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II SEM BCOM

COST ACCOUNTING
UNIT I

INTRODUCTION TO COST
Accounting information is important for every business which will serve the
needs of variety of interested parties. To satisfy the needs of all interested
parties a sound accounting system is very necessary. Accounting may be
divided into three parts i. Financial accounting ii. Cost accounting iii.
Management accounting.
Cost accounting developed to help the internal management in decision
making. The information provided by cost accounting acts as a managerial
tool so that business can utilise the available resources at optimum level.
Meaning of Cost
Cost is the amount of resource given up in exchange for some goods or
services. The resources given up are money or moneys equivalent expressed
in monetary units.
The Chartered Institute of Management Accountants, London defines cost
as the amount of expenditure (actual or notional) incurred on, or
attributable to a specified thing or activity.
Costing
Costing is the techniques and processes of ascertaining costs. These
techniques consist of principles and rules which govern the procedure of
ascertaining cost of products or services. The techniques to be followed for
the analysis of expenses and the processes of different products or services
differ from industry to industry.
The main object of costing is the analysis of financial records, so as to
subdivide expenditure and to allocate it carefully to selected cost centers,
and hence to build up a total cost for the departments, processes or jobs or
contracts of the undertaking.
Cost Accounting
Cost accounting may be regarded as ``a specialised branch of accounting
which involves classification, accumulation, assignment and control of
costs.
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The Costing terminology of C.I.M.A. London defines cost accounting as ``The


establishment of budgets, standard costs and actual costs of operations,
processes, activities or products, and the analysis of variances, profitability
or the social use of funds.
Cost Accountancy
Cost Accountancy has been defined 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. It includes the
presentation of information derived there from for the purpose of
managerial decision making.
Scope of Cost Accounting
The terms costing and cost accounting are many times used
interchangeably. However, the scope of cost accounting is broader than that
of costing. Following functional activities are included in the scope of cost
accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs
incurred from their incurrence to their charge to departments, products and
services. Such recording is preferably done on the basis of double entry
system.
2. Cost system: Systems and procedures are devised for proper accounting
for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,
services, etc., is the important function of cost accounting. Cost
ascertainment becomes the basis of managerial decision making such as
pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors of
actual costs varying from the budgeted costs and fixation of responsibility
for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between
cost from alternative courses of action such as use of technology for
production, cost of making different products and activities, and cost of
same product/ service over a period of time.
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6. Cost Control: Cost accounting is the utilisation of cost information for


exercising control. It involves a detailed examination of each cost in the light
of benefit derived from the incurrence of the cost. Thus, we can state that
cost is analysed to know whether the current level of costs is satisfactory in
the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost
accounting. These reports are primarily for use by the management at
different levels. Cost Reports form the basis for planning and control,
performance appraisal and managerial decision making.
Objectives of cost accounting
There is a relationship among information needs of management, cost
accounting objectives, and techniques and tools used for analysis in cost
accounting. Cost accounting has the following main objectives to serve:
1. Determining selling price,
2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.
1. Determining selling price: The objective of determining the cost of
products is of main importance in cost accounting. The total product cost
and cost per unit of product are important in deciding selling price of
product. Cost accounting provides information regarding the cost to make
and sell product or services. Other factors such as the quality of product,
the condition of the market, the area of distribution, the quantity which can
be supplied etc., are also to be given consideration by the management
before deciding the selling price, but the cost of product plays a major role.
2. Controlling cost: Cost accounting helps in attaining aim of controlling
cost by using various techniques such as Budgetary Control, Standard
costing, and inventory control. Each item of cost [viz. material, labour, and
expense] is budgeted at the beginning of the period and actual expenses
incurred are compared with the budget. This increases the efficiency of the
enterprise.
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3. Providing information for decision-making Cost accounting helps the


management in providing information for managerial decisions for
formulating operative policies. These policies relate to the following matters:
(i) Determination of cost-volume-profit relationship.
(ii) Make or buy a component
(iii) Shut down or continue operation at a loss
(iv) Continuing with the existing machinery or replacing them by improved
and economical machines.
4. Ascertaining costing profit: Cost accounting helps in ascertaining the
costing profit or loss of any activity on an objective basis by matching cost
with the revenue of the activity.
5. Facilitating preparation of financial and other statements: Cost
accounting helps to produce statements at short intervals as the
management may require. The financial statements are prepared generally
once a year or half year to meet the needs of the management. In order to
operate the business at high efficiency, it is essential for management to
have a review of production, sales and operating results. Cost accounting
provides daily, weekly or monthly statements of units produced,
accumulated cost with analysis. Cost accounting system provides
immediate information regarding stock of raw material, semi finished and
finished goods. This helps in preparation of financial statements.
Importance of Cost accounting
The limitation of financial accounting has made the management to realise
the importance of cost accounting. The importance of cost accounting are
as follows:
1. Importance to Management
Cost accounting provides invaluable help to management. It is difficult to
indicate where the work of cost accountant ends and managerial control
begins. The advantages are as follows :
Helps in ascertainment of cost Cost accounting helps the management in
the ascertainment of cost of process, product, Job, contract, activity, etc.,
by using different techniques such as Job costing and Process costing.
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Aids in Price fixation By using demand and supply, activities of


competitors, market condition to a great extent, also determine the price of
product and cost to the producer does play an important role. The producer
can take necessary help from his costing records.
Helps in Cost reduction Cost can be reduced in the long-run when cost
reduction programme and improved methods are tried to reduce costs.
Elimination of wastage As it is possible to know the cost of product at
every stage, it becomes possible to check the forms of waste, such as time
and expenses etc., are in the use of machine equipment and material.
Helps in identifying unprofitable activities With the help of cost
accounting the unprofitable activities are identified, so that the necessary
correct action may be taken.
Helps in checking the accuracy of financial account Cost accounting
helps in checking the accuracy of financial account with the help of
reconciliation of the profit as per financial accounts with the profit as per
cost account.
Helps in fixing selling Prices It helps the management in fixing selling
prices of product by providing detailed cost information.
Helps in Inventory Control Cost furnishes control which management
requires in respect of stock of material, work in progress and finished
goods.
Helps in estimate Costing records provide a reliable basis upon which
tender and estimates may be prepared.
2. Importance to Employees
Worker and employees have an interest in which they are employed. An
efficient costing system benefits employees through incentives plan in their
enterprise, etc. As a result both the productivity and earning capacity
increases.
3. Cost accounting and creditors
Suppliers, investors financial institution and other moneylenders have a
stake in the success of the business concern and therefore are benefited by
installation of an efficient costing system. They can base their judgement
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about the profitability and prospects of the enterprise upon the studies and
reports submitted by the cost accountant.
4. Importance to National Economy
An efficient costing system benefits national economy by stepping up the
government revenue by achieving higher production. The overall economic
developments of a country take place due to efficiency of production.
5. Data Base for operating policy
Cost Accounting offers a thoroughly analysed cost data which forms the
basis of formulating policy regarding day to day business, such as:
(a) Whether to make or buy decisions from outside?
(b) Whether to shut down or continue producing and selling at below cost?
(c) Whether to repair an old plant or to replace it?
LIMITATIONS OF COST ACCOUNTING
Like other branches of accounting, cost accounting is not an exact science
but is an art which has developed through theories and accounting
practices based on reasoning and common sense. These practices are not
static but changing with time. Cost accounting lacks a uniform procedure.
There is no stereotyped system of cost accounting applicable to all
industries. There are widely recognised cost concepts but understood and
applied differently by different industries. Cost accounting can be used only
by big enterprises.
The limitations of cost accounting are as follows:
It is expensive because analysis, allocation and absorption of overheads
require considerable amount of additional work.
The results shown by cost accounts differ from those shown by financial
accounts. Preparation of reconciliation statements frequently is necessary
to verify their accuracy. This leads to unnecessary increase in workload.
It is unnecessary because it involves duplication of work. Some industrial
units are functioning efficiently without any costing system.

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Costing system itself does not control costs. If the management is alert and
efficient, it can control cost without the help of the cost accounting.
Therefore it is unnecessary.
Differences between Cost accounting and Financial accounting
Points of
Cost accounting
Financial accounting
Differences
1. Purpose The purpose of financial The purpose of cost accounting
accounting
is
external is internal reporting, i.e., to the
reporting mainly to owners, mangement of every business.
creditors, tax authorities,
government, and prospective
investors.
2.
2. This is to be maintained Cost accounting is maintained
Obligation compulsorily by higher forms voluntarily. In some cases
to
of business organizations. government has directed some
maintain
The preparation of accounts companies to maintain cost
accounts
must be in accordance with accounts to improve efficiency.
the statutory provisions.
3.
(a)
Financial
accounting (a) Cost accounting records
Recording records transactions in a transactions in an objective
subjective
manner,
i.e., manner, i.e., according to
according to the nature of purpose for which costs are
expenditure.
incurred.
(b) In financial accounting (b) In cost accounting costs are
expenses are recorded in expressed by proper analysis
totals.
and classification in order to
(c)
Financial
accounting find out cost per unit.
records all transactions which (c) Cost accounting records
takes place in the business.
only those costs which affect
(d)
Financial
accounting production and sales.
records only historical costs.
(d) Cost accounting records
both historical and estimated
costs
4. Analysis Financial
accounting Cost accounting shows the
of profit
discloses profit for the entire profitability or otherwise of
business as a whole.
each product, process or
operation so as to reveal the
areas of profitability.
5. Control (a) It does not make use of (a) It makes use of some
any control techniques.
important control techniques
(b) It does not control such as Marginal Costing,
materials
by
using
any Budgetary Control, Standard
technique.
Costing, etc., in order to control
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(c) Control over labour is not cost.


exercised.
(b) It exercises control over
materials
using
some
techniques
such
as
ABC
analysis,
level
setting,
economic order quantity, etc.
(c) Control over labour is
exercised and efforts are taken
to minimise idle time, over time
etc.
6.
Generally,
financial Cost accounting furnishes cost
Duration
accounting provides financial data at frequent intervals.
of
information once a year.
Some reports are daily. Some
reporting
are weekly and some monthly
7.
The information provided by The
cost
data
helps
in
Evaluation financial accounting is not evaluating the efficiency of the
of
sufficient to evaluate the businesses.
efficiency
efficiency of the business.
8. Pricing
It
fails
to
guide
the It provides adequate data for
formulation of pricing policy. formulating pricing policy
9.
stock is valued at cost or Stock is always valued of cost
Valuation market price whichever is less price
of Stock

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UNIT II

CLASSIFICATION OF COSTS
The different bases of cost classification are:
1. By time (Historical, Pre-determined).
2. By nature or elements (Material, Labour and Overhead).
3. By degree of traceability to the product (Direct, Indirect).
4. Association with the product (Product, Period).
5. By Changes in activity or volume (Fixed, Variable, Semi-variable).
6. By function (Manufacturing, Administrative, Selling, Research and
development, Pre production).
7. Relationship with accounting period (Capital, Revenue).
8. Controllability (Controllable, Non-controllable).
9. Cost for analytical and decision-making purposes (Opportunity, Sunk,
Differential, Joint, Common, Imputed, Out-of-pocket, Marginal,
Uniform, Replacement).
10.
Others (Conversion, Traceable, Normal, Avoidable, Unavoidable,
Total).
1. Classification on the Basis of Time
(a) Historical Costs: These costs are ascertained after they are incurred.
Such costs are available only when the production of a particular thing has
already been done. They are objective in nature and can be verified with
reference to actual operations.
(b) Pre-determined Costs: These costs are calculated before they are
incurred on the basis of a specification of all factors affecting cost. Such
costs may be:
(i) Estimated costs: Costs are estimated before goods are produced; these
are naturally less accurate than standards.
(ii) Standard costs: This is a particular concept and technique. This
method involves:
(a) Setting up predetermined standards for each element of cost and each
product;
(b) Comparison of actual with standard to find variation;
(c) pin-pointing the causes of such variances and taking remedial action.
Obviously, standard costs, though pre-determined, are arrived with much
greater care than estimated costs.
2. By Nature or Elements
There are three broad elements of costs:

