OM SAI RAM

COST & MANAGEMENT ACCOUNTING

[EXECUTIVE PROGRAMME]

CA. Jitender Singh

Get ready to LEARN with FUN…..

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 INDEX
S. NO. TOPIC PAGE NO.
1 MATERIAL 3
2 LABOUR 41
3 MACHINE HOUR RATE 87
4 OVERHEADS 91
5 MARGINAL COSTING 125
6 RATIO ANALYSIS 162
7 STANDARD COSTING 203

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CHAPTER 1
INTRODUCTION

Material is one of the important elements of cost and it has been observed that in the total cost
structure of a product, material content is about 60 to 65%. The term 'material' generally used
in manufacturing concerns, refers to raw materials used for production, sub-assemblies
and fabricated parts.

Material can be divided into two categories

 Direct material.
 Indirect material.

DIRECT MATERIALS
Materials which can be conveniently identified with and can be directly allocated to a particular
product, job or process. It is a part of prime cost

Examples:

Basic Raw-Materials Primary Packing Materials

Timber in furniture Can for tinned food and drink
Cloth in Garments Bottles for water, wine and whisky
Milk & cream in ice cream Plastic Packing for Milk, Ghee & Oil
Paper in Books Tin packing for Ghee & Oil

INDIRECT MATERIALS

Materials which cannot be conveniently identified with and cannot be directly allocated to a
particular product, job or process. It may or may not vary with the volume of output. It is a part of
overheads.

Examples :
(1) Stores used for maintaining machines such as lubricant oil & grease, cotton waste,
consumable stores etc.
(2) Stores used by service departments (like power house, boiler house).
(3) Materials of small value like nails used in furniture, thread used in stitching garments.

Distinction between Direct Material and Indirect Material

Basis of Direct Material Indirect Material

Distinction
Identification It can be readily identified
with a specific job, contract or
work order.
Treatment of cost It is directly charged to the
specific job, contract or order
It cannot readily be identified with a
specific job, contract or work order.
It cannot be directly charged to the
specific job, contract or work order and is

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 and forms part of prime cost. treated as part of overheads.
Variability It varies directly with the It may or may not vary directly with the
volume of output. volume of output.

Note: Material which is direct in one unit may be indirect in another unit due to difference in the
nature of work, process or method.

Importance of Distinction
1. For Ascertainment of Cost-It helps in ascertaining the material cost of different cost centers.
2. For Exercising Control over Cost-It helps in exercising proper control over material cost.
3. For Accounting Treatment-Direct material cost is treated as part of prime cost and
indirect material cost is treated as part of production overheads.

CONCEPT AND OBJECTIVES OF MATERIALS (INVENTORY) CONTROL

Meaning of Material Control

It involves the planning, organizing and controlling the procurement, storage and usage of
materials so as to achieve the objectives of efficiency and economy.

Meaning of Inventory
Inventory comprises -
(a) Stock of Raw-materials;
(b) Stock of Work-in-progress;
(c) Stock of Finished Goods; and
(d) Stock of Stores and Spares

Meaning of Inventory Control

It involves the planning, organizing and controlling the purchase and storage of inventory so
as to ensure the availability of inventory -
(a) Of the required quality
(b) In the required quantity
(c) At the required time
(d) At the minimum cost

Objectives of Material Control

1. To avoid the situation of under stocking i.e. to provide continuous supply of required
materials so that the activities of production and service departments may not be held up.
2. To avoid the situation of over-stocking i.e. to maintain optimum investment in inven-
tory so as to reduce carrying costs.
3. To ensure the procurement of materials and stores of the required quality at minimum cost
from a reliable source.
4. To minimise the total cost (i.e. ordering costs & carrying costs).
5. To avoid wastages and losses during storage and usage.
6. To maintain proper and upto date records of inventory
7. To provide the required information to help the management in taking inventory decisions.

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Steps Involved in Purchase Procedure :

Step -1 – Receipt of Purchase Requisition.

Step -2 – Issue of Enquiry letters and tenders.
Step -3 – Finalization of quotations and placing of purchase orders on suppliers.
Step -4 – Preparation, placement and follow up of purchase order.
Step -5 – Receipt of Material.
Step -6 – Inspection of Materials.
Step -7 – Return of rejected Materials.
Step -8 – Checking and passing of purchase invoices for payments.
Step -9 –Making Payment to Supplier.

CERTAIN IMPORTANT TERMS

1. PURCHASE REQUISITION NOTE

Meaning
Purchase Requisition is a written document prepared by the department requiring
material which is used to make a formal request to the purchase department to purchase
the materials specified therein.

Purposes of Purchase Requisition

A purchase requisition serves the following purposes:
(1) It authorizes the purchasing department to purchase the materials specified therein
(2) It provides written record of details of materials required.

Numbers of Copies of Purchase Requisition

Generally 3 copies of purchase requisition are prepared which are used as under:
(i). The original copy is send to the purchase department
(ii). The second is retained by the store keeper
(iii). Third copy is send to the costing department

Format of Purchase Requisition

A general format of purchase requisition is given below:
PQR Ltd.
P.R. No……… Date…….
Department…….. Date by which materials are required…..
Place where materials are required……..
Serial No. Description Code No. Quantity Remarks

Requested by……………. Checked by…………………. Approved by………………..

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Content of purchase requisition
 Requisition no.
 Date of requisition.
 Code no of item required.
 Description of item.
 Quantity of item.
 Signature of concerned person.

2. ABC ANALYSIS
Meaning of ABC Analysis
ABC analysis is a system of inventory control which exercises discriminating control over
different items of stores classified on the basis of the investment involved. It is based on the
principle of management by exception i.e. concentrate more on critical areas than others.

Working of ABC Analysis

Usually all items of stores are classified into 3 categories according to their importance (i.e.
their value and frequency of replenishment during a period) as follows:

Category Composition Control

A It consists of those items. Which require
large investments (say about 70% of total
value of stores) but constitute a small
percentage (say about 10%) of total items of
stores.
B It consists of those items which require
relatively moderate investment (say about
20% of total value of stores) but constitute
relatively moderate percentage (say about
20%) of total items of stores.
C It consists of those items which require
small investment (say 10% of total value of
stores) but constitute a large percentage
(say about 70%) of total items of stores.
High degree of control is exercised by
use of various techniques such as Fixing
Stock Levels like Max level, Min. Level,
Reorder lever, Determining EOQ.
Moderate degree of control is
exercised. Orders are placed on a
periodic review basis.
Lower degree of control is exercised.
Orders of large size are placed either
after 6 months or once in a year to
minimise ordering costs and to take
advantages of bulk purchase.

Illustration of ABC Analysis

Following illustration will make clear this concept:
No. of items % of total no. of Items Value % of total value Category
100 10 70,000 70 A
200 20 20,000 20 B
700 70 10,00.0 10 C
1000 100 1,00,000 100

Advantages of ABC Analysis

The advantages of ABC analysis are the following:

(i). It ensures effective control on costly items (i.e. A category items) which require large
investment.
(ii). It saves time and cost by exercising economic systems of control over low value items (i.e. C
category items).

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(iii). It ensures optimum investment in inventory considering the operational requirements and
financial resources with the use of economic order quantities.
(iv). It ensures minimum total cost (i.e. ordering costs and carrying costs) of inventory.
(v). It helps in the maintenance of high inventory turnover rate.

3. VED ANALYSIS [VITAL – ESSENTIAL - DESIRABLE ]

VED analysis is generally used for spare parts. The requirements and urgency of spare parts is
different from that of materials. The demand for spare depends upon the performance of the
Plant and Machinery. Spare Parts are classified as VITAL (V), Essential (E) and Desirable (D).

VITAL Spares : Are must for running the concern smoothly. These must be stored adequately,
otherwise it may cause havoc in the concern.

ESSENTIAL Spares : These are also necessary spares but their stock may be kept at low level.

DESIRABLE Spares : Stocking of these type of spares may be avoided, if lead time is less.

Classification in V, E and D categories should be left to Technical Staff because they know the
need, urgency and use of these spares.

4. FSN ANALYSIS [FAST – SLOW – NON MOVING]

FAST Moving : Materials which are very rapidly consumed either in actual production or in
maintenance so that the stocks are to be replenished very frequently.

SLOW Moving : Materials which are not frequently required for consumption and not to be
replenished so frequently. These are requisitioned by foreman once in a quarter or so.

NON Moving : Materials which are not moving temporarily but movement is expected soon
because of their requirement in production. It is also known as DORMANT stock. If dormant
materials are not required for production, these are to be declared as SURPLUS and should be
disposed and loss on disposal should is treated as Factory Overhead.

Also, Obsolescence of material may arise on account of change in design or a change in the
process of production. Surplus stores having no utility should be disposed off and loss on
disposal of obsolete stores, being abnormal in nature, should be debited to COSTING PROFIT
AND LOSS ACCOUNT.

5. ECONOMIC ORDER QUANTITY

Introduction
One important question that is to be answered by the Purchase Manager is how much
quantity is to be ordered at anyone point of time? It will be noticed that there are costs
attached to the ordering quantity. These costs are of two types, the first is the ordering cost
and the other one is the carrying cost.

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 Ordering cost is the cost of placing an order. These costs include costs like handling and
transportation costs, stationery costs, costs incurred for inviting quotations and tenders etc.
The more is the frequency of order, the more are these costs.

Carrying cost is the real out of pocket cost associated with having inventory on hand, such as
warehouse charges, insurance, lighting, losses due to handling, spoilage, breakage etc, and
another important component of carrying cost is the amount of interest lost due to the
investment in the inventory. Carrying costs will go on increasing if the quantity of material in
inventory goes on increasing.

Both, the carrying costs and the ordering costs are variable costs, of opposite behavior. If
orders are more frequent, ordering costs will go on increasing but as the material ordered will
be in less quantity, the carrying costs will decrease. On the other hand, if numbers of orders are
reduced, the quantity per order will increase and the carrying cost will increase. The ordering
cost will come down due to reduction of number of orders.

The most desirable quantity to be ordered is that quantity at which both, the ordering costs
and carrying costs will be minimum. This quantity is called as 'Economic Order Quantity'.

The Economic Order Quantity guides the Purchase Manager regarding the quantity to be
purchased of a particular material. This concept is based on some assumptions which are as
follows:
 The concerned material will be available all the time. ( i.e. Continuous supply).
 The material price will remain constant.
 Ordering cost and carrying costs are variable.
 Impact of quantity discounts on the prices is negligible..

Meaning of Economic Order Quantity (EOQ)

Re-order quantity is the quantity for which order is placed when the stock reaches reorder
level. It is known as economic order quantity when it is the quantity which is most
economical to order.

The EOQ refers to the quantity of inventory, at which total of ordering costs and the carrying
costs is minimum.

At EOQ the ordering costs are equal to carrying costs.

Factors to be considered
EOQ is determined after considering the following factors:

1. Ordering Costs
The term 'Ordering Costs' refer to the costs incurred for acquiring inputs. These costs
include -
(i). Cost of placing an order,
(ii). Cost of transportation,
(iii). Cost of receiving goods,
(iv). Cost of inspecting goods.

There is an inverse relationship between order size and ordering cost.

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Larger the order size Lower the ordering costs because of fewer orders
Smaller the order size Higher the ordering costs because of more orders

2. Carrying Costs
The term 'Carrying Costs refer to the costs incurred in maintaining a given level of inventory.
These costs include -
(i). Cost of storage space,
(ii). Cost of handling materials,
(iii). Cost of Insurance,
(iv). Cost of deterioration or obsolescence,
(v). Cost of store staff.
There is positive relationship between order size and carrying cost
Larger the order Size Higher the carrying costs because of high average inventory.
Smaller the order size Lower the carrying costs because of low average inventory.

3. Annual consumption (usage) of inventory.

Annual consumption in unit terms shall be taken into consideration not in monetary
terms
Importance of EOQ
The EOQ technique solves one of the major problems of the inventory management i.e. the
order quantity problem by answering to the question: 'How much inventory should be ordered
at a particular point of time?'

Assumptions of EOQ Technique (Most – Imp)

Following are the assumptions of EOQ:
 Prior knowledge of Annual Usage (consumption) Of inventory
 Constant rate of usage
 Constant ordering costs
 Constant carrying costs, and
 Zero lead-time/delivery period

How to determine EOQ?

EOQ may be determined by any of the following three methods:
1. Graphical Method
2. Tabular Method
3. Formula Method

1. Graphical Method
The optimum quantity of inventory which should be ordered at a point of time is determined
after achieving a trade off between ordering cost and carrying costs.

Tutorial Notes:
 Annual total cost of ordering and carrying is minimum at EOQ order size.
 Carrying cost and ordering cost are equal at EOQ order size.

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 Y
Minimum
total cost
t
os
lC
ta
To
st
Co

Costs (Rs)
g
rr yin
Ca

Ordering Cost

X
O EOQ Order Size Q

2. Tabular or Trial and Error Method

The ordering and carrying costs for different order sizes are computed and the order size with
lowest total cost (ordering and carrying) of inventory is the EOQ as follows:

Particulars Different Order Sizes

Order size I Order size II Order size III
(A). Annual Consumption (Units) …… …… ……
(B). Order Size (Units) …… …… ……
(C). No. of Order (A/B) …… …… ……
(D). Cost per order (Rs.) …… …… ……
(E). Total Ordering Cost (C X D) …… …… ……
(F). Average Inventory (Units) (Order Size / 2) …… …… ……
(G). Carrying cost per unit …… …… ……
(H). Total Carrying cost (F X G ) …… …… ……
(I). Total Cost (E + H) …… …… ……

Alternatively, total annual ordering and carrying' cost at different order sizes may be computed as
follows:

Total annual ordering and carrying cost at any order size =

[(No. of orders × Ordering cost per order) + (Average Inventory × Carrying cost per unit p.a.)
Or
= [(Annual consumption / Order Size × ordering cost per order) + (Order size / 2 × Carrying cost
per unit p.a.)]

Tutorial Note: Where quantity discounts are offered by the supplier of inputs, the most
economical purchase level is that order size at which the total cost (i.e. total annual ordering &
carrying Costs + Total Purchase price of annual consumption of inputs) is minimum.

3. FORMULA METHOD
EOQ may be calculated with the help of following formula

2×A ×O
EOQ = 𝐶

Where

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A = Annual consumption of unit in input
O = Ordering cost per order
C = Carrying cost per unit per annum

Limitations of EOQ Technique

(1) Expected annual usage may not be same as the actual due to unusual and unexpected
demand for inventory.
(2) Rate of usage may not be constant due to unusual and unexpected demand for inventory.
(3) Ordering and carrying costs may not be constant due to fluctuations in the costs of
various components comprising costs.
(4) Lead-time may not be constant due to reason beyond Supplier’s control.

6. FIXATION OF LEVEL OR STOCK LEVELS (Most – Imp)

Another important aspect of material procurement is not to purchase too much or too little.
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.

Re-order Level
Meaning Re-order level is that level of stock at which fresh order should be placed for
replenishment of stock. It is fixed somewhere between maximum and minimum
levels in such a way that fresh supplies are received in such a way that fresh
supplies are received just before the minimum level is reached. It is the level at
which purchase requisition should be made out for fresh supplies.
Objective The objective of fixing Re-order Level is to determine when the fresh order should
be placed for replenishment of stock.
Factors This level is fixed after considering the following factors:
(a) Maximum Rate of Consumption
(b) Maximum Re-order Period
(c) Minimum Level
Formula Re-order level is computed with the help of the following formula:
Re-order level = Maximum Consumption × Maximum Re-order Period
Or, = Minimum Level + (Normal Consumption × Normal Re-order Period)

Maximum Stock Level

Meaning Maximum Stock Level is that level of stock above which the stock in hand should
not normally be allowed to exceed. It is the largest quantity of a particular
material which may be held in the store at any time.
Objective The objective of fixing the maximum stock level is to avoid the costs of over-
stocking such as -Cost of storage, cost of investment in stock, Cost of insurance,
risk of obsolescence etc.
Factors This level is fixed after considering the following factors:
(a) Re-order Level
(b) Re-order Quantity
(c) Minimum Rate of Consumption
(d) Minimum Re-order Period
(e) Availability of Working Capital

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 (f) Availability of Storage space
(g) Extra Cost of Storage
(h) Extra Cost of Insurance
Formula Maximum Stock level is computed with the help of following formula:
Maximum Level = Re-order + Re-order Quantity – (Minimum Consumption x
Minimum Re-order Period)

Minimum Stock Level

Meaning Minimum Stock Level is that level of stock below which the stock in hand should
not normally be allowed to fall. It is the lowest quantity of a particular material
which must be held in the store at all times.
Objective The objective of fixing the minimum stock level is to avoid the costs of under-
stocking such as costs of stoppage of production due to shortage of materials like
cost of idle labour, cost of idle plant & machinery etc.
Factors This level is fixed after considering the following factors:
(a) Re-order Level
(b) Normal Rate of Consumption
(c) Normal Re-order period
Formula Minimum Stock Level is computed with the help of following formula:
Minimum Level = Re-order Level – (Normal Consumption x Normal Re-order
Period)

Average Stock Level

Meaning Average Stock Level indicates the average stock held by the organisation.
Formula This level of stock may be computed by using anyone of the following formula:

Average inventory level = minimum level + ½ Re-order quantity

𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐥𝐞𝐯𝐞𝐥 + 𝐌𝐢𝐧𝐢𝐦𝐮𝐦 𝐥𝐞𝐯𝐞𝐥

OR =
𝟐

Danger Level
Meaning Danger level is the level at which normal issues of the raw material inventory are
stopped and emergency issues are only made on special requisition approved by
the competent authority. When stock reaches this level an urgent action is
required for the fresh supplies of materials. It is generally below the minimum
level. However some enterprises treat minimum level as danger level whereas
some others fix the danger level above the minimum level but below the re-order
level. Fixing danger level below the minimum level is meant for taking urgent
corrective action whereas fixing it above the minimum level is for preventive
action.
Objective The objecting of fixing danger level (below minimum level) is to determine when
an urgent action is required for fresh supplies of materials.
Factors This level is fixed after considering the following factors:
(a) Normal Rate of Consumption
(b) Maximum Re-order Period for emergency purchases
Formula Danger level is computed with the help of the following formula:
Danger Level = Normal Rate of Consumption × maximum Re-order Period for
emergency purchases

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7. INVENTORY TURNOVER RATIO
There are several items in the store which are slow moving which means that they are issued to
the production after a long time gap. Some items are such that they are never issued to the
production as they have become obsolete or outdated and need to be disposed off. For
identifying these items, it is necessary to compute the inventory turnover ratio. Inventory
turnover ratio enables the management to avoid the capital being locked in such items. This
ratio indicates the efficiency or inefficiency with which inventories are maintained. Inventory
turnover ratio is calculated in the following manner.

Inventory Turnover Ratio =

𝐂𝐨𝐬𝐭 𝐨𝐟 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐜𝐨𝐧𝐬𝐮𝐦𝐞𝐝

= …… Times
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝐡𝐞𝐥𝐝 𝐝𝐮𝐫𝐢𝐧𝐠 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫

Where,
Cost Materials Consumed = Opening Stock + Purchases – Closing Stock

(Opening stock + Closing)

Average stock =
2

𝐃𝐚𝐲𝐬 𝐝𝐮𝐫𝐢𝐧𝐠 𝐭𝐡𝐞 𝐩𝐞𝐫𝐢𝐨𝐝

Average No. of days for which an average inventory is held =
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 𝐫𝐚𝐭𝐢𝐨

Objective of Inventory Turnover Ratio

The objective of computing the Inventory Turnover Ratio is to determine the efficiency with which
inventories are maintained. In other words, the objective is to find out -
(a) Fast Moving Stock i.e. stock in great demand
(b) Slow Moving Stock i.e. stock in low demand
(c) Dormant Stock i.e. stock having no demand at present
(d) Obsolete Stock i.e. stock no longer in demand

Interpretation of Inventory Turnover Ratio

It indicates the speed with which the inventory is consumed. In general, a high ratio indicates fast
moving stock and a low ratio indicates slow moving stock. However, too high ratio and too low
ratio call for further investigation.
A too high ratio may be the result of a very low inventory levels which may result in frequent
stock-outs and thus the firm may incur high stock-outs.
On the other hand, a too low ratio may be the result of excessive inventory levels, slow-moving or
dormant or obsolete inventory and thus, the firm may incur high carrying costs. Thus, a firm
should have a satisfactory level.

MATRIAL ISSUE PROCEDURE

The following two documents are used for issue of materials to production department:
(a) Material Requisition (or Stores Requisition)
(b) Bill of Materials

8. MATERIAL REQUISITION

Meaning - Material Requisition is a document which is used to authorize and record the issue
of materials from the store.

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 Who prepares It? - It is usually prepared by a foreman but in case of costly materials or large
quantity of materials, an approval by some higher authority may be required.

No. of Copies - Usually three copies of material requisition are prepared. One Copy for the
Storekeeper, One Copy for the Cost Accounting Department and One Copy for the department
initiating it.

Procedure - Two Copies of material requisition are sent to storekeeper. Storekeeper makes the
entries in the Bin Card and then issues materials to the requisitionist and then sends one copy
of requisition after signature to the Cost Accounting department that fills up the rate and
amount column of requisition and makes in the entries in the Stores Ledger .

9. BILL OF MATERIALS (MATERIAL SPECIFICATION LIST)

Meaning - Bill of Materials is a list of standard quantities of all materials required for a
particular job or work order or a process.

Who prepares It? - Bill of Materials is prepared by engineering or planning department

in a standard form on receipt of an order.

No. of Copies - Usually four copies of the Bill of Materials are prepared - one copy for
Production Department, one copy for Stores Department, one copy for Cost Accounting
Department and one copy is retained by engineering or Planning Department.

Procedure
(i). Engineering Department sends three copies of Bill of Materials to Production Department
(ii). Production Department sends two copies to Stores Department
(iii). Store Department makes entries in the Bin Cards and then issues materials to the
Production Department and then sends one copy of Bill of Materials after signature to Cost
Accounting Department.
(iv). Cost Accounting department fills up rate and amount column of bill of materials and makes
entries in the Stores Ledger.

Basic Difference between Material Requisition and Bill of Materials

(1) Material Requisition is prepared when a single or a few items of materials are requisitioned
whereas a Bill of Materials is prepared when all the materials required for a particular job are
requisitioned.
(2) Material requisition is prepared by foreman whereas Bill of Materials is prepared by
Engineering Department.

10. TWO BIN SYSTEM OR DOUBLE BIN SYSTEM

(a) Under Two Bin System each bin is divided into two parts-one smaller part, to store the
quantity equal to the minimum stock or even the re-ordering level, and the other to store the
remaining quantity .
(b) Issues are made out of the larger part; but as soon as it becomes necessary to use quantity
out of the smaller part of the bin, fresh order is placed.
(c) On receipt of supply of fresh order, quantity already issued out of smaller part of the bin is
replaced out of fresh supply.

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 Smaller Part Lager Part

Minimum S. Level
Or
Even ordering level Remaining Quantity

__________________________________Two Bin system________________________________

INVENTORY SYSTEMS
There are two inventory systems
1. Periodic Inventory System and
2. Perpetual Inventory System.

11. PERIODIC INVENTORY SYSTEM

Periodic Inventory System is a system of ascertaining the quantity and value of inventory on the
basis of an actual physical count or measure or weight of all the inventory items on hand at the
end of accounting period. It usually requires closing down of normal functioning for stock-
taking. The cost of materials issued is calculated as a residual figure (Which may include cost of
materials lost also) as under:

Cost of Materials issued = Opening Inventory + Purchases – Closing Inventory

12. PERPETUAL INVENTORY SYSTEM

Perpetual Inventory system is a system of recording stores balances after every receipt
and issue, to facilitate regular checking and to obviate closing down for stocktaking.

Objective of Perpetual Inventory System

The basic objective of perpetual inventory system is to provide a continuous quantitative -
cum-value record of receipts, issues and balances of each item of stores followed by
continuous stock taking.

13. INVENTORY RECORDS

BIN CARD OR STOCK CARD

Meaning: Bin Card consists of two terms 'Bin and Card'. Bin refers to an almirah, a rack, box,
container or space where materials are kept. A separate bin is maintained for each item of
material and is assigned an identification number.

A card is tied to or placed outside each bin to record the quantity of materials received, issued,
returned and in hand in the bin. This card is called bin card or stock card.

This card also contains particulars regarding maximum level, minimum level, reorder level,
Bin no, name and code of material, location and stores ledger folio.

Objective - The basic objective of Bin Card is to provide a continuous record of the quantity of
materials received, issued, returned and in hand.

Who maintains It? - Bin Card is maintained by storekeeper in the stores.

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STORES LEDGER

Meaning - Stores Ledger is a subsidiary ledger in which a separate account is opened for each
item of materials in the store to record both the quantity and cost of the materials received,
issued, returned and in hand.

Objective - The basic objective of stores ledger is to provide a continuous record of both the
quantity and cost of the materials received, issued, retuned and in hand.

Who maintains It - Stores Ledger is maintained by Cost Accounting Department and not by
Stores Department.

Distinction between Bin Card and Stores Ledger

Bin Card differs from Stores Ledger in the following respects:

Basis of Distinction Bin Card Stores Ledger

(1) What it records? It records only the quantity of It records both the quantity and
material received, issued and in value of materials received, issued
hand. and in hand.
(2) Who maintained? It is maintained by storekeeper. It is maintained by Cost
department
(3) Periodicity of Posting in bin card is done Position in the stores ledger is
posting simultaneously with the receipts usually done after the transaction
and issues of materials. at periodic intervals.
(4) Where Kept? It is kept outside the bin in store. It is kept outside the store
generally in costing department.
(5) Physical It facilities physical verification as It does not facilitate physical
verification records are updated as per verification
physical movement
(6) Chances of error Less chances of error More chances of error

14. JUST IN TIME INVENTORY:

This principle envisages that there should be no intermediate stage like storekeeping.
Material purchased from supplier should directly go the assembly line, i.e. to the production
department. There should be no need of storing the material. The storing cost can be saved to
a great extent by using this technique. The benefits of Just in time system are as follows :
 Right quantities are purchased or produced at right time.
 Cost effective production or operation of correct services is possible.
 Inventory carrying costs are eliminated totally.
 The stores function is eliminated and hence there is a considerable saving in the stores cost.
 Losses due to breakage, wastage, pilferage etc are avoided.

15. 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. Hence it is
necessary to price the issues by using certain methods. The various methods of pricing of
issues are given below :

16
1) First In First Out [FIFO]:-
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. 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. 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 of inventory according to
this method is not accepted for inventory valuation in the preparation of financial statements.

3) Highest In First Out [HIFO]:-

Under this method, the materials with highest prices are issued first, irrespective of the date
upon which they are purchased. The basic assumption is that in fluctuating and inflationary
market, the cost of material are quickly absorbed into product cost to hedge against risk of
inflation. As the issues are shown at highest prices, the product costs tend to be on the higher
side and hence this method is not suitable in competitive environment.

4) Simple Average Cost Method:-

Under this method, the issues are charged at the average price of the material purchased
without taking into consideration the quantities involved in the same. For example, if materials
are purchased in three batches at prices of `18, `19 and ` 23, the issue will be charged at the
average price of the three prices, i.e. `18 + `19 + ` 23 = ` 60/3 = ` 20. This method does not
consider the quantities purchased. In price fluctuations this method is useful but if fluctuations
are too wide, the method may not be useful.

5) Weighted Average Method:-

This method considers 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 `10, ` 12 and ` 11 and the
quantities involved are respectively 1,000, 1,200 and 1,400. The weighted average price will be
calculated as shown below.
`10 × 1,000 + `12 × 1,200 + ` 11 × 1,400 = ` 10,000 + `14, 400 + `15, 400 = ` 39, 800/3,600 =
`11.05. The subsequent issue will be charged at this price. This method is that it evens out
the price fluctuations and reduces the number of calculations to be made.

6) Periodic Average Cost Method:-

Under this method, instead of recalculating the simple or weighted average cost every time
there is a receipt, periodic average is computed. The average may be calculated for the entire
period. The price may be calculated as given below.
Cost of Opening Stock + Total Cost of all receipts/Units in Opening Stock + Total Units received
during the period.

17
7) Standard Cost Method:-
Under this method, material issues are priced at a predetermined standard issue price. Any
difference between the actual purchase price and the standard price is written off to the
Costing Profit and Loss Account. Standard Cost is a predetermined cost and if it is set
accurately, it can be very effective.

8) Replacement Cost [Market Price]:-

It means the cost at which material identical to that is to be replaced could be purchased at the
date of pricing of the issues as distinct from the actual cost price at the date of purchase. The
replacement price is the price of replacing the material at the time of the issue of materials or
on the date of valuation of closing stock.

9) Next In First Method:-

Under this method, the price quoted on the latest purchase order or contract is used for all
issues until a new order is placed. Thus this method is a variation of the Replacement Cost
Method.

16. MATERIAL LOSSES (Most – Imp)

One of the main reasons of rising material costs is the loss of material in the production
process. 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 Profit and Loss
Account.

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.

18
 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.

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.

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.

17. MATERIAL RETURN NOTE I.E., RETURN OF MATERIALS TO STORE

 Whenever materials supplied to a job are in Excess of its requirement or Found defective
such materials are returned to the stores.
1. Such materials should be returned with 'Material Returned Note'.
2. Material Returned Note is a document which contains details regarding the materials returned
to store.
3. The form of Material Returned Note is similar to that of Materials Requisition Slip and hence to
distinguish between the two, different colours are used.
4. Returning department-
(i). prepares three copies of Material Returned Note
(ii). sends two copies to the Stores Department
(iii). retains one copy for its own reference
5. Stores Department records in the Bin Card and sends one copy after signature to the Cost
Accounting Department.
6. Cost Accounting Department gives the necessary credit to the concerned job / department for
the cost of materials returned.

18. TECHNIQUES OF INVENTORY CONTROL

The various techniques of inventory control are as follows:
(1) ABC Analysis
(2) Economic Order Quantity (EOQ)

19
 (3) Stock Levels, Minimum Lever, Maximum Level, Recorder Level, Re-order Quantity.
(4) Inventory Turnover Ratio and review of Slow and Non-moving items.
(5) Proper Purchase Procedure
(6) Proper Storage Procedure
(7) Proper Issue Procedure
(8) Two Bin system
(9) Use of Perpetual Inventory Records and Continuous Stock Verification.
(10) Establishment of a system of Budgets.

19. ORDER CYCLING SYSTEM

In the order cycling system, quantities in hand of each item or class of stock is reviewed
periodically say, 30, 60 or 90 days. If in the course of a scheduled periodic review it is observed
that the stock level of a given item will not be sufficient till the next scheduled review keeping
in view its probable rate of depletion, an order is placed to replenish its supply. Review period
will vary from firm to firm and also among different materials in the same firm. Critical items
of stock usually require a short review cycle.

20
 CLASSROOM PRACTICE – LETS PLAY TOGETHER

Qus 1.
From the following figures relating to two components X and Y, compute Reorder Level,
Minimum Level, Maximum Level and Average Stock Level.
Particulars Component X Component Y
Maximum consumption per week 75 units 75 units
Average consumption per week 50 units 50 units
Minimum consumption per week 25 units 25 units
Reorder period 4 to 6weeks 2 to 4 weeks
Reorder quantity 400 units 600 units

Ans
The computation of various levels is shown below.
(A). Reorder Level = Maximum Consumption × Maximum Reorder Period
Component X = 75 units × 6 weeks = 450 units
Component Y = 75 units × 4 weeks = 300 units.

(B). Minimum Level = Reorder Level- Average Consumption × Average Reorder Period
Component X = 450 units - [50 units × 5 weeks] = 200 units
Component Y = 300 units - [50 units × 3 weeks] = 150 units

(C). Maximum Level = Reorder Level + Reorder Quantity - [Minimum Consumption × Minimum
Reorder Period]
Component X = 450 units + 400 units - [25 units × 4 weeks] = 750 units
Component Y = 300 units + 600 units - [25 units × 2 weeks] = 850 units

(D). Average Level = ½ [Maximum Level+ Minimum Level]

Component X = ½ [750 units + 200 units] = 475 units
Component Y = ½ [150 units + 850 units] = 500 units

Qus 2.
PQR Ltd., manufacturers a special product, which requires 'ZED'. The following particulars
were collected for the year 2007-08:
(i). Monthly demand of Zed : 7,500 units
(ii). Cost of placing an order : `500
(iii). Re-order period : 5 to 8 weeks
(iv). Cost per unit : `60
(v). Carrying cost % p.a. : 10%
(vi). Normal usage : 500 units per week
(vii). Minimum usage : 250 units per week
(viii). Maximum usage : 750 units per week

Required:
(i). Re-order quantity
(ii). Re-order level
(iii). Minimum stock level
(iv). Maximum stock level
(v). Average stock level

21
Ans
2𝐴𝑂
(i) Re-order quantity = 𝐶

2×500×52 ×500
= = 2,082 unit
60 ×10%

(ii) Re-order level = Maximum re- order period × Maximum usage per week
= 8 × 750 units per week
= 6,000 units

(iii) Maximum stock level = re-order level – normal usage × Average recorder period
= 6,000 – (500 × 6.5)
=2,750 units

(iv) Maximum stock level = re- order level + re-order quantity – (minimum usage × minimum
period)
= 6,000 + 2082 – (5×250)
= 6,832 units

(v) Average stock level = ½ (minimum stock level + maximum stock level )
= ½ (2,750 + 6832)
= 4,791 units.

Qus 3.
Materials X and Y are used as follows:
Minimum usage − 50 units each per week
Maximum usage − 150 units each per week
Normal usage − 100 units each per week
Ordering quantities X = 600 units
Y = 1,000 units
Delivery period X = 4 − 6 weeks
Y = 2 − 4 weeks
Calculate for each material (i) Maximum level (ii) Minimum level and (iii) Ordering level.

Ans:
Material X
Ordering level = Maximum usage × Maximum delivery period
= 150 × 6
= 900 units.
Minimum level = Ordering level - (Normal usage × Normal delivery period)
= 900 − (100 × 5)
= 400 units
Maximum level = (Ordering level + Ordering quantity) − (Minimum usage × Minimum
delivery period)
= 900 + 600 − (50 × 4)
= 1,500 − 200
= 1,300 units
Material Y
Ordering Level = Maximum usage x Maximum delivery period

22
 = 150 × 4 = 600 units
Minimum Level = Ordering level − (Normal usage × Normal delivery period)
= 600 − (100 × 3) = 300 units.
Maximum Level = (Ordinary level + Ordering quantity) - (Minimum usage × Minimum
delivery
period)
= 600 + 1,000 − (50 × 2)
= 1,600 − 100 = 1,500 units.
Normal delivery period has been computed as follows:
4+6
Material X = = 5 weeks
2

2+ 4
Material Y = = = 3 weeks
2

Qus 4.
In a company, the weekly minimum and maximum consumption of Material-A are 25 and 75 units
respectively. The re-order quantity as fixed by the company is 300 units. Material-A is received
within 4 and 6 weeks from the date of issue of supply order. Calculate minimum level and
maximum level of Material-A.

Ans:
Computation of Minimum Level:-
= Re-order Level - (Average rate of consumption × Average re-order period)
= 450 units - (50 units × 5 weeks) = 200 units

Computation of Maximum Level :-

= Re-order level + Re-order quantity - (Minimum rate of consumption × Minimum re-order period)
= 450 units + 300 units - (25 units × 4 weeks) = 650 units

Working Note:
Computation of Re-order level = Maximum usage per period × Maximum re-order period
= 75 units × 6 weeks = 450 units.

Qus 5.
A company manufactures a product from a raw material, which is purchased at As60 per kg. The
company incurs a handling cost of `360 plus freight of `390 per order. The incremental carrying
cost of Inventory of raw material is ` 0.50 per kg per month. In addition, the cost of working
capital finance on the investment in inventory of raw material is ` 9 per kg. per annum. The annual
production of the product is 1, 00,000 units and 2.5 units are obtained from one kg of raw
material.
Required
i). Calculate the economic order quantity of raw materials.
ii). Advise, how frequently should orders for procurement be placed.

Ans:
A = Annual requirement of raw material in kgs. = 1 kg × 1, 00,000 units/2.5 units = 40,000
kgs
O = (handing and freight cost per order) = ` 360 + ` 390 = ` 750
C = Carrying cost per unit per annum + investment cost per Kg. per annum
= (0.5 × 12 months) + ` 9 = ` 15 per unit

23
 2𝐴𝑂 2×40,000×750
(I). EOQ = = = 2,000 kgs
𝐶 15

(II). Frequency of orders for procurement ;

= 365 days/ no. of orders = 365/ (40,000/2,000) = 18

Qus 6.
ZED Company supplies plastic crockery to fast food restaurants in metropolitan city. One of its
products is a special bowl, disposable after initial use, for serving soups to its customers. Bowls are
sold in pack 10 pieces at a price of ` 50 per pack.
The demand for plastic bowl has been forecasted at a fairly steady rate of 40,000 packs every year.
The company purchases the bowl direct from manufacturer at ` 40 per pack within a three days
lead time. The ordering and related cost is ` 8 per order. The storage cost is 10% per cent per
annum of average inventory investment.
Required:
i). Calculate Economic order quantity
ii). Calculate number of orders needed every year.
iii). Calculate the total ordering and carrying cost of bowls for the year.
iv). Determine when the next order to be placed should. (Assuming that the company does
maintain a safety stock and that the present inventory level is 333 packs with a year of 360
working days.

Solution
(i) Number of orders per year
2𝐴𝑂 2×40,000×8
EOQ = = = = 1,60,000 = 400 packs
𝐶 4

Annual requirements 40,000

(ii) Economic Order Quantity = = = 100 order per year
Economic order quantity 400
(iii) Ordering and storage costs
Ordering costs = 100 orders × ` 8.00 = ` 800
Storage cost = (400/2) × (10% of 40) = ` 800
Total cost of ordering & storage ` 1,600

(iv) Timing of next order

(a) Day's requirement served by each order.

𝐍𝐨.𝐨𝐟 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐝𝐚𝐲𝐬

Number of days requirements =
𝐍𝐨.𝐨𝐟 𝐨𝐫𝐝𝐞𝐫 𝐢𝐧 𝐚 𝐲𝐞𝐚𝐫

360
= 100 = 3.6 days supply

This implies that each order of 400 packs supplies for requirements of 3.6 days only.

(b) Days requirement covered by inventory

Units in inventory
= × (Day requirement served by an order)
Economic order quantity

24
 333
= × 3.6 days = 3 days requirement
400

(c) Time interval for placing next order

Inventory left for day's requirement - Lead time of delivery
3 day's requirements - 3 days lead time = 0
This means that next order for the replenishment of supplies has to be placed
immediately.

Qus 7.
The following data are available in respect of material X for the year ended 31st March. 1997:
Opening stock ` 90,000
Purchases during the year ` 2,70,000
Closing stock ` 1,10,000
Calculate: (i) Inventory turnover ratio; and (ii) the number of days for which the average
inventory is held.
Solution:
Cost of sock of raw material consumed 2,50,000
(i) Inventory Turnover Ratio = = = 2.5
Average stock of raw material 1,00,000

365 365days
(ii) Average number of days = = = 146 days
Inventory turnover ratio 2.5

Which the average inventory is held

Working Note:
Cost of sock of raw material consumed
Average Stock of raw material
= Op. Stock + Purchase – Cl. Stock
= ` 90,000 + ` 2, 70,000 - ` 1, 00,000 = 2, 50,000
= (Opening Stock + Closing Stock) ½
= ( ` 90,000 + ` 1,10,000) / 2 = ` 1,00,000

Qus 8.
A company has the option to produce a particular material from two sources:
Source I assures that defectives will not be more than 2% of supplied quantity.
Source II does not give any assurance, but on the basis of past experience of supplies received from
it, it is observed that defective percentage is 2.8%.

The material is supplied in lots of 1,000 units. Source II supplies the lot at a price, which is lower
by `100 as compared to Source I. The defective units of material can be rectified for use at a cost of
`5 per unit.
You are required to find out which of the following sources is more economical.

Ans:
Comparative Statement of Procuring Material from two sources
Material Source I Material Source II
Defective (in %) 2 2.8
Total defective units in a lot 20 (i.e. 1,000 units × 2%) 28 (i.e. 1,000 units × 2.8%)
(A) Additional price paid per lot (`) 100 -
(B) Rectification cost of defect (`) 100 (i.e. 20 units × `5) 140 (i.e. 28 units × `5)
(C) Total additional cost per lot (`): 200 140
[A + B]

25
Decision: on comparing the total additional cost incurred per lot of 1,000 units, we observe that it
is more economical, if the required material units are procured from material source II.
Qus 9.
A consignment consisting of 4 grades of materials was purchased for ` 1,20,000. Storekeeper
sorted them out and recorded the following:
Grade A - 4,000 units Grade B - 8,000 units
Grade C-10,000 units Grade D-12,000 units
Total sales of grade A amounted to ` 16,000 (rate of profit being 33 1/3% of cost) and those of B at
a price 1.5 times that of A, but the rate of profit was 33-1/3 % of sales. Similarly Grade C material
was sold for ` 50,000, yielding a profit of 20% on sales.
Calculate the purchase price of each grade on the basis of the above information.
Ans:
Grade A
Total Cost of A = Sales - Profit = ` 16,000 - ` 4,000 = ` 12,000
Cost Price per unit of A 12,000/4,000 = ` 3 per unit
Selling Price per unit of A = 16,000/4,000 = ` 4 per unit
Grade B
1
Selling Price per unit = ` 4 × 12 =` 6
=`2
Less: Profit (33 1/3% of Sales)
=`4
Cost per unit of B
= 8,000 × 4 = ` 32,000
Total Cost of B
Grade C
Total Sales = ` 50,000
Less: Profit (20% of sales) = ` 10,000
Total Cost = ` 40,000
Cost per unit = ` 40,000/10,000 = ` 4 per unit.
Grade D
Total cost of D = Total Cost of A,B,C&D - Total Cost of A, B & C
= ` 1,20,000 - (` 12,000 + ` 32,000 + ` 40,000) = ` 36,000
= 36,000/12,000 = ` 3 per unit
Cost per unit of Grade D
Thus, cost details are:
Grade of Material Units Per Unit (`) Total (`)
A 4,000 3 12,000
B 8,000 4 32,000
C 10,000 4 40,000
D 12,000 3 36,000
1,20,000

26
 JUDGE URSELF

Qus 10.
The following information is available in respect of material of No. 30:
Re-ordering quantity = 1,500 units
Re-order period = 4 to 6 weeks
Maximum consumption = 400 units per week
Normal consumption = 300 units per week
Minimum consumption = 250 units per week.

Calculate:
a) Re-order level;
b) Minimum level;
c) Maximum level; and .
d) Average Stock level.

Ans. (a) 2,400 units; (b) 900 units; (c) 2,900 units (d) 1,900 units

Qus 11.
From the following information you are required to calculate maximum level, minimum, level and
ordering level for materials X and Y:
X Y
Normal usage per week 150 200
Recording quantity 900 1,500
Maximum usage per week 225 250
Minimum usage per 75 100
Recording period (weeks) 12 to 18 6 to 12

[Ans Max. Level Min. Level Ordering Level

X 4,050 1,800 4,050
Y 3,900 1,200 3,000]

Qus 12.
In manufacturing its product Z, a company uses two types of raw-materials A and B in respect of
which the following information is supplied:

One unit of Z requires 10 kg. of A and 4 kg. of B materials. Price per kg of A material is ` 10 and that
of B is ` 20. Reorder quantities of A and B materials are 10,000 kg and 5,000 kg. Reorder levels of
A and B materials are 8,000 kg and 4,750 kg respectively. Weekly production varies from 175 units
to 225 units averaging 200 units. Delivery period of A materials is 1 to 3 weeks and B materials is
3 to 5 weeks.
Compute: (i) Minimum Stock Level of A.
(ii) Maximum Stock Level of B.
Ans. (i) 4,000 kg., (ii) 7,650 kg.

Qus 13.
From the following information, calculate (a) Economic order quantity and (b) Total Annual
Carrying and Ordering cost at that quantity (c) Re-order level, (d) Minimum level, (e) Maximum
level, (f) Average Stock Level, (g) Danger level

27
 Rate of Usage: 5 kg. per unit of finished product. Weekly production of finished product varies
from 50 units to 150 units.
Purchase price of input unit ` 20.
Annual carrying cost 6.5%
Ordering cost per order `100
Lead time: 3 weeks to 7 weeks, For emergency purchase 2 weeks.
[Ans: (a) 2,000 units (b) ` 2,600 (e) 5,250 units (d) 2,750 units
(e) 6,500 units (f) 4,625 units or 3,750 units (g) 1,000 units]

Qus 14.
From the following particulars, compute Economic Order Quantity
Annual consumption = 8, 10, 000 units
Order placing and receiving costs: ` 10 per order
Annual stock holding stock: ` 20
Ans: 900 units

Qus 15.
From the following particulars find out the economic order Quantity:
i). Annual demand 12,000 units
ii). Ordering cost ` 90 per order
iii). Inventory carrying cost per annum `15
Ans: 379 units (approx.)

Qus 16.
A manufacturer buys certain equipment from outside suppliers at ` 30 per unit. Total annual
needs are 800 units.

The following further data are available :

Annual return on investment 10%
Rent, taxes, insurance per unit, per year `1
Cost of placing an order ` 100
Determine the economic order quantity.
Ans: 200 units.

Qus 17.
Calculate the Economic Order Quantity from the following information. Also state the number of
orders to be placed in a year :
Consumption of materials per annum 10,000 kg.
Order placing costs per order ` 50
Cost per kg.of raw-materials `2
Storage cost 8% of average inventory
Ans: (i) 2,500 Kg., (ii) 4.

Qus 18.
What do you understand by Economic Order Quantity? Find out the EOQ from the following:
Annual usage ` 1,60,000 @ ` 40 per unit: Cost of placing and receiving one order ` 200: Annual
carrying cost : 25% of inventory value.
Ans : 400 units.

28
Qus 19.
Calculate the economic order quantity and the number of orders to be placed in a year in each of
the following cases: (Most-imp)
Particular Case (a) Case (b) Case (c) Case (d)
Annual Consumption 1,00,000 units ` 1,60,000 3600 units ` 5,20,000
Cost of placing an order ` 50 ` 200 ` 40 ` 100
Annual Carrying Cost 8% 25% 5% 6.5%
Price per unit of material ` 20 ` 40 ` 64 ` 200
[Ans: (a) 2500 units, 40, (b) 400 units, 10 (c) 300 units, 12 (d) 200 units 13]

Qus 20.
Calculate Economic Order Quantity from the following information:
Annual Consumption 1,00,000 units
Carrying Cost 8% of Average Stock
Per unit Cost ` 20
Ordering Cost ` 50 per order
[Ans: 2500 units]

Qus 21.
A company manufactures a product having monthly demand of 2,000 units. For one unit of
finished product 2 kgs of a particular raw material item is needed. The purchase price of the
material is ` 20 per kg. The ordering cost is ` 120 per order and the holding cost is 10% per
annum. Calculate:
(i). Economic Order Quantity (EOQ), and
(ii). Annual cost of purchasing and storage of the raw material at that quantity.
[Ans: (i) 2400 kg. (ii) ` 4,800]

Qus 22.
An average annual consumption of a material is 18,250 units at a price of `36.50 per unit. The
storage cost is 20% on an average inventory and the cost of placing an order is `50. How much
quantity is to be purchased at a time?
Ans: 500

Qus 23.
After inviting tenders, two quotations are received as under :
Supplier A-` 2.20 per unit.
Supplier B-` 2.10 per unit + ` 2,000 fixed charges irrespective of units ordered.
(i) Calculate the order quantity for which the purchase price per unit will be the same.
(ii) Select the supplier if the purchase officer wants to place an order for 15,000 units.
Ans. (i) 20,000; (ii)A.

Qus 24. (Dec-2013)

A manufacturer uses 75,000 units of a particular material per year. The material cost is `1.50 per
unit and the carrying cost is estimated at 25% per annum of average inventory cost. The cost of
placing an order is `18. You are required to determine the economic order quantity (EOQ),
frequency of orders per annum and time between two consecutive orders.
(4 marks)

29
 PAST EXAMINATION QUESTIONS

MULTIPLE CHOICE QUESTIONS

1. The term 'economic batch quantity' is used in relation to -
(a) Operating costing
(b) Batch costing
(c) Process costing
(d) Unit costing.

2. Re-ordering level is equal to -

(a) Maximum consumption x Minimum Re-order period
(b) Maximum consumption x Maximum Re-order period.
(c) Minimum consumption x Minimum Re-order period.
(d) Normal usage x Normal delivery period.

3. When prices fluctuate widely, the method that will avoid the effect of fluctuations is -
(a) FIFO
(b) LIFO
(c) Simple average
(d) Weighted average

4. Obsolete stocks are those having-

(a) Low turnover rate
(b) No demand for technological change
(c) No present demand, but may be in future
(d) None of the above.

5. Continuous stock taking is a part of-

(a) Annual stock taking
(b) Perpetual inventory
(c) ABC Analysis
(d) None of the above.

6. The type of spoilage that does not affect the cost of inventories is -
(a) Normal spoilage
(b) Standard spoilage
(c) Abnormal spoilage
(d) Seasonal spoilage.

FILL IN THE BLANKS

1. Quantitative record of receipts, issue and balance items of material in stores are entered in……
2. Economic lot size is the order size that ……… the total cost of ordering and storing.
3. Inflated price method of valuing material issue is suited ……
4. Material losses due to abnormal reasons be transferred to …….
5. The three categories of inventory for a manufacturer are raw material, work-in-process and …..

30
6. The process of physical verification of stores throughout the year is known as …….

True and False/Correct and Incorrect

1. Loss of material due to fire is treated as overhead and included for calculating cost of
production.
2. Bin card maintained by the costing department.
3. Bin card shows the value of a material at any moment of time.
4. Assuming inflation, if a company wants to maximize net income, it would select FIFO as
the method of pricing raw materials.

Answer : MCQs
Answers 1 2 3 4 5 6
Options (b) (b) (d) (a) (b) (a)

Answers : Fill in the Blanks

1. Bin card
2. Minimizes
3. When there is unavoidable wastage of material
4. Costing Profit and Loss Account
5. Finished goods
6. Perpetual inventory system

Answers : True/False
1. False, Loss of material due to fire is treated as abnormal loss and it is Charged to costing profit
& loss account.
2. False, Bin Card is maintained by the stores department.
3. False, A separate bin card is maintained for each item of inventory indicating the quantity of
stock at any point of time.
4. Ans. True, In Inflation prices are rising production cost is understated, thereby the net income
is maximised under FIFO method.

