for games Rs. 250. No costs are incurred in respect of the accompanying teachers (except the allowance of Rs. 50 per teacher). You are required to prepare a. A flexible budget estimating the total cost for the levels of 30, 60, 90, 120 and 150 students. Each item of cost is to be indicated separately. Compare the average cost per student of these levels. What will be your conclusions regarding the break even level of students if the school proposes to collect Rs. 45 per student? 5 10 3 2

b. c.

Budgetary Control

463

Solution : No. of Students a. b. Variable Cost Semi-fixed costs Rent of the bus Permit Fees Allowances to teachers c. Fixed Costs Entrance Fees Prizes to students Total Costs Average Cost per student Total Cost No. of students (12) Prepare the flexible budget for overheads on the basis of data given below. Ascertain the overheads rates at 50%, 60% and 70% capacity. At 60% capacity Rs. Variable Overheads Indirect Material Indirect Labour Semi-Variable Overheads Electricity (40% fixed, 60% variable) Repairs and Maintenance (80% fixed, 20% variable) Fixed Overheads : Depreciation Insurance Salaries Total Overheads Estimated Direct Labour Hours 16,500 4,500 15,000 93,000 1,86,000 3,000 30,000 6,000 18,000 250 250 1900 63.33 250 250 3300 55.00 250 250 3900 43.33 250 250 5300 44.17 250 250 5900 39.33 650 50 100 1300 100 200 1300 100 200 1950 150 300 1950 150 300 30 600 60 1200 90 1800 120 2400 150 3000

464

Management Accounting

Solution : Calculation of Overheads Rates 50% Capacity Rs. Variable Overheads Indirect Material Indirect Labour Semi Variable Overheads Electricity Repairs and Maintenance Fixed Overheads Depreciation Insurance Salaries Total Overheads Estimated Direct Labour Hours Overhead Rate (Labour Hour Rate) Re.0.55 Re.0.50 Re.0.46 1,55,000 1,86,000 2,17,000 16,500 4,500 15,000 85,900 16,500 4,500 15,000 93,000 16,500 4,500 15,000 1,00,100 27,000 2,900 30,000 3,000 33,000 3,100 5,000 15,000 6,000 18,000 7,000 21,000 60% Capacity Rs. 70% Capacity Rs.

(13) A Factory can produce 60,000 units per annum at its 100% capacity. The estimated costs of production are as under. Direct Materials Direct Labour Indirect Expenses Fixed Variable Semi-variable Rs. 1,50,000 per annum Rs. 5 per unit Rs. 50,000 per annum up to 50% capacity and an extra expenses of Rs. 10,000 for every 20% increase in capacity or part thereof. Rs. 3 per unit. Rs. 2 per unit

The factory produces only against orders. If the production programme of the factory is as indicated below, and the management desires to ensure a profit of Rs.1,00,000 for the year, work out the average selling price at which each unit should be quoted.

Budgetary Control

465

For three months of the year - 50% capacity Remaining nine months of the year - 80% capacity Solution : Calculation of total cost 50% capacity Number of units produced Direct Material - Rs. Direct Labour - Rs. Variable Expenses - Rs. Fixed Expenses Semi-Variable Expenses - Rs. Total Cost 7,500 22,500 15,000 37,500 37,500 12,500 1,25,000 80% capacity 36,000 1,08,000 72,000 1,80,000 1,12,500 32,500 5,05,000 Total capacity 43,500 1,30,500 87,000 2,17,500 1,50,000 45,000 6,30,000

Thus, the total cost during the year is likely to be Rs.6,30,000. If it is desired to earn a profit of Rs. 1,00,000 the total amount to be covered by the units to be sold will have to be Rs.7,30,000 (i.e. Rs. 6,30,000 + Rs. 1,00,000). As the total units produced are estimated to be 43,500, the above amount will have to be covered by 43,500 units. Hence, the average selling price per unit will be Rs.7,30,000 43,500 Notes : (1) (2) It is assumed that whatever units are produced can be sold. It is assumed that the production and the incidence of all the indirect expenses is equally spread during the year. From the following particulars, prepare a flexible budget for the three months ending 30th September showing the estimated sales, sales cost and profit for 60%, 80% and 100% activity. Assume that all items produced are sold. Rs. 4,20,000 2,80,000 3,50,000 4,45,000 14,95,000 466
Management Accounting

Rs. 16.78 per unit (approx.)

(3)

Fixed Expenses Management salaries Rent and Taxes Depreciation on machinery Sundry office cost

Rs. Semi-variable expenses at 50% capacity Plant Maintenance Indirect Labour Salesmens Salary & Expenses Sundry Expenses 1,25,000 4,95,000 1,45,000 1,30,000 8,95,000 Variable Expenses at 50% capacity Materials Labour Salesmens Commission 12,00,000 12,80,000 1,90,000 26,70,000 Semi-variable expenses remain constant between 41% and 70% activity, increase by 10% of the above figures between 71% and 80% activity and increase by 15% of the above figures between 81% and 100% activity. Fixed expenses remain constant whatever may be the level of activity. Sales at 60% activity are Rs.51,00,000, at 80% activity are Rs. 68,00,000 and at 100% activity are Rs.85,00,000. Flexible Budget 60% capacity Rs. (A) Sales (B) Sales Cost (1) Fixed Expenses Management Salaries Rent and Taxes Depreciation on Machinery Sundry office cost 4,20,000 2,80,000 3,50,000 4,45,000 14,95,000 4,20,000 2,80,000 3,50,000 4,45,000 14,95,000 4,20,000 2,80,000 3,50,000 4,45,000 14,95,000 51,00,000 80% capacity Rs. 68,00,000 100% capacity Rs. 85,00,000

Budgetary Control

467

60% capacity Rs. (2) Semi Variable Expenses Plant Maintenance Indirect Labour Salesmens Salary and Expenses Sundry Expenses 1,25,000 4,95,000 1,45,000 1,30,000 8,95,000 (3) Variable Expenses Material Labour Salesmans Commission 14,40,000 15,36,000 2,28,000 32,04,000 Total Sales Cost 1 + 2 + 3 (C) Profit A - B 55,94,000 (4,94,000)

80% capacity Rs.

100% capacity Rs.

1,37,500 5,44,500 1,59,500 1,43,000 9,84,500

1,43,750 5,69,250 1,66,750 1,49,500 10,29,250

19,20,000 20,48,000 3,04,000 42,72,000 67,51,500 48,500

24,00,000 25,60,000 3,80,000 53,40,000 78,64,250 6,35,750

(15) Based on sales foreast for the season, C Ltd. has prepared the following production scheme for the coming month. 30,000 units of Product A and 20,000 units of product B. the manufacturing specifications for the products are as follows. Product A 2 Kgs. Material X @ Rs. 3 1/2 Kg. Material Y @ Rs. 2 2 hours direct labour @ Rs. 20 Product B 3 Kgs. Material W Rs. 8 3/4 Kg. Material Y @ Rs. 2 11/2 hours direct labour @ Rs. 20

To the direct labour hours, a 5% allowance for idleness (accounted for as overheads) should be added. Indirect labour time is estimated to be 5% of direct labour hours (excluding idleness) and the wage rate for indirect labour is Rs. 15. The overhead estimate (not shown above) is as follows Fixed Cost per month Depreciation Insurance Superintendence Rs. Rs. Rs. 69,000 8,000 30,000

Rs. 1,07,000 468


Management Accounting

Variable Costs : Rs 8 per direct labour hour. Note : This rate includes the cost of idle lime and indirect labour. It is planned to increase the inventory of raw material X by 4,000 Kgs and to decrease the inventory of raw material W by 2,000 Kgs. as of the begining after next month. You are required to prepare and estimate of the amount of cash necessary for manufacturing operations of the coming month. Assume that the materials and wages cost are paid in the month of purchase. Solution : Computation of Requirement of Cash (A) For Raw Material : (Both Products A & B) X - 60,000 Kgs @ Rs. 3 Y - 30,000 Kgs @ Rs. 2 W - 60,000 Kgs @ Rs. 8 Rs. 1,80,000 60,000 4,80,000 7,20,000 Add : Increase in stock of X 4,000 kgs @ Rs. 3 12,000 7,32,000 Less : Decrease in stock of W 2,000 Kgs @ Rs. 8 16,000 7,16,000 (B) For Direct Wages Product A - 60,000 hours @ Rs. 20 Product B - 30,000 hours @ Rs. 20 12,00,000 6,00,000 18,00,000 (C ) For Overheads (1) Idle Time - 5% of 90,000 hours i.e. 4,500 hours @ Rs. 20 (2) Indirect Labour - 5% of 90,000 hours i.e. 4,500 hours @ Rs. 15 (3) (4) Variable Costs - 90,000 hours @ Rs. 8 Fixed Overheads 67,500 7,20,000 1,07,000 9,84,500 35,00,500 90,000 Rs.

Budgetary Control

469

(16) A company is at present working at 90% of its capacity and producing 13,500 units perannum. It operates a flexible budgetary control system. The following figures (excluding material and labour cost) are obtained from its budget : 90% (a) (b) (c) (d) Sales Fixed Expenses Semi-Fixed Expenses Semi-Variable Expenses Rs. Rs. Rs. Rs. 15,00,000 3,00,500 97,500 1,42,000 100% 16,00,000 3,00,500 1,00,500 1,49,500

Material and Labour Cost per unit are constant under present conditions. Profit margin is 10% at 90% capacity : (a) (b) You are required to determine the cost of producing an additional 1,500 units. What would you recommend for an export price for these 1,500 units taking into account that overseas prices are much lower than indigenous prices?

Solution : Cost Sheet 90% Capacity Variable Cost Material / Labour Variable portion of Semi-Fixed Expenses Variable portion of Semi-Variable Expenses a. Total Variable Cost Fixed Cost Fixed Expenses Fixed portion of Semi-Fixed Expenses Fixed portion of Semi-Variable Expenses b. c. d. e. 470 Total Fixed Cost Total Cost (a+b) Profit Sales 74,500 4,45,500 13,50,000 1,50,000 15,00,000 74,500 4,45,500 14,50,500 1,49,500 16,00,000
Management Accounting

100% Capacity

8,10,000

9,00,000

27,000

30,000

67,500 9,04,500

75,000 10,05,000

3,00,500

3,00,500

70,500

70,500

Hence, the cost of producing 1,500 units will be Rs. 1,00,500 i.e. Rs. 14,50,500 less Rs. 13,50,000. Recommended export price for these 1,500 units will be Rs. 67 i.e. Rs. 1,00,500 / 1,500. Working Notes : a. Semi-Fixed Expenses With every 10% capacity increase, semi-fixed expenses increase by Rs. 3,000. This means that variable portion of semi-fixed expenses is Rs. 3,000 for 10% capacity. For 90% capacity it will be Rs. 27,000 and for 100% capacity, it will be Rs. 30,000. b. Semi-Variable Expenses With every 10% capacity increase, semi-variable expenses increase by Rs. 7,500. This means that variable portion of semi-fixed expenses is Rs. 7,500 for 10% capacity. For 90% capacity it will be Rs. 67,500 and for 100% capacity, it will be Rs. 75,000. (17) Develope the proforma (estimated) income statement for the months of October, November and December of Ajax Lunatics Ltd. from the following information. (a) (b) (c) (d) (e) (f) Sales are projected at Rs. 2,50,000, Rs. 3,00,000 and Rs. 2,00,000 for October, November and December respectively. Cost of goods sold is Rs. 75,000 plus 20% of sales per month. Selling Expenses are 3% of sales. Rent is Rs. 7,500 per month. Administrative Expenses is 15% of sales per month. The company has Rs. 3,00,000 at 10% loan-The interest is payable monthly. Corporate tax rate is 60%

Solution : Proforma (Estimated) Income Statement of Ajax Lunatics Limited. October (A) Sales (B) Cost Cost of goods sold Selling Expenses Rent Administretive Expenses Interest on Loan Total Cost (C ) Profit before tax (A - B) (D) Income Tax - 60% of C (E) Profit after tax (C - D) 2,50,000 1,37,500 7,500 7,500 37,500 2,500 1,92,500 57,500 34,500 23,000 November 3,00,000 1,50,000 9,000 7,500 45,000 2,500 2,14,000 86,000 51,600 34,400 December 2,00,000 1,25,000 6,000 7,500 30,000 2,500 1,71,000 29,000 17,400 11,600

Budgetary Control

471

(18) M/s. Agarval fabricating and Manufacturing Co. Ltd. is presently working at 50% capacity, producing and selling, 1,000 units of a product. You are required to find out the profits the concern will make by working at 60% and 80% capacity. At 50% capacity, the selling price is Rs. 200 per unit. Whereas the product cost is Rs. 160 as given below. Rs. Materials Cost Direct wages Factory overheads Selling and Admn. overheads 80 30 30 (of which 60% is variable) 20 (of which 50% is fixed).

At 60% capacity, material prices go up by 10% and selling price reduced by 5%. At 80% capacity, there is increase in labour cost by 10% and variable factory overheads go up by Rs. 2 per unit. The variable selling and administration overheads increase by Re. I per unit, the other costs and selling price remain unchanged as at 60%. Flexible Budget 50% Capacity (A) Number of units sold Selling Price per unit Sales (B) Cost (1) Materials Cost (2) Direct Wages (3) Variable Overheads Factory Selling & Administration (4) Fixed Overheads Factory Selling & Administration Total Cost (C) Profit i.e. A - B 12,000 10,000 1,60,000 40,000 12,000 10,000 1,97,200 30,800 12,000 10,000 2,65,200 38,800 18,000 10,000 21,600 12,000 32,000 17,600 Rs. Rs. Rs. 80,000 30,000 1,05,600 36,000 1,40,800 52,800 1,000 200 2,00,000 60% Capacity 1,200 190 2,28,000 80% Capacity 1,600 190 3,04,000

472

Management Accounting

QUESTIONS 1. What do you mean by Budget and Budgetary Control? What are the advantages of Budgetary Control as a cost control technique? What are the prerequisites for the successful implementation of Budgetary Control System? What is the meaning of Budget and Budgetary Control. State and explain various budgets which can be established in the following functional areas of operation a) b) c) 3. Sales/Marketing Production Finance

2.