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(1) Material: The substance from which the product is made is known as
material. It can be direct as well as indirect.
Direct material: It refers to those materials which become a major part of
the finished product and can be easily traceable to the units. Direct
materials include:
(i) All materials specifically purchased for a particular job/process.
(ii) All material acquired and latter requisitioned from stores.
(iii) Components purchased or produced.
(iv) Primary packing materials.
(v) Material passing from one process to another.
Indirect material: All material which is used for purposes ancillary to
production and which can be conveniently assigned to specific physical
units is termed as indirect materials. Examples, oil, grease, consumable
stores, printing and stationary material etc.
(2) Labour: Labour cost can be classified into direct labour and indirect
labour.
Direct labour: It is defined as the wages paid to workers who are engaged
in the production process whose time can be conveniently and economically
traceable to units of products. For example, wages paid to compositors in a
printing press, to workers in the foundry in cast iron works etc.
Indirect labour: Labour employed for the purpose of carrying tasks
incidental to goods or services provided, is indirect labour. It cannot be
practically traced to specific units of output. Examples, wages of storekeepers, foreman, time-keepers, supervisors, inspectors etc.
(3) Expenses: Expenses may be direct or indirect.
Direct expenses: These expenses are incurred on a specific cost unit and
identifiable with the cost unit. Examples are cost of special layout, design or
drawings, hiring of a particular tool or equipment for a job; fees paid to
consultants in connection with a job etc.
Indirect expenses: These are expenses which cannot be directly,
conveniently and wholly allocated to cost centre or cost units. Examples are
rent, rates and taxes, insurance, power, lighting and heating, depreciation
etc.
It is to be noted that the term overheads has a wider meaning than the term
indirect expenses. Overheads include the cost of indirect material, indirect
labour and indirect expenses. Overheads may be classified as
(a) production or manufacturing overheads, (b) administration overheads,
(c) selling overheads, and (d) distribution overheads.
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3. By Degree of Traceability to the Products


Cost can be distinguished as direct and indirect.
Direct Costs: The direct costs are those which can be easily traceable to a
product or costing unit or cost center or some specific activity, e.g. cost of
wood for making furniture. It is also called traceable cost.
Indirect Costs: The indirect costs are difficult to trace to a single product
or it is uneconomic to do so. They are common to several products, e.g.
salary of a factory manager. It is also called common costs.
Costs may be direct or indirect with respect to a particular division or
department. For example, all the costs incurred in the Power House are
indirect as far as the main product is concerned but as regards the Power
House itself, the fuel cost or supervisory salaries are direct. It is necessary
to know the purpose for which cost is being ascertained and whether it is
being associated with a product, department or some activity.
Direct cost can be allocated directly to costing unit or cost center. Whereas
Indirect costs have to be apportioned to different products, if appropriate
measurement techniques are not available. These may involve some formula
or base which may not be totally correct or exact.
4. Association with the Product
Cost can be classified as product costs and period costs.
Product Costs: Product costs are those which are traceable to the product
and included in inventory values.
In a manufacturing concern it comprises the cost of direct materials, direct
labour and manufacturing overheads. Product cost is a full factory cost.
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Product costs are used for valuing inventories which are shown in the
balance sheet as asset till they are sold. The product cost of goods sold is
transferred to the cost of goods sold account.
Period Costs: Period costs are incurred on the basis of time such as rent,
salaries, etc., include many selling and administrative costs essential to
keep the business running. Though they are necessary to generate revenue,
they are not associated with production, therefore, they cannot be assigned
to a product.
They are charged to the period in which they are incurred and are treated
as expenses. Selling and administrative costs are treated as period costs for
the following reasons:
(i) Most of these expenses are fixed in nature.
(ii) It is difficult to apportion these costs to products equitably.
(iii) It is difficult to determine the relationship between such cost and the
product.
(iv) The benefits accruing from these expenses cannot be easily established.
The net income of a concern is influenced by both product and period costs.
Product costs are included in the cost of the product and do not affect
income till the product is sold. Period costs are charged to the period in
which they are incurred.
5. By Changes in Activity or Volume
Costs can be classified as fixed, variable and semi-variable cost.
Fixed Costs: The Chartered Institute of Management Accountants, London,
defines fixed cost as the cost which is incurred for a period, and which,
within certain output and turnover limits, tends to be unaffected by
fluctuations in the levels of activity (output or turnover).
These costs are incurred so that physical and human facilities necessary for
business operations, can be provided. These costs arise due to contractual
obligations and management decisions. They arise with the passage of time
and not with production and are expressed in terms of time. Examples are
rent, property taxes, insurance, supervisors salaries etc.
It is wrong to say that fixed costs never change. These costs may vary
depending on the circumstances. The term fixed refer to non-variability
related to the relevant range. Fixed cost can be classified into the following
categories for the purpose of analysis:

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(a) Committed Costs: These costs are incurred to maintain certain facilities
and cannot be quickly eliminated. The management has little or no
discretion in this cost, e.g., rent, insurance etc.
(b) Policy and Managed Costs: Policy costs are incurred for implementing
particular management policies such as executive development, housing,
etc. Such costs are often discretionary. Managed costs are incurred to
ensure the operating existence of the company e.g., staff services.
(c) Discretionary Costs: These are not related to the operations and can be
controlled by the management. These costs result from special policy
decisions, new researches etc., and can be eliminated or reduced to a
desirable level at the discretion of the management.
(d) Step Costs: Such costs are constant for a given level of output and then
increase by a fixed amount at a higher level of output.
Variable Cost: Variable costs are those costs that vary directly and
proportionately with the output e.g. direct materials, direct labour. It should
be kept in mind that the variable cost per unit is constant but the total cost
changes corresponding to the levels of output. It is always expressed in
terms of units, not in terms of time.
Management decisions can influence the cost behaviour patterns. The
concept of variability is relative. If the conditions upon which variability was
determined changes, the variability will have to be determined again.
Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable
elements. Because of the variable element, they fluctuate with volume and
because of the fixed element; they do not change in direct proportion to
output. Semi-variable costs change in the same direction as that of the
output but not in the same proportion. Depreciation is an example; for two
shifts working the total depreciation may be only 50% more than that for
single shift working. They may change with comparatively small changes in
output but not in the same proportion.
6. Functional Classification of Costs
A company performs a number of functions. Functional costs may be
classified as follows:
(a) Manufacturing/production Costs: It is the cost of operating the
manufacturing division of an undertaking. It includes the cost of direct

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materials, direct labour, direct expenses, packing (primary) cost and all
overhead expenses relating to production.
(b) Administration Costs: They are indirect and covers all expenditure
incurred in formulating the policy, directing the organisation and
controlling the operation of a concern, which is not related to research,
development, production, distribution or selling functions.
(c) Selling and Distribution Cost: Selling cost is the cost of seeking to
create and stimulate demand e.g. advertisements, market research etc.
Distribution cost is the expenditure incurred which begins with making the
package produced available for dispatch and ends with making the
reconditioned packages available for re-use e.g. warehousing, cartage etc. It
includes expenditure incurred in transporting articles to central or local
storage. Expenditure incurred in moving articles to and from prospective
customers as in the case of goods on sale or return basis is also distribution
cost.
(d) Research and Development Costs: They include the cost of discovering
new ideas, process, products by experiment and implementing such results
on a commercial basis.
(e) Pre-production Cost: When a new factory is started or when a new
product is introduced, certain expenses are incurred. There are trial runs.
Such costs are termed as pre-production costs and treated as deferred
revenue expenditure. They are charged to the cost of future production.
7. Relationships with Accounting Period
Costs can be capital and revenue.
Capital expenditure provides benefit to future period and is classified as
an asset. On the other hand, revenue expenditure benefits only the
current period and is treated as an expense. As and when an asset is
written off, capital expenses to that extent becomes cost. Only when capital
and revenue is properly differentiated, the income of a particular period can
be correctly determined. It is not possible to distinguish between the two
under all circumstances.
8. Controllability
Cost can be Controllable and Non-Controlable.
Controllable Cost: The Chartered Institute of Management Accountants
defines controllable cost as cost which can be influenced by its budget
holder.
Non-Controllable Cost: It is the cost which is not subject to control at any
level of managerial supervision.
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The difference between the terms is very important for the purpose of cost
accounting, cost control and responsibility accounting.
A controllable cost can be controlled by a person at a given organisational
level. Controllable cost are not totally controllable. Some costs are partly
controllable by one person and partly by another e.g., maintenance cost can
be controlled by both the production and maintenance manager. The term
controllable costs is often used to mean variable costs and noncontrollable costs as fixed.
Belkaoni has mentioned the following fallacies about controllable costs:
(i) All variable costs are controllable and fixed are not.
(ii) All direct costs are controllable and indirect costs are not.
(iii) All long-term costs are controllable.
Sometimes the time factor and the decision making authority can make a
cost controllable. If the time period is long enough, all costs can be
controlled. Proper delegation helps in establishing clear responsibility and
controllability. But all costs can be controlled by one or another person. The
authority and responsibility of cost control is delegated to different levels,
though the managing director is responsible for all the costs.
9. Costs for Analytical and Decision Making Purposes
(a) Opportunity Costs: Opportunity cost is the cost of selecting one course
of action and the losing of other opportunities to carry out that course of
action. It is the amount that can be received if the asset is utilised in its
next best alternative.
Edwards, Hermanson and Salmonson define it as the benefits lost by
rejecting the best competing alternative to the one chosen. The benefit lost
is usually the net earnings or profit that might have been earned from the
rejected alternative
Example: Capital is invested in plant and machinery. It cannot be now
invested in shares or debentures. The loss of interest and dividend that
would be earned is the opportunity cost. Another example is when the
owner of a business foregoes the opportunity to employ himself elsewhere.
Opportunity costs are not recorded in the books. It is important in decision
making and comparing alternatives.
(b) Sunk Costs: A sunk cost is one that has already been incurred and
cannot be avoided by decisions taken in the future. As it refers to past
costs, it is called unavoidable cost.
The National Association of Accountants (USA) defines a sunk cost as an
expenditure for equipment or productive resources which has no economic
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relevance to the present decision making process. This cost is not useful
for decision making as all past costs are irrelevant. CIMA defines it as the
past cost not taken into account in decision making. It has also been
defined as the difference between the purchase price of an asset and its
salvage value.
(c) Differential Cost: Differential cost has been defined as the difference in
total cost between alternatives, calculated to assist decision making.
Differential cost is the increase or decrease in total costs resulting out of:
(a) Producing and distributing a few more or few less of products;
(b) A change in the method of production/distribution;
(c) An addition or deletion of a product or a territory; and
(d) The selection of an additional sales channel.
The differential cost between any two levels of production is the difference
between the marginal costs at these two levels and the increase or decrease
in fixed costs, if any. These costs are usually specific purpose costs as they
are determined for a particular purpose and under specific circumstances.
Incremental cost measures the addition in unit cost for an addition in
output. This cost need not be the same at all levels of production. It is
usually expressed as a cost per unit whereas the differential cost is
measured in total. The former applies to increase in production and is
restricted to the cost only, whereas the differential cost has a
comprehensive meaning and application in the sense that it denotes both
increase or decrease.
Differential costs is useful in planning and decision making and helps to
choose the best alternative. It helps management to know the additional
profit that would be earned if idle capacity is used or when additional
investments are made.
(d) Joint Costs: The processing of a single raw material results in two or
more different products simultaneously. The joint products are not
identifiable as different types of product until a certain stage of production
known as the split-off point is reached. Joint costs are the costs incurred
upto the point of separation. One product may be of major importance and
others of minor importance which are called by-products.
Bierman and Djckman define it as: Joint costs relate to a situation in
which the factors of production by their basic nature result in two or more
products. The jointness results from there being more than one product,
and these multi-products are the result of the methods of production or the

