Study Material Accounting

SEM – I - STUDY MATERIAL ON ACCOUNTING
Basic Concepts
Financial Accountancy –
Accounting is the art of recording, classifying and summarizing in a significant

manner and in terms of money, transactions and events which are in part at least
of a financial character and interpreting the results thereof.
Financial accounting refers to – Collection, classification, recording and

presentation of financial data to serve the various purposes of management,
shareholders, creditors, bankers, outsiders etc.
Book Keeping is nothing but keeping books of accounts. It is a system by which

business transactions are recorded systematically.
Accountancy is concerned with formulation of principles to be followed in

recording of business transactions
Objectives of book keeping / Why Book keeping –
Primary objective of book keeping is to enable the businessman to know the

following information accurately and with a minimum of time and efforts –
1. Amount of profits earned or loss suffered by business for a particular

period.
2. Amount of his capital in the business.
3. Amount of his assets and liabilities in the business on any particular date.
Apart from above objectives a businessman would like to know the following
things as well –
1. Amount due to his creditors

2. Amount due from his debtors
3. To understand how the profit is made up of
4. Compare his business with that of others engaged in similar lines
5. To ascertain amount of tax liability
6. To get information about following matters –
a. Manner in which capital is invested
b. Cash balance at the end of day / month/ year
c. Value of stocks at hand
7. To review the progress of business from year to year
8. To prevent frauds and errors
9. To maintain record for using it in future if required.
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All above information helps to keep a check or exercise effective control over the
business as a whole. He can take appropriate action in time if information is
readily available with him.
Basic Terms used in Accounting
1. Transaction – It is an event, recognition of which gives rise to an entry in

accounting books. It involves exchange of goods and services between
two or more persons. An exchange means giving and receiving of equal
values. Transaction may be –
a. Cash transactions
b. Credit transactions
c. Paper transaction
d. Physical transaction
2. Voucher – represents a document which serves an as evidence of

transaction. For example in case of cash purchase transaction, voucher is
‘cash memo’. In case of credit purchase voucher is ‘bill or invoice’
3. Entry – it is recording of transaction in books of accounts. It is based on

voucher which is an evidence of transaction.
4. Goods – These are the commodities in which a proprietor deals with.

Goods have two aspects – purchase and sale, similarly purchase return
and sales return
5. Profit or loss – Excess of Income over expenses is Profit whereas,

excess of expenses over income is loss.
6. Assets – The entire property possessed by or owing to a person /

organization is called an asset. For example – land, building, machinery,
cash, bank balance, furniture etc. We can have fixed assets or current
assets. Fixed assets are those which are held for the purpose of
producing goods and services. They are not held for resale in normal
course of business. Fixed assets are used to covert raw material into
finished goods. Current assets are those assets which are held for
conversion of the same into cash and for the consumption in production of
goods and services. Question is how to decide whether an asset is current
asset or fixed asset. Basically it depends on the purpose for which it is
held. For example if one purchase land for the purpose of sale of the
same and he is doing the business of purchase and sale of land, then for
him land will be treated as current asset. Whereas for a businessman who
wants to set up a plant for production of goods, if he purchase a land for
construction of plant and building, this land will be treated as fixed asset
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So, in simple terms if all the answers of following questions are negative,
the asset will be treated as fixed asset –
a. Whether it is cash or bank

b. Whether it is expected to be converted into cash / bank
c. Whether it is expected to be converted into production of goods and
services during the year as a normal course of business
7. Liability – It refers to debt or amount due from business to others either

for money borrowed or for goods purchased on credit. These are the
obligations of business. These are the claims of others on assets of
business. Liabilities are also of two types – current liability and long term
liability. Current liability are those which fall due for payment in relatively
short period (normally one year) Long term liability on the other hand is a
liability which needs to be paid back over a long period of time (generally
more than a year)
8. Net worth – It is also called as proprietary fund. It is the amount of fund

provided by proprietors. It is also known as own funds. It is equal to capital
+ Reserves( Reserves represents undistributed profits)
9. Contingent liability – these are the liabilities which are dependent on