Write short notes on a) b) c) Budget Manual Fixed and Flexible Budgets Cash Budget

Budgetary Control

473

PROBLEMS (1) The sales manager of a manufacturing company expects to sell 25,000 units of a certain product. The production director provides the following information. Two kinds of raw materials X and Y are required for each unit of final product and 2 units of X and 3 units of Y are required for one unit of final product. The estimated opening balance at the commencement of next year areFinal product X Y - 5,000 units - 6,500 units - 8,000 units

The desirable closing balance at the end of next year are Final Product X Y - 7,000 units - 6,500 units - 8,000 units

Draw the production budget for the next year.

(2)

A Ltd. manufactures two products X and Y making the use of following raw materials in the proportion shown. Raw material Rl R2 R3 R4 Product X 80% 20% 50% 50% Product Y

The finished weight of products X and Y are equal in weight of their ingredients. During a month, it is expected that 1200 kgs. of X and 4000 kgs of Y will be sold.

474

Management Accounting

Actual and budgeted inventories for the month are as below. Material Actual Opening Stock Kgs. R1 R2 R3 R4 X Y 300 200 4000 5000 200 1000 Budgeted Closing Stock Kgs. 400 800 6000 4000 100 1200

The purchase price of materials is expected to be as below. Cost Per Kg. Rs. R1 R2 R3 R4 50 40 10 20

All materials will be purchased on 1st of the month. Prepare -(a) Production Budget. (b) Purchases Budget. (3) A Ltd. produces a standard product. The estimated cost per unit in given below. Rs. Raw materials Direct wages Direct Expenses Variable Overhead 10 8 2 5

Fixed overheads are estimated to Rs. 70,000 selling price per umt is Rs. 40. Prepare a flexible budget at 50%, 70% and 90% level of activity. Assume that output at 100% level of activity is 10,000 units.

Budgetary Control

475

(4)

The following expenses relate to a cost centre operating at 80% of normal capacity (Sales are Rs.1,20,000) Draw up flexible Administration, Selling and Distribution costs budget operating at 90%, 100% and 110% of normal capacity. Administration Costs Office Salaries General Expenses Depreciation Rates and Taxes Selling Costs Salaries Travelling Expenses Sales Office Expenses General Expenses Distribution Costs Wages Rent Other Expenses Rs.3,000 0.5% of sales 2% of sales 4% of sales 1.5% of sales 1% of sales 1% of sales Rs. 3,000 1.5% of sales Rs. 1,500 Rs. 1,750

(5)

The expenses budgeted for production of 10,000 units in a factory are furnished below. Per Unit Rs. Materials Labour Variable Overheads Fixed Overheads ( Rs.1,00,000) Variable Expenses (Direct) Selling Expenses (10% Fixed) Distribution Expenses (20% Fixed) Adinimstrative Expenses (Rs.50,000) Total Cost of sale per unit (to make and sale) Prepare a budget for the production of a. 8,000 units and b. 6,000 units. 70 25 20 10 5 13 7 5 155

476

Management Accounting

Assume that administrative expenses are rigid for all levels of production. (6) Following are the actuals for the year 1985. Rs. Sales 20,000 units @ Rs.3 per unit Raw Material Direct Labour Cost Variable Overheads Fixed Overheads 60,000 26,500 5,000 8,000 10,000

The management expects following estimate in 1986. Sales to increase to 30,000 units, selling price remaining unchanged. Raw materials prices increase by 10%, wage rate to increase by 10% but labour productivity improves by 5%. Fixed overheads are expected to increase by Rs. 2,000. You are required to prepare the budget for 1986. (7) Production costs of a factory for a year are as follows. Direct Wages Direct Materials Production Overheads : Fixed Variable Rs. 40,000 Rs. 60,000 Rs. 90,000 Rs. 1,20,000

During the forthcoming year, it is anticipated that : (a) The average rate for direct labour remuneration will fall from 90 paise to 75 paise per hour. Production efficiency will be reduced by 5%. Price per unit of direct material and other materials and services which comprise overheads will remain unchanged and Direct labour hours will increase by 33 1/3.

(b) (c)

(d)

Draw up a budget and compute a factory overhead rate, the overheads being absorbed on a direct wages. (8) ABC Ltd. manufacturing a single product is facing a severe competition in selling at Rs. 50 per unit. The company is operating at 60% level of activity at which level sales are Rs. 12,00,000. Variable costs are Rs.30 per unit. Semi variable costs may be considered

Budgetary Control

477

as fixed at Rs. 90,000 when output is nil and variable element is Rs.250 for each additional 1% level of activity. Fixed costs are Rs, 1,50,000 at the present level of activity, but at the level of activity of 80% or above if reached, these costs are expected to increase by Rs.5,000. To cope with the competition, the management of the company is considering a proposal to reduce the selling price by 5%. You are required to : (a) Prepare a statement showing the operating profit at levels of activity of 60%, 70% and 80%. Assuming that the selling price remains at Rs.50 per unit. If selling price is reduced by 5%, show the number of units which will be required to be sold to maintain the present profits.

(b)

(9)

A company, producing electronic watches, estimates the following factory overheads costs for producing 5,000 Units Indirect Materials Indirect Labour Inspection Cost Heat, light & power Expendable tools Supervision Costs Equipment depreciation Factory Rent Rs. 16,000 Rs. 30,000 Rs. 16,000 Rs. 8,000 Rs. 8,000 Rs. 8,000 Rs. 4,000 Rs. 4,000

Indirect labour, indirect material and expendable tools are entirely variable. Heat, light and power and inspection costs are variable to the extent of 50% and 40% respectively. Other costs are fixed costs for a month. Prepare a flexible budget for overheads for production of 4,000 and 6,000 units per month. Also find out the average factory overheads per unit for these two production levels. (10) Anil and Avinash Enterprises is currently working at 50% capacity and produces 10,000 units. Estimate the profits of the company when it works at 60% and 70% capacity. At 60% capacity, the raw materials cost increases by 2% and the selling price falls by 3%. At 70% capacity the raw materials cost increases by 4% and selling price falls by 5%. At 50% capacity, the product costs Rs. 180 per unit and is sold for Rs.200 per unit.

478

Management Accounting

The unit cost of Rs. 180 is made up as below. Materials cost Wages Factory overheads Administration overheads Rs. 100 Rs. 30 Rs. 20 (40% Fixed) Rs. 30 (50% fixed)

(11) ABC Ltd. manufactures a single product for which market demand exists for additional quantity. Present sale of Rs. 60,000 per month utilities only 60% capacity of the plant. Sales Manager assures that with a reduction of 10% in the price, he would be in a position to increase the sale by about 25% to 30% . The following data are available. (a) (b) (c) (d) Selling price Variable cost Semi-variable cost Fixed coct - Rs. 10 per unit - Rs. 3 per unit - Rs. 6,000 plus Rs.0.50 per unit Rs. 20,000 at present level, estimated to be Rs.24,000 at 80% output.

You are required to submit the following statements to the Board showing. (1) The operating profits at 60%, 70% and 80% levels at current selling price and at proposed selling price. The percentage increase in the present output which will be required to maintain the present profit margin at the proposed selling price.

(2)

(12) A manufacturing company has an installed capacity of 1,20,000 units per annum. The cost structure of the products manufactured is as under : (i) Variable Cost ( Per Unit) Materials Labour Rs. 8 Rs. 8

(Subject to a minimum of Rs.56,000 per month) Overheads (ii) Rs. 3

Fixed overheads are Rs. 1,04,000 per annum.

(iii) Semi variable overheads Rs.48,000 per annum at 60% capacity, which will increase by Rs.6000 per annum for increase of every 10% of the capacity utilization or any part thereof.

Budgetary Control

479

The capacity utilization for the next year is estimated at 60% for 2 months, 75% for 6 months and 80% for the balance part of the year. If the company is planning to have a profit of 25% on the selling price, calculate the estimated selling price for each unit of production. Assume there is no opening or closing stock. (13) The monthly budgets for manufacturing overhead of a concern for two levels of activity were as follows Capacity Budgeted Production (units) Wages Consumable Stores Maintenance Power and Fuel Depreciation Insurance You are required to a. b. c. Indicate which of the items are fixed, variable and semi-variable. Prepare a budget for 80% capacity. Find out the total cost, both fixed and variable, per unit of output at 60%, 80% and 100% capacity. 60% 600 (Rs.) 1,200 900 1,100 1,600 4,000 1,000 9,800 100% 1000 (Rs.) 2,000 1,500 1,500 2,000 4,000 1,000 12,000

(14) From the following data, prepare a flexible budget for the production of 40,000 units, 60,000 units and 75,000 units, distinctly showing variable and fixed costs as well as total costs. Also indicate element wise cost per unit. Budgeted output and budgeted cost per unit Budgeted output Direct Material Direct Labour Direct Variable Expenses Manufacturing Variable Overheads Fixed Production Overheads Administration Overheads (Fixed) Selling Overheads Distribution Overheads 100000 units Per unit cost Rs. 90 45 10 40 5 5 10 (10% fixed) 15 (20% fixed)

480

Management Accounting

(15) The budget manager of Progressive Electrical Limited, is preparing a flexible budget for the accounting year commencing 1st April 1995. The company produces one product a component - Kaypee. Direct Material costs Rs. 7 per unit. Direct Labour averages Rs. 2.50 per hour and requires 1.60 hours to produce one unit of Kaypee. Salesmen are paid a commission of Re. 1 per unit sold. Fixed selling and administration expenses amount to Rs. 85,000 per year. Manufacturing overheads under specified conditions of volume have been estimated as follows Volume of Production (units) 1,20,000 Rs. Indirect Materials Indirect Labour Inspection Maintenance Supervision Depreciation Engineering Services Total Manufacturing Overheads 2,64,000 1,50,000 90,000 84,000 1,98,000 90,000 94,000 9,70,000 1,50,000 Rs. 3,30,000 1,87,500 1,12,500 1,02,000 2,34,000 90,000 94,000 11,50,000

Normal capacity of production of the company is 1,25,000 units. Prepare a budget of total cost at 1,40,000 units of output. (16) Excellent Manufacturers can produce 4000 units of a certain product at 100% capacity. The following information is obtained from the books of accounts June 94 2,800 Rs. 500 1,800 700 1,400 1,000 200 1,400 July 94 3,600 Rs. 560 2,000 900 1,800 1,000 240 1,400

Units produced Repairs and Maintenance Power Shop Labour Consumable Stores Salaries Inspection Depreciation

The rate of production is 10 units per hour. Direct Materials cost is Re. 1 and Direct Wages per hour is Rs. 4. You are required to -

Budgetary Control

481

a. b.

Compute the cost of production at 100%, 80% and 60% capacity showing the variable, fixed and semi-fixed items under the flexible budget. Find out the overhead absorption rate per unit at 80% capacity.

(17) The following data are available for a manufacturing company for a yearly period Rs. in Lakhs Fixed Expenses - Wages and Salaries - Rent, Rates and Taxes - Depreciation - Sundry Administrative Expenses Semi-Variable Expenses (at 50% capacity) - Maintenance and Repairs - Indirect Labour - Sales Department Salaries - Sundry Administrative Salaries Variable Expenses (at 50% capacity) - Material - Labour - Other Expenses 9 .5 6.6 7.4 6 .5 3 .5 7 .9 3 .8 2.8 21.7 20.4 7.9 98.0 Assume that the fixed expenses remain constant at all levels of production, semi-variable expenses remain constant between 45% and 65% of capacity increasing by 10% between 65% and 80% capacity and by 20% between 80% and 100% capacity. Sales at various levels are Rs. in Lakhs 50% capacity 60% capacity 75% capacity 90% capacity 100% capacity 100 120 150 180 200

Prepare a flexible budget for the year at 60% and 90% capacities and estimate the profits at these levels of output.

482

Management Accounting

(18) A factory is currently running at 50% capacity and produces 5,000 units at a cost of Rs. 90/- per unit as per details below : Rs. Material Labour Factory overheads Administrative overheads 50 15 15 (Rs. 6/- fixed) 10 (Rs. 5/- fixed)

The current selling price is Rs. 100/- per unit. At 60% working, material cost per unit increases by 2% and selling price per unit falls by 2%. At 80% working, material cost per unit increases by 5% and selling price per unit falls by 5%. Estimate profits of the factory at 60% and 80% working and offer your comments. (19) On 30th September 1990, the Balance Sheet of Melodies Pvt. Ltd. retailers of musical instruments, was as under Liabilities Ordinary shares of Rs.10 each fully paid Reserves and surplus Trade Creditors Proposal Dividend 20,000 10,000 40,000 15,000 Stock Trade Debtors Balance at Bank 85,000 Rs. Assets Equipment (at cost) Less : Depreciation Rs. 20,000 5,000 15,000 20,000 15,000 35,000 85,000

The company is developing a system of forward planning and on 1st October 1990, it supplies the following information. Credit Sales Rs. Sept. 90 (Actual) Oct. 90 (Budget) Nov. 90 (Budget) Dec. 90 (Budget) 15,000 18,000 20,000 25,000 Cash Sales Rs. 14,000 5,000 6,000 8,000 Credit Purchases Rs. 40,000 23,000 27,000 26,000

All trade debtors are allowed one months credit and are expected to settle promptly. All trade creditors are paid in the month following delivery.
Budgetary Control

483

On 1st October 1990, all the equipment was replaced at a cost of Rs. 30,000. Rs. 14,000 was allowed in exchange for the old equipment and a net payment of Rs. 16,000 was made. Depreciation is to be allowed at the rate of 10% per annnm. The proposed dividend will be paid in December 1990. The following expenses will be paidWages Rs. 3,000 per month. Administration Rs. 1500 per month. Rent Rs. 3600 for the year to 30th September 1991 (to be paid in October, 1990) The gross profit percentage on sales is estimated at 25%. You are required (1) (2) To prepare cash budget for the months of October, November and December. To prepare Income Statement for the three months ended 31st December 1990.