31
 TRAIN UR BRAIN
1. Material are purchased by – 9. In ……. method, price of the latest
a) Purchase department available stock in taken as the issue
b) Sales Department price.
c) Accounts Department a) LIFO b) FIFO
d) Material Department c) Simple Average
2. Direct Material is a - d) Weighted average
a) Variable cost 10. The quantity of materials which should
b) Fixed Cost be ordered every time when an order is
c) Semi variable cost placed is known as –
d) Manufacturing cost a) EOQ b) ABC Analysis
3. Which of the following is an accounting c) VED Analysis d) Level Setting
record? 11. ……… are the costs of bringing a material
a) Stores ledger into the stores and the incurred every
b) Bills of materials time an order is placed.
c) Bin card a) Carrying costs b) Ordering Costs
d) All of these c) Average Costs
4. Bin Card is also known as – d) None of the above
a) Stores ledger 12. ……… are the costs incurred on the
b) Bills material maintenance of material in the stores
c) Stock card and includes clerical handling,
d) None of the above obsolescence, loss on holding stock,
5. Stores ledger is maintained by – pilferage, etc.
a) Marketing department a) Average Costs b) Ordering Costs
b) Cost Department c) Carrying costs d) Marginal costs
c) Purchase Department 13. A process whereby all stock items are
d) Sales Department physically counted and then value is
6. In manufacturing industries, the known as –
important element of cost is – a) Periodic stock taking
a) Labour b) Overhead b) Continuous stock taking
c) Material d) All of the c) Two Bin system
above d) None of these
7. The store keeper should intimate a 14. An important factor of determining
purchase requisition when stock reaches economic order quantity is –
– a) Storage costs b) Financial Cost
a) Maximum Level b) Minimum c) Inventory Cost d) Material Cost
Level 15. All manufacturing concerns appoints a
c) Re-order Level d) Average Stock person as a -
8. In ……… method, the materials are priced a) Store Keeper b) Broker
in the order of their receipts i.e., price of c) Agent d) Salesman
the oldest available stock is taken the 16. When inter departmental transfer of
issue price. material take place within the
a) LIFO b) FIFO organization, it is supported with –
c) HIFO d) NIFO a) Credit Note b) Debit Note

32
 c) Material transfer Note cost is 15% of the annual inventory
d) Stores requisition Note value. Company operates 250 days per
17. ABC analysis is a technique of – year. The procurement time is 10 days
a) Inventory control and safety stock is 1,000 units. Calculate
b) Budgetary control the maximum stock level.
c) Cost control a) 8071 units b) 7071 units
d) None of these c) 2349 units d) 2683 units
18. …….. is the optimum size of the order for 23. The average annual consumption of
a particular item of inventory, at that material is 20,000 kgs at a price of ` 2
point that ordering and carrying costs of per kg. The storage cost is 16% on
inventory are minimized. average inventory and the cost of placing
a) EOQ b) ABC Analysis one order is ` 50. How much is to be
c) JIT System d) Material purchased at a time?
19. Re-ordering level is equal to – a) 2400 kgs b) 2500 kgs
a) Maximum consumption × minimum b) 2000 kgs d) 1500 kgs
re-order period. 24. If the minimum stock level and average
b) Maximum consumption × maximum stock level of raw material X are 4,000
re-order period. and 9,000 units respectively. Find out the
c) Normal usage × normal delivery re-order quantity.
period. a) 15,000 units b) 10,000 units
d) Minimum consumption × minimum c) 25,000 units d) 20,000 units
re-order period. 25. Cost of goods sold = ` 1,20,000, Gross
20. Calculate EOQ. Given Loss ¼ of sales. What is the amount of
Weekly average requirement of raw sales?
material EXE – 50 units a) ` 1,92,000 b) ` 50,000
Cost of placing an order ` c) ` 72,000 d) ` 96,000
100
26. If the ordering cost per order is ` 40,
Annual carrying cost per unit of EXE `
15 carrying cost is 10% of average
Annual carrying cost per unit of EXE inventory value. Purchase cost is ` 10 per
a) 195 units b) 200 units unit and Economic Order Quantity (EOQ)
c) 186 units d) 159 units for the product is 800 units; What is the
21. A manufacturer uses 75,000 units of a expected annual demand for the
particulars material per year. The product?
materials cost is ` 1.50 per unit and the a) 8,000 units b) 10,000 units
carrying cost is estimated to be 25% p.a. of c) 20,000 units
average inventory cost. The cost of placing d) None of the above
order is ` 18. 27. The annual demand of certain
Calculate EOQ and frequency of order per component bought from the market is
annum. 1,000 units. The cost of placing an order
a) 2863 units, 29 times is ` 120 and the annual storing charges
b) 2385 units, 82 times work out 10% of the Cost of component.
c) 2683 units, 28 times To get maximum benefit the firm should
d) 2349 units, 15 times place order for how many units at a
22. Annual consumption of a material of a time?
company is 1,00,000 units at ` 2.40 er a) 1,000 units b) 900 units
unit. Each order costs ` 90 and carrying c) 800 units d) 600 units

33
28. for a particular item of store, the 34. For EOQ, how frequently should orders
following information are available: be placed
Re-order quality = 1200 units a) 20 days b) 19 days
Maximum consumption per week = 300 c) 24 days d) 18.25 days
units 35. For EOQ, Total Ordering Cost
Normal consumption per week = 200
a) 3600 b) 4000
units
Re-order period = 2 to 4 weeks c) 4400 d) 5000
The Re-order level will be – 36. For EOQ, Total Carrying Cost
a) 600 units b) 400 units a) 4500 b) 3600
c) 1200 units c) 6000 d) None
d) None of the above 37. Total Annual Carrying and Ordering cost
at that quantity
If the minimum stock level and average a) 10000 b) 9000
stock level of raw materials Aare 4000 to c) 8000 d) 7200
9000 units respectively
29. Calculate Re-order Level Tulip Ltd produces a product which has a
b) 9,000 units b) 10,000 units monthly demand of 4,000 units. The
c) 4,000 units d) 5,000 units product Requires Components-A which is
purchased at ` 20 for every finished
Consumption of materials per annum : product one unit of Component-A is
10,000 kg required. The ordering cost is ` 120 per
Order placing cost per order : ` 50 order and the holding cost is 10% per
Cost per kg of raw materials : ` 2 annum.
Storage costs: 8% on average Calculate –
Inventory
38. Economic Order quantity
30. Calculate the Economic Order Quantity a) 2500 b) 2600
a) 2,500 kg b) 2,000 kg c) 2400 d) 2700
c) 1,500 kg d) 3,000 kg 39. If the minimum lot size is 4,000 units,
31. Calculate the number of orders to be what is the extra cost Tulip Ltd. has to
placed in a year. incur?
a) 5 b) 4 a) 640 b) 440
c) 3 d) 2 c) 460 d) 840

From the following information: A factory requires 1,500 units of an item

Annual Consumption of input 48000 per month. The cost of each unit is ` 27.
units The cost per order is ` 150 and inventory
Annual carrying cost 12% carrying charges work out to 20% of the
Purchase price of input unit ` 25 average inventory.
Ordering cost per order ` 180 Calculate –

32. Economic order quantity 40. Economic order Quantity (EOQ)

a) 2000 b) 2400 a) 1000 b) 2000
c) 4000 d) 8000 c) 3000 d) 4000
33. For EOQ, the number of orders per year 41. Number of orders to be placed per year
a) 30 b) 25 a) 20 b) 10
c) 20 d) 10 c) 30 d) 18

34
42. Would you accept a 2% price discount on A firm requires 50 items every day for a
a minimum supply of 1,200 units? machine. A fixed cost of ` 50 per order is
a) Yes b) No incurred for placing an order. The
inventory carrying cost per item amounts
to ` 0.02 per day. The lead period is 32
X Limited manufacturers of a special
days.
product, follows the policy of EOQ
Compute
(Economic Order Quantity) for one of its
components. The components’ details are
46. Economic order quantity
as follows:
Purchase price per components ` 200 a) 500 b) 1000
Cost of an order ` 100 c) 1500 d) 2000
Annual cost of carrying one unit in 47. Re-order level
inventory 10% of purchase units a) 1800 b) 1600
Total cost of carrying inventory and c) 1900 d) 1400
ordering per annum ` 4,000
The company has been offered a discount
A factory buys and uses components for
of 2% on the price of the components production at ` 10 per unit. Annual
provides the lot size is 2,000 components
requirement is 20,000 units. The carrying
at a time.
cost of inventory is 10% per annum and
ordering cost is ` 40 per order.
43. Compute the EOQ
a) 300 b) 400 48. Calculate EOQ
c) 200 d) 4000 a) 1400 b) 1265
c) 1600 d) 1700
EXE Limited has received an offer of
49. Calculate No. of order to be placed
quantity discounts on its order of
materials as under: a) 17 b) 18
Price per Tonne Tonnes c) 16 d) 19
1,200 Nos 50. Total cost at EOQ
1,180 Less than 500 a) 201280 b) 201272
1,160 500 and less than 1,000 c) 202000 d) 203000
1,140 1,000 and less than 51. Total cost of acquiring 20,000 units in
2,000
one order and get a 3% discount from
1,120 3,000 and above
The annual requirement for the materials the supplier
is 5,000 tonnes. The ordering cost per a) 203740 b) 203000
order is ` 1,200 and the stock holding cost c) 203470 d) 203400
is estimated at 20% of materials cost per
annum. X Ltd. manufacturers a special product
‘ZED’ and provides the following
44. Compute the most economical purchase information:
level. Demand of ZED various from 500 units to
a) 1000 b) 2000 1500 units per month.
c) 3000 Semi-Annual carrying cost 6%.
Raw –materials required per unit of
d) None of the above
finished product 2 kg
45. Find EOQ if there are no discounts Ordering cost per order ` 90
offered and the price per tone is ` 1,500? Purchase price of input unit ` 25 per kg.
a) 300 b) 800 52. Calculate Economics order quantity
c) 600 d) 200 a) 1400 b) 1200
c) 1500 d) 1800

35
 Deterioration and obsolescence Cost: ` 10 per
Pumpkin Pump Co. uses about 75,000 unit p.a.
valves per year and the usage is fairly Interest Rate: 15% p.a.
constant at 6,250 valves per month. The Storage Cost: ` 4,50,000 for 90,000 units
valves cost ` 1.50 per unit when bought in Purchase Price of a component: ` 100
quantities and the carrying cost is
estimated to be 20% of average inventory 60. Calculate Economic Order Quantity
investment on the annual basis. The cost a) 400 b) 300
to place an order and process the delivery c) 500 d) 600
is ` 18. It takes 45 days to receive from the
date of an order and a safety stock of Ram Enterprises manufacturers a special
3,200 valves is desired. product “ZED”. The following particulars
were collected for the year 1986:
53. The most economical order quantity (a) Monthly demand of ZED – 1,000 units.
a) 4000 b) 5000 (b) cost of placing an order ` 100
c) 3000 d) 6000 (c) Annual carrying cost per unit ` 15
54. Frequency of orders (d) Normal usage 50 units per week
a) 30 b) 35 (e) Minimum usage 25 units per week.
c) 40 d) 25 (f) Maximum usage 75 units per week
55. The order point (g) Re-order period 4 to weeks.
a) 12575 b) 12675 Compute from the above.
c) 12775 d) 12875
61. Re-order Quantity
Normal usage 50 per week a) 186 b) 200
Maximum usage 75 per week c) 300 d) 500
Minimum usage 25 per week
62. Re-order level
Re-order quantity 300
Re-order period 4 to 6 weeks a) 550 b) 450
Calculate for each component c) 650 d) 750
63. Minimum level
56. Re-ordering level a) 400 b) 500
a) 550 b) 450 c) 200 d) 100
b) 650 d) 750 64. Maximum level
57. Minimum level a) 400 b) 536
a) 200 b) 250 c) 600 d) 700
b) 300 d) 400
58. Maximum level The following details are available from
a) 400 b) 500 the books of Ruby Engineering Works Ltd.
b) 600 d) 650 for the year ended 31st March, 2009:
Monthly Demand (units) 2000
59. Average stock level
Cost of placing an order (`) 200
a) 525 b) 425 Annual Carrying Cost (` per unit) 30
b) 225 d) 325 Normal Usage (units per month) 100
Maximum Usage (units per month) 150
Monthly demand of product X – 1500 units Minimum Usage (units per month) 50
Requirement of component to produce 1 Re-order Period (weeks) 4-6
unit of product X : 5 units Assume 52 weeks in a year.
Ordering, receiving and handling cost: ` Calculate the following:
10 per order
Trucking Costs: ` 5 per order 65. Re-order Quantity

36
 a) 130 b) 140 73. Calculate the value of closing stock from
c) 126 d) 160 the following according to FIFO method:
66. Re-order Level 1st January, 2014:
a) 207 b) 350 Opening balance: 50 units @ ` 4
c) 250 d) 400 Receipts”
67. Minimum Level 5th January, 2014: 100 units @ ` 5
12th January, 2014: 200 units @ ` 4.50
a) 200 b) 300
Issues:
c) 100 d) 92
2nd January, 2014: 30 units
68. Maximum Level 18th January, 2014: 150 units
a) 400 b) 287 a) ` 765 b) ` 805
c) 150 d) 200 c) ` 786 d) ` 700
74. Calculate the value of closing stock from
A company manufacturers a product from the following according to LIFO method.
a raw material, which is purchased at ` 60
January, 2014: Opening Balance : 50
per kg. The company incurs a handling
cost of ` 360 plus freight of ` 390 per units @ ` 4
order. The incremental carrying cost of 5th January, 2014: 100 units @ ` 5
inventory of raw material is ` 0.50 per kg 12th January, 2014: 200 units @ ` 4.50
per month. In addition, the cost of Issues:
working capital finance on the investment 2nd January, 2014 : 30 units
in inventory of raw material is ` 9 per kg. 18th January, 2014: 150 units
per annum. The annual production of the a) ` 765 b) ` 805
product is 1,00,000 units and 2.5 units are c) ` 786 d) ` 700
obtained from one kg of raw material. 75. Calculate the value of ordering stock
69. Calculate the economic order quantity of from the following according to weighted
raw materials average method:
a) 3000 b) 2000 1st January, 2014: Opening Balance: 50
c) 1000 d) 5000 units @ `
70. How frequently should orders for Receipts:
procurement be placed 5th January, 2014: 100 units @ ` 5
a) 20 days b) 19 days 12th January, 2014: 200 units @ ` 4.50
Issues:
c) 18 days d) 25 days
2nd January, 2014: 30 units
71. Calculate Re-order level from the 18th January, 2014: 150 units
following: a) ` 765 b) ` 805
Consumption per week: 100-200 units c) ` 786 d) ` 700
Delivery period: 14-28 days 76. Which of these is not a Material control
a) 5600 units b) 800 units
technique:
c) 1400 units d) 200 units
a) ABC Analysis
72. Calculate EOQ (approx.) from the
b) Fixation of raw material levels
following details:
c) Maintaining stores ledger
Annual Consumption: 24000 units
d) Control over slow moving and non
Ordering cost: ` 10 per order
Purchase Price: ` 100 per unit moving items
Carrying cost: 5% 77. Out of the following, what is not the work
a) 310 b) 400 of purchase department:
c) 290 d) 300 a) Receiving purchase requisition
b) Exploring the sources of material
supply

37
 c) Preparation and execution of
purchase orders
d) Accounting for material received
78. Bin Card is a
a) Quantitative as well as value wise
records of material received, issued
and balance;
b) Quantitative record of material
received, issued and balance
c) Value wise records of material
received, issued and balance
d) A record of labour attendance.
79. Sores Ledger is a:
a) Quantitative as well as value wise
records of material received, issued
and balance;
b) Quantitative record of material
received, issued and balance
c) Value wise records of material
received, issued and balance
d) A record of labour attendance
80. Re-order level is calculated as:
a) Maximum consumption × Maximum
re-order period
b) Minimum consumption × Minimum
re-order period
c) ½ of (Minimum + Maximum
consumption)
d) Maximum level – Minimum level
81. Economic order quantity is that quantity
at which cost of holding and carrying
inventory is:
a) Maximum and equal
b) Minimum and equal
c) It can be maximum and minimum
depending upon case to case.
d) Minimum and unequal
82. ABC analysis is an inventory control
technique in which:
a) Inventory levels are maintained
b) Inventory is classified into A, B and C
category with A being the highest
quantity lowest value.
c) Inventory is classified into A, B and C
category with A being the lowest
quantity highest value
d) Either b or c
83. Which one out of the following is not an
inventory valuation method?
a) FIFO b) LIFO
c) Weighted Average d) EOQ
84. After inviting tenders for supply of raw
materials, two quotations are received as
follows –
Supplier P ` 2.20 per unit, Supplier Q `
2.10 per unit plus ` 2,000 fixed charges
Irrespective of the units ordered. The
order quantity for which the purchase
price per unit will be the same –
a) 22,000 units b) 20,000 units
b) 21,000 units
c) None of the above
85. Material control does not cover the
following stage:
a) Purchase of materials
b) Storing of materials
c) Issue of materials
d) Production
86. Material control aims at achieving
effective _________.
a) Material management
b) Quality control
c) Accounting of material
d) Material supply
87. Material cost control is best defined as:
a) The recording of accounting
transactions relating to material cost.
b) Ensuring that losses due to poor
stores procedures are minimized.
c) Minimizing material cost by
implementing control from the
point at which the material is
chosen to its issue into the
production process.
d) The process of having a
management member responsible
for each phase of the movement of
materials from the choice of
material to its issue into the
production process.
88. A perpetual inventory system may be
defined as:
a) The checking of physical stock
against the bin card information on a
continuous basis.
38
 b) The documentation system which a) Finished goods
records all stores transactions on a b) Raw Materials
continuous basis. c) Work-in-progress
c) The checking of stock on the same d) All of the above
date in each accounting period. 95. Stores Ledger is maintained in the
d) Ensuring that stocktaking __________.
procedures conform to a previously a) Store
agreed procedure. b) Finance department
89. Inventory consists of ____________. c) Cost Accounting department
a) Intangible property d) Both a and b
b) Tangible Property 96. Stock verification sheet are maintained
c) Either of (a) or (b) to record the results of ____________.
d) Both (a) and (b)
a) Physical verification
90. Which of the following statement is
b) Financial control
correct in relation to “Need for proper c) financial verification
inventory control”? d) Quality verification
a) Inventory may lead to keep men and 97. Stock adjustment Account is debited
machines waiting. with ___________ and credited with
b) Materials do not constitute a _____________.
significant part of the total
a) Surplus, Shortage of stock
production cost hence proper
b) Shortage of stock, surplus
planning and controlling of
c) Excess, loss
inventories is not a big deal.
d) None of these
c) Funds are not tied up in surplus
98. Bin card is a record of _______________
stores and stock.
d) All of the above only.
91. Inventory is valued at ___________. a) Cost b) Value
a) Replacement price c) Quantity d) Expense
b) Replacement price or purchase 99. Bind card is maintained by the
value, whichever is lower ____________.
c) At cost or net realizable value a) Cost accountant b) Clerk
whichever is lower c) Storekeeper
d) Replacement price or net realizable d) Branch Accountant
value whichever is lower. 100. Material abstract is also known as
92. _____________ indicates the level of each __________.
particular item of stock at any point of a) Material issue analysis sheet
time. b) Bill of materials
a) Bill of material c) Stores Ledger
b) Material requisition note d) None of the above
c) Bin Card
d) All of the above ANSWERS
93. Which of the following details are 1. a 2. a 3. a
recorded in bin card? 4. c 5. b 6. c
a) Date of order and suppliers name 7. d 8. b 9. a
along with address 10. a 11. b 12. c
b) Record of quantities 13. a 14. a 15. a
c) Record of both quantities and values 16. c 17. a 18. a
d) All of the above
94. Inventory held for sale in the ordinary 19. b 20. c 21. c
course of business is known as 22. a 23. b 24. b
_____________. 25. d 26. a 27. a

39
28. c 29. b 30. a
31. b 32. b 33. c
34. d 35. a 36. b
37. d 38. c 39. a
40. a 41. d 42. a
43. c 44. a 45. d
46. a 47. b 48. b
49. c 50. b 51. a
52. b 53. c 54. d
55. a 56. b 57. a
58. d 59. b 60. b
61. a 62. b 63. c
64. b 65. c 66. a
67. d 68. b 69. b
70. c 71. b 72. a
73. a 74. b 75. c
76. c 77. d 78. b
79. a 80. a 81. b
82. c 83. d 84. b
85. d 86. a 87. c
88. b 89. b 90. a
91. c 92. c 93. b
94. a 95. c 96. a
97. b 98. c 99. c
100. a

40
CHAPTER 2
MEANING OF LABOUR
Labour is an essential factor of production. It is a human resource and participates in the
process of production. Labour cost is a significant element of cost of a product or service. For
costing purposes, labour may be classified into two broad categories
1. Direct Labour and
2. Indirect Labour.

DIRECT LABOUR
Meaning
Direct labour is that labour which can be readily identified with a specific job, contract or work
order. It includes:
a) All labour directly engaged in converting raw materials into finished goods or in altering the
construction, composition or condition of the product.
b) Any other form of labour which is incurred wholly or specifically for any particular job,
contract or work order.

Features
The main features of direct labour are:
a) It can be easily identified with a specific job, contract or work order.
b) It varies directly with the volume of output.

Treatment
Wages paid to direct labour are termed as 'Direct labour cost' and form part of Prime cost.

Examples
Some examples of direct labour are:
(a) Weaver in weaving unit
(b) Carpenter in furniture unit
(c) Tailor in Readymade wears unit
(d) Baker in Baking unit
(e) Halwai in confectionery unit
(f) Labour employed on construction contract

INDIRECT LABOUR
Meaning
Indirect labour is that labour which cannot be readily identified with a specific job, contract or
work order. It includes all labour not directly engaged in converting raw-materials into finished
goods or in altering the construction, composition or condition of the product.

Features
The main features of indirect labour are:
a) It cannot be easily identified with a specific job, contract or work order.
b) It may or may not vary directly with the volume of output.

41
Treatment
Wages paid to indirect labour are termed as 'Indirect labour cost' and are treated as part of
overheads.

Examples
Some examples of indirect labour are:
a) Labour employed in Personnel Department
b) Labour employed in Time-keeping Department
c) Labour employed in Pay-roll Department
d) Labour employed in Cost Accounting Department
e) Labour employed in Repairs & Maintenance Department

Distinction between Direct Labour and Indirect Labour

Direct labour differs from Indirect labour in the following respects:
Basis of Direct Labour Indirect Labour
Distinction
1. Identification It can be readily identified with It cannot readily be identified with a specific
a specific job, contract or work job, contract or work order.
order.
2. Treatment of Direct labour cost is directly Indirect labour cost cannot directly be
cost charged to the specific job, charged to the specific job, contract or work
contract or work order and order and is treated as part of overheads
forms part of prime cost. which are absorbed on some suitable basis.
3. Variability It varies directly with the It may or may not vary directly with the
volume of output. volume of output.

Note: Distinction is relative to each particular firm or industry since labour which is direct in one
unit may be indirect in another unit due to difference in the nature of work, process or method.

Importance of Distinction
1. For ascertainment of cost-It helps in ascertaining the labour cost of different cost units.
2. For exercising control over cost-It helps in exercising proper control over labour cost.
3. For accounting treatment- Direct labour cost is treated as part of prime cost and indirect
labour cost is treated as part of production overheads.

LABOUR TURNOVER

Meaning of Labour Turnover

Labour Turnover is the rate of change in the composition of labour force of an organisation due to
retirement, resignation or retrenchment etc. during a particular period. It may be defined as the
number of workers left or replaced or both in relation to the average number of workers
employed during the period.

Three Methods of Measurement of Labour Turnover

1. Separation Rate Method

No.of Separations
Labour Turnover =
Average Number of workers in the period× 100

Where,

42
 No. of separations = No. of workers left

No.of Workers in the beg + No.of Workers at the end

Average no. of workers =
2

2. Replacement Rate Method

No.of replacement
Labour Turnover =
Average Number of workers in the period× 100

Where,
No. of Replacements = No of workers recruited in the vacancies of those leaving excluding
those recruited on account of expansion scheme

3. Flux method

No.of Separations + No.of replacement

Labour Turnover =
Average Number of workers in the period× 100

OR
No. of Separations + No. of accessions
Average Number of workers in the period × 100

No. of Accessions = no. of Workers recruited in the vacancies of those leaving and those recruited
on account of its expansion

Equivalent Annual Labour Turnover Rate

In case Labour Turnover Rate is based on a period other than a year, An Equivalent Annual Labour
Turnover Rate may be calculated as follows:

Turnover rate for the period × 365

Equivalent Annual Labour Turnover Rate =
Number of days in the period

Causes of Labour Turnover

Type of Causes Examples
a) Personal Causes a. Change of jobs for betterment.
These include those causes which b. Premature retirement due to ill health or old age.
induce or compel workers to leave c. Domestic problems and family responsibilities.
their jobs. d. Discontent over the jobs and working environment.
b) Unavoidable Causes a. Seasonal nature of the business;
These include those causes which b. Shortage of raw material, power, slack market for the
are not within the control of the product etc;
management. c. Change in the plant location;
d. Disability, making a worker unfit for work;
e. Disciplinary measures;
f. Marriage (generally in the case of women).
c) Avoidable causes a. Dissatisfaction with job, remuneration, hours of
There include those causes which work, working conditions, etc.,
are within the control of the b. Strained relationship with management, supervisors
management and which require or fellow workers;
the attention of management on a
c. Lack of training facilities and promotional avenues;

43
 continuous basis so as to keep the d. Lack of recreational and medical facilities;
labour turnover ratio as low as e. Low wages and allowances.
possible .

Effects of High Labour Turnover

High Labour Turnover increases the cost of production and decreases the profitability because of-
1. Loss of output between the time when worker left and new workers recruited
2. Increased cost of Selection and recruitment
3. Increased cost of Training
4. Increased cost of Tools, Equipments and machine breakages
5. Increased cost of scrap, wastage, spoilage and defective wor
6. Loss of output due to lower productivity of new worker along with fall in quality.

Two Types of Cost of Labour Turnover

1. Preventive Costs There are the costs which are incurred to keep the labour force contended
so that high labour turnover may be prevented. These costs include the following;
(i). Cost of Personnel Administration
(ii). Cost of Medical Services
(iii). Cost of Welfare Activities such as canteen services etc.
(iv). Cost of Social Security Schemes such as Pension, Provident Fund Schemes, Gratuity etc.
(v). Cost of perquisites in excess of the average prevailing in industry.

2. Replacement Costs There are the costs which are incurred to meet the consequences of high
labour turnover, There include the following;
(i). Loss of output between the time when worker left and new workers recruited
(ii). Increased cost of Selection and recruitment
(iii). Increased cost of Training
(iv). Increased cost of Tools, Equipments and machine breakages
(v). Increased cost of scrap, wastage, spoilage and defective work
(vi). Loss of output due to lower productivity of new worker

Suggestion Each company must work out the optimum level of labour turnover keeping in view its
personnel policies and the behaviour of replacement cost and preventive costs at various levels of
labour turnover rates.

Treatment of Costs of Labour Turnover

Labour Turnover Costs
a) Preventive Costs
b) Replacement Costs
(i). Arising on account of fault of These costs should be charged as part of a production
any particular department.
(ii). Arising due to general
reasons
Accounting Treatment
There costs should be charged a part of production
overheads and should be apportioned to different
departments on the basis of number of workers engaged in
each department.
These costs should be charged directly to that department.
overheads and should be apportioned to different
departments on the basis of number of workers engaged in
each department.

44
Remedial Steps to Minimize Labour Turnover
The following steps are suggested to minimize labour turnover.
1. Exit interviewAn interview should be arranged with each outgoing employee to ascertain
the reasons of his leaving the organisation.
2. Job analysis and evaluationBefore recruiting workers, job analysis and evaluation may be
carried out to ascertain the requirements of each job.
a) A standardised policy for Recruitment, Replacement, Performance Appraisal,
Education, Training and Development of Employees, Selection, Transfers, Promotions.
3. A satisfactory level of Salaries and Wages
4. A satisfactory level of Welfare Schemes like canteen, medical, housing, recreation etc.
5. A satisfactory Social Security Schemes like, gratuity, pension, provident fund, industrial
accident compensation,
6. A standardised Grievance Procedure to settle worker's grievances with management.
7. A satisfactory policy for Workers' participation in management and Joint Consultation
Scheme.

INCENTIVE SCHEMES
Meaning of Incentive
Incentive may be defined as "the stimulation of effort and effectiveness by offering monetary
inducement or enhanced facilities'. It may be monetary or non-monetary. It may be provided
individually to every worker or collectively to a group of workers. The basis objective of incentive
is to improve productivity and increase production so as to bring down the unit cost of
production.

Essential Characteristics of a Good Incentive System

A good incentive system should have the following characteristics:
1. It should be simple to understand and easy to operate.
2. It should be economical to introduce and operate.
3. It should be fair to both employees and employer
4. It should guarantee hourly wages to every worker irrespective of level of his efficiency.
5. It should provide adequate incentive to efficient workers.
6. It should place no limit on the earnings of workers.
7. It should not penalise the workers for reason beyond their control such as machine break
down, power failure etc.
8. It should provide for prompt payment of incentives at short intervals of time.
9. It should have approval of workers and trade union.
10. It should be capable of improving the morale of workers.
11. It should have managerial support in so far as production material, quality control,
maintenance, and non-monetary incentives are concerned.
12. It should be relatively permanent and should not be allowed to change very frequently.
13. It should be flexible enough so as to introduce the necessary changes (if any required)

TYPES OF INCENTIVES SYSTEMS

The incentives systems can be classified under various heads.

1. HALSEY PREMIUM PLAN

The system is also known as split bonus plan or fifty-fifty plan. The plan was introduced by
F.A. Halsey, an American engineer. Under this plan, a minimum hourly wage is paid and in

45
 addition the worker is paid a premium or bonus, if his performance is better than the accepted
standard. If the job in completed in less than the standard time, he is paid bonus in addition to
a minimum hourly wage. In practice, the bonus is calculated to give the employee 50% of the
time saved. The remaining 50% goes to the employer.

1. Features
The main features of Halsey Premium plan are as follows:
a) Standard time is fixed for each work.
b) It guarantees the hourly wages to workers for the actual time taken.
c) Bonus is paid if the time is saved (i.e., when actual time is less than the standard time).
d) Bonus is equal to 50% of the time wages of time saved.

2. Computation of Total Earning

Total Earnings = Time Rate Wages + Bonus
Or = Actual Time Taken × Time Rate + 50% [Time saved × Time Rate]

3. Example
Time taken 6 Hours, Time Rate `10 per hour, Time Allowed 8 hours
Total Earnings = 6 hours × `10 + 50% [(8 hours – 6 hours)] × `10
= `60 + `10 = ` 70
4. Advantages
 It guarantees the hourly wages to workers for the actual taken time.
 It provided an incentive for an efficient worker who completes his work in less than the
standard time.
 It provides an incentive to the employer to provide better production facilities as he
receives 50% share in savings achieved.

2. HALSEY-WEIR SYSTEM
This plan was introduced by G & J Weir Ltd. in Glasgow. This is the modified version of
Halsey plan. The Halsey Weir System is the same as the Halsey System except that the bonus
paid to workers is 30% of the time saved.

This method enjoys all the advantages of the Halsey plan but earned the unpopularity as
larger share of bonus goes to the employer

3. ROWAN PLAN
This plan was introduced by the J. Rowan. Under the Rowan method, the worker’s day rate is
guaranteed. A standard time is fixed and if a saving is effected by the worker, a percentage
equal to the percentage of saving is added to the actual time taken.

1. Features
a) Standard time is fixed for each work.
b) It guarantees the hourly wage to workers for the actual time taken.
c) Bonus is paid if the time is saved (i.e., actual time is less than the standard time)
d) Bonus is that proportion of time wages as time saved bears to the standard time.

2. Computation of Total Earnings

Total Earning = Time Rate Wages + Bonus OR

46
 Time Saved
Actual Time Taken x Time Rate + × (Actual Time x Time Rate)
Time allowed

3. Example
Time taken 6 hours, time Rate ` 10 per hour, Time Allowed 8 hours
10+8−6
Total earnings = 6 hours ×` 8 × (6 hours ×` 10)
= ` 60 + 2/8 ×` 60 = ` 75

4. Advantages
a) It provides more incentive to moderately efficient workers who save time up to 50% of
the standard time than Halsey Plan.
b) It provides an incentive to the employer to provide better production facilities as he
receives a large share in savings achieved.
c) It protects the employer against wrong rate setting as the bonus can never reach 100% of
time wages as in Halsey Plan.

Comparison between Halsey Plan and Rowan Plan (Imp.)

Time Saved Bonus, Earning Per Hour and Labour cost per
unit
a) When time saved is less than 50% of Bonus, Rate of increase in per hour earning and
standard time Labour cost per unit is higher in Rowan plan than
Halsey Plan.
b) When time saved is 50% of standard Bonus, Earning per hour and labour cost per unit
time are same under both the plans.
(c) When time saved is more than 50% of Bonus, Rate of increase in per hour earning, and
standard time labour cost per unit are higher in Halsey Plan than
Rowan Plan.

4. TAYLOR’S DIFFERENTIAL PIECE RATE SYSTEM

The scheme was first introduce in the U.S.A. by F.W.Taylor, the father of scientific
management, and was subsequently modified by Merrick. This system is based upon two or
more fixed piece rates. One piece rate is used for workers, whose production is lower than
the minimum prescribed production and a higher rate is paid per piece to workers who
produce above the level.
The system was designed with the following objective :
 To discourage below average worker by providing no guaranteed wages and setting low
piece rate for low level of production
 To reward the efficient worker by setting higher piece rate for higher level of production.

1. Features
a) Standard time is fixed for each work.
b) Two piece rates are fixed- (i) a lower rate (i.e., 80% of normal piece rate) for the worker
who produces below the standard output (ii) a higher rate (i.e., 120% of normal piece
rates) for the worker who produces standard output or more than the standard output.
Note: Some authors also use 83%, and., 125% of the normal piece rates as lower and higher
rates respectively.

2. Computation of Total Earnings

a) For worker who produces less than the standard output

47
 Total earning = Actual output × Normal piece Rate × 80%

b) For worker who produces standard output or more than the standard output
Total earning = Actual output × Normal piece Rate × 120%

3. Example : Standard output 100 units, Normal piece Rate Re 1 per piece, X produced 60 units,
Y produced 100 units, Z produced 110 units. Earnings using Taylor's differential piece rate
will be as follows:
X’s earning = 60 units × Re 1 × 80% = ` 48
Y’s earning = 100 units × Re 1 × 120% = `120
Z’s earning = 110 units × Re 1 × 120% = ` 132

4. Advantages
a) It provides incentive to efficient workers.
b) It helps the employer to increase the production by offering higher rates to more efficient
workers.
c) It helps the employer to reduce the overhead cost per unit because of increased
production.

5. Disadvantages
a) It penalizes very severely the inefficient workers because a slight reduction in output
may result in a larger reduction in their earnings.
b) It does not guarantee the hourly wages and this insecurity affects the morale of worker.
c) Labour cost will differ between two levels of performance because of two different rates.
d) Higher and lower rates may be the source of conflict among the workers.
e) Employer- Employee relations may also be strained if the standard is put at a high level.

5. BAUM’S DIFFERENTIAL SCHEME (MILWAKEE SCHEME)

It is the combination of Halsey and Taylor’s differential piece rate system. This system
provides incentives at different level of efficiency.

6. MERRICK’S DIFFERENTIAL PIECE RATE

Under Taylor differential rate system, a below average worker is dealt with very severely.
Merrick modified the Taylor’s differential piece rate system. Under this system, the punitive
lower rate is not imposed for performance below standard and performance above standard is
rewarded by more than one higher differential rate.
1. Features
The main features of Merrick's Differential Piece Rate are as follows:
a) Standard time is fixed for each work.
b) Three piece rates are fixed as follows:

2. Reward
Efficiency attained Piece Rate
Upto 83(1/3)% 100% of Ordinary Piece Rate
Above 83(1/3)% and upto 100% 110% of Ordinary Piece Rate
Above 100% 120% of Ordinary Piece Rate

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3. Computation of Total Earnings
a) For worker who produces up to 83(1/3)% of standard output
Total earning = Actual output × Normal Piece Rate

b) For worker who produces above 83(1/3)% and up to 100% of standard output
Total earning = Actual output × Normal Piece Rate × 110%

c) For worker who produces above 100 % of standard output

Total earning = Actual output × Normal piece Rate × 120%

4. Example
Standard output 100 units, Normal piece Rate Re 1 per piece, X produced 60 units, Y produced
100 units, Z produced 110 units. Earnings using Merrick's Differential Piece rate will be as
follows:
X’s earnings = 60 units ×` 1 = ` 60
Y's earnings = 100 units ×` 1 × 110% = ` 110
Z’s earnings = 110 units ×` 1 × 120% = ` 132

5. Advantages
In additional to advantages of Taylor's Differential Piece Rate System, one more advantage of
Merrick's Differential piece Rate System is that it does not penalize the workers producing
below the standard output by the low piece rate.

6. Disadvantages
It has same disadvantages as Taylor's Differential Piece Rate system has except that it does not
penalise the workers producing below standard output by the low piece rate.

Distinction between Taylor's Differential Piece Rate and Merrick's Differential Piece
Rate
Basis of Distinction Taylor's Differential Piece Merrick's Differential
Rate System Piece Rate System
1. No. of Piece Rate Two piece rates are fixed. Three piece rates are fixed.
2. Penalty for workers It penalises workers It does not penallse worker
producing below producing below standard producing below standard
standard output output by low piece rate . output by low piece rate.

7. EMERSON’S EFFICIENCY SYSTEM

1. Features
(a) Standard time is fixed for each work.
(b) It guarantees the day wages to the worker regardless of performance.
(c) Up to 66-(2/3)% efficiency - Hourly (Time) rate
Above 66-(2/3)% but up to 90% - Time Rate + 10% as Bonus
Above 90% but up to 100% - Time Rate + 20% as Bonus
Above 100% - Time Rate + 20% as Bonus + Additional
Bonus of 1% for every increase of 1% beyond 100% efficiency.

49
2. Example Standard output 100 units, Daily wage Rate ` 100, X produced 60 units, Y produced
100 units, Z produced 110 units

Earnings under Emerson’s Efficiency System

A B Actual C Level of D E Bonus F = D+E
Worker output Efficiency Guaranteed Earnings Per
Time Wages Worker `
`
X 60 60% 100 Nil 100
Y 100 100% 100 20% of ` 100 = 120
20
Z 110 110% 100 (20% + 10%) of 130
` 100 = ` 30

3. Advantages
a) It guarantees the day wages to the worker and then provides security.
b) It provides incentives even for those workers whose level of efficiency exceeds 66(2/3) %
but does not exceed 100%.
c) It provides additional incentive for those workers whose level of efficiency exceeds 100%.

4. Disadvantages
a) The incentive is quite small to attract very efficient and ambitious workers.
b) It does not provide any incentive for those whose level of efficiency is upto 66(2/3)%.

8. GANTT TASK AND BONUS SYSTEM

This system combines time rate, piece work system and bonus. This system attempt to gain
immediately some of the many advantages, which the introduction of Taylor’s differential,
piece rate system promises to assure gradually.

1. Features
a) It is combination of time rate, piece rate and bonus plan.
b) Standard time is fixed for each work.
c) It guarantees the day wages to the worker.
Three rates of payments are fixed as follows:
Worker Rate of payment
For worker who produces less than the standard Guaranteed Time Rate
output
For worker who produces standard output only 120% of time Rate
For worker who produces more than the standard 120% of Piece Rate
output

2. Computation of Total Earnings

Worker Total Earning
a) For worker who produces less than = AH × Time Rate
the standard output
b) For worker who produces Standard = (AH × Time Rate) × 120%
output only

50
 c) For worker who produces more than = (Actual Output × Piece Rate) × 120%
the standard output

3. Example
Standard Hours allowed to produce 40 units - 8 hours, Standard wage Rate ` 20 per hour, X, V
and Z completed the task in 10 hours, 8 hours and 6 hours respectively.
Earning under Gantt Task and Bonus System
X's earnings = 10 hours ×` 20 = ` 200
Y's earnings = 8 hours ×` 20 × 120% = ` 192
Z's earnings = 40 units ×` 4 × 120% = ` 192
Note: Piece Rate = 8/40 ×` 20 = ` 4 per piece

4. Advantages
(a) It guarantees hourly rate wages to less efficient workers.
(b) It provides incentive to efficient workers.
(c) It encourages better supervision and planning.
(d) It helps the employees to increase the production by offering higher rates to more
efficient workers.
(e) It helps the employer to reduce overheads costs per unit because of increased
production.

5. Disadvantage
Guaranteed time rate may act as a disincentive for less efficient worker to increase his output
in case high rate is fixed.

9. BEDAUXE POINT SYSTEM

Under this system, the value of time saved is shared 75% to worker and 25% to supervisor.
Workers who are not able to complete tasks allotted to them within the standard time are paid
at the normal daily rate. In this system B’s (BEDAUXE)Points saved are calculated and 75% of
B’s saved is given as bonus to worker. B simply means standard minutes.
Example : If standard time is 10 hours and time taken is 8 hours and rate per hour is ` 1, the
worker will get : [(8 hours X 1) + 75% X 120 (Points saved)]/ 60 = ` 9.50.

10. HAYNE’S MANIT SYSTEM

Under this system Time Wages are guaranteed. Standard time is set in terms of standard man
minutes called ‘MANITS’. A manit means a standard work performed in a standard minute.
Bonus is given for the time saved. Ratio of sharing of Bonus between Worker, Employer and
Supervisor will be 5:4:1.

11. BARTH SHARING PLAN

This scheme does not provide guaranteed wages.

Total Wages = Hourly Rate X [ Square root of ( Standard Time X Time Taken)]

Total Wages is higher for less efficient people. As the efficiency increases, the earning
decrease, therefore this plan is suitable for beginners and trainees. It does not encourage
efficient workers.

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12. DIEMER SCHEME
This is a combination of Halsey’s and Gantt’s Schemes. A straight line increasing incentive is
given beyond 100% efficiency.

13. ACCELERATED PREMIUM SYSTEM

Increments of bonus increases at a faster rate as production increases. As this scheme
encourages to get higher production, it should not be used where quality of output is
important. Formula for calculating wages differ from one concern to another.

MEANING OF CERTAIN IMPORTANT TERMS

A. TIME STUDY
1. Meaning
Time study is a technique which is used to measure the time that may be taken by a
workman of reasonable skills and ability to perform various elements of the tasks in a job.
2. Purpose
The purpose of time study is to determine-
i). Time normally required to perform a certain job, and
ii). A fair day's work for the workman.
3. Advantage of time study
 Better control of production
 Better control of cost
 Improved quality
 Lower percentage of spoiled work

B. MOTION STUDY
1. Meaning
Motion study is a technique which involves close observation of the movements of body
and limbs required to perform a job.
2. Purpose
The purpose of motion study is-
i). To eliminate waste motion, and
ii). To determine the best way of doing a job.
3. Tools
Time study is conducted with the help of a movie camera connected with micro-chronometer
(i.e., a kind of clock).
Distinction between Time Study and Motion Study
Basis of Time Study Motion Study
Distinction
1. Meaning It is a technique which is used to It is a technique which involves
measure the time that may be taken close observation of the
by a workman of reasonable skills movements of the body and
and ability to perform various limbs required to perform a job.
elements of the tasks in a job.
2. Purpose Its purpose is to determine time Its purpose is to detect and
normally required to perform a eliminate wasteful motions and
certain job and a fair day’s work for determine the best way of
the workmen. doing a job.

52
 3. Tools of It is conducted with the help of It is conducted with the help of
study stopwatch a movie camera connected with
micro-chronometer (i.e., a kind
of clock)
C. MERIT RATING
1. Meaning
Merit Rating rates the individual merits of a job holder on the job. It is the quantitative or
qualitative assessment of an employee's personality or his performance on the job made
by his supervisor or any other competent person. This assessment will be applied to all
workers, who fall within the groups being rated.

2. Objectives
The objective of merit rating is to provide a scientific basis for determining fair wages for each
worker based on his ability and performance.

3. Factors
Usually the following factors are considered for merit rating purposes:
Quality of work done, Quantity of work done, Knowledge applied, Skills used, Sense of
Responsibility, Sense of judgment, Integrity, Punctuality, Reliability, Discipline, Co-operation.

4. Advantages
Advantages of merit rating are as follows:
a) Merit Rating helps in determining fair wages for each worker.
b) It helps in taking decisions like who deserves promotion, who deserves increment?
c) It reveals employee's strong and weak points.
d) It helps in ascertaining the suitability of the worker for a particular job when it is linked
with job evaluation.
Distinction between Job Evaluation and Merit Rating
Basis of Job Evaluation Merit Rating
Distinction
1. Meaning It is assessment of relative worth It is the assessment of the
of jobs hierarchy. relative worth of a jobholder.
2. Job vs. It rates the jobs It rates the jobholders.
jobholder
3. Objectives Its objectives is to set up a rational Its objectives is to provide a
wage and salary structure scientific basis for determining
fair wages for each worker
based on his ability and
performance
4. Usefulness It helps in establishing a simplified It helps in determining fair
and rational wages and salary wages for each worker.
structure.

D. TIME KEEPING
Time keeping is a system of recording the arrival and departure time of each worker.

Objectives of Time Keeping

1. To provide data for the preparation of payroll.
2. To meet statutory requirements (i.e., Attendance Record)
3. To ascertain the Overtime

53
4. To ascertain the Idle Time
5. To ascertain the Labour Cost
6. To provide a basis for apportionment of overheads if based on labour hours
7. To control labour cost
8. To maintain discipline and punctuality among the workers

Methods of Time Keeping

The various methods of Time Keeping are as follows:

Methods of Time Keeping

Manual Methods Mechanical Methods

Attendance Register/Muster Roll Time Recording Clocks

E. TIME BOOKING
Meaning of Time Booking
Time Booking is a system of recording the time spent by each worker on various jobs, orders or
processes.

Objectives of Time Booking

1. To ascertain the labour cost of a job, order or process.
2. To check wastage of time by the worker after he enters the factory.
3. To ascertain the cost of idle time.
4. To provide a basis for apportionment of overheads where overheads are to be apportioned on
the basis of time spent on various jobs, orders or processes.
5. To control labour cost by comparing actual time with the standard time allowed on various
jobs.
6. To provide information for the computation of wages and bonus for the time saved under
various schemes of wage payment.
7. To ensure that the time for which a worker is paid is properly utilized.

Methods of Time Booking

Depending upon the size of organisation, time booking may be done manually or mechanically.
Large sized organisations use time recording clocks for recording starting and closing timings of
work by every worker in respect of every job.

Distinction between Time Keeping and Time Booking

Basic Time Keeping Time Booking
Distinction
1. Meaning Time keeping is a system of Time Booking is a System of
recording the arrival and recording the time spent by each
departure time of each worker. worker on various jobs, orders or
processes.

54
 2. Basic Its basic objectives are to maintain Its basic objective is to ascertain
Objective attendance record as per statutory the labour Cost of a job, order or
requirements and to provide data process.
for the preparation of payroll.
3. Methods Manual Methods 1) Daily Times Sheet
 Attendance Register / 2) Weekly Time sheet
Muster
Roll
Mechanical Methods
 Time Recording Clocks

F. CASUAL WORKERS
Meaning of Casual Workers
Casual Workers are those who are not on the pay-roll of the factory but are engaged casually
whenever there is extra load in the factory or whenever a regular worker is absent because of any
reason.

Payment to casual Workers

Usually casual workers are paid on daily basis.

Treatment of Wages Paid to Casual Workers

a) Wages paid to casual workers in the nature of direct labour are treated as direct labour cost
forming part of prime cost.
b) Wages paid to casual workers in the nature of indirect labour are treated as production
overheads.

G. OUTWORKERS
Meaning of Outworkers
Outworkers are those who work outside the factory premises and may be put under the
following two categories:

I. Workers who are on the Pay-roll of the factory

a) They are on the pay roll of the factory.
b) They are sent at customer's premises to perform some specific duties such as Repair
work, plumber's work, sanitary work, Electric work etc.
c) Job cards are usually issued to such workers to record the time spent by them on various
jobs.

II. Workers who are not on the payroll of the factory

a) They are not on the payroll of the factory.
b) They are supplied materials and specific tools.
c) They use their own premises, lighting, tools etc.
d) They deliver manufactured products.
e) Strict supervision and control is required to ensure-
i). That all material & tools if any, issued are properly accounted for,
ii). That tool issued if any, from the factory are returned without undue wear and tear.
iii). That quantity and quality of output are as per specifications given.

55
 H. PAY-ROLL ACCOUNTING
Meaning of Pay-Roll Accounting
Pay- Roll accounting is that part of financial accounting which is concerned with-
1. the computation of gross wages and deductions from gross wages with a view to ascertain net
wages payable to each employee during a particular period, and
2. the preparation of Pay Roll and Pay Slip at periodic intervals (say weekly or monthly)

Meaning of Pay Roll (or Wage Sheet)

Pay Roll is a periodic statement which shows:
a) Gross wages earned by each worker
b) Deductions from Gross wages, and
c) Net wages payable to each worker

How to calculate Gross Wages?

Method of Wages How to Calculate Gross Wages
Payment
1. Time Wage System Gross Wages = Ordinary wages + Overtime Premium
Where,
Ordinary wages = Total hours as per Time card × Hourly
Rate
Overtime Premium = Overtime Hours × Over Time
Premium Rate
2. Piece Wage System Gross Wages = No. of Good units × Rate per unit
(a) At a fixed rate per unit
Note: In case a worker is to be allowed a minimum
guaranteed time wage, any deficit will be entered in the
wage sheet as ‘Wages make up’ and charged to Production
Overheads.
(b) At a standard rate per Gross wages =Allowed Hours × Standard rate per Hour
hour for allowed hours
for a job

Example I: A Worker's time as per Time Card 50 hours (including 10 overtime hours). Normal
wage rate is ` 10 per hour and Overtime Wage Rate is 150% of Normal Wages Rate.
Ordinary Wages = 50 ×` 10 = ` 500
Add: Overtime Premium = 10 ×` 5 = `50
Gross Wages = ` 550

Example II: A worker produced 100 units. Piece rate per unit is ` 5.
Gross Wages = 100 ×` 5 = ` 500

Deductions from Gross Wages

The Payment of Wages Act, 1963 authorises the following deductions:
i). Fines and deductions for absence from duty.
ii). Deductions for damage or loss of goods or money expressly entrusted to the employed person.
iii). House rent and cost of other amenities and services.
iv). Deduction for recovery of advance.
v). Income-tax.
vi). Deductions in respect of an order of a court or other competent authority.
vii). Provident fund.

56
viii). Deductions of co-operative society dues.
ix). Deduction for life insurance premium.
x). Employee's State insurance contribution.

I. IDLE TIME
Idle Time is that time for which payment made but no direct production/benefit is
obtained. The question of Idle Time arises only when the payment is made on time basis. It is
calculated as follows:
Idle time = Time Recorded as per Time card - Time Booked on Job as per Job card.

Causes of Idle Time

Idle time may arise due to anyone or more of the following causes.
Production causes a) Machine Break Down
b) Power failures
c) Waiting for work
d) Waiting for Tools
e) Waiting for Materials
f) Waiting for Instructions
Administration causes (which arise a) Decision not to retrench regular trained workers in
due to administrative decisions) the period of depression
b) Decision not to work up to full capacity of plant.
Economic causes (Which arise due Closure of seasonal industry during off- season.
to economic conditions & decisions)

Treatment of Idle Time Cost in Cost Accounts

Idle Time cost may be treated in Cost Accounts as follows:
Idle Time Cost Accounting Treatment
a) Cost of normal & controllable Idle Time a) It is treated as part of cost and hence
(e.g., Machine Breakdown, waiting for treated as part of production overheads
work, tools, materials or instructions)
b) Cost of normal but uncontrollable Idle b) It is treated as part of cost and hence
Time (e.g., set up time machine, interval charged directly to job by inflating wage
between one job and another, personal rates (for example if wage rate is ` 5 per
needs) hour and worker’s effective hours during
8 hour work is 7 hours only, the inflated
wage rate will = ` 5.71
c) Cost of abnormal Idle Time (i.e., due to c) It is not treated as part of cost and hence
abnormal reasons such as power failure, charged to Costing Profit & Loss Account.
strikes, lock out, fire, flood etc.)

Control of Idle Time

To exercise an effective control over Idle Time, the following steps are suggested:

Practical Steps involved in exercising Control over Idle Time

Step 1- Fix the standards for normal idle time such as tea/lunch breaks.
Step 2- Prepare Periodic Idle Time Report showing the Idle Time, reasons and cost and submit the
same to the competent authority.

57
Step 3- Compare the Actual Idle Time with the standard Idle Time to find out the difference. (If
any)
Step 4- Investigate the causes of the difference.
Step 5- Take the necessary corrective action promptly.

J. OVERTIME PREMIUM OR OVERTIME WAGES

Meaning of Overtime
Overtime is an extra time over and above the normal working hours. According to the Factories
Act, 1949, a worker is entitled to overtime wages when he works for more than 9 hours on any day
or more than 48 hours in-a-week.

Meaning of Overtime Payment

In India, Overtime is to be paid at double the normal rate of wages. Overtime payment consists of
following two parts:

Overtime Payment = Overtime Hours × Overtime Wage

Rates

Overtime Normal Payment Overtime Premium Payment

= Overtime Hours × Normal Rate of Wages = Overtime Hours × Extra Rate of Wages

Circumstances under which Overtime may arise

1. When it is desired at customer's request to complete the work within specified time.
2. When it is required to increase the output as per general production programme.
3. When it is required to make up any short fall in production due to abnormal conditions such
as flood, earthquake, breakdown of machinery etc.
4. When it is required to meet seasonal demand.
5. When it is required to increase the output to meet the additional market demand .

Effects of Overtime Payment

1. The overhead payment increases the cost of production in the following ways:
a) Extra Cost There is an extra payment over and above the normal rate of wages.
b) Reduced output during overtime there may be reduced output during overtime because of fall
in workers' efficiency during late hours.
c) Reduced output during Normal Time There may be reduced output during normal time
because of development of a tendency to work in overtime.
2. Overtime working as regular feature has an adverse effect on the health of workers.
3. Overtime may lead to discontent among workers if overtime is not properly distributed
Treatment of Overtime Premium in Cost Accounts
Overtime Premium is treated as follows:

Circumstances Treatment of Overtime Premium

a) When it is desired at customer's request to It should be charged directly to the job or work
complete the work within specified time. concerned.

58
 b) When it is required to Increase the output It should be treated as production overhead.
as per general production programme/
When it is required to meet the seasonal
demand/ When it is required to increase
the output to meet the additional market
demand
c) When It is required to make up any short It should be charged to Costing Profit & Loss
fall In production due to abnormal Account.
conditions such as flood, earthquake,
breakdown of machinery etc.

METHODS OF WAGE PAYMENTS

The two principal methods of wage payment are as follows:
1. Time Rate Wage System
2. Piece Rate Wage System

Time Rate Wage System

1. Features a) A worker is paid a fixed rate per hour or per day or per month for
the time devoted him.
b) The time rate may be fixed with reference to rate prevailing in the
industry for similar work. But it must be noted that this rate must
not be less than the minimum wages fixed under the Minimum
Wages Act or any other Act for the time being in force.
c) Output produced by the worker is not relevant for calculating wages.
2. Computation Wages = Actual time devoted × Time rate
of Wages
3. Example Mr X, a worker, gets ` 10 per hour. If he works for 8 hours, he will get `
80 (i.e., 8 ×` 10).
4. Advantages a) It provides guaranteed time wages to workers.
b) Workers concentrate on the quality rather than the quantity of job
because they are not in hurry to complete the job.
c) There is reduced damage or rough handling of machines, tools and
equipments due to slow and steady pace of the workers.

5. Disadvantages a) It does not act as an incentive to workers.

b) It tends to increase overhead cost and labour production cost per
unit because of low production.
c) There develops a tendency to go slow during the normal working
hours in the hope of getting overtime wages. This tendency arises
where the practice of overtime wages is prevailing. There is lack of
incentive to reach and sustain a reasonable level of work.
d) High degree of supervision is required to secure a fair day’s work.

Piece Rate Wage System

1. Features a) A worker is paid at a fixed rate per unit produced or job completed.
b) Time spent on job is not considered for calculating wages.

59
 2. Computation Wages = Number of units produced x piece rate per unit
of wages
3. Example Mr Y, a worker gets ` 5 per piece. If the produces 20 pieces, he will
get ` 100 (i.e., 20 ×` 5).
4. Advantages a) It acts as an incentive to workers to produce more and earn more as
the remuneration is directly linked with performance.
b) It tends to reduce overhead cost and labour cost per unit because of
high production.
c) It eliminates the tendency of workers to go slow as remuneration is
directly linked with performance.
d) Low degree of supervision is required because the worker
themselves take care of the time and output.
e) It simplifies cost ascertainment because labour cost per unit is
available in advance.

5. Disadvantages a) It does not guarantee time wage to workers and hence workers feel
insecure.
b) Workers tend to increase the quantity ignoring the quality thereof.
c) There may be excessive damage to machines, tools and equipment
and excessive wastage of materials due to speedy pace of workers.
d) The calculation of pieces rate is more difficult than time rate.
e) It is usually opposed by trade unions and workers.
f) It is detrimental to the long-term health and working efficiency of
the workers because in his anxiety to earn more he may overstrain
and overwork resulting in fatigue and breakdown of the biological
system.
g) It is not suitable for setting up group incentive plans unless all the
workers' jobs happen to carry the same hourly wage rate or
production standard.

Distinction between Time Rate Wage System and Piece Rate Wage System
Time Rate Wage System and Piece Rate Wage System can be distinguished as follows:
Basis of Time Rate Wage System Piece Rate Wage System
Distinction
1. Basis of A worker is paid at a fixed rate per A worker is paid at a fixed rate
Payment hour, per day or per month for the per unit produced or job
time devoted by him. completed.
2. Linkage There is no linkage between The linkage between
between performance and reward. Both performance and reward
Performance efficient and inefficient workers get motivates the people to produce
the same amount of wages so long as more and earn more.
and Reward
they spend equal time on the job.
3. Quality Quality of work tends to be high. Quality of work tends to be low.
4. Wastage There is less chance of wastage of There are more chances of
materials and machinery. wastage of materials and
machinery.
5. Supervision Close supervision is required. Close supervision is not
required.

60
 6. Maintenances Cost of maintenance is low. Cost of maintenance is high.
7. Attitude of Trade Unions prefer it. Trade Union oppose it
Trade Unions
8. Economic It provides sense of economic It does not provide sense of
Security security to employees. economic security to employees.
9. Usefulness This method is useful where a This method is useful where a
worker has to do a variety of worker has to do the jobs of a
dissimilar jobs or where tasks cannotrepetitive nature or where tasks
be readily measured, inspected and can be readily measured,
counted. inspected and counted.
10. Adoption This method is adopted for This method is adopted for
compensating clerical staff, managerscompensating skilled and official
and operatives employed in jobs workers who can increase their
which do not require much skill. earning by working to their full
capacity.
11. Assurance A worker is assured of his wages for No such assurance is given.
work period irrespective of his
output.

GROUP BONUS SYSTEM

1. Meaning of Group Bonus System
Group Bonus Scheme is a scheme in which bonus is calculated on the basis of collective
production of a group of workers and is distributed among the individual members of the
group on some agreed basis.
2. When Introduced
Group Bonus Scheme is generally introduced where performance of an individual worker
cannot be measured and the ultimate production is dependent on the collective efforts of a
group of workers. For example, in the construction work, it is the teamwork that produces
results.
3. Types of Group Bonus Plans
a) Priest man Production Bonus Plan – Bonus is payable to the Department if Actual Output
is greater than Standard Output. Bonus is given on the basis of the percentage by which actual
output exceeds standard output.
b) Cost Premium System – Here Bonus is dependent on output and agreed % of any Cost
Saved in use of Material and services.
c) Rucker’s Plan (Share of Production Plan) – Ratio of Earning and Added value is
calculated. Any reduction in this ratio increases the wages. Added value is the change in
market value.
d) Scanlon Plan – It is similar to Rucker’s Plan. But ration of Earnings and Production at
Selling Price is used for Bonus.
e) Towne Gain Sharing Plan - Bonus is half of any saving in Labour Cost as compared to
Standard Cost of Labour.

PROFIT SHARING SCHEMES

1. Meaning Profit sharing is one of the monetary incentive schemes under which in addition to
wages, worker are entitled to share the profit of the concern at an agreed rate.
2. How to distribute share in profit Worker's share in profit may be distributed in any of the
following ways:
i). By paying in cash
ii). By crediting to Provident Fund

61
 iii). By paying some part in cash and by crediting remaining part to Provident Fund.
3. How to treat Share of Profit in Cost Accounts
In India, profit sharing schemes take the form of an annual bonus that is governed by the
Payment of Bonus Act, 1965. Payment of Bonus should be treated in Cost Accounts as follows:
Bonus Accounting Treatment
(i). Minimum Statutory Bonus to Direct It may be taken as direct charge by inflating
workers wage rate.
(ii). Minimum Statutory Bonus to Indirect It may be taken as an item of overheads.
Workers
(iii). Extra Bonus to Direct and Indirect It should be excluded from Cost Accounts.
Workers

CO-PARTNERSHIP
1. Meaning of Co-Partnership
Co-partnership is one of the monetary incentive schemes under which workers are given
opportunity to have a share in capital, profit and control of the business in which they are
employed.
2. Example of Co-partnership
When Shares are allotted to workers of a company in proportion to their share of bonus,
workers are entitled to receive dividend on shares held by them and are entitled to participate
in the management of the company because of voting power attached to shares held by them.

ELEMENTS OF WAGES
Elements of Wages

Basic Wages Benefits in Cash Benefits in kind (Fringe benefits)

1. Dearness Allowance
1. Medical facilities
2. House Rent Allowance
2. Housing facilities
3. City Compensatory Allowance
3. Canteen facilities
4. Night Shift Allowance
4. Conveyance facilities
5. Uniform Allowance
5. Recreational facilities
6. Conveyance Allowance
7. Medical Allowance 6. Educational facilities
8. Bonus
9. Employer's Contribution to 7. Training facilities
Provident Fund
10. Employer's Contribution to
Employee's State Insurance
11. Leave Pay
12. Holiday Pay
13. Sick Pay
14. Gratuity
15. Pension
16. Overtime

62
Tutorial Notes:
i). Provident Fund, Employees' State Insurance Corporation Premium and bonus are payable on
the basic wages, dearness allowance and value of food concession.
ii). Following items are considered while computing labour cost and not Gross Wages earned by
worker.
a) Employer's contribution to P.F., ESI, Family Pension Fund
b) Expenditure on amenities
c) Leave Salary
iii). Overtime wages are considered while computing Gross Wages and not labour cost.
iv). Holiday Pay (Leave with Pay) : Employees are entitled to certain holidays. Amount paid for
these days are known as Holiday Pay. It is treated as part of Production Cost either by
charging it as overheads or by inflating the labour cost.
v). Night Shift Allowance : Allowance given for working at night to clear the heavy work load. It
is a part of work overheads. If night shift is worked at customer’s request, then it should be
charged to that job.
vi). Learner’s Wages : It is treated as Direct Labour if it can be identified with Job/Product;
otherwise it is considered as part of overheads.
vii). Training Cost : It is apportioned to various departments on the basis of number of trainees
in each Department.

63
 CLASSROOM PRACTICE – LETS PLAY TOGETHER

Que 1.
Problem based on labour turnover
The extracts from the payroll of a factory is a follows:
Number of Employees at the beginning of April 2013 150
Number of Employees at the end of April 2013 250
Number of Employees resigned during April 2013 25
Number of Employees discharged during April 2013 5
Number of Employees replaced due to resignations and discharges during April 20
2012
Required: Calculate the labour turnover rate and equivalent annual rate for the factory by
different methods.
Ans:
No.of Separation
1. Separation Rate Method = AverageNo.of Workers × 100

25 + 5
= (150 + 250)/2×100 = 15%

Turnoverratefortheperiod
Equivalent Annual Labour Turnover Rate = Numberofdaysintheperiod ×365

15%
Equivalent Annual Labour Turnover Rate = ×365= 182.5%
30

No.of Replacement
2. Replacement Method = AverageNo.of Workers× 100

20
= 200× 100 = 10%

10%
Equivalent Annual Labour Turnover Rate = ×365= 121.67%
30

No.of Separation + No. of Replacements

3. Flux Rate = × 100
AverageNo.of Workers

30 + 20
= × 100 = 25%
200

25 %
Equivalent Annual Labour Turnover Rate = ×365= 304.17%
30

Que 2.
From the following data provided to you, find out the Labour Turnover Rate by applying:
a) Flux Method
b) Replacement Method
c) Separation Method
No. of workers on the payroll:
At the beginning of the month 500
At the end of the month 600
During the month, 5 workers left, 20 persons were discharged and 75 workers were recruited.
Of these, 10 workers were recruited in the vacancies of those leaving, while the rest were
engaged for an expansion scheme.

64
 Computation of Labour Turnover Rate

No.of Separation + No. of Replacements

Flux Method = × 100
AverageNo.of Workers in period

5 + 20 + 10 35
= (500+600)/2 × 100 = 550 × 100 = 6.36%

No.of Replaced during the period

Replacement Method = × 100
AverageNo.of Workers in period

10
= (500 + 600)/2 × 100 = 1.82%

No.of Separation during the period

Separation Method = AverageNo.of Workers in the Period × 100

5+20
= (500+600)/2 × 100 = 4.545%
Que 3.
From the following Information, calculate Labour Turnover rate and Labour flux rate
No. of Workers as on 01.01.2013 = 7,600
No. of workers as on 31.12.2013 = 8,400
During the year, 80 workers left while 320 workers were discharged 1,500 workers were
recruited during the year of these, 300 workers were recruited because of exits and the rest were
recruited in accordance with expansion plans.

Ans:
Method Formula &
Basic Calculations
Answer
7600+8400 Separation S 400
1. Average Labour Force = L = = 8,000 = L = 8000= 5%
2
workers.
2. Number of Separations = S = Left + Discharged Accession A 1200
=L= = 15%
8000
= 80 + 320 = 400 workers
3. Number of Accessions = A = 1,200 workers Flux S+A 400+1200
= L = =
8000
(given) 20%

Notes: Replacements and New Recruitments are

not relevant for calculation, in this question.

Que 4.
The extracts from the payroll of a factory is a follows:
Number of Employees at the beginning of April 2013 300
Number of Employees at the end of April 2013 500
Number of Employees resigned during April 2013 50
Number of Employees discharged during April 2013 10
Number of Employees replaced due to resignations and discharges during April 40
2013
Required: Calculate the labour turnover rate for the factory by different methods.