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nature of raw material and not of a decision by management to produce


both.
The National Association of Accountants defines it as follows:
Joint costs relate to two or more products produced from a common
production process or element-material, labour or overhead or any
combination thereof or so locked together that one cannot be produced
without producing the other.
Joint costs can be apportioned to different products only by adopting a
suitable basis of apportionment.
(e) Common Costs: Common costs are those costs which are incurred for
more than one product, job, territory or any other specific costing object.
They are not easily related with individual products and hence are generally
apportioned.
The National Association of Accountants defines the term as the cost of
services employed in the creation of two or more outputs which is not
allocable to those outputs on a clearly justified basis.
It should be kept in mind that management decisions influence the
incurrence of common costs e.g. rent of the factory is a common cost to all
departments located in factory.
(f) Imputed Costs: Some costs are not incurred and are useful while taking
decision pertaining to a particular situation. These costs are known as
imputed or notional costs and they do not enter into traditional accounting
systems.
Examples: Interest on internally generated funds, salaries of owners of
proprietorship or
partnership, notional rent etc.
(g) Uniform Costs: They are not distinct costs as such. Uniform costing
signifies common costing principles and procedures adopted by a number of
firms. They are useful in inter-firm comparison.
(h) Marginal Costs: It is the aggregate of variable costs, i.e., prime cost plus
variable overheads. Thus, costs are classified as fixed and variable.
(i) Replacement Costs: This is the cost of replacing an asset at current
market values e.g. when the cost of replacing an asset is considered, it
means the cost of purchasing the asset at the current market price is
important and not the cost at which it was purchased.
(j) Out of Pocket Cost: It involves payment to outsiders i.e. gives rise to
Cash Expenditure as opposed to such costs as depreciation which dont

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involve any cash expenditure. Such costs are relevant for price fixation
during recession or when make or buy decision is to be made.
10. Other Costs
(i) Conversion Cost: It is the cost of a finished product or work-in-progress
comprising direct labour and manufacturing overhead. It is production cost
less the cost of raw material but including the gains and losses in weight or
volume of direct material arising due to production.
(ii) Normal Cost: This is the cost which is normally incurred at a given level
of output in the conditions in which that level of output is achieved.
(iii) Traceable Cost: It is the cost which can be easily associated with a
product, process or department.
(iv) Avoidable Costs: Avoidable costs are those costs which under the
present conditions need not have been incurred. Example: (a) Spoilage in
excess of normal limit; (b) Unfavourable cost variances which could have
been controlled.
(v) Unavoidable Costs: Unavoidable costs are those costs which under the
present conditions must be incurred.
(vi) Total Cost: This is the sum of all costs associated to a particular unit,
or process, or department or batch or the entire concern. It may also mean
the sum total of material, labour and overhead. The term total cost however,
is not precise, it needs to be made precise by using terms that indicate the
elements of cost included.
(vii) Value Added: Strictly, it is not cost. It means the selling price of the
product/service less the cost of materials used in the product or the service.
Often depreciation is also deducted for ascertaining value added.
COST CENTRE AND COST UNIT
A cost accountant has to ascertain cost by cost centre or cost unit or by
both.
Cost Centre
According to the Chartered Institute of Management Accountants, London,
cost centre means, a production or service location, function, activity or
item of equipment whose costs may be attributed to cost units.
Cost centre is the smallest organisational sub-unit for which separate cost
collection is attempted. Thus cost centre refers to one of the convenient unit
into which the whole factory organisation has been appropriately divided for
costing purposes. Each such unit consists of a department or a subdepartment or item of equipment or, machinery or a person or a group of
persons. For example, although an assembly department may be supervised
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by one foreman, it may contain several assembly lines. Sometimes each


assembly line is regarded as a separate cost centre with its own assistant
foreman. Take another example, in a laundry, activities such as collecting,
sorting, marketing and washing of clothes are performed. Each activity may
be considered as a separate cost centre and all costs relating to a particular
cost centre may be found out separately.
Cost centres may be classified as follows :
(i) Productive, Unproductive and Mixed Cost Centres: Productive cost
centres are those which are actually engaged in making the products - the
raw materials are handled here and converted into saleable products. In
such centres both direct and indirect costs are incurred, machine shops,
welding shops, and assembly shops are examples of production cost centres
in an engineering factory. Service or unproductive cost centres do not make
the products but are essential aids to the productive centres. Examples of
such service centres are those of administration, repairs and maintenance,
stores and drawing office departments. Mixed cost centres are those which
are engaged some on productive and other lines on service works. For
instance, a tool shop serves as a productive cost centre when it
manufactures dies and jigs for specific order, but serves as servicing cost
centre when it does repairs for the factory.
(ii) Personal and Impersonal Cost Centre: A personal cost centre consists
of a person or a group of persons. An impersonal cost centre is one which
consists of a department, plant or item of equipment (or group of these).
(iii) Operation and Process Cost Centre: In case a cost centre consists of
those machines and/or persons which carry out the same operation is
termed as operation cost centre. If a cost centre consists of a continuous
sequence of operations it is called process cost centre.
The determination of a suitable cost centre is very important for
ascertainment and control of cost. The manager in charge of a cost centre is
held responsible for control of cost of his cost centre.
Cost Unit
The Chartered Institute of Management Accountants, London, defines a
unit of cost as a unit of product or service in relation to which costs are
ascertained.
A cost unit is a devise for the purpose of breaking up or separating costs
into smaller sub-divisions. These smaller sub-divisions are attributed to
products or services to determine product cost or service cost or cost of time
spent for a particular job etc. We may for instance determine the cost per
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ton of steel, per tonne kilometre of a transport service or cost per machine
hour. The forms of measurement used as cost units are usually the units of
physical measurements like number, weight, area, length, value, time etc.
Unit selected should be unambiguous, simple and commonly used.
Following are some examples of cost unit:
Industry/Product
Cost unit
Automobile
Number
Brick works
1000 bricks
Cement
Tonne
Transport
Tonne - Kilometre
Passenger - Kilometre
Chemicals
Litre, gallon, kilogramme, tonne
Steel
Tonne
Sugar
Tonne
The selection of suitable cost centres or cost units for which costs are to be
ascertained in an undertaking depends upon a number of factors which are
listed as follows:
(i) Organisation of the factory.
(ii) Conditions of incidence of cost.
(iii) Requirements of the costing system i.e. suitability of the units of
centres for cost purposes.
(iv) Availability of information.
(v) Management policy regarding making a particular choice from several
alternatives.
PREPARATION OF COST SHEET
When costing information is set out in the form of a statement, it is called
Cost Sheet. It is usually adopted when there is only one main product and
all costs almost are incurred for that product only. The information
incorporated in a cost sheet would depend upon the requirement of
management for the purpose of control.
Cost sheet is one of the method of unit costing. The format of cost sheet is
as under:Cost Sheet for the Period___________________
Production __________ Units
Particulars
Amount
Amount
Opening Stock of Raw Material
***
Add: Purchase of Raw materials
***
Add: Purchase Expenses
***
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Less: Closing stock of Raw Materials


Raw Materials Consumed
Direct Wages (Labour)
Direct Charges

***
***
***
***
Prime cost (1)

Add :- Factory Over Heads:


Factory Rent
Factory Power
Indirect Material
Indirect Wages Supervisor Salary
Drawing Office Salary
Factory Insurance
Factory Asset Depreciation
Works cost Incurred
Add: Opening Stock of WIP
Less: Closing Stock of WIP
Works cost (2)
Add:- Administration Over Heads:Office Rent
Asset Depreciation
General Charges
Audit Fees
Bank Charges
Counting house Salary
Other Office Expenses
Cost of Production (3)
Add: Opening stock of Finished Goods
Less: Closing stock of Finished Goods
Cost of Goods Sold
Add:- Selling and Distribution OH:Sales man Commission
Sales man salary
Traveling Expenses
Advertisement
Delivery man expenses
Sales Tax
Bad Debts
Cost of Sales (5)
Profit (balancing figure)
Sales

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***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
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***
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***

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UNIT-III

MATERIALS
The materials are a major part of the total cost of producing a product and
are one of the most important assets in majority of the business
enterprises. Hence the total cost of a product can be controlled and reduced
by efficiently using materials.
The materials are of two types, namely:
(i) Direct materials: The materials which can be easily identified and
attributable to the individual units being manufactured are known as direct
materials. These materials also form part of finished products. All costs
which are incurred to obtain direct materials are known as direct material
costs.
(ii) Indirect materials: Indirect materials, on the other hand, are those
materials which are of small value such as nuts, pins, screws, etc. and do
not physically form part of the finished product. Costs associated with
indirect materials are known as indirect material costs.
Factory supplies, office supplies and selling supplies are generally termed
as stores.
Classification and Codification of Material:
In case of large organizations the number and types of materials used is
considerable and unless each item is distinguished and stored separately it
would be impossible to find them out when they are required for production
or any other operation. It may happen that either one type of material is in
excess or another type may be altogether non-existent. It is therefore,
essential that a proper system of classification and codification.
Classified into different categories according to their nature or type, viz.,
mild steel, tool steel, brass, bronze, copper, glass, timber, etc., and then
again within such broad classification into rounds; bars, strips; angles, etc.
There are two steps in the classification and codification of materials
determination of the number of items, their nature, other characteristics
and classification of the items of comparable nature or type into suitable
groups or classes.
Various classes of coding are in practice and the common types are stated
below:
(a) Alphabetical Scheme: Alphabetics are only used for codification. Like
Mild Steel Sheets are coded as MSS.

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(b) Numeric Scheme : In this scheme numericals are used instead of


alphabets, For example If steel is given main code of 300 mild steel may be
coded as 310 and mild steel sheet may be coded as 311, mild steel bar may
be coded as 3112.
(c) Decimal Scheme: It is similar to the numeric scheme in which the
groups are represented by number and digits after the decimal indicate
sub-groups of items. For example, where the steel is coded as 3.00 mild
steel may be coded as 3.10 and mild steel sheet can be coded as 3.11 and
mild sheet bar as 3.12 and so on.
(d) Block Scheme: In this case block of number are allotted for
classification of specific groups such as for material classification the block
of number 1 to 999 may be reserved, for raw materials; 1000 to 1999 for
stores and spares; 2000 to 2999 for finished goods.
(e) Combination Scheme : Here the code structure takes in account both
alphabetic and numeric schemes and strikes a balance between the two.
Mild steel by coded as MS and the sheets, bars, strips, rounds of mild steel
may be coded as MS01, MS02, MS04 and so on. This code is most
commonly used because this system has got the advantage of both the
alphabetic and numeric systems and is quite flexible in nature.
Advantages of Classification & Codification of materials:
(a) The procedure assists in the easy identification and location of the
materials because of their classification.
(b) It minimises the recording of the nature/ type of the materials with
detailed description on every document relating to the transaction of
materials.
(c) Codification is a must in the case of mechanisation of the stores
accounting.
(d) The method is simple to operate and definitely saves time and money in
respect of both physical location/ identification of materials as well as
recording of the materials.
After the material classification and codification is done for all the
materials, for each material code we have to fix the Minimum Level,
Maximum Level, Re-order Level and Re-order Quantity. It is the
storekeepers responsibility to ensure inventory of any material is
maintained between the Minimum Level and Maximum Level.