(20) Develop Performa income statement for the months of July, August and September for a company for the following information. (a) Sales are projected at Rs. 2,25,000, Rs. 2,40,000 and Rs. 2,15,000 for July, August and September respectively. Cost of goods sold is Rs.50,000 plus 30% of selling price per month. Selling Expenses are 3% of sales. Rent is Rs. 7,500 per month, administrative expenses for July are expected to be Rs. 60,000 but are expected to rise 1% per month over the previous months expenses. The company has Rs.3,00,000 of 8% loan interest payable monthly. Corporate Tax rate is 70%.

(b) (c) (d)

(e) (f)

(21) The projected sales and purchases of ABC Ltd. for the months July to November 1983 are Sales (Rs.) July August September October November 6,20,000 6,40,000 5,80,000 5,60,000 6,00,000 Purchases (Rs.) 3,80,000 3,33,000 3,50,000 3,90,000 3,40,000

484

Management Accounting

The wages are expected to be Rs.100,000 per month. The management is expected to pay two months wages as bonus during October 1983. The company is expected to pay advance income tax Rs. 90,000 before 15th September 1983. The company has ordered in June 1983 for a machine costing Rs. 16,00,000. The Bank has agreed to finance the purchase of the machine which is expected to be delivered in January 1984. The company has advanced 5% in June 1983 and they have agreed to pay another 10% advance after 3 months. The company extends 2 months credit for the customers and enjoys one month credit from the suppliers. The general expenses for the company is Rs.60,000 per month payable at the end of each month. The company anticipates to receive dividends of 10% for the investments of 90,000 shares of Rs. 10 each during October 1983. The company anticipates to have an overdraft of Rs. 40,000 on 1st September 1983 (limit sanctioned is Rs. 55,000). Draw a cash budget for September 83 to November 83 for approaching bankers for a short term further credit. (22) From the following budgeted data of ABC Ltd., prepare cash budget for the quarter ending 31st December 1984. Month August September October November December Additional information : Cash on hand on 1,10.84 Rs. 5,000 Sales 20% realised in the month of sale. Discount allowed 2%. Balance realised in subsequent month. Purchases - These are paid in the following the month of supply. Wages - 25% in arrears paid in the following month. Misc. Expenses - Paid a month in arrears. Rent - Rs.1,000 per month paid quarterly in advance, due in October. Income Tax - Instalments of Rs. 25,000 due on or before 15.12 84. Income from investment - Rs. 5,000 received quarterly April, July, October etc. Insurance claim - Rs. 72,936 receivable in December. Sales 1,20,000 1,30,000 80,000 1,16,000 88,000 Purchases 84,000 1,00,000 1,04,000 1,06,000 80,000 Wages 10,000 12,000 8,000 10,000 8,000 Misc. Exp. 7,000 8,000 6,000 12,000 6,000

Budgetary Control

485

(23) A firm expects to have to Rs. 30,000 in Bank on 1.10.86 and requires you to prepare an estimate of cash position during the three months October 86 to December 86. The following information is supplied to you. Month Sales Purchases Rs. August September October November December 40,000 46,000 50,000 72,000 84,000 Rs. 24,000 28,000 32,000 36,000 40,000 Wages Rs. 6,000 6,500 6,500 7,000 7,250 Factory Exp. Rs. 3,000 3,500 4,000 4,000 4,250 Office Exp. Rs. 4,000 4,000 4,000 4,000 4,000 Selling Exp. Rs. 3,000 3,500 3,500 4,000 4,000

Other information : (1) (2) (3) (4) (5) 25% of the sales are for cash, remaining amount in the month following that of sale. Suppliers supply goods at 2 months credit. Delay in the payment of wages and all other expenses one month. Income Tax of Rs.l0,000 is due to be paid in December. Preference shares dividend of 10% on Rs.l ,00,000 is to be paid in October.

(24) Mr. Ashok Kumar, the Finance Manager of Mazumdar Castings Ltd. is preparing the cash budget for the first six months of 1982, on the basis of the following information : (i) (ii) Costs and Price remains unchanged. Out of the total sales, cash sales are 25%, the balance being credit sales. 60% of the credit sales are collected in the month after sales, 30% are collected in the second month, and the balance 10% in the third month after sale. He does not expect any bad debts.

(iii) The Gross Profit Margin is expected to be 20% (iv) Actual sales and forecast sales are as follows : Oct. 81 Nov. 81 Dec. 81 Jan. 82 Feb. 82 486 Rs. Rs. Rs. Rs. Rs. 12,00,000 14,00.000 16,00,000 8,00,000 8,00,000 Mar. 82 April 82 May 82 Jun. 82 Jul. 82 Rs. Rs. Rs. Rs. Rs. 8,00,000 12,00,000 12,00,000 8,00,000 10,00,000

Management Accounting

(v)

Anticipated Cash Purchases, there being no Credit Purchases: Jan 82 Feb. 82 Mar. 82 Rs. Rs. Rs. 6,40,000 7,00,000 10,00,000 April 82 May 82 Jun. 82 Rs. Rs. Rs. 9,10,000 6,40,000 9,60,000

(vi)

Wages and salaries to be paid in cash : Jan 82 Feb. 82 Mai. 82 Apr. 82 May 82 Jun 82 Rs. Rs. Rs. Rs. Rs. Rs. 1,40,000 1,60,000 2,00,000 2,20,000 1,60,000 1,40,000

(vii) Interest on 20,00,000 8% Debentures was due on June 30, 1982 (half yearly) (viii) Excise deposit due on March 31, 1982 Rs. 3,00,000. (ix) Acquisition of plant and equipment planned for May 1982 Rs. 10,00,000. (x) Miscellaneous Expenses on a cash basis every month at Rs. 15,000 plus 10% of sale.

(xi) The company will have a cash balance of Rs. 5,00,000 on 31.12,81. Mr. Ashok Kumar believes that this is a high level and is planning on a continuous balance of Rs. 4,00,000 (a) (b) Prepare the Cash budget for six months to June 1982 . If additional finance is required, recommend the type of finance to be obtained.

(25) A company has its cost of goods of 70% of its sales, 70% of this cost is paid in the month of the sale and the balance in the next month. Salary and administrative expenses amount to Rs. 40,000 per month plus 5% of sales. These expenses must be paid during the month following the month when expenses are actually incurred . The company has also 10% Debentures of Rs. 1,50,000 and interest has to be paid in 4 quarters from January onwards. The company gives its actual and forecast sales as below. Actual Sales January February March April Rs. 2,00,000 2,00,000 3.00,000 3,00,000 Forecast sales May June July August Rs. 2,00,000 2,50,000 2,50,000 3,00,000

Budgetary Control

487

You are required to prepare a cash flow schedule for six months from March onwards. (26) Following details are available in case of Pam Industries Ltd. Actual Sales January February March April Rs. 65,000 75,000 90,000 80,000 Estimated sales May June July August Rs. 1,05,000 1.20,000 1,25,000 1,35,000

Consider the following additional information : (1) Cash sales are 50 per cent of the total sales. The remaining 50 per cent will be collected equally during the following two months. Cost of goods manufactured is 70 per cent of sales. 90 per cent of this cost is paid during the first month after incurrence and the balance is paid in the following month. Sales and administrative expenses are Rs. 15,000 per month plus 10 per cent of sales. All these expenses are paid during the month of incurrence. Half- yearly interest of 6 per cent on Rs. 4,50,000 Debentures is paid during July. Rs. 60,000 are expected to be invested in fixed assets during July. A dividend of Rs. 15,000 will be paid in July. An income tax of Rs. 15,000 will be paid in July.

(2)

(3)

(4) (5) (6) (7)

It is the policy of the company to have a minimum cash balance of Rs. 30,000/-. Accordingly as on 30th April, the actual cash balance was Rs. 30,000/-. The Management wishes to know whether it will be required to borrow during the quarter ending on 31st July and if so when and how much. (27) Prepare a cash budget for the three months ending 30th June 1986 from the information given below. (a) Month February March April May June 488 Sales Materials Rs. Rs. 14,000 15,000 16,000 17,000 18,000 9,600 9,000 9,200 10,000 10,400 Wages Rs. 3,000 3,000 3,200 3,600 4,000 Overheads Rs. 1,700 9,900 2,000 2,200 2,300

Management Accounting

(b)

Credit terms are : Sales/Debtors - 10% of sales are on cash, 50% of the credit sales are collected next month and balance in the month following Creditors Materials Wages Overheads - 2 months - 1/4 month - 1/2 month

(c) (d) (i)

Cash and Bank balance on 1st April 1986 is expected to be Rs.6,000. Other relevant information : Plant and Machinery will be installed in February 1986 at a cost of Rs. 96,000. The monthly instalments of Rs. 2,000 is payable from April onwards. Dividend @ 5% on preference share capital of Rs.2,00,000 will be paid on 1st June.

(ii)

(iii) Advance to be received for sale of vehicle Rs. 9,000 in June. (iv) (v) Dividends from investment amounting to Rs. 1,000 expected to be received in June Income Tax advance is to be paid in June - Rs. 2,000.

(28) Prepare a cash budget of XYZ Ltd. on the basis of the six months commencing from April 1989. (1) (2) (3) Cost and prices remain unchanged. Cash sales are 25% of the total sales and balance 75% will be credit sales. 60% of credit sales are collected in the month following the sales, balance 30% and 10% in the two following months thereafter. No bad debts are anticipated. Sales forecasts are as follows - (Rs. in lakhs) Jan. 89 April 89 July 89 Oct. 89 (5) (6) - 12 -6 - 12 -12 Feb. 89 May 89 August 89 - 14 -8 - 10 March 89 June 89 Sept. 89 - 16 -8 -8

(4)

Gross Profit margin 20% Anticipated purchases - (Rs. in lakhs) April 89 July 89 - 6.40 - 8.00 May 89 August 89 - 6.40 - 6.40 June 89 Sept. 89 - 9.60 - 9.60

Budgetary Control

489

(7)

Wages and Salaries to be paid - (Rs. in lakhs) April 89 July 89 - 1.20 - 2.00 May 89 August 89 - 1.60 - 1.60 June 89 Sept. 89 - 2.00 - 1.40

(8)

Capital expenditure for plant and machinery planned for September 1989 is Rs. 1,20,000. Company has a cash balance of Rs. 4,00,000 as at 31st March, 1989 and will maintain it in future also at minimum level.

(9)

(10) The Company can borrow on monthly basis. (11) Rent is Rs. 8,000 per month. (29) Lal and Company has given the forecast sales for January 1989 to July 1989 and actual sales for November and December 1988 as under. With the other particulars given, prepare a Cash Budget for the five months i.e. from January 1989 to May 1989. (1) Sales November 88 December 88 January 89 February 89 March 89 (2) 1.60 1.40 1.60 2.00 1.60 Lakhs Lakhs Lakhs Lakhs Lakhs April 89 May 89 June 89 July 89 2.00 Lakhs 1.80 Lakhs 2.40 Lakhs 2.00 Lakhs

Sales 20% cash and 80% credit, payable in the third month (January sales in March). Variable expenses 5% on turnover, time lag half month. Commission 5% on credit sales payable in the third month. Purchases being 60% of the sales of the third month, payment will be made on 3rd month of purchases. Rent and other expenses Rs. 6,000 paid every month. Other Payments Fixed Assets Purchases - March Rs. 1,00,000 Taxes - April Rs. 40,000

(3) (4) (5)

(6) (7)

(8)

Opening cash balance Rs. 50,000

490

Management Accounting

NOTES

Budgetary Control

491

NOTES

492

Management Accounting

Chapter 1 3
STANDARD COSTING

INTRODUCTION : The determination of the actual cost on the basis of various costing records maintained is no doubt important, but such actual cost (or historical cost) involves some limitations as to its utility. (1) The actual cost information is available only after the completion of the job, process or service and hence is of no practical utility from control point of view, as no basis is provided with which the actual costs can be compared. There are various kinds of managerial decisions where cost is an inevitable basis E.g. price fixation or submission of quotations. However if the details of actual cost are available too late, such cost details are of no practical utility for the purpose of price fixation or submission of quotation. The actual costs may be affected due to the inefficient functioning. The actual costs may be excessive due to abnormal expenses, avoidable wastes, inefficient use of labour and excessive use of materials. As such, actual costs are not useful for providing a yardstick for measuring efficiency of performance. Actual costing is comparatively expensive as it involves the maintenance of various records and documents. The above stated limitations involved with the determination of actual costs has given rise to the technique of standard costing.

(2)

(3)

(4)

CONCEPT OF STANDARD COST AND STANDARD COSTING : The term standard cost has been defined as a pre-determined cost which is calculated from the managements standards of efficient operation and the relevant necessary expenditure. The term standard costing has been defined as the preparation and use of standard costs, their comparison with actual costs and the measurement and analysis of variances to their causes and points of incidence.

Standard Costing

493

Thus, standard cost is the normal cost under the ideal circumstances. It may be used as a base for the purpose of price fixation and submission of quotations. Moreover, the standards when compared with the actual cost may also be used as tools for cost control and as a yardstick for measuring efficiency of performance, which is possible with standard costing system. As such, the process of standard costing involves the following stages. (1) Predetermination of technical data related to production i.e. details of materials and labour operations required for each product, the quantum of inevitable losses, level of activity etc. Predetermination of standard costs in full details under each element of cost i.e. Labour, Material and Overhead. Comparison of actual performance and costs with standards and working out the variances i.e. the difference between the actual and the standards. Analysis of variances in order to determine the reasons for deviations of actuals from the standards. Presentation of information to the appropriate level of management to enable suitable action being taken, or revision of standards.