Ans:

65
 No.of Separation
1. Separation Rate Method = × 100
AverageNo.of Workers

50 +10
= (300+500)/2×100 = 15%

Turnover rate for the period

Equivalent Annual Labour Turnover Rate = ×365
Number of days in the period
15%
Equivalent Annual Labour Turnover Rate = ×365 = 182.5%
30

No.of Replacement
2. Replacement Method = × 100
Average No. of Workers

40
= 400× 100 = 10%

10%
Equivalent Annual Labour Turnover Rate = ×365 = 121.67%
30

No.of Separation + No. of Replacements

3. Flux Rate = × 100
Average No. of Workers

60 + 40
= × 100 = 25%
400
25 %
Equivalent Annual Labour Turnover Rate = ×365 = 304.17%
30

Que 5.
Calculate the number of separations during the year from the following information:
Labour Turnover Rate (based on Separations) 10%
Labour Turnover rate (based on Replacements) 8%
No. of Replacements during the year 16
Ans:
Step 1 Calculation of Average No. of Employees
No.of Replacements
Labour Turnover Rate (based on Replacements) = Average No.of Employees ×100

16
8 = Average No.of Employees × 100
16
Average No. of Employees = .08 = 200

Step 2 Calculation of No. of Separations

No.of Separations
Labour Turnover Rate (based on Separations) = Average No. × 100
of Employess

No.of Separations
10 = × 100
200

No. of Separations during the year = 10% of 200 = 20

Que 6.
Calculate the number of workers replaced from the following information:
Labour Turnover Rate (based on separations) 3%
Labour Turnover Rate (based on flux) 8%
No. of workers left & discharged 18

66
Ans:
Step 1 Average No. of Workers
No.of Separations
Labour Turnover Rate (based on Separations) = Average No.of Workers × 100

18
3 = Average No.of Workers × 100
18×100
Average No. of workers = = 600
3

Step 2 Calculation of No. of Replacements

No.of Separations+No.of Replacements
Labour Turnover Rate (Flux Method) = ×100
Average No.of Workers

18+No.of Replacements
8= ×100
600
No. of Replacements = 48 – 18 = 30

Que 7.
The cost accountant of Y Ltd. has computed labour turnover rates for the quarter ended 31 st
March, 2011 as 10% , 5% and 3% respectively under 'Flux Method', 'Replacement method' and
'Separation Method'. If the number of workers replaced during that quarter is 30. Find out the
number of (a) workers left and discharged and (b) workers recruited and joined.

Ans:
Flux rate = 10%
Replacement Method = 5%
Separation Method = 3%
*If number of replacement and no. of separation would be taken then flux rate should be 8%.
Therefore no. of separation and no. of accessions would have been taken.
No.of Replacement
Replacement Rate = × 100
Average no. of workers

30
0.05 =
Average no. of workers

30
Average no. of workers = 0.05 = 600

No.of Separation
Separation Rate = ×100
Average no. of workers

No. of Separation
3= ×100
600
No. of separation = 18 workers

No. of Separation + No. of Accession

Flux Rate = ×100
Average no. of workers

18 + No. of Accession
10 = ×100
600

60 – 18 = No. of Accession
No. of Accession = 42 workers

Que 8.

67
 Calculate the earnings of a worker under (i) Halsey Plan and (ii) Rowan Plan from the following
particulars:
a) Hourly rate of wages guaranteed 0.50 paise per hour.
b) Standard time for producing one dozen articles - 3 hours.
c) Actual time taken by the worker to produce 20 dozen articles - 48 hours.

Ans:
Wage Rate per hour = ` 0.50
Standard Time Allowed per Dozen = 3 Hours
Actual Production = 20 Dozens
Standard Time Allowed for 20 Dozens = 3 Hours × 20 Dozens
= 60 Hours
Actual Time Taken to produce 20 Dozens = 48 Hours
Time Saved = 60 - 48 = 12 Hours
Earnings = Normal wages × Bonus

Under Halsey = (Actual Time Taken × Time Rate) + (50%× Time Saved × Time Rate)
= (48 Hours × 0.50) + (50% × 12 × 0.50)
= 24 + 3
= `27
Time Taken
Under Rowan = (Actual Time Taken × Time Rate) + (Time Saved × Time Allowed × Time Rate
48
= (48 Hours × 0.50) + (12 × 60 × 0.50)
= 24 + 4.80
= ` 28.80
Que 9.
The firm employs five workers at an hourly rate of ` 2.00. During the week, they worked for four
days for a total period for 40 hours each and completed a job for which the standard time was 48
hours for each worker. Calculate the labour cost under the Halsey method and Rowan method of
incentive plan payments.
Ans:
Statement showing the Calculation of Labour Cost
Particulars Halsey Method Rowan Method
(A) Actual Hours Worked (AH)
[40 × 5] 200 200
(B) Standard Hours (SH) [48 × 5] 240 240
400
(C) Hourly Rate Wages
400 AH
(AH × Rate) = [200 × ` 2] 1 AH
(D) Bonus = 2 × (SH – AH) × R (SH - AH) × R
SH

1 200
= 2 × (240 - 200) × ` 2 × (240 - 200) ×` 2
240
= 40 = 67
(E) Total Labour Cost [C + D] 440 467

Que 10.
A worker under the Halsey Method of remuneration has a day rate of ` 72 per week of 48 hours
plus a cost of living bonus of ` 0.60 per hour worked. He is given an 8 hours task to perform which
he accomplishes in 6 hours. He is allowed 30% of the time saved as premium bonus. What would
be his total hourly rate of earnings, and what difference would it make if he was paid under the
Rowan Method.

68
 Ans:
Standard Time allowed (SH) 8hours
Actual Time taken (AH) 6hours
Time Saved (SH - AH) 2hours
Bonus allowed 30%
Wage rate: (R) (` 72/48) ` 1.50 per hour
Living bonus rate: ` 0.60 per hr.
Premium bonus 30% of time saved (i.e. SH - AH)
Halsey method of remuneration= 6 X 2.10 + 2 X 1.5 X 30% = ` 13.5
Rowan method of remuneration= 6 X 2.10 + 6 X 1.5 X 2/8 = ` 14.85

Que 11.
A worker produced 200 units in a week's time. The guaranteed weekly wage payment for 45 hours
is ` 81. The expected time to produce one unit is 15 minutes which is raised further by 20% under
the incentive scheme. What will be the earnings per hour of that worker under Halsey (50%
sharing) and Rowan bonus schemes?

Ans:
Earning per hour under Halsey (50% sharing) Bonus Scheme:

200 units × 18 minutes

(A) Standard Hours for actual production (SH) = = 60 hours
60 Minutes

(B) Actual Hours (AH) = 45 Hours

1
(C) Earnings = (Hours Worked × Rate Per Hour) + 2 (SH - AH) ×Rate Per Hour
1
= (45 hours ×`1.80) + [2× (60 - 45) ×` 1.80]
= ` 81 + ` 13.50 = ` 94.50

94.50
(D) Earnings per hour = 45hours= ` 2.10 per hour

Earnings per hour under Rowan Bonus Scheme:

AH
Earnings = AH × Rate Per Hour + SH

45
= (45 hours ×` 1.80) + [60× (60 - 45) ×`1.80]
= ` 81 + ` 20.25 = ` 101.25

101.25
Earnings per hour = = ` 2.25 per our
45 hours

Working Notes:
(i). Expected time to produce one unit under incentive scheme = 15 × 1.20 minutes = 18 minutes
(ii). Wage rate per hour (` 81/45 hours) = ` 1.80.

Que 12. ( Most- Imp)

A skilled worker in XYZ Ltd. is paid a guaranteed wage rate of `30 per hour. The standard time per
unit for a particular product is 4 hours. P, a machine man, has been paid wages under the Rowan
Incentive Plan and he had earned an effective hourly rate of ` 37.50 on the manufacture of that
particular product.

69
 Required: What could have been his total earnings and effective hourly rate, had he been put on
Halsey Incentive Scheme (50%)?

Solution
1
Total earnings (under 50% Halsey Scheme) = Hours worked × Rate per hour + 2× Time saved
× Rate per hour
1
= (3 hours × ` 30) + (2 × 1 hour × ` 30)
Total Earnings Rs.105
Effective hourly rate = = = ` 35
Hour Taken 3 hours

Working Note:
Let T hours be the total time worked in hours by the skilled workers (machine man P), ` 30 is the
rate per hour; standard time is 4 hours per unit and effective hourly earnings rate is ` 37.S0 then
Time Saved
Earning (under Rowan plan) = Hours worked × Rate per hr + Time Allowed × Time taken
× Rate per hr
(4-T)
`37.5 T = (T × ` 30) = 4 × T × `30
`37.5 = ` 30 + (4 - T) × ` 7.5
Or, `7.5 T = ` 22.5
Or, T = 3 hours

Que 13. (Most – Imp)

Calculate the earnings of workers A, Band C under Straight Piece Rate System and Merrick's Piece
Rate System from the following particulars:
Normal Rate per Hour `5.40
Standard Time per Unit 1 Minute
Output per day is as follows:
Worker A - 390 Units
Worker B - 450 Units
Worker C - 600 Units
Working hours per day are 8.

Ans:
Earnings of Workers under Straight Piece Rate System:
Worker A = 390 units × ` 0.09 = ` 35.10
Worker R = 450 units × ` 0.09 = ` 40.50
Worker C = 600 units × ` 0.09 = ` 54.00

Earnings of Workers under Merrick's Multiple Piece Rate System

Particulars A B C
Efficiency level 81.25% 93.75% 125%
(Refer to Working note ii)
Applicable wage rate per unit 0.09 0.099 0.108*
Earnings (`) 35.10 44.55 64.80
(390 units (450 units × 0.099) (600 units × 0.108)
×0.09)

Note : *Some author suggests an increase of 30% over normal piece rate at an efficiency level
of

70
 120% or more. In such a case the rate per unit would be ` 0.117 and total earnings would
come to ` 72.20
Working Notes:
(i) Normal wage rate per unit = Normal Rate per Hour/Standard output per hour
= ` 5.40/60 = 9 Paise
(ii) Efficiency level
Workers: A B C
Actual output per day (units) 390 450 600
Standard output per day (units) 480 480 480

Efficiency level achieved

Actual output units 390 450 600
= Standard output units ×100 = 480 × 100 = 480 × 100 = 480 × 100
= 81.25% = 93.75% = 125%

Que 14.
Using Taylor's differential piece rate system, find the earning of A from the following particulars:
Standard time per piece 12 minutes
Normal rate per hour (in a 8 hours day) ` 20
A produced 37 units

Ans:
1. % of Efficiency
8×60
Standard output per day = = 40 units Actual output = 37 units
12
Actual Output 37
% of Efficiency Standard Output × 100 = 40× 100 = 92.5%

60 Minutes
2. Normal production per hour = StandardTimeperpiece,i.e.12minutes = 5 Units

`20
3. Normal piece rate per Unit = 5 Units = `4

4. Total Earnings = 37 ×4 x 80% = 118.4

Que 15.
Calculate the total wages earned by a workman for a working day of 8 hours under Halsey
and Rowan plans:
 Standard production per hour 20units
 Actual production of the day 200units
 Wages rate per hour `30

Ans:
𝟐𝟎𝟎
(i). Standard time = 𝟐𝟎 = 10 hours

(ii). Total wages of workman in Halsey scheme:

Total wages = (Actual time × wages rate) + 50% (Standard Time - Actual time) × wage rate
50
= 8 × 30 + 100 (10 - 8) × 30
= ` 270

(iii). Total wages In Rowan plan:

71
 Standard time-Actual Time
Total wages = (Actual time × wages rate) + × Actual time × wages rate
Standard Time
10−8
= 8 × 30 + × 8 × 30
10
= ` 288

Que 16. ( Group- Bonus)

In a factory, Group Bonus System is in use which is calculated on the basis of earnings under time
rate. The following particulars are available for a group of 4 workers P, Q, R and S.
i). Output of the group 16,000 units
ii). Piece rate per 100 units ` 2.50
iii). No. of hours worked by P 90
Q 72
R 80
S 100
iv). Time rate per hour for P ` 0.90
Q ` 1.00
R ` 1.20
S ` 0.90
Required: Calculate the total of Wages and Bonus earned by each worker.

Ans:
Statement showing Computation of Total of Wages & Bonus earned by each worker
Worker AH Rate Per Hour Wages Bonus Total/Wages
(`) (`) (WNs) & Bonus
Hrs. × Rate
A B C D=B×C E F=D+E

p 90 0.80 72 18 90
Q 72 1.00 72 18 90
R 80 1.20 96 24 120
S 100 0.80 80 20 100

320 80 400

Working Notes:
16000
(i). Total piece earnings of the group = 100 × 2.50 = ` 400.00
(ii). Total Bonus = ` 400 - 320 = ` 80 divided in the ratio of time wages.
80 80 80 80
P 320 × 72 = 18, Q 320 × 72 = 18, R × 96 = 24, S ×
320 320
80 = 20

Que 17. (Most – Imp)

Two workmen, 'A' and 'B', produce the same product using the same material. Their normal wage
rate is also the same. 'A' is paid bonus according to the Rowan system, while 'B' is paid bonus
according to the Halsey system. The time allowed to make the product is 50 hours. 'A' takes 30
hours while 'B' takes 40 hours to complete the product. The factory overhead rate is ` 5 per man-
hour actually worked. The factory cost for the product for 'A' is ` 3,490 and for 'B' it is ` 3,600.
Required:
a) Compute the normal rate of wages;
b) Compute the cost of materials cost;
c) Prepare a statement comparing the factory cost of the products as made by the two workmen.

72
Ans:
Let x be the cost of material and y be the normal rate of wage per hour.

Worker A Worker B
` `
Material cost X X
Labour wages 30Y 40Y
Bonus Rowan system Halsey system
Time taken Hours saved × 50% × rate
Time saved × Time allowed ×
rate
30 1
20 × 50 x y = 12y = 10 ×2 xy = 5y
Overheads 30 × 5 = 150 40 × 5 =200
Factory cost X+ 42y + 150 = 3,490 X+ 45y + 200 = 36,00
Solving (1) and (2) we get
X = 2,500 and y = 20
(i) Normal rate of wages is ` 20 per hour.
(ii) Cost of materials = ` 2,500

Comparative Statement of factory cost

Worker A Worker B
Material cost 2,500 2,500
Wages 30 × 20 = 600 40 × 20= 800
Bonus 20 1
( 50 × 30 ×20 ) = 240 (10 × 2 × 20 ) = 100
Overheads 30 × 5 =150 40 × 5 =200
Factory cost 3,490 3,600

73
 JUDGE URSELF

Que 18.
From the following data given by the personnel Department calculate the labour turnover rate by
applying:
a) Separation Method,
b) Replacement Method,
c) Flux Method.
No. of workers on the pay-roll:
At the beginning of the month 900
At the end of the month 1,100
During the month 10 workers left, 40 persons were discharged and 150 workers were recruited.
Of these, 25 workers are recruited in the vacancies of those leaving, while the rest engaged for an
expansion scheme.
Ans: A: 5%, B:2.5%, C: 7.5%

Que 19.
Calculate the number of employees in the beginning and at the end of the year from the following
information:
Labour Turnover Rate 3% Number of Separations during the year 12
No. of Employees at the end was 100 in excess of number of employees in the beginning.

Que 20.
The standard time allowed to complete a job is 100 hours and the hourly rate of wage payment is `
10. The actual time taken by the worker to complete the job is 80 hours. Calculate the total wages
of the worker on the basis of
a) (i) Time Rate
(ii) Halsey Plan
(iii) Rowan Plan
b) Also compute the effective earnings per hour under the above methods.
Ans: A(i) ` 800, A(ii) ` 900, A(iii) ` 960
B(i) ` 10, B(ii) ` 11.25, B(iii) ` 12
Que 21.
Standard Time allowed 10 units per hour
Normal Piece Rate ` 5 for 10 units
Differential Piece Rate:
80% of Piece Rate for output below standard
120% of Piece Rate for output at or above standard
A produces 75 units in a day of 8 hours
B produces 100 units in a day of 8 hours
Required: Compute wages of A and B and Labour Cost per unit under Taylor Differential Piece
Rate System.
Ans: Total Wages: A `30, B `60, Labour Cost per unit: A ` 0.40, B `0.60

Que 22.
Standard Rate ` 5 per hour
Standard Hours for the Job = 8 hours for 40 units
Standard Piece Rate Re 1 per unit
Worker A completes the work in 10 hours
Worker B completes the work in 8 hours
Worker C completes the work in 6 hours

74
Required: Compute the Total earnings and earnings pet hour of A, B and C under Gantt Task Bonus
Plan. Ans: Total earnings: A ` 50, B ` 48, C ` 48, Earning per Hour: A ` 5, B ` 6, C `8

Que 23.
From the following calculate Total Earnings of A, B and C and labour cost per unit of A , Band C
under merrick efficiency System.
Standard output: 2000 units per day
Standard Rate: ` 200 per day
Actual output: A - 1200 units, B 2000 units, C 2200 units

TRUE/FALSE QUESTIONS
State with reason whether the following statements are True and False:
1. Abnormal idle time wages are included in the cost of production.
2. Job card is used to record the attendance of workers.
3. Time card is used to record time spent on job.
4. Wage sheet is prepared by Cost Accounting department.
5. Time & Motion study is conducted by Time keeping department
6. Where quality is important, piece rate system is the most suitable method of wage payment.
7. Where quantity is important, time rate system is the most suitable method of wage payment.
8. When time saved is more than 50% of standard time Rowan Plan allows more earnings to
workers than Halsey Plan.
9. Overtime wages due to seasonal pressure of work should be charged to Costing Profit & Loss
Account.
10. Amount of bonus under Halsey Plan is always different from that under Rowan plan.
11. Cost of normal idle time should be charged to Costing Profit & Loss Account.
12. Fringe Benefits are charged to Costing Profit & Loss Account.
13. Minimum Statutory Bonus to Direct Workers should be treated as part of Overheads and to
indirect worker should be treated as part of direct labour cost.
14. Extra Bonus over minimum Statutory Bonus should be treated as overheads.

EXPLANATORY ANSWERS
Statement True/False Reason
No.
1. False Abnormal idle time wages are charged to Costing Profit & Loss
Account.
2. False Job Card is used to record time spent by workers on a job.
3. False Time card is used to record arrival and departure time of a
worker.
4. False Wage sheet is prepared by Payroll Department
5. False Time & Motion study is conducted by Engineering and Work
Study Department.
6. False Where quality is important, time rate system is the most
suitable method of wage payment.
7. False Where quantity is important, piece rate system is the most
suitable method of· wage payment.
8. False When time saved is more than 50% of standard time Halsey
Plan allows more earnings to workers than Rowan Plan.
9. False Overtime wages due to seasonal pressure of work should be
treated as overhead.

75
10. False Amount of bonus under Halsey Plan and Rowan Plan is same
when time saved is exactly 50% of standard time.
11. False Cost of normal idle time should be treated as part of cost of
production.
12. False Fringe Benefits are treated as part of cost of production.
13. False Minimum statutory Bonus to Direct Workers should be treated
as part of direct labour cost and to indirect workers should be
treated as part of overheads.
14. False Extra Bonus over Minimum Statutory Bonus should be
excluded from Cost Accounts.

76
 PAST EXAMINATION QUESTION

MULTIPLE CHOICE QUESTIONS

1. Under the high wage plan, a worker is paid -

(a) At a higher time rate than the usual rate
(b) According to his efficiency
(c) At a double rate for overtime
(d) Normal wages plus bonus.

2. Cost of labour turnover is –

(a) Preventive cost
(b) Direct cost
(c) Fixed cost
(d) Non-controllable cost.

3. The rate of change of labour force in an organization during a specified period is called-
(a) Labour efficiency
(b) Labour turnover
(c) Labour productivity
(d) None of the above

4. Holiday pay is treated as –

(a) Fringe benefits cost
(b) Direct labour cost
(c) Overheads
(d) Abnormal loss charged to profit and loss account.

5. Incentive schemes include-

(a) Piece rate wage plan
(b) Time rate wage plan
(c) Differential piece rate wage plan
(d) None of the above

FILL IN THE BLANKS

(a) The time for which the employer pays remuneration to workers but obtains no direct benefit
is called …….
(b) The time lost by workers who are paid on time basis, is known as …..

TRUE AND FALSE/CORRECT AND INCORRECT

1. If a labour saves half of time of the standard time, the incentive amount under Halsey
Plan and Rowan Plan will be equal.
2. High labour turnover rate denotes good human relations.
3. Under differential piece rate of incentive scheme, there is no encouragement to
improve the performance of the workers.

77
4. By job rotation, labour turnover can be controlled/reduced upto some extent.
5. Under Flux Method, labour turnover is calculated by number of workers left divided by
average number of workers.
6. There is no need to record attendance of piece rate workers since attendance is not
relevant for ascertaining the amount of wages to be paid.
7. Idle facility and idle time are the same.
8. Overtime premium paid to all factory workers is usually considered direct labour.
9. High wages means high cost of production.

Answer : MCQs
Answers 1 2 3 4 5
Options (a) (a) (b) (a) (d)

Answers : Fill in the Blanks

1. Idle time.
2. Idle time.

Answers : True/False
1. True,If the worker finishes the work in half of the time fixed for it, the wages earned under
Halsey and Rowan plans will be the same.
2. False, High labour turnover indicates an unhealthy working atmosphere may be due to poor
management policies or poor supervision, etc.
3. Incorrect, In differential piece rate system, higher wages, are given to more efficient workers.
Hence, it acts as an encouragement to improve the performance of workers.
4. Correct, Job rotation leads to change in monotonous job of workers which controls labour
turnover to a certain extent since, worker's requirement of better job are fulfilled.
5. Incorrect, Under Flux Method labour Turnover is calculated by Number of Workers Added and
separated divided by Average Number of Workers. i.e. Labour turnover according to Flux
Method:
= × 100

Average of employees during a period

=

6. Correct, Under Piece Rate System the attendance is not relevant rather detailed records of
individual workers output is necessary as wage are paid per piece.
7. False, Idle facility is the time allowed to the worker by the factory, where as idle time is the time
that is lost due to unavoidable reasons, like break-down, etc.
8. False, Overtime hours at normal rate are treated as labour cost and charged to production
accordingly but premium paid during the overtime is re- covered as production overhead
through overhead recovery rate.
9. False, Highly skilled labors are very expensive but they are the most efficient as well as are the
most expensive and can increase the production and thereby reduce the cost of production.
Since, the costs would be stagnant whereas the production units would increase. Thus, high
wages does not mean high cost of production.

78
 TRAIN UR BRAIN

1. Direct Labour means – 8. The causes which induce or compel

a) Permanent labour in the production workers to leave their jobs are –
department a) Unavoidable causes
b) Labour completing the work b) Avoidable causes
manually c) Personal causes
c) Labour which is recruited directly d) None of the above
and not through contractors. 9. Unavoidable causes includes –
d) Labour which can be conveniently a) Seasonal nature of the business
associated with a particular cost unit b) Dissatifaction with working
2. Labour turnover is measured by – conditions
a) Replacement method c) Lack of proper training facilities and
b) Separation method promotional avenues
c) Flux method d) Unhealthy relationship with the
d) All of the above management
3. The rate of change in labour force during 10. Avoidable causes includes –
a specified period measured against a a) Seasonal nature the business
suitable index is – b) Change in the location of the plant or
a) Direct Labour turnover factory
b) Preventive costs c) Lack of proper training facilities and
c) Labour productivity promotional avenues
d) Replacement cost d) Climatic condition
4. Labour cost which cannot be allocated 11. High Labour turnover increases the cost
but can be apportioned to or absorbed by of production by –
units or cost centres is known as – a) Even and continuous flow of
a) Direct Labour b) Indirect production is disturbed
Labour b) Increasing cost of training and
c) Labour turnover induction
d) None of the above c) New workers being in experienced
5. Under Rown plan bonus percentage is – are more prone to accidents all of the
a) Fixed b) Not fixed above
c) Fluctuating d) All of the above
d) None of the above 12. Work done by a worker beyond his
6. Cost of abnormal idle time is transferred normal working hours is known as –
to costing – a) Over time b) Idle time
a) Manufacturing Account c) Time rate d) Card time
b) Profit & Loss Account 13. A worker who does not work in the
c) Balance Sheet factory premises, but works at h is home
d) Trading Account or at site of the factory is called –
7. Overtime wage is paid at a higher rate a) In worker b) Out worker
than the normal wage rate – usually – c) Sub worker d) Worker
a) Single b) Triple 14. The expenditure which can be allocated
c) Double d) None conveniently to a unit of cost is known as
–

79
 a) Direct expenses 21. A worker is allowed 60 hours to
b) Indirect expenses complete the job on a guaranteed wage of
c) Advertising Expenses ` 10 per hour. Under the Rowan plan his
d) None of the above effective wage earnings are ` 12 per
15. Godwon keeper, office staff, salesman etc. hour. What is the earnings under Halsey
are treated as – Plan?
a) Direct Labour b) Indirect a) ` 12.25 b) ` 11.10
Labour c) ` 11.25 d) ` 10.25
c) Additional Labour
d) None of the above The cost Accountant of A Ltd. has
16. The department responsible for compound labour turnover rates for the
recruiting and training workers and quarter ended 31.3.1997 as 10%, 5% and
3% respectively under Flux method,
placing them to the jobs they are best-
Replacement method and separation
fitted in Labour Cost control is known as method respectively. If the number of
– workers replaced during that quarter is
a) Payroll Department 30.
b) Time keeping Department 22. Find the number of workers left and
c) Personnel Department discharged?
d) Cost Accounting Department a) 18 b) 22
17. The department which prepares the plan c) 26 d) 20
and specification for each job in Labour 23. Find the number of workers recruited
Cost Control is known as – and Joined.
a) Payroll Department a) 40 b) 41
b) Time keeping Department c) 42 d) 44
c) Personnel Department From the following particulars:
d) Engineering and work study 1. Hourly rate of wages guaranteed –
Department 0.50 paise per hour
18. The department which maintains a check 2. Standard time for producing one
on the attendance of the workers and dozen articles – 3 hours
the time recorded by the worker on 3. Actual time taken by the worker to
various jobs etc. in Labour Cost Control is produce 20 dozen articles – 48 hours
known as –
24. Calculate the earnings of a worker under
a) Time keeping Department
Halsey plan.
b) Payroll Department
a) ` 25 b) ` 27
c) Personnel Department
c) ` 29 d) ` 31
d) Cost Accounting Department
25. Calculate the earnings of worker under
19. Time and Motion study involves the
Rowan Plan.
Classification of labour movement into –
a) ` 28.80 b) ` 28
a) Direct and Indirect
b) Fixed and Variable c) ` 29.01 d) ` 29
c) Necessary and Wasteful
The following information relates to the
d) None of the above
personal department of a factory for the
20. The technique for evaluating individual month of April, 1995:
employee performance is known as – Number of workers on April 1, 950
a) Job Evaluation b) Merit Rating 1995
c) Time Booking d) Time Keeping Number of workers on Apri 30, 1,050

80
1995 in April
Number of workers who quit 10 Number of workers engaged in April
the fatory in April (including 120 on account of expansion
Number of workers discharged 30 scheme) 140
in April
Number of workers engaged in April 30. Calculate the labour turnover rate by flux
(including 120 on account of expansion method
scheme) 140 a) 4% b) 5%
c) 6% d) 2%
26. Calculate the labour turnover rate by
31. Equivalent annual rate
separation method
a) 73% b) 24.33%
a) 4% b) 5%
c) 48.67% d) None
c) 6 % d) 2%
27. Equivalent annual rate The labour turnover rates of a
a) 73% b) 24.33% manufacturing organization for the
c) 48.67% d) None quarter ended 31st March, 2009 are 10%,
5%, and 3% under flux method,
The following information relates to the replacement method, and separation
personnel department of a factory for the method respectively. The number of
month of April, 1995: workers replaced during the quarter is
Number of workers on April 1, 950 120.
1995
Number of workers on Apri 30, 1,050 32. Find the average number of workers
1995 a) 3000 b) 2400
Number of workers who quit 10 c) 4200 d) 6000
the fatory in April 33. Find the number of workers left and
Number of workers discharged 30 discharged
in April
a) 27 b) 72
Number of workers engaged in April
(including 120 on account of expansion c) 168 d) 186
scheme) 140 34. Find the number of workers recruited
and joined including replacements
28. Calculate the labour turnover rate by a) 27 b) 72
replacement method. c) 168 d) 18
a) 4% b) 5%
c) 6% d) 2% Labour turnover Rate 3%
29. Equivalent annual rate Number of Separations during the yr 12
a) 73% b) 24.33% No of Employees at the end were 100 in
excess of number of employees in the
c) 48.67% d) None
beginning
The following information relates to the 35. Calculate the number of employees in the
personnel department of a factory for the
beginning
month of April, 1995:
Number of workers on April 1, 950 a) 450 b) 350
1995 c) 550 d) 650
Number of workers on Apri 30, 1,050 36. Calculate the number of employees at the
1995 end of the year
Number of workers who quit 10 a) 450 b) 350
the fatory in April c) 550 d) 650
Number of workers discharged 30

81
Labour turnover rate (Based on 43. The relevant data is as below:
Separations) 10% Time Rate(p.h) `
Labour turnover rate (Based on 0.6
Replacements) 8% Time allowed 8 hours
No. of Replacements during the year 16 Time taken 6 hours
Time saved 2 hours
37. Calculate the average number of a) 5 b) 6
employees c) 4.50 d) 4.20
a) 300 b) 200 44. The relevant data is as below:
c) 600 d) 500 Time rate (per hour) ` 0.6
38. Calculate the number of separations Time allowed 8 hours
during the year Time taken 6 hours
a) 30 b) 40 Time saved 2 hours
a) 5 b) 6
c) 10 d) 20
c) 4.50 d) 4.20
Labour turnover rate (Based on
Separations) A worker produced 200 units in a week’s
3% time. The guaranteed weekly wage
Labour turnover rate (Based on Flux) payment for 45 hours is ` 1,350. The
8% expected time to produce one unit is 15
No. of Workers left & discharge 18 minutes which is raised further by 20%
under the incentive scheme.
39. Calculate the average number of
employees 45. Find earning per hour of the worker
a) 300 b) 200 under Halsey (50% sharing)
c) 600 d) 500 a) 35 b) 37.5
40. Calculate the number of workers c) 38 d) 40
replaced 46. Find earning per hour of the worker
a) 30 b) 40 under Rowan bonus scheme
c) 10 d) 20 a) 35 b) 37.5
b) 38 d) 40
The cost of accountant of Y Ltd. has Standard time allocated for a job is 20
computed labour turnover rates for the hours and the rate per hour is ` 1 plus a
quarter ended 31st March, 20XI as 10%, dearness allowance @ 0.30 paise per hour
5%, and 3% respectively under ‘Flux worked. Actual time taken by a worker is
method’, ‘Replacement method’ and 15 hours.
‘Separation method’. If the number of
workers replaced during that quarter is 47. Calculate earnings under Halsey plan
30. a) ` 25 b) ` 45
c) ` 30 d) ` 22
41. Find out the number of workers left and 48. Calculate earnings under Rowan plan
discharge a) ` 24.25 b) ` 23.25
a) 18 b) 22 c) ` 25.25 d) ` 22.50
c) 26 d) 20 49. Normal rate per hour for worker A in a
42. Find out the number of workers workers factory is ` 5.40. Standard time per unit
recruited and joined including for the worker is one minute. Normal
replacements. piece rate per unit for the worker is
a) 40 b) 41 a) ` 0.90 b) ` 0.09
c) 42 d) 44 c) ` 0.11

82
 d) None of the above
Computation of Normal Wage rate per unit
Normal Rate per hour ` 5.0
Standard Output per hour 60 units
Normal wages rate per hour (` 5.40/60
units) 0.09 p
50. Standard time is 60 hours and
guaranteed time rate is ` 50 per hour.
Under Rowan Plan, what is the amount of
wages, If job is completed in 48 hours?
a) ` 2.480 b) ` 2,680
c) ` 2,880
d) None of the above
51. Standard time is 60 hours and
guaranteed time rate is ` 50 per hour.
Under Halsey Plan, what is the amount of
wages, If job is completed in 48 hours?
a) ` 2,700 b) ` 2,680
b) ` 2,880
c) None of the above
52. Which of the following is an abnormal
cause of the Idle time:
a) Time taken by workers to travel the
distance between the main gate of
factory and place of their work
b) Time lost between the finish of one
job and starting of next job
c) Time spent to meet their personal
needs like taking lunch, tea etc.
d) Machine break downs
53. Labour turnover means
a) Turnover generated by labour
b) Rate of change in composition of
labour force during a specified period
c) Either of the above
d) Both of the above
54. Which of the following is not an
avoidable cause of labour turnover:
a) Dissatisfaction with Job
b) Lack of training facilities
c) Low wages and allowances
d) Disability, making a worker unit for
work
55. Calculate the labour turnover rate
according to replacement method from
the following No. of workers on the
payroll:
 At the beginning of the month: 500
 At the end of the month: 600
During the month, 5 workers left, 20
workers were discharged and 75
workers were recruited. Of these, 10
workers were recruited in the vacancies
of those leaving and while the rest were
engaged for an expansion scheme.
a) 4.55% b) 1.82%
c) 6% d) 3%
56. Calculate workers left and discharged
from the following:
Labour turnover rates are 20%, 10%
and 6% respectively under Flux method,
Replacement method and Separation
method. No. of workers replaced during
the quarter is 80.
a) 112 b) 80
c) 48 d) 64
57. Calculate workers recruited and joined
from the following:
Labour turnover rates are 20%, 10%
and 96% respectively under Flux
method, Replacement method and
Separation method. No. of workers
replaced during the quarter is 80.
a) 112 b) 80
c) 48 d) 64
58. At the time of coming in or leaving
premises, the employee will use _____ at
the factory gate for recording of the
starting and finishing time.
a) Job Card b) Clock card
c) Piece work card d) Time card
59. The difference between hours paid and
hours worked is called:
a) Normal time b) Time saved
c) Standard Time d) Idle time
60. The flux rate method of labour turnover
considers:
a) Employees joined
b) Employee left
c) Employees joined and left
d) Employees replaced
61. In Z Ltd. there were 80 employees on the
rolls at the beginning of a year and 620 at
83
 the end. During the year 300 persons left 67. A firm employee 5 worker at an hourly
service. The company has computed its rate of ` 2.00. During the work, they
labour turnover rates under flux method worked for four days for a total period of
is 80%. The number of accessions during 40 hours each and completed the job for
the period is: which the standard time was 48 hours
a) 220 b) 250 for each worker. The labour cost under
c) 360 d) 150 Halsey plan is:
62. Y Ltd. has 480 workers at the beginning a) ` 440 b) ` 467
and 520 workers at the end of the year. c) ` 480 d) ` 420
The company has computed its labour A worker takes 6 hours to complete a job
turnover rate for the year as 12%, 8% under a scheme of payment by results.
and 5% respectively under flux method, Standard time allowed for the job is 9
replacement method and separation hours. His wage rate is ` 1.50 per hour.
Material Cost of the Job is ` 16 and
method. The number of workers replaced
overhead are recovered at 200% of total
during the year is 24. The number of direct wages.
workers left and discharged is:
a) 30 b) 25 68. Calculate factory cost of the job under:
c) 28 d) 32 Rowan plan
63. X Ltd. has computed labour turnover a) 49.75 b) 50
rates for the year ended 31st March, 2009 c) 60 d) 52
as 9%, 6% and 3% respectively under 69. Calculate factory cost of the job under:
flux method, replacement method and Halsey Plan
separation method. The number of a) 49.75 b) 50
workers replaced during the year is 42. c) 60 d) 52
On an average how many workers on the 70. From the following particulars:
rolls. Normal Rate per Hour ` 5.40
a) 700 b) 650 Standard Time per unit 1 minute
c) 800 d) 820 Output per day of worker B 450 units
Working hours per day are 8
64. Under Taylor’s differential piece rate
Calculate the earnings of worker B
system, a worker whose production is under Merrick’s Multiple Piece Rate
higher than the standard will get ______ of System.
normal piece rate. a) 44 b) 44.55
a) 110% b) 115% c) 44.75 d) 45
c) 120% d) 130% 71. ___________ is a method of evaluating the
65. Under Hasley-Weir premium plan _____ of job in terms of its money value.
time saved is shared by employee. a) Job Analysis
a) 30% b) 50% b) Job Evaluation
c) 75% d) 60% c) Work measurement
66. The Standard time required per unit of a d) Motion Study
72. The requirements of a particular job are
product is 20 minutes. In a day of 8
known as _____________.
working hours a worker gives an output
a) Job Description b) Job Evaluation
of 30 unit. If he gets a time rate of ` 20/hr.
c) Job specification d) Motion study
his total earnings under Halsey bonus 73. Qualities demanded from the job holder
scheme was: is technically known as _______________
a) ` 200 b) ` 192 a) Job Description b) Job Evaluation
c) ` 180 d) ` 160 c) Job specification d) Motion study

84
74. For conducting ________ workers are
studied at their jobs and all their
movements and motions are noted.
a) Time study b) Merit Rating
c) Motion Study d) None of these
75. _______________ is connected with
discovery of facts concerning a job and
_________ is concerned with ascertaining
the money value of a job.
a) Job Analysis; Job evaluation
b) Job Specification; Job Evaluation
c) Job Description; Job Evaluation
d) Motion study
76. _______________ is the assessment of the
relative worth of jobs with a company
whereas __________ is the assessment of
the relative worth of man behind the
job.
a) Job Evaluation; Merit Rating
b) Job analysis; Job evaluation
c) Job Analysis; Merit Rating
d) None of theses
77. _________________ are maintained to know
how the worker’s time shown by the
time card is spent on various job.
a) Daily time sheets
b) Weekly time sheets
c) Job Card
d) None of theses
78. Overtime resorted at the desire of the
consumer, should be charged to:
a) Costing profit and loss account
b) to be charged directly to the job
c) not to be charged
d) charge to the highest profit making
department
79. Labour cost covers _________________
a) Salaries or wages paid to the workers
b) Various payments made to a worker
due to his employment
c) Overtime payments
d) All of the above
80. The labour cost which is not traceable
or identified to particular product or
cost centre is known as ___________
a) Indirect labour cost
b) Direct labour cost
c) Variable labour cost
d) Either (b) or (c)
81. Which of the following reason shows
that there is need for distinguishing
between direct and indirect labour cost?
a) Introduction of incentive schemes
b) Minimizing the competition in
domestic market
c) Introduction of new product in the
market
d) All of the above
82. Rent free accommodation or
accommodation provided at
concessional rate should be classified as
_____________
a) Fringe Benefits
b) Deferred Monetary Benefits
c) Fixed Standard labour cost
d) Pecuniary Benefits
83. __________________ is a process whereby
assessment is done to know the worth
of a particular job.
a) Merit Rating
b) Performance appraisal
c) Job Evaluation
d) Induction
84. In case of time based payment method
______ is of utmost importance.
a) Classification of workers as direct
labour and indirect labour
b) Computation of factory overhead rate
on the basis of labour hours
c) Correct recording of employees
attendance time
d) Classification of various payments
made to a worker.
85. Direct labour cost should be ____________
a) Treated as production overhead.
b) Charged using supplementary over-
head rate
c) Considered as part of prime cost.
d) Treated as abnormal cost and
charged to costing profit & loss
account.
86. In time wage system, wage are paid
according to the _______________.
a) Production b) Time
c) Both a and b d) None of these
87. Under piece rate system of wage
payment is made according to the
___________.
a) Quantity of work done
85
 b) Time 70. b 71. b 72. a
c) Both a and b 73. c 74. c 75. a
d) None of these 76. a 77. c 78. b
88. Taylors differential piece rate system
79. d 80. a 81. a
provide for higher rate to ____________
82. a 83. c 84. c
workers.
85. c 86. b 87. a
a) Inefficient b) Efficient
c) Both a and b d) Lazy 88. b 89. b 90. d
89. ______________ is most suitable when
quality of work is of prime importance.
a) Piece rate system
b) Time wage system
c) Both a and b
d) None of these
90. Formula of calculation of wages under
Halsey Premium System is __________.
a) R + [S × 50% ×R]
b) [H × R] + [H × 50% × R]
c) R + [H × 50% × R]
d) [H × R] + [S × 50% × R]

ANSWERS

1. d 2. d 3. a
4. b 5. a 6. b
7. c 8. c 9. a
10. c 11. d 12. a
13. b 14. a 15. b
16. c 17. D 18. a
19. c 20. B 21. c
22. a 23. C 24. b
25. a 26. A 27. c
28. d 29. B 30. c
31. a 32. B 33. b
34. c 35. B 36. a
37. b 38. D 39. c
40. a 41. A 42. c
43. d 44. C 45. a
46. b 47. D 48. b
49. b 50. C 51. a
52. d 53. B 54. d
55. b 56. C 57. a
58. b 59. D 60. c
61. a 62. B 63. a
64. c 65. A 66. c
67. a 68. D 69. a

86
CHAPTER 3
Qus 1.
[Calculation of Effective Machine Hours]
Calculate Effective Machine Hours for the purpose of computing Machine Hour Rate in each of the
following alternative cases:

Case (a) budgeted working hours 2400, Maintenance hours 10%

Case (b) Budgeted working hours 8 hours per day for 300 days, Maintenance hours 10%

Case (c) There is 13 holidays on account for festivals and national holidays not falling on
Sundays. The factory works 8 hours a day. Maintenance hours 10%

Case (d) Total working hours available per week 44 hours

Maintenance hours included in above 4 hours
Setting up time (productive) 5%
Machine hour rate is worked out at the beginning of a year on the basis of 13 week
period which is equal to 3 calendar months.

Case (e) Total working hours available per week 44 hours

Maintenance hours included in above 4 hours
Setting up time (unproductive) 5%
Machine hour rate is worked out at the beginning of a year on the basis of 13 week
period which is equal to 3 calendar months.

Ans:
Case (a) Effective Machine hours = Budgeted working hours - Maintenance hours
= 2400 hours - 10% of 2400 hours = 2160 hrs.

Case (b) Effective Machine hours = Budgeted working hours - Maintenance hours
= (300 days × 8 hours) - 10% of 2400 hours
= 2,160 hours

Case (c) (A) No. of working days in a year [365 - Holidays = 365 - (13 + 52)] 300 days
(B) No. of working hours per day 8 hours
(C) Total No. of working hours (A × B) [300 days × 8 hours] 2400
(D) Less: Maintenance hours @ 10% 240
(E) Effective Machine Hours 2160

Case (d) (A) No. of working weeks 13 weeks

(B) No. of working hours per week 44 hours
(C) Total No. of working hours for 13 week period (13 × 44) 572
(D) Less: Maintenance hours (13 × 4) 52
(E) Effective Machine Hours 520

87
Case (e) (A) No. of working weeks 13 weeks
(B) No. of working hours per week 44 hours
(C) Total No. of working hours for 13 week period (13 × 44) 572
(D) Less: Maintenance hours (13 × 4) 52
(E) Total Machine hours 520
(F) Less: Unproductive set up time 26
(G) Effective Machine Hours 494

Qus 2.
[Calculation of the Cost of power per hour]
Calculate the cost of power per hour for the purposes of computing Machine hour rate in each of
the following alternative cases:

Case (a) Power consumption of machine during production 10 units per hour at a cost of `4 P.U.

Case (b) Power consumption of machine during operation 15 units. Rate of power per 100 units
`500.

Case (c) Power consumption of machine during production 20 units per hour
Rate of power per 100 units ` 570
Estimated working hours 2200 hours
Maintenance hours 200 hours
set up item (productive) 5%
Power is used during setting up

Case (d)Power consumption of machine during production 20 units per hour

Rate of power per 100 units ` 570
Estimated working hours 2200 hours
Maintenance hours 200 hours
set up item (productive) 5%
No power is used during setting up

Case (e) Power consumption of machine during production 20 units per hour
Rate of power per 100 units ` 570
Estimated working hours 2200 hours
Maintenance hours 200 hours
set up item (unproductive) 5%
Power is used during setting up

Case (f) Power consumption of machine during production 20 units per hour
Rate of power per 100 units ` 570
Estimated working hours 2200 hours
Maintenance hours 200 hours
set up item (unproductive) 5%
No power is used during setting up.

Ans:
Case (a) Cost of Power per hour = 10 units × ` 4 = ` 40

𝑅𝑠.500
Case (b) Cost of Power per hour = 15 Units × = ` 75
100

88
 20 𝑢𝑛𝑖𝑡𝑠 ×𝑅𝑠.570×2000
Case (c) Cost of Power per hour = = ` 114
100×2000

Note: Effective Machine hours = 2200 - 200 = 2000 hours

20 𝑢𝑛𝑖𝑡𝑠 ×𝑅𝑠.570×1900
Cost of Power per hour = = ` 108.30
100×2000
Case (d) Note: Effective Machine hours = 2200 - 200 = 2000 hours
Effective Machine hours which consumed power = (2200 - 200) - 5% of 2000
= 1900 hours

20 units × Rs 570 × 2000

Cost of Power per hour = = ` 120
Case (e) 100×1900

Note: Effective Machine hours = 2200 - 200 - 5% of 2000 = 1900 hours

Effective Machine hours which consumed power = 2200 - 200 = 2000 hours

20 𝑢𝑛𝑖𝑡𝑠 ×𝑅𝑠.570×1900
Case (f) Cost of Power per hour = ` 114
100×1900

Note: Effective Machine hours = 2200 - 200 - 5% of 2000 = 1900 hours

Qus 3.
[Calculation of Depreciation per hour]
Calculate depreciation per hour in each of the following alternative cases:

Case (a) Original cost `1, 00,000, Installation charges `10,000, estimated scrap value at the
end
of useful life (10 years) 20% of original cost, Effective machine hours 2000.

Case (b) W.D.V. of machine (Deprecation @ 8% plus 2% on an average for extra shift
allowance)
`5, 20,000. Machine hour rate is worked out at the beginning of each year on the
basis of 13 week period which is equal to 3 calendar months

Total working hours available per week 44 hours

Maintenance hours included in above 4 hours
Setting uptime (productive) 5%

Ans:
Original Cost + Installation charges - Scrap Value
=
Case (a) Depreciation per hour Total useful life in hours

Rs. 1,00,000 + Rs. 10,000 - Rs.20,000

= = ` 4.50
10×2000

Case (b) Depreciation per hour 10 % 𝑜𝑓𝑅𝑠.5,20,000×3/12

= = ` 25
520 ℎ𝑜𝑢𝑟𝑠
Note: Effective Machine hours for 13 week period = (13 × 44) – (13× 4) = 520 hours

89
Qus 4.
A Machine costing ` 5,74,000 excluding installation and erection costs of ` 6,000, has an
anticipated life of 10 years, with a residual value of ` 10,000. It is depreciate on straight-line
method. From the given information, compute a machine-Hour rate on the basis of anticipated
working hours-
Rent and Rates for the factory is `40,000 per annum. Area occupied by this machine-10%
Insurance for this machine is ` 3,000 per annum.
Repairs& Maintenance for the whole factory for the year is ` 10,000, 25% of this relates to this
machine. Consumable stores attributable to this machine for the whole year is` 5,500. Total of
production services is 40,000, 20% of this amount is applicable to this machine. Power cost is ` 15
per working hour.

The year contains 250 working days of 8 hours each, and it is anticipate that the machine will
remain idle 20% of this time,

Ans:
1. Number of productive Hrs p.a. = Total Hours Less Idle time
= (250 days × 8 hours) - 20% thereon = 1,600 hours per annum

Statement of Overheads per annum

PARTICULARS COMPUTATION `
Depreciation Fixed [`5,74,000+`6,000-`10,000]÷10 year 57,000
Rennet and Rates Fixed `40,000×10% 4,000
Insurance Fixed Given 3,000
Repairs & Maintenance Fixed `10,000 2,500
Consumable Stores variable Given 5,500
Production Services variable `40,000×20% 8,000
Power variable 1,600 hours×`15 per hour 24,000
Total Overheads 1,04,000

90
CHAPTER 4
Meaning of Overhead
Overhead is the aggregate of indirect materials cost, indirect labour cost and indirect expenses
which cannot be conveniently identified with and directly allocated to a particular cost centre or
cost object in an economically feasible way. It is also known as indirect cost, burden or on cost.

Examples of Overhead
(a) Indirect Materials Cost
(b) Indirect Labour Cost
(c) Indirect Expenses
Stationery in Production Deptt., Administration Deptt., and
Selling and Distribution Deptt.
Salary of Works Manager/Office Manager/Sales Manager
Rent, Rates, Repairs, Insurance and Depreciation of Factory
Building, Adm office Building and Sales office Building

DIVISION- 1: CLASSIFICATION OF OVERHEADS

Meaning of Classification of Overheads

Classification of overheads is the process of grouping the various items of overheads into distinct
class/group on the basis of some common characteristics.

Bases of Classification of Overheads

Generally, overheads are classified on the following basis:

Classification of Overheads

By Function By Behaviour By Element

1. Production Overheads 1. Fixed Overheads 1. Indirect Materials

2. Administrative 2. Variable Overheads 2. Indirect Labour
Overheads,: 3. Semi-Variable 3. Indirect Expenses
3. Selling Overheads Overheads
Distribution Overheads

Classification Overheads by Function

1. Production/Manufacturing/Factory Overheads

Meaning: Production overheads represent all the indirect costs incurred in connection with the
production of product or service. These represent the aggregate of indirect materials cost, indirect
labour cost and indirect expenses incurred by production department.

91
Examples:
a) Indirect Materials Cost I. Cost of consumable stores and supplies like cotton waste,
lubricating oil etc.
II. Cost of printing, postage & stationary used in Production Deptt.
b) Indirect Labour Cost I. Salary of supervisor, works manager and departmental
superintendants.
II. Contribution to ESI, P.F., leave Pay, maternity Pay.
c) Indirect Expenses I. Rent, rates & taxes of factory building.
II. Repairs, insurance & depreciation of factory building, plant &
machines and furniture.
III. Factory telephone expenses.
IV. Lighting, heating & cleaning of factory.

2. Administration Overheads
Meaning Administration overheads represent the cost of formulating the policy, directing the
organisation and controlling the operations of an undertaking which is not related directly to
production, selling, distribution, research or development activity or function. These represent the
aggregate of material cost, labour cost and expenses incurred by Administration Department for
the general management of an organisation. These all costs are in the nature of indirect costs.

Examples:
a. Materials i). Cost of printing, postage & stationery used in Administration
Cost department.
ii). Cost of dusters, brushes etc. for cleaning.
b. Labour Cost i). Salary of managing director, whole time director, general manager,
finance manager, accounts manager, secretary, legal manager and other
staff working in Administration department.
ii). Remuneration of internal & statutory cost & financial auditors, Legal
Advisors.
c. Expenses i). Rent, rates & taxes of office building.
ii). Repairs, insurance & depreciation of office building, equipment, and
furniture.
iii). Administration office telephone expenses.
iv). Lighting, heating & cleaning of Administration office.

3. Selling Overheads
Meaning Selling overheads represent the cost of seeking to create and stimulate demand and of,
securing order. Thus, this is the cost of promoting sales and retaining customers. These represent
the aggregate of materials cost, labour cost and expenses incurred by sales department for the
sales management of an organisation. These all costs are in the nature of indirect costs.

Examples:
a) Material Cost i). Cost of printing, postage & stationery used in sales department.
ii). Cost of catelogues, list prices etc.
b) Labour Cost i). Salary of sales director, sales managers, sales officers, salesmen and
other staff working in sales department.
ii). Commission to selling agents.
c) Expenses i). Rent, rates & taxes of sales office/showroom.
ii). Repairs, insurance & depreciation of sales office building, equipment
and furniture.
iii). Sales office telephone expenses.
iv). Lighting, heating & cleaning of sales office.

92
 v). Advertising.
vi). Bad Debts.
vii). Debt collection charges.
viii). Salesmen's travelling expenses.
ix). Entertainment expenses on customer.

4. Distribution Overheads
It represent the cost of the 'sequence' of operations which begins with making the packed product
available for dispatch and ends with making the reconditioned returned empty package, if any,
available for reuse. These also include expenditure incurred in moving articles to central or local
storage, or in moving articles to and from prospective customers as in the case of goods on sale or
return basis.
In the gas, electricity and water industries 'Distribution' means pipes, mains and service which
may be regarded as equivalent to packing and transportation. These represent the aggregate of
materials cost, labour cost and expenses incurred by distribution department for the distribution
management of the organisation. These all costs are in the nature of indirect costs.

Examples:
a. Material Cost i). Cost of printing, postage & stationery used in distribution office
ii). Cost of secondary packaging
iii). Cost of materials used in reconditioning of the empty containers
returned by customers for re-use.
b. Labour Cost i). Salary of staff attached to distribution office like, packers, dispatch
staff
ii). Salary of driver of distribution vehicle.
c. Expenses i). Rent, rates & taxes of distributing office/godown/
storage/warehouse
ii). Repairs, insurance & depreciation of distribution office Building,
equipment & furniture, delivery van of distribution office
iii). Distribution office telephone expenses
iv). Lighting, heating & cleaning of distribution office
v). Depreciation, repairs & running expenses of delivery vans
vi). Freight & carriage outward
vii). Insurance of Finished Stock in godown.

Classification of Overheads by Behaviour/Variability

1. Fixed Overheads
Meaning Fixed overheads are those costs which do not vary with the change in the volume of
production upto a given range.
Examples Rent and Insurance of Building, Plant & Machinery & Furniture, Salary of manager etc.
Characteristics Fixed overheads have two characteristics:
i). Total fixed overheads do no vary with the change in the volume of production upto a given
range.
ii). Fixed overheads per unit varies with change in the volume of production i.e. fixed
overheads per unit decreases as the production increases and vice versa.
Practical Example:
output (unit) Total Fixed Overheads Fixed overheads per unit
A B C = B/A
1 `1,000 ` 1,000
10 `1,000 ` 100
100 ` 1,000 `10

93
Thus, Fixed overheads per unit goes on decreasing as the total number of output produced
increases.

2. Variable Overheads

Meaning Variable overheads are those costs which vary in direct proportion to the volume of
production.

Examples Consumable stores arid supplies, sales commission

Characteristics Variable overheads have two characteristics:

i). Total variable overheads vary in direct proportion to the volume of production i.e. total
variable overheads decrease as the production decreases and vice versa.

ii). Variable overheads per unit remains fixed.

Practical Example:
Output (unit) Total Variable Overheads Variable Overheads per unit
A B C = B/A
0 `0 `0
1 ` 10 `10
10 `100 ` 10
100 ` 1,000 ` 10
1,000 ` 10,000 `10

Thus, Variable Overheads per unit remains fixed end does not change with the changes in the
volume of output.

Semi-Variable Overheads

Meaning Semi-Variable overheads are those costs of which one part remain fixed upto a given
range and the other part varies with the change in the volume of production but not in the same
proportion. For Example, an expense may not change if output is upto 50% Capacity but may
increase by 2% for every 10% increase in output over 50% capacity but upto 70%.

Examples Telephone expenses of which hire part· is fixed and fee for calls is variable,
Depreciation, Repairs & Maintenance, Delivery Van expense

Practical Example:
Semi-Variable Overheads ` 3,00,000 are constant upto 75% capacity (7,500 units) but increase by
10% over 75% but upto 85% and then increase by 20% over 85% but upto 100% capacity.
Total semi-variable semi-variable Overheads per
Capacity Output (unit)
Overheads (`) unit (`)
A B C = B/A
50% 5,000 `3,00,000 ` 60.00
60% 6,000 ` 3,00,000 ` 50.00
70% 7,000 ` 3,00,000 ` 42.86
80% 8,000 ` 3,30,000 ` 41.25
90% 9,000 ` 3,00,000 ` 44.00
100% 10,000 ` 3.96,000 ` 39.60

94
 Classification of Overheads by Element

1. Indirect Materials Costs Indirect material costs are those materials costs which cannot
Conveniently be identified with and directly allocated to a particular cost centre or cost Object
in an economically feasible way. For Example, consumable stores and supplies, lubricants etc.

2. Indirect Labour Cost Indirect labour costs are those, labour costs Which cannot conveniently
be identified with and directly allocated to a particular cost center of cost object in an
economically feasible way. For example, salary of security staff salary of general manager.

3. Indirect Expenses Indirect Expenses are those expenses other than indirect material or
indirect labour, which cannot conveniently be identified with and directly allocated to a
particular cost center or cost object in an economically feasible way For example, rent, repairs,
insurance and depreciation of building.

METHODS OF SEGREGATING SEMI-VARIABLE OVERHEADS INTO FIXED AND VARIABLE

OVERHEADS

High and Low Method or Range Method

Under this method the variable element of overhead per unit and total fixed element are
ascertained as follows:
Variable Element of Overhead per unit=Difference between the total semi variable overhead at
highest and lowest volume / difference between the highest and lowest volume of output
Example:
Production Units Semi-Variable Overheads
Highest Volume 30,000 ` 80,000
Lowest Volume 20,000 ` 60,000

Variable Element of Overheads per unit = Difference between total semi - variable overheads at
highest and lowest volume/Difference between highest and lowest volume of output
= ` 20,000 /10,000 ` 2per unit
Total Variable Overheads at highest level = 30,000 × ` 2 = ` 60,000
Total Fixed Overheads = ` 80,000 - ` 60,000 = ` 20,000
Total Variable Overheads at lowest level = 20,000 × ` 2 = ` 40,000
Total Fixed Overheads = ` 60,000 - ` 40,000 = ` 20,000

DIVISION – II COLLECTION OF OVERHEADS

After classification, the next step is the collection of overheads

Meaning of Collection Overheads

Collection of overheads means the collection of various items of overheads under suitable account
heading and a unique Standing Order Number (S.O.N.) or Cost Account Number (C.A.N.).

Standing Order System

Meaning The production overheads are usually collected through a system of standing order
numbers. Standing order system is a system under which a distinct number is allotted to each item
of cost for the purpose of identification.

Essential requisites for an effective system of Standing Order Number

i). The S.O. numbers should be clearly defined so that all expenditure, may easily understand.

95
ii). The classification into very large number of S.O. numbers should be avoided because this
involves high cost of clerical labour. Besides this, this makes the control over costs very
difficult.

iii). The classification into S.O. numbers should be flexible so that according to the needs of the
factory, from time to time, suitable expansion or deletion of items can be easily done without
seriously dislocating the existing system.

Methods of Allotting S.O.N. Following methods can be used to allot symbols or code numbers to
identify each S.O.N:

a) Straight Numbering Method Under this method, each type of expenditure is allotted fixed
number. For example
Standing order number: 20 for indirect material.
Standing order number: 21 for indirect labour.
Standing order number: 22 for indirect expenses.

b) Number Blocks Under this method, a block of numbers is generally earmarked to indicate
the major heads of expenditure e.g. 1-20 for service labour, 21-50 for maintenance; 51-100 for
fringe benefits etc.

c) Combination of Symbols and Numbers Under this method a combination of symbol alphabet
and a number is used to represent a code. Here symbol alphabet stands for the main head of
the expenditure and the number represents the concerned department.
For example
R1 - Repair of factory building. [R stand for repair and 1 for Factory Building]
R2 - Repair of machines. [R stand for repair and 2 for Factory Machine]

Cost Account Numbers (C.A.N.) Generally S.O. numbers are used to refer to various items of
production overheads and Cost Account Numbers (C.A.N.) are used to refer to various items of
administration and selling & distribution overheads. The method of allotment of numbers is the
same in both the cases.