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Functions of Purchasing Department


The purchasing department is an organisational unit of a firm whose duties
include some part or all of the purchasing function. This disconnection
between function and, department is not always appreciated or understood
by top management.
The purchasing function is usually performed most economically and
efficiently by a specialised, centralised purchasing department, directed by
a skilled purchasing manager.
However, the purchasing function does not have to be performed in such a
manner. In theory, it can be performed, and in practice, it sometimes is
performed by any number of different company officers or departments.
The functions of purchasing department are varied and wide which are
based upon different approaches. The purchasing activities may be divided
into those that are always assigned to the purchasing department and those
that are sometimes assigned to some other department. The followings are
some of the important functions which are necessary to be performed.
1. Receiving indents
2. Assessment of demand or description of need
3. Selection of sources of supply
4. Receiving of quotation
5. Placing order
6. Making delivery at the proper time by following up the orders.
7. Verification of invoices
8. Inspection of incoming materials
9. Meeting transport requirements of incoming and outgoing materials
10. Maintaining purchasing records and files
11. Reporting to top management
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12. Developing coordination among other departments


13. Creating goodwill of the organisation in the eyes of the suppliers.
1. Receiving indents:
The first and foremost function of purchasing is receiving
demand/requisition of material from different departments of the
organisation, such as from production, stores, maintenance, administrative,
drawing office, planning, tool room, packing, painting, heat treatment etc.
After receiving the indent from users departments it examines in details
and takes action according to the need and urgency of any item. This is
called recognition of need. Sometimes, needs can be met by transfer of a
stock of one department to another department. In other cases, the reserve
stock or the stocks kept in bank can be utilized i.e., pledged stock with
bank.
2. Assessment of demand or description of need:
After recognising the need with appropriate description, i.e., qualitative as
well as quantitative, is necessary for the sound and successful purchasing.
An improperly described demand can cost heavily money-wise as well as
time-wise.
The real problem arises when the order is placed for want of preciseness in
the description of goods needed, the items are received and these are not
acceptable to the user department and it also becomes difficult to convince
the suppliers to return the goods in case of faulty supplies. Therefore,
purchasing department must have adequate knowledge of items being
purchased to be able to secure full description.
The purchasing department should not have such alternative purchases of
commodities, which are not available easily, on their own responsibility or
at a lower cost unless and until it gets the consent from the user
department.
In a nutshell, it is recommended that the description of items for purchase
on the part of indenter, purchaser and seller should be quite clear and
without ambiguity to promote harmony in an organisation.
3. Selection of sources of supply:
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Most important function of a purchasing department or officer is the


selection of the sources for the requisitioned items of stores. There are
different sources of supply which have no similarity between them.
For majority of items, selection of one of the vendors should be made. While
selecting the item, the purchase officer has to see whether the item to be
purchased is on a regular basis i.e., it is being purchased time and again or
it is a seldom purchase on non-recurring basis.
Whenever the items are to be bought from single manufacturer, such as
branded or patented item, there is no difficulty in the selection of the
sources of supply; the order can be placed with the party according to terms
and conditions of their sale.
Selection of source of supply requires the services of shrewd purchasing
officer who can keep pace with policies of the organisation and market from
where the materials have to be purchased.
4. Receiving of quotation:
As soon as the purchase requisition is received in the purchase division,
sources of supply will be located; a decision is then taken in respect of the
method of tendering/limitation of quotations from prospective suppliers.
Prices are also ascertained by preparing a comparative statement with the
help of either of the following documents supplied either by the supplier or
taken from the previous records of advertisements, like:
(a) Catalogues, price lists etc.
(b) Telephonic quotations.
(c) Previous purchase records.
(d) Quotation letter or tender i.e., letter of inquiry.
(e) Sample and related price cards.
(f) Negotiation between suppliers and the purchase department like
catalogue, price lists etc.

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It is in the interest of purchasing department to keep this information up to


date. Even for the items which are being purchased on a regular basis, the
purchasing section should invite tenders and know full well the market
price. It will ensure that prices being paid to the existing vendor are
competitive.
5. Placing order:
Placing a purchase order is the next function of purchasing officer. Since
purchase order is a legal binding between the two parties, it should always
be accurate, clear and acceptable to both. The purchase order should
contain the following particulars:
(a) Description and specifications of the material.
(b) Quantity order.
(c) Transport and packing charges and shipping instructions.
(d) Name and address of the supplier.
(e) Date, time and place of delivery.
(f) Price, discount and terms of payment.
(g) Signature of the purchase manager.
(h) The name and address of the buyer.
6. Making delivery at the proper time by following up the orders:
Since one of the objectives of successful purchasing is delivery of goods at
right time so as to ensure delivery when and where needed? In normal
practice, the responsibility of the purchasing department is upto the time
the material is received in the stores and is approved by the inspection
department.
Every purchasing department has the responsibility for follow-up of the
orders it places on different suppliers. All items do not require extensive
follow-up. For some less important and low value items follow-up would be
costly and wastage of money and time only.
7. Verification of invoices:
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In normal course, it is also the responsibility of purchase department to


check the invoices and accordingly advise the accounts department for
clearing the payment to the parties concerned. Contradictory statements
have been given as to who should be assigned this function.
Some are of the view that invoices should be checked by the purchase
department placed by it whereas other suggests that it should go to the
accounting department. In support of this, the experts add that it is part of
the responsibility of purchase department that orders are accurately
executed and properly filled as per terms and conditions of the contract.
If there is any error in the bills, the purchase department can get the
correction done or adjustment effected. If the invoices are checked by the
stores or accounts departments, there may be some delay in attending to
the errors.
8. Inspection of incoming materials:
The purchasing department should have a close contact with inspection
department. On receipt of the materials from different suppliers, they are to
be inspected as per specifications indicated in the purchase order to verify
their quality and quantity.
Uninspected materials are a burden on the economy of the organisation. If
inspection is delayed, the payments of the suppliers also are likely to be
delayed, resulting in bad relations between suppliers and purchasers.
9. Meeting transport requirements of incoming and outgoing materials:
The purchasing officer must make goods/materials available at the right
time they are required, at the place they are needed, and at the lowest
possible cost. It is a big responsibility, and even a slight error amounts to
delay in consignment required at a particular time.
In this regard, the purchase department should have a thorough knowledge
of the means of transportation. It should make a correct choice of carriers
or routes because otherwise it may entail delay and additional
transportation costs.
10. Maintaining purchasing records and files:
Purchasing involves a lot of paper work. Daily a number of letters, bills,
quotations, notes, challans, railway receipts, parcel, way bills, bills of
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ladings, goods received notes, lorry receipt, goods receipt (transport delivery
notes), inspection notes have to be dealt with. It involves a lot of clerical
work.
This department has to refer to previous correspondence on purchase
orders, notes, catalogues, blue prints, price lists etc. very frequently which
makes it imperative to maintain records in appropriate manner. These
records are essential for making the day to day purchase.
11. Reporting to top management:
It is also an important function of the purchasing department to prepare
weekly, monthly, quarterly, bi-annually and yearly reports regarding
expenditures of this department and send the same to top management
along with details of purchases made and suggestions or improvements, if
any.
12. Developing coordination among departments:
A purchasing department has to fulfill the needs of other departments in
the organisation. It is the function of purchasing department to work in
close coordination and cooperation with other departments of the company.
13. Creating goodwill of the organisation in the eyes of the suppliers:
Good vendor relationship has to be maintained and developed to reflect
enterprises image and goodwill. Maintaining such relations requires mutual
trust and confidence which grows out of dealings between the two parties
over a period of time. Worth of a purchasing department can be measured
by the amount of goodwill it has with its vendors
Storekeeping: Store keeping is a service function. The storekeeper is a
custodian of all the items kept in the store. The stores should be
maintained properly and cost minimized. The main objectives of store
keeping are:i) To protect stores against losses
ii) To keep goods ready for delivery/issue
iii) To provide maximum service at minimum cost.
The duties and functions of Store-keeper can be summarized as
follows: i) Materials should be received, unloaded, inspected and then
moved to stores. The materials have to be stored in appropriate places and
records the receipts in proper books.
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ii) The stores records should be maintained in an efficient and orderly


manner so that materials can be easily located and information can be
obtained for various departments.
iii) The stores should provide maximum protection and safety and
accessibility and utilize minimum space. Suitable storage devices should be
installed.
iv) The materials should be given special covering to prevent damage due to
atmospheric conditions.
v) All issues should be properly recorded, efficiently, promptly and
accurately. All issues should be duly authorized and procedures laid down
should be duly followed.
vi) The storekeeper is responsible for co-ordination with materials control
according to the type of production, size of the company, the organization
structure etc.
vii) Ensure that all transactions are posted in the Bin Card see that the Bin
Card is up-to- date.
viii) All items should be in its proper place.
ix) Maintenance of stores at required levels.
x) Neatness in stores to facilitate physical verification.
xi) Co-ordination and supervision of staff in the stores department.
xii) Periodical review of various scales, measuring instruments, conversion
ratios etc.
xiii) Protect stores from fires, rust, erosion, dust, theft, weather, heat, cold,
moisture and deterioration etc.
Stores (or Materials) records
In the stores the most important two records kept are bin cards and stores
ledger.
(a) Bin Card. A bin card is a record of the receipt and issue of material and
is prepared by the store keeper for each item of stores.
A bin card is also known as bin tag or stock card and is usually kept in the
rack where the material is kept.
In a bin card not only the receipt and issue of material is recorded,
minimum quantity, maximum quantity and ordering quantity are stated on
the card.
This helps the store keeper to send the material requisition for the purchase
of material in time.

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(b) Stores Ledger: This ledger is kept in the costing department and is
identical with the bin card except that receipts, issues and balances are
shown along with their money values. This provides the information for the
pricing of materials issued and the money value at any time of each item of
stores.

Difference between Bin Card and Stores Ledger


Bin Card
Stores Ledger
(a) It is a quantity record
(a) It is a record of quantity and
value.
(b) It is kept inside the stores
(b) It is kept outside the stores.
(c) It is maintained by the store keeper
(c) It is maintained by the
accounts department
(d) The postings are done before the
(d) The postings are done after the
transactions
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(e) Each transaction is individually posted


periodically

COST ACCOUNTING
Transaction take place
(e) Transactions may be posted
and in total.

Techniques of inventory control


1. Fixation of Level: Another important aspect of material procurement is
not to purchase too much or too little. Similarly the timing of the purchase
is also important. Fixation of levels of materials is done precisely with these
objectives in mind. The following levels of materials are fixed for achieving
objectives like avoiding overstocking, ensuring that the material is ordered
at right time and also avoiding shortage of materials.
a) Maximum Level:
The Maximum Level indicates the maximum quantity of an item of material
that can be held in stock at any time. The stock in hand is regulated in
such a manner that normally it does not exceed this level.
While fixing the level, the following factors are to be taken into
consideration:
(a) Maximum requirement of the store for production purpose, at any point
of time.
(b) Rate of consumption and lead time.
(c) Nature and properties of the Store: For instance, the maximum level is
necessarily kept low for materials that are liable to quick deterioration or
obsolescence during storage.
(d) Storage facilities that can be conveniently spared for the item without
determinant to the requirements of other items of stores.
(e) Cost of storage and insurance.
(f) Economy in prices: For seasonal supplies purchased in bulk during the
season, the maximum level is generally high.
(g) Financial considerations: Availability of funds and the price of the stores
are to be kept in view. For costly items, the maximum level should be as low
as possible. Another point to be considered is the future market trend. If
prices are likely to rise, the concern may like to stock-piling for keeping
large stock in reserve for long-term future uses and in such a case, the level
is pushed up.
(h) Rules framed by the government for import or procurement. If due to
these and other causes materials are difficult to obtain and supplies are
irregular the maximum level should be high.
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(i) The maximum level is also dependent on the economic ordering quantity.
Maximum Level = Re-Order Level + Re-Order Qty (Minimum Rate of
Consumption X Minimum Re-Order Period)
b) Minimum Level:
The Minimum Level indicates the lowest quantitative balance of an item of
material which must be maintained at all times so that there is no stoppage
of production due to the material being not available.
In fixing the minimum level, the following factors are to be considered:(a) Nature of the item: For special material purchased against customers
specific orders, no minimum level is necessary. This applies to other levels
also.
(b) The minimum time (normal re-order period) required replenishing
supply: This is known as the Lead
Time and are defined as the anticipated time lag between the dates of
issuing orders and the receipt of materials. Longer the lead time, lower is
minimum level, the re-order point remaining constant.
(c) Rate of consumption (normal, minimum or maximum) of the material.
Minimum Level=Re-Order level (Normal Rate of Consumption X
Normal Re-Order Period)
c) Re-Order Level:
When the stock in hand reach the ordering or re-ordering level, store keeper
has to initiate the action for replenish the material. This level is fixed
somewhere between the maximum and minimum levels in such a manner
that the difference of quantity of the material between the Re-ordering Level
and Minimum Level will be sufficient to meet the requirements of
production up to the time the fresh supply of material is received.
The basic factors which are taken into consideration in fixing a Re-ordering
Level for a store item include minimum quantity of item to be kept, rate of
consumption and lead time which are applied for computing of this level.
Re-Ordering level= Minimum Level + Consumption during lead time
= Minimum Level + (Normal Rate of Consumption Normal Reorder Period)
Another formula for computing the Re-Order level is as below
Re-Order level = Maximum Rate of Consumption X Maximum Re-Order
period (lead time)

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d) Danger Level:
It is the level at which normal issue of raw materials are stopped and only
emergency issues are only made. This is a level fixed usually below the
Minimum Level. When the stock reaches this level very urgent action for
purchases is indicated. This presupposed that the minimum level contains
a cushion to cover such contingencies. The normal lead time cannot be
afforded at this stage. It is necessary to resort to unorthodox hasty
purchase procedure resulting in higher purchase cost.
The practice in some firms is to fix danger level below the Re-Ordering Level
but above the Minimum Level. In such case, if action for purchase of an
item was taken when the stock reached the Re-Ordering Level, the Danger
Level is of no significance except that a check with the purchases
department may be made as soon as the Danger Level is reached to ensure
that everything is all right and that delivery will be made on the scheduled
date.
Danger Level = Normal Rate of Consumption Maximum Re-OrPeriod
for emergency purchases
f) Average Stock Level
The average stock level is calculated by the following formula:
Average Stock Level = Minimum Stock Level + of Re-order Quantity.
Or (Minimum Stock Level + Maximum Stock Level)
2. Economic Ordering Quantity (EOQ)
The quantity of material to be ordered at one time is known as economic
ordering quantity. This quantity is fixed in such a manner as to minimize
the cost of ordering and carrying the stock. The total costs of a material
usually consist of:
Total acquisition cost + total ordering cost + total carrying cost.
Since the acquisition cost per unit of material is same whatever is the
quantity purchased, it is usually excluded when deciding the quantity of a
material to be ordered at one time. The only costs to be taken care of are the
ordering costs and carrying costs which vary with the quantity ordered.
Carrying Cost: It is the cost of holding the materials in the store and
includes:
1. Cost of storage space which could have been utilized for some other
purpose.
2. Cost of bins and racks
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3. Cost of maintaining the materials to avoid deterioration.