(2)

(3)

(4)

(5)

It should be noted in this connection that standard costing is not a separate system of accounting but only a technique used with the intention of controlling the costs. Though it can be used in case of all methods of costing like job costing, process costing etc.; it can be more effective in case industries producing the standard products on continuous basis. Advantages of standard costing : (1) Standard costing provides a yardstick with reference to which the efficiency/inefficiency in performance may be established. This facilitates the basic management function of cost control. Standard costing provides the incentive and motivation to work with greater effort for achieving the standard. Standard costs may be used as the basis for the process of price fixation, filing the tenders and offering the quotations. If the prices are to be quoted on cost plus basis, actual costs may not be available in which case standard costs can be the base for fixation of selling prices. Standard costing system facilitates delegation of authority and fixation of responsibility for each individual or department. This also tones up the general organization of the concern.

(2)

(3)

(4)

494

Management Accounting

(5)

Variance analysis and reporting is based on the principle of management by exception. The top management may not be interested in details of actual performances but only in the variations from the standard, so that corrective measures may be taken in time. When constantly reviewed, the standards provide means for and encourage action for cost reduction. Focus on out of control situations, leads to cost reduction through the improved methods, improved quality of products, better material and workers, effective selection and use of capital resource etc. A properly laid down system of standard costing may facilitate the correct implementation of the technique of budgetary control which also is a good system of cost control.

(6)

(7)

Limitations of standard costing : (1) Establishment of standard costs is difficult in practice. Even though, standards are fixed after defining properly, there is no guarantee that the standards established will have the same tightness or looseness as envisaged. In the course of time, even in a short period, the standards become rigid. It may not be possible to maintain the standards to keep pace with the changes in manufacturing conditions. Revision of standards is costly. Sometimes, standards set create adverse effects. If standards are set tightly and there is non-achievement of the same, it creates frustration. The standard costing may not be suitable in all types of organizations e.g. (i) In case of small concerns- Where the production cannot be properly scheduled. In small concerns, personal contacts may be more effective than the standard costing. In case of industries having non-standardized products.

(2)

(3)

(4)

(ii)

(iii) In case of industries having repair jobs which keep changing as per customer requirements. (iv) In case of industries where products take more than one accounting period to complete e.g. contract jobs.

(5)

Due to the play of random factors, it may be difficult to properly examine the variance and distinguish between controllable and uncontrollable variances. e.g. Adverse labour time variance may be due to poor grade of labour, poor quality of material, defective plant and machinery and lack of trained workers. Lack of interest in standard costing on the part of the management makes the system ineffective and cant be used as a proper means of cost control.

(6)

Standard Costing

495

Standard costing and budgetary control compared : Both standard costing and budgetary control are the best possible tools available to the management for the purpose of controlling the costs. Both the techniques involve the process of setting the targets or standards, measurement of actual performance, comparison of actual performance with targets or standard set, computation and analysis of variations and the attempts to maintain favorable variations and remove unfavorable variations. The technique of budgetary control can be used effectively if the system of standard costing is prevailing. Thus, both the techniques complement each other but are not necessary dependent upon each other. On the other hand, in spite of the various similarities, both the techniques differ from each other in certain respects. (1) System of budgetary control may be operated even if no standard costing system is in use in the concern. Budgets are the ceilings or limits on expenses above which actual expenditure should not normally exceed and if it does, the planned profits will be reduced. Standard costs are minimum targets to be attained by the actual performance. Budgets may be prepared in the various areas of activities like sales, production, purchases, capital investment etc. Whereas standard costing specifically relates to the function of production and manufacturing costs. A more searching analysis is required to be made in case of standard costing variances than in case of budgetory control variances. Variances in case of budgets may point out efficiency or inefficiency. But variances in case of standard costing provide material for further probe and investigation. The scope of standard costing is much wide than that of budgetary control. Adherence to budgeted performance may indicate that the business is out of difficulties. A genuine attempt to attain the standards always provides the scope for improved performance. Budgets are based upon the future or estimated costs which may be used for forecasting the requirements of various factors of production like material, labour, finance etc. Standard costs are planned or ideal costs under the ideal situations as to operating efficiency, capacity level attainment and so on. Standard costs may not be necessarily useful for forecasting purposes.

(2)

(3)

(4)

(5)

(6)

Preliminaries for Establishing Standard Costing System : Before the standard costing system is established in an organization, the following preliminaries will have to be complied with.

496

Management Accounting

(1)

Establishment of cost centres : As explained before, a cost centre is any unit with respect to which the costs will be ascertained. If the standard costing system is to be implemented, the cost centres should be defined very clearly so that the responsibility can be fixed in case of non standard performance.

(2)

Design of Accounts : As the standard costing essentially involves the process of comparing the actual performance to standard performance and computation of variances therefrom, the accounts should be designed in such a way that the information about the actual performance is available as correctly as possible and as speedily as possible. For this purpose, the codification of accounts may be considered.

(3)

Establishment of standards : This is probably the most critical part of the implementation of standard costing i.e. to establish the standards with respect to the individual elements of cost i.e. Direct Material Cost, Direct Labour Cost and Overheads. It is necessary to exercise maximum care while establishing the standards as wrongly established standards may defeat the purpose of standard costing.

Following steps are involved in the process of establishing the standards. (a) Study of technical and operational details of the organization like the manufacturing process, levels of managements and their responsibilities, units and nature of inputs and outputs, details regarding wastes and losses, expected efficiency and capacity utilization etc. Study of existing cost accounting systems and formats in use. Decision about the types of standards to be used. It may be noted that there may be various types of standards.

(b) (c)

Basic Standards : These are established for an unaltered use over a longer period of time and they dont reflect the current conditions. These types of standards are not useful from the cost control point of view and can be used in case of industries where technical processes are fully established or in case of those types of costs which are fixed in nature viz. rent, remuneration to managerial personnel etc.

Standard Costing

497

Current Standards : These are established for a shorter period of time and are adaptable to change in current conditions. As current conditions are likely to change, the current standards are also subject to revision as per the changes in current conditions. Current standards may be of three types. Ideal Standards : These are the standards which are set which are attainable under the most favourable conditions possible and assumes the maximum utilization of various factors of production (like men, material and machines) which is not practicable and attainable. Thus, the ideal standards are generally theoretical in nature and the variances always show an unfavorable trend. The basic limitation of these types of standards is that the constant non achievement of these standards causes frustration among the staff and the constant reporting of unfavorable variances is presumed which results into lost impact of system itself. Expected Standards : These are the standards which are anticipated to be attained during the budget period. These are based upon the expected performance based upon the conditions which are likely to prevail during the budget period. Allowances are provided for the unavoidable deviations from the ideal performance e.g. Labour time wastage, excess material use, break down of machinery etc. Thus, these standards are more realistic in nature and are more useful from cost control point of view. Normal Standards : These are the standards which may be anticipated to be achieved in future, over a longer period of time, considering the past performance. As such, the inefficiencies of the past performance, if any, get reflected in these types of standards. Further, the problems faced in estimating the future over a longer period of time also restrict the use of these standards for cost control purposes. After the consideration of various types of standards which may be used, the process of establishment of standards with respect to various elements of costs comes into operation. As discussed above, the standards may be set for the various elements of costs i.e. Direct Material Cost, Direct Labour Cost and Overheads. (a) Direct Material Cost : Setting the Standard Cost for Direct Material, involves two stages i.e. To decide Price Standard and to decide Use Standard.

498

Management Accounting

Price Standard : It may involve the consideration of following factors. (i) (ii) Current market conditions and likely changes. Prices of current supply orders.

(iii) Prices of long term supply contracts. Along with the basic prices, it may involve the consideration of the factors like discount, packing charges, insurance, sales tax, octroi etc. It may be the primary responsibility of the Purchase Department to supply the details required for this purpose. Use Standard : It may be the primary responsibility of Engineering or Design Department to supply the details required for this purpose, on the basis of standard bill of material.This may involve the process of product study. Sufficient provisions should be made for unavoidable scrap or wastages. (b) Direct Labour Cost : Setting the standard cost for Direct Labour involves two stages i.e. To decide the wage rate standard and to decide Labour Efficiency standard. Wage Rate Standards : It may involve the consideration of following factors. (i) (ii) The system of wages payments prevailing i.e. Piece Rate Wages or Time Rate Wages Systems prevailing for bonus payments

(iii) The provisions of agreements with workers covering a future period of time. (iv) (v) Provisions of various laws and guidelines governing the fixation of wage rates Grades of workers required and likely trends of market conditions in respect of availability thereof.

Labour Efficiency Standards : It may be decided on the basis of the consideration of following factors. (i) (ii) Records of past performance. Time and motion study considering the details in respect of an average worker as the base.

Standard Costing

499

(iii) Trial Runs, specifically in respect of a new product. Sufficient provision should be made in respect of the unavoidable idle time. (c) Overheads Cost : Setting the standard cost of overheads involves the following stages. (i) (ii) Estimation of standard overheads cost. Estimation of standard level of activity ( in terms of labour hours, machine hours or units of production)

(iii) Estimation of standard overhead absorption rate which may be decided as below. Standard Overhead Cost Standard Level of Activity Thus, the standard absorption rate may be per unit of production, per labour hour or per machine hour. For better control purposes, the standards for overhead cost may be decided separately for fixed overheads and variable overheads, as fixed overbeads are normally uncontrollable at the lower level of management. (4) Reporting of Variances : The basic intention of implementation of standard costing system as a cost control device is not complete till the variances computed in respect of each element of cost are properly reported to the relevant level of management for the decision making purposes. For this purpose, the following propositions should be considered. (a) For effective cost control, the organizational structure should be clearly defined and responsibility of each individual should be clearly defined. The reports reporting the variances should be simple, clear and quick. The computation and analysis of variances in respect of each element of cost should be accurate. A wrong analysis of variances may result into misleading conclusions. For more effectiveness, the variances should be segregated as controllable variances and non controllable variances. However, the analysis of uncontrollable variances should be made with the same care as in case of controllable variances. The reporting of variances should contain a comparison with the planned results.

(b) (c)

(d)

(e)

500

Management Accounting

(f)

The format and the contents of reports reporting the variances may depend upon the level of management to whom reports are being made, The reports to top management would be obviously formal containing only the broad details and final results. The reports to lower level of management may contain the full analysis of each variance showing the causes therefor and locating the responsibilities therefor.

ANALYSIS OF VARIANCES : As stated earlier, the process of standard costing involves the establishment of standard costs and the computation of actual costs under each element of cost and the comparison between standard costs and actual costs. The difference between standard cost and actual cost is termed as Variance. If the actual cost is less than the standard cost, the variance is a favourable variance. If the actual cost is more than the standard cost, the variance is a unfavorable or adverse variance. The utility of standard costing as a technique of cost control is not complete only by the computation of variances unless these variances are further analysed as to the causes responsible for these variances. The basic objective of variance analysis is to classify the variances as controllable and uncontrollable ones E.g. If material actually used is in excess of standard quantity or if time actually taken by the workers is more than standard time, the variance will be an unfavorable one for which the responsibility can be assigned on the executives concerned. However if the variances occur due to general strike, general increase in wage rates, devaluation of currency, change in customers demands etc., the variances will be uncontrollable ones for which no responsibility can be assigned to any executive. By concentrating most on controllable and adverse variances, it is possible for the management to exercise control through exception which is the basic objective of standard costing. Thus, the stress can be laid on variances only and no further action will be necessary in cases where standard costs are matching with the actual costs, provided that the conditions underlying the fixation of standards remain unchanged. The variances arising in one period may be compared with a variances in the previous period for a better control. Thus a detailed analysis of variances, specifically the controllable ones, as to the causes leading to these variances, and the corrective actions required to be taken to reduce these variances enables the management to exercise proper cost control. However, it does not mean that the favourable variances need no investigation. A constant occurrence of favourable variance may indicate incorrect fixation of standards that need to be revised. A constant favourable variance may be due to a genuine improvement in performance or due to the manufacture of sub- standard products. We will discuss the variance under each element of cost.

Standard Costing

501

(A) MATERIAL COST VARIANCE : It is the difference between standard material cost and actual material cost. It may be further analysed as (i) (ii) (i) Material Price Variance Material Usage Variance Material Price Variance :

Its that portion which is due to difference between standard price specified and actual price paid. It is calculated as Actual Quantity (Actual Price - Standard Price) The causes for this may be traced as (1) (2) (3) (4) (5) (6) (7) (8) (9) Change in price of material. Change in quantity of purchase or uneconomical size of parchase order. Rush order to meet shortage of supply or purchase in less favourable market. Failure to take advantage of off season prices. Failure to get cash/trade discounts. Weak purchase organization. Payment of excess/less freight. Transit losses/discrepancies if prices include them. Change in quality or specification of material purchased.

(10) Use of substitute materials at different prices. (11) Change in pattern or amount of taxes or duties. From the above, it can be seen that the responsibility for this type of variance may be normally placed on Purchase Department. However, there may be some situations where the responsibility for this type of variance can not be placed on purchase department. E.g. When the purchases are made in uneconomic quantities due to the lack of working capital. (ii) Material Usage Variance :

It is that portion which is due to the difference between standard quantity specified and actual quantity used. Its calculated as -

502

Management Accounting

Standard Price (Actual Qantity - Standard Qantity) The causes to this may be traced as : (1) (2) (3) (4) (5) (6) (7) (8) (9) Inefficient or careless use of materials. Change in specification/design of the product. Inefficient/inadequate inspection of materials. Change in quality of material or purchases of inferior material. Production inefficiency resulting in wastages. Use of substitute materials. Theft/pilferage of materials. Inefficient labour not able to handle material properly. Defective machines and not proper maintenance of the same.