DIVISION – III : ALLOCATION OF OVERHEADS

Meaning
Allocation of overheads is the process of charging the amount of an individual item of cost directly
to a cost centre for which this item of cost was incurred.

Examples of Allocation of Overheads

a) Where separate electric meters are installed in each of the department, the electricity charges
on the basis of electricity bills can be allocated to the respective departments.
b) Salary & wages paid to indirect workers of each department can be allocated to the respective
departments.

Format of Statement showing the Allocation of Overheads

Statement showing the Allocation of Overheads
Items of overheads Production Department Service Department
Allocated P1 P2 P1 P2
Direct Material - - ….. …..
Direct Wages - - ….. …..
Direct Expenses - - ….. …..

96
Indirect Material ….. ….. ….. …..
Indirect Wages ….. ….. ….. …..

Tutorial Note: All costs of service departments are considered as OVERHEADS.

CLASSROOM PRACTICE – LETS PLAY TOGETHER

Qus 1.
B Ltd. has two production departments and two service departments and provides you the
following data:
Production Departments Service Departments
P1 P2 S1 S2
Direct Materials 40,000 30,000 20,000 10,000
Direct Wages 20,000 15,000 10,000 5,000
Direct Expenses 10,000 7,500 5,000 2,500
Indirect Materials 5,000 5,000 5,000 5,000
Indirect Wages 2,500 2,500 5,000 2,500
Required: Prepare the Statement showing the Allocation of Overheads.

Ans: Statement showing the Allocation of Overheads

Items of Overheads Allocated Production Departments Service Departments
P1 P2 S1 S2
Direct Materials - - 20,000 10,000
Direct Wages - - 10,000 5,000
Direct Expenses - - 5,000 2,500
Indirect Materials 5,000 5,000 5,000 5,000
Indirect Wages 2,500 2,500 5,000 2,500
Total Overheads Allocated 7,500 7,500 45,000 25,000

DIVISION IV: APPORTIONMENT OF OVERHEADS

Meaning
Apportionment of overheads is the process of charging the proportion of common items of cost to
two or more cost centers on some equitable basis (say Actual benefit/ Potential Benefit/Ability to
pay)

Examples of Apportionment of Overheads

a) Where only one electric meter is installed in a factory, the common electricity charges should
be apportioned to all the departments on the basis of no. of light points or floor area.
b) Factory Rent is incurred for the factory as a whole and benefits all the departments in the
factory. Hence, it should be apportioned to all the departments on the basis of floor area
occupied .

Basis of Apportionment of Overheads

The following table suggests the basis of apportionment of some common items of production
overheads:

Table Showing the Basis of Apportionment of some Common Items of Production

Overheads

97
 Common Items of Production Overheads Basis of Apportionment
a) Factory Rent, Rates & taxes Floor area occupied
b) Repairs & maintenance of factory building Floor area occupied
c) Insurance of factory building Floor area occupied
d) Depreciation of factory building (If owned) Floor area occupied
a) Repairs & maintenance of plant & machinery Capital cost of plant & machinery
b) Insurance of Plant & Machinery Capital cost of plant & machinery
c) Depreciation of Plant & Machinery Capital cost of plant & machinery
Insurance of stock Insured value of stock
a) Supervision No. of workers
b) Canteen, staff welfare expenses No. of workers
c) Time keeping & personnel office expenses No. of workers
a) Compensation to workers Wages
b) Employees' State Insurance Contribution Wages
c) Provident Fund Contribution Wages
Stores overhead/Stores keeping expenses Value of direct materials
Material Handling charges Weight of direct materials
Lighting & Heating No. of light points or floor area occupied
Power/steam consumption Horse power of machines or machine hours

Format of Statement Showing the Apportionment of Overheads Statement showing the

Apportionment of Overheads

Statement showing the Apportionment of Overhead

Items of Overheads Basic of Production Service Departments
Apportioned Apportionment Departments
P1 ` P2 ` S1 ` S2 `
Fixed Power
Generation Cost Normal Capacity ..... ….. ….. …..
Variable Power Actual Power ….. ….. ….. …..
Generation Cost Consumption (kwh)
Lighting No. of Light Points ….. ….. ….. …..
Depreciation Asset Value ….. ….. ….. …..
Insurance Asset Value ….. …… ….. …..
Rent, Rates & Taxes Floor Area ….. ….. ….. …..
Repairs Floor Area ….. ….. ….. …..
Stores Overheads Direct Material ….. ….. ….. …..
Employee’s Insurance Direct Wages ….. ….. ….. …..
Charges
Staff Welfare Expenses No. of Workers ….. ….. ….. …..
Supervision Expenses No. of Workers ….. ….. ….. …..
Total Overheads Apportioned ….. ….. ….. …..

Qus 2.
D Ltd. has two production departments and two service departments and provides you the
following data:
Production Departments Service Departments
P1 P2 S1 S2
Direct Materials 40,000 30,000 20,000 10,000
Direct Wages 15,000 20,000 5,000 10,000
Floor Area (sq. 5,000 4,000 3,000 2,000

98
feet)
Value of Plant &
50,000 60,000 20,000 10,000
Machinery
Value of Stock 35,000 25,000 5,000 5,000
No. of workers 100 50 25 25
No of light points 200 50 25 25
Horse power of
50 25 15 10
machines
The indirect expenses for the period were:
Factory Rent, Rates, Taxes & Repairs ` 14,000
Depreciation, Insurances & Repairs machinery ` 28,000
Insurance of stock ` 700
Supervision & Staff welfare expenses `2,000
Stores Overheads ` 1,000
Lighting & Heating ` 3,000
Power ` 1,000
Required: Prepare the Statement showing the apportionment of overheads.

Ans: Statement showing the Apportionment of Overheads

Items of Overheads Basis of Total Production Deptt. Service Deptt.
Apportionment ` P1 P2 S1 S2
` ` ` `
1. Factory Rent, Rates, Floor Area 14,000 5,000 4,000 3,000 2,000
Taxes & Repairs
2. Depreciation Value of Plant 28,000 10,000 12,000 4,000 2,000
Insurance & Repair of & Machinery
Machinery
3. Insurance of stock Value of stock 700 350 250 50 50
4. Supervision & No. of workers 2,000 1,000 500 250 250
5. Stores overhead Value of Materials 1,000 400 300 200 100
6. Lighting & Heating No. of light points 3,000 2,000 500 250 250
7. Power H.P. of Machinery 1,000 500 250 150 100
49,700 19,250 17,800 7,900 4,750

Basis of Apportionment of Overheads of service Departments

The following table suggests the basis of apportionment of some common items of overheads of
service departments:
Service Department Basis
1. Purchase department Number of purchase orders or number of purchase
requisitions or value of materials purchased.
2. Stores department Number of material requisitions or value materials
issued .
3. Time-keeping department Pay-roll Number of employees or total labour hours or
department machine hours .
4. Personnel department, canteen, Number of employees or total wages.
welfare, Medical, recreation dept.
5. Repairs and maintenance Number of hours worked in each department.
6. Power house Meter reading or H.P. Hour for powers.
Meter reading or floor space for lighting, heat consumed.
7. Inspection Inspection hours or value of items inspected.

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8. Drawing office Number of drawings made or man-hours worked.
9. Accounts department Number of workers in each department
SECONDARY DISTRIBUTION OF OVERHEADS

Meaning of secondary Distribution of Overheads

Secondary distribution of overheads means the apportionment of overheads of service
departments among the production departments on some suitable basis.

Methods of secondary Distribution

Methods of Secondary
Distribution

Apportionment to Production Apportionment to both

Departments only Production and Service
Department

On Non-reciprocal basis On Reciprocal basis

1.Simultaneous Equation 2.Repeated Distribution 3.Trial and Error Method

Method Method

Apportionment to Production Departments only

Under this method, the costs of service departments are directly apportioned to production
departments only, ignoring the services rendered by one services department to another service
department.

Qus 3.
(Simple Method)
CAS Ltd., has three production departments and four service departments. The expenses for
department as per Primary Distribution Summary are as follows:

Production Departments: ` `
A 60,000
B 52,000
C 48,000 1,60,000

Service Departments ` `
Stores 8,000
Time-keeping and Accounts 6,000
Power 3,200
Canteen 2,000 19,200

The following information is also available in respect of the production departments

Dept. A Dept. B Dept. C
Horse power of Machine 300 300 200
Number of Workers 20 15 15
Value of stores requisition in (Rs.) 2,500 1,500 1,000

100
Required: Apportion the costs of service departments over the production departments

Ans: Statement showing the Secondary Distribution of Overheads

Production Departments
Basis of Total
Item of Cost A B C
Apportionment `
` ` `
Cost as per primary 1,60,000 60,000 52,000 48,000
distribution summary
Stores Value of stores
requisition (5:3:2) 8,000 4,000 2,400 1,600
Time-keeping No. of workers (4:3:3) 6,000 2,400 1,800 1,800
and Accounts
Power H.P. of Machine (3:3:2) 3,200 1,200 1,200 800
Canteen No. of workers (4:3:3) 2,000 800 600 600
1,79,200 68,400 58,000 52,800

Apportionment to both Production and Service Departments

Under this method the costs of a service department are apportioned to both production
departments and other service departments on some equitable basis. This may be done on
reciprocal basis or non-reciprocal basis.

Apportionment on Non-reciprocal basis/Step Ladder Method This method involves the

following three steps:

Practical Step involved in the Step Ladder method

Step 1 – Apportion the cost of first service department which serves the largest number of
departments to production departments and other service departments
Step 2 – Apportion the cost of second service department which serves the next largest number of
departments
Step 3- Continue this process till the cost of last service department is apportioned. Thus, the cost
of Last service department is apportioned only to the production departments

Tutorial Note: Some authors are of the view that the cost of service department with largest
amount of cost should be distributed first.

Qus 4.
PH Ltd. is a manufacturing company having three production departments, 'A', 'B' and 'C' and two
service departments 'X' and 'Y'. The following is the budget for April 2008:

Total ` A (`) B (`) C (`) X (`) Y (`)

Direct Material 1,000 2,000 4,000 2,000 1,000
Direct Wages 5,000 2,000 8,000 1,000 2,000
Factory Rent 4,000
Power 2,500
Depreciation 1,000
Other Overheads 9,000
Additional Information:
Area (sq. ft.) 500 250 500 250 500
Capital Value of assets (` lacs) 20 40 20 10 10
Machine-Hours 1,000 2,000 4,000 1,000 1,000

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Horse Power of machines 50 40 20 15 25

A technical assessment of the apportionment of expenses of service departments is as under:

A% B% C% D% E%
Service Deptt. 'X' 45 15 30 - 10
Service Deptt. 'Y' 60 35 - 5 -

Required:
(i). A Statement showing distribution of overheads to various departments
(ii). A statement showing re-distribution of service departments expenses to production
Departments.
(iii). Machine hour Rates of the production departments 'A', 'B' and 'C'.
Ans
(I) Statement showing Distribution of Overheads to Various Departments

Total A B C X Y
Item Basis
` ` ` ` ` `
Direct Materials Actual 3,000 - - - 2,000 1,000
Direct Wages Actual 3,000 - - - 1,000 2,000
Factory Rent Area 4,000 1,000 500 1,000 500 1,000
Power H.P. x M. Hrs. 2,500 500 800 800 150 250
Depreciation Cap., Value 1,000 200 400 200 100 100
Other Overheads Machine hrs. 9,000 1,000 2,000 4,000 1,000 1,000
Total Overheads Apportioned 22,500 2,700 3,700 6,000 4,750 5,350

(II) Redistribution of Service Department's Expenses

A B C X Y
Particulars Ratio
` ` ` ` `
Total Overheads 2,700 3,700 6,000 4,750 5,350
Deptt. X overhead apportioned (45: 15 : 30 : 10) 2,138 712 1,425 -4750 475
Deptt. Y overhead apportioned (60 : 35 : - : 5) 3,495 2,039 - 291 -5,825
Deptt. X overhead apportioned (45: 15 : 30 : 10) 131 44 87 -291 29
Deptt. Y overhead apportioned (60 : 35 : - : 5) 17 10 - 2 -29
Deptt. X overhead apportioned 1 - 1 -2 -
Total Overheads of Production Departments 8,482 6,505 7,513

(III) Machine Hour Rate

Machine Hours 1,000 2,000 4,000
Machine Hour Rate (`) 8.48 3.25 1.88
1,000 2,000

Qus 5.
A manufacturing company has three production departments and two service departments. The
summary of departmental expenses are distributed as under:

` `
Production Deptt.
P1 32,000
P2 26,000
P3 28,000 86,000
Service Deptt.

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S1 9,360
S2 12,000 21,360

The service department expenses are charged on the following percentage basis:
Production Deptt. Service Deptt.
Service P1 P2 P3 S1 S2
Deptt.
S1 20% 25% 35% - 20%
S2 25% 25% 40% 10% -

Prepare a statement showing the apportionment of expenses of two service departments in

production departments by simultaneous equation method.

Ans
Statement showing Secondary Distribution by simultaneous Equation Method:
P1 P2 P3 Total
Production Departments
(`) (`) (`) (`)
As per Primary distribution 32,000 26,000 28,000 86,000
Service Department SI [80% of 10,776] 2,155 2,694 3,771 8,620
Service Department S2 [90% of 14,155] 3,539 3,539 5,662 12,740
37,694 32,233 37,433 1,07,360

Working Note:
Let X = Total overheads of Department of S1
Y = total overheads of Department of S2
X = 9,360 + 0.1Y
Y = 12,000 + 0.2 X
Solving (1) and (2) above
X = 9,360 + 0.1 (12,000 + 0.2X]
X = 9,360 + 1200 + 0.02 X
0.98 X = 10560
X = 10560/0.98 = 10,776
Substituting the value of X in (2) above
Y = 12000 + 0.2 x 10776
Y = 12000 + 2155 = 14,155

Qus 6. Dec 2013

A manufacturing company has three production departments and two service departments. Given
below are the production overheads incurred in respect of each department :

Production Department Service Department

P `1 ,80,000 X `2,34,000
Q `1,70,000 Y `3,00,000
R `1 ,50,000

Service department overheads are proposed to be charged to production departments on the

following basis :

P Q R X Y
Service Department X 20% 40% 30% --- 10%
Service Department Y 40% 20% 20% 20% ---

103
You are required to prepare an overhead distribution summary. Apportion the overheads of the
service departments using simultaneous equation method.
(4marks)
DIVISION V: ABSORPTION OF PRODUCTION OVERHEADS

Meaning of Absorption of Overheads

Absorption of overheads is charging overheads from cost centres to products or services by means
of absorption rate which is calculated as follows:

Overheads Absorption Rate = Total overheads of the cost centre / Total quantum of the base

Methods of Absorption of Production Overheads

The various methods of absorption of production overheads include the following:
1. Percentage of Direct Material cost
2. Percentage of Direct Labour cost
3. Percentage of Prime cost
4. Direct Labour Hour rate
5. Machine Hour Rate
6. Rate per unit of Production
Let us discuss these methods one by one:

Percentage of Direct Material Cost Method

Meaning Under this method direct material cost is used as basis for overhead absorption
rate. The rate is calculated as follows:
Factory Overheads Rate = Amount of Production Overheads / Direct Material
Cost × 100
Suitability This method is suitable in the following cases:
a) Where the prices of materials do not fluctuate much.
b) Where the output is uniform i.e. only one kind of product is produced.
c) Where the proportion of overheads to total cost is insignificant.
Advantages a) It is suitable where the output is uniform.
b) It is suitable where the prices of materials do not calculate widely
Disadvantages a) It ignores the time factor while most fixed factory overheads vary with time.
b) Production Overheads like factory manager’s salary, rent & insurance of
factory building do not change with every change in direct material cost.
c) It is not suitable where material prices fluctuate widely
d) It ignores the distinction between jobs done by skilled workers and those
done by unskilled workers.
e) It ignores the distinction between jobs done by manual labour and those
done by machines.
Practical Factory overheads ` 12,000, Direct Material Cost ` 50,000 A Job No. 101
Example requires direct material cost of ` 5,000.
a) Overheads Rate = ` 12,000 / ` 50,000 × 100 = 24%
b) Overheads Absorbed by Job No 101 = 24% of ` 5,000 = ` 1,200

Percentage of Direct Labour Cost Method

Meaning Under this method machines hours are used as basis for overhead absorption
rate. The rate is calculated as follows:

Factory Overheads Rate = Amount of production Overheads / Direct Labour

Cost × 100
Suitability This method is suitable in the following cases:

104
 a) Where labour is the major factor of production
b) Where labour rates do not fluctuate widely
c) Where both labour employed and work done are of uniform type.
Advantages a) It takes into account time factor.
b) It is suitable where the labour rates do not fluctuate widely.
Disadvantages a) It does not give satisfactory results where the workers are paid on piece rate
basis.
b) It is not suitable where labour rates fluctuate widely
c) It ignores the distinction between the jobs done by skilled workers and those
done by unskilled workers.
d) It ignores the distinction between the jobs done by manual labour and those
done by machines.
Practical Factory overheads ` 12,000, Direct Labour Cost ` 1,00,000 Job No. 101 requires
Example direct labour cost of ` 10,000
a) Overheads Rate = ` 12,000 / ` 1,00,000 × 100 = 12%
b) Overheads absorbed by job No. 101 = 12% of ` 10,000 = ` 1,200

Percentage of Prime Cost Method

Meaning Under this method, prime cost is used as basis for overhead absorption rate. The
rate is calculated as follows:
Factory Overheads Rate : Amount of Production Overheads × Prime Cost × 100
Suitability This method is suitable in the following cases:
a) Where output is uniform.
b) Where both the quantity of direct materials and direct labour hours are
constant.
Advantages a) It takes into account both direct materials cost and direct labour cost which
give rise to overhead expenses.
Disadvantages a) It has the same disadvantages as the first two methods have.
b) In fact, the results are liable to be more misleading because of the cumulative
error of using both the labour and material cost as the basis of allocation of
overhead expenses, on neither of which they are already dependent.
Practical Factory overheads ` 12,000, prime cost ` 1,50,000, A job No. 1-1 requires prime
Example cost of ` 15,000:
a) Overheads Rate = ` 12,000 / ` 1,50,000 × 100 = 8%
b) Overheads absorbed by job no. 101 = 8% of ` 15,000 = ` 1,200

Direct Labour Hour Rate

Meaning Under this method, direct labour hours are used for overhead absorption rate.
The rate is calculated as follows:
Factory Overhead Rate = Amount of production Overheads / Direct Labour
Hours
Suitability This method is suitability where manual is a dominant factor of production.
Advantages a) It takes into account time factor.
b) It is suitable where manual labour is a dominant factor of production.
Disadvantages a) It ignores the distinction between the jobs done by skilled workers and done
by unskilled workers.
b) It ignores the distinction between the job done by manual labour and those
done by machines.
c) It requires the detailed records of labour.
Practical Factory overheads ` 12,000, direct labour hours 10,000, A job No. 101 requires
Example 1000 direct labour hours:
a) Overheads Rate = ` 12,000 / 10,000 hours = ` 1.20 per direct labour hour

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 b) Overheads absorbed by Job No. 101 = 1000 ×` 1.20 = ` 1,200

Machine Hour Rate

Meaning
Suitability This method is suitable where major portion of production is performed by
machinery.
Advantages a) It takes into account time factor.
b) It is suitable when major portion of production is performed by machines.
c) It facilitates the ascertainment of accurate and reliable costs.
d) The under-absorption of overheads would indicate the idle capacity of
machines.
Disadvantages a) It is not suitable where major part of production is done by manual labour.
b) It requires the detailed records of machines for each job or operation.
c) It is difficult to understand and calculate.
d) It is quite difficult to estimate machine hours in advance.
Practical Factory overheads ` 12,000, Machine Hours 1,000, A Job No. 101 requires 100
Example Machine hours:
a) Overhead Rate = ` 12,000 / 1,000 = ` 12 per machine hour
b) Overhead absorbed by Job No. 101 = 100 ×` 12 = `1 ,200

Rate per unit of production

Meaning Under this method, number of units of production is used as basis for overheads
absorption rate. The rate is calculated as follows:
Factory Overheads Rate = Amount of Production Overheads/No. of Units of
Production
Suitability This method is suitable where output is uniform i.e. only single product or few
grades of the same product are produced.
Advantages a) It is suitable where output is uniform.
Disadvantages a) It ignores the time factor.
b) It ignores the distinction between the jobs done by skilled workers and those
done by unskilled workers.
c) It ignores the distinction between the jobs done by manual labour and those
done by machine.

REQUISITES OF A GOOD METHOD OF ABSORPTION OF PRODUCTION OVERHEADS

A good method of absorption of production overheads should possess the following
characteristics:
1. It should be simple to understand and easy to adopt.
2. It should take into consideration the time factor.
3. It should distinguish between the work done by skilled workers and work done by unskilled
workers.
4. It should distinguish between the work done by manual labour and the work done by machine.
5. It should not cause very much under/over absorption of overheads to any cost centre.
6. It should be economical to use.
Format of Statement showing the computation of Machine Hour Rate Statement showing the
computation of Machine Hour Rate.

Qus 7.
The following information relates to the production department for a certain period in a factory:
Direct Materials consumed ` 75,000
Direct Wages ` 50,000
Production overheads ` 1,50,000

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Labour Hours 30,000 hours
Machine Hours 25,000 hours

For one Order No, 101 carried out in the department during the period, the relevant data were:
Direct Material consumed ` 14,000
Direct Wages `11,000
Machine hours worked 5000 hours
Labour hours worked 7000 hours

Required: Prepare a Comparative Statement of Cost of this order by using the following methods:
(i) Direct Material Cost Percentage; (ii) Direct Labour Cost Percentage; (iii) Prime Cost Percentage;
(iv) Labour Hour Rate; (v) Machine Hour Rate,

Solution:
Step 1 : Computation of Production Overhead Rate
Production Overheads 1,50,000
(i) Direct Material Cost Percentage = × 100 = × 100 = 200%
Direct Material Cost 75,000

Production Overheads 1,50,000

(ii) Direct Labour Cost Percentage = × 100 = × 100 = 300%
Direct Labour Cost 50,000

Production Overheads 1,50,000

(iii) Prime Cost Percentage = × 100 = 1,25,000 × 100 = 120%
Prime Cost

Production Overheads 1,50,000

(iv) Labour Hour Rate = × 100 = = ` 5 per labour hour
Direct Labour Hours 30,000

Production Overheads 1,50,000

(v) Machine Hour Rate = = × 100 = ` 6 per machine hour
Machine Hours 25,000

Step 2 : Comparative Statement of Cost of Order No.101

Particulars DMC% DLC% Prime Direct Machine

Cost % Labour Hour
Hour Rate Rate
` ` ` ` `
Direct Material Cost 14,000 14,000 14,000 14,000 14,000
Direct Labour Cost 11,000 11,000 11,000 11,000 11,000
Prime Cost 25,000 25,000 25,000 25,000 25,000
Production Overheads
200% of DMC 28,000 - - - -

Qus 8.
The budgeted expenses for the year are as follows:
Direct Material ` 9,000
Direct Wages @ ` 10 per hour ` 20,000
Direct expenses ` 1,000
Works Overheads ` 5,000
Administration Overheads ` 3,500
Work overheads are charged at labour hour rate and administration overheads are charged as
percentage on work cost.

The details of Job No. 101 are as follows:

Direct Materials ` 2,250
Direct Wages ` 5,000

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Direct Expenses ` 250

Required:
a) Calculate rate of absorption of administration overheads.
b) What price should be charged to Job No. 101 so as to earn 1/6th profit on sales.

Ans:-
Calculation of Rate of Absorption of Administration Overheads
Direct Material 9,000
Direct Wages 20,000
Direct Expenses 1,000
Work overheads 5,000
Work Cost 35,000
Administration overheads ` 3,500

Administration overheads as a percentage of Works Cost = Adm. overheads / Work Cost × 100
= 3,500 / 35,000 × 100 = 10%

Statement showing the Calculation of Selling price of job No. 101

Direct Material 2,250
Direct Wages 5,000
Direct Expenses 250
PRIME COST 7,500
Works overheads [500 ×` 2.50] 1,250
WORK COST 8,750
Administration overheads [10% of ` 8,750] 875
TOTAL COST 9,625
Add: Profit @ 1/6th on sales means 1/5th on cost 1,925
Selling Price 11,550

Working Notes:
i). Direct Labour hours = Direct wages / Rate of hourly wages = ` 20,000 / ` 10 = 2,000 labour
hours
ii). Rate of absorption of Works Overheads = Work overheads / Direct Labour hours
= ` 5,000 / 2,000 = ` 2.50 per labour hour

UNDER AND OVER ABSORPTION OF OVERHEADS

When may the situation of under/over absorption of overheads arise?

The situation of under/over absorption of overheads (or overhead variance) may arise where a
predetermined overhead rate is used to charge overheads.

Meaning of Under-absorption of Overheads

Under-absorption of overheads means that the amount of overheads absorbed in the production is
less than the amount of actual overheads incurred. For example, if overheads absorbed are `
1,00,000 and the actual overheads incurred are ` 1,50,000 there is under-absorption to the extent
of ` 50,000.

Meaning of Over-absorption of Overheads

Over-absorption of overheads means that the amount of overheads absorbed in the production is
more than the amount of actual overheads incurred. For example, if overheads absorbed are `

108
1,50,000 and the actual overheads incurred are `1,00,000 bra is over-absorption to the extent of `
50,000.

Causes of Under/over Absorption of Overheads

Under/over absorption of overheads may arise due to anyone or more of the following reasons:
(a) Wrong estimation of overhead expenses.
(b) Wrong estimation of output
(c) Wrong estimation of machine/labour hours to be worked
(d) Under/over utilization of production capacity
(e) Seasonal fluctuations in the overhead expenses in some particular industries.
(f) Unanticipated changes in Methods of production.

Treatment/Disposal of Under/Over Absorbed Overheads

The under/over absorbed overheads may be disposed off by anyone of the following three
methods:

1. Use of Supplementary Rate Method

(a) When to use this method is usually used
(i). When the amount of under/over absorption of overheads is quite large &
(ii). The under/over absorption of overheads is due to normal reasons like increase in
material prices/labour rates.

(b) How to calculate Supplementary of under/over absorbed overheads / Actual Base

Amount of under/over absorbed overheads

Supplementary rate =
Actual base

( c ) How to use

(i). In case of under-absorption The cost of Sales, Stocks of Finished Goods

(ii). In case of over-absorption
and Work-in-progress are increased by
applying positive supplementary rate.
The Cost of Sales, Stock of Finished Goods
and Work-in-progress are reduced by
applying negative supplementary rate.

Write off to Costing profit & Loss Account Method

(a) When to use: This method is usually used when:
(i). The amount of under/over absorbed overheads is not very large, or
(ii). The under/over absorption of overheads is due to abnormal reasons like defective
planning, idle capacity etc. In this case, even large amounts are written off to Profit Loss
Account.
(b) How to use the amount of under absorbed overheads is transferred to the debit of Costing
profit & Loss Account and the amount of over absorbed overheads is transferred to the credit
of Costing Profit & Loss Account.

2. Carry over to Next Accounting Period Method

When to use: This method is usually used when:
(a) The period of normal business cycle is more then 1 year and overhead rates are determined on
a long-term basis.
(b) In case of new projects more output in the next period(s) than that in initial stages is expected.

How to use : The amount of under absorbed overheads is transferred to the debit of Overhead

109
 Reserve/Suspense Account and the amount of over absorbed overheads is transferred to the
credit of Overhead Reserve/Suspense Account.

Qus 9.
Overheads actually incurred ` 1,50,000
Overheads absorbed ` 1,00,000
Goods sold 12,000 units
Stock of Finished Goods 11,000 units
Stock of Work-in-progress 1000 units (20% complete)
Unabsorbed overheads were due to rising price levels.

Required:- How would under-absorbed overheads be treated in cost accounts?

Ans:-

Step 1 - Under absorbed overheads = Actual overheads - Absorbed overheads

= ` 1,50,000 - ` 1,00,000 = ` 50,000

Step 2 – Total equivalent units = 12,000 + 11,000 + 20% of 10,000 = 25,000 units

Amount of under − absorbed overheads

Step 3 – Supplementary Rate =
Total equivalent units

Rs.50,000
= = `.2 per unit
25,000
Step 4 - Charging by Supplementary Rate:
Cost of Sales (12,000 units ×` 2) ` 24,000
Stock of Finished Goods (11,000 units ×` 2) ` 22,000
Stock of Work-in-progress (2000 units ×` 2) ` 4,000
`50,000
Step 5 – Journal Entry
Cost of Sales A/c Dr. ` 24,000
Finished Goods Ledger Control A/c Dr. `. 22,000
Work-in-progress Ledger Control A/c Dr. ` 4,000
To Overheads Control A/c ` 50,000

Qus 10.
X Ltd. which absorbs overheads at a pre-determined rate, provides you the following information :
Overhead actually incurred ` 2,25,000
Overhead absorbed ` 1,00,000
It was round that 60% of the unabsorbed overheads were due to defective planning.

Required: How would unabsorb overheads due to defective planning be treated in cost accounts?

Ans:
Step 1- Under-absorbed overheads = Actual overheads - Absorbed overheads
= ` 2, 25,000 - ` 1, 00,000 = ` 1, 25,000
Step 2 - 60% of unabsorbed overheads due to defective planning = 60% of ` 1, 25,000 = ` 75,000
Step 3- ` 75,000 should be transferred to Costing Profit & Loss Account
Step 4 - Journal entry
Costing Profit & Loss A/c Dr. ` 75,000
To Overheads Control A/c ` 75,000

110
Qus 11.
The total overhead expenses of a factory are ` 4,46,380. Taking into account the normal working of
the factory, overheads were recovered from production at ` 1.25 per hour. The actual hours
worked were 2,93,104. How would you proceed to close the books of account, assuming that
besides 7,800 units produced of which 7,000 were sold? There were 200 equivalent units in work-
in-progress.
On investigation, it was found that 50% of the unabsorbed overheads were on account of increase
in the cost of indirect material and indirect labour and the other 50% was due to factory's
inefficiency.
Ans:
Unabsorbed overheads: `
Overhead recovered from production = (2,93, 104hrs ×`1.25) = 3,66,380
Actual Overheads = 4,46,380
Unabsorbed Overheads = 80,000

Out of the total unabsorbed overheads of ` 80,000, 50% was due to increase in the cost of indirect
material and labour. The amount of ` 40,000 (50% of ` 80,000) should therefore, be charged to
units produced by means of supplementary rate.

Unabsorbed overhead = ` 40,000

Units produced = 8,000

Supplementary Rate = ` 40,000 / 8,000 = ` 5per unit'

Apportionment of Overheads:
The amount of overheads of ` 40,000 will be apportioned between cost of sales, finished goods
and work in progress as follows:
`
Cost of Sales Account = 7,000 × ` 5 = 35,000
Finished goods Account = 800 × ` 5 = 4,000
Work in progress Account = 200 × ` 5 = 1,000
= ` 40,000
The balance of ` 40,000(50% of 80,000) which represents unabsorbed overheads on account of
factory's inefficiency (an abnormal factor) should be transferred to Costing Profit and Loss
Account.

ACTUAL OVERHEAD RATES VS PRE -DETERMINED OVERHEAD RATES

Overhead absorption rate may be actual (i.e. based on actual figures) or pre-determined (i.e. based
on estimated figures).
Actual Overhead Rate
(a) Meaning Actual overhead Rate is that rate of overhead absorption which is calculated
after the actual overheads have been incurred.
(b) Computation It is calculated by dividing the actual overheads by the actual base.
(c) Formula Actual Overhead Rate = Actual Overheads for the period / Actual Base for the
period
(d) Limitations (i). It does not facilitate the prompt preparation of cost sheet! quotations.
(ii). It does not provide any basis for cost control.
(iii). It does not facilitate comparison of cost of one period with that of
another .period because it may fluctuate from period to period due to
fluctuations in the amount of overheads.
Pre-determined Overhead Rate

111
(a) Meaning Pre-determined overhead Rate is that rate of overhead absorption which is
calculated in advance before the incurrence of actual overheads, during the
Period in which it is to be used.
(b) Computation It is computed by dividing the budgeted overheads by the budgeted base.
(c) Formula Pre-determined Overhead Rate = Budgeted Overheads for the period /
Budgeted Base for the period
(d) Advantages The advantages of using Pre-determined rates are as follows:
(i). Prompt Cost Ascertainment The pre-determined rates help in prompt
cost ascertainment because these are computed in advance.
(ii). Cost Control The pre-determined rates help in cost control because
actual overheads can be compared with predetermined overheads
recovered.
(iii). Uniformity The pre-determined rates maintain uniformity by charging
overheads at uniform overhead rate for the full budget period and thus,
facilitates comparison of cost of one period with that of another period.
Distinction between Actual and Pre-determined Overhead Rate
Basis of Distinction Actual Overhead Rate Pre-determined Overhead Rate
1. Meaning Actual overhead rate is Pre-determined overhead rate is
calculated by dividing the actual calculated by dividing the budgeted
overheads by the actual base. overheads by the budgeted base.
2. Formula = Actual Overheads for the = Budgeted Overheads of the period
period / Actual Base for the / Budgeted base for the period.
period
3. Use of overheads Actual overheads are used. Budgeted overheads are used
4. Use of base Actual base is used Budgeted base is used
5. When computed? It is computed after the expenses It is computed before the expenses
have been incurred. are incurred.
6. Preparation of It does not facilities the prompt It facilitates the prompt preparation
cost preparation of cost of cost sheets/quotations.
sheets/Quotations sheet/quotations.
.
7. Cost control It does not facilitate cost control. It facilitates cost control by
comparison of actual overheads with
pre-determined overheads
recovered.

BLANKET OVERHEAD RATE VS DEPARTMENTAL OVERHEADS RATES

Overhead absorption rate may be blanket (i.e. single rate for the entire factory) or departmental
(i.e. separate rate for each department/cost centre).

Blanket Overhead Rate

Meaning Blanket Overhead Rate is the single rate of overhead absorption which is
computed for the entire factory.
Computation It is computed by dividing the total overheads or all departments/cost centres by
the total base for all departments/cost centres.
Formula Blanket Overhead Rate
= Total overheads for all departments/cost centres / Total base for all
departments/cost centres
Suitability It is suitable only under the following cases:
(i). Where only one product is produced
(ii). Where two or more products are produced but

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 a. all products pass through all departments, and
b. all products are processed for the same length of time in each department.
Limitations (i). It gives misleading and erroneous results where two or more products are
produced and all of these do not pass through all departments, for the uniform
length of time.
(ii). It does not facilitate the proper assessment of the performance of individual
departments or cost centres, and hence exercise of control becomes difficult.
(iii). It may over value work-in-progress if units included in work-in-progress do
not ass through all the departments.

Departmental Overheads Rate

(a) Meaning Departmental Overhead rate is a separate rate of overhead absorption which
is computed for each department/cost centre. Under this practice, there is
use of multiple rates. For example, separate rates may be calculated for
Production department, Service department, Cost centre, Product, Fixed
overheads, Variable overheads.
(b) Computation It is computed by dividing the total overheads of a department/ cost centre
by the base for that department/cost centre.
(c) Formula Departmental Overhead Rate = Total overheads of a department/cost centre
/ Base for that department/cost centre
(d) Suitability It is suitable where two or more products are produced and all of these do
not pass through all departments for the uniform length of time.
Distinction between Blanket Overhead Rate and Departmental Overhead Rates
Basis of Blanket overhead Rate Departmental Overhead Rates
Distinction
1. Meaning It is a single rate of overhead There are the separate rates of overhead
absorption computed for the absorption computed for each individual
entire factory. department/cost centre.
2. Single vs. Under this practice there is only Under this practice there are multiple
Multiple a single rate. rates.
3. Factory vs. It is computed for the entire These are computed for each of the
Departmental factory. departments.
4. Suitability It is suitable where one product These rates are suitable where two or
is manufactured or where work more products are manufactured and
performed is more or less where work per-formed in different
uniform. departments is different.
5. Formula Total overheads for all = Total overheads of a department/cost
departments/cost centres/Total centre / base for that department/cost
base for all departments/cost centre
centres
Qus 12.
From the following information calculate Actual and Pre-determined overhead absorption rates:
Budgeted Actual Budgeted Actual labour
Overheads overheads Labour hours
Deptt. A ` 50,000 ` 48,000 ` 5,000 ` 6,000
Deptt. B ` 25,000 ` 27,000 `10,000 `9,000
Ans:-
a) Actual overhead absorption rate = Actual overheads of a department / Actual labour hours of a
department
Deptt. A = 48,000 / 6,000 = ` 8 per hour
Deptt. B = 27,000 / 9,000 = ` 3 per hour

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 b) Budgeted overhead absorption rate = Budgeted overheads of a department / Budgeted labour
hours of a department
Deptt. A = ` 50,000 / 5,000 = ` 10 per hour
Deptt. B = ` 25,000 / 10,000 = ` 2.50 per hour

Qus 13.
From the following information calculate blanket and departmental overhead absorption rates:

Overheads Direct wages

Deptt. A `50,000 `25,000
Deptt. B `25,000 ` 50,000

Ans:
a) Blanket(or Single) overhead rate = Total Overheads for all departments / Total Direct wages of
all departments × 100
= ` 75,000 / ` 75,000 × 100 = 100%

b) Departmental Overhead rate = Total Overheads for a department / Total Direct Wages of a
department × 100
Deptt. A = ` 50,000 / ` 25,000 × 100 = 200%
Deptt. B = `25,000 / ` 50,000 × 100 = 50%

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 JUDGE URSELF

State with reason whether the following statements are True or False:
1. Allocation of overheads is the process of charging proportion of common items of overheads
to a particular cost centre.
2. Apportionment of overheads is the process of charging full amount of overheads to different
cost centres.
3. Absorption of overheads is the process of charging overheads to cost centres.
4. Charging a cost centre to those overheads which result only from the existence of that cost
centre is known as apportionment.
5. The code number given to factory overhead item is termed as Cost Account Number.
6. The code number given to Administration overhead item is termed as Standing Order
Number.
7. When actual overheads are less than the absorbed overheads, it is a case of under absorption.
8. In case the amount of under/over absorbed overheads is negligible, it is adjusted by
Supplementary Rate Method.
9. Under/over absorption of overheads arises only when actual overhead rates are used.
10. Under absorption of overheads decreases profit in Costing Books.
11. Under absorption of fixed overheads means the absence of capacity.

Explanatory Answers
Statemen True / Reason
t No. False
1. False Allocation of overheads is the process of charging the full amount of
overheads to a particular cost centre.
2. False Apportionment of overheads is the process of charging a proportion of
common item of overheads to different cost centres.
3. False Absorption of overheads is the process of charging overheads to products or
services.
4. False Charging a cost centre to those overheads which result only from the
existence of that cost centre is known as allocation
5. False The code number given to factory overhead item is termed as Standing
Order Number.
6. False The code number given to Administration overhead item is termed as Cost
Account Number.
7. False When actual overheads are less than the absorbed overheads. it is a case of
over-absorption.
8. False In case the amount of under/over absorbed overheads is negligible, it is
transferred to Costing Profit & Loss Account.
9. False Under/over absorption of overheads arises only when pre-determined
overhead rates are used.
10. False Under absorption of overheads decreases profit in financial books.
11. False Under absorption of fixed overheads means the existence of Idle capacity.

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 PAST EXAMINATION QUESTIONS

MULTIPLE CHOICE QUESTIONS

1. When the under or over absorbed overheads amount is significant, it should be disposed
off by
(a) Transferring to costing profit and loss account
(b) Using a supplementary rate
(c) Carry over to next year
(d) None of the above.

2. In element-wise classification of overheads, which one of the following is not included-

(a) Fixed overheads
(b) Indirect labour
(c) Indirect materials
(d) Indirect expenditure.

3. Absorption means-
(a) Charging of overheads to cost centers
(b) Charging of overheads to cost units
(c) Charging of overheads to cost centres or cost units
(d) None of the above.

Fill in the Blanks

(1) …….. is the allotment of proportion of items of cost of cost centre/cost units.
(2) The process of apportionment of factory overheads among production and service
department is called ……………… of factory overheads.

True and False / Correct and Incorrect

1. When the amount of under/over absorption is signification, it should be disposed off by

carrying over as a deferred charge to the next accounting year.

Answer : MCQs
Answers 1 2 3
Options (b) (a) (b)

Answers : Fill in the Blanks

1. Allocation
2. Departmentalisation

Answers : True/False
1. False, We should follow supplementary rate to show the effect in the over- heads itself.

116
 TRAIN UR BRAIN
1. The total cost of indirect materials, c) Cost Categories
indirect labour and indirect expense is d) Cost Sheet
called – 10. The process of distributing common costs
a) Material b) Labour on a proportionate basis is known as –
c) Overhead d) Cost sheet a) Cost Allocation
2. Overheads include – b) Cost Categories cost apportionment
a) Rent b) Electricity c) Cost sheet
c) Depreciation d) All of the above 11. Both allocation and apportionment of
3. ……………… includes all the indirect cost costs over the various production and
related to the manufacturing activities of service departments is done in the table
any company. known as –
a) Production b) Selling a) Primary Distribution Table
c) Distribution d) Fixed b) Secondary Distribution Table
4. All cost incurred for carrying out the c) Preliminary Distribution Table
administrative functions like formulation d) None of the above
of policy decision making etc. of the 12. ……….. method is used to apportion total
organization under – costs of service departments to production
a) Production Overhead departments.
b) Office and Administration Overhead a) Direct b) Step Ladder
c) Selling Overhead c) Trial and Error d) All of the above
d) Distribution Overhead 13. The recovery rate is calculated by dividing
5. ………. do not change with change in the overhead cost by the number of labour
production or activity. hours worked in the cost centre under –
a) Selling Overhead b) Fixed Overhead a) Prime Cost Method
c) Variable Overhead b) Labour Hour Rate Method
d) Distribution Overhead c) Machine Hour Rate method
6. Overheads which vary in direct proportion d) Production Unit Method
with change in level of activity is – 14. The decrease in the value of the asset due
a) Variable overheads to use, wear and tear and lapse of time is
b) Fixed Overheads known as –
c) Selling Overheads a) Depreciation b) Assets
d) Distribution Overheads c) Time
7. Those which can be controlled by the d) Diminishing Depreciation
management with proper care and 15. Warehouse expenses is an example of –
efficient planning are known as – a) Selling Overhead b) Fixed Overhead
a) Variable Cost b) Fixed cost b) Distribution Overhead
c) Controllable Cost c) Production Overhead
d) Uncontrollable Cost 16. Direct expenses is also known as –
8. Those costs which cannot be controlled by a) Period Cost b) Prime Cost
the management are not predictable in c) Variable Cost d) Chargeable Cost
nature are known as – 17. The process of redistribution of support
a) Controllable cost departments cost to operating
b) Uncontrollable Cost departments is called -
c) Fixed Costs a) Secondary distribution
d) Variable Costs b) Primary Distribution
9. The process of assigning manufacturing c) Classification
costs to various cost centres is referred to d) All of the above
as – 18. Where a cost is directly attributable to
a) Cost apportionment department, it is called -
b) Cost Allocation a) Departmentalization

117
 b) Allocation 28. When the under or over absorbed
c) Service Department overheads amount is significant, it should
d) Classification be disposed off by ___________
19. Overhead is classified on the basis of - a) Supplementary rate
a) Element b) Function b) Transfer to costing p/l account
c) Behaviour or Nature c) Both
d) All of the above d) None
20. Administration overheads include – 29. State whether the following statement is
a) Office rent, rates, taxes “True” or “False”
b) Salaries of administrative Staff Administration overheads are recovered
c) Audit and legal fees as a percentage of works cost.
d) All of the above a) True b) False
21. Packing and delivery charges is the item of 30. The process by which cost items are
– charged direct to a cost unit or cost centre
a) Distribution Overheads is called _________
b) Selling Overheads a) Absorption b) Apportionment
c) Administration Overheads c) Allocation d) Allotment
d) Production Overheads 31. Another name for direct expenses:
22. Which of the following is method of a) Period Cost b) Variable Cost
treatment of under/over absorption of c) Prime cost
overheads? d) Chargeable expenses
a) Carry forward to subsequent year 32. An organization is divided into number of
b) Application of supplementary rates departments and overheads are collected,
c) Write Off to costing profit and loss allocated or apportioned to respective
account departments is called ___________
d) Both (a) and (b) a) Service Departments
23. Administration overheads are generally b) Divisionalisation
absorbed as a percentage of – c) Departmentalization
a) Works Cost b) Labour Cost d) Classification
c) Prime Cost d) All of the above 33. A common absorption rate used
24. A cost centre which consist of person or throughout a factory for all jobs and units
group of persons is known as – of output irrespective of the departments
a) Operating Cost centre in which they were produced is called
b) Process Cost Centre _________
c) Personal Cost Centre a) Machine Hour Rate
d) Impersonal Cost Centre b) Department Absorption Rate
25. The apportionment of overheads of c) Overall absorption rate
service department among the production d) Blanket Absorption rate
department are known as – 34. Which of the following is not a method of
a) Secondary Distribution of overhead cost absorption?
b) Primary distribution of overhead a) Percentage of direct material cost
c) Territorial Distribution of overhead b) Machine hour rate
d) None of the above c) Labour Hour rate
26. Salary of a supervisor is an example of – d) Repeated distribution method
a) Production Method 35. Service departments costs should be
b) Selling overhead allocated to:
c) Administrative Overhead a) Only service departments
d) Manufacturing Overhead b) Only Production departments
27. Indirect cost can be classified as – c) Both Production and service
a) Indirect materials b) Indirect labour departments
c) Indirect expenses d) All of the above d) None of the production and service
departments

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36. Most suitable basis for apportioning a) 100% b) 200%
insurance of machine would be: c) 50% d) 150%
a) Floor Area
b) Value of Machines From the following information
c) No. of Workers Budgeted Budgeted
d) No. of Machines Overheads Labour
37. Blanket overhead rate is: hours
a) One single overhead absorption rate Deptt A ` 50,000 ` 5,000
for the whole factory Deptt B ` 25,000 ` 10,000
b) Rate which is blank or nil rate
c) Rate in which multiple overhead rates 45. Calculate Pre-determined overhead
are calculated for each production absorption rate of deptt. a:
department, service department etc. a) 12/h b) 10/h
d) Always a machine hour rate c) 2.5/h d) 5/h
38. Factory overheads includes: 46. Calculate Pre-determined overhead
a) All manufacturing costs absorption rate of deptt. B
b) All manufacturing costs except direct a) 12/h b) 10/h
materials and direct labor. c) 2.5/h d) 5/h
c) Indirect materials but not indirect
labor. The budgeted expenses for the year are as
d) Indirect labor but not indirect material follows: -
39. Prime cost means, Direct Material ` 9,000
a) Direct materials b) Direct labor Direct Wages @ ` 10 per hour ` 20,000
c) Direct materials and direct labor Direct expenses ` 1,000
d) Direct materials, direct labor and direct Works Overheads ` 5,000
expenses Administration Overheads ` 3,500
40. Rent of the business premises is, Work overheads are charged at labour hour
a) Fixed Cost b) Variable Cost rate administration overheads are charged
c) Semi-Variable Cost d) None of these as a percentage on work cost.
41. Apportionment of overheads of service The details of Job No 101 are as follows:
departments to production departments is Direct materials ` 2,250
called as, Direct wages ` 5,000
a) Primary distribution of overheads Direct Expenses ` 250
b) Secondary distribution of overheads
c) Allocation of overheads 47. Calculate rate of absorption of
d) Absorption of overheads administration overheads
a) 20% b) 30%
From the following information c) 10% d) 40%
Overheads Direct wages 48. What price should be charged to Job No
Deptt A ` 50,000 ` 25,000 101 so as to earn 1/6th profit on sales
Deptt B ` 25,000 ` 50,000 a) 12000 b) 11550
c) 13000 d) 14000
42. Calculate blanket absorption rate of the
factory Calculation Effective Machine Hours for the
a) 100% b) 200% purpose of computing Machine Rate in each
c) 50% d) 150% of the following alternative cases:
43. Calculate departmental overhead
absorption rate of deptt. A 49. Budgeted working hours 2400,
a) 100% b) 200% Maintenance hours 10%
c) 50% d) 150% a) 2160 b) 1980
44. Calculate departmental overhead c) 2400 d) 594
absorption rate of deptt. B

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50. Budgeted working hours 8 hours per day a) 50 b) 40
for 300 days, Maintenance hours 10% c) 60 d) 75
a) 2160 b) 1980
c) 2400 d) 594 57. Compute the machine hour rate from the
51. There are 13 holidays on account for following data:
festivals and holidays not falling on `
Sundays. The factory works 8 hours a day. Cost of Machine 1,00,000
Maintenance hour 10%. Installation charges 10,000
a) 2160 b) 1980 Estimated scrap value after the 5,000
c) 2400 d) 594 expiry of its life (15 years)
52. There are 12 holidays on account of General lighting for the shop 200
festivals and national holidays not falling per month
on Sundays and Saturdays. The factory Insurance premium for the 300
works 8 hours a day and 4 hours on machine per annum
Saturdays Maintenance hour 10%. Repairs and maintenance 960
a) 210 b) 1980 expenses per annum
c) 494 d) 520 Power consumption – 10 units 1,000
53. Total Working hours available per week per hour
44 hours Rate of power per 100 units 20
Maintenance hours included in above Estimated working hours per
4 hours annum – 2,200
Setting up time (productive) 5% This includes Setting-up time
Machine hour rate is worked out at the of 200 hours
beginning of a year on the basis of 13 Shop supervisor’s salary per 600
week period which is equal to 3 calender month
months.
The machine occupies 1/4th of the total
a) 2160 b) 1980
area of the shop. The supervisor is
c) 94 d) 520
expected to devote 1/5th of his time for
54. Total Working hours available per week
supervising the machine. General lighting
44 hours
expenses are to be apportioned on the
Maintenance hours included in above
basis of floor area.
4 hours
a) 8.95 b) 7.95
Setting up time (productive) 5%
c) 8.88 d) 9
Machine hour rate is worked out at the
58. Calculate the machine hour rate from the
beginning of a year on the basis of 13 week
following data:
period which is equal to 3 calender
`
months.
Cost of Machine 18,000
a) 2160 b) 1980
Cost of installation 2,000
c) 494 d) 520
Scrap value after 10 years 2,000
Calculate the cost of power per hour for the Rates and rent for a quarter for 600
purposes of computing Machine hour rate the shop
in each of the following alternative cases: General lighting 200 p.m.
Shop supervisor’s salary 6,000
Per quarter
55. Power consumption of machine during
Insurance premium for a 120 p.a.
production 10 units per hour at a cost of `
machine
4 per unit
Estimated repair 200 p.a.
a) 50 b) 40
Power 2 units per hour @ ` 150 per 100
c) 60 d) 70
units
56. Power consumption of machine during
Estimated working hours p.a. 2,000
operation 15 units. Rate of power per 100
The machine occupies 1/4th of the total
units
area of the shop. The supervisor is

120
 expected to devote 1/6th of his time for 66. Machine hour rate is not suitable for
supervising the machine. General lighting absorption of overheads if the work is
expenses are to be apportioned on the done mainly by machines
basis of floor area. a) True b) False
a) 8.95 b) 7.95 67. If the amount of under/absorption of
c) 6.66 d) 9 overheads is significant, it is transferred to
Costing Profit and Loss A/c
The following Information relates to the a) True b) False
activities of production department for a 68. Cost of tube used for packing tooth paste is
certain period in a factory: indirect material cost.
` a) True b) False
Materials Used 72,000 69. Cost of floppy disk used for office
Direct Wages 60,000
computer is administration overhead
Hours of Machine operation 20,000
Labour Hours worked 24,000
a) True b) False
Overheads chargeable to the 48,000 70. Fixed costs vary with volume rather than
department time.
One order carried out in the department a) True b) False
during the period, the relevant data were: 71. Variable Cost varies with time
` a) True b) False
Materials used 4,000 72. If the factory overheads for the month of
Labour Hours 1,650 April were ` 60000 and during the period
Direct Wages 3,300
150 workers worked for 25 days at 8
Machine Hours 1,200
hours per day then overhead absorption
Compute factory overhead rates of
rate as per direct labour hour will be
overheads by
a) 16 b) 300
c) 2 d) 400
59. Direct Labour Hour Rate Method
73. The budgeted overheads amounted to `
a) 2.4 b) 2
84,000. The budgeted and actual
c) 3 d) 4
production amounted to 20,000 and
60. Direct Labour Cost Rate Method
24,000 units respectively. This means that
a) 50% b) 60%
there will be,
c) 80% d) 100%
a) An under absorption of ` 16,800
61. Machine Hour Rate Method
b) An under absorption of ` 14,000
a) 2.4 b) 2
c) An under absorption of ` 16,800
c) 3 d) 4
d) An under absorption of ` 14,000
State whether each of the statement is True
or False, give reasons in brief. X Ltd. which absorbs overheads at a pre-
determined rate, provides you the
62. Allocation and apportionment of following information:
overheads is one and the same. Overheads actually incurred ` 1,50,000
a) True b) False Overheads absorbed ` 1,00,000
63. When actual overheads are more than the Goods sold 12,000 units
absorbed overheads, it is called as over Stock of finished goods 11,000 units
absorption of overheads Stock of Work-in-progress 10,000 units
a) True b) False (20%
64. Under/over absorption of overheads takes complete)
place only when a predetermined rate of Unabsorbed Overheads were due to rising
overheads is used. price levels.
a) True b) False
65. A blanket overhead rate means a single 74. Calculate under absorption of overheads
overhead rate for the entire factory. a) 60000 b) 50000
a) True b) False c) 10000 d) 100000

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75. Find equivalent units planning and the rest was attributed to
a) 30000 b) 40000 normal cost increase.
c) 25000 d) 80000
76. Calculate supplementary rate 81. Calculate under absorption of overheads
a) 2/u b) 3/u a) 60000 b) 50000
c) 4/u d) 5/u c) 80000 d) 10000
82. Find equivalent units
The total overheads expenses of a factory a) 8000 b) 40000
are ` 4,46,380. Taking into account the c) 25000 d) 80000
Normal working of the factory, overhead 83. Calculate supplementary rate
was recovered in production at ` 1.25 per a) 0.2/u b) 0.1/u
hour. The actual hours worked were c) 0.4/u d) 0.5/u
2,93,104. How would you proceed to close 84. Calculate the amount charged to Costing
the books of Accounts, assuming that Profit & Loss Account
besides 7,800 units produced of which a) 4000 b) 5000
7,000 were sold, there 200 Equivalent units c) 6000 d) 10000
in works-in-progress. On investigation, it 85. Directors remuneration and expenses
was found that 50% of the unabsorbed from a part of:
overhead was on account of increase a) Production overhead
materials and indirect labour and the b) Administration overhead
remaining 50% was due to factory c) Selling Overhead
inefficiency. d) Distribution Overhead
86. Salary of a foreman should be classified as
77. Calculate under absorption of overheads a:
a) 60000 b) 50000 a) Fixed Overhead
c) 80000 d) 100000 b) Variable Overhead
78. Find equivalents units c) Semi-Fixed or Semi-Variable overhead
a) 8000 b) 40000 d) None of the above
c) 25000 d) 80000 87. Which of the following is a service
79. Calculate supplementary rate department?
a) 2/u b) 3/u a) Refining department
c) 4/u d) 5/u b) Machining Department
80. Calculate the amount charged to Costing c) Receiving Department
Profit & Loss Account d) Finishing Department
a) 40000 b) 50000 88. Which method of absorption of factory
c) 80000 d) 100000 overheads do you suggest in a concern
which produces only one uniform item of
In a factory overheads of a particular product?
department are recovered on the basis of ` a) Percentage of direct wage basis
5 per machine hour. The total expenses b) Direct Labour hour rate
incurred and the actual machine hours for c) Machine Hour Rate
the department for the month of August d) A rate per unit of output
were ` 80,000 and 10,000 hours 89. Factory overhead should be absorbed on
respectively. Of the amount of ` 80,000, ` the basis of:
15,000 became payable due to an award of a) Relationship to cost incurred
the labour court and ` 5,000 was in respect b) Direct Labour hours
of expenses of the previous year booked in c) Direct Labour cost
the current month (August). Actual d) Machine hours
production was 40,000 units, of which 90. What is the basis for distribution of
30,000 units were sold. On analyzing the indirect material cost to various
reasons, It was found that 60% of the under departments?
absorbed overhead was due to defective a) Direct Allocation

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 b) Cost of direct materials consumed
c) Machine hours worked
d) Either of the three
91. Basis of apportionment of stores service
expenses is ________________.
a) Value of Material consumed.
b) Units of material consumed.
c) Units produced
d) None of the above
92. Basis of apportionment of welfare
department expenses is ____________
a) Wages of each department
b) Number of employees
c) Material consumed
d) Number of machineries
93. Under step method of re-apportionment
of costs of service departments, the cost
of last service department is apportioned
only to the _____________
a) Production Department
b) Service Department
c) Both a and b
d) None of the above
94. Machine hour rate is obtained dividing
the total running expense of a machine
during a particular period by the __________
a) Number of workers
b) Number of products produced
c) Number of machine hours
d) Wages
95. _____________ is the amount by which the
absorbed overheads fall short of the
actual amount of overheads incurred.
a) Over absorption of overheads
b) Under absorption of overheads
c) Overhead absorption
d) None of these
96. Which of the following is not a method of
cost absorption?
a) Percentage of direct material cost
b) Machine hour rate method
c) Labour hour rate method
d) Repeated distribution method
97. In element-wise classification of
overheads, which one of the following is
not included?
a) Indirect Materials b) Indirect labour
c) Fixed overheads
d) Indirect expenditure
98. Which of the following statement is
correct to relation to the term
“Overheads”?
a) Overheads are attributable or
traceable to particular job, process,
service, cost unit or cost centre and
hence treated as traceable costs.
b) Overheads cannot be allocated to any
specific job, process because they are
not capable of being identified with
specific job or process.
c) Overheads forms part of prime cost.
d) None of the above
99. Which of the following is not a production
cause of idle capacity?
a) Set-up and change-overtime
b) Lack of supervision and instruction.
c) Lack of materials and tools
d) Strike
100. In which of the following “Line of best fix”
is drawn to find out “variable overheads”
and “fixed overheads” out of “Semi-
variable” Overheads?
a) Graphical Presentation Method
b) Analytical Method
c) High & Low Point Method
d) Least Square Method
101. Idle Capacity = ………………………
a) Capacity Utilized (-) Practical Capacity
b) Practical Capacity (×) Capacity Utilized
c) Capacity Utilized (+) Practical Capacity
d) Practical Capacity (-) Capacity Utilized
102. Which of the following is correct
treatment for “bad debts” in cost
accounts?
a) A part of default amount is treated as
bad debts and is recovered as selling
overhead and absorbed in product
cost.
b) Bad debt forms part of the prime cost
of the product
c) If the bad debt is abnormal in nature,
the abnormal portion in excess of the
standard normal portion should be
excluded from cost accounts and
transferred to costing profit and loss
Account.
d) Either (a) or (c)
103. When _______________ is used on the basis of
budgeted overheads and the rate is
applied to the actual basis, the actual
overhead expenses may be different from
the charged overheads.
a) Predetermined rate
b) Actual rate method of absorption
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 c) Both a and b
d) None of these 1. c 2. d 3. a
104. Expenses incurred during production 4. b 5. b 6. a
other than direct materials and direct 7. c 8. b 9. b
labour are called ___________ factory 10. c 11. a 12. d
expenses; those charged to production on 13. b 14. a 15. c
estimated basis are called ______________. 16. d 17. a 18. c
a) Actual, Applied b) Applied, Actual 19. d 20. d 21. a
c) Indirect, Direct d) None of these 22. d 23. a 24. c
105. The per unit expense of the _____________ 25. a 26. d 27. d
portion factory overhead varies with the 28. a 29. a 30. c
volume of production while _____________ 31. d 32. c 33. d
portion remains the same with volume. 34. d 35. c 36. b
a) Variable, Fixed
37. a 38. b 39. d
b) Variable, Semi-Variable
40. a 41. b 42. a
c) Fixed, Variable
43. b 44. c 45. b
d) None of these
46. c 47. c 48. b
106. _______________ expenses are excluded from
cost. 49. a 50. a 51. a
a) Normal b) Abnormal 52. b 53. d 54. c
c) Both a and b d) None of these 55. b 56. d 57. b
107. Such expenses which are included even 58. c 59. b 60. c
though they are not incurred for taking 61. a 62. b 63. a
managerial decisions are called 64. a 65. a 66. b
____________. 67. b 68. b 69. a
a) Normal expenses b) Actual expenses 70. b 71. b 72. c
c) Imputed expenses 73. a 74. b 75. c
d) Notional Expenses 76. a 77. c 78. a
108. An overhead absorption (recovery) rate 79. d 80. a 81. d
is used to : ………………….. 82. b 83. b 84. c
a) Share out common costs over 85. b 86. c 87. c
benefiting cost centres. 88. d 89. a 90. a
b) Find the total overheads for a cost 91. a 92. b 93. a
centre 94. c 95. b 96. d
c) Charge overheads to products 97. c 98. b 99. d
d) Control overheads 100. d 101. d 102. d
109. The arrangement of various items of 103. a 104. a 105. c
overhead costs in logical groups having 106. b 107. d 108. c
regard to their nature is known as 109. d 110. a
………….
a) Absorption of overheads
b) Apportionment of overheads
c) Allocation of overheads
d) Classification of overheads
110. Maximum capacity of a plant refers to it:
………………..
a) Theoretical Capacity
b) Normal capacity
c) Practical Capacity
d) Capacity based on sales expectancy

ANSWERS

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CHAPTER 5
INTRODUCTION

The CIMA has defined marginal cost as ''the cost of one unit of product or service which would
be avoided if that unit were not produced or provided."