4. Amount of interest payable on the amount of money locked up in the
materials.
5. Cost of spoilage in stores and handling.
6. Transportation cost in relation to stock.
7. Cost of obsolescence of materials due to change in the process or
product.
8. Insurance cost
9. Clerical cost etc.
Ordering Cost: It is the cost of placing orders for the purchase of materials
and includes:
1. Cost of staff posted in the purchasing department, inspection section and
stores accounts department.
2. Cost of stationary postage and telephone charges.
Thus, this type of costs includes cost of floating tenders, cost of comparative
evaluation of quotations, cost of paper work, and postage involved in
placing the order, cost of inspection and cost of accounting and making
payments. In other words, the cost varies with the number of orders.
When the quantity of materials ordered is less, the cost of carrying will
decrease but ordering cost will increase and vice versa.
Q=
Q = Quantity to be ordered
C = Consumption of the material concerned in units during a year.
O = Cost of placing one order including the cost of receiving the goods i.e.
the cost of getting an item into the firms inventory
I = Interest payment including variable cost of storing per unit per year i.e
holding costs of inventory.
3. ABC System:
In this technique, the items of inventory are classifi ed according to the
value of usage.
Materials are classified as A, B and C according to their value.
Items in class A constitute the most important class of inventories so far as
the proportion in the total value of inventory is concerned. The A items
constitute roughly about 5-10% of the total items while its value may be
about 80% of the total value of the inventory.
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Items in class B constitute intermediate position. These items may be


about 20-25% of the total items while the usage value may be about 15% of
the total value.
Items in class C are the most negligible in value, about 65-75% of the total
quantity but the value may be about 5% of the total usage value of the
inventory.
The numbers given above are just indicative, actual numbers may vary from
situation to situation. The principle to be followed is that the high value
items should be controlled more carefully while items having small value
though large in numbers can be controlled periodically.
Material Losses:
One of the main reasons of rising material costs is the loss of material in
the production process. It is of paramount importance that there should be
rigid control over the material losses failing which it will be very difficult to
keep the material costs in check. The material losses can be categorized as
given below.
Waste:- Waste is a loss of material either in stores or in production due to
reasons like evaporation, chemical reaction, shrinkage, unrecoverable
residue etc. Wastages may be visible or invisible. It is necessary to take
steps to control the material wastage. In cost accounting, the wastage is
divided into the following categories.
Normal Wastage:- This wastage is such that it cannot be avoided. It is
inherent in any production process. The normal wastage is normally
estimated in advance and included in the material cost. In other words, the
good units should bear the cost of normal wastage.
Abnormal Wastage:- Any wastage over and above the normal wastage is
the abnormal wastage. In other words it is more than the standard wastage.
The cost of the abnormal wastage is not charged to the production, but it is
written off to the Costing Profi t and Loss Account.
Wastage can be controlled by adopting strict quality control measures.
Normal allowance of waste can be fixed with technical assessment and past
experience as well as by identifying the special features of materials. The
causes for abnormal wastages should be studied in detail and responsibility
should be fixed for wastage. Better material handling system will also help
in controlling the wastage.

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Scrap:- Scrap is a residual material resulting from a manufacturing


process. It has a recovery value and is measurable. The treatment of scrap
in cost accounts is normally as per the following details.
If the value of scrap is negligible, the good units should bear the cost of
scrap and any income collected will be treated as other income.
If the value of scrap is considerable and identifiable with the process or
job, the cost of job will be transferred to scrap account and any realization
from sale of such scrap will be credited to the job or process account and
any unrecovered balance in the scrap account will be transferred to the
Costing Profit and Loss Account.
If scrap value is quite substantial and it is not identifiable with a
particular job or process, the amount will be transferred to factory overhead
account after deducting the selling cost. This will reduce the cost of
production to the extent of the scrap value.
Control of Scrap:- For the control purpose, scrap may be divided into the
following categories.
Legitimate Scrap:- This is predetermined or anticipated in advance due
to experience in manufacturing operations.
Administrative Scrap:- This results from administrative decisions, e.g.
change in design of a product or discontinuation of existing product lines.
Defective Scrap:- This results from poor quality of raw material,
negligent handling of material etc.
Scrap can be controlled through selection of right type of material,
selection of right type of manpower, determination of acceptable limits of
scrap, and reporting the source of waste.
Spoilage:- Spoilage is the production that fails to meet quality or
dimensional requirements and so much damaged in manufacturing
operations that they are not capable of rectification and hence has to
withdraw and sold off without further processing. Rectification can be done
at a cost which may not be economic. If the spoilage is within limits, it is
called as normal spoilage and anything exceeding this limit is called as
abnormal spoilage. The accounting treatment of spoilage is as follows.
The cost of normal spoilage is spread over to the good production by
charging either to the specific production order or to the product overheads.
The cost of abnormal spoilage is charged to the Costing Profit and Loss
Account.

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Defectives :- The defectives are part of production units which do not


confirm to the standards of quality but can be rectified with additional
application of materials, labor and/or processing and made it into saleable
condition either as firsts or seconds depending upon the characteristics of
the product. The accounting treatment of defectives is the same like that of
spoilage. The cost of normal defectives is spread over the good units and the
cost of additional processing is charged to a particular department/process
if it is identifiable with the same. If it cannot be identified, it is charged to
factory overheads. Cost of abnormal defectives is charged to the Costing
Profit and Loss Account.
Pricing of Issues
One of the important aspects of issue control is of pricing of the issues.
Material is issued to production and it is necessary to find out the
consumption value of the material. However the question is that at what
price the issue is to be charged. Obviously the answer is that the issues
should be priced at the same price at which they are purchased. But it is
not practical as it is virtually impossible to identify the material issued.
Hence it is necessary to price the issues by using certain methods. The
various methods of pricing of issues are given below.
1. First In First Out:- As per this method, material received first is issued
first. Thus the material in stock at the beginning of a period is issued firstly
and then the issues are made according to the dates of purchases made.
This method is quite logical as the sequence of issue is as per the dates of
purchases.
However the consumption value will be as per the purchases made earlier
and hence the latest price may not be charged to the consumption. In case
of rising prices it will result in charging lower prices while in case of falling
price it will result in charging higher prices to the material consumption.
The closing stock will be shown at the latest prices as the material
purchased towards the end of the period will remain the stock.
2. Last In First Out [LIFO]:- The assumption under this method is that the
material which is purchased last is issued first to the production. Therefore
the issue should be charged at the latest prices. The main advantage of this
method is that the issues are priced at the latest prices and hence
consumption value is also the latest. This will make the product cost more
realistic. However, the inventory valuation will be at the older price as
material in balance will be from the earlier batches of purchases. Valuation
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of inventory according to this method is not accepted for inventory valuation


in the preparation of financial statements.
3. Weighted Average Method:- This method takes into consideration the
prices as well as the quantities of materials purchased. Thus weighted
average is computed after each receipt by dividing the total amount by the
total quantity. The issue is charged at prices arrived at according to this
calculation.
For example, if three consignments of materials are purchased at prices of
Rs.10, Rs.12 and Rs.11 and the quantities involved are respectively 1,000,
1,200 and 1,400. The weighted average price will be calculated as shown
below.
Rs.10 1,000 + Rs.12 1,200 + Rs.11 1,400 = Rs.10, 000 + Rs.14,400 +
Rs.15,400 = Rs.39,800 / 3,600 = Rs.11.05. The subsequent issue will be
charged at this price. The main advantage of this method is that it evens
out the price fluctuations and reduces the number of calculations to be
made.

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UNIT IV
LABOUR
Labour cost is a second major element of cost. The control of labour cost
and its accounting is very difficult as it deals with human element. Labour
is the most perishable commodity and as such should be effectively utilized
immediately.
Importance of Labour Cost Control
Labour is of two types (a) direct labour, (b) indirect labour.
Direct Labour is that labour which is directly engaged in the production of
goods or services and which can be conveniently allocated to the job,
process or commodity or process. For example labour engaged in spinning
department can be conveniently allocated to the spinning process.
Indirect Labour is that labour which is not directly engaged in the
production of goods and services but which indirectly helps the direct
labour engaged in production. The examples of indirect labour are
supervisors, sweepers, cleaners, time-keepers, watchmen etc. The cost of
indirect labour cannot be conveniently allocated to a particular job, order,
process or article.
The distinction between direct and indirect labour must be observed
carefully because payment of direct labour is a direct expenditure and is a
part of prime cost whereas payment of indirect labour is an item of indirect
expenditure and is shown as works, office, selling and distribution
expenditure according to the nature of the time spent by the indirect
worker.
Management is interested in the labour costs due to the following
reasons.
workers.
ascertaining the
cost of every product, order, or process.
t labour cost as a basis for absorption of overhead, if
percentage of direct labour cost to overhead is to be used as a method of
absorption of overhead.
To reduce the labour turnover. Hence control of labour cost is an
important objective of management and the realization of this objective

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depends upon the co-operation of every member of the supervisory force


from the top executive to foremen.
Time keeping
Time-keeping will serve the following purposes:
1. Preparation of Pay Rolls in case of time-paid workers.
2. Meeting the statutory requirements.
3. Ensuring discipline in attendance.
4. Recording of each workers time in and out of the factory making
distinction between normal time, overtime, late attendance, early leaving.
5. For overhead distribution when overheads are absorbed on the basis of
labour hours.
Methods of Time-keeping
There are two methods of time-keeping. They are the manual methods and
the mechanical methods. Whichever method is used it should make a
correct record of the time and the method should be cost effective and
minimize the risk of fraud.
The manual methods of time keeping are as follows:
a) Attendance Register Method, and
b) Metal Disc Method
Attendance Register Method
This is the traditional method where an attendance register or muster roll is
kept at the time office near the factory gate or in each department. The
timekeeper records the name of the worker, the workers number, the
department in which he is working, the rate of wages, the time of arrival
and departure, normal time and overtime. If the workers are literate, they
may make a record of time themselves in the presence of a time-keeper or
foreman.
This method is simple and inexpensive and can be used in small firms
where the number of workers is not large. However recording the time of
workers who work at customers premises and places which are situated at
a distance from the factory is not practical in this method.
Metal Disc Method
Under this method, each worker is allotted a metal disc or a token with a
hole bearing his identification number. A board is kept at the gate with pegs
on it and all tokens are hung on this board. These boards can be
maintained separately for each department so that the workers can remove
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the token without delay and put it in a tray or box kept near the board.
Immediately after the scheduled time for entering the factory, the box is
removed and the latecomers will have to give their tokens to the timekeeper
and their exact time of arrival is recorded. The tokens or disc left on the
board will represent the absentee workers. Later the timekeeper records the
attendance in the attendance register and subsequently it is passed on to
the Pay Roll Department.
Mechanical Methods
The mechanical methods that are generally used for the recording of time of
workers may be as follows:
(a) Time Recording Clocks
(b) Dial Time Records
Time Recording Clocks
The time recording clock is a mechanical device which automatically
records the time of the workers. Under this method, each worker is given a
Time Card which is kept in a tray near the factory gate and as the worker
enters the gate, he picks up his card from the tray, puts it in the time
recording clock which prints the exact time of arrival in the proper space
against the particular day.
This procedure is repeated for recording time of departure for lunch, return
from lunch and time of leaving the factory in the evening. Late arrivals and
overtime are recorded in red to attract the attention of the management.