happening or non happening of certain events. These are liabilities which
will arise in future. Whether there is a liability, it depends on future event.
10. Capital – Total monetary value of everything brought into the business by
proprietor is called capital. It is equal to total assets minus outside
liabilities like creditors, bank loan etc.
11. Drawings – It is the amount withdrawn by the proprietor from business in

cash or in kind. It the value of cash or goods withdrawn from business. It
reduces the capital contributions. Drawings are never expenses of
business. Amount of capital gets reduced to the extent of amount of
drawings made by proprietor.
12. Debtor – These are the persons and other entities that are to pay an
enterprise an amount for receiving goods and services on credit. It is the
amount which business is going to receive in future as per terms of credit
allowed by business
13. Creditors – These are the persons or entities that have to be paid by
business against the goods or services purchased by business. It
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represents the amount which a business has to pay in future as per terms
of credit provided by the suppliers of goods and services.
14. Capital expenditure – It is the expenditure incurred to yield the benefit

over a longer period. The benefit out of such expenditure will not exhaust
within a year. For example, Purchase of machinery – business is going to
use the machinery over next 10-15 years. It is generally non recurring in
nature, amount involved is huge. Therefore decision has to be taken
carefully. It is irreversible decision.
15. Revenue expenditure – it is day to day expenditure – for example, salary

wages, telephone, travelling, printing, taxes, depreciation etc. It is
recurring in nature. Amount involved is not as huge as capital expenses.
The benefit is not extended beyond one year.
16. Deferred revenue expenditure – the expenditure is revenue expenditure

but the benefit of which is extended beyond one year. For example,
expenses on Research and development, heavy expenses on repairs of
assets, heavy expenses on advertisement – effect lasts longer – more
than a year.
17. Trade discount – It is the allowance allowed by manufacturer or whole

seller to retailer. The purpose is to enable retailer to sell goods at lesser
price and earn profits. Amount of trade discount is deducted from the listed
price. It is shown in invoice. It is not recorded in books. For example – Mr.
Kumar (wholesaler) sold goods to Mr. Vishal (retailer) for Rs. 20,000
(listed price) less 10% trade discount. Only 18000 are recorded in books
of accounts.
18. Cash discount – It is the concession allowed by seller to buyer to

encourage making payment promptly. It is allowed when a buyer pays the
amount within a stipulated period. It is recorded in books of accounts. For
example – to extend the above example of trade discount, Mr
Vishal( retailer ) give 5% cash discount – 5% to be calculated on 18000 =
900/- , here Goods purchased / sold will be recorded at 18000/- cash
received or paid will be recorded at 17100 and discount received or paid
will be recorded at 900
19. Solvent – A person who is in position to pay off his debts as and when
they become due is called as solvent.
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20. Insolvent – a person, who is not in a position to pay off his debts as and
when it becomes due. Is an insolvent
21. Accounting year- it is the period for which the accounts are being
maintained by the proprietor or business concern. Generally in India it is
from 1st April to 31st March
22. Goodwill – It is an intangible asset having realizable value. It is cost of

reputation of business. It is also known as cost of business connections. It
is present value of future expected earnings. It is for the brand name
established by business in market.
Difference between cash discount and trade discount
1. Trade discount is reduction in list price granted by supplier on business

considerations such as quantity bought, trade practices etc (other than
prompt payment) where as cash discount is reduction granted by supplier
from invoice price in consideration of prompt payment.
2. Trade discount is allowed to promote sales, where as cash discount is
allowed to promote prompt payment
3. Trade discount is allowed on purchase of goods, where as cash discount
is allowed on making prompt payment for purchase of goods
4. Trade discount comes first then cash discount
5. Trade discount account is not opened, where as cash discount account is
opened. Trade discount is not recorded, where as cash discount is
recorded.
6. Trade discount value may vary as per quantity purchased, where as cash
discount amount may vary as per time of payment and amount paid.
7. Trade discount is generally given by manufacturer to whole seller or
distributor. Whereas cash discount is given by distributor to dealer or
dealer to consumer.
Different accounting Concepts and conventions -
Accounting concepts are necessary assumptions or conditions on which