Marginal costing is a technique of decision making, which involves:

(a) Ascertainment of total costs
(b) Classification of costs into (i) Fixed and (ii) Variable
(c) Use of such information for analysis and decision making.

Thus, marginal costing is defined as the ascertainment of marginal cost and of the effect on profit
of changes in volume of type of output by differentiating between fixed costs and variable costs.

 Marginal costing is mainly concerned with providing of information to management to assist in

decision-making and to exercise control.

 Marginal costing is also known as variable costing or out of pocket costing.

The total cost is divided between variable and fixed cost. The variable cost per unit remains the
same. It is the cost directly connected with each unit produced and sold. When a unit is realized
and cost for that unit is incurred and paid, the excess of selling price per unit over variable cost per
unit is called contribution per unit.

Margin: Net operating profit divided by sales.

Marginal Cost: The amount of any given volume of output, by which aggregate variable costs
are changed if the volume of output is increased by one unit.

Marginal Cost = Variable Cost = Direct Labour + Direct Material + Direct Expenses +
Variable Overheads

FEATURES OF MARGINAL COSTING

1. Costs are separated into the fixed and variable elements and semi-varible costs are also
differentiated like-wise.

2. Only the variable costs are taken into account for computing the value of stocks of work-in-
progress and finished products.

3. Fixed costs are charged off to revenue wholly during the period in which they are incurred
and are not taken into account for valuing product cost/inventories.

4. Prices may be based on marginal costs and contribution, but in normal circumstances prices
would cover costs in total.

5. It combines the techniques of cost recording and cost reporting.

125
6. Profitability of departments or products is determined in terms of marginal contribution.

7. The unit cost of a product means the average variable cost of manufacturing the product.

8. Only the variable costs (marginal costs) are treated as the cost of the product.

9. The stock of finished goods and work-in-progress are valued at marginal cost only.

10. Prices are based on marginal cost plus contribution. Contribution is the difference between
selling price and variable cost.

Differential Cost: A difference in cost between any two alternatives. Also seen as Incremental
cost. Any cost that differs between alternatives in a decision making situation. In managerial
accounting, this term is synonymous with avoidable cost and relevant cost.

DIRECT COSTING
Direct costing is the practice of charging all direct cost to operations, processes or products,
leaving all indirect costs to be written off against profits in the period in which they arise. Under
direct costing the stocks are valued at direct costs, i.e., costs whether fixed or variable which can
be directly attributable to the cost units.

DIFFERENTIAL COSTING
Differential cost is the increase or decrease in total cost or the change in specified elements of
costs that result from any variation in operation. It represents an increase or decrease in total cost
resulting out of:
(a) Producing or distributing a few more or few less of the products.
(b) A change in the method of production or of distribution.
(c) An addition or deletion of production or a territory; and
(d) Selection of an addition sales channel.

Differential cost thus includes fixed and semi-variable expenses. It is difference between the total
costs of two alternatives. It is an ad hoc cost determined for the purpose of choosing between
competing alternatives, each with its own combination of income and costs. Differential cost many
be incremental or decremental.

INCREMENTAL COSTING
Incremental costs and revenue are the difference between costs and revenue for the
corresponding item under each alternative being considered.

For example: The incremental costs of increasing output from 1000 to 1100 units per week are
the additional costs of producing an extra 100 unit per week.
Incremental costs may or may not include fixed costs. If fixed costs change as a result of a decision,
the increase in costs represents an incremental cost. If fixed costs do not change as a result of a
decision, the incremental costs will be zero.
Incremental costs and revenues can be compared with economist’s concept of marginal cost and
marginal revenue. The main difference is that marginal cost/revenue represents the additional
cost/ revenue of one extra unit of output whereas incremental cost/revenue represents the
additional cost/revenue resulting from a group of additional unit of output.

126
ABSORPTION COSTING
Absorption Costing: A costing method that includes all manufacturing costs - direct materials,
direct labour and both variable and fixed manufacturing overhead – in the cost of a unit of
product. Absorption costing is also referred to as the full cost method.

Absorption costing technique is also known by other names as “Full costing” or “Traditional
costing”. According to this technique, all costs are recognized or identified with the products
manufactured. Both Fixed and variable costs of each product manufactured are taken into account
to ascertain the total cost.

Income Determination under Marginal and Absorption Costing

Under Marginal Costing, only factory overheads costs that tend to vary with volume are charged
to product cost in addition to prime cost. While evaluating inventory only direct materials, direct
labour and variable factory overheads are included and are considered as product costs.
Fixed factory overheads under direct or marginal costing are not included in inventory. It is
treated as a period cost and charged against revenue when incurred.

Under Absorption Costing, sometimes called full or conventional costing, all manufacturing
costs, both fixed and variable are charged to product costs.
Absorption Costing ` Marginal Costing `
Sales Revenue --- Sales Revenue ---
Less: Manufacturing expenses --- Less: All variable costs (both ---
(both fixed and variable) production and non-
production)
Gross profit --- Contribution ---
Less: Non-Production costs --- Less: All fixed cost (both ---
(both Fixed and variable) Production and non-
production)
PBT --- PBT ---
Less: Tax Provision --- Less: Tax Provision ---
Net Income --- Net Income ---

ABSORPTION COSTING vs. MARGINAL COSTING

Under marginal costing, it is presumed that variable costs are related to output and Fixed costs are
related to the period. Hence, the Fixed costs are charged off to the Profit and Loss Account.

Marginal Costing Format

Particulars Amount Amount
Sales Value xxx
Less: Variable Cost
Direct Materials Cost xxx
Direct Labour Cost xxx
Variable Factory OH and Selling & Distribution Overhead xxx
xxx xxx
Contribution = Sales – Variable Costs xxx
Less: Fixed cost
Fixed Factory Overheads xxx
Administration Overheads xxx
Fixed Selling & Distribution Overheads xxx
xxx xxx
Profit or Loss = Contribution – Fixed Costs xxx

127
 Absorption Costing Format
Particulars Product A Product B Product C Total
Sales Revenue xxx xxx xxx xxx
Less: Variable Costs xxx xxx xxx xxx
Contribution Xxx xxx xxx xxx
Less: Fixed Costs xxx
Profit xxx

DISTINCTION BETWEEN MARGINAL AND ABSOPRTION COSTING

Marginal Costing

(a) The fixed production overhead is treated a period cost. It is charged at the period for which it
is incurred.

(b) The opening and closing stocks are valued at variable production cost. The profit arrived
under marginal costing is realistic profit.

Absorption Costing
(a) The fixed production overhead recovery rate is calculated on the basis of normal production.
Overhead is charged on the quantity produced. Hence it is initially treated as product cost. If
the actual production quantity is different from budgeted quantity, then there may arise
under recovery or over recovery of fixed production overhead. It is finally adjusted with the
cost of sales.
(b) The opening/ closing stock is valued at total cost per unit (variable + fixed). Hence the profit
under absorption costing differs from profit under marginal costing.

The key differences can be summarised as under:

Basis of Difference Absorption Costing Marginal Costing

1. Charge Full costs (fixed and variable) Only variable costs are charged to
are charged to production. production.
2. Classification Expenses are classified on The classification is as per nature of
functional basis. expenses fixed and variable.
3. Consideration of Fixed costs are considered Fixed costs are considered as period
Cost inventariable costs. costs.
4. Focus The emphasis is on profit (sales The thrust is on contribution (sales
minus total cost). minus variable cost). Increase in
contribution means increase in profit.
5. Inventory Valuation Basis of inventory valuation Inventories are valued at marginal or
takes into account fixed variable cost.
component of overheads.
6. Overheads Since all overheads are On account of only variable overheads
Absorption absorbed to production, over- being absorbed to production, there'
recovery of overheads can be can be under recovery of overheads.
there.
7. Treatment of Over under-recovery of Actual fixed overheads are wholly
Overheads overheads can be transferred to transferred to Costing Profit and Loss
Costing Profit & Loss Account. Account.
8. Decision Making Product Costing depends on Product costing considers only the
total cost per unit. variable costs, hence decision making
is affected.

128
 CLASSROOM PRACTICE – LETS PLAY TOGETHER

Use of Absorption Costing Method for the Valuation of Finished Goods Inventory

When absorption costing method is used, production fixed overheads are charged to production
and are included in product costs. Consequently, the closing stocks are valued on total cost
(including fixed overheads) basis. The net effect is that the charge of fixed overheads to P/L
account gets reduced, if closing stock is greater than the opening stock. This situation has the effect
of inflating the profit for the period.

Where stock levels are likely to fluctuate significantly, profits may be distorted if calculated
on absorption costing basis. If marginal costing is used, since the fixed costs are charged to P/L
account as period cost, such a situation will not arise. The impact of using absorption costing on
profits can be summarized as under:

 When sales are equal to production, profits will be the same under absorption costing and
marginal costing.

 If production is higher than sales, the absorption costing will post higher profits than marginal
costing.

 If sales are in excess of production, absorption costing will show lower profits than marginal
costing.

Since profit calculation in absorption costing can produce strange result, the managers may
deliberately alter the stock levels to influence the profits if absorption costing is used. Hence, it is
true to say that if absorption costing method is used, managers have the incentive to over
produced to show better result.

LIMITATIONS OF MARGINAL COSTING

(i) Marginal cost assumes that all costs can be classified into fixed and variable but it is not so as
there are costs which are either fixed or variable. For example, various amenities provided to
workers may have no relation either to volume of production or time factor.

(ii) Contribution of a product itself is not a guide for optimum profitability unless it is linked with
the key factor.

(iii) Marginal costing ignores time factor and investment. For example, the marginal cost of two
jobs may be the same but the time taken for their completion and cost of machines used may
differ. The true cost of a job which takes longer time and uses costlier would be higher. This
fact is not disclosed by marginal costing.

(iv) The overheads of fixed nature cannot altogether be excluded particularly in large contracts
while valuing work-in-progress. In order to show and correct position fixed overheads have
to be included in work-in-progress.

(v) In the long run, the selling prices should be based on total cost, i.e., inclusive of fixed cost also.
In the short run or in special situation when a production is sold below the total cost,
customers may insist on the contribution of reduced prices forever which may not be
possible in all cases.

129
(vi) The main assumptions regarding behavior of costs are not true. The variable costs do not
remain constant per unit of output. There may be changes in the prices of raw materials,
wage rates etc., after a certain level of output has been reached due to shortage of material,
shortage of skilled labour, concessions of bulk purchases etc. Similarly, the fixed costs do not
remain static. They may change from one period to another. For example, salaries bill may go
up because of annual increments or due change in pay rate etc.

CONTRIBUTION

Contribution margin of a product is the difference between the selling price and its variable cost. It
is obtained by subtracting marginal cost from sales revenue of a given activity. The difference
between sales revenue and variable cost is called contribution since it contributes towards fixed
expenses and profit of the entire business.

It is also known as 'unit contribution margin' or 'marginal contribution per unit'.

In normal circumstances, selling prices contain an element of profit but there may be
circumstances, when products may have to be sold at cost or even at loss. Therefore, the character
of contributions will have the following composition under different circumstances:

(i) Selling price containing profit: Contribution = Fixed cost + Profit

(ii) Selling price at Cost: Contribution = Fixed Cost
(iii) Selling price at loss: Contribution = Fixed Cost – Loss

The contribution concept is based on the theory that the profit and fixed expenses of a business is
a joint cost which cannot be equitably apportioned to different segments of the business. The
concept of break-even analysis emerges out of this theory.

Product A Product B Product C

Sales Revenue Sales Revenue Sales Revenue
Less: Variable Cost Less: Variable Cost Less: Variable Cost
= Contribution = Contribution = Contribution

Fund Towards Fixed Cost and Profits

Example 1: Variable cost = ` 50,000; Fixed Cost = ` 20,000, Selling price = ` 80,000
Contribution = Selling price – Variable Cost = ` 80,000 - ` 50,000 = ` 30,000
Profit = Contribution – Fixed Cost = ` 30,000 - ` 20,000 = ` 10,000

Since, contribution exceeds fixed cost, the profit is of the magnitude of ` 10,000. Suppose the fixed
cost is ` 40,000 then the position shall be:

Contribution – Fixed Cost = Profit = `30,000 - ` 40,000 = - ` 10,000

The amount of ` 10,000 represents extent of loss since the fixed costs are more then the
contribution. At the level of fixed cost of ` 30,000, there shall be no profit and no loss.

C0ST-VOLUME-PROFIT ANALYSIS
The Cost-Volume-Profit (CVP) Analysis is the analysis of three variables cost, volume and profit. It
helps management in finding out the relationship of costs and revenues to profit. It is a managerial

130
tool showing the relationship between various ingredients of profit planning viz., cost, selling price
and volume of activity.

The CVP analysis is very useful in profit planning. This analysis has facilitated the achieving of
production and profit goals. As profit forecasting is possible in this accounting technique, CVP has
gained popularity. Analysis of cost-volume-profit involves consideration of the interplay of the
following factors:

(a) Changes in volume of sales;

(b) Changes in selling price;
(c) Changes in product costs per unit; and
(d) Changes in variable costs per unit; and
(e) Changes in total fixed costs.

The relationship between two or more of these factors may be

(i) Present in the form of reports and statements.
(ii) Shown in charts or graphs, or
(iii) Established in the form of mathematical deductions.

Importance of CVP Analysis

It provides the information about the following matters:

(i) The behavior of cost in relation to volume.
(ii) Volume of production or sales, where the business will break-even.
(iii) Sensitively of profits due to variation in output.
(iv) Amount of profit for a projected sales volume.
(v) Quantity of production and sales for a target profit level.

PROFIT-VOLUME RATIO

CVP analysis examines the behavior of total revenue, total costs and operating income as changes
occur in the ouput level, the selling price, the variable cost per unit, or the fixed cost of a product.

Contribution per Unit = Selling Price Per Unit – Variable Cost Per Unit

The fixed production and selling overhead is fixed cost in terms of amount. This amount will
continue to be the same at all levels of production and sales. The fixed overhead cost is net out of
contribution and then the balance is profit.

Sales value (Selling price per unit × No. of units) xxxx

Less: Variable Cost (Variable cost per unit × No. of units) xxxx
Contribution xxxx
Less: Fixed Costs xxxx
Profit xxxx

Contribution
P/V Ratio: It is called contribution to sales ratio (or profit volume ratio) = × 100
Sales

The P/V Ratio shows percentage of contribution to the sales value i.e. margin as percentage of
sales out of it the fixed cost is met and there is a profit.

Contribution = Sales Value × P/V Ratio

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P/V ratio is a relative ratio. It cannot be adopted independently. If it is studied in an isolated way,
it will not give much information. As fixed costs are not relevant in the calculation of P/V ratio,
erroneous conclusions may be arrived.

How to improve P/V Ratio

P/V Ratio can be improved by:
(i) Increasing the selling price.
(ii) By reducing the variable costs.
(iii) Reducing direct and variable costs by effectively utilizing men, machines and materials.
(iv) Switching the production to more profitable products showing a higher P/V ratio.

P/V Ratio
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐚𝐭𝐢𝐨𝐧
=
𝐒𝐚𝐥𝐞𝐬
Or
𝐒𝐚𝐥𝐞𝐬 – 𝐕𝐚𝐫𝐢𝐚𝐛𝐥𝐞𝐂𝐨𝐬𝐭𝐬
=
𝐒𝐚𝐥𝐞𝐬
Or
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
=
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬

Or
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐏𝐫𝐨𝐟𝐢𝐭
=
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐚𝐥𝐞𝐬

Que 1.
[Computation of P/V Ratio]
Calculate P/V Ratio in each of the following cases:
Case (a) Contribution ` 3, Sales ` 15
Case (b) Sales ` 10 and Variable Cost ` 4
Case (c) Variable Cost ` 4, and Contribution ` 4
Case (d) Variable Cost to Sales Ratio 40%
Case (e) Fixed Cost ` 2,000, Profit ` 400, Sales ` 6,000
Case (f) 2004 2005
Sales `4, 50,000 ` 5, 10,000
Profit ` 60,000 ` 75,000

Solution:
Contribution Rs. 3
Case (a) P/V Ratio = × 100 = Rs. 15×100 = 20%
Sales

Sales – Variable Cost Rs. 10 – Rs. 4

Case (b) P/V Ratio = × 100 = ×100 = 60%
Sales Rs. 10

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 Rs. 4
Case (c) P/V Ratio = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝐶𝑜𝑠𝑡+𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 × 100 = Rs. 4 + Rs. 4×100 =50%

Case (d) P/V Ratio = 100 – Variable Cost to sales Ratio =100 – 40 % = 60%

Fixed Cost – Profit Rs. 2000 + Rs. 400

Case (e) P/V Ratio = × 100 = ×100 = 40%
Sales Rs. 6,000

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 Change in Profit Rs. 75,000 – Rs. 60,000
Case (f) P/V Ratio = × 100 = ×100
Change in Sales Rs. 5,10,000
Rs. 15,000
= × 100 =25%
Rs. 60,000
Que 2.
[Computation of New P/V Ratio]
Selling Price per unit ` 10, Variable Cost per unit ` 4
Calculate P/V ratio in each of following cases:

(a). If selling price is reduced by 20%.

(b). If selling price is increased by 20%
(c). If variable cost is decreased by 25%
(d). If variable cost is increased by 25%
(e). If selling price and variable cost are reduced by 20% and 25% respectively.
(f). If selling price and variable cost are increased by 20% and 25%respectively.

Solution:

New selling Price-Variable Cost

New P/V Ratio = ×100
New Selling Price

(Rs. 10 – 20% of Rs. 10) – Rs. 4

(a) New P/V Ratio = ×100 =50%
(Rs. 10 – 20% of Rs. 10)

(Rs. 10 + 20% of Rs. 10) – Rs. 4 2

(b) New P/V Ratio = ×100 =663%
(Rs. 10 + 20% of Rs. 10)

Selling Price-New Variable Cost

New P/V Ratio = ×100
Selling Price

Rs. 10-(Rs. 4 – 25% of Rs. 4

(c) New P/V Ratio = ×100 =70 %
Rs. 10

Rs. 10-(Rs. 4 + 25% of Rs. 4

(d) New P/V Ratio = ×100 =50%
Rs. 10

New Selling Price-New Variable Cost

New P/V Ratio = ×100
New Selling Price

(Rs. 10 – 20 % of Rs. 10) – (Rs. 4 – 25% of Rs. 4)

(e) New P/V Ratio = ×100 = 62.5%
(Rs 10 – 20 % of Rs. 10)

(Rs. 10 + 20 % of Rs. 10) – (Rs. 4 + 25% of Rs. 4)

New P/V Ratio = = ×100 = 58.33%
(Rs 10 + 20 % of Rs. 10)

BREAK-EVEN ANALYSIS

Break-Even is the point where total revenue equals the total costs (variable and fixed). It is that
level of activity at which n enterprise makes neither a loss nor any profit. At this point or level, the
sales revenues are just equal to the costs incurred.

133
Methods for Determining Break-Even Points
Break even analysis may be conducted by the following two methods:
(i) Algebraic computations
(ii) Graphic presentations

Algebraic Methods
(i) Contribution Margin Approach

Fixed Cost
Break-Even Point (Units) = Contribution per Unit

Fixed Cost
Break-Even point (`) = P/V Ratio

Or = Break Even units × Selling price p.u.

Contribution
P/V Ratio = × 100
Sales

Fixed Cost +Desired Profit

Desired Sale = P/V Ratio
Desired sales or profit or fixed cost or to know variable cost we can use following equation
i.e.,
Sales * P/V Ratio = Total Fixed Cost – Profit

At Break-Even Point:
Contribution = Fixed Cost
Contribution – Fixed Cost = 0

B.E.P (in %) Fixed Costs

= Total Contribution× 100

Or

B.E.P.(in value )
= Total × 100
Sales (in value )

Or

B.E.P.(in units )
= Total × 100
Sales (in units )

At BEP, Total Costs = Total Sales ….i

𝐓𝐨𝐭𝐚𝐥 𝐂𝐨𝐬𝐭
∴ At BEP 𝐓𝐨𝐭𝐚𝐥 𝐒𝐚𝐥𝐞𝐬 = 1 ….ii

At BEP, Contribution = Fixed Cost ….iii

Fixed Cost
Or =1 ….iv
Total Contribution

(ii) Equation Technique

It is based on an income equation i.e.,

134
 Sales – Total costs = Net Profit
Breaking up total costs into fixed and variable,
Sales – Fixed costs – Variable cost = Net Profit
Sales = Fixed costs + Variable cost + Net Profit i.e., SP(S) = FC + VC (S) + P.

Where,
SP = Selling Price per unit
S = Number of units required to be sold to break-even
FC = Total fixed costs
VC = Variable cost per unit
P = Net Profit (Zero)
SP(S) = FC + VC (S) + 0
SP (S) – VC (S) = FC
Or, S(SP – VC) = FC FC
S = FC (SP – VC)

To calculate the level of sales required to earn a particular level of profits, the formula is:
Required Sales = (Fixed Cost + Desired Profit)/P/V ratio.

Assumptions of Break-Even Analysis

The Assumptions underlying break-even analysis are as below:

(i) All costs can be easily classified into fixed and variable components.
(ii) Both revenue of cost functions are linear over the range of activity under consideration.
(iii) Prices of output and input remain unchanged.
(iv) Productivity of the factors of production will remain the same.
(v) The state of technology and process of production will not change.
(vi) There will be no significant change in the levels of inventory.
(vii) In the case of a multi-product company, the sales mix will remain unchanged.

Que 3.
[Computation of New B.E.P]
Selling Price per unit ` 10, Variable Cost per unit ` 4, Fixed Costs ` 35,000
Calculate New B.E.P. in each of the following cases:

(a). If selling price is reduced by 20%.

(b). If variable cost is decreased by 25%.
(c). If fixed cost is increased by 20%.
(d). If selling price and variable cost are decreased by 20% and 25% respectively and fixed cost
is increased by 20%.

Solution:-
New Selling Price – Variable Cost
(a) New P/V Ratio = × 100
New Selling Price

(Rs 10 – 20% of Rs 100)– Rs 4

= × 100 = 50%
(Rs 10 – 20% of Rs 10)

Fixed Cost Rs.35,000

New B.E.P. = New P/V Ratio = = ` 70,000
50 %

135
 Selling Price –New Variable Cost
(b) New P/V Ratio = × 100
Selling Price

Rs 10 – (Rs 4 – 25% of Rs 4)
= × 100 = 70%
Rs.10

Fixed Cost Rs.35,000

New B.E.P. = New P/V Ratio = = `50,000
70 %

Rs 10 – Rs 4
(c) P/V Ratio = × 100 = 60%
Rs 10

New Fixed Costs Rs 35,000 + 20 % of Rs 35,000

New B.E.P. = = = ` 70,000
P/V Ratio 60%

New Selling Price – New Variable Cost

(d) New P/V Ratio = × 100
New Selling Price

(Rs 10 – 20% of Rs 10) – (Rs 4 – 25% of Rs 4)

= × 100 = 62.5%
Rs 10 – 20% of Rs 10

New Fixed Costs

New B.E.P. = New P/V Ratio

Rs 35,000 + 20% of Rs 35,000

= = ` 67,200
62.5%

BREAK-EVEN CHART

According to the Chartered Institute of Management Accountants, London, the Break-even chart
means, “A Chart which shows profit or loss at various levels of activity, the level at which neither
profit or nor loss is shown being termed as the break-even point”.
It is a graphic relationship between costs, volume and profits. It shows not only the BEP but
also the effects of costs and revenue at varying levels of sales. The Break-even chart can, therefore,
be more appropriately called the cost-volume-profit graph.

Computation of profit to earn a given level of profit

F+P
Output required to earn a given level of profit = O = S − V

Que 4.
Selling Price per unit ` 10, Variable cost per unit ` 6, Fixed Cost ` 2,000. Calculate the number of
units to be produced and sold to earn (a) zero profit (b) ` 400 (c) ` 500
Solution:
S = ` 10, V = ` 6, F = ` 2,000

F+P 2,000 + 0
(a). O = = = 500 units
S−V 10 −6

F+P 2,000 + 400

(b). O = S−V = = 600 Units
10 −6

F+P 2,000 + 500

(c). O = S−V = = 625 units
10 −6

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MARGIN OF SAFETY

Margin of safety is the excess of sales over the break-even sales. It may also be considered as the
excess of production over break-even point. It can be expressed in value as well as in percentage.
The size of margin of safety shows the strength of the business. Small size of margin of safety
indicates that the firm has large fixed expenses and is more vulnerable to changes in sales.
In other words, if the margin of safety is large, a slight fall in sales may not affect the business very
much but when it is small then a slight fall in sales may adversely affect the business. The margin
of safety is calculated by using the following formula:

Proift Profit
Margin of Safety = or
P/V Ratio (Contribution + Sales )

Margin of safety is also immensely useful for making inter-firm comparison. This is being done by
calculating their margin of safety ratio. This ratio can be calculated by using the following formula:

Marg in of Safety Actual Sales −Break Even Sales

Margin of Safety Ratio = × 100 = × 100
Sales Sales

The soundness of a business is gauged by the size of the margin of safety. A low margin of safety
usually indicates high fixed overheads so that profits are not made until there is a high level of
activity to absorb fixed costs.
A high margin of safety shows that break-even point is much· below the actual sales, so that even if
there is a fall in sales, there will still be a point. A low margin of safety is accompanied by high fixed
costs, so action is called for reducing the fixed costs or increasing sales volume.

Measures for Improving Margin of Safety

Margin of Safety can be improved by taking the following measures:

(i) Increasing the selling price, provided the demand is inelastic so as to absorb the increased
prices.
(ii) Reduction in fixed expenses.
(iii) Reduction in variable expenses.
(iv) Increasing the sales volume provided capacity is available.
(v) Substitution or introduction of a product mixes such that more profitable lines are
introduced.

Que 5. [Computation of Margin of Safety]

Selling Price per unit ` 10, Variable Cost per unit ` 6

Fixed Cost ` 2,000, Actual Sales ` 20,000
Calculate Margin of Safety (in units).Margin of Safety (in value) and Margin of Safety (In %).

Solution: - Marginal Cost-Sheet

A. Actual Sales (in units) 2,000
B. selling Price Per unit ` 10
C. Total Sales (A × B) ` 20,000
D. Less: Total Variable Cost (2000 × ` 6) ` 12,000
E. Total Contribution (C - D) ` 8,000
F. Less: Fixed Costs ` 2,000
G. Profit ` 6,000

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Margin of Safety Profit Rs 6,000
= Contribution = Rs 10 – Rs 6 = 1500 units
per unit
(in units)
Margin of Safety Profit
= Contribution per unit × Selling Price per unit
(in value)
Rs 6,000
= Rs 10 − Rs 6 × ` 10 = ` 15,000

Margin of Safety Margin of Safety (in units)

= × 100
Actual Sales (in units)
(In %)
1500
= 2000 × 100 = 75%
Or,

Margin of Safety (in Value)

= ×100
Actual Sales (in units)

Rs 15,000
= × 100 =75%
Rs.20,000
Or

Profit Rs 6,000
=Total Contribution × 100 = Rs 8,000 × 100 = 75%

Que 6.
The following information is given by Bharat Ltd.
Selling Price per unit ` 10, Variable Cost per unit ` 6, Fixed Costs ` 24,000

You are required to calculate:

a) Profit-Volume Ratio
b) Break-even Sales (in units) and (in rupees)
c) Profit when sales are 10% above the Break-even Sales
d) Sales to earn profit of ` 4,000
e) Sales to earn profit of ` 2 per unit
f) New B.E.P. if selling price is reduced by 10%
g) Margin of Safety sales if profit is ` 60,000.

Solution:-
(a) Profit – Volume Ratio = Contribution / Sales × 100 = ` 10 – ` 6 / ` 10 × 100 = 40%
(b) B.E.P. (in units) = Fixed Costs / Contribution per unit = ` 24,000 / ` 4 = 6,000 units
B.E.P. (in Rs) = Fixed Costs / P/V Ratio = ` 24,000 / 40% = ` 60,000
(c) rofit When Sales are 6,600 units (i.e. 6,000 + 10% of 6,000)
A. No. of Sales units 6,600
B. Selling Price per unit ` 10
C. Total Sales ` 66,000
D. Less: Variable Cost (6,600 × ` 6) ` 39,600
E. Contribution ` 26,400
F. Less: Fixed Costs ` 24,000
G. Profit ` 2,400

Alternatively Profit on 600 units = (600 × ` 10) × 40% = ` 2,400

(d) Sales to earn a profit of ` 4,000

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 Desired Sales (in Units) = Fixed Cost + Desired Profit / Contribution per unit

Rs 24,000 + Rs 4,000
= = 7,000 units.
Rs 4
Fixed Cost + Desired Profit
Desired Sales (in units) = = ` 70,000
P/V Ratio

(e) Sales to earn a profit of ` 2 per unit

Let Desired Sales be x and hence Desired Profit is ` 2x.
Desired Sales (in units) x = Fixed Cost + Desired Profit / Contribution Per Unit
= ` 24,000 + ` 2x / ` 4
x = ` 24,000/2 = 12,000 units.
Desired Sales (in `) = 12,000 × ` 10 = ` 1,20,000

(f) New Contribution = (` 10 - ` 1) – ` 6 = ` 3

B.E.P. (in units) = Fixed Costs / Contribution Per Unit = Rs 24,000 / Rs 3 = 8,000 units

Fixed Costs
B.EP. (in `) = Contribution Per unit × Selling Price per unit

24,000
= × ` 9 = ` 72,000
3

Profit
(g) Margin of Safety = P/V Ratio

60,000
= = ` 1,50,000
40%

ANGLE OF INCIDENCE
The angle between the total cost line and total sales line shows the angle of incidence. It is an
indicator of profitability above the break-even point. If the angle is large, the firm is said to make
profits at a high rate and vice-versa. A high angle of incidence and a large margin of safety indicate
sound business conditions.
Example 3: DAKSH Ltd. provides the following data:
Sales: ` 4,00,000, Variable costs: ` 2,40,000, Fixed costs: ` 1,00,000 and Net Profit : ` 60,000.
Required: Draw a Profit-Volume graph and show the angle of incidence.

Solution:

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From the above graph, the following data can be calculated:

P/V Ratio = Sales – Variable Expenses × 100/Sales

= (` 4,00,000 - ` 2,00,000 × 100)/ ` 4,00,000
= (` 1,60,000 × 100) / ` 4,00,000 = 40%

BEP = Fixed Cost/ P/V Ratio = (` 1,00,000 × 100)/40 = ` 2,50,000

Margin of Safety = Profit / P/V Ratio = ` 60,000/40%

= ` 60,000 × 100/40 = ` 1,50,000

LIMITATIONS OF BREAK-EVEN POINT

Break-Even Point: It is the level of activity at which total only of the units equal total
revenue, leaving no profit of loss.

The limitations of a break-even chart are as follows:

(i) While preparing a break-even chart, it is assumed that revenue and costs can be
represented with the help of straight lines. It may not always be true.

(ii) The preparation of a break-even chart requires the segregation of semi-variable costs into
fixed and variable components. It may not always be possible to segregate semi-variable
costs into fixed and variable elements accurately. There may be situation when semi-
variable cost cannot be split.

(iii) A break-even chart assumes the selling price and variable cost per unit are constant at all
levels of activity. It may not always be ture. Selling price as well as variable cost may either
increase or decrease with the change in volume. Fixed costs also tend to vary beyond a
certain output.

(iv) When a firm produces a number of products the apportionment of fixed expenses over
various products may be difficult and often it may be done arbitrarily.
(v) A break-even chart assumes that business conditions will not change. This is hardly so.

(vi) A break-even chart does not consider the amount of capital employed in the business a very
important factor for determining profitability of a concern.

Que 7.
From the following information, you are required to find out (i) margin of safety; and (ii) volume
of sales required earning profit of 10% on sales:

Total fixed cost (`) 4,500

Total variable cost (`) 7,500
Total sales (`) 15,000
Sales (units) 5,000

Solution:
Sales−Variable Expenses
(i)Contribution per Unit = Units sold

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 Rs.15,000 − Rs.7,500
= = ` 1.5
5000
Fixed expense Rs.4,500
Break-even Point = Contribution per unit = = 3,000 units
Rs.1.5

Break-even Point Sales = 3,000 × ` 3 = ` 9,000

Margin of Safety = Actual Sales - Sales at Break-even Point

= ` 15,000 - ` 9,000 = ` 6,000
(ii) Let units sold be x.
Then the sales @ ` 3per unit will be = 3x
Now 3x = 1.5x + 4,500 + .3x
Or 1.2x = 4500 or x = 3750 units
Or ` 3 × 3,750 units = ` 11,250.
Volume of sales required to earn profit of 10% on sales = 3.750 units
Or 3,750 × ` 3 = ` 11,250.

CASH BREAK-EVEN POINT

When break-even point is calculated only with those fixed costs which are payable in cash, such a
break-even point is known as cash break-even point. This means that depreciation and other non-
cash fixed costs are excluded from the fixed costs in computing cash break-even point. Its formula
is –

𝐂𝐚𝐬𝐡 𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭𝐬

Cash break-even Point = 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

APPLICATIONS OF MARGINAL COSTING IN DECISION MAKING

PROFIT PLANNING
There are four ways in which profit performance of a business can be improved:
(a) By increasing volume;
(b) By increasing selling price;
(c) By decreasing variable costs; and
(d) By decreasing fixed costs.
Profit planning is the planning of future operations to attain maximum profit or to maintain a
specified level of profit. The contribution ratio (which is the ratio of marginal contribution to
sales) indicates the relative profitability of the different sectors of the business whenever there is a
change in selling price, variable costs or product mix.

Pricing decision in special circumstances

The problem of pricing can be summarized under three heads –

(a) Pricing in period of recession: During recession times, a firm may sell its articles at a price
less than the total cost but above the marginal cost for a limited period. This enables the
firm to produce and use the services of skilled employees who are well-trained, to avoid
deterioration of plant and machinery if kept idle, to keep the competitor away from
securing the business of the firm and to take advantage of improved business conditions at
a later date.

(b) Differential selling prices: There are two ways of doing this:

141
 (i) The firm producing the branded article which covers the entire fixed overheads and
uses the surplus capacity to produce another article which may be sold at a price
above its marginal cost.

(ii) A firm may produced and sell a branded article which covers the entire fixed
overheads and uses the surplus capacity to produced another article which may be
sold at a price above its marginal cost.

(c) Acceptance of an offer: When a firm having surplus capacity receives an offer from a
special or export market, a decision as to whether or not to accept the offer can be taken
after analysis of the incremental cost and incremental revenue.

Submission of Tender: For submitting tender also the incremental cost and incremental revenue
analysis is useful.

Make-or-buy Decisions: When the management is confronted with the problem whether it would
be economical to purchase a component or a product from outside sources, or to manufacture it
internally, marginal cost analysis renders useful assistance in the matter. Under such
circumstances, a misleading decision would be taken on the basis of the total cost analysis. In case
the proposal is to buy from outside, then what is already being made, and the price quoted by the
outsider should be lower than the marginal cost. If the proposal is to make something that is being
purchased outside, the cost of making should include all additional costs like depreciation on new
plant, interest on capital involved and that cost should be compared with the purchase price.

Retain or Replace Decision: There are three major methods to arrive at a decision whether
machine should be retained or replaced.
(a) Marginal costing approach
(b) Differential cost approach with interest on capital
(c) Discounted cash flow method.

Shut down or continue: Very often, it becomes necessary for a firm to temporarily close down the
factory due to trade recession with a view to reopen it in future. In such cases decisions should be
based on the marginal cost analysis.
Export vs. local sale: When the firm is catering to the needs of the local market and surplus
capacity is still available, it may think of utilising the same to meet export orders at a price lower
than that prevailing in the local market.

Change vs status quo: Any change regarding the firm or the decision to maintain status quo must
be taken after proper marginal cost analysis.

Expand or contract: Considerations should be given to the following:

(a) Additional fixed expenses to be incurred.
(b) Possible decrease in selling price due to increase in production.
(c) Whether the demand is sufficient to absorb the increased production.

Product Decisions: Many times the management has to take a decision whether to produce one
product or another instead.

KEY FACTOR OR LIMITING FACTOR

Key Factor or Limiting factor represents a resource whose availability is less than its requirement.
It is factor, which at a particular time or over a period limits the activities of a firm. It is also called

142
Critical Factor (since it is vital or critical to the firm’s success) and Budget Factor (since budgets
are formulated by reference to such limitations or restraints).

Examples of Key Factors: (a) Shortage of raw material; (b) Labour Shortage; (c) Plant capacity;
(d) Sales Expectancy; (e) Cash availability etc.

In case of key factor situation the procedure for decision-making is as under:

Steps Description
Step 1 Identify the key factor
Step 2 Compute total contribution or contribution per unit of the product.
Step 3 Compute contribution per unit of the key factor, i.e. Contribution per hour,
contribution per kg of raw material etc.
Step 4 Rank the products based on contribution per unit of the key factor.
Step 5 Allocate the key resources based on ranks given above.

To decide upon the priority of products, the following guidelines may be used:

Case Basis for deciding upon the priority of

products
(a) If maximum sales (in units) is s limiting (a). Contribution per unit
factor
(b) If maximum sales (in value) is a limiting (b). Profit-volume ratio (or P/V Ratio)
factor
(c) Of raw material is a limiting factor (c). Contribution per unit of raw material
required to produce one unit of a product
(d) If labour hour is a limiting factor (d). Contribution per unit of labour hour required
to produce one unit of a product
(e) If machine hour is a limiting factor (e). Contribution per unit of machine hour
required to produce one unit of a product
(f) If there is heavy demand for the product (f). Profit/Volume Ratio (or P/V Ratio)
(g) If there is low demand for the product (g). Low Break even point

Que 8. (Key Factor)

X Ltd. which produces two products using the same raw-material and production facilities,
provides you the following information:
Product A Product B
` `
Selling Price per unit 100 80
Material @ ` 2 per kg 20 10
Labour @ ` 3 per hour 15 30
Variable Overheads @ ` 4 per machine hour 40 16
Total fixed overheads: ` 6,00,000

Required: Comment on the profitability of each product when:

(a) Sales Quantity is limited;
(b) Sales Value is limited;
(c) Raw-material is in short supply;
(d) labour hours are limited;
(e) Production Capacity (in terms of Machine Hours) is limited;

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Solution:- Statement showing the Contribution per unit of key factor
Particulars Product A Product B
` `
A. Selling Price per unit 100 80
B. Less: Variable Cost
Material 20 10
Labour 15 30
Variable overheads 40 16
75 56
C. Contribution per unit (A - B) 25 24
Contribution
D. P/V Ratio × 100 25% 30%
Sales
E. Contribution per kg of Material
( Contribution per unit / Raw 25 24
`10 = ` 2.5 ` 5 = ` 4.8
material required per unit)
F. Contribution per labour hour
( Contribution per unit / Labour 25 24
`5 =`5 `10 = Rs. 2.4
hours required per unit)
G. Contribution per Machine hour
( Contribution per unit / Machine hrs 25 24
` = ` 2.5 `4 =`6
required per unit) 10
H. Break Even Point
6,00,000 6,00,000
(Fixed Overheads / Contribution per unit) ` 25
= 24,000 units ` 24
= 25,000 units

A) When sales quantity is limited, Product A is more profitable because its contribution per unit is
higher than that of Product B.

B) When sales value is limited, Product B is more profitable because its P/V Ratio is higher than
that of Product A.

C) When Raw- Material is in short supply, Product B is more profitable because its contribution
per kg. of raw material is higher than that of Product A.
D) When Labour hours are limited, Product A is more profitable because its contribution per
labour hour is higher than that of Product B.

E) When Production capacity in terms of machine hours is limited , Product B is more profitable
because its contribution per machine hour is higher than that of Product A.

Que 9.
You are given the following information in respect of products X and Y of Bee Cee Co. Ltd.
Product X Product Y
Selling price ` 42 ` 33
Direct material ` 15 ` 15
Labour hours (50 paise per hour) 18 hours 9 hours
Variable overheads 50% of Direct wages
Show which product is more profitable during labour shortage.

Solution:
Computation of Marginal Contribution
Product X Product Y
Selling price 42.00 33.00

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Less: Variable cost 28.50 21.75
Marginal contribution 13.50 11.25
Contribution
Profitability = Key factor

13.5
For product X = = 0.75
18

1125
For product Y = 9 = 1.25
Thus, product Y is more profitable than X during labour shortage.

Que 10. (Accepting an Offer or Exporting Below Normal Price)

The cost of a manufacturing company for the product is:
`
Materials 12.00
Labour 9.00
Variable expenses 6.00
Fixed expenses 18.00
Total 45.00

The unit of product is sold for ` 51. The company's normal capacity is 1, 00,000 units. The figures
given above are for 80,000 units. The company has received an offer for 20,000 units @ ` 36 per
unit from a foreign customer.
Advice the manufacturer on whether the order should be accepted. Also give your advice if the
order is from a local merchant.

Solution:
Marginal cost for additional 20,000 units
Per unit for 20,000 units
Material 12.00 2, 40,000
Labour 9.00 1, 80,000
Variable expenses 6.00 1, 20,000
Marginal cost 27.00 5, 40,000
Additional revenue to be realised 7, 20,000
Marginal cost 5, 40,000
Net additional revenue (Marginal contribution) 1, 80,000

The offer should be accepted because it gives an additional contribution of ` 1, 80,000. The total
profit will also increase by ` 1, 80,000 because fixed expenses have already been recovered from
the local market. Further some, the order from the local customer should not be accepted at ` 36
per unit or at any rate below the normal price i.e., ` 45 because it will result in the general
reduction of selling prices of the product.

Note: Acceptance of the additional order should not lead to production being in excess of the
present capacity since, in that case, some fixed expenses may also go up substantially. If there is
such an increase in fixed expenses, the increase should also be considered by inclusion in the total
additional cost to be compared with the additional revenue.
When alternative use of production facilities or alternative methods of manufacturing a product
are available, contribution analysis should be used to arrive at the final choice. The alternative
which will yield highest contribution shall generally and obviously be selected.

145
 Que 11. (Make or Buy)
Piquant Ltd. produces a variety of products, each having a number of component parts.
Component-B has a selling price of ` 50 and a marginal cost of ` 30 per unit. It takes 5 hours to
process on machine working to full capacity. Component A-10 used for Product-A could be made
on the same machine in 2 hours for a marginal cost of ` 5 per unit. The supplier's price is ` 12.50.
Should Piquant Ltd. make or buy Component A-10? Assume that machine hours are limited.

Solution:
Contribution per unit of Component B = ` 50 - ` 30 = ` 20
Rs.20
Contribution per machine hour = 5 = ` 4
If Component 'A-10' is produced, contribution lost = ` 4 × 2 = ` 8
So the full cost of producing one unit of component 'A-10' = ` 5 +8 = ` 13
Since it is available, in the market at ` 12.50, it is economical to buy Component A-10

COMPOSITE BREAK EVEN POINT

A business undertaking may have different manufacturing establishments each having its own
production capacity, and fixed costs but producing the same product. At the same time, the
concern as a whole is a unit having different establishments under the same management. Hence
the combined fixed costs have to be met by the combined BEP sales. In this analysis, there are two
approaches namely:

(i). Constant product mix approach.

(ii). Variable product mix approach.
Under the first approach, the ratio in which the products of the various establishments are mixed
is constant. This mix will be maintained at BEP sales also. Under the second approach the product
of that establishment would be preferred where the contribution ratio is higher. The above two
approaches are explained by the following illustration.

Que 12.
There are two plants manufacturing the same products under one corporate management which
decides to merge them.

Following particulars are available regarding the two plants:

Plant I Plant II
Capacity operation 100% 60%
Sales ` 6,00,00,000 ` 2,40,00,000
Variable costs ` 4,40,00,000 ` 1,80,00,000
Fixed costs ` 80,00,000 ` 40,00,000

You are required to calculate for the consideration of the Board of directors:
(a) What would be the capacity of merged plant to be operated for purpose of break-even?
(b) What would be the profitability on working at 75 per cent of the merged capacity?

Solution:
Note: Sales and variable costs of Plant II must be brought from 60% to 100% before merger of two
plants data at 100% capacity operation.

(a) Calculation of the Capacity of Merged Plant to Break-even at 100% Capacity.

146
 Contribution
P/V Ratio = × 100 = P/V Ratio
Sales

2,60,00,000
= 10,00,000 × 100 = 26 per cent.

Fixed Costs
Sales at Break-even Point = P/V Ratio

= `1,20,00,000 / 26%
= ` 4,61,53,846 (Approx.)

In terms of percentage capacity, sales at break-even point work out to 46.15 per cent
approximately.
4,61 ,53,846
(` × 100)
10,00,00,000

Workings Notes:
100
Sales at 100% capacity = ` 6, 00, 00,000 + ( 60 × ` 2, 40, 00,000)
= ` 10, 00, 00,000

Contribution at 100% capacity = (` 6, 00, 00,000 - ` 4, 40, 00,000)

100
+ ( 60 + ` 2, 40, 00,000)

100
- ( 60 + ` 1, 80, 00,000)

= ( ` 1, 60, 00,000) + ( ` 1, 00, 00,000)

= ` 2, 60, 00,000.

(b) Calculation of profit on working at 75% of the merged capacity.

Marginal Cost Statement

`
Sales (75% of `. 10, 00,000) 7,50,00,000
75% of (` 4, 40, 00,000) + 100/60 × ` 1, 80,00,000 5,55,00,000
Contribution 1, 95, 00,000
Less: Fixed Costs 1, 20, 00,000
Profit 75, 00,000

Que 13.
Two manufacturing companies which 'have the following operating details decided to merge:
Company - I Company II
Capacity utilisation (%) 90 60
Sales (` in lakhs) 540 300
Variable costs (` in lakhs) 396 225
Fixed costs (` in lakhs) 80 50

147
Assuming that the proposal in implemented, calculate-
1. Break-even sales of the merged plant and the capacity utilisation at that stage.
2. Profitability of the merged plant at 80% capacity utilisation.
3. Sales turnover of the merged plant to earn a profit of ` 75 lakh.

Solution:
1. Position of the Merged Plant at 100% capacity
Company I Company II Total
Sales 600 500 1,100
Less: Variable Costs 440 375 815
Contribution 160 125 285
Less: Fixed Costs. 80 50 130
Profit 80 75 155

P/V Ratio of the merged plant = [(Contribution + Sales) × (100)]

285
=1,100 × 100 = 25.909%
Fixed Cost 130 × 1,100
Break even sales of the merged plant = = ` 501.75 lakhs
P/V Ratio 285

501.75
Percent of capacity utilization = × 100 = 45.61%
1,100

2. Profitability of the merged plant at 80% capacity

` (Lakhs)
Sales (at 80% capacity i.e., 80% of ` 1,100 lakh) 880
Less: Variable Costs (80% of ` 815 lakh) 652
Contribution 228
Less: Fixed costs 130
Profit 98
OR
Total contribution at 80% capacity = 2851akh × 80% 228
Less: Fixed Costs 130
Profit
98 × 100
Profitability = 880 = 11.14% 98
3. Sales required to earn a profit of ` 75 lakh:

Fixed Cost + Desired Profit Rs.130 Lakh + Rs.75 lakh

=
P / V Ratio 285/1100
OR
205 × 1,100
= = ` 791.23 lakh
285

INDIFFERENCE POINT
It is level of sales at which total cost (and hence total profits) of two options are equal. The
decision-maker is indifferent as to option chosen since both options will result in the same amount
of profit.

Difference in Fixed Cost

Indifference Point (In `) = Difference in Variable cost ratio

Differnece in Fixed Cost

= Difference in PV Ratio

148
 Difference in Fixed Cost
Indifference Point (Quantity) = Difference in Variable Cost per Unit

Difference in Fixed Cost

= Difference in Contribution per unit

Indifference point represents a cut-off indicator for deciding on the most profitable option. At the
level of sales (i.e. indifference point)

Level of Sales Most Profitable Option to be Reason

(i) Below Indifference Point
(ii) At Indifference Point
(iii) Above indifference point
Option with lower fixed cost Lower the fixed cost, lower
will be the BEP, Hence more
profits beyond the BEP.
Both Options are equally Indifference point
profitable
Option with Higher PV ratio The higher the PV ratio the
(lower variable cost) better it is.

ASSUMPTIONS OF CVP ANALYSIS

(i) There is a linear function and a linear cost function.

(ii) Price, total fixed costs and unit variable costs can be accurately identified and remain
constant over the relevant range.
(iii) What is produced is sold.
(iv) For multiple product analysis, the sales mix is known.
(v) The selling price and costs are known with certainty.

CVP ANALYSIS UNDER RISK AND UNCERTAINTY

A variety of methods can be used by managers to cope with risk and uncertainty to apply CVP
analysis. Some of them are following:

1. Management must realize the uncertain nature of future prices, cost and quantities.
2. Managers should more away from consideration of break-even point to what might be
called a break-even band.
3. Managers may engage in sensitivity or what-if analysis.
4. Normal probability distribution can be used to estimate the risk.
5. Two concepts useful to management are margin to safety and operating leverage. Both
the concepts are considered as measures of risk.

149
 JUDGE URSELF

Que 14.
A product is sold at a price of ` 120 per unit and its variable cost are ` 80 per unit. The fixed
expenses of the business are ` 8,000 per year. Find (i) BEP in ` and units, (ii) profits made when
sales are 240 units, (iii) Sales to be made to earn a net profit of ` 5,000 for the year.

Que 15.
From the following figures ascertain the break-even sales.
`
Sales 20,00,000
Fixed Costs 5,00,000
Variable costs 12,00,000
Que 16.
The sales of a company are @ ` 200 per unit ` 20,00,000
Variable cost 12,00,000
Fixed cost 6,00,000
The capacity of the factory 15,000 units

Determine the BEP. How much profit is the company making?

Que 17.
Sales are ` 1, 50,000, producing a profit of ` 4,000 in period I. Sales are ` 1, 90,000, producing a
profit of ` 12,000 in period II. Determine the BEP.

Que 18.
A factory produces 300 units of a product per month. The selling price is ` 120 and variable cost `
80 per unit. The fixed expenses of the factory amount to ` 8,000 per month. Calculate: (i) the
estimated profit in a month wherein 240 units are produced, (ii) the sales to be made to earn a
profit of ` 7,000 per month.

Que 19.
A company has annual fixed cost of ` 1, 40, 00,000. In the year 2007 - 08, sales amounted to
` 6, 00, 00,000 as compared with ` 4, 50, 00,000, in the preceding year 2006-07. Profit in 2007-08
is ` 42,00,000 more than that in 2006-07. On the basis of the above information, answer the
following:

1. At what level of sales, the company would have break-even?

2. Determine profit/loss on a forecasted sales volume of ` 8, 00, 00,000.
3. If there is a reduction in selling price by 10% in the financial year 2008 - 09 and company
desires to earn the same amount of profit as in 2007 - 08, what would be the required sales
volume?

Que 20.
The sales turnover and profit during two periods were as follows.
Period-1 - Sales: ` 20 lakh; and Profit: ` 2 lakh
Period-2 - Sales: ` 30 lakhs; and Profit: ` 4 lakh

Calculate:
1. P/V ratio;
2. Sales required to earn a profit of ` 5 lakh; and
3. Profit when sales are ` 10 lakh.

150
Que 21.
A company sells its products at ` 15 per unit. In a period if it produces and sells 8,000 units, it
incurs a loss of ` 5 per unit if the volume is raised to 20,000 units; it earns a profit of ` 4 per unit.
Calculate break-even point in terms of rupees as well as in units.

Que 22.
Calculate the 'break-even-point' in units and in rupees and also arrive at 'margin of safety ratio'
from the following information:
`
Estimated sales (1,00,000 units) 20,00,000
Less: Variable cost 12,00,000
Fixed cost 4,00,000 16,00,000
Net profit 4,00,000

Que 23.
Dinesh Ltd. has provided following information:
Sale price ` 20 per unit
Variable cost ` 14 per unit
Fixed overheads ` 7, 92,000 per annum.
How many units must be sold to earn 10% of sales?

Que 24.
A company produces a single product and sells it at ` 200 each. The variable cost of the product is
` 120 per. unit and the fixed cost for the year is ` 96,000. Calculate:

1. P/V ratio.
2. Sales at break-even point.
3. Sales units required to earn a target net profit of ` 1, 20,000.
4. Sales units required to earn a target net profit of `1, 00,000 after income-tax, assuming
income-tax rate to be 50%.
5. Profit at sales of ` 7, 00,000.

Que 25.
Kaku Ltd. produces one standards type of article. The results of the last four months of the year
2013 are as follows:
Output units
September, 2013 200
October, 2013 300
November, 2013 400
December, 2013 600
Prime cost is `10 per unit. Variable expenses are `2 per unit. Fixed expenses are `36,000 per
annum. Find out the cost per unit in each month.
[Ans.: September: ` 27.00, October: `22.00,
November: `19.50, December: `17.00].
Que 26.
From the following data, which product would you recommend to be manufactured in a factory,
time being the key factor?

Per unit of Per unit of

Product A Product B
Direct material 24 14
Direct labour(`1 per hr.) 2 3

151
Variable overhead(`2 per hr.) 4 6
Selling price 100 110
[Ans.: Contribution per hour: A: `35 per hr., B: `29 per hr. Therefore product ‘A’ is recommended].

Que 27.
From the following information, find out the amount of profit earned during the year using the
marginal costing technique:
Fixed cost ` 5,00,000
Variable cost `10 per unit
Selling price `15 per unit
Output level 1,50,000 units
[Ans.: Profit: `2,50,000]
Que 28.
From the following data, recommend the most profitable product mix, presuming that direct
labour hours available are only 700:
Products
A B
Contribution per unit `30.00 `20.00
Direct labour per unit 10 hrs. 5 hrs.

The maximum production possible for each of the products A and B is 100 units. Fixed overheads
are`2,000.
[Ans.: Product A - 20 units, Product B - 100 units; Net Profit - `600]

Que 29.
A factory produces 1, 00,000 units and sells the whole quantity @ `40. The variable cost is `18
and the fixed cost is `5 per unit. An order is received for 20,000 units @ `26 per unit. State the
circumstance(s) in which the order should be accepted.
[Ans: If there is idle capacity and if the order is from govt. or from abroad]

Que 30.
A company produces a component for its main product at a cost of `15 per unit the operations are
heavily mechanised. An outsider offers to supply the component at 14, should the offer be
accepted?

Que 31.
You are given the following data for the coming year of a factory:
Budgeted output 80,000 units
Fixed expenses `4,00,000
Variable expenses per unit `10
Selling price per unit `20

Draw a break even chart showing the break-even point. If the selling price is reduced to `16 per
unit what will be the new break-even point?

Que 32.
(a) Explain P/V ratio.
(b) The sales turnover and profit during two periods were as follows:
Period No. 1 Sales `20 lakhs Profit `2 lakhs
Period No. 2 Sales `30 lakhs Profit ` 4 lakhs

(i) Calculate P/V Ratio,

(ii) The sales required to earn a profit of `5 lakhs.