Dial Time Records


Under this method, a dial time recorder machine us used. It has a dial with
number of holes (usually about 150) and each hole bears a number
corresponding to the identification number of the worker concerned. There
is one radial arm at the centre of the dial. As a worker enters the factory
gate, he is to press the radial arm after placing it at the hole of his number
and his time will automatically be recorded on roll of a paper inside the dial
time recorder against the number. The sheet on which the time is recorded
provides a running account of the workers time and it can calculate the
number of hours and prepare the wage sheets. However, the high
installation cost of the dial time recorder and its use for only a limited
number of worker are the drawbacks of this method.
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Time Booking
Time booking is the recording of time spent by the worker on different jobs
or work orders carried out by him during his period of attendance in the
factory. The objects of time booking are:
1. To ensure that time spent by a worker in a factory is properly utilized on
different jobs or work orders.
2. To ascertain the labour cost of each individual job or work order.
3. To provide a basis for the apportionment of overhead expenses over
various jobs or work orders when the method for the allocation of overheads
depends upon time spent on different jobs.
4. To ascertain unproductive time or idle time so as to make efforts to keep
it in limit.
5. To know the time taken to complete a particular job so that bonus can be
paid as per the incentive schemes.
6. To know the efficiency of workers, it is necessary to make the comparison
of actual time taken with time allowed for completing a particular task.
Following documents are generally used for time booking:
1. Daily Time Sheets
2. Weekly Time Sheets
3. Job Tickets or Job Cards.
Daily time sheets are given to each worker where he records the time spent
by him on each job or work order.
Weekly time sheets record the same particulars for a week and hence one
card is required for a week.
Job cards are used to keep a close watch on the time spent by a worker on
each job so that the labour cost of a job may be conveniently ascertained.
Idle Time
There is always a difference between the time booked to different jobs or
work orders and the time recorded at the factory gate. This difference is
known as idle time. Idle time is of two types.
(a) Normal Idle Time
(b) Abnormal Idle Time
Normal Idle Time: This represents the time, the wastage of which cannot
be avoided and, therefore, the employer must bear the labour cost of this
time. But every effort should be made to reduce it to the lowest possible
level. Examples of normal idle time are: time taken in going from the factory
gate to the department in which the worker is to work and back at the end
of the day, time taken in picking up the work for the day, time between the
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completion of one work and the start of another work, time taken for
personal needs like tea or toilet, time taken for machine maintenance, time
taken for waiting for instructions, printouts, machine set-up time etc.
Normal Idle Time is unavoidable cost as such should be included in cost of
production. The cost of normal idle time can be treated as an item of factory
expenses and recovered as an indirect charge or added to labour cost.
Abnormal Idle Time: It is that time the wastage of which can be avoided if
proper precautions are taken. Example: time wasted due:- to breakdown of
machinery on account of inefficiency of the works engineer, failure of the
power supply, shortage of materials, waiting for instructions, waiting for
tools and raw materials, strikes or lock-outs in the factory.
It is a principle of costing that all abnormal expenses and losses should not
be included in costs and as such wages paid for abnormal idle time should
not form part of the cost of production. Hence it is debited to Costing Profit
and Loss Account.
Over Time: - It is the work done beyond the normal working period in a day
or week. For overtime done, the workers are given double the wages for the
overtime done. The additional amount paid on account of overtime is known
as overtime premium.
Overtime increases the cost of production and should not be
encouraged as it has the following disadvantages.
1. Overtime is paid at higher rate.
2. Overtime is done at late hours when workers have become tired and
efficiency will it be as much as during the normal working hours.
3. Workers will develop the habit of working slowly during normal hours
and complete the work using overtime to earn more wages.
4. Expenses like lighting, cost of supervision, and wear and tear of
machines will increase disproportionately.
Overtime should be recorded separately and thoroughly investigated to see
that it is incurred only when genuinely required.
The treatment of overtime depends on the situation. If overtime is incurred
for because of the sequence of jobs, then normal wages is charged to labour
cost for the overtime also but if it is a rush job, then the overtime wages is
added to the cost of labour. On the other hand if overtime arises due to any
abnormal reason like breakdown of machinery or power failure, overtime
premium is excluded from the cost of production and is debited to the
Costing Profit and Loss Account

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Methods of remuneration / System of Wage Payment


System of Wage Payment There is no single method of wage payment which
is acceptable both to the employers and the workers. The system of wages
should result into higher production, improved quality of output and a
contented labour force.
There are two principal wage systems:
(i) Payment on the basis of time spent in the factory irrespective of the
amount of work done. This method is known as time wage system.
(ii) Payment on the basis of the work done irrespective of the time taken by
the worker. This method is called piece rate system.
Other methods called premium plans or bonus and profit sharing schemes
are used with either of the two principal methods of wage payment.
Time Wage System
Under this method of wage payment, the worker is paid at an hourly, daily,
weekly or monthly rate.
This payment is made according to the time worked irrespective of the work
done.
This method is highly suitable for following types of work:
1. Where highly skilled and apprentices are working.
2. Where quality of goods produced is of extreme importance eg., artistic
goods
3. Where the speed of work is beyond the control of the workers.
4. Where close supervision of work is possible.
5. Where output cannot be measured.
The disadvantages of this method are:
1. Workers are not motivated.
2. Workers will get payment for idle time.
3. Efficient workers will become inefficient in the long run as all of them get
same wages.
4. Employer finds it difficult to calculate labour cost per unit as it varies as
production increases and decreases.
5. Strict supervision is necessary to get the work done.
6. Inefficiency results in upsetting the production schedule and increases
the cost per unit.
7. It will encourage a tendency among workers to go slow so as to earn
overtime wages. Thus this method does not establish a proportionate
relationship between effort and reward and the result is that it is not helpful
in increasing production and lowering labour cost per unit.
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Piece Rate System (payment by result)


Under this system of wage payment, a fixed rate is paid for each unit
produced, job completed or an operation performed. Thus, payment is made
according to the quantity of work done no consideration is given to the time
taken by the workers to perform the work.
There are four variants of this system.
a) Straight piece rate system
b) Taylors differential piece rate system
c) Merricks multiple piece rate system
d) Gants task and bonus plan
(a) Straight piece rate system
Payment is made as per the number of units produced at a fixed rate per
unit. Another method is piece rate with guaranteed time rate in which the
worker is given time rate wages if his piece rate wages is less than the time
rate.
Advantages
1. Wages are linked to output so workers are paid according to their merits.
2. Workers are motivated to increase production to earn more wages.
3. Increased production leads to decreased cost per unit of production and
hence profit per unit increases.
4. Idle time is not paid for and is minimized.
5. The employer knows his exact labour cost and hence can make
quotations confidently.
6. Workers use their tools and machinery with a greater care so that the
production may not be held up on account of their defective tools and
machinery.
7. Less supervision is required because workers get wages for only the units
produced.
8. Inefficient workers are motivated to become efficient and earn more
wages by producing more.
Disadvantages
1. Fixing of piece work rate is difficult as low piece rate will not induce
workers to increase production.
2. Quality of output will suffer because workers will try to produce more
quickly to earn more wages.
3. There may not be an effective use of material, because of the efforts of
workers to increase the production. Haste makes waste. Thus there will be
more wastage of material.
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4. When there is increased production, there may be increased wastage of


materials, high cost of supervision and inspection and high tools cost and
hence cost of production might increase.
5. Increased production will not reduce the labour cost per unit because the
same rate will be paid for all units. On the other hand, increased production
will reduce the labour cost per unit under the time wage system.
6. Workers have the fear of losing wages if they are not able to work due to
some reason.
7. Workers may work for long hours to earn more wages, and thus, may
spoil their health.
8. Workers may work at a very high speed for a few days, earn good wages
and then absent themselves for a few days, upsetting the uniform flow of
production.
9. Workers in the habit of producing quality goods will suffer because they
will not get any extra remuneration for good quality.
10. The system will cause discontentment among the slower workers
because they are not able to earn more wages.
This method can be successfully applied when:
1. The work is of a repetitive type.
2. Quantity of output can be measured.
3. Quality of goods can be controlled.
4. It is possible to fix an equitable and acceptable piece rate
5. The system is flexible and rates can be adjusted to changes in price level.
6. Materials, tools and machines are sufficiently available to cope with the
possible increase in production.
7. Time cards are maintained so that workers are punctual and regular so
that production may not slow down
(b) Taylors Differential Piece Rate system
This system was introduced by Taylor, the father of scientific management
to encourage the workers to complete the work within or less than the
standard time. Taylor advocated two piece rates, so that if a worker
performs the work within or less than the standard time, he is paid a higher
piece rate and if he does not complete the work within the standard time, he
is given a lower piece rate.
c) Merricks Multiple Piece Rate System
This method seeks to make an improvement in the Taylors differential piece
rate system. Under this method, three piece rates are applied for workers
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with different levels of performance. Wages are paid at ordinary piece rate to
those workers whose performance is less than 83% of the standard output,
110% of the ordinary piece rate is given to workers whose level of
performance is between 83% and 100% of the standard and 120% of the
ordinary piece rate is given to workers who produce more than 100% of the
standard output.
This method is not as harsh as Taylors piece rate because penalty for slow
workers is relatively lower.
Premium and Bonus Plan
The object of a premium plan is to increase the production by giving an
inducement to the workers in the form of higher wages for less time worked.
Under a premium plan, a standard time is fixed for the completion of a
specific job or operation at an hourly rate plus wages for a certain fraction
of the time saved by way of a bonus. The plan is also known as incentive
plan because a worker has the incentive to earn more wages by completing
the work in less time.
This system of wage payment is in between the time wage system and piece
work system. In time wage system, worker does not get any reward for the
time saved and in piece work system, the worker gets full payment for time
saved whereas in a premium plan both the worker and the employer share
the labour cost of the time saved.
The following are some of the important premium plans.
(i) Halsey Premium Plan: Under this method, the worker is given wages for
the actual time taken and a bonus equal to half of wages for time saved.
The standard time for doing each job or operation is fixed. In practice the
bonus may vary from 33 % to 66 % of the wages of the time saved. Thus
if S is the standard time, T the time taken, R the labour rate per hour, and
% the percentage of the wages of time saved to be given as bonus, total
earnings of the worker will be:
T x R + % (S-T) R
The advantages of the Halsey Premium Plan are:
It is simple to understand and relatively simple to calculate.
1. It guarantees time wages to workers.
2. The wages of time saved are shared by both employers and workers, so it
is helpful in reducing labour cost per unit.
3. It motivates efficient workers to work more as there is increasing
incentive to efficient workers.
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4. Fixed overhead cost per unit is reduced with increase in production.