(10) Change in the composition of material mix. If more than one materials are mixed to get the final product, any change in the standard mix may result into material usage variance. It may arise in case of textile, chemical, rubber industries etc. (11) Change in the yield. If a certain amount of standard output is expected from some inputs, any variance in actual output may result in material usage variance. It may arise in case of processing industries. The material usage variances may further be analysed in the following ways: (a) Materials Mix Variance : As stated above, it is that part of usage variance which may arise due to change in the standard composition of material mix where more than one materials are required to be mixed together to get the final product. This may be a peculiar feature of the industries like textile, chemical, rubber etc. The actual mix of materials may be different than the standard mix due to non - availability of specified material. Increased proportion of costly material in the mix results into adverse materials mix variance and vice-versa. This variance is calculated as Standard price (Actual mix - Standard mix)

Standard Costing

503

(b)

Materials Yield Variance : As stated above, it is that part of usage variance which may arise due to difference between standard yield expected and the actual yield obtained, where a certain specified yield is expected from a given input of materials. This may be a peculiar feature of the processing industries. A low actual yield indicates consumplion of materials in excess of standards set resulting into an adverse variance and vice versa. This variance is calculated as : Standard Yield Price (Actual Loss - Standard Loss) Where standard yield price is calculated as : Total Standard Cost Total Standard Output

Illustration : I Material Qty. Kgs. A B C 500 400 300 1200 Less : 10% Normal Loss 120 1,080 5,400 Actual Loss 220 1080 5,320 Standard Price Rs. 6.00 3.75 3.00 Total Rs. 3,000 1,500 900 Actual Qty. Kgs. 400 500 400 1300 Price Rs. 6.00 3.60 2.80 Total Rs. 2,400 1.800 1,120

Calculate material cost variances. Solution : (A) Material Cost Variance Standard Material Cost - Actual Material Cost. = 5,400 - 5,320 80 (Favourable)

504

Management Accounting

(B) Material Price Variance AQ (AP - SP) Where AP Material A Material B Material C = = = = Actual Price 400 (6.00 - 6.00) 500 (3.60 - 3.75) 400 (2.80 - 3.00) AQ = SP = = = = Actual Quantity. Standard Price Nil 75 (Favourable) 80 (Favourable) 155 (Favourable) (C) Material Usage Variance SP (AQ - SQ) Where AQ = Actual Quantity SP = SQ = = = = Standard Price Standard Quantity 600 (Favourable) 375 (Adverse) 300 (Adveise) 75 (Adverse) (D) Materials Mix Variance Standard Price (Actual Mix - Standard Mix) Material A = 6.00 (400 - 541.67) Material B = 3.75 (500 - 433.33) Material C = 3.00 (400 - 325) = = = 850 (Favourable) 250 (Adverse) 225 (Adverse) 375 (Favourable) Note : The standard mix is calculated as below. When total input is 1,200 Kgs, the Materials A,B, and C are mixed in the proportion of 500 Kgs,, 400 Kgs and 300 Kgs. respectively. When total input is 1,300 Kgs. the materials should have been mixed in the following proportion. 500 Material A = 1200 400 Material B = Material C = 1200 300 1200 X 1300 = 541.67 Kgs. X 1300 = 433.33 Kgs.

Material A = 6.00 (400 - 500) Material B = 3.75 (500 - 400) Meterial C = 3.00 (400 - 300)

X 1300 = 325.00 Kgs.

Standard Costing

505

(E)

Materials Yield Variance Standard Yield Price (Actual Loss - Standard Loss) 5 (220 - 130) = 450 (adverse) Note : Standard Yield Price is calculated as below Total standard cost Total standard output = Rs. 5400 1080 Kgs. = Rs.5/Per Kg.

Check : Material Cost Variance = Materials Price Variance + Material Usage Variance

Materials Usage Variance = Materials Mix Variance + Materials Yield Variance 80 (F) = 155 (F) + 375 (F) + 450 (A)

Where, F indicates favourable and A indicates adverse variance. LABOUR COST VARIANCES : It is the difference between standard direct wages specified and actual wages paid. It is further analysed as (i) Wage/Labour Rate Variance : It is that portion which is due to difference between standard pay of wages specified and actual rate paid. It is calculated as Actual Hours (Actual Rate - Standard Rate) The causes of this may be traced as (1) (2) Change in wage structure or piece-work rate. Variation due to different grades of workers and their wages differing from those specified. Use of different methods of payment e.g. Actual payment on time basis whereas standards are set on piece rate basis. Employment of casual/temporary workers to meet seasonal demands. New workers not being allowed full normal wages. Overtime or night shift allowance more or less than standard. Composition of gang as regards the skill and rates of wages different than specified standards.
Management Accounting

(3)

(4) (5) (6) (7)

506

Though the responsibility of wages/labour rate variances can be placed on Personnel Department, in practice, this type of variance is usually an uncontrollable one. (ii) Labour Efficiency Time Variance : It is that portion which is due to difference between standard labour hours specified and the actual labour hours expended. It is calculated as : Standard Rate (Actual Hours - Standard Hours) The causes of this may be traced as : (1) (2) (3) Lack of proper supervision. Poor working conditions. Delays due to waiting for materials, tools, instructions etc, if not treated as idle time. Defective tools, equipments etc. Machine break down if not treated as idle time. Work on new machines requiring less time. Basic inefficiency of workers due to lack of morale, insufficient training, faulty instructions etc. Use of non-standard material requiring higher lime for processing. Operations not provided for and booking them under direct wages.

(4) (5) (6) (7)

(8) (9)

(10) Wrong selection of workers. (11) Increase in labour turnover. (12) Incorrect recording of performance i.e. time or output. The labour efficiency variance may be further analysed in the following manner. (a) Idle Time Variance : It is the standard cost of actual hours recorded as idle time due to abnormal circumstances like strike, lock out, power failure, machinery breakdown etc. It is calculated as Standard rate x Idle Hours This type of variance is normally calculated separately and not kept only as a part of efficiency variance, as the employees should not be blamed for inefficiency when the idle time arises due to circumstances beyond their control, say power failure. It is needless to state that this variance is always unfavorable and needs further investigation as to the causes for abnormal idle time.
Standard Costing

507

(b)

Labour Mix Variance (Gang Composition Variance) :

It indicates that part at efficiency variance which arises due to change in Actual Gang of labour from that of Standard Gang of labour if various grades of labour are included in a gang and if certain grades of labour are not available. It is calculated as : Standard Rate (Revised Standard Hours- Actual Hours) Where the revised standard hours indicate the actual labour hours divided in the ratio of standard hours. It should be noted that if the idle time variance is calculated separately, the idle time hours should be excluded from actual total hours in standard ratio. (c) Labour Yield Variance :

In many cases, this variance is calculated separately which indicates the effect on labour cost of actual yield or output being different from standard yield or output. In numerical terms, it is equal to revised efficiency variance i.e. after separating Mix Variance and Idle Time Variance from Efficiency Variance, which is calculated as Standard Rate (Standard Hours - Revised Standard Hours) Illustration 2 : Following details are available from the records of A Ltd. for a month regarding the standard labour hours and rates of an hour for a product Hours Skilled Semi- Skilled Unskilled 10 8 16 Rate per hour Rs. 3.00 1.50 1.00 Total Rs. 30.00 12.00 16.00 58.00 The actual production for the product was 1,500 units for which the actual hours worked and rates were as below. Hours Skilled Semi- Skilled Unskilled 13,500 12,600 30,000 Rate per hour Rs. 3.50 1.80 1.20 Total Rs. 47,250 22,680 36,000

508

Management Accounting

Compute : (a) (b) (c) (d) Labour Cost Variance Labour Rate Variance Labour Efficiency Variance Labour Mix Variance

(a)

Labour Cost Variance :

Solution : Standard Hours Rate per Hr. Skilled Semi-Skilled Unskilled 15,000 12,000 24,000 51,000 Actual Cost - Standard Cost 1,05,930 - 87,000 = 18,930 (A) (b) Labour Rate Variance : Actual Hours (Actual Rate - Standard Rate) 13,500 (3.50 - 3.00) = 12,600 (1.80 - 1.50) = 30,000 (1.20 - 1.00) = 6,750 3,780 6,000 16,530 (c) Labour Efficiency Variance : Standard Rate (Actual Hours- Standard Hours) 3.00 (13,500 - 15,000) = 4,500 1.50 (12,600 - 12,000) = 900 (F) (A) (A) (A) (A) (A) (A) (A) 3.00 1.50 1.00 Total 45,000 18,000 24,000 87,000 Hours 13,500 12,600 30,000 56,100 Actual Rate per Hr. 3.50 1.80 1.20 Total Rs. 47,250 22,680 36,000 1,05,930

1.00 (30,000 - 24,000) = 6,000 2,400

Standard Costing

509

(d)

Labour Mix Variance : Standard Rate (Actual Hours - Revised Standard Hours) 3.00 (13,500 - 16,500) = 9,000 1.50 (12,600 - 13,200) = 900 (F) (F) (A) (F)

1.00 (30,000 - 26,400) = 3,600 6,300 OVERHEAD COST VARIANCES :

The analysis of overheads variances is different and the most complex task than the calculation of material and labour variances. It is so due to the fact that establishment of a standard overhead absorption rate is difficult as a part of total overheads is fixed, which affects the overhead absorption rate with the change in volume. It should be noted in this connection that the overhead absorption rate can be computed in the following way. (a) If the overhead rate is expressed in terms of labour hours. Hourly Rate (b) = Budgeted Overhead Cost Budgeted Labour Hours

If the overhead rate is expressed in terms of units produced Unit Rate = Budgeted Overhead cost Budgeted output in units

As the overheads can be either the variable overheads or fixed overheads, the overhead cost variances may be seperately calculated for variable overheads and fixed overheads. Variable Overheads Variance : It is that amount of overheads which change directly with the level of activity and per unit variable overheads remain constant. As such, the variable overheads are not affected with the change in volume of operations. The common method of analyzing the variable overheads variances is shown in the chart below. Overhead Cost Variance Expenditure Variance Efficiency Variance

510

Management Accounting

(a)

Overheads Cost Variance It is the difference between standard overheads cost absorbed and actual overheads cost incurred. It is calculated as -

[
(b)

Standard Hours for Actual production

Standard Hourly Rate Actual Overhead

Overheads Expenditure Variance : It is the difference between the standard allowance for the output achieved and actual overheads cost incurred. It is calculated as Revised Budgeted Overheads for Actual Hours - Actual Overheads

(c)

Overhead Efficiency Variance : It is due to the difference between budgeted efficiency of production and actual efficiency attained. It is calculated as Standard Hourly X Rate

Standard Hours for Actual production

Actual Overheads

Fixed Overheads Variances : In modern times, especially in the days of rapid mechanization of production processes, the fixed overheads form a major portion of the production cost. As such, it is necessary that the management is properly informed about the standard fixed overheads or any deviations therefrom. The common method of analyzing the fixed overheads variances is shown in the chart below. Overhead Cost Variance Expenditure variance Volume Variance Efficiency Variance Capacity Calender

Variance Variance

As each of the above variances can be computed either on the basis of units of production or on the basis of hours. We will first study the nature of the above variances and then the methods of computation.

Standard Costing

511

(a)

Overhead Cost Variance : It is the difference between the total standard overheads cost absorbed in the output achieved and the total actual overheads cost. Thus, it can be seen that the overheads cost variance is simply the under or over absorption of overheads.

(b)

Expenditure Variance : It is the difference between the standard allowance for the output achieved and the actual overheads cost incurred. The causes of this variance may be (1) (2) Change in the quality/ price of indirect material. Change in the labour rates for indirect workers or change in the grade of indirect workers. Change in the rate of power, insurance and other overheads.

(3) (c)

Volume Variance : It is that protion of the overhead variance which is due to the difference between the budgeted level of output and the actual level of output. The causes of this variance may be as below. (1) (2) (3) (4) (5) (6) Labour problems like strikes, lockouts etc. Material shortage Machinery Breakdown Waiting for tools/instructions/material Power failure. Change in the demand for product

It will not be out of place to mention here that in case of the variable overheads, per unit or per hour overheads remain constant and are not affected by the change in the level of output. As such, volume variance does not arise in case of variable overheads. (d) Efficiency Variance : It is that portion of the overhead variances, as a part of volume variance, which is due to the difference between budgeted efficiency of production and the actual efficiency attained. The causes of this variance may be as below.

512

Management Accounting

(1) (2) (3) (4) (5) (e)

Poor working conditions. Change in the labour performance Defective and faulty tools. Incorrect Machine operations. Defective or inferior material.

Capacity Variance : It is that portion of the overhead variances, as a part volume variance, which is due to the working at higher or lower capacity than standard. The causes of this variance may be as below. (1) (2) (3) (4) Seasonal variations. Shortage of labour force. Abnormal idle time due to the reasons like power failures, strikes, lock outs etc. Change in the customer demand.

(f)

Calender Variance : It is that portion of overhead variances, as a part of volume variance, which is due to the difference between the number of working days in the budget period and the actual number of working days in the period in which the budget is applied. Calender Variance arises only if there is abnormal increase or decrease in the number of working days, as the normal holidays are already considered while setting the standard. Thus, the declaration of an unexpected day as holiday may result into calender variance.