152
Que 33.
From the following results of a company, determine by how much the value of sales must be
increased for the company to break-even?
Net sales `4,00,000
Fixed costs `2,00,000
Variable costs `2,40,000

Que 34.
Golden Ltd. has annual fixed cost of `1,20,000. In the year 2010 sales amounted to `6,00,000 as
compared with `4,50,000 in 2009 and the profit for 2010 was `50,000 higher than in 2009. You
are required to:

(i) Estimates profits for 2011 on forecast sales volume of `8,40,000 on the assumption that this
would not involve any addition to the company’s capacity; and
(ii) Calculate the break-even sales volume (in rupees) [Ans.: (i) `1,50,000 (ii) `3,60,000]

Que 35.
Following information are available from the cost records of a manufacturing company:
Fixed expenses `4,000
Break-even point `10,000

You are required to calculate:

(i) P/V ratio
(ii) Profit where sales are `20,000
(iii) New break even point if selling price is reduced by 20%.
[Ans.: (i) 40%; (ii) `4,000; (iii) `16,000].
Que 36.
From the following information, calculate the break-even point and the turnover required to earn
a profit of `36,000.
`
Fixed overheads 1,80,000
Variable cost per unit 2.00
Selling price 20.00
If the company is earning a profit of `36,000 express the margin of safety available to it.
[Ans.: 10,000 units; `2,40,000; `40,000]

Que 37.
Merry Manufacturers Ltd., has supplied you the following information in respect of one of its
products:
Total fixed costs 18,000
Total variable costs 30,000
Total sales 60,000
Unit sold 20,000
Find out:
(a) Contribution per unit,
(b) Break-even point,
(c) Margin of safety
(d) Profit and
(e) Volume of sales to earn a profit of `24,000.
[Ans.: (a) `1.50; (b) 12,000 units; (c) 8,000 units;
(d) `12,000; (e) 28,000 units].

153
 Que 38.
State, with reasons in brief, whether the following statements are true or false:
1. When a factory operates at full capacity, fixed cost also becomes relevant for make or buy
decision
2. Semi-variable costs are ignored in marginal costing.
3. ‘Cost volume profit relationship’ is a more comprehensive term than ‘break-even analysis.
4. Margin of safety is the difference of actual sale and standard sale.
5. Contribution is not only the criterion for deciding profitability.
Solution:
(i) True, (ii) False, (iii) True, (iv) False, (v) True]

Que 39.
Write the most appropriate answer from the given options in respect of the following:
(i). Product cost under marginal costing include —
(a) Prime cost only
(b) Prime cost and fixed overheads
(c) Prime cost and variable overheads
(d) Material cost and variable overheads.

(ii). Fixed cost per unit increases when ––

(a) Production volume decreases
(b) Production volume increases
(c) Variable cost per unit decreases
(d) Variable cost per unit increases.

(iii). The costing method in which fixed factory overheads are added to inventory is —
(a) Direct costing
(b) Marginal costing
(c) Absorption costing
(d) Activity based costing.

(iv). When the sales increase from `40,000 to `60,000 and profit increases by `5,000, the P/V
ratio is
(a) 20%
(b) 30%
(c) 25%
(d) 40%.

(v). A company which has a margin of safety of `4,00,000 makes a profit of `80,000. Its fixed
cost is ` 5,00,000, its break-even sales will be —
(a) `20 lakh
(b) `30 lakh
(c) `25 lakh
(d) `40 lakh.

(vi). Absorption means —

(a) Charging of overheads to cost centres
(b) Charging of overheads to cost units
(c) Charging of overheads to cost centres or cost units
(d) None of the above

(vii). Fixed costs remain fixed —

(a) Over a short period

154
 (b) Over a long period and within relevant range
(c) Over a short period and within a relevant range
(d) Over a long period.

Solution:
(i) (c), (ii) (a), (iii) (c), (iv) (c), (v) (c), (vi) (a) or (c), (vii) (c)

Que 40.
Re-write the following sentences after filling-in the blank spaces with appropriate word(s)/
figure(s) :
(a) At break-even point, the contribution will be equal to __________. (fixed costs)
(b) Excess of budgeted revenues over the break-even revenue is called__________, (Margin of
Safety)
(c) When there is no _______, profit figures revealed under marginal and absorption costing are
identical. (Inventories)

Que 41.
Explain Cost-Volume-Profit (CVP) analysis.

Answer:
Cost-Volume Profit Analysis: A producer always wishes to produce and sells a product till sales
revenue at least equal to marginal costs plus fixed costs. Marginal costs are closely connected with
volume and vary directly and proportionately with variations in volume.

On the other hand, fixed Costs remain constant and are not affected by the change in the volume of
production. Thus, the amount of profit on the sale of a product depends upon the volume of
production and its cost. Thus, we see that there is a close relationship between volume cost and
profit. When an effort is made to establish this relationship; that process is known as 'cost volume
profit analysis'. The cost volume profit analysis is an attempt to measure the effect of changes in :
(a) Volume of production
(b) Cost
(c) Price (selling) and
(d) Product mix on profit

155
 TRAIN UR BRAIN
1. Marginal Costing is important to 11. A large margin of safety means –
understand the relationship between cost, a) Over production
value, and profiting in - b) Under Production
a) Financial Accounting c) Under capitalization
b) Management Accounting d) The favourable condition of business
c) Cost Accounting 12. When contribution sales ratio is 30% and
d) Computerized Accounting margin of safety in 10%, then profit will be
2. In cost accounting marginal cost does not –
include – a) 10% b) 30%
a) Fixed Cost b) Variable Cost c) 12%
c) Inventory Cost d) Cannot be computed
d) None of the above 13. Margin of safety can be improved by
3. The profit volume ratio indicates – reducing the –
a) The value of profit a) Variable Cost b) Prime Cost
b) The value of sale c) Period Cost d) Fixed Cost
c) The rate of profit 14. When the firm neither earn profit nor
d) The rate of turnover incur loss, then it is known as -
4. Sales minus variable cost = Fixed cost plus a) Margin of safety b) P/V Ratio
– c) Break-even point
a) Purchase b) Profit d) None of the above
c) Variable Cost d) Loss 15. P/V ratios shows the relation between –
5. Total cost is equal to _________ at break- a) Fixed cost and sales
even point. b) Variable cost and sales
a) Purchase Value b) Inventory Value c) Profit and sales
c) Sales value d) Profit d) Contribution and sales
6. Profit is equal to – 16. Marginal costing is also known as -
a) P/V Ratio ÷ Margin of Safety Sales a) Direct Costing
b) P/V Ratio + Margin of Safety Sales b) Absorption Costing
c) P/V Ratio - Margin of Safety Sales c) Variable Cost
d) P/V Ratio × Margin of Safety Sales d) Variable Costing
7. Contribution minus ___________ Cost is 17. If the fixed cost exceeds the amount of
profit. contribution, it represents –
a) Fixed b) Prime a) Profit b) Loss
c) Variable d) Direct c) Surplus d) Deficit
8. Margin of safety sales indicates – 18. In ‘make or buy’ decisions, it is profitable
a) Total Sales ÷ Breaks even sales to buy from outside only when the
b) Total Sales × Breaks even sales suppliers price is below the firm’s own –
c) Total Sales + Breaks even sales a) Fixed Cost b) Variable Cost
d) Total Sales - Breaks even sales c) Contribution d) Profit
9. Break Even sales = 19. Marginal costing technique help in –
Fixed Cost a) Decision Making
a) P/V Ratio
Fixed Cost
b) Controlling costs
b) c) Both (a) and (b)
Total Cost × Sales
c)
Fixed Cost d) None of the above
Contribution per unit 20. An increase in variable cost –
P/V Ratio
d) Fixed Cost a) Reduces contribution
10. When value of production in nil, the loss b) Increases profit-volume ratio
will be equal to – c) Increase margin of safety
a) Prime cost b) Period cost d) None of the above
c) Fixed Cost d) Variable Cost

156
21. For make or buy decision variable cost c) ` 15,000 d) ` 20,000
should be compared with ________ price. 31. Sales ` 10,000, variable cost ` 6,000, fixed
a) Cost b) Invoice cost ` 2,000, P/V Ratio will be –
c) Market a) 10% b) 30%
d) None of the above c) 20% d) 40%
22. Contribution = 32. When break-even point is ` 10,000, profit
a) Sales + P/V Ratio is ` 500 and fixed cost is ` 2,000, then the
b) Sales - P/V Ratio variable cost will be –
c) Sales × P/V Ratio a) ` 5,000 b) ` 7,500
d) Sales ÷ P/V Ratio c) ` 10,000 d) ` 12,500
23. Break even is the point at which – 33. __________when sales is ` 1,00,000, fixed
a) TR > TC b) TR < TC cost is ` 15 and P/V Ratio is 40%, then
b) TR = TC profit will be –
c) None of the above a) ` 12,000 b) ` 25,000
24. A low margin of safety usually indicate c) ` 50,000 d) ` 80,000
high – 34. A company maintains a margin of safety of
a) Fixed cost 25% on its current sales and earns profit
b) Fixed overheads of ` 60 lakhs per annum. If the company
c) Fixed Income has a profit volume (PV) ratio of 40%, its
d) All of the above current sales amount to –
25. If total sales of a company is ` 9,60,000 a) ` 400 lakhs b ) ` 600 lakhs
and profit is ` 1,20,000 and contribution to c) ` 625 lakhs
sales ratio is 25%. Then fixed cost will be d) None of the above
– 35. If sales are ` 2 lakhs, fixed cost is ` 30,000
a) ` 1,50,000 b) ` 1,00,000 and P.V. ratio is 40%, the amount of profit
c) ` 1,20,000 d) ` 1,60,000 will be –
26. If the profit volume ratio of a company is a) ` 50,000 b) ` 80,000
40%, sales value is ` 2,00,000 and margin c) ` 20,000
of safety is 30%, then the net profit will be d) None of the above
– 36. X Ltd. has earned contribution of `
a) ` 20,000 b) ` 22,000 2,00,000 and profit of ` 1,50,000 on sales
c) ` 26,000 d) ` 24,000 of ` 8,00,000. What is the margin of safety?
27. The sales price per unit is ` 50 and the a) ` 5,75,000 b) ` 4,00,000
variable cost to sales percentage is 5%. If b) ` 7,00,000 d) ` 6,00,000
the fixed cost for a period is ` 5,00,000, 37. A company maintains a margin of safety of
then the required sales to earn profit of 25% on its current sales and earns a profit
10% on sales is – ` 15 lakhs annum. If the company has a PV
a) ` 10,00,000 b) ` 20,00,000 ratio of 40%, its current sales amount to –
c) ` 30,00,000 d) ` 40,00,000 a) ` 100 lakhs b) ` 150 lakhs
28. The fixed cost is ` 10,000, sales ` 80,000 c) ` 165 lakhs
and P/V ratio 30%. The amount of profit is d) None of the above
– 38. Selling price of a product is ` 5 per unit,
a) ` 7,000 b) ` 15,000 variable cost is ` 3 per unit and fixed cost
c) ` 14,000 d) ` 9,000 is ` 5,000. Then Break-even point in units
29. The selling price per unit ` 10, variable will be –
cost ` 6 per unit and fixed cost ` 8,000, the a) 5,000 b) 2,500
break even production in units will be – c) 3,750
a) ` 800 b) ` 2,000 d) None of the above
c) ` 3,000 d) ` 1,000 39. The P/V ratio of a product is 0.4 and the
30. Sales ` 10,000, variable cost ` 6,000, fixed selling price is ` 0 per unit. The marginal
cost is ` 2,000. Break even sales will be – cost of the product would be,
a) ` 5,000 b) ` 10,000 a) ` 8 b) ` 24

157
 c) ` 20 d) ` 25 c) 6000 d) Nil
40. The selling price is ` 20 per unit, variable 51. Calculate Break-Even point (in %)
cost ` 12 per unit, and fixed cost ` 16,000, a) 70% b) 50%
the breakeven point in units will be c) 20% d) 25%
a) 800 units b) 2000 units
c) 3000 units d) None of these Selling price per unit ` 10, Variable Cost per
unit ` 4, Fixed Costs ` 35,000
Calculate P/V Ratio in each of the following
cases: 52. Calculate New B.E.P if selling price is
reduced by 20%
41. Contribution ` 3, Sales ` 15 a) 80000 b) 70000
a) 60% b) 50% c) 50000 d) 35000
c) 20% d) 40% 53. Calculate New B.E.P if variable cost is
42. Sales ` 10 and Variable Cost `4 decreased by 25%
a) 60% b) 50% a) 80000 b) 70000
c) 20% d) 40% c) 50000 d) 35000
43. Variable Cost ` 4, and Contribution ` 4
a) 60% b) 50% X Ltd. provides you the following
c) 20% d) 40% information
44. Variable Cost to Sales Ratio 40% Fixed Expenses ` 4,000
a) 60% b) 50% Break Even Point ` 10,000
c) 20% d) 40%
45. Fixed Cost ` 2,000, Profit ` 400, Sales ` 54. Calculate P/V Ratio
6,000 a) 50% b) 60%
a) 60% b) 50% c) 40% d) 80%
c) 20% d) 40% 55. Profit when Sales are ` 20,000
a) 4000 b) 5000
Selling price per unit ` 10, Variable Cost per c) 6000 d) Nil
unit ` 4 56. Sales to earn profit of ` 6,000
Calculate P/V ratio in each of following a) 40000 b) 50000
cases: c) 20000 d) 25000
57. New Break Even Point if variable cost is
46. If selling price is reduced by 20% increased by 25%
a) 60% b) 50% a) 16000 b) 50000
c) 20% d) 40% c) 20000 d) 25000
47. If variable cost is increased by 25%
a) 70% b) 50% Selling price per unit ` 10, Variable Cost per
c) 20% d) 40% unit ` 6, Fixed Cost ` 2,000, Actual Sales `
48. If selling price and variable cost are 20,000
reduced by 20% and 25% respectively
a) 60% b) 50% 58. Calculate Margin of safety (in units)
c) 62.5% d) 40% a) 1000 units b) 2000 units
c) 1500 units d) 3000 units
Selling price per unit ` 10, Variable Cost per 59. Dinesh Ltd. has provided following
unit ` 6 information:
Fixed Cost ` 2,000, Actual Sales ` 20,000 Sale price ` 20 per unit
Variable Cost ` 14 per unit
49. Calculate Break-Even Point (in units) Fixed Overheads ` 7,92,000
a) 1000 units b) 2000 units per annum
c) 500 units d) 3000 units How many units must be sold to earn 10%
50. Calculate Break-even point (in value) of sales?
a) 5000 b) 8000 a) 200000 units b) 198000 units

158
 c) 300000 units d) 400000 units a) 25000 b) 39000
c) 24000 d) Nil
P/V Ratio 40% Margin of Safety 60%, Sales 70. A company makes a single product and
` 1,50,000 incurs fixed costs of ` 30,000 per annum.
Variable cost per unit is ` 5 and each unit
60. Calculate Break-Even Sales sells for ` 15. Annual sales demand is
a) 24000 b) 60000 7,000 units. The breakeven point is:
c) 36000 d) 40000 a) 2,000 units b) 3,000 units
61. Calculate Fixed Cost c) 4,000 units d) 6,000 units
a) 24000 b) 60000 71. A company makes a single product and
c) 36000 d) 40000 incurs fixed costs of ` 30,000 per annum.
62. Calculate Net Profit Variable cost per unit is ` 5 and each unit
a) 24000 b) 60000 sells for ` 15. Annual sales demand is
c) 36000 d) 40000 7,000 units. The Margin of safety sales
(units) is:
Selling Price per unit ` 12, Variable Cost per a) 2,000 units b) 3,000 units
unit ` 6 c) 4,000 units d) 6,000 units
Fixed Cost ` 2,400
A company produces a single product and sells
63. Calculate Break Even Point (in units) it at ` 200 each . The variable cost of the
a) 200 units b) 900 units product is ` 120 per unit and the fixed cost for
c) 300 units d) 400 units the year is ` 96,000.
64. Calculate Break Even Point (in value)
a) 5000 b) 4800 72. P/V ratio.
c) 4000 d) 8000 a) 50% b) 60%
65. A Company budgets a production of c) 40% d) 80%
10,000 units. The variable cost is 73. Sales at break-even point.
estimated at ` 2 per unit. The fixed costs a) 250000 b) 390000
are estimated ` 60,000. The selling price is c) 240000 d) Nil
fixed it earn a profit of 25% on cost. 74. Sales units required to earn a target net
Compute how many units must be profit of ` 1,00,000 after Income-tax,
produced and sold to earn a profit of ` assuming income-tax rate to be 50%.
60,000. a) 2,000 units b) 3,700 units
a) 20000 units b) 9000 units c) 2,700 units d) 6,000 units
c) 30000 units d) 15000 units 75. `
The Sales of a company are @ 20,00,000
A product is sold at a price of ` 120 per unit ` 200 per unit
and its variable cost is ` 80 per unit. The Variable cost 12,00,000
fixed expenses of the business are ` 8,000 Fixed cost 6,00,000
per year. The capacity of the factory 15,000
units
66. Find BEP in ` Determine the BEP (units)
a) 25000 b) 39000 a) 2,000 units b) 3,000 units
c) 24000 d) Nil c) 4,000 units d) 7,500 units
67. Find BEP in units
a) 200 units b) 900 units If the total fixed costs are ` 20,000 and
c) 300 units d) 400 units there are four products having a total sales
68. Profits made when sales are 240 units value of ` 1,00,000 and total variable costs
a) 1000 b) 1700 of ` 60,000.
c) 1060 d) 1600
69. Sales to be made to earn profit of ` 5,000 76. Calculate Composite P/V ratio
for the year. a) 50% b) 60%

159
 c) 40% d) 80% The annual saels of the company should be
77. Calculate Composite Break-Even Point ` ________ lakhs to have a Margin of Safety
a) 24000 b) 60000 of 25%.
c) 36000 d) 50000 a) 400 b) 500
c) 600 d) 700
84. The variable cost of product increases by
Two manufacturing companies have decided 10% and the management raise the unit
to merge into one company. The operating selling price by 10%. The fixed cost remain
details of two companies are as follows: unchanged. Then BEP of the firm _________
Company I Company II a) Increases b) Decreases
Percentage of capacity 90% 60% c) Remain the same d) Either a or b
utilization
85. A company maintains a margin of safety of
Sales (`) 5,40,00,000 3,00,00,000
Variable costs (`) 3,96,00,000 50,00,000 25% on its current sales and earns a profit
Assuming that these two companies merge of ` 30 lakhs per annum. If the company
into one, determine: has a profit volume (P/V) ratio of 40%, its
current sales amount to
78. The break-even sales of the merged a) ` 200 lakhs b) ` 300 lakhs
company utilization at the breakeven level c) ` 325 lakhs
a) ` 5,01,73,678 d) None of the above
b) ` 5,01,73,600 86. When the sales increase from ` 40,000 to
c) ` 5,01,73,700 `6 0,000 and profit increases by ` 5,000,
d) ` 5,01,73,800 the
79. The profitability of the merged company at a) 20% b) 30%
the 80% level of capacity utilization c) 25% d) 40%
a) ` 198,00,000 b) ` 298,00,000 87. Which of the below is the technique of
c) ` 98,00,000 d) ` 398,00,000 costing?
80. The turnover of the merged company a) Process Costing
required to earn a profit of ` 75,00,000 b) Contract costing
a) ` 398,00,000 b) ` 608,00,000 c) Marginal costing
c) ` 7,91,20,000 d) Nil d) Activity based costing
81. There are two factories under the same 88. Marginal costing provides required
management. It is desired to merge these information to _________ for enabling them
two factories. to take decisions.
The following information is available: a) Creditors b) Management
Factory A Factory B c) Bankers
Capacity Operation 100% 60% d) None of the above
Sales (`) 300 lakhs 120 lakhs 89. Marginal cost ______________ with
Variable costs (`) 220 lakhs 150 lakhs _____________ in output.
Fixed Cost 40 lakhs 20 lakhs a) Increases, Increase
Calculate the profit on working at 75% of b) Increases, Decrease
the merged capacity. c) Decreases, Decrease
a) 5000000 b) 3000000 d) Both (a) and (c)
c) 3750000 d) 9000000 90. Under Marginal costing fixed cost are
82. ABC Ltd. manufactures a single product assumed to __________________ with the
which it sells for ` 20 per unit. Fixed costs change in the level of production.
are ` 60,000 per annum. The contribution a) Remain constant b) Increase
to sales ratio is 40 percent. ABC Ltd. c) Change
breakdown d) None of the above
a) 7,500 b) 8,000 91. Under Marginal costing variable cost are
c) 7,000 d) 7,400 assumed to _____________ with the increase
83. A company’s fixed cost amounts to ` 120 in the level of production.
lakhs p.a. and its overall P/V ratio is 0.4. a) Remain constant b) Increase

160
 c) Change 76. C 77. d 78. a
d) None of the above 79. A 80. c 81. c
92. According to marginal costing 82. A 83. a 84. c
assumptions costs are influenced by 85. B 86. c 87. c
___________ mainly. 88. B 89. d 90. a
a) Output b) Selling price 91. B 92. a 93. d
c) Variable Cost d) Fixed Cost 94. A 95. a
93. Advantages of marginal costing are _______
a) Helps in managerial decisions
b) Simple technique
c) Cost Control
d) All of the above
94. Under Marginal costing variable cost are
assumed to ____________ with the decrease
in the level of production.
a) Decrease b) Increase
c) Change
d) None of the above
95. In _____________ costing both variable and
fixed cost are charged to products.
a) Absorption b) Marginal
c) Both (a) and (b)
d) None of the above

ANSWERS

1. B 2. b 3. c
4. B 5. c 6. d
7. D 8. d 9. a
10. C 11. d 12. d
13. D 14. c 15. d
16. D 17. b 18. b
19. C 20. a 21. c
22. C 23. c 24. b
25. C 26. d 27. b
28. C 29. b 30. a
31. D 32. c 33. b
34. B 35. a 36. d
37. B 38. b 39. b
40. B 41. c 42. a
43. B 44. a 45. d
46. B 47. a 48. c
49. C 50. a 51. d
52. B 53. c 54. c
55. A 56. d 57. a
58. C 59. b 60. b
61. A 62. c 63. d
64. B 65. d 66. c
67. A 68. d 69. b
70. B 71. c 72. c
73. C 74. b 75. d

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CHAPTER 6

RATIO AND ACCOUNTING RATIO

A Ratio is the numerical or an arithmetical relationship between two figures. It is expressed

when one figure is divided by another. Ratio when calculated on the basis of accounting
information, are called ‘Accounting Ratios’.

An Accounting Ratio may be defined as the mathematical expression of the relationship between
two accounting figures having a mutual cause and effect relationship. For example, the figure of
TURNOVER and GROSS PROFIT.

Ratio can be expressed as:

1. Percentage say, gross profit ratio is 20% of sales
2. Proportion say, current ratio is 2:1;
3. Fraction say, net profit is one-tenth of sales;
4. Times say, capital turnover ratio is 5 times.

MEANING OF RATIO ANALYSIS

Ratio analysis is the process of identifying the financial strengths and weakness of the enterprise
by logically establishing relationship between the items of Balance Sheet or Income Statement or
both to derive meaningful conclusions. The universally used technique for analysis of financial
statements in modern times is the 'Ratio Analysis'.

INTER- FIRM COMPARISON

Meaning –Inter – firm comparison involves the comparison of actual ratios of one firm with those
of other similar firms belonging to the same industry or industry averages at the same point of
time.
Examples – Let us compare the Net Profit Ratio of X Ltd with that of Y Ltd & Z Ltd and industry for
the year 2011.
X Ltd Y Ltd Z Ltd Industry
16% 18% 21% 19%

The above table clearly indicates that – Net Profit Ratio of X Ltd is less than that of Y Ltd., Z Ltd and
industry.
Purpose – The purpose of Cross-Sectional Analysis is to ascertain the relative position of the
enterprise in the industry and to identify the problem areas (if any).

TIME SERIES ANALYSIS

Meaning – Time Series Analysis involves the comparison of actual ratios of one period with those
of earlier periods for the same enterprise.

Examples – Let us analyse the Net profit Ratios of X Ltd over a period of 4 years:
2009 2010 2011 2012
20% 19% 18% 16%

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The above table clearly indicates that the Net Profit Ratio is declining over a period of 4 years.
Purposes – The purpose of Time Series Analysis is to observe the behaviour of the same ratio over
a given period of time.

BENCHMARKS

Benchmarks is a yardstick against which actual ratio is to be compared in order to make a

qualitative judgement about the various aspects of the financial position and performance of an
enterprise. Benchmark may be:

A past ratio of the same enterprise – a ratio could be compared with the past ratio of the same
enterprise. This type of comparisons is known as Intra-firm comparison as is done under Time
Series Analysis.

Ratio of Similar Firms – A ratio could be compared with the ratio of similar firms belonging to the
same industry at the same point of time. This type of comparison is known as inter-firm
comparison as is done under Cross Sectional Analysis.

Industry Average – A ratio could be compared with the industry average at the same point of
time. This type of comparison is known as pattern comparison as in done under Cross Sectional
Analysis.

Rule of Thumb – Rule of Thumb have evolved over a period of time. A ratio could be compared
with rule of thumb. However these rules of thumb should be used cautiously.

Ratio Rule Of Meaning

Thumb
1 Current ratio 2:1 Current Assets should be twice the Current Liabilities.
2 Quick ratio 1:1 Quick Assets should be equal to Current Liabilities.
3 Debt-Equity 2:1 Long-term Debts could be twice the Shareholders’ Funds.
ratio

IMPORTANCE OF RATIO ANALYSIS TO VARIOUS PARTIES INTERESTED IN FINANCIAL

STATEMENTS

The importance of Financial Statement analysis is different for the various users of information as
management, investors, creditors, laborers, government and others.

Importance to Management – To get an overall view of the financial operations and condition of
the company which enables them to plan and control the company's activities more effectively, to
spot weaknesses in operations and take corrective action.

Importance to Investors - To form their own opinion as to the soundness of investing in a

company by computing earnings per share, risk involved in the investment, the future earning
potential and the investment opportunities, elsewhere.

Importance to Creditors - Creditors are interested in the company's ability to meet its financial
obligations. Those who have lent money for short period, are more interested in the company's
ability to repay the debts as and when it will become due.

Importance of Debenture holders - Short term creditors are interested in the liquidity of the
concern and from the Funds Flow Statement they are able to determine whether the amounts

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 owing to them will be paid when due, while the long term creditors determine whether their
principals (capital amount) and the interest thereon will be paid when due. Hence they analyze the
profit-earning capacity, capital structure and future funds flow of the concern.

Importance to Government - Government regulates economic activities in various spheres and

for this purpose analysis of financial statements of companies in one industry or of all companies
is very helpful. Earning ratios and turnover ratios are used as barometers to indicate the health of
an industry as a whole.

Importance to Labour - Labour has an interest in the operating results and the financial strength
of a company. The remuneration of the worker must be generated from the company revenues
thus, the worker's wages, to a great extent, depend upon the success of the firm. Frequently, labour
unions use the information presented in the financial statements as a basis for their demand for
increase in wages.

Importance to Others - Besides, the news agencies, trade associations, labour bureaus, economic
and commercial research institutes, stock exchanges, economists and research workers also are
interested in the results arrived at by analysis of financial statements to know the progress being
made and the present position of an industry.

CLASSIFICATION OF RATIOS

In view of the requirements of various users (e.g., Short-term Creditors, Long-term Creditors,
Management, Investors) of the ratios, one may classify the ratios into the following four groups:
1. Liquidity Ratios
2. Solvency Ratios
3. Activity Ratios
4. Profitability Ratios

LIQUIDITY RATIOS

Short-term Creditors are primarily interested in liquidity or short-term Solvency of the enterprise
since their claims are to be met in the short-run. Liquidity or Short-term Solvency means the
ability of the enterprise to meet short-term obligations as and when they become due.
Usually the following ratios are calculated for this purpose:

1. Current Ratio
2. Quick Ratios
3. Absolute Cash Ratio

1. CURRENT RATIO

(a) Meaning – This ratio establishes a relationship between Current Assets and Current liabilities.

(b) Objective – The objective of computing this ratio is to measure the ability of the firm to meet
its short-term obligations and to reflect the short-term financial strength/Solvency of a firm,
i.e., to measure the safety margin available for short-term creditors.

(c) Components – There are two components of this ratio as follows:

1. Current Assets: Current Assets refer to those assets which are held for their conversion into
cash normally within a year. An asset is classified either as a Current Asset or Non-current Asset
on the basis of the purpose for which an asset is held in the hands of user.

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 Examples of Current Assets
Cash Balance, Bank Balance, Debtors (after deducting Provision), Bills Receivable (after deducting
provision), Marketable Securities (Realisable value), Stock, Prepaid Expenses, Short-term Loans &
Advances (Debit Balance).

Important Notes
 The 'Provision for doubtful debts/bills' is deducted from the total amount of Debtors/Bills
Receivable in order to ascertain the realisable value of Trade debt Receivable.
 Unless otherwise stated, it is assumed that Debtors, B/R and Marketable Securities realizable
at their given book values.

2. Current Liabilities: Current Liabilities refer to those liabilities which are expected to be
matured normally within a year.

Examples of Current Liabilities

Creditors for Goods, Creditors for Expenses (or O/S Exp)
Provision for Tax Unclaimed dividend
Bills Payable Bank Overdraft
Short-term Loans and Advances (Credit Balance) Incomes received-in-advance

Computation – This ratio is computed by dividing the current assets by the current liabilities. This
ratio is usually expressed as a pure ratio e.g. 2:1. In the form of a formula, this ratio may be
expressed as follows:

𝐂𝐮𝐫𝐫𝐞𝐧𝐭𝐀𝐬𝐬𝐞𝐭𝐬
Current Ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Imp Notes
1. Current Ratio is calculated at a particular date and not for a particular period.
2. The excess of Current Assets over Current Liabilities is known as Working Capital.

Interpretation – It indicates rupees of current assets available for each rupee of current liability.
Higher the ratio, greater the margin of safety for short-term creditors and vice-versa. However, too
high/too low ratio calls for further investigation since the too high ratio may indicate the presence
of idle funds with the, firm or the absence of investment opportunities with the firm and too low
ratio may indicate the over trading/under capitalisation if the capital turnover ratio is high.

Traditionally, a current ratio of 2:1 is considered to be a satisfactory ratio. On the basis of this
traditional rule, if the current ratio is 2 or more, it means the firm is adequately liquid and has the
ability to meet its current obligations but if the current ratio is less than 2, it means the firm has
difficulty in meeting its current obligations. The logic behind this rule is that even if the value of
current assets becomes half, the firm can still meet its short-term obligations.

2. QUICK RATIO [OR LIQUID RATIO]

(a) Meaning – This ratio establishes a relationship between quick assets and current liabilities.

(b) Objective – The objective of computing this ratio is to measure the ability of the firm to meet
its short-term obligations as and when due without relying upon the realization of stock.

(c) Components – There are two components of this ratio as follows:

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(i) Quick Assets: Quick Assets refer to those current assets which can be converted into cash
immediately or at a short notice without a loss of value.

Examples of Quick Assets

Cash Balances Bills Receivable (after deducting provision)
Bank Balances Marketable Securities (Realizable Value)
Debtors Short-term Loans and Advances
(after deducting provision) (Debit Balance)

Imp Notes
1. Inventories are not considered as quick assets because there is uncertainty as to whether or
not and the inventories can be Sold
2. Prepaid Expenses are not considered as quick assets because they usually cannot be converted
into cash.
3. The 'Provision for doubtful debts/Bills' is deducted from the total amount of Trade
Debtors/Bills Receivable in order to ascertain the realizable value of Trade Debtors/Bills
Receivable.
4. Unless otherwise stated, it is assumed that Debtors, B/R and Marketable Securities are
realizable at their given book values.

(ii) Current Liabilities: Current Liabilities refer to those liabilities which are expected to be
matured normally within a year. (Same as above)

Computation –This ratio is computed by dividing the quick assets by the current liabilities. This
ratio is usually expressed as a pure ratio e.g., 1:1. In the form of a formula, this ratio may be
expressed as under:
Quick Assets
Quick Ratio =
Current Liabilities

Alternatively – Quick Ratio may be computed by dividing the Quick Assets by the Quick Liabilities
as follows:

Quick Assets
Quick Ratio =
Quick Liabilities

Where, Quick Liabilities = Current Liabilities – Bank Overdraft – Cash Credit

Tutorial Note
Quick Ratio is calculated at particular date and not for a particular period.

Interpretation – It indicates rupees of quick assets available for each rupee of current liability.
Traditionally, a quick ratio of 1:1 is considered to be a satisfactory ratio. However, this traditional
rule should not be used blindly since a firm having a quick ratio of more than 1 may not be meeting
its short-term obligations in time if its current assets consist of doubtful and slow paying debtors
while a firm having a quick ratio of less than 1, may be meeting its short-term obligations in time
because of its very efficient inventory management.
Thus, an enterprise should have neither a very high nor a very low ratio, it should have a
satisfactory ratio. To judge whether the ratio is satisfactory or not, it should be compared with its
own past ratios or with the ratio of similar enterprises in the same industry or with the industry
average.

Distinction between Current Ratio and Quick Ratio

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 Basis of Current Ratio Quick Ratio
Distinction
Relationship Current Ratios shows relationship Quick Ratio shows relationship between
between, Current Assets and Current Quick Assets and Current Liabilities
Liabilities
Objectives Current ratio measures ability to meet Quick Ratio measures enterprise's
current obligations as and when they ability to meet current obligations
fall due for payment over a period without relying on the sale and
normally not exceeding one year collection of inventories.
Components The components of Current Ratio are The components of Quick Ratio are
of Ratio Current Assets and Current Liabilities Quick Assets and Current Liabilities.
Formula for Quick Assets Quick Assets
Quick Ratio = Current Liabilities Quick Ratio =Quick Liabilities
Computation
Traditional
Satisfactory It is 2:1 It is 1:1
Standard
Precaution While computing and using Current While computing and using Quick Ratio,
Ratio, quality of both inventory and quality of receivables is required to be
receivables is required to be carefully carefully assessed (since the inventory
assessed. has already been excluded)

3. ABSOLUTE CASH RATIO

(a) Meaning – This ratio measures a relationship between cash & marketable securities and
current liabilities.

(b) Objectives – The objectives of computing this ratio is to measure the ability of the enterprise
to meet its short-term obligations as and when due without relying upon the realization of
stock and debtors.

(c) Components – There are two components of this ratio as follows:

1. Cash and Marketable Securities and
2. Current Liabilities

(d) Computation – This ratio is computed by dividing the Cash and Marketable Securities by
Current Liabilities. This ratio is usually expressed as a pure ratio e.g. 1:1. In the form of a
formula, this ratio may be expressed as under:

Cash & 𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠

Absolute Cash Ratio =
Current Liabilities

Interpretation – It indicates Cash and Marketable Securities available for each rupee of Current
Liability. A very high absolute ratio indicates high liquidity at the cost of profitability since idle
cash does not generate any return and marketable securities generate return at a rate lower than
the rate of operating margin.

SOLVENCY RATIOS

Long-term Creditors are primarily interested in long-term Solvency of the enterprises since their
claims are to be met in the long-run. Long-term creditors are the creditor having maturity after
one year.

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Long-term Solvency means the ability of the enterprise to meet long-term liability on the due date.
Long-term lender of funds is basically interested in two things:
(a) Safety of Principal which is given by way of a loan.
(b) Regular servicing of the loan in the form of –
1. Payment of Interest on loan, and
2. Repayment of Instalment of loan.

For example - A loan of ` 1 crore at 12% rate of interest is granted by X ltd. term of 5 years. X ltd.
would like to be sure that –

(i) The principal amount of ` 1 crore is safe for 5 years

(ii) It will get an interest of ` 12 lacs every year.

Solvency ratios show the long-term financial Solvency and measure the en ability to pay the
interest regularly and to repay the principal (i.e., capital a maturity or in pre-determined
installments at due dates. Usually the following calculated to judge the long-term financial
Solvency of the concern:

SOLVENCY RATIOS
1. Debt-Equity Ratio
2. Total Assets to Debt Ratio
3. Proprietary Ratio
4. Capital Gearing Ratio
5. Interest Coverage Ratio
6. Preference Dividend Coverage Ratio
7. Debt-Service Coverage Ratio
8. Fixed Assets Ratio
9. Ratio of Current Assets to Fixed Assets

1. DEBT-EQUITY RATIO

(a) Meaning – This ratio establishes a relationship between long-term debts and shareholders’
funds.

(b) Objectives – The oobjective of computing this ratio is to measure the relative proportion of
debt and equity in financing the assets of a firm.

(c) Components – There are two components of this ratio as follows:

(i). Long-term Debts which mean long-term loans (whether secured or unsecured) (e.g.,
debentures, bonds, loans from financial institutions).

(ii). Shareholders’ Funds which means equity share capital plus preference share capital plus
reserves and surplus minus fictious assets (e.g., preliminary expenses).

(d) This ratio is computed by dividing the long-term debts by the shareholders' funds. This ratio is
usually expressed as a pure ratio e.g., 2:1. In the form of a formula, this ratio may be expressed
as follows:
Long − term Debts
Debt − Equity Ratio =
Shareholders’ Funds

(e) Interpretation – It indicates the margin of safety to long-term creditors. A low debt-equity
ratio implies the use of more equity than debt which means a larger safety margin for
creditors since owner's equity is treated as a margin of safety by creditors and vice versa.

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 Case Creditors Implications from the point of view of Firm
In case of low Larger margin of safety
1. Debt servicing is less burdensome.
Debts-Equity since owner’s equity is
2. Less pressure and interference of creditors in
Ratio treated as margin of management.
safety by creditors. 3. Capacity to raise additional debt.
4. Not much benefit of trading on equity when the firm
earns a rate higher than the interest rate on borrowed
funds.
In case of High Greater the risk to
1. Debt servicing is burdensome under adverse business
Debt-Equity creditors conditions.
Ratio 2. Pressure & interference of creditors in management.
3. Difficulties in raising additional debt.
4. Benefits of trading on equity when the firm earns a
rate higher than the interest rate on borrowed funds.

2. TOTAL ASSETS TO DEBT RATIO

(a) Meaning – This ratio establishes a relationship between total assets and: long-term debts.

(b) Objectives –The objective of computing this ratio is to measure the safety margin available to
the suppliers of long-term debts. It measures the extent which debt is being covered by assets.

(c) Components – There are two components of this ratio as follows:

(i). Total Assets (Excluding fictitious assets like preliminary expenses)
(ii). Long-term Debts which mean long-term loans (whether secure unsecured) (e.g.,
debentures, bonds, loans from financial institutions).

(d) Computations – This ratio is computed by dividing the total assets by the 1 term debts. This
ratio is usually expressed as a pure ratio e.g., 2:1.

Total Assets
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝐭𝐨 𝐃𝐞𝐛𝐭 𝐑𝐚𝐭𝐢𝐨 =
Long − term Debts
Tutorial Note
Total Assets to Debt Ratio is calculated at a particular date and not for a particular period.

(e) Interpretations – In indicates the margin of safety to long-term creditors. A high Total Assets
to Debt ratio implies the use of more equity than debt which means a larger safety margin for
creditors since owner's equity is treated as a m of safety by creditors and vice versa.

3. PROPRIETORY RATIO

(a) Meaning – This ratio measures a relationship between Equity and the Total Assets.

(b) Objectives – The objective of computing this ratio is to measure the proportion of total assets
financed by the Equity (or Proprietors' Funds).

(c) Components – There are two components of this ratio as follows:

(i). Proprietors' Funds (same a Equity Shareholders' Funds)

Note: Proprietors' Funds/Shareholders' Funds/Equity mean equity share capital plus
preference share capital plus reserves and surplus minus fictitious assets (e.g., preliminary
expenses).

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 (ii). Total Assets (excluding fictitious assets like preliminary expenses.

(d) Computation – This ratio is computed by dividing the Proprietors' Funds by Total Assets. It is
expressed as a percentage. In the form of a formula, this ratio may be expressed as follows:

𝐏𝐫𝐨𝐩𝐫𝐢𝐞𝐭𝐨𝐫𝐬’ 𝐅𝐮𝐧𝐝𝐬
Proprietary Ratio= ×100
𝐓𝐨𝐭𝐚𝐥𝐀𝐬𝐬𝐞𝐭𝐬

(e) Interpretation – This ratio indicates the extent to which the assets of the enterprise have been
financed out of Proprietors' Funds. A high proprietary ratio indicates the larger safety margin
for creditors and the enterprise is not taking the benefit of trading on equity. A low proprietary
ratio indicates the greater risk to creditors and the enterprise is taking the benefit of trading on
equity.

Traditionally, a Proprietary Ratio of 1:4 is considered to be satisfactory which means 25% of the
total assets should be financed out of equity.

4. CAPITAL GEARING

(a) Meaning – This ratio establishes a relationship between funds bearing Fixed Financial
Payments and Equity Shareholders' Funds.
(b) Objective – The objective of computing this ratio is to measure the relative proportion of funds
bearing Fixed Financial Payments to Equity Shareholders' Funds.
(c) Components – There are two components of this ratio as follows:

(i). Funds bearing Fixed Financial Payments e.g., debentures, bonds, loans from financial
institutions, preference share capital.

(ii). Equity Shareholders' Funds which means Equity Share Capital + Reserves & Surplus
minus
fictitious assets.

(d) Computation – This ratio is computed by dividing the funds bearing fixed financial payments
by equity shareholders' funds. This ratio is usually expressed as a pure ratio e.g., 3:1. In the form
of formula, this ratio may be expressed as follows:

Funds bearing Fixed Financial Payments

Capital Gearing Ratio =
Equity Shareholders’ Funds

Tutorial Note
Capital Gearing Ratio is calculated at a particular date and note for a particular period.

(e) Interpretation – If the Capital Gearing Ratio is less than 1, the company is said to be lowly
geared and if it is more than 1, it is said to be highly geared. Capital gearing shows the extent of
the risk (in relation to payment of fixed financial payments) to which the company is subject
and also the opportunity for trading on equity. It indicates the margin of safety available to
suppliers of funds bearing fixed financial payments. A high total Capital Gearing Ratio implies
the use of less equity than funds bearing fixed financial payments which means a lower safety
margin for funds bearings funds financial payments since owner's equity is treated as a margin
of safety by the suppliers of funds bearing fixed financial payments and vice versa. Thus, the
position highly geared and lowly geared company is as follows:

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 5. INTEREST COVERAGE RATIO (OR TIMES – INTEREST EARNED RATIO)

(a) Meaning – This ratio establishes a relationship between net profits before interest and taxes
and interest on long-term debt.

(b) Objectives – The objective of computing this ratio is to measure the debt servicing capacity of
a firm so far as fixed interest on long-term debt is concerned.

(c) Components – There are two components of this ratio as follows:

(i). Net profits before interest and taxes
(ii). Interest on long-term debts.

(d) Computation – This ratio is computed by dividing the net profits before interest and taxes by
interest on long-term debt. This ratio is usually expressed as 'X' number of times. In the form of
a formula, this ratio may be expressed as follows:

Net profit before interest and taxes

Interest Coverage Ratio =
Interest on Long−term debt

(e) Interpretation – Interest coverage ratio shows the number of times the amount of interest on
long-term debt is covered by the profits out of which that will be paid. It indicates the limit
beyond which the ability of the firm to service its debt would be adversely affected. For
instance, interest coverage of five times would imply that even if the firm's net profits before
interest and tax decrease by 80% of the present level. the firm will still be able to pay interest
out of profits. Higher the ratio, greater the firm's ability to pay interest but very high ratio may
imply lesser use of debt and very efficient operations.

6. PREFERENCE DIVIDEND COVERAGE RATIO

(a) Meaning – This ratio establishes a relationship between net profits after interest and taxes
and Preference Dividend on Preference Shares.

(b) Objectives – The objective of computing this ratio is to measure the Preference Shares
servicing capacity of a firm so far as Fixed Dividend on Preference Shares is concerned.

(c) Components – There are two components of this ratio as follows:

(i). Net profits after interest and taxes;
(ii). Preference Dividend on Preference Shares

(d) Computation – This ratio is computed by dividing the net profits after interest and taxes by
preference dividend on Preference Shares. This ratio is usually expressed as 'X' number of
times. In the form of a formula, this ratio may be expressed as follows:

Net Profit after interest and taxes

Preference Dividend Coverage Ratio =
Preference Dividend on Pref.Share

(e) Interpretation – Preference Dividend Coverage Ratio shows the number of times the
amount of Preference Dividend is covered by the profits out of which that will be paid. It
indicates the limit beyond which the ability of the firm to service its preference share capital
would be adversely affected. For instance, preference dividend coverage of five times would
imply that even if the firm's net profits after interest and tax 'decrease by 80% of the present
level. The firm will still be able to pay preference dividend out of profits. Higher the ratio,

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 greater the firm's ability to pay preference dividend but very high ratio may imply lesser use
of preference share capital and very efficient operations.

7. DEBT-SERVICE COVERAGE RATIO

(a) Meaning – This ratio measures the relationship between Net Profits before Interest and Tax
and Interest + Principal Portion of instalment.

(b) Objective – The objective of computing this ratio is to determine the firm's ability to payoff
both the current interest and principal portion of the instalment.

(c) Components – There are two components of this ratio as follows:

(i). Net Profit before Interest and Tax
(ii). Interest and Principal portion of Instalment

(d) Computation – This ratio is calculated by dividing the Net Profit before Interest and Tax by
the aggregate of Interest and Principal portion of Instalment. It is usually expressed in
number of times.

In the form of a formula, this ratio may be expressed as follows:

Net profit before Interest and Tax

Debt –Service Ratio = = times
Interest +Principal portion of Instalment

Note: The principal portion of instalment is adjusted for tax effects since such payment is not
deductible from net profit for tax purposes.

(e) Interpretation – Debt-Service Coverage Ratio shows the number of times the amount of
interest on long-term debts and the principal portion of instalment is covered by the profits out
of which that will be paid. It indicates the limit beyond which the ability of the firm to service
its debt would be adversely affected. For instance, an debt service of five times would imply
that even if the firm's net profits before interest and tax decrease by 80% of the present level,
the firm will still be able to pay interest and instalment out of profits. Higher the ratio, greater
the firm's ability to pay current interest and instalment but very high ratio may imply lesser
use of debt and very efficient operations.

8. Fixed Assets Ratio

This ratio establishes a relationship between fixed assets and capital employed in the enterprise.
The objective of computing this ratio is to measure the relative portion of capital employed being
invested in fixed assets of the enterprise. This ratio is computed by dividing the fixed assets with
capital employed. This ratio may be expressed as follows:

𝐅𝐢𝐱𝐞𝐝 𝐀𝐬𝐬𝐞𝐭𝐬
Fixed Assets Ratio = 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝

9. Ratio of Current Assets to Fixed Assets

This ratio establishes a relationship between current assets and fixed assets. This ratio is
computed by dividing current assets with fixed assets. This ratio may be expressed as follows:

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 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Current Assets to Fixed Assets Ratio = 𝐅𝐢𝐱𝐞𝐝 𝐀𝐬𝐬𝐞𝐭𝐬

ACTIVITY RATIOS
Activity ratios measure the effectiveness with which a firm uses its available resources. These
ratios help in commenting on the efficiency of the enterprise in managing its assets. These ratios
are also called 'Turnover Ratios' since they indicate the speed with which the resources are being
turned (or converted) into Sales or Cost of Sales.
Usually the following turnover ratios are calculated:
ACTIVITY RATIOS
1. Capital Turnover Ratio
2. Fixed Assets Turnover Ratio
3. Current Assets Turnover Ratio
4. Net Working Capital Turnover Ratio
5. Stock Turnover Ratio
6. Debtors Turnover Ratio
7. Creditors Turnover Ratio

Tutorial Note
These ratios may be calculated with reference to Sales or Cost of Sales but the same basis (i.e.,
Sales or Cost of Sales) once selected, should be used on consistent basis

1. CAPITAL TURNOVER RATIO

(a) Meaning – This ratio establishes a relationship between net sales and capital employed.

(b) Objectives – The objective of computing this ratio is to determine the efficiency with which
the capital employed is utilised.

(c) Components – There are two components of this ratio as follows:

(i). Net Sales which mean gross sales minus sales returns; and
(ii). Capital Employed which may be calculated as follows:
(iii).

Liabilities Side Approach ` Assets Side Approach `

Equity Share Capital XXX Net Fixed Assets XXX
+ Reserves & Surplus XXX +Investment XXX
(-)Miscellaneous Expenditure XXX + Current Assets XXX
Equity Shareholders’ Funds XXX Total Assets XXX
+ Preference Share Capital XXX (-)Current Liabilities XXX
Shareholders’ Funds XXX

+ Long term Debts XXX

Capital Employed XXX XXX

Tutorial Notes
Some accountants feel that the figure of' Capital Employed’ should be fairly representative of the
capital investment throughout the accounting period and therefore, they prefer to make use of the
concept of ‘Average Capital Employed’ which can be obtained by dividing the aggregate of capital
employed at the beginning and at the end of the accounting period, by 2.

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(d) Computation – This ratio is computed by dividing the net sales by the capital employed.
This ratio is usually expressed as 'x' number of times. In the form of a formula, this ratio may
be expressed as follows:

𝐍𝐞𝐭𝐒𝐚𝐥𝐞𝐬
Capital Turnover ratio= = …… Times
𝐂𝐚𝐩𝐢𝐭𝐚𝐥𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝

Interpretation – It indicates the firm's ability to generate sales per rupee of capital employed. In
general, higher the ratio, the more efficient the management and utilisation of capital employed. A
too high ratio may indicate the situation of over-trading (or under-capitalisation) if current ratio is
lower than that required reasonably and vice versa.

2. FIXED ASSETS TURNOVER RATIO

(a) Meaning – This ratio establishes a relationship between net sales and fixed assets.

(b) Objective – The objective of computing this ratio is to determine the efficiency with which the
fixed assets are utilised.

(c) Components – There are two components of this ratio as follows:

(i). Net Sales which means gross sales minus sales returns;
(ii). Net Fixed (operating) Assets which mean gross fixed (operating) assets minus
depreciation thereon.

(d) Computation – This ratio is computed by dividing the net sales by the net fixed (operating)
assets. This ratio is usually expressed as 'x' number of times. In the form of a formula, this
ratio may be expressed as follows:

Net Sales
Fixed Assets Turnover Ratio = = Times …..
Net Fixed (Operating) Assets

(e) Interpretation – It indicates the firm's ability to generate sales per rupee of investment in
fixed assets. In general, higher the ratio, the more efficient the management and utilisation of
fixed assets, and vice versa. It may be noted that there is no direct relationship between sales
and fixed assets since the sales are influenced by other factors as well (e.g., quality of product,
delivery terms, credit terms, after sales service, advertisement and publicity etc.).

3. CURRENT ASSETS TURNOVER RATIO

(a) Meaning – This ratio establishes a relationship between net sales and current assets.

(b) Objectives – The objective of computing this ratio is to determine the efficiency with which the
current assets are utilised.

(c) Components – There are two components of this ratio as follows'

(i). Net Sales which means gross sales minus sales returns;
(ii). Current Assets: Current Assets refer to those assets which are held for their conversion
into cash normally within a year. An asset is classified either as a Current Asset or Non-
current Asset on the basis of the purpose for which an asset is held in the hands of user.
(d) Computation – This ratio is computed by dividing the net sales by the current assets. This
ratio is usually expressed as 'x number of times. In the form of a formula, this ratio may be
expressed as follows:

174
 𝐍𝐞𝐭𝐒𝐚𝐥𝐞𝐬
Current Assets Turnover Ratio = = ……. times
𝐂𝐮𝐫𝐫𝐞𝐧𝐭𝐀𝐬𝐬𝐞𝐭𝐬

(e) Interpretation – It indicates the firm's ability to generate sales per rupee of investment in
current assets. In general, higher the ratio, the more efficient the management and utilisation
of current assets, and vice versa. It may be noted that there is no direct relationship between
sales and current assets since the sales are influenced by other factors as well (e.g., quality of
product, delivery terms, credit terms, after sales service, advertisement and publicity etc.).

4. WORKING CAPITAL TURNOVER RATIO

(a) Meaning – This ratio establishes a relationship between net sales and working capital.

(b) Objectives – The objective of computing this ratio is to determine the efficiency with which the
working capital is utilised.

(c) Components – There are two components of this ratio as follows:

(i). Net Sales which mean gross sales minus sales returns; and
(ii). Working Capital which means current assets minus current liabilities.

Tutorial Note
Some accountants feel that the figure of ‘Working Capital’ should be fairly representative of the
working capital throughout the accounting period and therefore, they prefer to make use of the
concept of 'Average Working Capital' which can be obtained by dividing the aggregate of the
working capital at the beginning and at the end of the accounting period, by 2.

(d) Computation – This ratio is computed by dividing the net sales by the working capital. This
ratio is usually expressed as 'x' number of times. In the form of a formula, this ratio may be
expressed as follows:

Net Sales
Working Capital Turnover Ratio = Working = …… Times
Capital

(e) Interpretation – It indicates the firm's ability to generate sales per rupee of working capital. In
general, higher the ratio, the more efficient the management and utilisation of working capital
and vice versa.

5. STOCK TURNOVER RATIO

(a) Meaning – This ratio establishes a relationship between cost of goods Sold and average
inventory of finished goods.

(b) Objectives – The objective of computing this ratio is to determine the efficiency with which the
inventory is converted into sales.

(c) Components – There are two components of this ratio as follows:

(i). Cost of Goods Sold which is calculated as follows:

Cost at Goods Sold = Opening Inventory + Net Expenses - Closing Inventory
Or, = Net Sales - Gross Profit

(ii). Average Inventory which is calculated as follows:

Average Inventory = (Opening Inventory plus Closing Inventory)/2

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 Tutorial Note
1. If their figure of 'Average Inventory' cannot be ascertained due to the absence of the figure
of ‘Opening inventory’, the figure of 'Closing Inventory' may be applied by giving a suitable
note to that effect.

2. If the figure of Cost of Goods Sold cannot be ascertained, the figure of sales may be used by
giving a suitable note to that effect.

(d) Computation – This ratio is computed by dividing the cost of goods Sold by the average
inventory. This ratio is usually expressed as 'x number of times. In the form of a formula, this
ratio may be expressed as follows:

Cost of Goods Sold

Stock Turnover Ratio = ……. Times
Average Inventory

(e) Interpretation – It indicates the speed with which the inventory is converted into sales. In
general, a high ratio indicates efficient performance since an improvement in the ratio shows
that either the same volume of sales has been maintained with a lower investment in stocks, or
the volume of sales has increased without any increase in the amount of stocks. However, too
high ratio and too low ratio call for further investigation. A too high ratio may be the result of a
very low inventory levels which may result in frequent stock-outs and thus the firm may incur
high stock-out costs. On the other hand, a too low ratio may be the result of excessive inventory
levels, slow-moving or absolute inventory and thus, the firm may incur high carrying costs.

(f) Stock Velocity – This velocity indicates the period for which sales can be generated with the
help of an average stock maintained and is expressed in terms of period. This velocity may be
calculated as follows:

Average Stock
Stock Velocity = …..Days
Average Cost of Goods Solutiond per day

Or

12 months/52 weeks/365 days

= ….. Months/Weeks/Days
Stock Turnover Ratio

Cost of Goods Sold

Note: Average Cost of Goods Sold per day =
No .of working days in the year

6. DEBTORS TURNOVER RATIO (OR RECEIVABLES TURNOVER RATIO)

(a) Meaning – This ratio establishes a relationship between net credit sales and average trade
debtors (or receivables)
(b) Objectives – The objective of computing this ratio is to determine the efficiency with which the
trade debtors are converted into cash.
(c) Components – There are two components of this ratio as follows:
(i). Net Credit Sales which mean gross credit sales minus sales returns; and
(ii). Average Debtors (or Receivables) which are calculated as follows:

Opening Trade Debtors + Opening Bills Receivable + Closing Trade Debtors + Closing Bills receivable
2

Tutorial Notes

176
 1. If the figure of Average Debtors cannot be ascertained due to the absence of the figure of
opening Debtors, the figure of closing Debtors may be applied by giving a suitable note to that
effect.
2. If the figure of Net Credit Sales is not ascertainable, the figure of total sales given may be used
assuming that all sales are credit sales.

(d) Computation – This ratio is computed by dividing the net credit sales by average trade
debtors. This ratio is usually expressed as 'x' number of times. In the form of a formula, this
ratio may be expressed as follows:

Net Credit Sales

Debtors Turnover Ratio = = …… Times
Average Debtors

(e) Interpretation – It indicates both the quality of debtors and the credit collection efforts of the
enterprise. It indicates the speed with which the debtors are converted into cash each year. In
general, a high ratio indicates the shorter collection period which implies prompt payments by
debtors, and a low ratio indicates a longer collection period which implies delayed payments
by debtors. However, too high ratio and too low ratio calls for further investigation. A too high
ratio may be the result of a restrictive credit and collection policy which may curtail the sales
and consequently profits. On the other hand, a too low ratio may be the result of liberal and
inefficient credit and collection policy which may involve the risk of bad debts and burden of
high interest cost involved in maintaining a higher level of debtors.

(f) Average Debt Collection Period (or Debtors’ Velocity) – This period shows an average
period for which the credit sales remain outstanding or the average credit period actually
enjoyed by the debtors. It measures the quality of debtors. It indicates the rapidity or slowness
with which the money is collected from debtors. This period may be calculated as follows:

Average Debtors
Debt Collection Period = …… Times
Average net Credit Sales per day

12 months/52 weeks/365 days

Or, = ……. Months/Weeks/Days
Debtors Turnover Ratio

Net Credit Sales for the year

Note: Average Credit Sales per day = = …. Per day
No.of working days in the year

7. CREDITORS TURNOVER RATIO (OR PAYABLES TURNOVER RATIO)

(a) Meaning – This ratio establishes a relationship between net credit purchases and average
creditors (or payables)

(b) Objectives – The objective of computing this ratio is to determine the efficiency with which the
creditors are managed and paid.

(c) Components – There are two components of this ratio as follows:

(i). Net Credit Purchases which mean gross credit purchases minus purchases returns; and
(ii). Average Creditors (or Payables) which are calculated as follows:

Opening Trade Creditors + Opening Bills Payables + Closing Trade Creditors + Closing Bills Payables
2
Tutorial Notes

177
 1. If the figure of Average Creditors cannot be ascertained due to the absence of the figure of
Opening Creditors, the figure of Closing Creditors may be applied by giving a suitable note I to
that effect.
2. If the figure of Net Credit Purchases is not ascertainable the figure of Total Purchases given
may be applied assuming that all purchases are credit purchases.

(d) Computation – This ratio is computed by dividing the net credit purchases by average trade
creditors. This ratio is usually expressed as 'x' number of times. In the form of formula, this
ratio may be expressed as follows:

Net Credit Purchase

Creditors Turnover Ratio = = ……. Times
Average Creditors

Interpretation – It indicates the speed with which the creditors turn over on an average each
year. In general, a high ratio indicates the shorter payment period which implies either the
availability of less credit or earlier payments or a low ratio indicates a larger payment period
which implies either the availability of more credit or delayed payments.
Prudence demands that one should not make payment to creditors at a pace which is faster them
the pace of receiving payments from debtors. That's why one should compare Creditors Turnover
Ratio with Debtors Turnover Ratio to observe pace of discharging creditors.