5. The employer is able to reduce cost of production by having reduction in
labour cost and fixed overhead cost per unit. So, he is induced to provide
the best possible equipment and working conditions.
Disadvantages
1. Quality of work suffers because workers are in a hurry to save more and
more time to get more and more bonus.
2. Workers criticize this method on the ground that the employer gets a
share of wages of the time saved.
(ii) Rowan Plan: The difference between Halsey plan and Rowan Plan is the
calculation of the bonus. Under this method also the workers are
guaranteed the time wages but the bonus is that proportion of the wages of
the time taken which the time saved bears to the standard time allowed.
Total Earnings = T x R + S-T x T x R
S
Advantages
1. It guarantees time wages to workers
2. The quality of work does not suffer as they are not induced to rush
through production as bonus increases at a decreasing rate at higher levels
of efficiency.
3. Labour cost per unit is reduced because wages of time saved are shared
by employer and employee.
4. Fixed overhead cost is reduced with increase in production.
Disadvantages
1. The Rowan plan is criticized by workers on the ground that they do not
get the full benefit of the time saved by them as they are paid bonus for a
portion of the time saved.
2. The Rowan plan suffers from another drawback that two workers, one
very efficient and the other not so efficient, may get the same bonus.
Labour Turnover
Labour Turnover of an organisation is change in the labour force during a
specified period measured against a suitable index. The rate of Labour
Turnover in an industry depends upon several factors such as, nature of
the industry, its size, location and composition of the labour force. A
controlled level of Labour Turnover is considered desirable because it helps
the firm to adjust the size of its labour force in response to needs such as
for seasonal changes or changes in technology.
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Causes of Labour Turnovers:


The causes giving rise to high labour turnover may be broadly classified
under the following the heads:
(i) Personnel Causes: Workers may leave employment purely on personal
grounds, e.g.,
(a) Dislike for the job, locality or environments.
(b) Domestic troubles and family responsibilities.
(c) Change of line for betterment.
(d) Retirement due to old age and ill health.
(e) Death.
In all such cases, personal factors count the most and employer can
practically do nothing to help the situation.
(ii) Unavoidable Causes: In certain circumstances it becomes obligatory on
the part of the management to ask some of the workers to leave. These
circumstances are:
(a) Retrenchment due to seasonal trade, shortage of any material and other
resources, slack market for the product, etc.
(b) Discharge on disciplinary grounds.
(c) Discharge due to continued or long absence.

(iii) Avoidable Causes: Under this head, may be grouped the causes which
need the attention of the management most so that the turnover may be
kept low by taking remedial measures. The main reasons for which workers
leave are:
(a) Unsuitability of job.
(b) Low pay and allowance.
(c) Unsatisfactory working conditions.
(d) Unhappy relations with co-workers and unsatisfactory behaviour of
superiors.
(e) Dispute between rival trade unions.
(f) Lack of transport, accommodation, medical and other factors.
(g) Lack of amenities like recreational centres, schools, etc.
The above causes may also be classified in a different manner under three
heads, viz., Financial Causes, Social and Economic Causes and
Psychological Causes relating to human relationship.

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Measurement of Labour Turnover:


It is essential for any organisation to measure the Labour Turnover. This is
necessary for having an idea about the turnover in the organisation and
also to compare the Labour Turnover of the previous period with the
current one. The following methods are available for measurement of the
Labour Turnover:(a) Additions Method: Under this method, number of employees added
during a particular period is taken into consideration for computing the
Labour Turnover. The method of computing is as follows.
Labour Turnover=(Number of additions/Average number of workers during
the period) 100
(b) Separation Method: In this method, instead of taking the number of
employees added, number of employees left during the period is taken into
consideration. The method of computation is as follows.
Labour Turnover = Number of separations/Average number of workers
during the period)100
(c) Replacement Method: In this method neither the additions nor the
separations are taken into consideration. The number of employees
replaced is taken into consideration for computing the Labour turnover.
Labour Turnover = (Number of replacements/Average number of workers
during the period)100
(d) Flux Method: Under this method Labour Turnover is computed by
taking into consideration the additions as well as separations. The turnover
can also be computed by taking replacements and separations also.
Computation is done as per the following methods.
Labour Turnover = [Number of additions + Number of separations]
/Average number of workers during the period X100
Labour Turnover = [Number of replacements + Number of separations]
/Average number of workers during the period X 100

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UNIT V
OVERHEADS
Overhead may be defined as the cost of indirect material, indirect labour
and such other expenses, including services, as cannot be conveniently
charged direct to specific cost centres or cost units. It should be noted that
direct costs (materials, labour, etc.) are associated with individual jobs or
products. Indirect expenses or overheads are not associated with individual
jobs or products; they represent the cost of the facilities required for
carrying on the operations.
CIMA, London defines overhead as Expenditure on labour, materials or
services which cannot be economically identified with a specific saleable
cost unit.
Overhead Accounting
The ultimate aim of overhead accounting is to absorb them in the product
units produced by the firm. Absorption of overhead means charging each
unit of a product with an equitable share of overhead expenses. In other
words, as overheads are all indirect costs, it becomes difficult to charge
them to the product units. In view of this, it becomes necessary to charge
them to the product units on some equitably basis which is called as
Absorption of overheads. The important steps involved in overhead
accounting are as follows.
A. Collection, Classification and Codification of Overheads
B. Allocation, Apportionment and Reapportionment of overheads
C. Absorption of Overheads.
A. Collection, Classification and Codification of Overheads :I. Collection of Overheads: - Overheads collection is the process of
recording each item of cost in the records maintained for the purpose of
ascertainment of cost of each cost center or unit. The following are the
source documents for collection of overheads.
i. Stores Requisition
ii. Wages Sheet
iii. Cash Book
iv. Purchase Orders and Invoices
v. Journal Entries
vi. Other Registers and Records
For the purpose of overhead accounting, collection of overheads is very
important. It is necessary to identify the indirect expenses and the above
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mentioned source documents are used for this. Proper collection of


overhead expenses will help to understand accurately the total overhead
expenses.
II. Classification of Overheads :- Classification is defined by CIMA as, the
arrangement of items in logical groups having regard to their nature (
subjective classification ) or the purpose to be
fulfilled. ( Objective classification ) In other words, classification is the
process of arranging items into groups according to their degree of
similarity. Accurate classification of all items is actually a prerequisite to
any form of cost analysis and control system. Classification is made
according to following basis.
i. Classification according to Elements :- According to this classification
overheads are divided according to their elements. The classification is done
as per the following details.
Indirect Materials :- Materials which cannot be identified with the given
product unit of cost center is called as indirect materials. For example,
lubricants used in a machine is an indirect material, similarly thread used
to stitch clothes is also indirect material. Small nuts and bolts are also
examples of indirect materials.
Indirect Labor :- Wages and salaries paid to indirect workers, i.e. workers
who are not directly engaged on the production are examples of indirect
wages.
Indirect Expenses :- Expenses such as rent and taxes, printing and
stationery, power, insurance, electricity, marketing and selling expenses etc
are the examples of indirect expenses.
ii. Functional Classification :- Overheads can also be classified according
to their functions. This classification is done as given below.
Manufacturing Overheads :- Indirect expenses incurred for
manufacturing are called as manufacturing overheads. For example, factory
power, works managers salary, factory insurance, depreciation of factory
machinery and other fixed assets, indirect materials used in production etc.
It should be noted that such expenditure is incurred for manufacturing but
cannot be identified with the product units.
Administrative Overheads :- Indirect expenses incurred for running the
administration are known as Administrative Overheads. Examples of such
overheads are, office salaries, printing and stationery, office telephone,
office rent, electricity used in the office, salaries of administrative staff etc.
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Selling and Distribution Overheads :- Overheads incurred for getting


orders from consumers are called as selling overheads. On the other hand,
overheads incurred for execution of order are called as distribution
overheads. Examples of selling overheads are, sales promotion expenses,
marketing expenses, salesmens salaries and commission, advertising
expenses etc. Examples of distribution overheads are warehouse charges,
transportation of outgoing goods, packing, commission of middlemen etc.
Research and Development Overheads :- In the modern days, firms
spend heavily on research and development. Expenses incurred on research
and development are known as Research and Development overheads.
iii. Classification according to Behavior :- According to this classification,
overheads are classified as fixed, variable and semi-variable. These concepts
are discussed below.
Fixed Overheads :- Fixed overheads are commonly described as those that
do not vary in total amount with increase or decrease in production volume,
for a given period of time, may be a year. Salaries, depreciation of fixed
assets, property taxes, are some of the examples of fixed costs. Total fixed
costs remain same irrespective of changes in volume of production but per
unit of fixed cost is variable. It increases if production decreases while if
production increases, it decreases.
Variable Overheads :- Variable overheads are those which go on increasing
if production volume increases and go on decreasing if the volume
decreases. Such increase or decrease may or may not be in the same
proportion. Variable overheads are generally considered to be controllable
as they are directly connected with the production.
Semi-variable Overheads :- These types of overheads remain constant over
a relatively short range of variation in output and then are abruptly
changed to a new level. In other words, they remain same up to a certain
level of output and after crossing that level, they start increasing. For
example, supervisors salary is treated as fixed but if a decision is taken to
operate a second shift, additional supervisor may have to be appointed
which results into increase in the salary of the supervisor. This indicates
that it is a semi-variable overheads. Similarly, maintenance expenditure, fi
re insurance are also semi-variable overheads.
III. Codification of Overheads: - It is always advisable to codify the
overhead expenses. Codification helps in easy identification of different
items of overheads. There are numerous items of overheads and a code
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number to each one will facilitate identification of these items easily.


Codification can be done by allotting numerical codes or alphabetical codes
or a combination of both. Whatever system is followed, it should be
remembered that the system is simple for understanding and easy to
implement without any unnecessary complications.
Allocation and Apportionment of Overhead to Cost Centres (Departmentalisation of Overhead)
When all the items are collected properly under suitable account headings,
the next step is allocation and apportionment of such expenses to cost
centres. This is also known as departmentalization or primary distribution
of overhead.
A factory is administratively divided into different departments like
Manufacturing or Producing department, Service department, partly
producing departments.
Allocation of Overhead Expenses
Allocation is the process of identification of overheads with cost centres. An
expense which is directly identifiable with a specific cost centre is allocated
to that centre. Thus it is allotment of a whole item of cost to a cost centre or
cost unit. For example the total overtime wages of workers of a department
should be charged to that department. The electricity charges of a
department if separate meters are there should be charged to that
particular department only.
Apportionment of Overhead Expenses
Cost apportionment is the allotment of proportions of cost to cost centres or
cost units. If a cost is incurred for two or more divisions or departments
then it is to be apportioned to the different departments on the basis of
benefit received by them. Common items of overheads are rent and rates,
depreciation, repairs and maintenance, lighting, works managers salary
etc.
Basis of Apportionment
Suitable bases have to be found out for apportioning the items of overhead
cost to production and service departments and then for reapportionment of
service departments costs to other service and production departments. The
basis selected should be correlated to the expenses and the expense should
be measurable by the basis. This process of distribution of common
expenses over the departments on some equitable basis is known as
Primary Distribution.
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The following are the main bases of overhead apportionment utilized in


manufacturing concerns:
Direct Allocation. Under direct allocation, overheads are directly allocated
to the department for which it is incurred. Example overtime premium of
workers engaged in a particular department, power, repairs of a particular
department etc.
(i) Direct Labour/Machine Hours. Under this basis, overhead expenses are
distributed to various departments in the ratio of total number of labour or
machine hours worked in each department. Majority of general overhead
items are apportioned on this basis.
(ii) Value of materials passing through cost centres. This basis is
adopted for expenses associated with material such as material handling
expenses.
(iii) Direct wages. Expenses which are booked with the amounts of wages
e.g.:- workers insurance, their contribution to provident fund, workers
compensation etc. Are distributed amongst the departments in the ratio of
wages.
Re-apportionment of Service Department Costs to Production
Departments
Service department costs are to be reapportioned to the production
departments or the cost centres where production is going on. This process
of re-apportionment of overhead expenses is known as Service
Distribution. The following is a list of the bases of apportionment which
may be accepted for the service departments noted against
Service Department
Cost Basis of Apportionment
1. Maintenance Department
-Hours worked for each department
2.
Payroll
or
time-keeping -Total labour or Machine hours or
department
number of
employees in each department
3. Store keeping department
- no. of requisitions or value of
materials of each department.
4.
Employment
or
Personnel - Rate of labour turnover or number
Department.
of employees in each department.
-no. of purchase orders or value of
5. Purchase Department
materials
6. Welfare, ambulance, canteen -No.
of
employees
in
each
service, recreation room expenses.
department.
7. Building service department
-Relative are in each department
8. Internal transport service or -Weight, value graded product
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overhead crane service

handled,
weight
and
distance
travelled.
9. Transport Department
-crane hours, truck hours, truck
mileage, truck tonnage, truck tonnehours, tonnage handled, number of
packages.
10. Power House (Electric power wattage, horse power, horse power
cost)
machine hours, number of electric
points etc.
Distinction between Allocation & Apportionment
Although the purpose of both allocation and apportionment is identical, i.e
to identify or allot the costs to the cost centres or cost unit, both are not the
same.
Allocation deals with the whole items of cost and apportionment deals with
proportion of items of cost.
Allocation is direct process of departmentalization of overheads, where as
apportionment needs a suitable basis for sub-division of the cost.
Whether a particular item of expense can be allocated or apportioned does
not depends on the nature of expense, but depends on the relation with the
cost centre or cost unit to which it is to be charged.
Secondary Distribution of Production Overheads
After the primary distribution as shown above is over, the next step is to redistribute the service department costs over the production departments.
This also needs to be done on some suitable basis, as there may not be a
direct linkage between services and production activity. The products
actually do not pass through the service departments. So does it mean that
the service cost is not a part of cost of production? It very much is the part
of production cost! Hence the loading of service costs onto the production
departments is necessary. This process is called secondary distribution of
overheads.
The basis for secondary distribution is dependent on:(i) The nature of service given e.g. it may be maintenance department or
stores.
(ii) Measurement of service based on surveys or analysis.
(iii) General use indices
Methods of Secondary Distribution