COMPUTATION OF FIXED OVERHEADS VARIANCES : As discussed earlier, the fixed overheads variances may be computed on the basis of units of production or on the basis of hours. (A) On the basis of units of production : (1) Overheads Cost Variance : Standard Overhead Cost - Actual Overhead Cost (2) Expenditure Variance : Budgeted Overhead Cost - Actual Overhead Cost

Standard Costing

513

(3)

Volume Variance : Standard Rate per unit X [Actual Production - Budgeted Production]

(4)

Efficiency Variance : Standard Rate per unit X [Actual Production - Standard Production in Actual Hours]

(5)

Capacity Variance: Standard Rate per unit X Standard Production in Actual Hours

Revised Budgeted Production

(6)

Calender Variance : Standard Rate per unit X [Revised Budgeted Production - Budgeted Production]

ILLUSTRATION 3 : An Engineering Company has furnished you the following data Budget No of working days Production in Units Fixed overheads in Rs. 25 20,000 30,000 Actual July 1986 27 22,000 34,000

Budgeted fixed overhead rate is Rs. 1 per hour. In July 1986, the actual hours worked were 31,500. Calculated the following variances. (a) (b) (c) (d) (e) (f) Total overheads Variance Expenditure Variance Volume Variance Efficiency Variance Capacity Variance Calender variance

Solution : (1) Total Overheads Variance : Standard Overheads Cost - Actual Overheads Cost 33,000 - 34,000 = 1,000 (A)

514

Management Accounting

(2)

Expenditure Variance : Budgeted Overheads Cost - Actual Overheads Cost 30,000 - 34,000 = 4,000 (A)

(3)

Volume Variance : Standard Rate per unit x [Actual Production - Budgeted Production] 1.5 X (22,000 - 20,000) = 3,000 (F)

(4)

Efficiency Variance : Standard Rate per unit x [Actual Production - Standard Production in Actual Hours] 1.5 X ( 22,000 - 21,000) = 1.500 (F)

(5)

Capacity Variance : Standard Rate per unit x [Standard Production in Actual Hours - Revised Budgeted Production] 1.5 X (21,000 - 21,600) = 900 (A)

(6)

Calender Variance : Standard Rate per Unit x [Revised Budgeted Production - Budgeted Production] 1.5 x (21,600 - 20,000) = 2,400 (F)

Check : Volume variance = Efficiency Variance + Capacity Variance + Calender Variance 3000 (F) Total Variance 1000 (A) Working Note : (A) (1) Standard Rate per unit is calculated as below Budgeted Overhead Cost Budgeted Production
Standard Costing

= 1500 (F) + 900 (A) + 2400 (F) = Expenditure Variance + Volume Variance = 4000 (A) + 3000 (F)

515

(2)

30,000 20,000

Rs. 1.5 Per Unit

Standard Production in actual hours is calculated as below : Budgeted overheads are Rs.30,000, while budgeted fixed overhead rate is Rs. l per hour. Therefore, budgeted hours are 30,000, while budgeted production is 20,000 units. It means that one unit requires 1.5 hours.(standard) As actual hours worked are 31.500, the standard production in those many hours will be 31,500 = 21,000 Units 1.5 Revised Budgeted Production is calculated as below. Budgeted Number of working days are 25 while budgeted production is 20,000 units. It means that standard production in one day is 20,000 Units = 25 days 800 Units

(3)

As actual number of working days is 27, the standard production in those many days will be 800 units x 27 days = 21,600 units (B) On the basis of hours : (1) Overheads Cost Variance : Standard Overheads Cost - Actual Overheads Cost (2) Expenditure Variance : Budgeted Overheads Cost - Actual Overheads Cost (3) Volume Variance : Standard Hourly Rate x [Standard Hours for Actual Production - Budgeted Hours] (4) Efficiency Variance : Standard Hourly Rate x [Standard hours for Actual Production - Actual Hours] (5) Capacity Variance : Standard Hourly Rate x [Actual Hours - Revised Budgeted Hours] (6) Calender Variance : Standard Hourly Rate x [Revised Budgeted Hours - Budgeted Hours]

516

Management Accounting

ILLUSTRATION : 4 An engineering company has furnished you with the following data. Budget No. of working days Production in Units Fixed 0verheads (in Rs.) 25 20,000 30,000 Actual (July 1986) 27 22,000 34,000

Budgeted fixed overhead rate is Rs. 1 per hour. In July 1986, the actual hours worked were 31,500. Calculate the following variances (a) (b) (c) (d) (e) (f) Total Overheads Variance Expenditure Variance Volume Variance Efficiency Variance Capacity Variance Calender Variance

Solution : Calculation of overhead variances will be as below. (1) Total Overhead Variance : Standard Overheads - Actual Overheads 33,000 - 34,000 = 1,000 (A) (2) Expenditure Variance : Budgeted Overheads - Actual Overheads. 30,000 - 34,000 = 4,000 (A) (3) Volume Variance : Standard Hourly Rate X [Standard Hours for Actual Production - Budgeted Hours] = 1 (33,000 - 30,000) = 3,000 (F) (4) Efficiency Variance : Standard Hourly Rate (Standard hours - Actual hours) 1 (33,000 - 31,500) = 1,500 (F)

Standard Costing

517

(5)

Capacity Variance : Standard Hourly Rate (Actual hours - Revised Budgeted Hours) 1 (31,500 - 32,400) = 900 (A)

(6)

Calender Variance : Standard Hourly Rate (Revised Budgeted Hours - Budgeted Hours) 1 (32,400 - 30,000) = 2,400 (F)

Check : Volume Variance = Efficiency Variance + Capacity Variance + Calender Variance. 3000 (F) = 1500 (F)+900 (A)+ 2400 (F) Total Overhead Cost Variance = Expenditure Variance + Volume Variance 1000 (A) = 4000 (A) + 3000 (F) Working Notes : (1) Standard rate per hour is known to be Rs. 1. As Budgeted overheads are Rs.30,000, Budgeted Hours will be 30,000. (2) Budgeted Hours are known to be 30,000 for the Budgeted production of 20,000 units, indicating that standard time required for one unit is 1 1/2 hours. If the actual production is 22,000 units, the standard time required for actual production will be 33,000 hours. (3) The budgeted number of working days are 25 and budgeted hours are 30,000, indicating that the standard hours available in one day are 1,200. If the company has actually worked for 27 days, the revised budgeted hours will be 32,400 i.e. 1,200 hours per day x 27 days. SALES VARIANCES : While standard costing principles are mainly applied in the area of costs i.e. Material cost, Labour cost and overheads cost, some companies calculate the sales variances also which is the difference between budgeted sales and actual sales and its impact on profits. There may be two ways to calculate sales variances. (A) The turnover/value method. (B) The margin/profit method.
Management Accounting

518

(A)

The Turnover/Value Method : The common method of analysing sales variances under this method is shown in the chart below. Sales Value Variance Sales Price Variance Mix Variance (1) Sales Value Variance : It is the difference between the budgeted sales and the actual sales. It is calculated as Actual Sales - Budgeted Sales (2) Sales Price Variance : It is that portion of sales variance which is due to the difference between standard price specified and the actual price charged. It is calculated as Actual Sales Volume x [Actual Price - Standard Price] (3) Sales Volume Variance : It is that portion of sales variance which is due to the difference between the standard quantity specified and the actual quantity sold. It is calculated as Standard Price x [Actual sales volume - Standard sales volume] (4) Sales Mix Variance : It is that portion of sales volume variance which may arise due to change in actual composition of sales mix from the standard composition of sales mix, where more than one products are dealt with. It is calculated as Standard Sales - Revised Standard Sales Where Standard Sales are actual quantity sold at budgeted price. Revised Budgeted sales are standard sales rearranged in the budgeted ratio. Sales Volume Variance Quantity Variance

Standard Costing

519

Note : It should be noted that the sales mix variance, under turnover method will always be zero. This is so because though the sales mix is varied, the actual sales at budgeted price are rearranged in the budgeted ratio. (5) Sales Quantity Variance : It is that portion of sales volume variance, which may arise due to the difference between standard value of actual sales at standard mix and budgeted sales. It is calculated as Revised Standard Sales - Budgeted Sales. Illustration 5 : Standard Product A. B. C. Qty. 500 400 300 1200 Calculate the Sales Variances. Solution : (A) (1) Sales Value Variance : Actual Sales - Budgeted Sales (2) 7,000 - 9,000 = 2,000 (F) Sale Price Rs. 5 6 7 Total Rs. 2,500 2,400 2,100 7,000 Qty. 500 600 400 1500 Actual Sale Price Rs. 5.40 5.50 7.50 Total Rs. 2,700 3,300 3,000 9,000

Sales Price Variance : Actual Sales Volume (Actual Price - Standard Price) A - 500 (5.40 - 5.00) = B - 600 (5.50 - 6.00) = C - 400 (7.50 - 7.00) = 200 300 200 100 (F) (A) (F) (F)

520

Management Accounting

(3)

Sales Volume Variance : Standard Price (Actual Sales Volume - Standard Sales Volume) A - 5 (500 - 500) B - 6 (600 - 400) C - 7 (400 - 300) = = = Nil 1200 700 1900 (F) (F) (F)

(4)

Sales Mix Variance : Standard Sales - Revised Standard Sales

Where standard sales are actual quantity at standard price and Revised standard sales are standard sales rearranged in budgeted ratio.

Standard Sales Qty. A B C 500 600 400 Price Rs. 5 6 7 Total Rs. 2500 3600 2800 8900 Ratio is calculated as below A B C 2500 7000 2400 7000 2100 7000 X X X 100 100 100 = = = 35.71% 34.29 30%

Revised Standard Sale Ratio 35.71% 34.29% 30.00% Total 3178 3052 2670 8900

Sales Mix Variance A B C 2500 - 3178 = 678 3600 - 3052 = 548 2800 - 2670 = 130 Nil (A) (F) (F)

Standard Costing

521

(5)

Sales Quantity Variance Revised Standard Sales - Budgeted Sales : A B C 3178 - 2500 3052 - 2400 2670 - 2100 = = = = 678 652 570 1900 (F) (F) (F) (F)

Check : Sales Value Variance = Sales Price Variance + Sales Mix Variance + Sales Quantity Variance = 2000 (F) = 100(F)+Nil +1900 (F) (B) The Margin / Profit Method : This method of sales variances measures the effect of actual sales and budgeted sales on profit. As this method does not consider the cost variances, all costs are assumed to be standard costs. The common method of analysing sales variances under this method is shown in the chart below. Total Sales Margin Variance Sales Margin Price Variance Sales Margin Volume Variance Sales Margin Mix Variance (1) Total Sales Margin Variance : It is the difference between actual margin (by considering standard costs) and budgeted margin. It is calculated as Actual Profit - Budgeted Profit (2) Sales Margin Price Variance : It is that portion of total sales margin variance which is due to the difference between standard price of actual sales made and actual price. It is calculated as Actual Profit - Standard Profit Sales Margin Quantity Variance

522

Management Accounting

(3)

Sales Margin Volume Variance : It is that portion of total sales-margin variance which is due to the difference between standard profit and budgeted profit. It is calculated as Standard Profit - Budgeted Profit.

(4)

Sales Margin Mix Variance : It is that portion of sales margin volume variance which is due to the difference between standard profit and revised standard profits. It is calculated as Standard Profit - Revised Standard Profit.

(5)

Sales Margin Quantity Variance : It is that portion of sales margin volume variance which is due to the difference between budgeted profit and revised standard profits. It is calculated asRevised Standard Profits - Budgeted Profit.

Illustration 6 : A Ltd. has budgeted the following sales for the month A - 900 units at Rs. 50 per unit. B - 650 units at Rs, 100 per unit. C - 1200 units at Rs. 75 per unit. Actual sales were A - 950 units at Rs. 58 per unit. B - 700 units at Rs. 90 per unit. C - 1200 units at Rs. 80 per unit. Costs per unit of A, B and C were Rs. 40, Rs. 88 and Rs.60 respectively. Compute the Sales Margin variances.

Standard Costing

523

Solution : SALES Product BUDGET A B C 900 650 1200 50 100 75 45,000 65,000 90,000 2,00,000 ACTUAL A B C 950 700 1200 58 90 80 55,100 63,000 96,000 2,14,100 40 88 60 38,000 61,600 72,000 1,71,600 18 2 20 17,100 1,400 24,000 42,500 40 88 60 36,000 57,200 72,000 1,65,200 10 12 15, 9,000 7,800 18,000 34,800 Qty Price Rs. Total Rs. COST OF SALES Per unit Rs. PROFIT Total Rs.

Total Per unit Rs.

Standard sales and revised standard sales are calculated as below STANDARD SALES : SALES Product A B C Qty 950 700 1200 Price Rs. 50 100 75 Total Rs. 47,500 70,000 90,000 2,07,500 REVISED STANDARD SALE Product Revised Standard sales Rs. A B C 46,688 67,437 93,375 2,07,500 Revised Standard profit Rs. 9,338 8,092 18,675 36,105 COST OF SALES Per unit Rs. 40 88 60 PROFIT Total Rs. 9,500 8,400 18,000 35,900

Total Per unit Rs. 38,000 61,600 72,000 1,71,600 10 12 15

524

Management Accounting

Calculation of Variances (1) Total Sales Margin Variance : Actual Profit - Budgeted Profit 42,500 - 34,800 = 7,700 (F) (2) Sales Margin Price Variance Actual Profit - Standard Profit 42,500 - 35,900 = 6,600 (F) (3) Sales Margin Volume Variance Standard Profit - Budgeted Profit. 35,900 - 34,800 = 1,100 (F) (4) Sales Margin Mix Variance : Standard Profit - Revised Standard Profit. 35.900 - 36,105 = 205 (A) (5) Sales Margin Quantity Variance : Revised Standard Profit - Budgeted Profit 36,105 - 34,800 = 1,305 (F) ILLUSTRATIVE PROBLEMS (1) Following standard and actual data relates to a manufacturing concern. Material X Y Standard 40 kgs. at Rs. 6 60 kgs. at Rs. 4 240 240 480 Standard output is 80% of input i.e. 80 units. Process loss is 20%. Material X Y Actual 600 kgs. at Rs. 4 400 kgs. at Rs. 6

Actual output is 70% of input i.e. 700 units. Process loss is 30%.

Standard Costing

525

Calculate (1) (2) (3) (4) (5) Cost variance Price variance Total Quantity usage variance Mix variance Revised usage variance

Solution : (1) Cost Variance : Actual Material Cost - Standard material Cost 4800 - 4200 = 600 (A) (2) Price Variance : Actual Quantity (Actual Price - Standard Price) X 600 (4-6) Y 400 (6-4) = = 1200 800 400 (3) Total Usage Variance : Standard Price (Actual Quantity - Standard Quantity) X - 6 ( 600 - 350) Y - 4 ( 400 - 525) = = 1500 500 1000 (4) Mix Variance : Standard Price (Actual Mix- Revised Standard Quantity X - 6 (600 - 400) Y - 4 (400-600) = = 1200 800 400 (5) Revised Usage Variance : Standard Price (Revised Standard Quantity - Standard Quantity) X - 6 (400 - 350) Y - 4 ( 600 - 525) = = 300 300 600 (A) (A) (A) (A) (F) (A) (A) (F) (A) (F) (A) (F)

526

Management Accounting

(6)

Yield Variance : Standard Cost per unit (Actual Loss - Standard Loss) 6 (300 - 200) = 600 (A)

Check : Cost Variance = Price Variance + Mix Variance + Yield Variance 600 (A) = 400 (F) + 400 (A) + 600 (A) Notes : (1) Standard Cost is calculated as below . Standard input for the output of 80 units is 100 kgs. If the actual output is 700 units, the standard input for the same will be 700 X 100 80 = 875 kgs.