(e) Debts Payment Period (or Creditors’ Velocity) – This period shows an average period for
which the credit purchases remain outstanding or the average credit period actually availed of
This period may be calculated as follows:

Average Creditors
Average Debt Payment period = = …… Days
Average net Credit Purchases per day

12 months /52 weeks / 365 days

Or, = ……… Months/Weeks/Days
Creditors Turnover Ratio

Net Credit Purchase for the year

Note: Average Net Credit Purchases per day = = ….. per day
No .of working days in the year

PROFITABILITY RATIOS IN RELATION TO SALES

1. GROSS PROFIT RATIO

(a) Meaning – This ratio measures the relationship between gross profit and net sales.

(b) Objectives – The main objective of computing this ratio is to determine the efficiency with
which production and/or purchase operations and selling operations are carried on.
(c) Components – There are two components of this ratio as follows:
(i) Gross Profit – This is the excess of Net Sales over Cost of Goods Sold.
(ii) Cost of Goods Sold is calculated as follows:

Cost of Goods Sold in case of a Trading Concern

Particulars `
A. Opening Stock xxx
B. Add: Net Purchases xxx
C. Add: Direct Expenses (e.g. carriage inward) xxx
D. Less: Closing Stock xxx
E. Cost of Goods Sold (A + B + C - D) xxx

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 Net Sales –which is Gross Sales (both cash and credit) minus Sales Returns.

(d) Computation - This ratio is computed by dividing the gross profit by the net sales. It is
expressed as percentage. In the form of a formula, this ratio may be expressed as follows:

Gross Profit
Gross Profit Ratio × 100 = ……. %
Net Sales

2. OPERATING PROFIT RATIO

(a) Meaning – This ratio measures the relationship between operating profit and net sales.

(b) Objective – The main objective of computing this ratio is to determine the operational
efficiency of the management.

(c) Components – there are two components of this ratio as follows:

(i). Operating Profit which is the excess of Gross Profit over other Operating Expenses (e.g.,
Office and Administrative Expenses, Selling and Distribution Expenses, Discount, Bad
debts, Interest on short-term debts) and

(ii). Net Sales which means Gross Sales (both Cash = Credit) minus Sales Returns.

(d) Computation – This ratio is computed by dividing the operating profit by the net sales. It is
expressed as a percentage. In the form of a formula, this ratio may be expressed as follows:

Operating profit
Operating Profit Ratio = × 100 = ……. %
Net Sales

3. NET PROFIT RATIO

(a) Meaning - This ratio measures the relationship between net profit and net sales.

(b) Objective - The main objective of computing this ratio is to determine the overall profitability
due to various factors such as operational efficiency, trading on equity etc.

(c) Components - There are two components of this ratio as follows:

1. Net Profit
2. Net Sales

(d) Computation - This ratio is computed by dividing the net profit by the net sales. The figure of
Net Profit may be taken either before tax or after tax. It is expressed as a percentage. In the
form of a formula, this ratio may be expressed as follows:

Net Profit Before Tax

𝐍𝐞𝐭𝐏𝐫𝐨𝐟𝐢𝐭𝐑𝐚𝐭𝐢𝐨 = × 100= ……%
Net Sales

Net Profit After Tax

𝐍𝐞𝐭𝐏𝐫𝐨𝐟𝐢𝐭𝐑𝐚𝐭𝐢𝐨 = × 100= ……%
Net Sales

Interpretation - This ratio indicates (a) an average net margin earned on a sale of ` 100 (b) what
portion of sales is left to pay dividend and to create reserves, and (c) firm's capacity to withstand
adverse economic conditions when selling price is declining, cost of production is rising and the
demand for the product is falling. Higher the ratio, greater is the capacity of the firm to withstand
adverse economic conditions and vice versa.

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 4. OPERATING RATIO

Meaning - This ratio measures the relationship between operating cost and net sales.

Objective - The main objective of computing this ratio is to determine the operational efficiency
with which production and/or purchases and selling operations are carried on.

Components - There are two components of this ratio as follows:

1. Operating Cost in the cost relating to the Operations of a business enterprise. Operating Cost
which comprises (a) Cost of Goods Sold and (b) other Operating Expenses (e.g., Administrative
Expenses, Selling and Distribution Expenses, Interest on short-term loans, Discount allowed
and Bad Debts).
2. Net Sales which means gross sales minus sales returns.

Computation - This ratio is computed by dividing the operating cost by the net sales. This ratio is
expressed as a percentage. In the form of a formula, this ratio may be expressed as follows:

Operating Cost
Operating Ratio = × 100 = ……… %
Net Sales

Interpretation - This ratio indicates an average operating cost incurred on a sales of goods worth
` 100. Lower the ratio, greater is the operating profit to cover the non-operating expenses, to pay
dividend and to create reserves and vice versa.

Tutorial Note:
Both Operating Profit Ratio and Operating Ratio are complementary to each other and thus, if one
of such ration is deducted from 100, another ratio may be obtained.

Distinction between Operating Ratio and Operating Profit Ratio

Operating Ratio differs from Operating Profit Ratio in the following respects:

Basis of Operating Ratio Operating Profit Ratio

Distinction
Relationship It shows the relationship between It shows the relationship between
Operating Cost and Net Sales Operating Profit and Net Sales.
Objective The objective of computing this ratio is The objective of computing this ratio is
to determine the efficiency with which to determine the operational efficiency
production/purchase and selling of the management.
operations are carried on.
Interpretation This ratio indicates an average This ratio indicates (a) an average
operating cost incurred on a sales of Rs operating margin as a sales of Rs. 100.
100 (b) What portion of sales is left to over
non-operating expenses to pay
dividend and to create reserves.
Formula Operating Cost Operating Profit
× 100 = ……… % × 100 = ……… %
Net Sales Net Sales

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EXPENSES RATIOS

To identify the causes of variations in the operating ratio, the following expenses ratios may be
calculated:

1. MATERIAL CONSUMED RATIO

This ratio indicates the efficiency or otherwise in purchasing/utilising the raw materials. It is
expressed as a percentage. in the form of a formula, this ratio may be expressed as follows:

Matgerial Consumed pertaining to units Solutiond

Material Consumed Ratio = × 100 = ……%
Net Sales

2. CONVERSION COST RATIO

This ratio indicates the efficiency or otherwise of the manufacturing process. This ratio is
expressed as a percentage. In the form of a formula, this ratio may be expressed as follows:

Conversion Cost Ratio=

All manufacturing Expenses (excludingcost of material) pertaining to units Solutiond
× 100…%
Net Sales

3. ADMINISTRATIVE EXPENSES RATIO

This ratio indicates the efficiency or otherwise in the incurrence of administrative expenses. It is
expressed as a percentage. In the form of a formula, this ratio may be expressed as follows:

Administrative Expenses pertaining to unit Solutiond

Administrative Expenses Ratio = × 100 = … %
Net Sales

4. SELLING AND DISTRIBUTION EXPENSES RATIO

This ratio indicates the efficiency or otherwise in the incurrence of selling and distribution
expenses. It is expressed as a Percentage . In the form of a formula, this ratio may be expressed as
follows:

Selling & 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

Selling and Distribution Expenses Ratio = × 100 = …….%
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬

PROFITABILITY RATIOS IN RELATION TO INVESTMENT

Since the term 'Investment' may refer to 'Total Assets', 'Capital Employed' or 'Shareholders'
Funds', the Return on Investment (ROI) can be calculated in anyone of the following ways:
1. Return on Total Assets
2. Return on Capital Employed
3. Return on Shareholders' Funds.

Tutorial Notes:
Denominator to be used in calculating these ratios should be calculated preferably on average
basis. If such average cannot be calculated then the amount of denominator in the beginning of
accounting period should be used.

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 1. RETURN ON TOTAL ASSETS

(a) Meaning - This ratio measures a relationship between net profit before interest and tax, and
total assets.

(b) Objective - The objective of computing this ratio is to find out how efficiently the total assets
have been used by the management.

(c) Components - There are two components of this ratio as follows: (i) Net Profit before
Interest and Tax. (ii) Total Assets (excluding fictitious assets, e.g., preliminary expenses)

Tutorial Note:
Some accountants feel that the figure of 'Total Assets' should be fairly representative of the
Investment in total assets throughout the accounting period and therefore, they prefer to make
use of the concept of 'Average Assets' which can be obtained by dividing the aggregate of the total
assets at the beginning and at the end of the accounting period, by 2.

Computation - This ratio is computed by dividing the net profit before interest and tax by total
assets. This ratio is expressed as a percentage. In the form of a formula, this ratio may be
expressed as follows:

Net Profit before Interest and Tax

Return on Total Assets = ×100 = …….. %
Net Sales

Interpretation - This ratio indicates the firm's ability of generating profit per rupee of total assets.
Higher the ratio, the more efficient the management and utilization of total assets.

2. RETURN ON CAPITAL EMPLOYED/RETURN ON INVESTMENT (ROI)

(a) Meaning - This ratio measures a relationship between net profit before interest and tax and
capital employed.

(b) Objective - The objective of computing this ratio is to find out how efficiently the long-term
funds supplied by the creditors and shareholders have been used.

(c) Components - There are two components of this ratio as follows:

1. Net profit before Interest and Tax;
2. Capital Employed which refers to long-term funds supplied by the long-term creditors and
shareholders. It comprises the long-term debt and shareholders' funds.

Tutorial Notes:
Some accountants feel that the figure of 'Capital Employed' should be fairly representative of the
capital investment throughout the accounting period and therefore they prefer to make use of the
concept of 'Average Capital employed' which can be obtained by dividing the aggregate of capital
employed at the beginning and at the end of the accounting period, by 2.

Computation - This ratio is computed by dividing the net profit before interest and tax by capital
employed. It is expressed as a percentage. In the form of formula, this ratio may be expressed as
follows:
Net Profit before Interest and tax
Return on Capital Employed = × 100 = …… %
Capital Employed

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 Interpretation - This ratio indicates the firm's ability of generating profit per rupee of capital
employed. Higher the ratio, the more efficient the management and utilisation of Capital employed.

ROI = Operating Profit Ratio × capital Turnover Ratio

𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 & 𝑇𝑎𝑥 𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬

× 100 ×
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝

𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 & 𝑇𝑎𝑥

= × 100
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝

3. RETURN ON SHAREHOLDERS' FUNDS (OR RETURN ON EQUITY)

(a) Meaning - This ratio measures a relationship between net profit after interest and tax, and
shareholders' funds.

(b) Objective - The objective of computing this ratio is to find out how efficiently the funds
supplied by all the shareholders (Equity and Preference) have been used.

(c) Components - There are two components of this ratio as follows:

1. Net profit after Interest and Tax:
2. Shareholders' Funds which mean Equity Share Capital plus Preference Share Capital plus
Reserves and Surpluses minus Fictitious Assets (if any).

(d) Computation - This ratio is computed by dividing the net profit after interest and tax by
shareholders' funds. It is expressed as a percentage. In the form of a formula, this ratio may be
expressed as follows:
Net Prof it after Interest and tax
Return on Shareholders’ Funds = × 100 = ……. %
Shareholders’ Funds

Interpretation - This ratio indicates the firm's ability of generating profit per rupee of
shareholders' funds. Higher the ratio, the more efficient the management and utilization of
shareholders' funds.

4. RETURN ON EQUITY SHAREHOLDERS FUNDS

(a) Meaning - This ratio measures a relationship between net profit after interest, tax. and
preference dividend, and equity shareholders' funds.

(b) Objective - The objective of computing this ratio is to find out how efficiently the funds
supplied by the equity shareholders have been used.

(c) Components - There are two components of this ratio as follows:

1. Net profit after interest, tax and preference dividend (including participating dividend
if any, due to Participating Preference Shareholders).

2. Equity Shareholders' Funds which mean Equity Share Capital Plus Reserves and
Surplus minus Fictitious Assets (if any).

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 5. EARNING PER SHARE (EPS)

(a) Meaning - This ratio measures the earnings available to an equity shareholder on a per
share basis.

(b) Objective - The objective of computing this ratio is to measure the profitability of the firm
on per equity share basis.

(c) Components - There are two components of this ratio as follows:

1. Net Profit after Interest, Tax and Preference Dividend;
2. Number of Equity Shares

(d) Computation - This ratio is computed by dividing the net profit after interest, tax and
preference dividend by the number of equity shares. It is expressed as anSolutionute figure.
In the form of a formula, this ratio may be expressed as follows:

Earningsper Share (EPS) = Net Profit after Interest,

Tax and Preference Dividend
= ` … per share
Number of Equity Shares

Interpretation - In general, higher the EPS, better it is and vice versa. While interpreting this
ratio, it must be seen whether there is any increase in Equity Shareholders' Funds as a result of
retained earnings without any change in numbers of outstanding shares. For instance, in the case
of a company which is following a practice of ploughing back of profits and which is not
capitalising its profits by way of issue of bonus shares, the interpretation of EPS without
considering the effect of profits ploughed back in the business on earnings, will not be appropriate.
EPS helps in determining the market price of the equity shares of the company. It also helps in
estimating the company's capacity to pay dividend.

6. DIVIDEND PER SHARE

(a) Meaning - This ratio measures the dividend distributed per equity share.

(b) Objective - The objective of computing this ratio is to measure the dividend distributed per
equity share.

(c) Components - There are two components of this ratio as follows:

1. Profits Distributed as dividend
2. Number of Equity Shares

(d) Computation - This ratio is computed by dividing the profit distributed as equity dividend
by the number of equity shares. It is expressed as an absolute figure. In the form of a
formula, this ratio may be expressed as follows:
(e)
Profit distributed an Equity dividend
Dividend per Share (EPS) = = ` …….. as share
Number of Equity Shares

Interpretation - In general, higher the DPS, better it is and vice versa.

7. PRICE EARNING RATIO

(a) Meaning - This ratio measures the relationship between the market price per share and
earning per share.

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 (b) Objective - The objective of computing this ratio is to find out expectations of the
shareholders about the earnings of the firm.
(c) Components - There are two components of this ratio as follows:
1. Market Price Per Share
2. Earnings per Share (EPS).
(d) Computation - This ratio is computed by dividing market price per share by the earning
per share. It is usually expressed as a pure number. In the form of a formula, this ratio may
be expressed as follows:
Note: Market Price per share may be Average Share Price or Closing Share Price

Market Price Per Share

Price-Earnings Ratio =
Earning Per Share (EPS )

Interpretation - It indicates the number of times of EPS, the share is being quoted in the market.
In other words, it indicates the payback period within which the prospective investor can recover
his investment in a single share by way of Earning Per Share (EPS). Unless affected by speculation
usually higher P/E Ratio indicates that the company is growing and has good earning prospects
but a lower P/E ratio need not always necessarily mean that the company is not growing and has
no good prospects as it happens in case of a closely held public company where only a few shares
are available in the market for general investors who generally do not trade much in those limited
shares.

8. DIVIDEND PAYOUT RATIO

(a) Meaning - This ratio measures the portion of earning per share distributed as dividend.

(b) Objective - The objective of computing this ratio is to measure the portion of EPS
distributed as dividend.

(c) Components - There are two components of this ratio as follows:

1. Earnings Per Share (EPS)
2. Dividend Per Share (DPS)

(d) Computation - This ratio is computed by dividing the DPS by EPS. It is usually expressed as
a percentage. In the form of formula, this ratio may be expressed as follows:
(e)
Dividend Per Share (DPS )
Dividend Payout ratio = × 100
Earning Per Share (EPS )

Interpretation - In general higher the DP Ratio, better it is. An enterprise should have a
satisfactory ratio. To judge whether the ratio is satisfactory or not, it should be compared with its
own past ratios or with the ratio of similar enterprises in the same industry or with the industry
average.
Dividend Payout Ratio = Dividend Per share/Earning Per Share × 100

9. EARNING YIELD (EY)

(a) Meaning - This ratio measures the relationship between Earning Per Share (EPS) and
Maker price per share.

185
(b) Objective - The objective of computing this ratio is to measure the performance of earnings
in relation to market price per share.

(c) Components - There are two components of this ratio as follows:

1. Earnings Per Share
2. Market Price Per Share

(d) Computation - This ratio is computed by dividing the EPS by the market price per share. It
is usually expressed as a percentage. In the form of a formula, this ratio may be expressed
as follows:

Earning Per Share (EPS)

Earning Yield = × 100
Market Price Per Share

186
 CLASSROOM PRACTICE – LETS PLAY TOGETHER

Que 1
The Balance Sheet of Jain Ltd. as at 31st March 2013 is as under:
Liabilities ` Assets `
Equity Share Capital (` 10 each) 1,00,000 Land & Building 6,00,000
18% Pref. Share capital 1,00,000 Plant & Machinery 5,00,000
General Reserve 60,000 Furniture & Fixture 1,00,000
Profit & Loss A/c 2,40,000 12,00,000
15% Debentures 8,00,000 Less: Depreciation (2,00,000)
Trade Creditors 40,000 10,00,000
Bills Payable 30,000 Trade Investments (long-term) 1,00,000
Outstanding Expenses 20,000 Stock 95,000
Bank overdraft 10,000 Debtors 3,40,000
Provision for Tax 2,40,000 Less: Provision 30,000 3,10,000
Marketable Securities 10,000
Cash 10,000
Bills receivables 10,000
Prepaid Expenses 5,000
Preliminary Expenses 60,000
Underwriting Commission 40,000
16,40,000 16,40,000

Net Sales for the year 2012-2013 amounted to `20, 00,000. Net profit after tax ` 2, 40,000, Tax @
50%. Calculate Current Ratio as at 31.3.2013.

Solution
Current Assets = Stock + Debtors - Provision on Debtors + Marketable Securities + Cash +
B/R
+ Prepaid Expenses

= ` 95,000 + ` 3, 40,000 - ` 30,000 + ` 10,000 + ` 10,000 + ` 10,000 + ` 5,000

= ` 4, 40,000

Current Liabilities = Trade Creditors + B/P + O/s Exp + Bank O/D + Provision for Tax
= ` 40,000 + ` 30,000 + ` 20,000 + ` 10,000 + ` 2, 40,000
= ` 3, 40,000

Current Assets
Current Ratio =
Current Liabilities

Rs.4,40,000
=
Rs.3,40,000

= 22:17

Que 2
Creditors `20,000, Working Capital ` 3,60,000, Other Current Liabilities ` 1,00,000. Calculate
Current Ratio.

Solution
Current Liabilities = Creditors + Other Current Liabilities

187
 = ` 20,000 + ` 1, 00,000 = ` 1, 20,000
Current Assets = Current Liabilities + Working Capital
= `1, 20,000 + ` 3, 60,000 = ` 4, 80,000
Current Ratio = Current Assets / Current Liabilities
= ` 4, 80,000 / ` 1, 20,000 = 4:1

Que 3
Calculate the Quick Ratio from the following information:
Current Assets ` 4,40,000, Stock ` 95,000, Prepaid Expenses ` 5,000, Current Liabilities `3,40,000.
Creditors `20,000.
Solution
Quick Assets = Current Assets - Stock - Prepaid Expenses
= ` 4, 40,000 - ` 95,000 - ` 5,000
= ` 3, 40,000

Quick Ratio = Quick Assets / Current Liabilities

= ` 3, 40,000 / ` 3, 40,000 = 1:1
Note: Creditors are already included in current liabilities.

Que 4
X has a current ratio of 2.5:1. Its stock is ` 80,000 and its current liabilities are ` 80,000.
Calculate the liquid ratio.
Solution
Current Ratio = Current assets/Current liabilities = 2.5
Or = Current assets/` 80,000 = 2.5
Or, Current assets = ` 80,000 × 2.5 = ` 2, 00,000
Liquid Assets = Current assets - Stock
= ` 2, 00,000 - ` 80,000 = ` 1, 20,000
Liquid Ratio = Liquid assets/Current liabilities
= ` 1, 20,000/` 80,000 = 1.5: 1

Que 5
X Ltd. has a current ratio of 2:1 and quick ratio of 1.5:1. Its current liabilities are ` 80,000.
Calculate the value of stock.
Solution
Current Ratio = Current Assets/Current Liabilities = 2
Or, = Current Assets/` 80,000 = 2
Current Assets = ` 80,000 × 2 = ` 1, 60,000
Quick Ratio = Quick Assets/Current liabilities = 1 .5
Or, = Quick Assets/` 80,000 = 1.5
Quick Assets = `80,000× 1.5 = ` 1, 20,000
Stock = Current Assets - Quick Assets
= ` 1, 60,000 - ` 1, 20,000 = ` 40,000

Que 6
X Ltd. has a current ratio of 2.5:1 and quick ratio of 1.5:1. Its current assets are Rs. 2, 00,000.
Calculate the value of stock.
Solution
Current Ratio = Current Assets/Current Liabilities = 2.5
Or, = ` 2, 00,000/Current Liabilities = 2.5
Current Liabilities = ` 2, 00,000/2.5 = Rs. 80,000
Quick Ratio = Quick Assets/Current Liabilities = 1.5

188
 Or, = Quick Assets/` 80,000 = 1.5
Quick Assets = ` 80,000 × 1.5 = ` 1, 20,000
Value of Stock = Current Assets - Quick Assets
= ` 2, 00,000 - ` 1, 20,000 = `80,000

Que 7
Capital Employed ` 24, 00,000. Long-term Debt ` 16, 00,000. Calculate the Debt-Equity Ratio.
Solution
Shareholders' Funds = Capital Employed - Long-term Debt
= ` 24, 00,000 - `16, 00,000
= ` 8, 00,000
Long-term Debts = ` 16, 00,000
Debt-Equity Ratio = Long Term Debts / Shareholders' Funds
= ` 16, 00, 00 / ` 8, 00,000 = 2: 1

Que 8
Total Debt ` 9, 00,000, Capital Employed ` 12, 00,000, Current Liabilities ` 1, 00,000, Calculate the
Debt-Equity Ratio.
Solution
Long-term Debt = Total Debt - Current Liabilities
= ` 9, 00,000 - ` 1, 00,000
= ` 8, 00,000
Shareholder’s fund = Capital Employed - Long-term Debt
= ` 12, 00,000 - ` 8, 00,000
= ` 4, 00,000
Debt Equity Ratio = Long-term Debts / Shareholder’s Funds
= ` 8, 00,000 / ` 4, 00,000
= 2:1
Que 9
Total Assets ` 2, 60,000, Total Debt ` 1, 80,000, Current Liabilities ` 20,000. Calculate the Debt-
Equity Ratio.
Solution
Long-term Debt = Total Debt – Current Liabilities
= ` 1, 80,000 – ` 20,000 = ` 1, 60, 000
Shareholder’s Funds = Total Assets / Total Debt
= ` 2, 60,000 - 1, 80,000 = ` 80,000
Debt-Equity Ratio = Long-term Debt / Shareholder’s
= ` 1, 60,000 / ` 80,000 = 2:1
Que 10
Net profit before Interest and Tax `3, 20,000.Interest on Long term debt ` 40,000. Calculate
Interest Coverage Ratio.

Solution
Net Profit before Interest and Taxes
Interest Coverage Ratio =
Interest on Long−term Debt

Rs.3,20,000
= = 8 times
Rs.40,000
Que 11
Calculate Interest Coverage Ratio from the following information: 15% Debentures ` 8,00,000, Net
Profit after Interest & Tax ` 2,40,000, Tax ` 2,40,000.

189
 Solution
Interest on Long-term Debt
Net Profit before Interest & Tax
= ` 8, 00,000× 15/100 = ` 1, 20,000
= Net Profit after interest & tax + Tax + Interest
= ` 2, 40,000 + ` 2, 40,000 + ` 1, 20,000
= ` 6, 00,000

Net Profit before Interest and Taxes

Interest Coverage Ratio =
Interest on Long−term Debt

Rs.6,00,000
= = 5 times
Rs.1,20,000
Que 12
Fixed Assets (at cost) ` 12,00,000, Accumulated Depreciation till date `2,00,000, Trade
Investments ` 1,00,000, Current Assets ` 4,40,000, Current Liabilities ` 3,40,000, Cash Sales `
4,00,000, Gross Credit Sales `17,00,000, Sales Returns ` 1,00,000, calculate Capital Turnover Ratio.
Solution
Capital Employed = Net Fixed Assets + Trade Investments + Current Assets - Current Liabilities
= ` 12,00,000 - ` 2,00,000 + `1,00,000 + ` 4,40,000 - ` 3,40,000
= ` 12, 00,000
Net Sales = Cash Sales + Net Credit Sales
= ` 4, 00,000 + (` 17,00,000 - ` 1,00,000)
= ` 20, 00,000
Net Sales Rs.12,00,000
Capital Turnover Ratio = = = 1.67 times
Capital Employed Rs.12,00,000

Que 13
Shareholders Funds ` 4, 00,000, Long-term Debt ` 8, 00,000, Gross Profit at 20% on cost was
` 8, 00,000. Calculate Capital Turnover Ratio.
Solution
Capital Employed = Shareholders' Funds + Long-term Debt
= ` 4, 00,000 + ` 8, 00,000
= ` 12, 00,000
If Cost is ` 100, Gross Profit = `20
then Sales = ` 100 + ` 20 = ` 120
If Gross Profit is ` 20, then sales = 120

Rs.120
If Gross Profit is ` 8,00,000, then Sales = × 8,00,000 = ` 48,00,000
Rs.20

Rs.Net Sales Rs.48,00,000

Capital Turnover Ratio = = = 4 times
Capital Employed 12,00,000

Que 14
You are given the following figures: `
Current ratio 2.5
Liquidity ratio 1.5
Net working capital `3,00,000
Fixed assets turnover ratio (on cost of sales) 2 times
Average debt collection period 2 months
Stock turnover ratio (cost of sales/closing stock) 6 times
Gross profit ratio 20%

190
 Fixed assets/shareholders net worth 0.80
Reserve and surplus/capital 0.50
Draw up the balance sheet of the company.
Solution: Balance Sheet as on…………..
` `
Share capital 5,00,000 Fixed assets 6,00,000
Reserves and surplus 2,50,000 Stock 2,00,000
Long-term borrowings (balancing 1,50,000 Debtors 2,50,000
figure)
Current liabilities 2,00,000 Bank 50,000

Workings
If current liabilities =1
Current assets = 2.5
It means the difference or working capital = 1.5
Working capital or 1.5 = `3, 00,000
∴Current assets = ` 5,00,000
Current liabilities = ` 2, 00,000
Liquidity ratio = 1.5
And current liabilities = `2, 00,000
Liquid assets (bank and debtors) (2,00,000 × 1.5) = `3,00,000
Stock (5,00,000 - 3,00,000, i.e. current assets - liquid assets) =`2,00,000
Cost of sales (as stock turnover ratio is 6) = `12, 00,000

Sales as G.P. ratio is 20%

(12,00,000+ 20/80 × 12,00,000) = = ` 15, 00,000
Fixed assets, `12,00,000/2 as fixed assets turnover is 6 = ` 6,00,000
Debtors, `15,00,000 / 6 Debt collection period being 2 months = ` 2,50,000
Shareholders' net worth, ` 6,00,000 × 1/ 0.80 = ` 7,50,000
Out of shareholders' net worth, reserves and surplus = ` 2, 50,000
Share capital = ` 5, 00,000

Que 15
From the following information relating to Wise Ltd, prepare its summarised Balance Sheet.
Current Ratio - 2.5 Sales to Debtors Ratio - 6.0
Acid Test Ratio - 1.5 Reserves to Capital Ratio - 1.0
Gross Profit to Sales Ratio - 0.2 Net Worth to Long Term Loan -
Net Working Capital to Net Worth - Ratio - 20.0
Ratio - 0.3 Stock Velocity - 2 months
Sales to Net Fixed Assets Ratio - 2.0 Paid up Share Capital - `10 lakhs
Sales to Net Worth Ratio - 1.5

Solution: Balance Sheet of Wise Limited

Liabilities ` Assets `
Share Capital (given) 10,00,000 Fixed Assets (WN 12) 15,00,000
Reserves(WN 1) 10,00,000 Current Assets
Long-Term Loans (WN 3) 1,00,000 Stock (WN8) 4,00,000
Current Liabilities(WN 10) 4,00,000 Debtors (WN 5) 5,00,000
Bank (WN 10) 1,00,000 10,00,000
Total 25,00,00 Total 25,00,000
0
Working Notes and calculations

191
 Reserves
1. =1 Since capital = ` 10, 00,000, Reserves also = ` 10, 00,000
Capital

2. Net Worth = capital + Reserves = ` 20,00,000

Net Worth Rs.20,00,000

3. = 20. So, = 20
Long Term Loan Long Term Loan

Rs.20,00,000
Hence, Long Term Loan = =` 1, 00,000
20

Sales Sales
4. =6 So, = 1.5
Net Worth 20,00,000

Hence, Sales = ` 20, 00,000 × 1.5 = ` 30, 00,000

Sales 30,00,000
5. =6 So, =6
Debtors Debtors

30,00,000
Hence, Debtors = = ` 5, 00,000
6

6. Gross Profit Ratio = 20% of Sales.

So Gross Profit = 20% ×` 30,00,000 = ` 6,00,000

7. Cost of Goods Sold = Sales - Gross Profit

= ` 30, 00,000 – ` 6, 00,000 = ` 24, 00,000

COGS Rs .24,00,000
8. Stock Velocity = =
Inventory Inventory

24,00,000
= 6 times. So, Inventory = = ` 4,00,000
6

Note: In the absence of information, it is assumed that Opening Stock = Closing Stock = Average
Stock.

Net Working Capital Net Working Capital

9. = =0.3.
Net Worth Rs.20,00,000

So, Net Working capital = ` 20, 00,000 × 0.3 =` 6, 00,000

Current Assets
10. Current Ratio = = 2.5 times.
Current Liabilities

So, Current Assets = 2.5 × Current Liabilities

Net Working Capital = Current Assets - Current Liabilities = ` 6, 00,000.

2.5 × Current Liabilities - Current Liabilities =` 6, 00,000
1.5 × Current Liabilities = `. 6, 00,000

192
 6,00,000
So, Current Liabilities = = ` 4, 00,000
1.5

Hence, Current Assets = 2.5 × 4, 00,000 = ` 10, 00,000

Inventory Debtors cash and Bank

(WN 8) = ` 4, 00,000 (WN 5) = ` 5, 00,000 (bal. fig) ` 1, 00,000
Quick Assets
11. Quick Ratio = = 1.5 times
Quick Liabilities

Current Assets- Stock

So, = 1.5.
Current Liabilities – Bank OD

Rs. 10, 00,000- Rs. 4, 00,000

On substitution = = 1.5 times
Rs. 4, 00,000 – Bank OD

OnSolving, we get, Bank O/D = Rs. NIL

Sales Rs. 30,00,000

12. = 2. So, =2
Net Fixed Assets Net Fixed Assets

Rs. 30, 00,000

Hence, Net Fixed Assets = = ` 15, 00,000
2

193
 TRAIN UR BRAIN
1. _________ is used to evaluate relationships
among financial items. 9. ______ is interested in ratios because they
a) Ratio Analysis b) Trends Ratios help in the formulation of policies,
c) Accounting Ratios decision making and evaluating the
d) None of the above performance and trends of the business
2. The ratios are used to identify trends over and its various segments.
time for one organization or to compare a) Management b) Shareholders
two or more organizations at one point in c) Investors d) Creditors
time. 10. _______ deal with relationship between two
a) True b) False individual or group of items appearing in
c) Partly True d) Partly False the income or profit and loss statement.
3. Ratio Analysis focuses on – a) Balance Sheet Ratio
a) Liability b) Profitability b) Operating ratio or Profit and Loss
c) Solvency d) All of the above Ratio
4. Ratios can be used in a form of _______ to c) Combined Ratios
identify areas when performance has d) None of the above
improved or deteriorated over time. 11. ________ gives some yardstick to measure
a) Short term Analysis the profit in relative terms with reference
b) Trend Analysis to sales assets or capital employed.
c) Vertical Analysis a) Profitability Ratio
d) Horizontal Analysis b) Turnover Ratio
5. _______ are relationships, expressed in c) Financial Ratio
arithmetical terms, between figures which d) Market Test Ratios
have a cause and effect relationship or 12. ________ are calculated to judge the financial
which are connected with each other in position of the organization from short-
some other manner. term as well as long-term solvency point of
a) Ratio Analysis b) Trends Ratio view.
c) Accounting Ratio a) Profitability Ratio b) Turnover Ratio
d) None of the above c) Financial Ratio
6. Ratio Analysis are useful tool for grasping d) Market Test Ratio
the true message of the financial 13. Profitability Ratio =
statements and understanding them. Operating Profit (Net Margin )
a) Operating Capital Employment + 100
a) True b) False Operating Profit (Net Margin )
c) Partly True d) Partly False b) - 100
Operating Capital Employment
7. Ratios act as indicators of - Operating Profit (Net Margin )
c) ×100
a) Financial Soundness Operating Capital Employment
Operating Profit (Net Margin )
b) Strength d) ÷ 100
Operating Capital Employment
c) Position
14. Capital employed comprise –
d) All of the above
a) Share Capital + Reserve and Surplus +
8. Ratio useful for all the constituents of the
Long-term loans + Non Operating
company i.e.
Assets + Fictitious Assets
i) Management
b) Share Capital + Reserve and Surplus +
ii) Shareholders
Long-term loans - Non Operating
iii) Investors
Assets - Fictitious Assets
iv) Creditors
c) Share Capital + Reserve and Surplus -
v) Government
Long-term loans + Non Operating
a) (i), (ii), (iii), (iv)
Assets + Fictitious Assets
b) (ii), (iii), (iv), (v)
d) Share Capital - Reserve and Surplus -
c) (i), (ii), (iv), (v)
Long-term loans + Non Operating
d) All of the above
Assets + Fictitious Assets

194
15. _________ is also referred to as return on net 24. Debtors collection period depend upon the
worth. –
a) Profitability a) Nature of the industry
b) Return on Investment b) Seasonal character of the business
c) Return on Shareholder’s Funds c) Credit policy of the firm
d) Return on Assets d) All of the above
16. Return on shareholder’s Funds = 25. The term ‘creditors’ include –
Net Profit after Interest and Tax a) Trade Creditors b) Bills Payable
a) + 100
Shareholders ′ Fund
Net Profit after Interest and Tax c) Both (a) and (b)
b) - 100 d) None of the above
Shareholders ′ Fund
Net Profit after Interest and Tax 26. Current Assets normally include –
c) × 100
Shareholders ′ Fund
Net Profit after Interest and Tax i) Inventories
d) ÷ 100 ii) Sundry Debtors
Shareholders ′ Fund
17. _________ Ratio express the relationship of iii) Loans and Advances
gross profit to net sales or turnover. iv) Marketable Securities
a) Gross Profit b) Net Profit v) Bills Payable
c) Operating d) Activity vi) Provision for Taxation
18. Gross Profit Ratio = vii) Bank Overdraft
Gross Profit
a) Net Sales + 100 a) (i), (ii), (iii), (iv)
Gross Profit b) (iii), (iv), (v), (vi)
b) - 100 c) (v), (vi), (iv), (viii)
Net Sales
Gross Profit
c) ×100 d) All of the above
Net Sales
Gross Profit 27. Current Liabilities consists of –
d) Net Sales ÷ 100 i) Inventories
19. The major component of cost is - ii) Sundry Debtors
a) Material b) Labour iii) Loans and Advances
c) Overheads d) All of the above iv) Marketable Securities
20. Fixed Assets Turnover Ratio = v) Sundry Creditors
a) Net Sales + Fixed Assets vi) Bills Payable
b) Net Sales - Fixed Assets vii) Provision for Taxation
c) Net Sales × Fixed Assets viii) Bank Overdraft
d) Net Sales ÷ Fixed Assets a) (i), (ii), (iii), (iv)
21. _________ Ratio is an indicator of the b) (iii), (iv), (v), (iv)
efficiency of the use of investment in stock. c) (v), (vi), (iv), (viii)
a) Fixed Assets Turnover d) All of the above
b) Working Capital Turnover Shareholders ′ Funds
28. Proprietary ratio =
c) Stock Turnover ?
d) Debtors Turnover a) Long term funds
22. Average inventory is calculated on the b) Fixed Assets
basis of the average inventory at the c) Total Assets
beginning and at the end of the accounting d) Interest Charges
?
period. 29. Fixed Assets Ratio = Long Term Funds
a) True b) False a) Long Term Funds
c) Partly True d) Partly False b) Fixed Assets
23. _________ ratio measures the net credit sales c) Total Assets
of a firm to the recorded trade debtors d) Interest Charges
thereby indicating the rate at which cash is 30. ______ Ratio is also known fixed charges
generated by turnover of receivable or over or interest cover.
debtors. a) Debt Service b) Capital gearing
a) Fixed Assets turnover c) Market Test
b) Working Capital Turnover d) Earning per share
c) Stock Turnover
d) Debtors Turnover

195
31. Debt Service Ratio = c) Firms A and B have the same level of
Net Pro fit Before Interest and Tax net income. If firm A has a higher
?
interest expense, its return on equity
a) Long Term Funds b) Fixed Funds
(ROE) must be greater than that of firm
c) Total Assets
B.
d) Interest Charges
? 38. If a company revalues its assets, its net
32. EPS = No .of Equity Shares worth –
a) Net Profit b) Gross Profit a) Will improve
c) Debtors b) Will remain same
d) None of the above c) Will be positively affected
33. _________ ratio establishes relationship d) None of the above
between the market price of shares of a 39. Proprietary ratio is calculated by –
company and its earnings per share (EPS). a) Total Assets/ Total Outside Liability
a) Price Earning b)Pay Out b) Total Outside Liability/Total tangible
c) Dividend Yield d) Debt equity Asset Fixed Assets/ Long Term Source
34. ________ ratio expresses the relationship of fund
between what is available as earning per c) Proprietor’s Funds/Total Tangible
share and what is actually paid in the form Assets
of dividends out of available earnings. 40. Current Ratio of a concern is 1, its net
a) Price Earning b) Pay-out working capital will be –
c) Dividend Yield d) Debt Equity a) Positive b) Negative
35. Dividend Pay-out Ratio = c) Nil
Dividend per share d) None of the above
a) Market Price per share + 100
Dividend per share
41. Quick assets does not include –
b) - 100 a) Government Fund
Market Price per share
Dividend per share b) Book Debts
c) ×100
Market Price per share c) Advance for supply of raw materials
Dividend per share
d) ÷ 100 d) Inventories
Market Price per share
42. The ideal quick ratio is –
36. Which of the following actions will cause
a) 2 : 1 b) 1 : 1
an increase in its current ratio?
c) 5 : 1
a) $ 1,000 worth of inventory is sold, and
d) None of the above
an account receivable is created. The
43. A very high current ratio indicates -
receivable exceeds the inventory by
a) High Efficiency
the amount of profit on the sale, which
b) Flabby Inventory
is added to retained earnings.
c) Position of more long term funds
b) A small subsidiary which was acquired
d) Either (b) or (c)
for $ 100,000 two years ago which was
44. Financial leverages means –
generating profits at the rate of 10% is
a) Use of more debt capital to increase
sold for $ 100,000 cash (Average
profit
company profits are 15% of assets).
b) High degree of solvency
c) Marketable securities are sold at cost.
c) Low bank finance
d) Both (a) and (b)
d) None of the above
37. Which of the following statement is
45. The Capital gearing ratio is high for a
correct?
company. It indicates a position of –
a) If firms A and B have the same level of
a) Low debts
earnings per share. And the same
b) High preference capital
market to book ratio, they must have
c) High equity
the same price earnings ratio.
d) Low Debt equity ratio
b) Firms A and B have the same level of
46. Current liabilities are equal to –
net income, taxes paid, earning power
a) Working Capital + Current Assets
ratio (BEP) must be greater than that
b) Working Capital – Current Assets
of firm B.
c) Current Assets – Working Capital

196
 d) Current Assets + Working Capital 56. The average collection period of a
47. The nature of ratio analysis is – company is 40 days. If the receivables
a) Quantitative Analysis balance is ` 20 lakhs, then calculate the
b) Qualitative Analysis amount of sales.
c) Both Quantitative and Qualitative a) ` 182.00 lakhs b) ` 182.50 lakhs
Analysis c) ` 181.50 lakhs d) ` 181.00 lakhs
d) None of the above 57. The equity capital and total debt of Super
48. Stock is not a quick asset for the purpose Industries Ltd. amount to ` 150 lakhs and
of calculating acid test ratio. ` 300 lakhs respectively. The EBIT of the
a) True b) False company amounts to ` 90 lakhs. Calculate
c) Partly True d) Partly False the return on investment of the company.
49. A firm with a very high current ratio and a) 5% b) 10%
very low liquid ratio has very low level of c) 20% d) 40%
inventory. 58. If the stock turnover = 6, cost of goods sold
a) True b) False = ` 5,000 and opening stock = ` 8,000,
c) Partly True d) Partly False then calculate the value of closing stock.
50. Quick Ratio is the indicator of _________ a) ` 5,000 b) ` 15,000
position of an enterprise. c) ` 20,000 d) ` 10,000
a) Social b) Financial 59. Working capital of a company is ` 1,35,000
c) Economical d) Political and current ratio is 2.5. Liquid Ratio is 1.5
51. The net income of company after and the proprietary ratio is 0.75. Bank
preference dividend is ` 40,000 and the Overdraft is ` 30,000. There are no long
number of equity shares is 6,000 then EPS term loans and fictitious assets. Reserves
= and surplus amount to ` 90,000 and the
a) ` 0.15 per share b) ` 6.66 per share gearing ratio (Equity Capital/ Preference
c) ` 1.5 per share d) ` 15 per share Capital) is 1.2.
52. If a company declares 20% dividend on its i) Current Assets
share of ` 20 each having a market value of a) ` 2,25,000 b) ` 1,35,000
` 40 each, then the real rate of return is c) ` 2,70,000 d) ` 60,000
not 20% but is 10%. Dividend yield ratio is ii) Net Block
– a) ` 2,25,000 b) ` 1,35,000
a) 20% b) 5% c) ` 2,70,000 d) ` 60,000
c) 10% d) 40% iii) Proprietary Fund
53. If the dividend payout ratio is 0.40 and the a) ` 2,25,000 b) ` 1,35,000
P/E ratio is 8, then calculate the dividend c) ` 2,70,000 d) ` 60,000
yield iv) Quick Liabilities
a) 8% b) 5% a) ` 2,25,000 b) ` 1,35,000
c) 7% d) 6% c) ` 2,70,000 d) ` 60,000
54. If the net profit margin is 8%, the asset to v) Quick Assets
equity ratio is 3.00 and total asset a) ` 90,000 b) ` 1,35,000
turnover is 1.5 then calculate the return on c) ` 1,20,000 d) ` 60,000
equity. vi) Stock
a) 12% b) 24% a) ` 90,000 b) ` 1,35,000
c) 36% d) 48% c) ` 1,20,000 d) ` 60,000
55. Orient Ltd. has financed its assets by vii) Preference and Equity Capital
taking debt as high as 60% of the value of a) ` 90,000, ` 1,35,000
the assets. If the equity capital of the b) ` 1,35,000, ` 1,20,000
company is ` 60 lakhs, then calculate the c) ` 1,20,000, ` 60,000
debt. d) ` 60,000, ` 1,20,000
a) ` 90 lakhs b) ` 60 lakhs 60. Following information are given below:
c) ` 75 lakhs d) ` 85 lakhs  Inventory turnover ratio is 6 times

197
  year and debtors are outstanding for 2 If Tapley could streamline operations, cut
months, year and creditors are operating costs, and raise net income to $
outstanding for 73 days. 300, without affecting sales or the balance
 Ratios of cost of goods sold to: (a) sheet (the additional profits will be paid
Proprietors’ funds 2 : 1, (b) fixed out as dividends), by how much would its
assets is 4 : 1 ROE increase?
 Ratio of gross profit to sales is 20% a) 3.00% b) 3.50%
 Closing stock is greater than the c) 4.00% d) 4.50%
opening stock by ` 10,000 63. Q Corp. has a basic earnings power (BEP)
 The gross profit for the year ended ratio of 15% and has a times interest
31st march, 2014 is ` 1,20,000 earned (TIE) ratio of 6. Total assets are $
 Reserves and surplus appearing in the 1,00,000. The corporate tax rate is 0%.
balance sheet as at 31st March, 2014 What is Q Corp’s return on assets (ROA)?
total to ` 40,000 a) 7.5% b) 10.0%
The directors’ of Bharucha enterprises c) 12.2% d) 13.1%
Ltd. ask you to ascertain: 64. You are considering adding a new product
i)I Proprietors’ Fund to your firm’s existing product line. It
a) ` 2,40,000 b) ` 1,20,000 should cause a 15% increase in your profit
c) ` 1,00,000 d) ` 98,000 margin (i.e., new PM = old PM × 1.5), but it
i)II Fixed Assets: will also require a 50% increase in total
a) ` 2,40,000 b) ` 1,20,000 assets (i.e., new TA = old TA ×1 .5). You
c) ` 1,00,000 d) ` 98,000 expect to finance this asset growth entirely
i)III Closing Debtors: by debt. If the following ratios were
a) ` 2,40,000 b) ` 1, 20,000 computed before the change what will be
c) ` 1,00,000 d) ` 98,000 the new ROE if the new product is added
i)IV Closing Creditors: and sales remain constant?
a) ` 2,40,000 b) ` 1,20,000 Ratios before new product
c) ` 1,00,000 d) ` 98,000 Profit margin = 0.10
i)V Closing Stock Total Assets turnover = 2.00
a) ` 85,000 b) ` 2,00,000 Equity Multiplier = 2.00
c) ` 33,000 d) ` 83,000 a) 11% b) 46%
i)VI Share Capital c) 40% d) 20%
a) ` 85,000 b) ` 2,00,000 65. Oliver incorporated has a current ratio =
c) ` 33,000 d) ` 83,000 1.6, and a quick ratio equal to 1.2. The
i)VII Cash and Bank Balances company has $ 2 million in sales and its
a) ` 85,000 b) ` 2,00,000 current liabilities are 1 $ million. What is
c) ` 33,000 d) ` 83,000 the company’s inventory turnover ratio?
61. Russell securities has $ 100 million in total a) 5.0 b) 5.2
assets and its corporate tax rate is 40%. c) 5.5 d) 6.0
The company recently reported that its 66. The Meridian Company has determined
basic earning power ratio was 15% and that its return on equity is 15%.
that its return on assets (ROA) was 9%. Management is interested in the various
What was the company’s interest expense? components that went into this
a) $ 0 b) $ 2,000,000 calculation. You are given that following
c) $ 6,000,000 d) $ 15,000,000 information: Total Debt/ Total assets =
62. Tapley Dental Supply Company has the 0.35 and total assets turnover = 2.8. What
following data: is the profit margin?
Net Income: % 240 Sales: % 10,000 a) 3.48% b) 5.42%
Total assets: $ 6,000 Debt Ratio: 75% c) 6.96% d) 2.45%
The Ratio: 2.0 Current Ratio: 1.2 67. Traft Technologies has the following
BEP ratio: 13.33% relationships:
Annual Sales $ 1,200,000
Current Liabilities $ 375,000

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 Days sales outstanding (DSO) (365-day the company’s current ratio, assuming that
year) 40 it is successful in improving its inventory
Inventory Turnover Ratio 4.8 turnover ratio to 5?
Current Ratio 1.2 a) 1.33 b) 1.67
The company’s current assets consist of c) 1.22 d) 0.75
cash, inventories, and accounts receivable. 71. Debt Equity Ratio is 3 : 1, the amount of
How much cash Taft have on its balance total assets ` 20 lack, current ratio is 1.5:1
sheet? and owned funds ` 3 lac. What is the
a) $ 8.333 b) $ 68.493 amount of current asset?
c) $ 125,000 d) $ 200,000 a) ` 5 lac b) ` 3 lac
68. Thomas Corp. has the following simplified c) ` 12 lac
balance sheet: d) None of the above
Cash $50,000 Current $ 125,000 72. Current ratio is 4 : 1. Net Working Capital
Liabilities
Inventory 150,000 is ` 30,000. Find the amount of current
Accounts 100,000 Long-term 175,000 Assets,
receivable debt a) ` 10,000 b) ` 40,000
Net fixed 200,000 Common 200,000
Assets Equity
c) ` 24,000 d) ` 6,000
Total $ 500,000 Total $ 500,000 73. Current Ratio is 2:5. Current Liability is `
Sales for the year totaled $ 600,000. The 30,000. The Net working capital is
company president believes the company a) ` 18,000 b) ` 45,000
carries excess inventory. She would like c) ` (-) 45,000 d) ` (-) 18,000
the inventory turnover ratio to be 8x and 74. The ratio of Current Assets (` 6,00,000) to
would use the freed up cash to reduce Current Liabilities (` 4,00,000) is 1.5 : 1.
current liabilities. If the company follows the accountant of the firm is interested in
the president’s recommendation and sales maintaining a Current Ratio of 2 : 1, by
remain the same, the new quick ratio paying off a part of the Current Liabilities.
would be Compute the amount of Current Liabilities
a) 2.4 b) 4.0 that should be paid, so that the Current
c) 4.5 d) 3.0 Ratio at the level of 2 : 1 may be
69. Southeast Packaging’s ROE last year was maintained.
only 5%, but its management has a) ` 2,00,000 b) ` 3,00,000
developed a new operating plan designed c) ` 2,50,000 d) ` 4,00,000
to improve things. The new plan calls for a 75. Current Liabilities of a company are `
total debt ratio of 60% which will result in 3,00,000. Its Current ratio is 3 : 1 and
interest charges of $ 8,000 per year. liquid ratio is 1 : 1. Calculate the value of
Management projects an EBIT of $ 26,000 stock assuming that the only other current
on sales of $ 240,000, and it expects to asset is stock.
have a total assets turnover ratio of 2.0. a) ` 6,50,000 b) ` 7,00,000
Under these conditions, the average tax c) ` 7,50,000 d) ` 6,00,000
rate will be 40%. If the changes are made, 76. The Current Ratio of A Ltd. is 4.5 :1 and
what return equity will southeast earn? Liquid Ratio is 3 : 1. Stock is ` 3,00,000.
a) 9.00% b) 11.25% What are the Current Liabilities?
c) 17.50% d0 22.50% a) ` 1,00,000 b) ` 2,00,000
70. Vance Motors has current assets of $ 1.2 c) ` 2,50,000 d) ` 3,00,000
million. The company’s current ratio is 1.2, 77. Total Current liabilities of A Ltd. are `
its quick ratio is 0.7, and its inventory 5,00,000 and acid test ratio is 3 : 1. Stock is
turnover ratio is 4. The company would ` 2,50,000. Find out the Current ratio.
like to increase its inventory turnover a) 4.5 : 6 b) 2.3 : 2
ratio to the industry average, which is 5, c) 4.5 : 1 d) 3.5 : 1
without reducing its sales. Any reductions 78. Quick Ratio 1.5, Current Assets ` 1,00,000,
in inventory will be used to reduce the Current Liabilities ` 40,000. Calculate the
company’s current liabilities. What will be value of stock.

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 a) ` 40,000 b) ` 45,000 a) ` 40,000 b) ` 25,000
c) ` 50,000 d) ` 30,000 c) ` 30,000 d) ` 20,000
89. Calculate the value of opening stock
Working Capital of a Company is ` 60,000. a) ` 40,000 b) ` 25,000
Its Current Ratio is 2.5:1. c) ` 50,000 d) ` 20,000
Calculate the value of: 90. Calculate Debtors Turnover Ratio
a) 3 times b) 2 times
79. Current Liabilities c) 1 times d) 4 times
a) ` 36,000 b) ` 30,000 91. Calculate current Assets of a company
c) ` 35,000 d) ` 40,000 from the following information:
80. Current Assets Stock Turnover Ratio: 4 times
a) ` 2,00,000 b) ` 3,00,000 Stock in the end is ` 20,000 more than
c) ` 1,00,000 d) ` 3,00,000 stock in the beginning.
81. Acid test ratio assuming stock of ` 40,000. Sales ` 3,00,000
a) 1.5 : 1 b) 2.5 : 1 Gross Profit Ratio 25%
c) 3.5 : 1 d) 4.5 : 1 Current Liabilities ` 40,000
82. Calculate Debt-Equity Ratio from the Quick Ratio 0.75
following data: a) ` 90,250 b) ` 80,250
Total Assets ` 1,25,000 c) ` 96,250 d) ` 95,250
Total debt ` 1,00,000
Current Liabilities ` 50,000 92. Ratio Analysis aids in ______________________
a) 2 : 3 b) 2 : 5 a) Financial Accounting
c) 2 : 1 d) 1 : 2 b) Cost accounting
c) Decision making
` 2,00,000 is the cost of goods sold, d) None of the above
inventory turnover 8 times; stock at the 93. Which of the following is not the
beginning is 1.5 time more than the stock at advantage of ratio analysis?
the end. a) Forecasting
b) Inter-firm comparison
83. Calculate the value of closing stock c) Historical analysis
a) ` 35,713 b) ` 14,285 d) Clues to further investigation
c) ` 40,713 d) ` 30,713 94. Which of the following is not the
84. Calculate the value of opening stock limitation of ratio analysis?
a) ` 35,713 b) ` 56,713 a) Not free from bias
c) ` 40,713 d) ` 30,713 b) Only symptoms and not cure
85. Calculate the value of opening stock c) Only quantitative analysis and not
a) ` 35,000 b) ` 56,000 qualitative analysis
c) ` 40,000 d) ` 50,000 d) Simplicity
86. Calculate the value of opening stock 95. Ratio analysis facilitates __________
a) ` 35,000 b) ` 14,000 comparisons.
b) ` 40,000 d) ` 60,000 a) Inter-firm b) Intra-firm
87. Calculate stock (inventory) turnover Ratio c) Pattern
a) 3 times b) 2 times d) All of the above
c) 1 times d) 4 times 96. Liquidity ratios measure _____________
obligations.
From the Following: a) Short-term b) Long-term
Closing Debtors ` 40,000, credit sales being c) Very-Short-term
25% of cash sales, Excess of closing Debtors d) Both (a) & (b)
over opening Debtors ` 20,000, Total Sales 97. A very high current ratio will:
` 1,50,000. a) Increase the profitability
b) have adverse impact on profitability
88. Calculate Net Credit Sales c) not affect the profitability

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 d) None of the above c) not affect the profitability
98. A very high current ratio may be due to: d) None of the above
a) Pilling up inventory 107. The ratio which measures the average
b) inefficiency in collection of debtors period for which quick assets are
c) high balances in cash and bank without available to meet average daily operating
proper investment expenses is:
d) all of the above a) Absolute cash ratio
99. Traditionally, a current ratio of _________ is b) Current Ratio
considered to be a satisfactory ratio. c) Quick Ratio
a) 2 : 1 b) 1 : 1 d) Internal interval measure ratio
c) 1 : 2 108. A low interval measure ratio is indicator
d) None of the above of:
100. A firm seeks to increase its current ratio a) Short term profitability
from 1.5 before its closing date of the b) Short term liquidity
accounts. The action that would make it c) Long term profitability
possible is: d) Long term liquidity
a) Delaying payment of salaries 109. Which of the following firms would have
b) Increase charge for depreciation the least liquidity?
c) Making cash payment to creditors a) Current Ratio – 2.2 and Quick Ratio –
d) Selling marketable securities for cash 1.6
at book value. b) Current Ratio – 2.2 and Quick Ratio –
101. Which of the following is not an absolute 1.1
liquid asset? c) Current Ratio – 1.2 and Quick Ratio –
a) Cash in hand 0.6
b) Cash at bank d) Current Ratio – 1.2 and Quick Ratio –
c) bills receivables 0.8
d) Marketable investments 110. ______________ is also known as working
102. Which one of the following is not a quick capital ratio.
liabilities? a) Quick Ratio b) Current Ratio
a) Creditors c) Liquid Ratio
b) Outstanding expenses d) Debt-Equity Ratio
c) Cash credit
d) All of the above ANSWERS
103. Which one of the following is not a quick
assets? 1. a 2. a 3. d
a) Debtors 4. b 5. c 6. b
b) Marketable securities 7. d 8. d 9. a
c) Cash at bank 10. b 11. a 12. c
d) Prepaid expenses 13. c 14. b 15. c
104. Traditionally, a quick ratio of ___________ is 16. c 17. a 18. c
considered to be a satisfactory ratio. 19. d 20. d 21. c
a) 1 : 2 b) 1 : 1 22. a 23. d 24. d
c) 2 : 1 25. c 26. a 27. c
d) None of the above 28. c 29. b 30. a
105. In computing quick assets, cost of 31. d 32. a 33. a
inventory are excluded while realizable 34. b 35. b 36. d
value of inventory (if any) are included.
37. b 38. a 39. d
a) True b) False
40. c 41. d 42. b
c) Either (a) or (b)
43. d 44. a 45. c
d) None of the above
46. b 47. c 48. a
106. A very high absolute cash ratio will:
a) Increase the profitability 49. b 50. b 51. b
b) Have adverse impact on profitability 52. c 53. b 54. c

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55. a 56. b 57. c
58. d 59. (i) a (ii) b
(iii) c (iv) d (v) a
(vi) b (vii) d 60. (i) a
(ii) b (iii) c (iv) d
(v) a (vi) b (vii) c
61. a 62. c 63. a
64. b 65. a 66. a
67. b 68. d 69. d
70. c 71. c 72. a
73. d 74. a 75. d
76. b 77. d 78. a
79. d 80. c 81. a
82. c 83. b 84. a
85. c 86. d 87. a
88. c 89. d 90. c
91. c 92. c 93. c
94. d 95. d 96. a
97. b 98. d 99. a
100. c 101. c 102. c
103. d 104. b 105. a
106. b 107. d 108. b
109. c 110. b

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CHAPTER 7
INTRODUCTION
Standard Cost: Standard cost is a predetermined cost which is calculated from the
management standards of efficient operation and relevant necessary expenditure.

Standard costing system is a costing system that:

(i) Traces direct costs to output produced by multiplying the standard prices or rates by the
Standard Quantities of inputs allowed for Actual Output produced (SQAO), and

(ii) Allocates overhead costs on the basis of the standard overhead – costs rates times the
standard quantities of the allocation bases allowed for the actual outputs produced.
According to ICMA, London, Standard Costing refers to “the preparation and use of
standard costs, their comparison with actual costs and the analysis of variances to their
causes and points of incidence.”

Standard Costing involves the following steps:

(a) Setting up of standards

(b) Ascertainment of Actual Costs
(c) Comparison of Actual and Standard Costs to determine variance and
(d) Investigation of variance and taking appropriate action thereon wherever necessary.

Installation of standard costing system involves the following preliminary steps:

(a) Establishment of Responsibility Centres: The key areas of operation in the enterprise
should be identified into responsibility centres with clearly defined roles e.g. cost control
revenue maximization etc. Such responsibility centres may be identified either through (1)
Departmentation or (2) Activity Based Costing.

(b) Classification of Accounts: The various heads of expense accounts should be classified and
codified for collection and comparison of actual costs with standard costs. This will also
help the process of mechanized/ computerized accounting.