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The following are the various methods of re-distribution of service


department costs to production departments.
1. Direct re-distribution method
2. Step distribution method
3. Reciprocal Services method
a. Simultaneous Equation Method
b. Repeated Distribution Method
c. Trial and Error Method
Direct re-distribution method
Under this method, the costs of service departments are directly
apportioned to production departments without taking into consideration
any service from one service department to another service department.
Thus, proper apportionment cannot be done on the assumption that service
departments do not serve each other and as a result the production
departments may either be overcharged or undercharged. The share of each
service department cannot be ascertained accurately for control purposes.
Budget for each department cannot be prepared thoroughly. Therefore,
Department Overhead rates cannot be ascertained correctly.
Step Distribution Method
Under this method, the cost of most serviceable department is first
apportioned to other service departments and production departments. The
next service department is taken up and its cost is apportioned and this
process goes on till the cost of the last service department is apportioned.
Thus, the cost of last service department is apportioned only to production
departments.
Reciprocal Services Method
In order to avoid the limitation of Step Method, this method is adopted. This
method recognizes the fact that if a given department receives service from
another department, the department receiving such service should be
charged. If two departments provide service to each other, each department
should be charged for the cost of services rendered by the other. There are
three methods available for dealing with inter-service departmental transfer:
a. Simultaneous Equation Method
b. Repeated Distribution Method
c. Trial and Error Method
(a) Simultaneous Equation method
Under this method, the true cost of the service departments are ascertained
first with the help of simultaneous equations; these are then redistributed
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to production departments on the basis of given percentage. The following


illustration may be taken to discuss the application of this method.
(b) Repeated Distribution Method
Under this method, the totals are shown in the departmental distribution
summary, are put out in a line, and then the service department totals are
exhausted in turn repeatedly according to the agreed percentages until the
figures become too small to matter.
(c) Trial and Error Method
Under this method, the cost of one service department is apportioned to
another centre. The cost of another centre plus the share received from the
first centre is again apportioned to the first cost centre and this process is
repeated till the balancing figure becomes negligible.
Machine Hour Rate. Machine hour rate is the cost of running a machine
per hour. It is one of the methods of absorbing factory expenses to
production. There is a basic similarity between the machine hour and the
direct labour hour rate methods, in so far as both are based on the time
factor. The choice of one or the other method depends on the actual
circumstances of the individual case. In respect of departments or
operations, in which machines predominate and the operators perform a
relatively a passive part, the machine hour rate is more appropriate. This is
generally the case for operations or processes performed by costly machines
which are automatic or semi-automatic and where operators are needed
merely for feeding and tending them rather than for regulating the quality
or quantity of their output. In such cases, the machine hour rate method
alone can be depended on to correctly apportion the manufacturing
overhead expenses to different items of production. What is needed for
computing the machine hour rate is to divide overhead expenses for a
specific machine or group of machines for a period by the operating hours
of the machine or the group of machines for the period. It is calculated as
follows:
Machine hour rate =
Amount of overheads
---------------------------------------------Machine hours during a given period
The following steps are required to be taken for the calculation of machine
hour rate:
1) Each machine or group of machine should be treated as a cost centre.
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2) The estimated overhead expenses for the period should be determined for
each machine or group of machines.
3) Overheads relating to a machine are divided into two parts i.e., fixed or
standing charges and variable or machine expenses.
4) Standing charges are estimated for a period for every machine and the
amount so estimated is divided by the total number of normal working
hours of the machine during that period in order to calculate an hourly rate
for fixed charges. For machine expenses, an hourly rate is calculated for
each item of expenses separately by dividing the expenses by the normal
working hours.
5) Total of standing charges and machines expenses rates will give the
ordinary machine hour rate.
Some of the bases which may be adopted for apportioning the different
expenses for the purpose of calculation of machine hour rate are given
below.
Some of the expenses and the basis of apportionment are given below.
1. Rent and Rates - Floor area occupied by each machine including the
surrounding space.
2. Heating and Lighting - The number of points used plus cost of special
lighting or heating for any individual machine, alternatively according to
floor area occupied by each machine.
3. Supervision estimated time devoted by the supervisory staff to each
machine.
4. Lubricating Oil and Consumable Stores On the basis of past
experience.
5. Insurance Insurable value of each machine
6. Miscellaneous Expenses Equitable basis depending upon facts.
Machine Expenses
1. Depreciation cost of machine including cost of stand-by equipment
such as spare motors, switchgears etc., less residual value spread over its
working life.
2. Power Actual consumption as shown by meter readings or estimated
consumption ascertained from past experience.
3. Repairs Cost of repairs spread over its working life.
Activity Based Costing

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Meaning :- CIMA defines Activity Based Costing as, cost attribution to cost
units on the basis of benefit received from indirect activities e.g. ordering,
setting up, assuring quality.
One more definition of Activity Based Costing is, the collection of financial
and operational performance information tracing the significant activities of
the firm to product costs.
Objectives of Activity Based Costing
The objectives of Activity Based Costing are discussed below.
To remove the distortions in computation of total costs as seen in the
traditional costing system and
bring more accuracy in the computation of costs of products and services.
To help in decision making by accurately computing the costs of products
and services.
To identify various activities in the production process and further
identify the value adding activities.
To distribute overheads on the basis of activities.
To focus on high cost activities.
To identify the opportunities for improvement and reduction of costs.
To eliminate non value adding activities.
STAGES IN DEVELOPING ACTIVITY BASED COSTING SYSTEM
Step 1. IDENTIFY RESOURCES Resources represent the expenditure of an
organization. These are the same costs that are represented in a traditional
accounting, ABC links these cost to products, customers or services.
Step2. IDENTIFY ACTIVITIES Activities represent the work performed in
an organization. ABC accounts for the costs based on what activities caused
them to occur. By determining the actual activities that occur in various
departments it is then possible to more accurately relate these costs to
customers, products and services.
Step 3. IDENTIFY COST OBJECTS ABC provides profitability by one or
more cost object. Cost object profitability is utilized to identify money losing
customers to validate separate divisions or business units. Defining outputs
to be reviewed is an important step in a successful ABC implement action.
Step 4. DETERMINE RESOURCE DRIVERS Resource drivers provide the
link between the expenditure of an Organisation and activities performed
within the Organisation.

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Step 5. DETERMINE COST (ACTIVITY) DRIVERS Determination of cost


drivers completes the last stage of the model. Cost drivers trace or links the
cost of performing certain activities to cost objects.
Activity Cost Driver Rate =
Total Cost of Activity(Cost pool )
Activity Cost Driver
Step 6. ASSIGN COSTS TO THE COST OBJECTS
We can use following formula for assigning costs to the cost objects
Costs = Resources Consumed Activity Cost Driver Rate
IMPORTANCE OF ACTIVITY BASED COSTING (ABC)
ABC provides information for decision making about product costs and
product-line profitability. Implementation of ABC will emphasis on more
precise profit analysis, more accurate costing, better allocation of overhead,
improved cost control and cost management. It supports the manager in
operating decisions, such as performance measurement, product design
and process improvement. It is also used to advocate for strategic decisions,
such as customer profitability and pricing and product mix. Due to the
increasing accuracy of output costs, ABC information enables managers to
make better decisions on product, product design, process improvement,
market segments and customer mix. . It can lead product designers to
decisions on tradeoffs between minimizing cost and desired performance
and it provides the cost information of diverse designs that product
designers can compare moreover, using product costing techniques at the
design stage can be combined with target costing since product costs can
determine the mix of products to manufacture and to sell and can evaluate
profitability by product group or customer type.
We can summarise the importance of ABC as under:
1. To link the cost to its causal factor i.e. the Cost Driver
2. To identify costs of activities rather than cost centres
3. To ascertain product costs with greater accuracy by relating overheads to
activities
4. To overcome the inherent limitations of traditional absorption costing and
use of blanket overhead rates
5. To assist managers in budgeting and performance measurement
6. To provide the links between the activities, the organizational acts and
the resources consumed,
and illustrate the differences between resource consumption and resource
provision

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7. To help in cost control and cost reduction, as well as improved


profitability.
8. To provide valuable economic information to support a companys
operational improvement and customer satisfaction programs.
9. To furnish many significant benefits over traditional costing techniques
(a) Most accurate data about product cost;
(b) More comprehensive cost information for performance measurement;
(c) Relevant data for managements decision-making;
(d) More potential for sensitivity analysis;
(e) Providing a model prospect on value-adding organizational transactions
and activities
USES OF ACTIVITY BASED COSTING
The areas in which activity based information is used for decision making
are as under: 1. Activity costs: ABC is designed to track the cost of activities, so we can
use it to see if activity costs are in line with industry standards. If not, ABC
is an excellent feedback tool for measuring the ongoing cost of specific
services as management focuses on cost reduction.
2. Customer profitability: Though most of the costs incurred for individual
customers are simply product costs, there is also an overhead component,
such as unusually high customer service levels, product return handling,
and cooperative marketing agreements. An ABC system can sort through
these additional overhead costs and determine which customers are
actually providing a reasonable profit. This analysis may result in some
unprofitable customers being turned away, or more emphasis being placed
on those customers who are contributing more in profits.
3. Distribution cost: Organisation uses a variety of distribution channels
to sell its products, such as retail, Internet, distributors, and mail order
catalogs. Most of the structural cost of maintaining a distribution channel is
overhead, so if we can make a reasonable determination of which
distribution channels are using overhead, we can make decisions to alter
how distribution channels are used, or even to drop unprofitable channels.
4. Make or buy: ABC enables the manager to decide whether he should get
the activity done within the firm or outsource the same. Outsourcing may
be done if the firm is incurring higher overhead costs as compared to the
outsourcer or vice-versa.
5. Margins: With proper overhead allocation from an ABC system, we can
determine the margins of various products, product lines, and entire
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subsidiaries. This can be quite useful for determining where to position


company resources to earn the largest margins.
6. Minimum price: Product pricing is really based on the price that the
market will bear, but the marketing manager should know what the cost of
the product is, in order to avoid selling a product that will lose a company
money on every sale. ABC is very good for determining which overhead costs
should be included in this minimum cost, depending upon the
circumstances under which products are being sold.
7. Production facility cost: It is usually quite easy to segregate overhead
costs at the plant-wide level, so we can compare the costs of production
between different facilities.
LIMITATIONS OF ACTIVITY BASED COSTING
Activity based costing help managers in decision making. However activity
based costing has certain
Limitations or disadvantages which as are under:
1. Implementing an ABC system requires substantial resources, which is
costly to maintain.
2. Activity Based Costing is a complex system which need lot of record for
calculations.
3. In small organisation mangers are accustomed to use traditional costing
systems to run their operations and traditional costing systems are often
used in performance evaluations.
4. Activity based costing data can be easily misinterpreted and must be
used with care when used in decision making. Managers must identify
which costs are really relevant for the decisions at hand.
5. Reports generated by this systems do not conform to generally accepted
accounting principles (GAAP). Consequently, an organization involved in
activity based costing should have two cost systems - one for internal use
and one for preparing external reports.

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