The standard proportion of the materials is 40% for X and 60% for Y. As such, for the standard input of 875 kgs, the standard proportion will be X - 40% of 875 kgs i.e. 350 kgs. Y - 60% of 875 kgs i.e. 5:25 kgs. The standard cost will be as follows. Material Standard Quantity kgs. 350 525 Standard Price Rs. 6 4 Cost Rs. 2,100 2,100 4.200 (2) Revised standard quantity is calculated as below. Total input is 1000 kgs. The standard proportion of the materials is 40% for X and 60% for. Y. As such, the revised standard quantity should have been X - 40% of 1000 kgs. i.e. 400 kgs. Y - 60% of 1000 kgs. i.e. 600 kgs.

X Y

Standard Costing

527

(3)

The standard material cost of a normal mix of one tonne of chemical X is based on Chemical A B C Usage Kgs. 240 400 640 Price per Kg. 6 12 10

During a month, 6.25 tonnes of X were produced from Chemical A B C Analyse the variances. Solution : Calculation of standard cost Chemical A B C Quantity kgs. 1500 2500 4000 Rate per kg. Rs. 6 12 10 Total Cost Rs. 9,000 30,000 40,000 79.000 Calculation of Actual cost Chemical A B C Quantity kgs. 1600 2400 4500 Rate per kg. Rs. 7 12.5 10.5 Total cost Rs. 11,200 30,000 47,250 88,450 (1) Material Cost Variance : Standard Cost - Actual Cost 79,000 - 88,450 = 9,450 (A) Consumption (Tonnes) 1.6 2.4 4.5 Cost (Rs.) 11,200 30,000 47,250

528

Management Accounting

(2)

Material Price Variance : Actual Quantity (Actual Price - Standard Price) A - 1600 (7-6) B - 2400 (12.5-12) C - 4500 (10.5 - 10) = = = 1,600 1,200 2,250 5,050 (A) (A) (A) (A)

(3)

Material Usage Variance : Standard Price (Actual Quantity - Standard Quantity) A - 6 (1,600 - 1500) B - 12 (2,400 - 2500) C - 10 (4,500 - 4000) = = = 600 1200 5000 4,400 (A) (F) (A) (A)

(4)

Material Mix Variance : Standard Price (Actual Mix - Standard Mix) A - 6 (1,600 - 1593.75) = B - 12 (2,400 - 2656.25) = C - 10 (4500 - 4250) = 37.5 3075.0 2500.0 537.5 (A) (F) (A) (F)

Note : The standard mix is calculated as below. When total input is 8000 kgs. Chemicals A, B and C are mixed in the proportion of 1500 kgs, 2500 kgs and 4000 kgs respectively. When total input is 8500 kgs, the chemicals should have been mixed in the following proportion. Chemical A 1500 8000 Chemical B 2500 8000 4000 Chemical C 8000 X 8500 = 4250 kgs. X 8500 = 2656.25 kgs. X 8500 = 1593.75 kgs.

Standard Costing

529

(5)

Material Sub-usage Variance : Standard Price (Standard Quantity - Standard Mix) A - 6 (1500 - 1593.75) B - 12 (2500 - 2656.25) C - 10 (4000 - 4250) = = = 562.5 (A) 1875.0 (A) 2500.0 (A) 4937.5 (A)

(6)

XYZ forecasts its overhead expenditure for a period as under. Rs. 30,000 for 10,000 hours. Rs. 27,500 for 9,000 hours. Rs. 25,000 for 8,000 hours.

The normal volume of activity is 10,000 hours. During a period 8,750 hours were utilised for a total overhead expenditure of Rs. 28,750 of which fixed overheads totalled to Rs. 5,250. The standard utilisation of labour should have been less by 5%. How will you analyse the overhead variance. Solution : From the variation of total overheads, it is noted that for the variation of 1,000 hours. The overheads very to the extent of Rs. 2,500. Thus, indicates that the rate of variable overheads is Rs. 2.50 per hour. At the normal level of activity, the distribution of overheads will be as below. Variable Overheads - 10,000 hours x Rs.2.50 Fixed Overheads - Balance Rs. 25,000 Rs. 5,000

Rs. 30,000 Variable Overheads Variances : (1) Overheads Cost Variance : Hours for [ Standard actual production = X Standard Hourly Rate - Actual Overheads

8930 X 2.50 - 23.500 22,325 - 23,500 = 1,175 (A)

530

Management Accounting

(2)

Expenditure Variance : [Revised Budgeted Overheads for Actual hours] - Actual Overheads. 8,750 x 2.50 - 23,500

= 21,875 - 23,500 = 1,625 (A) (3) Efficiency Variance : [Standard Hours for Actual Production - Actual Hours] x Standard Hourly Rate [8,930 - 8.750] x 2.50 = 450 (F) Notes : (a) Total overheads cost actually incurred is Rs. 28,750 out of which fixed overheads are Rs. 5,250. Hence, balance is variable overheads i.e. Rs. 28,750 - Rs. 5,250 = Rs. 23,500 (b) Standard Hourly Rate is calculated as below. Total Budgeted Variable Overheads/Total Budgeted Hours. = (c) Rs. 25,000 10,000 Standard-hours for actual production are calculated as below. Actual overheads are Rs. 23,500. As the standard hourly rate is Rs.2.50 per hour, the ideal hours should have been Rs. 32,500 = 9,400 Rs. 2.50 However, standard utilisation should have been less by 5%. Hence, standard hours will be 95% of 9,400 hours i.e. 8,930 hours. (d) Revised budgeted overheads for Actual Hours are worked out as below. Actual hours are 8,750 and standard hourly rate is Rs. 2.50 per hour. Hence, the revised budgeted overheads should have been Rs. 21,875 i.e. 8,750 x 2.50. Rs. 2.50 per hour.

Standard Costing

531

Check : Overheads Cost Variance = Expenditure Variance + Efficiency Variance 1175 (A) = 1625 (A) + 450 (F) Fixed Overheads Variance : (1) Overheads Cost Variance : Standard Overheads Cost - Actual Overheads Cost 4,987.5 - 5,250 = 262.5 (A) (2) Overheads Expenditure Variance : Budgeted Overheads Cost - Actual Overheads Cost 5000 - 5250 = 250 (A) (3) Overheads Volume Variance : Standard Hourly Rate x [Standard Hours for Actual Production - Budgeted Hours] 0.50 X (9,975 - 10,000) = 0.50 x 25 = 12.5 (A) (4) Overheads Efficiency Variance : Standard Hourly Rate x [Standard Hours for Actual Production - Actual Hours] 0.50 X (9,975 - 8750) = 0.50 x 1225 = 612.5 (F) (5) Overheads Capacity Variance : Standard Hourly Rate X [Actual Hours - Budgeted Hours] 0.50 X (8,750 - 10,000) = 0.50 x 1250 = 625 (A) Notes : (a) Standard Hourly Rate is calculated as below, Total Budgeted Fixed Overhead Total Budgeted Hours Rs. 5,000 10,000 = Rs. 0.50 per hour

532

Management Accounting

(b)

Standard Hours for actual production are calculated as below. Actual Overheads are Rs. 5,250. As the standard hourly rate is Rs, 0.50 per hour, the ideal hours should have been 10,500. However, standard utilisation should have been less by 5%. Hence, standard hours will be 95% of 10,500 hours i.e. 9,975 hours.,

(c)

Standard overheads cost is calculated as Standard Hours x Standard Hourly Rate 9,975 x 0.50 = 4,987.50

(d)

As the details of capacity variation due to the change in the number of working days is not known, calender variance cannot be calculated. As such, the calculation of capacity variance is made on the basis of comparison between actual hours and budgeted hours.

Check : Overheads Cost Variance = Expenditure Variance + Efficiency Variance + Capacity Variance. = 262.5 (A) = 250 (A)+612.5 (F)+625 (A) (4) The sales manager a company engaged in the manufacture and sale of three products P, Q and R gives you are following information for the month of October 1982. Budgeted Sales : Product Units sold Selling Price Per unit Rs. 12 8 5 Standard Margin per unit Rs. 6 4 1

P Q R Actual Sales P - 1,500 units for Rs. 15,000 Q - 2,500 units for Rs. l7,500 R - 3,500 units for Rs. 21,000

2,000 2,000 2,000

You are required to Calculate the following variances (i) (ii) The Sales Price Variance The Sales Volume Variance

(iii) The Sales Quantity Variance (iv) The Sales Mix Variance 533

Standard Costing

Solution : (A) As per Turnover/ Value Method : (1) Sales Price Variance :

Actual Sales Volume (Actual Price - Standard Price) P - 1,500 (10 - 12) Q - 2,500 (7 - 8) R - 3,500 (6 - 5) = = = 3,000 2,500 3,500 2,000 (2) Sales Volume Variance : (A) (A) (F) (A)

Standard Price (Actual Sales Volume - Standard Sales Volume) P - 12 (1,500 - 2,000) Q - 8 ( 2,500 - 2,000) R - 5 (3,500 - 2,000) = = = 6,000 4,000 7,500 5,500 (3) Sales Mix Variance : (A) (F) (F) (P)

Standard Sales - Revised Standard Sales Where standard sales are actual quantity at standard price and revised standard sales are standard sales rearranged in budgeted ratio. Standard Sales Price Rs. 12 8 5 Revised Standard Sales Ratio Total Rs. 1/3 1/3 1/3 18,500 18,500 18,500 55,500

Qty. P Q B 1,500 2,500 3,500

Total Rs. 18,000 20,000 17,500 55,500

Sales Mix Variance : P Q R 18,000 20,000 17,500 18,500 18,500 18,500 = = = 500 (A) 1,500 (F) 1,000 (A) NIL

534

Management Accounting

(4)

Sales Quantity Variance :

Revised Standard Sales - Budgeted Sales : P - 18,500 - 2,000 x 12 Q - 18,500 - 2,000 x 8 Q - 18,500 - 2,000 X 5 = = = 5,500 2,500 8,500 5,500 (B) As per Margin/ Profit Method Cost per unit = Selling price per unit - Contribution per unit P Q R
PRODUCT Qty. Budgeted

(A) (F) (F)

12 - 6 8 -4 5 -l

=6 =4 =4
SALES COST OF SALES Per unit Rs. Total Rs. PROFIT Per unit Rs. Total Rs.

Price Rs.

Total Rs.

P Q R Actual P Q R

2,000 2,000 2,000

12 8 5

24,000 16,000 10,000 50,000

6 4 4

12,000 8,000 8,000 28,000

6 4 1

12,000 8,000 2,000 22,000

1,500 2,500 3,500

10 7 6

15,000 17,500 21,000 53,500

6 4 4

9,000 10,000 14,000 33,000

4 3 2

6,000 7,500 7,000 20,500

Standard sales and revised standard sales are calculated as below : Standard Sales P Q R 1,500 2,500 3,500 12 8 5 18,000 20,000 17,500 55,500 6 4 4 9,000 10,000 14,000 33,000 6 4 1 9,000 10,000 3,500 22,500

Standard Costing

535

Revised Standard Sales Revised Standard Sales Rs. P Q R 25,680 17,120 10,700 53,500 (1) Sales Margin Price Variance : Actual Profit - Standard Profit (2) 20,500 - 22,500 = 2,000 (A) Revised Standard Profit Rs. 12,840 8,560 2,140 23,540

Sales Margin Volume Variance : Standard Profit - Budgeted Profit 22,500 - 22,000 = 500 (F)

(3)

Sales Margin Mix Variance : Standard Profit - Revised Standard Profit 22,500 - 23,540 = 1,040 (A)

(4)

Sales Margin Quantity Variance : Revised standard Profit - Budgeted Profit 23,540 - 22,000 = 1,540 (F)

QUESTIONS 1. What do you mean by standard costing? Differentiate between Standard Costing and Budgetary Control as cost control techniques. state the advantages and limitations of standard costing. 2. What do you understand by standard costing? What preliminaries will have to be complied with before introducing the technique of standard costing. 3. Describe the procedure of establishing standard costs in the area of materials cost, labour cost and overheads cost. What do you mean by variances and variance analysis. Explain the various factors affecting the variances in the area of materials cost, labour cost and overheads cost.

4.

536

Management Accounting

PROBLEMS 1. The standard materials cost to produce a tonne of chemcial X is 300 kgs of material A @ Rs. 10 per kg. 400 kgs of material B @ Rs. 5 per kg. 500 kgs of material C @ Rs. 6 per kg. During the period 100 tones of chemical X were produced from the usage of 35 tonnes of material A for a cost of Rs.9,000 per tonne 42 tonnes of material B for a cost of Rs. 6,000 per tonne 53 tonnes of material C for a cost of Rs. 7,000 per tonne Calculate price, mix and usage variances. 2. Mixers Ltd. is engaged in producing a standard mix using 60 kgs. of chemical X and 40 kgs of chemical Y. The standard loss of production is 30%. The standard price of X is Rs.5 per kg. and of Y is Rs. 10 per kg. The actual mixture and yield were as follows. X 80 kgs. @ Rs. 4.50 per leg and Y 70 kgs @ Rs.8.00 per kg. Actual yield 115 kgs. Calculate material variances (Price, Usage, Yield, Mix) 3. Given that the cost standards for material consumption are 40 kgs at Rs. 10 per kg., compute the variance when the actuals are a. b. c. d. 4. 48 kgs @ Rs. 10 per kg. 40 kgs @ Rs. 12 per kg. 48 kgs @ Rs. 12 per kg. 36 kgs @ Rs. 10 per kg.