(c) Selection of a suitable type of standard: For operational requirements a suitable type of a
standard should be selected.

(d) Length of the period of use: The duration for which the standards are to be used should
be determined.

OBJECTIVES FOR ADOPTING STANDARD COSTING SYSTEM

(i) Cost Management

(ii) Planning and Control
(iii) Decision-Making
(iv) Product Costing

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Advantage of Standard Costing:

(i) Measuring Performance: Standards provide a base for measurement of actual

performance. Standard costing will eliminate any variations in profit due to changes in the
values of stock holding from period to period and will thus provide a true basis for the
measurement of profit.

(ii) Cost Control: Variance analysis and investigation of reasons thereof will provide the basis
for appropriate control action. Adverse variances can be controlled and their recurrence
avoided.

(iii) Price Fixing: Standard cost will remain stable over a period of time as opposed to actual
cost which may fluctuate violently. Hence, where demand for a product is elastic standard
cost can be used as a basis for fixing the selling price.

(iv) Management by Exception: If the variance is negligible, it means that performance is

more or less in accordance with the standards. Significant variances that warrant the
attention of the manager are brought to his knowledge. This facilitates control by exception.

(v) Introduction of Incentives: Standard costing facilitates evaluation of jobs and

introduction of incentives job values can be determined by the use of evaluation and scale
of wages fixed according to the responsibility involved in each job.

(vi) Quotations and Estimates: Standard costing facilitates the estimation of the cost of new
products with greater accuracy. It can also be used for jobbing industries.

RELATIONSHIP BETWEEN STANDARD COSTING AND BUDGETARY CONTROL

Distinction Between Standard Costing and Budgetary Costing

Particulars Standard Costing Budgetary Control

Meaning Standard costs are pre-determined Budgets are financial and/or
costs representing what the costs quantitative statements prepared and
should be at the level of efficient approved prior to a defined period of
conditions of production and time of the policy to be pursued
operation. during that period for the purpose of
attaining a given objective.
Coverage They are generally restricted to costs. They include estimates of income
costs and employment of capital.
These are determined based on
management’s plants of what should
be done to achieve a certain objective
and how to actually achieve it.
Basis These are determined by the Budgeted costs are estimated keeping
collection of technical data related to in view actual conditions and
production and applying costs to each attainable targets of a period under
element of production. review, in view of the conditions that
likely to be prevalent in that year.
The effect of short-term changes in
cost structure, etc. will be fully in
budgeted costs.
Effect of If in a particular year the costs are They are estimated usually for one
temporary likely to be high due to certain factors year and take into account the

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 conditions standard costs are not changed unless practical problems of operations and
the factors are permanent in nature. are kept at a level which the firm
Effects of short-run temporary hopes to achieve in the year for which
changes will not be reflected in the budget is being prepared.
Standard costs.
Permanence Standard cost is usually semi-
permanent in nature and may not be
changed unless and until there are
changes in the basic price structure or
in the methods of operation.

Relationship
 Budgeted and standard costs are set up to exercise costs control and judger performance by
setting up targets.
 Both systems provide benchmarks against which the actual performance and costs are
compared variance are calculated and the reasons for the variance ascertained.
 A budgetary control system can operate without standard costs. The two systems are not
interdependent i.e., they can exist independently.
 However, when budgets are being developed standard costs are of immense help since they
are long-term estimates of the same activity and represent management’s view of the level
of efficiency that should prevail. Similarly, for determination of standards, information on
past budgeted and actual costs is useful.

ESTABLISHING STANDARDS
Developing and establishing standards requires significant inputs from various sources. Three
potential sources of quantitative standards are as follows:
(i) Historical experience
(ii) Engineering studies
(iii) Input from operating personnel

CLASSIFICATION OF STANDARDS
 Basic/Fixed/Static Standard: Basic standard is a standard which is established for some
base year and remain in use for a long period of time.
 Current Standard: Current standard is a standard which is established for a limited period
and is related to current conditions. These standards call for periodical review and frequent
revisions.
 Ideal/ Theoretical Standard: Ideal standard is a standard which is based on perfect
performance without making any allowance for unavoidable losses (e.g. Normal Idle time,
normal waste/ scrap/ defectives/ spoilage etc.). It is merely a theoretical standard which is
unrealistic and unattainable.
 Expected/ Attainable/Practical Standard: Expected or practical standard is a standard
which is based on expected performance after making a reasonable allowance for
unavoidable losses (e.g. Normal Idle Time, Normal Value/ Scrap/ Defectives/ Spoilage etc.).
It is realistic and attainable standard. Variances from the expected standard indicate real
deviations from the attainable performance.
 Normal Standard: Normal standard is a standard which is based on average performance
in the past, It is attainable under normal conditions.
 Historic Standard: It is the average standard of past achievement. It may not be adopted as
past performance including inefficiencies.

Standard cost is a carefully determined cost of a unit of output. According to CIMA official
terminology standard cost is: ‘A predetermined calculation of how much costs should be under

205
specified working conditions. It is built up from an assessment of the value of cost elements and
correlates technical specifications and the qualification of minerals, labour and other costs to the
prices and/or usage rates expected to apply during the period in which the standard cost is
intended to be used. Its main purpose is to provide basis for control through variance accounting
for the valuation of stock and work-in-progress and in some cases, for fixing selling prices.”

VARIANCE ANALYSIS AND ACCOUNTING

Variance analysis is the analysis of the cost variances and its component parts and explanation of
these variances, Cost variance is the difference between a standard cost and the companies actual
cost incurred during a period.
Standard Cost per unit: The Standard cost of a unit of product as shown on the standard cost
card, it is computed by multiplying the standard quantity or hours by the standard price or
rate for each cost element.

Variances: The difference between standard prices and quantities on the one hand and actual
prices and quantities on the other hand.

Methods of Cost Variances Disposed off in a Standard Costing System

There is no unanimity of opinion among Cost Accountants regarding the disposition of variances.
The following are commonly used methods of their disposition:
(i) Transfer all variances to profit and loss account. Under this method, stock of work-in-
progress. Finished stock and cost of sales are maintained at standard cost and variances
arising are transferred to profits and loss account.
(ii) Distributing variances on pro-rata basis over the cost of sales, work-in-progress and
finished goods stocks by using suitable basis.
(iii) Write off quantity variance to profit and loss account and spread price variance over to
cost of sales work in progress and finished goods. The reason behind apportioning price
variance to inventories and cost of sales is that they represent costs although they are
derived as variances

CLASSIFICATION OF VARIANCES
The concern prepares budget for the current period. This budget is based on actual data of
previous period then the current period actual operation is current this actual is compared with
the standard and variance is found. Standard means budget for actual production and sales.

Example 1: Suppose a budget is prepared as follows:

Production unit = 10,0000 units
Raw material requirement per unit = 2.5 kg/unit
Labour hour per unit = 4 hours
(i) During the period the actual production was 12,000 units.
Standard i.e., budget for actual production
Material = 12,000 × 2.5 kg = 30,000 kg
Labour = 12,000 × 4 hrs. = 48,000 hrs.
(ii) Actual position for 12,000 units products
Material sed = 26,000 kgs.
Labour required = 52,000 hrs.
The actual may be different (varied) from standard. Hence, a variance analysis is carried out for
each component of cost: material, labour and overhead and also for sales.

Direct Material Price Variance = Actual Quantity (Standard Price – Actual Price)

Direct Material Usage Variance = Standard Price (Standard Quantity – Actual Quantity)

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 COST VARIANCE

+ Favourable
- Adverse

Material Cost Labour Cost Variable Overhead Fixed Overhead

MATERIAL
The material cost consists of quantity and price. Hence, the overall cost variance is calculated as a
difference between standard cost of material and actual cost of material.
This overall cost variance is subdivided between price variance and usage variance.
Material cost variance = (Standard cost of material) – (Actual cost of material)
= [(Budgeted Quantity for actual production × Standard price per unit) – (Actual quantity of actual
production × Actual price per unit)]
Material price Variance = It shows the difference in price of material for actual quantity of
material used.
= Actual quantity of material × (Standard price per unit – Actual price per unit)
= (Standard price per unit × Actual quantity of material used) – (Actual price per unit × Actual
quantity of material used)
Material Usage Variance: This shows the variance between the standard quantity required for
actual production and actual quantity of material used in actual production.
= Standard price per unit of material (Standard quantity of material for actual production – Actual
quantity of material for actual production)

S.P. × S.Q. S.P. × A.Q. A.P. × A.Q.

Usage Variance Price variance

Cost Variance

MATERIAL COST VARIANCE

Material Price Variance Material Usage Variance

(Standard price – Actual Price) × Actual Quantity (Standard Quantity – Actual quantity) × Standard
price

At the time of Purchase At the time of Consumption

(Standard price – actual price) (Standard price – Actual price)
× Actual quantity purchased × Actual quantity consumed

If required If Silent
1. MPV (At the time of purchase) + MUV ≠ MCV
2. MPV (at the time of consumption) + MUV = MCV

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Causes of material price variance:
 Change in the market prices of materials.
 Failure to purchase the specified quality, thereby resulting in a different price being paid.
 Change in quantity of materials purchased, thereby leading to lower/ higher quantity
discount.
 Not availing cash discounts, when standards set took into account such discounts.
 Inefficient purchasing.
 Change in the delivery costs
 Rush purchases
 Purchase of a substitute material on account of non-availability of the material specified.
 Change in the rate of excise duty, purchase tax etc.
 Off-season purchasing for certain seasonal products like jute, cotton etc.

Causes of Material Usage Variance

 Use of non-standard materials.
 Use of non-standard material mixture
 Use of substitute material
 Inefficiency in the use of materials.
 Change in quality of materials
 Change in the design or specification of the product
 Change in the method of production
 Yield from materials in excess of or less than standard yield
 Pilferage
 Detect in plant and machinery

Causes of Direct Material Yield Variance

 Lack of due care in handling
 Lack of proper supervision
 Defective methods of operation
 Improper equipments, tools etc.
 Sub-standard quality of materials-fault of purchase department.

TIMING OF PRICE VARIANCE COMPUTATION

The direct material price variance can be computed at one of two points:
(i) When the direct materials are issued for use in production, or
(ii) When they are purchased.
Computing the price variance at the point of purchase is preferable. It is better to have information
on variances earlier than later. The more timely the information, the more the likeliness of a
proper managerial action.

TIMING OF THE COMPUTATION OF THE DIRECT MATERIAL USAGE VARIANCE

The direct material usage variance should be computed as direct materials are issued for
production. To facilitate this process, many companies use three points:
(i) A standard bill of materials.
(ii) Color-coded excessive usage forms, and
(iii) Color-coded returned – material forms.
Direct Labour Rate Variance = Actual Time × (Standard Rate – Actual Rate)
Direct Labour Efficiency Variance = Standard Rate × (Standard Time – Actual Rate)

RESPONSIBILITY FOR THE DIRECT MATERIAL VARIANCES

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The responsibility for controlling the direct material price variance is usually lies with the
purchasing manager. The production manager is responsible for direct material usage. However,
at times, the cause of the variance is attributable to other individuals and factors outside the
production area. For example, purchase of low quality direct material may give a bad output. In
this case, the responsibility should be assigned to purchasing rather than production.

Material Yield Variance: This is the Sub-variance of material usage variance which results from the
difference between actual yield and standard yield.

Material Price Variance: A measure of the difference between the actual unit price para for an item
and the standard price, multiplied by the quantity purchased.

Material Quantity Variance: A measure of the difference between the actual quantity of materials used
in production and the standard quantity allowed, multiplied by the standard price per unit of materials.

Direct Material Mix and Yield Variance

The mix variance is the difference in the standard cost of the actual mix of inputs used and the
standard cost of the mix of inputs that should ideally have been used.
A yield variance occurs whenever the actual yield (output) differs from the standard yield.
For direct materials, the sum of the mix and yield variances equals the direct material usage
variance.

Direct Material Mix Variance = Total Actual Quantity × (Standard Cost per Unit of Standard Mix –
Standard Cost per Unit of Standard Mix)
Or, Standard Price × (Revised Actual Quantity – Annual Quantity)
Direct Material Yield Variance = Standard Price of Yield × (Actual Yield – Standard Yield)
Or, Standard Price × (Standard Quantity – Revised Actual Quantity)

MATERIAL USAGE VARIANCE

Material Mix Variance Material Yield Variance

Standard Rate (Standard Ratio for Actual Mix
- Actual Ratio for Actual Mix)
(Standard Ratio for total Standard Mix – Standard
Ratio for Total Actual Mix) Standard Rate
Or
(Total Standard Quantity - Total Actual Quantity)
Weighted Average Budgeted Rate

Note: If Budgeted output and actual output are not given, we should presume actual output =
Budgeted output = 1.
If Budgeted output is given but actual output is not given, actual output = Budgeted output
and vice versa.

Note:
If the price variance is calculated on the actual quantity purchased instead of the actual quantity
used, the price variance plus the usage variance will agree with the total variance only when the
quantity purchased is equal to the quantity which is used in the particular accounting period.
Reconciling the price and usage variance with the total variance is merely a reconciliation exercise,
and you should not be concerned if reconciliation of sub-variances with the total variances is not
possible.

209
LABOUR
The cost of labour is determined by the price paid for labour and the quantity of labour used. Thus
a price and quantity variance will also arise for labour. Unlike materials, labour cannot be stored,
because the purchase and usage of labour normally takes place at the same time. Hence the actual
quantity of hours purchased will be equal to the actual quantity of hours used for each period. For
this reason the price variance plus the quantity variances should agree with the total labour
variance.
S.P. × S.Q. S.P. × A.Q. A.P. × A.Q.
Efficiency Variance Rate variance

Cost Variance
Labour Rate Variance: A measure of the difference between actual hourly labour rate and the
standard rate, multiplied by the number of hours worked during the period.

Labour Efficiency Variance: A measure of the difference between the actual hours taken to
complete a task and the standard hours allowed, multiplied by the standard hourly labour rate.

MATERIAL COST VARIANCE

Labour Rate Variance Labour Idle Variance Labour Efficiency

(Standard Rate – Actual Rate) × (Actual Payment hours - Actual working hours) (Standard hours – Actual working
Actual payment hour × Standard Rate hours) × Standard Rate

Resp. Personnel Manager Always-adverse Production manager

Management’s fault

Specially given in question

Causes for Labour Rate Variance:

 Change in the basic wage rates
 Change in the method of wage payment.
 Use of grades of labour different from the standard grade specified due to non-availability
of the labour grade specified or any other reason.
 Unscheduled overtime
 New workers not being paid at full rates.

Causes for Labour Efficiency Variances:

 Use of non-standard grade of workers
 Use of standard grade of workers but workers are inefficient
 Use of defective method of operation
 Use of defective or non-standard materials.
 Use of defective tools and plant and machinery
 Poor working conditions e.g. inadequate lighting etc.
 Incompetent supervision.

Causes for Idle Time Variance:

210
 Break-down of plant and machinery
 Super-optimal condition of equipments
 Inappropriate equipment
 Poor placement of workers
 Delay in giving production instructions
 Changes in methods of production
 Improper supervision in the factory
 Too frequent changes in workers work
 Power failure

Note:
The similarity between this variance and material price variance: Both variances multiply the
difference between the standard price and actual price paid for a unit of a resource by the actual
quantity of resources used.

RESPONSIBILITY FOR THE DIRECT LABOUR VARIANCES

Direct labour rates are largely determined by such external forces as labour market and union
contracts. When direct labour rate variances occur, they often do so because an average wage rate
is used for the rate standard or because more skilled and more highly paid labourers are used for
less skilled task. However, the use of direct labour is controllable by the production manager. For
this reason, responsibility for the direct labour rate variance is generally assigned to the
individuals who can take good decision for allocation of labour.
The same is true of the direct labour efficiency variance. However, as is true of all variances, once
the cause is discovered, responsibility may be assigned elsewhere.

DIRECT LABOUR MIX AND YIELD VARIANCE

The direct labour mix and yield variance is calculated in the same way as the direct material mix
and yield variance.
Direct Labour Mix Variance = Total Actual Time × (Standard Rate of Standard Labour – Standard
Rate of Actual Labour)
Or, (Revised Actual hours – Actual Hours) × Standard Rate
Direct Labour Yield Variance = Standard Rate × (Total Standard Time – Total Actual Time)
Or, Standard Rate × (Standard Hours – Revised Actual Hours)

VARIABLE OVERHEAD
Where variable overheads vary with direct labour or machine hours of inputs the total overhead
variance will be due to one or both of the following:
(i) A price variance arising from actual expenditure being different from budgeted experience.
(ii) A quantity variance arising from the actual direct labour or machine hours of inputs being
different from the hours of input, which should have been used.
VARIABLE OVERHEAD VARIANCE

Variable Overhead Variable Overhead

Expenditure Variance Efficiency Variance

(Standard Rate – Actual Rate) × Actual Hours (Standard Hours – Actual Hours) × Standard Rate
Variance Overhead Efficiency Variance
The variable overhead efficiency variance is directly related to the direct labour efficiency
variance. If variable overhead is truly driven by direct labour hours, then like the direct labour
efficiency variance, it is caused by efficient or inefficient use of direct labour. If more (or fewer)

211
direct labour hours are used the standard calls for then the total variable cost will increase (or
decrease)
Note:
If it is assumed that variable overheads vary with labour hours of input; this variance is identical to the
labour efficiency variance. Consequently, the reasons for the variance are the same as those described
previously for the labour efficiency variance.

RESPONSIBILITY FOR VARIABLE OVERHEAD EXPENDITURE VARIANCE AND VARIABLE

OVERHEAD EFFICIENCY VARIANCE
Ability to control is a prerequisite for assigning responsibility. Price changes of variable overhead
items are generally beyond the control of supervisors. If price changes are small, the expenditure
variance is primarily a matter of the efficient use of overhead in production, which is controllable
by production supervisors. Accordingly, responsibility for the variable overhead expenditure
variance is generally assigned to production departments.

The reasons for unfavorable variable overhead variance are similar to direct labour efficiency
variance. Responsibility for the variable overhead efficiency variance should be assigned to the
production manager.
Variable overhead Efficiency: The difference between the actual activity (direct labour-hours,
machine-hours, or some other base) of a period and the standard activity allowed, multiplied by the
variable part of the predetermined overhead rate.

Variable Overhead Expenditure Variance

It is similar to the price variance of direct materials and direct labour though there some
conceptual difference. Variable overhead is not a homogenous input- it is made up of a large
number of individual items such as indirect materials, indirect labour, electricity, maintenance,
and so on.
A variable overhead expenditure variance can arise because prices for individual variable
items have increased or decreased. The variable overhead expenditure variance is also affected by
how efficiently overhead is used. The waste or inefficiency in the use of variable overhead
increases the actual variable overhead cost. This increased cost, in turn, is reflected in an increased
actual variable overhead rate. Thus, even if the actual prices of the individual overhead item were
equal to the budgeted or standard prices, an unfavourable variable overhead expenditure variance
could still take place.
Variable overhead Spending: The difference between the actual variable overhead cost incurred
during a period and the standard cost that should have been incurred based on the actual activity of the
period.

FIXED OVERHEAD

Volume Variance
The volume variance reflects the fact that the fixed overheads do not fluctuate in relation to output
in the short term. Whenever the actual production is less than the budgeted production, the fixed
overhead charged to production will be less than the budgeted costs, and the volume variance will
be adverse. Conversely, if the actual production is greater than the budgeted production, the
volume variance will be favourable.
Variable Variance: It is the variation in manufacturing overheads due to difference in budgeted and
the actual volume of activity.

212
Volume Efficiency Variance
The Volume efficiency variance is the difference between the standard hours of output (SH) and
the actual hours of input (AH) for the period multiplied by the standard fixed overhead rate (SR):
(SH – AH) × SR
You may have noted that the physical content of this variance is a measure of labour efficiency and
is identical with the labour efficiency variance. Consequently the reasons for this variance will be
identical with those previously described for the labour efficiency variance. Note also that since
this variance is a sub-variance of the volume variance, the same comments apply as to the
usefulness of attaching a value for fixed overheads because fixed overhead represent sunk costs.
The fixed overhead will not change because of the efficiency of the labour. Again it would be better
to measure this variance in terms of the lost contribution arising from lost sales.

Volume Capacity Variance

The volume capacity variance is the difference between the actual hours of input (AH) and the
budgeted hours of input (BH) for the period multiplied by the standard fixed overhead rate (SR):
(AH – BH) × SR
A failure to achieve the budgeted capacity may be for a variety of reasons. Machine breakdowns,
material shortages, poor production scheduling, labour disputes and a reduction in sales demand
are all possible causes of an adverse volume capacity variance. Again it is better to express this
variance in terms of lost contribution from lost sales caused by a failure to utilize the capacity. It is
not very meaningful to attach fixed costs to the variance, since the total fixed costs will not be
affected by a failure to utilize capacity.

Things to Remember:
(i) Total Fixed Overhead Variance = Absorbed Fixed Overhead – Actual Fixed Overhead
(ii) Fixed Overhead Expenditure Variance = Budgeted Overhead – Actual Overhead
(iii) Fixed Overhead Volume Variance = Standard Rate of Absorption Per Unit × (Actual
Production – Budgeted Production)
(iv) Fixed Overhead Capacity Variance = Standard Rate of Absorption Per Hour × (Actual
Hours Capacity - Budgeted Hours Capacity)
(v) Fixed Overhead Efficiency Variance = Standard Rate of Absorption Per Hour × (Standard
Hours Required – Actual Hours)

FIXED OVERHEAD VARIANCE

Volume Variance Expenditure Variance

(Recovered – Budgeted) or (Budgeted overhead – Actual overhead)
(Standard Hours – Budgeted) × Recovery Rate

Efficiency Variance Capacity Variance

(Standard Hours – Actual Working Hours) (Actual Working Hours – Budgeted Hours) × Recovery Rate
× Recovery Rate

Calender Variance Balance Capacity Variance

(Actual days - Budgeted days × Recovery rate/ day) (Revised Capacity)
(Total Capacity Variance – Calender variance)

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Causes of Fixed Overhead Expenditure Variance:
 Seasonal conditions
 Improper use of available facilities
 Use of efficient tools and equipments
 Improperly set standards
 Rise in price due to inflation
 Change in methods of operation

Causes for Fixed Overhead Volume Variance:

 Power Failure
 Machine breakdown
 Waiting for tools, work, instructions, machine, materials etc.
 Idle or excess capacity
 Variation in customer’s demands and orders booked
 Labour strikes or lock-outs etc.
 working overtime due to rush orders etc.
 Defective scheduling and routing of production.

Causes for Fixed Overhead Efficiency Variance:

 Poor working conditions
 Poor supervision
 Poor scheduling of production processes
 Frequent power failures
 Improperly set standards

Causes for Fixed Overhead Capacity Variance:

 Chance in scheduling of production process
 Power failures
 Labour troubles
 Lock-out
 Shortage of materials
 Machine break-down
 Slump in customer’s demand
 Decline in sales volume
 Inefficient supervision
 Defective material

Notes:
Similarities between materials, labour and overhead variances
1. The standard quantity is derived from determining the quantity that should be used for the actual
production for the period so that the principles of flexible budgeting are applied. The price
variances (i.e. material price, wage rate and variable overheads expenditure variances) were
calculated by multiplying the difference between the standard price (SP) and the actual price
(AP) per unit of resources by the actual quantity (AQ) of resources acquired/ used. The price
variance can be formulated as
(SP – AP) × AQ
This can also be expressed as

(AQ × SP) – (AQ × AP)

2. The first term in this formula (with AQ representing actual hours) is equivalent to the budgeted
fixed variable overheads that we used to calculate the variable overhead expenditure variances.
The last term represents the actual cost of the resource consumed.

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CONTROL RATIOS
These ratios are generally expressed in terms of percentage. If the ratio is 100% or more, it
indicates a favourable position. If the ratio is less than 100%, it indicates unfavourable position.
The important control ratios are given below:
(a) Efficiency Ratio: It is defined as “the standard hours equivalent to the work produced
expressed as a percentage of actual hours spent in production”. Thus, this ratio shows
whether actual time taken in production is more or less than the time allowed by the
standard. Its method of calculation is:
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐇𝐨𝐮𝐫𝐬 𝐟𝐨𝐫 𝐚𝐜𝐭𝐮𝐚𝐥 𝐨𝐮𝐭𝐩𝐮𝐭
Efficiency Ratio = 𝐀𝐜𝐭𝐮𝐚𝐥 𝐇𝐨𝐮𝐫𝐬 𝐰𝐨𝐫𝐤𝐞𝐝
× 100

(b) Activity Ratio: It is defined as “the standard hours equivalent to the work produced,
expressed as percentage of budgeted standard hours”. This ratio shows the extent to which
the production facilities have been utilized as compared with that contemplated in budgets.
Its formula is:
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐇𝐨𝐮𝐫𝐬 𝐟𝐨𝐫 𝐚𝐜𝐭𝐮𝐚𝐥 𝐨𝐮𝐭𝐩𝐮𝐭
Activity Ratio = × 100
𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐇𝐨𝐮𝐫𝐬

(c) Capacity Ratio: It shows the relationship between actual hours worked and the budgeted
hours. Its formula is:
𝐀𝐜𝐮𝐭𝐚𝐥 𝐇𝐨𝐮𝐫𝐬 𝐖𝐨𝐫𝐤𝐞𝐝
Capacity Ratio = 𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐇𝐨𝐮𝐫𝐬
× 100

(d) Calender Ratio: Sometimes calendar ratio is also calculated. This ratio indicates the extent
of actual working days availed during the budget period. It is calculate by using the
following formula:
𝐀𝐜𝐭𝐮𝐚𝐥 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐝𝐚𝐲𝐬 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐮𝐝𝐠𝐞𝐭 𝐩𝐞𝐫𝐢𝐨𝐝
Calender Ratio = 𝐁𝐮𝐝𝐠𝐞𝐭𝐞𝐝 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐝𝐚𝐲𝐬 𝐢𝐧 𝐭𝐡𝐞 𝐛𝐮𝐝𝐠𝐞𝐭 𝐩𝐞𝐫𝐢𝐨𝐝 × 100

215
 CLASSROOM PRACTICE – LETS PLAY TOGETHER

Qus1.
Standard cost of a product in a factory is predetermined as follows:
`
Material (5 units @ `4 each) 20
Labour (20 hours @ `1.50 per hour) 30
Overhead expenses 10
Total 60
During a period, 8,000 units were produced whose actual cost was as follows:
`
Material (40,500 units @ `5 each) 2, 02,500
Labour (1,50,000 hours @ `1.60 each) 2,40,000
Overhead expenses 90,000
Total 5, 32,500
Prepare a statement showing standard cost, actual cost and variances.

Qus2.
PQ Ltd. which has adopted standard costing furnishes the following information:
Standard:
Material for 7 kg. of Finished Products 10 kgs.
Price of materials `10 per Kg.
Actual:
Output 21,000 Kgs.
Material used 28,000 kgs.
Cost of materials `2,52,000

Calculate:
(a) Material Usage Variance;
(b) Material Price Variance;
(c) Material Cost Variance.

Qus3. UV Ltd. presents the following information for November, 2008:

Budgeted production of product P = 200 units.
Standard consumption of Raw materials = 2 kg per unit of P.
Standard price of material A = ` 6 per kg.
Actually, 250 units of P were produced and material A was purchased at Rs 8 per Kg and
consumed at 1.8 kg per unit of P. Calculate the material cost variances.

Qus4.
RS Ltd. has established the following standard mix for producing 9 tonnes of product Z.
`
5 tonnes of material A at ` 7 per tonnes = 35
3 tonnes of material B at ` 5 per tonnes = 15
2 tonnes of material C at ` 2 per tonnes = 4
`54

A standard loss of 10% of input is expected to occur. Actual input was as under:
53,000 tonnes of material A at `7 per tonnes.
28,000 tonnes of material Bat `5.30 per tonnes.
19,000 tonnes of material C at`.2.20 per tonnes
Actual output for a period was 92,700 tonnes of product Z.

216
Compute:
(i). Material Mix Variance;
(ii). Material Yield Variance.

Qus5.
For producing one unit of a product, the materials standard is:
Material X : 6 kg. @ `8 per kg., and
Material Y : 4 kg. @ `10 per kg.
In a week, 1,000 units were produced the actual consumption of materials was:
Material X : 5,900 kg. @ `9 kg., and
Material Y : 4,800 kg. @ `9.50 per kg.
Compute the various variances.

Qus6.
In a manufacturing process, the following standards apply:
Standard Price: Raw material A`1 per kg.
Raw materials B `5 per kg.

Standard Mix 75% A; 25% B (by weight)

Standard Yield : 90%

In a period the actual costs, usage and output were as follows:

Used: 4,400 kgs. of A costing `4,650
1,600 kgs.of B costing `7,850
Output: 5,670 kgs. of products

Qus7.
The standard material input required for 1,000 kgs. of a finished product are given below:
Material Quantity (Kg.) St. Rate per Kg. (`)
P 450 20
Q 400 40
R 250 60
1,100
Standard loss 100
Standard output 1,000
Actual production in a period was 20,000 kg. of finished product for which the actual quantities of
materialused and the prices paid therefore were as under:
Material Quantity (Kg.) Purchase price per Kg. (`)
P 10,000 19
Q 8,500 42
R 4,500 65
Calculate:
(i) Material cost variance;
(ii) Material price variance;
(iii) Material usage variance; and
(iv) Material yield variance.
Also show a reconciliation of the variances.

Qus8.
Time 15 hours per unit
Cost `3 per hour

217
 Actual Performance in a Cost Period
Production 500 units
Hours taken Production 7,800 hours
Idle Time 200 hours
Total Time 8,000 hours
Payment made ` 24,800 (average per hour ` 3.10). Calculate labour variances.
Qus9.
100 skilled workmen, 40 semi-skilled workmen and 60 unskilled workmen were to work for 30
weeks to get a contract job completed. The standard weekly wages were ` 60, ` 36 and ` 24
respectively. The job was actually completed in 32 weeks by 80 skilled, 50 semi-skilled and 70
unskilled workmen who were paid ` 65, Rs. 40 and ` 20 respectively as weekly wages. Find out the
labour cost variance, labour rate variance, labour mix variance and labour efficiency
Qus10.
Compute wage variance
Actual hours worked 5,6000
Actual wage paid ` 7,840
Standard rate per hour `2
Standard hours produced 4,000
Qus11.
A factory, working for 50 hours a week, employs 100 workers on a job work. The standard rate is
`1 an hour and standard output is 200 units per gang hour. During a week in June, ten employees
were paid at 80 p. an hour and five at `1.20 an hour. Rest of the employees were paid at the
standard rate. Actual number of units produced was 10,200
Calculate labour cost variances.

VARIABLE OVERHEADS VARIANCES

Qus12.
Actual variable overhead `. 10,000
Budgeted variable overhead ` 12,000
Budgeted production 500 units
Actual production 450 units
Actual hours 200Hrs
Standard time for 1 unit 30 minutes
Qus13.
The following data is obtained from the books of a manufacturing company regarding variable
overheads:
Budgeted production for January 300 units
Budgeted variable overhead `7,800
Standard time for one unit 20 hours
Actual production for January 250 units
Actual hours worked 4,500 hours
Actual variable overhead `7,000
Qus14.
From the following information extracted form the books of a manufacturing company, calculate
Fixed and Variable Overhead Variances.

Particulars Budgeted Actual

Production in units 22,000 24,000
Fixed overheads `44,000 `49,000
Variable Overheads ` 33,000 `39,000

218
 Number of Day 25 26
Number of man hours 25,000 27,000

Qus15.
The following information relates to the month of June, 2013
Budgeted Actual
Output 20,000 units 22,000 units
` ``
Overheads - Variable 1,00,000 1,07,000
- Fixed 1,50,000 1,58,000
Compute the overheads variance.

Solution:
Variable overheads allowed or budgeted for actual output
`
Standard Overhead for actual output (10000/20000 × 22000) 1,10,000
Actual amount spent 1,07,000
Variable overhead variance 3,000 (F)

Fixed overheads for the period (change in output having no effect on expenditure) 1,50,000
Actual fixed overhead 1,58,000
Fixed overheads expenditure variance 8,000 (A)
Total overheads variance 5,000 (A)

FIXED OVERHEAD VARIANCES

Qus16.
From the following data, calculate Fixed Overheads Expenditure and Volume Variances:
Fixed Overhead budget for November ` 1,00,000
Budgeted production for the month (1 hour per unit) 50,000 units
Actual production for the month 54,000 units
Actual fixed overhead incurred ` 1,20,000
Qus17.
The following information was obtained from the records of a manufacturing unit using Standard
Costing System:
Standard Actual
Production 4,000 units 3,800 units
Working Days 20 21
Fixed Overheads 40,000 39,000
You are required to calculate the following Fixed Overheads Variances:-
1. Cost Variance
2. Expenditure Variance
3. Volume Variance
4. Efficiency Variance
5. Capacity Variance

Qus18.
In Department A the following data is submitted for the week ended 31st October 2013:-
Standard output for 40 hours per week 1,400 units
Standard fixed Overhead ` 1,400
Actual output 1,200 Units
Actual hours worked 32 hours
Actual fixed overhead ` 1,500

219
 TRAIN UR BRAIN
1. Standard can be divided into ________ types. a) Reducing Losses b) Controlling Cost
a) Two b) Three c) Measuring efficiency
c) Four d) Five d) None of the above
2. ________ based upon engineering 12. The formula for calculating material Cost
specification. Variance is –
a) Standard Cost b) Product Cost a) Standard Cost for Actual Output –
c) Prime Cost d) Marginal Cost Actual Cost
3. _________ Is a technique which involves the b) Standard Cost for Actual Output +
ascertainment of standard cost and their Actual Cost
comparison with actual cost for the c) Standard Cost for Actual Output ×
purpose of cost control? Actual Cost
a) Process costing d) Standard Cost for Actual Output
b) Standard Costing ÷Actual Cost
c) Job Costing 13. Material Usage Variance is calculated by –
d) Operation Costing a) Standard Price (Standard Quantity +
4. _________ standard is established at a Actual Quantity)
particular point of time. b) Standard Price (Standard Quantity -
a) Current b) Ideal Actual Quantity)
c) Basic d) Normal c) Standard Price (Standard Quantity –
5. ________ standard is for a certain period, for Standard Rate)
certain conditions and for certain d) Standard Price (Standard Quantity +
circumstances. Standard Rate)
a) Current b) Expected 14. The formula for calculating Material Yield
c) Ideal d) Normal variance is –
6. ________ represents future performance and a) Standard cost per unit of yield ×
objectives which are reasonably (Standard yield in actual quantity +
attainable. Actual yield)
a) Basic b) Idle b) Standard cost per unit of yield +
c) Normal d) Expected (Standard yield in actual quantity ×
7. _________ standard is fixed on the basis of Actual yield)
ideal conditions, which are difficult to c) Standard cost per unit of yield ×
obtain. (Standard yield in actual quantity -
a) Expected b) Ideal Actual yield)
c) Basic d) Current d) None of the above
8. In cost variances, if the standard cost of 15. Material Mix Variance is calculated by –
actual exceeds the actual cost. Then the a) Standard Rate × (Standard Mix in
variance is said to be – actual quantity – Actual quantity)
a) Favourable b) Unfavourable b) Standard Rate + (Standard Mix in
c) Average d) All of the above actual quantity + Actual quantity)
9. Marginal variances, Labour Variances, c) Standard Rate ÷ (Standard Mix in
Variable Overhead Variances and fixed actual quantity × Actual quantity)
Overhead Variances are the parts of - d) Standard Rate × (Standard Mix in
a) Sales Variance b) Profit Variance actual quantity ÷ Actual quantity)
c) Cost Variances 16. Material Price Variance is calculated by –
d) None of the above a) Actual quantity + (Standard price –
10. The difference between the actual cost and Actual Price)
the standard cost is known as – b) Actual quantity - (Standard price +
a) Profit b) Differential Cost Actual Price)
c) Variance d) Loss c) Actual quantity ÷ (Standard price ×
11. Standard costing help in – Actual Price)

220
 d) Actual quantity × (Standard price ÷ 24. Standard hours/minute means be quality
Actual Price) of work achievable at standard
17. The formula for calculating Material performance expensed in terms of a
Purchase Price Variance is – standard unit of work in a standard period
a) Actual quantity purchased + (Standard of time.
Price + Actual Price) a) True b) False
b) Actual quantity purchased × (Standard c) Partly True d) Partly False
Price - Actual Price) 25. The technique which uses standards for
c) Actual quantity purchased × (Standard costs and revenues for the purpose of
Price + Actual Price) control through variance analysis is –
d) Actual quantity purchased - (Standard a) Variance Accounting
Price - Actual Price) b) Standard Costing
18. Standard cost is a projection of – c) Budgetary Control
a) Cost Accounts d) Performance Analysis
b) Management Accounts 26. A pre-determined calculation of how much
c) Financial Accounts costs should be under specified working
d) None of the above conditions is called -
19. Standard costs are scientifically a) Standard Cost
predetermined in respect of – b) Pre-determined cost
a) Materials b) Labour c) Estimated Cost
c) Overheads d) All of the above d) Actual Cost
20. __________ is a predetermined cost on a 27. The management’s time is saved by
scientific basis taking into consideration reporting only the deviations from the pre-
all the factors relating to costs e.g. raw determined standards is called -
material consumption rate, labour a) Management by objectives
efficiency, machine efficiency, etc. b) Budgetary control
a) Material Cost b) Standard Cost c) Standard costing
c) Labour Cost d) Overhead Cost d) Management by exception
21. An ________ Variance is one which is not 28. _________ can be compared with standard
amendable to control by individual or cost in order to evaluate performance.
departmental action. a) Actual Revenue b) Budgeted Costs
a) Controllable b) Uncontrollable c) Actual Costs
c) Cost d) Labour d) Predetermined Costs
22. Material Yield variance = 29. ___________ are predetermined cost base on
a) Standard yield of the actual material past performance adjusted to anticipated
input + actual yield changes.
b) Standard yield of the actual material a) Estimated Costs b) Standard Cost
input - actual yield c) Revised Costs
c) Standard yield of the actual material b) Revised estimated costing
input × actual yield 30. The difference between planned,
d) Standard yield of the actual material budgeted, a standard cost and actual costs
input ÷ actual yield and similarly in respect of revenues is
23. __________ is a technique where by the known as –
planned activities of an undertaking are a) Variance
quantified in budgets, standard costs, b) Planning Variance
standard selling prices, and standard c) Operational Variance
profit margins, and the differences d) Efficiency Variance
between these and the actual results are 31. Material cost variance is also known as –
compared. a) Material Yield Variance
a) Variance Accounting b) Material Price Variance
b) Standard Accounting c) Material Usage Variance
c) Cost Accounting d) Material total Variance
d) None of the above 32. Material cost variance =

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 a) Material Price Variance
b) Material Cost Variance
c) Material Usage Variance
d) Material Yield Variance
33. Hours paid - Hours Worked is known as –
a) Labour Rate Variance
b) Labour Efficiency Variance
c) Idle Time Variance
d) Net Efficiency Variance
34. Labour Cost Variance –
a) Standard labour cost – actual labour
cost
b) Fixed labour cost - Variable labour
cost
c) Estimated labour cost – Standard cost
d) None of these
35. ______ is developed using utopian
conditions for a given manufacturing
process.
a) Basic Standard
b) Projected Standard
c) Ideal Standard
d) None of these
36. ________ is a control technique involving
study of comparisons of actual costs with
standard costs and as a control device it is
studied to assign responsibility for
deviations and thus to control costs.
a) Variance Analysis b) Profit Analysis
c) Cost Analysis
d) Labour Efficiency
37. If actual hours worked exceed the
standard hours allowed, the variance
which will occur is known as –
a) Favourable labour Efficiency variance
b) Adverse labour efficiency variance
c) Adverse labour rate variance
d) Favourable labour rate variance
38. The budgeted fixed overheads for a
budgeted production of 20,000 units in `
40,000. For a certain period the actual
production was 22,000 units and actual
expenditure came to ` 48,000. Then the
volume variance is ` _________
4,000 (A) b) 2,000 (F)
2,000 (A) d) 4,000 (F)
39. In a factory where standard costing is
followed, 9,600 kgs of material at ` 10.50
kg. were actually consumed resulting in a
price variance of ` 4,800 (A) and usage
variance of ` 4,000 (F). The standard cost
of actual production is ` _________
a) 1,00,000 b) 96,000
c) 1,20,000 d) 1,10,000
40. If the capacity usage ratio of a production
department is 90% and activity ratio is
99% then the efficiency ratio of the
department is _______ %.
a) 120 b) 110
c) 90 d) 80
41. The standard variable overhead cost of a
product is ` 10 (5 hours @ ` 2/hr). In a
certain month it took 1800 hours at a cost
of ` 4,200 to manufacture 400 units. The
variable overhead expenditure and
efficiency variance are _______ and ________
respectively.
a) ` 600 (F) and ` 400 (F)
b) ` 600 (A) and ` 400 (A)
c) ` 600 (F) and ` 400 (A)
d) ` 600 (A) and ` 400 (A)
42. In a factory of A ltd. Where standard
costing is followed, the budgeted fixed
overheads for a budgeted production of
4800 units is ` 24,000. For a certain period
actual expenditure incurred was ` 22,000
resulting in a fixed overhead volume
variance of ` 3,000 (adv.) then standard
material cost of actual production was –
a) 5,400 units b) 4,200 units
c) 3,000 units d) None of these
43. In a factory of XY Ltd. operating standard
cost system, 2,000 kgs. of a material @ `
12 per kg, were used for a product,
resulting in price variance of ` 6,000 (fav)
and usage variance of ` 3,000 (adv). Then
standard material cost of actual
production was –
` 24,000 b) ` 27,000
` 30,000 d) ` 33,000
44. A company budgets for fixed overhead of `
12,000 and production of 2,400 units.
Actual production is 2,100 units and fixed
overhead cost incurred is ` 11,000. The
fixed overhead volume variance is -
a) ` 3,000 (A) b) ` 1,500 (A)
c) ` 1,500 (F) d) ` 3,000 (F)
45. AB Ltd. purchased 3,425 kgs, of materials
for ` 10,960. the material price variance
was ` 685 (favourable). The standard
price per kg. was –
a) ` 3.00 b) ` 3.20
c) ` 3.40 d) None of these
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46. The budgeted standards hours of a factory
are 6,000. The capacity utilization ratio of
April, 2013 stood as 45% while the
efficiency ratio for the month came to
60%. The actual production in standard
hours for april, 2013 was _________.
a) 10,800 b) 13,333
c) 14,400 d) 12,800
47. In a factory of A ltd. where standard
costing is followed, the budgeted fixed
overheads for a budgeted production of
2,400 units is ` 12,000. For a certain
period actual expenditure was ` 11,000
resulting in a fixed overhead volume
variance of ` 1,500 (A). the actual
production for the period was -
a) 1,500 units b) 2,100 units
c) 2,700 units
d) Insufficient information
48. A chemical is manufactured by combining
two standard items of input X (Standard
price ` 60/kg) and Y (` 45/kg) in the ratio
of 60% : 40%. Ten present of input is lost
during processing. If during a month 1,200
kg. of the chemical is produced incurring a
total cost of ` 69,600, the total material
cost variance will be ________.
a) ` 2,400 (A) b) ` 2,400 (F)
c) ` 3,000 (A) d) ` 2,000 (F)
49. The information relating to the direct
material cost of a company is as under:
Standard price per unit ` 1.80
Actual quantity purchased units 800
Standard quantity allowed for actual
production units 725
Material price variance on purchase `120
(F)
What is the actual purchase price per unit?
a) ` 1.06 b) ` 1.11
c) ` 1.65 d) ` 1.75
50.A factory, operates a standard cost system,
where 1000 kgs. Of raw material @ ` 6 per
kg. were used for a product, resulting in
price variance of ` 3,000 (F) and usage
variance of ` 1,500 (A). Then standard
material cost of actual production was -
a) ` 5,000 b) ` 7,500
c) ` 10,000 d) ` 2,500
51. Standard cost is a _________________ cost.
a) Predetermined b) Historical
c) Actual d) Final
52. The limitations of _________________ has led
to the development of standard costing
system.
a) Cost Accounting
b) Historical costing system
c) Management accounting
d) None of the above
53 Standard costing is more widely applied
in ___________ industries.
a) Jobbing b) Construction
c) Process and engineering
d) All of the above
54. Three types of standards are _____________
a) Actual standard, base standard and
normal standard
b) Currency standard, basic standard and
normal standard
c) Expected standard, ideal standard and
normal standard
d) Current standard, basic standard and
normal standard
55. The deviation of the actual cost or profit
or sales from the standard cost or profit
or sale is known.
a) Difference b) Variance
c) Discrepancy d) Inconsistency
56. Management by exception is exercising
control over _____________.
a) Costs
b) Favorable items
c) Unfavorable items
d) All of the above
57. Material price variance is the difference
between standard and actual prices of
materials used multiplied by _____________.
a) Actual quantity of material used
b) Budgeted quantity of material used
c) Standard quantity of material used
d) Either (b) and (c)
58. Labour cost variance is the difference
between standard cost of labour and
________________.
a) Budgeted cost of labour
b) Estimated cost of labour
c) Actual cost of labour
d) None of the above
59. Idle time variance is ____________.
a) Idle time × Actual Labour
b) Idle time × Standard labour rate
c) Idle time × Budgeted labour rate
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 d) Idle time × Historical cost
60. Volume variance is divided into
___________.
a) Capacity variance, calendar variance
and efficiency variance
b) Capacity variance, calendar variance
and expenditure variance.
c) Capacity variance, expenditure
variance and efficiency variance
d) Calender variance, expenditure
variance and efficiency variance.
61. A standard which assumes efficient level
of operations, but which includes factors
such as waste and machine downtime is
known as an allowance for ……………….
a) Ideal Standard
b) Normal standard
c) Attainable standard
d) None of the above
62. Which of the following would not be an
important factor while analyzing sale
variance?
a) Mix Variances
b) Recovery rate variances
c) Selling price variances
d) Volume variances
63. The reason for favourable materials price
variance could be due to ……………….
a) Exchange rate depreciation if materials
are imported
b) Inferior quality materials being used
c) More wastage of materials incurred
d) Higher factory overhead costs.
64. The reason for favourable total sales
variance could be due to …………………
a) Lower output leading to favorable
total cost variances.
b) A fall in sales volume and a price
reduction
c) A price cut leading to a proportionally
lower increase in sales volume.
d) A price cut leading to a proportionally
higher increase in sales volume
65. When calculating cost variances under a
standard costing system we must
……………
a) Compare actual cost s with those that
were budgeted
b) Compare standard costs with actual
costs at the standard level of activity
c) Compare actual costs with standard
costs at the actual level of output
d) Compare actual outputs against
budgeted outputs.
66. A primary purpose of using a standard
cost system is …………….
a) To make things easier for managers in
the production facility.
b) To provide a distinct measure of cost
control.
c) To minimize the cost per unit of
production.
d) (b) and (c) correct
67. An adverse material usage variance
together with a favourable materials
price variance could suggest that
……………
a) We are paying the same for our
materials but we are using more than
expected
b) We are using less material than
expected but in total we are paying
more than we should
c) We are paying less for our materials
than expected but we are using more
materials
d) We are paying higher prices for our
materials than expected.
68. Standard cost may be used by ………………
a) Universities
b) Government agencies
c) Business organizations
d) All of the above
69. Standard cost may be used for ……………..
a) Product costing b) Planning
c) Controlling
d) All of the above
70. Which of the following statements about
standard is false?
a) A properly set standard should
promote efficiency
b) Standard cost facilitate management
planning
c) Standard should not be used in
‘management by exception’
d) Standard cost can simplify the costing
of inventories
71. Standards set provide yardsticks against
which ______________ are compared.
a) Budgeted costs b) Estimated costs
c) Actual costs
d) None of the above
72. The technique of standard costing may not be
applicable in case of:
a) Larger concern b) Small concerns
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 c) All concerns
d) None of the above
73. Total Material cost variance =
a) Budgeted cost of materials – actual
cost of materials
b) Standard cost of materials - actual cost
of materials
c) Budgeted cost of materials – standard
cost of materials
d) Actual cost of materials - budget cost of
materials
74. Material Usage Variance = Material Mix
Variance + ___________.
a) Material yield variance
b) Material cost variance
c) Material price variance
d) Material usage variance
75. Material Price Variance = Actual Usage ×
______________.
a) Standard Price – Budgeted price
b) Standard Price – Actual price
c) Actual Price – Standard Price
d) None of the above
76. Material usage Variance = Standard Price ×
____________.
a) Standard usage – Actual usage
b) Standard price – Actual price
c) Standard quantity
d) Actual quantity
77. Material mix variance = standard cost of
standard mix - _________________
a) Actual cost of actual mix
b) Actual cost of standard mix
c) Standard cost of actual mix
d) Standard cost of budgeted mix
78. Total Labour cost variance = ________________
a) Standard rate (standard time for actual
output – actual time paid)
b) Standard cost of labour – actual cost of
labour
c) Standard rate (standard time for actual
output – actual time work)
d) Actual time taken (standard rate –
actual rate)
79. Fixed Overhead Volume Variance =
_____________
a) Standard rate per hour (standard
hours produced – actual hours)
b) Standard rate (Actual output –
Budgeted output)
c) (Actual output × Standard price) –
budgeted fixed overheads
d) All of the above
80. A favourable variance will arise when capital
revenues are _________________ than expected.
a) More b) Less
c) Lesser
d) None of the above
81. An unfavourable material price variance
occurs because of:
a) Less than anticipated normal wastage in
the manufacturing process
b) Price increases in raw materials
c) More than anticipated normal wastage in
the manufacturing process
d) Price decrease in raw materials
82. The type of standard best suitable for cost
control purpose is ___________________.
a) Basic Standard
b) Ideal Standard
c) Normal Standard
d) Expected Standard
83. An unfavourable material usage arises
because of:
a) Less than anticipated normal wastage in
the manufacturing process
b) Price increases in raw materials
c) More than anticipated normal wastage in
the manufacturing process
d) Price decrease in raw materials
84. Volume variance arises because of:
a) Increase or decrease in actual output
as compared to the budgeted output
b) Increase in overhead rate per hour
c) Difference in budgeted overheads and
actual overheads
d) Decrease in overhead rate per hour
85. Labour rate variance is computed by
multiplying the:
a) Standard Labour rate with the
difference between standard labour
hours and actual labour hours
b) Actual Labour hour with the difference
between standard labour hours and
actual labour hours.
c) Actual labour rate with the difference
between standard labour rate and
actual labour hours
d) None of the above
86. The control ratios used by the management
to know whether the deviations of the actual
performance from the budgeted performance
are favourable or unfavourable are
_____________
a) Capacity ratio, activity ratio
b) Efficiency ratio, Calender ratio
c) Both (a) and (b)
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 d) None of the above
87. _______________ is a technique which uses
standards for costs and revenues for the
purpose of control through variance analysis.
a) Standard Costing
b) Standard cost
c) Management by exception
d) None of the above
88. The management’s time is saved by
reporting only the deviations from the
predetermined standard is called:
a) Standard Costing
b) Standard cost
c) Management by exception
d) None of the above
89. ______________ is predetermined cost based
on past performance adjusted to
anticipated changes.
a) Estimated cost
b) Actual cost
c) Standard cost
d) None of the above
90. Material cost variance is also called as
_________________.
a) Variance
b) Material total variance
c) Material usage variance
d) Material price variance
91. Difference between budget and standard is
that ………………
a) A budget express what cost were,
while a standard express what cost
should be.
b) A budget express management plan,
while standard reflects what actually
happened
c) A budget express total amount
standard express a unit amount
d) Standards are excluded from cost
accounting system whereas budget are
included in cost accounting system.
92. If more direct materials were used for
production than were allowed for the output,
then the ………………
a) Direct labour efficiency variance will
be unfavorable
b) Direct labour rate variance will be
favorable
c) Direct materials price variance will be
favorable
d) Direct materials usage variance will be
unfavorable
93. Which of the following variances would be
least likely if the materials used were of much
poorer quality than the standard?
a) Unfavorable direct materials price
variance
b) Unfavorable direct materials efficiency
variance
c) Unfavorable direct labour efficiency
variance
d) All of the above would be equally likely
to Occur
94. An unfavourable material usage arises
because of …………….
a) Price increase in raw materials
b) Price decrease in raw materials
c) Less than anticipated normal wastage
in the manufacturing process
d) More than anticipated normal wastage
in the manufacturing process
95. Volume variance arises because of
……………….
a) Increase in overhead rate per hour
b) Decrease in overhead rate per hour
c) Increase or decrease in actual output
as compared to the budgeted output
d) Difference in budgeted overheads &
actual overheads
96. Consider the following statements and state
which of the following is/are true?
1. The standard cost per unit of materials
is used to calculate a materials price
variance.
2. The standard cost per unit of materials
is used to calculate a materials
quantity variance
3. The standard cost per unit of materials
cannot be determined until the end of
the period
a) (1) only b) (2) only
c) (1) & (2) only d) (1), (2) & (3)
97. SK Ltd. reported a favourable materials price
variance and an unfavourable materials
quantity variance. Based on the above data, it
can be concluded that _________________.
a) More materials were purchased than
were used.
b) More materials were used than were
purchased
c) The actual cost per unit of materials
was less than the standard cost per
unit
d) The actual usage of materials was less
than the standard allowed
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98. If the actual number of direct labour hour c) Historical cost
worked is less than the standard labour d) None of the above
hours allowed for equivalent units produced, 105. Actual costs can be compared with ___________
this indicates ……………… in order to evaluate performance.
a) An unfavorable labour rate variance a) Material price variance
b) A favorable total labour variance b) Material usage variance
c) An unfavorable labour efficiency c) Material cost variance
variance d) Material yield variance
d) A favorable labour efficiency variance 106. The difference between standard material
99. Which of the following is false? cost of actual production and the actual cost
a) A standard is a benchmark or norm of direct material is ___________.
used for planning and control a) Favorable variance
b) The difference between standard cost b) Unfavorable variance
and actual cost is referred to as a c) Either (a) or (b)
variance. d) None of the above
c) In manufacturing, standards are 107. Where the actual performance is better that
developed for materials, labour and the standard, the extent of the achievement is
overhead expressed in financial terms as ___________.
d) Because of their extensive knowledge a) Expected standard
of operations, the accountants should b) Ideal Standard
be the sole group that sets standards c) Current standard
for most organizations. d) Normal standard
100. Which of the following is true about standard 108. A standard that is developed using
costs? theoretical conditions for a given
a) They are the actual costs for manufacturing process is known as:
delivering a product or service under a) True b) False
normal conditions. c) Either (a) or (b)
b) They are predetermined costs for d) None of the above
delivering a product or service under 109. Standard costing may not be suitable for
normal conditions. small concerns.
c) They are the actual costs for a) True b) False
producing a product under normal c) Either (a) or (b)
conditions d) None of the above
d) They are predetermined costs for 110. Analysis of variance is done in order to
determine the reasons for increase or
delivering a product or service under
decrease in profit.
normal and abnormal conditions.
a) True b) False
101. Which of the following is true about standard
c) Either (a) or (b)
costs?
a) Actual hours b) Standard hours d) None of the above
c) Idle hours d) Budgeted hours 111. Which of the following is true when
recording variances in a standard costing
102. _____________ represents the difference
system?
between hours aid and hours worked.
a) All unfavorable variance are debited
a) Favorable b) Unfavorable
b) Only unfavorable material variances
c) Either (a) or (b)
are credited
d) None of the above
c) Only unfavorable material variances
103. Idle time variance is always ______________.
are debited
a) Standard cost b) Actual Cost
d) Only unfavorable variance are credited
c) Historical cost
112. Standard costing can be used for …………..
d) None of the above
a) External reporting
104. _____________ is a predetermined calculation of
b) Internal reporting
how much costs should be under specified
working conditions. c) Internal and external reporting
a) Standard cost b) Actual Cost d) Stakeholders reporting
113. Standard costing is ………………….

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 a) Costing method a) True b) False
b) Costing technique c) Either (a) or (b)
c) Costing classification d) None of the above
d) Costing absorption 123. Standard hour is the standard time required
114. Standard may be expressed both in …… per unit of production.
a) Quantitative measures a) True b) False
b) Monetary measures c) Either (a) or (b)
c) Quantitative & Monetary measures d) None of the above
d) Quantitative or Monetary measures 124. Standards are arrived at based on past
115. If material price variance is zero than which performance.
of the following two variance will be same? a) True b) False
a) Material cost variance & Material c) Either (a) or (b)
Usage Variance d) None of the above
b) (a) and (d) 125. Labour efficiency variance is due to the
c) Material Usage Variance & Material Mix different between standard hours for actual
Variance output and actual hours for actual output.
d) Material Sub-Usage Variance & a) True b) False
Material Yield Variance c) Either (a) or (b)
116. Standard costs are based on technical d) None of the above
assessments.
a) True b) False ANSWERS
c) Either (a) or (b)
d) None of the above 1. d 2. a 3. b
117. An uncontrollable variance is one which is 4. c 5. a 6. d
not amendable to control by individual or 7. b 8. a 9. c
departmental action. 10. c 11. c 12. a
a) True b) False 13. b 14. c 16. a
c) Either (a) or (b) 17. d 18. b 19. a
d) None of the above 20. d 21. b 22. b
118. A favourable material variance is always 23. b 24. a 25. a
advantageous for concern.
26. b 27. a 28. d
a) True b) False
29. c 30. a 31. a
c) Either (a) or (b)
32. d 33. b 34. c
d) None of the above
35. a 36. c 37. a
119. Material yield variance is the difference
between Standard yield specified and the 38. b 39. d 40. a
actual yield obtained. 41. b 42. b 43. b
a) True b) False 44. b 45. b 46. c
c) Either (a) or (b) 47. b 48. b 49. b
d) None of the above 50. c 51. a 52. b
120. All the variance of major nature, whether 53. c 54. d 55. b
favorable or unfavorable are to be reported 56. c 57. a 58. c
to management along with the reasons there 59. b 60. a 61. c
of is called management information systems. 62. b 63. b 64. d
a) True b) False 65. c 66. c 67. c
c) Either (a) or (b) 68. d 69. d 70. c
d) None of the above 71. c 72. c 73. b
121. Equal emphasis should be laid on favorable 74. a 75. b 76. a
or unfavorable variances.
77. c 78. b 79. d
a) True b) False
80. a 81. b 82. d
c) Either (a) or (b)
83. c 84. a 85. d
d) None of the above
122. Variances analysis and variance accounting is 86. c 87. a 88. c
same. 89. a 90. b 91. c

228
92. d 93. a 94. d
95. c 96. c 97. c
98. d 99. d 100. c
101. c 102 b 103 a
104 a 105 c 106 a
107 b 108 a 109 b
110 b 111 a 112 b
113 b 114 c 115 b
116 a 117 a 118 b
119 a 120 b 121 a
122 b 123 a 124 b
125 a

229