The standard cost of material for manufacturing a unit of a particular product FEE is estimated as follows. 16 kgs of raw material @ Re. 1 per kg. On completion of the unit, it was found that 20 kgs of raw material costing Rs.1.50 per kg. has been consumed. Compute material variances (price, usage, cost)

5.

A company manufacturing distempers operates a standard costing system. The standard cost for one of the products of the company shows the following materials standards.

Standard Costing

537

Materials A B C

Quantity 40 10 50

Standard Price per kg Rs. 75 50 20

Total Rs. 3,000 500 1,000

Material cost per unit (Total) 4,500 The standard input mix is 100 kgs and the standard output of the finished product is 90 kgs. The actual results for a period are Material Used. A - 2,40,000 kgs @ Rs. 80/kg B - 40,000 kgs. @ Rs. 52/kg C - 2,20,000 kgs @ Rs. 21/kg Actual output of the finished product - 4,20,000 kgs. Yon are required to calculated the material price, mix and yield variance. 6. In a factory 100 workers are engaged and the average rate of wages is 50 paise. Standard working hours per week are 40 and the standard performance is 10 units per gang hour. During a week in March, wages paid for 40 workers were at the rate of 50 paise per hour, 10 workers at 70 paise per hour and 40 workers at 40 paise per hour. Actual output was 380 units. Factory did not work for 5 hours due to breakdown of machinery. Calculate appropriate labour variances 7. The standard cost of a unit shows the following costs of material and labour Material 4 pices @ Rs. 5.00 Labour 10 hours @ Rs. 1.50 5,700 units of the product were manufactured during the month of March 1987 with the following material and labour costs. Material 23,000 pieces at Rs. 4.95 Labour 56,800 hours at Rs. 1.52

538

Management Accounting

You are required to calculate (1) (2) (3) (4) (5) (6) 8. Material Price variance Material Cost variance Material Usage variance Labour Rate variance Labour Efficiency variance Labour Cost variance

The standard labour component and the actual labour component engaged in a week for a job are as under. Skilled Workeis (a) Standard number of workers in the gang (b) (c) Standard wage rate per hour (Rs.) Actual number of workers employed in the gang during the week. (d) Actual wage rate per hour (Rs.) 4 3 2 32 3 28 12 2 18 6 I 4 Semi Skilled Workers Unskilled Workers

During the 40 hours working week, the gang produced 1800 standard hours of work. Calculate the following variances. (i) (ii) Labour cost variance Labour efficiency variance

(iii) Labour rate variance (iv) 9. Labour mix variance Budget 20 8,000 1.0 1,60,000 Actual 22 8,400 0.9 1,68,000

Items No. of working days Month hours per day Output per manhour in units Overhead cost (Rs.) Calculate overhead variances.

10. From the following data of A Co. Ltd. relating to budgeted and actual performance for the month of March 87, compute the Direct Material and Direct Labour cost variances.

Standard Costing

539

Budgeted data for March : Units to be manufactured Units of direct material required (Based on standard rates) Planned purchases of Raw Materials (Units) Average unit cost of Direct Material Direct Labour hours per unit of finished goods Direct Labour cost (Total) Rs. Actual data at the end of March : Units actually manufactured Direct Material cost (Purchase cost based on units actually issued) Rs. Direct Material cost (Purchase cost based on units actually purchased) Rs. Average unit cost of Direct Material Total Direct Labour hours for March Total Direct Labour cost for March. 11. 45,10,000 Rs.8.20 1,25,000 Rs. 33,75,000 43,41,900 1,60,000 4,95,000 5,40,000 Rs.8 3/4 hr. 29,92,500 1,50,000

The following details relating to the Product X during the month of March 1989 are available. You are required to compute the material and labour cost variance and also to reconcile the standard and the actual cost with the help of such variances. Standard cost per unit Materials 50 kgs. @ Rs. 40 per kg. Labour 400 hours @ Rs. 1.00 per hour. Actual cost for the month Material 4900 kgs @ Rs. 42 per kg. Labour 39,600 hours @ Rs. 1.10 per hour Actual production - 100 units.

540

Management Accounting

12. Following data are available in respect of a particular department for weekly operations: Standard output for 40 hours week Standard fixed overheads Actual output Actual hours worked Actual fixed overheads Calculate overhead variances 13. Dustfree Products manufactures and sells a patented vaccum cleaner for domestic use and the following data is available for October 1983. Actual Direct Labour hours Direct Labour cost (Rs.) Direct Material (Tonnes) Direct Material cost (Rs.) 10,500 21,500 550 52,250 Actuals (For October) Overheads: Fixed Variable (varies with volume of production) Overhead is budgeted for normal activity of 1,44,000 hours of direct labour per annum, equally phased. Compute labour, material and overheads variances. 14. The budgeted and actual sales of a concern manufacturing and marketing a single product are furnished below. Budgeted sales Qty. Price per Units Rs. 10,000 3.00 Actual sales Price per unit Amount Rs. 3.00 2.50 Rs. 15,000 20,000 6,200 15,200 Standard 10,000 (10 hrs. per unit) 2.10 per hour 540 100 per Tonne Budgeted (For the year) 72,000 216,000 - 2,000 units - Rs. 2,000 - 1,800 units - 32 -Rs. 2,250

Amount Rs. 30,000

Qty. units 5,000 8,000

Ascertain, (a) (b) Sales Price Variance Sales Volume Variance.

Standard Costing

541

17. From the following information about sales, calculate (a) (b) (c) (d) (e) Total Sales Variance Sales Price Variance Sales Volume Variance Sales Mix Variance Sales Quantity Variance Standard Rate (Rs.) 5 6 7 Actual Rate (Rs.) 6 5 8

Product A B C

Nos. 5,000 4,000 3,000 12,000

Rs. 25,000 24,000 21,000 70,000

Nos. 6,000 5,000 4,000 15,000

Rs. 36,000 25,000 32,000 93,000

18. Budgeted and actual sales for a month of two products A and B were as below Budget Unit Price Rs. 10.00 Actual Units 2,500 1,000 B 5,000 2.00 4,000 1,200 Unit Price Rs. 10.00 9.50 2.00 1.90

Units A 3,000

Budgeted costs for the products A and B were Rs.8 and Rs. 1.50 respectively. Work out the following variances. (a) (b) (c) (d) (e) Sales Value Variance Sales Volume Variance Sales Price Variance Sales Mix Variance Sales Qunatity Variance

19. X Ltd. operates a budgetory control and standard costing system. From the following data calculate (a) (b) (c) Sales Variance Sales Volume Variance Sales Price Variance

542

Management Accounting

Product A B C D

Budgeted Units to be Sales Value Rs. 100 50 100 75 325 1,200 600 900 450 3,150

Actual Units sold Sales value Rs. 100 50 200 50 400 1,100 600 1,700 300 3,700

20. The records of an engineering company indicate the following for the month of April 1986 Standards Direct Materials Direct Labour Factors 4 gallons @ Rs. 1.20 3 hours @ Rs. 1.80 Unit cost (Rs.) 4.80 5.40 1.80 12.00

Factory overheads Rs.0.60 per labour hour Total manufacturing cost Activity for the month of April 1986 (1)

Production during the month of April 1986 has been 6,500 units with no beginning or ending work in progress inventories. Materials purchased 32,000 gallons @ Rs. 1.18 per gallon. Used in production 25,600 gallons. Labour hours worked 20,000. Average hourly wage rate Rs. 1.75 Factory overheads - Total overheads costs incurred Rs. 12,500

(2)

(3) (4)

Calculate material variances, labour variances and total variance for factory overheads. 21. A factory supplies the following figures of production and overheads for September 1983 Budgeted Production (Units) Variable overheads (Rs.) Fixed overheads (Rs.) Number of hours Work out the variances that are involved. 50,000 4,00,000 6,00,000 2,00,000 Actual 52,000 4,10,000 6,20,000 2,20,000

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22. It is estimated that in the manufacture of a product, for each ton of material consumed, 100 articles should be produced. The Standard Price per ton of material is Rs. 10. During the first week of January, 200 tons of materials were issued to the production department, the purchase price of which was Rs. 10.50 per ton. The actual output for the period was 20,500 units. Calculate the Material Variances.

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NOTES

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545

NOTES

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Chapter 1 4
UNIFORM COSTING

It refers to the use of same costing principles and methods by several undertakings. Its not a separate method of cost accounting but only a particular technique which applies the usual accounting methods like process costing, job costing, standard costing, budgetory costing and marginal costing. Main feature of uniform costing is that whenever a particular method of costing is applied it is applied uniformly in a number of concerns in the same industry or even different but similar industries. This enables cost and accounting data of the member undertakings to be compiled on a comparable basis so that useful and crucial decisions can be taken. It attempts to establish uniform methods so that comparison of performances in the various undertakings can be made to the common advantages of all the constituent units. Scope of Uniform Costing : Uniform costing methods may be advantageously applied (i) In single organisation having a number of branches, each of which may be a separate manufacturing unit. In this case, the head office controls the operations of the uniform costing methods. In a number of concerns in the same industry bound together through a trade association or otherwise. In this case, the procedure for uniform costing may be devised and controlled by the association or any other central body prescribed for this purpose.

(ii)

(iii) In industries which are similar such as gas and electricity, cotton, jute and woolen textiles. Requisites for uniform costing : The success of uniform costing will depend upon the following : (1) (2) There should be a spirit of mutual trust and policy of give and take. There should be free exchange of ideas and methods.

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(3)

Bigger units should be ready to share with smaller ones, improvements, achievements of efficiency and know how. There should not be any hiding or withholding of information. There should be no rivalry, competition or sense of jealousy among the members.

(4) (5)

Advantages of uniform costing : (1) Uniform costing is a useful tool for management control. Performances of individual units can be measured against norms set for the industry as a whole. It avoids cut throat competition by ensuring that competition among the members will proceed on healthy lines. Weaker units in the industry can take the advantage of the efficient methods of production and production control of better managed units so as to increase their own efficiency. The fruits of the research and development programmes which can be carried out only by the bigger units, may be shared by the smaller units. By showing one best way of doing things, it creates cost consciousness and provides the best system of cost control or cost presentation in the entire industry. Prices based on uniform costing may be taken to be reliable and representative of the whole industry. This creates customer confidence and improves relations between customer and business. It assists in educating the less informed units as regards the cost accounting methods. In India, where public undertakings operate alongwith the private sector undertakings, uniform costing enables a comparitive assessment to be made of the two sectors. Uniform costing enables the furnishing of suitable statistics to the Government wherever called upon to do so. This may be required by Government for effective price control or to give protection or subsidy to a particular industry etc.

(2)

(3)

(4)

(5)

(6)

(7) (8)

(9)

(10) It simplifies the work of wage boards set up to fix minimum wages and fair wages for an industry.

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Disadvantages of Uniform Costing : (1) The practices and methods followed by various units in the industry may vary from one unit to another. The factors for such differences like location, age, capital investment and condition of plant, degree of mechanisation etc. may be so wide from each other that to have a uniform costing system suitable for big as will as small units becomes impossible. For small units, cost of installation and operation of uniform costing system may not be commensurate to the advantages therefrom. If some reservations are made while giving certain information by some units or if some information is withheld on the grounds of secrecy or privacy, the statistics presented cannot be relied upon. It may create conditions which are likely to develop monopolistic tendencies within the industry. Prices may be raised arbitrarily and supplies curtailed.

(2)

(3)

(4)

Fields covered by uniform costing : Considering the basic nature of uniform costing as discussed above, it goes without saying that the success of uniform costing system depends upon the extent to which uniformity can be brought about in various areas. The various areas in which uniformly can be attempted to be brought are as discussed below. (1) Method of cost accounting to be implemented viz. job costing, process costing, unit costing and so on. Costing Techniques employed i.e. marginal costing, standard costing etc. Methods of pricing the issues from stores. viz. FIFO, LIFO, Weighted Average and so on. Method followed for valuation of inventories. Methods followed for inventory control. Method followed for charging depreciation viz. written down value, straight line etc. Methods of remunerating the workers. Treatment given to certain specific types of costs like bonus, idle time wages and so on. Methods for apportionment and absorption of overheads and treatment given to under or over absorption of overheads.

(2) (3)

(4) (5) (6) (7) (8) (9)

(10) Treatment given to material scrap, wastes, spoilages and defectives.

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(11) Treatment given to research and development costs. (12) Definition of the term capacity for setting overhead absorption rates. (13) Procedure for classification and codification of accounts. (14) Items to be excluded from cost accounts. Uniform Cost Manual : It is a document which lays down the cost accounting plans and procedures to be followed by the constituent units. This document once circulated among the constituent units helps to guide them to formulate their system of accounting in such a way that the principles of uniform costing can be uniformly and correctly applied. The various contents of an uniform cost manual can be stated us below : (1) Introduction : This part may state the objects and purposes of uniform cost system, advantages derived therefrom and the cooperation expected from constituent units. Organisation : This part may include the organisation for establishing and running the uniform cost system. E.g. whether the system is to be established and run by outside cost consultants or by those internal to the various constituent units. Cost Accounting System : This part includes accounting systems and procedures to be followed lo bring about uniformity E.g. classification and codification of accounts, definition of a cost centre and cost unit, relationship between cost and financial accounting, items to he included in or excluded from cost accounting, collection of various costs viz. material, labour and overheads and so on. Presentation of information : This part may include the forms and contents of various cost and financial ratios, presentation of various production and operation costs and so on. Miscellaneous : This part may include any of their information to be communicated to the constituent units but not included in any of the above mentioned sections.

(2)

(3)

(4)

(5)

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QUESTIONS 1. 2. What are the advantages and limitations of uniform costing? Write short notes Uniform Costing Manual 3. What do you mean by Uniform Costing? What are the various advantages and disadvantages of Uniform Costing? State the pre-requisites for the success of Uniform Costing. Explain the various areas where uniform costing can be used.

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NOTES

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