accounting is based. They are developed to convey the same meaning to all
people. Different accounting concept -
1. Business entity concept – Business is treated as separate entity from its

promoter/s, partners, and shareholders. All accounting transactions are
recorded in the books of “business “. This is applicable to all forms of
business – sole proprietor, partnership firm, private limited company,
public limited company etc. Business is separate from the person who has
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started the business. Therefore the capital becomes a liability for a

business because it is the amount which business owes to a person who
has provided it.
2. Money measurement concept – In Accounting, everything is recorded in

terms of money. Therefore the events or transactions which are not
measurable in terms of money are not recorded, for example resignation
of manager, death of the proprietor or shareholder is an important event
but it can not be expressed in monetary terms, so not recorded.
3. Cost concept - This concept does not recognize the realizable value,
replacement value. Thus an asset is ordinarily recoded at the price paid to
acquire such an asset. For example , land purchased for 5 lacs on 1 st
September and the Balance sheet date is 31 st March, Even though the
market value of land is 10 lacs on 31 st March, it is recorded at the cost
price ( 5 lacs ) which might be below or above the market price.
4. Going concern – It is assumed that the business concern will continue for
a fairly long period, unless and until it is liquidated. It is based on this
assumption that accountants depreciate the assets based on their
expected lives rather than market value. Business never dies with the
death of its proprietor
5. Realization concept – According to this assumption, profit is recorded

only when it is actually realized. Purchase is recorded only when the
goods actually received at godown and not merely by raising purchases
order.
6. Accrual concept - The accrual system is a method whereby revenue and

expense are identified with specific period of time like a month, a year. It
implies recording of revenues and expenses of a particular accounting
period, whether or not they are actually paid or received. For example, if
suppose telephone bill for March 2009 is received but not actually paid
before 31st March, However as per this concept, the amount towards
telephone bill for March has to be shown in books of accounts for the year
2008-09
7. Dual Aspect – This is basic concept. Every business transaction has dual
effect. One is the receiver of the benefit and other is giver of benefit. Every
transaction has effect on two accounts. Even though the amount recorded
in both account is same, the recording is made in contrast. In a sense that
one account is debited while the other is credited. That is the reason why
the accounts tallies at the end of the year. When a capital is introduced
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with cash, cash account is debited and shown under asset side, where as
capital account is credited and shown under liability side.
8. Matching Concept – As per this concept the accounting should reveal the
information which should match with each other. In a sense that if
Revenue or income from the sale of a particular items is recorded in
books, the books should also record the corresponding expenses to
produce and sale of those items.
Accounting Conventions –
1. Conservatism – It refers to policy of playing safe game. All prospective

losses are taken into consideration, but not all prospective profits. In other
words, anticipate no profits but provide for all losses. However this has to
be applied cautiously, otherwise the results may be distorted, and some
times more conservatism leads to overstating liabilities and understating
assets.
2. Materiality – Every accountant should attach importance to material

details and ignore insignificant details. If this is not done, accounts and
audit will be overburdened. An item is said to be significant and material if
there is a reason to believe that knowledge of it would influence the
decision of the owners and management.
3. Consistency – Comparison of one accounting period with that of another

is possible only when the convention of consistency is followed. For
example, if company is following a SLM method of depreciation, it has to
follow the same for all accounting years to come.
4. Full Disclosure – Accounting reports should disclose fully and fairly the
information they purport to represent. It should disclose the sufficient
information which is of material interest.
Different types of accounts
There are basically three types of accounts. These are –

1. Real account
2. Nominal account
3. Personal account
Real accounts are those which deal with assets or properties of business. These
are again classified into tangible and intangible. Tangible assets are like which
are in physical form, which we can see, touch for example, cash, furniture,
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machinery, land building etc. Intangible assets are those which we can not see or
feel such as good will of business, trade marks, patents etc.
Rule for accounting of real account is –
Debit what comes in, Credit what goes out
Nominal account – These comprises of all accounts of expenses losses incomes

and gains. For example, telephone, salaries and wages, interest received, rent
paid etc
Rule for accounting of nominal account is –
Debit the expenses and losses, and credit incomes and gains
Personal account – A Person can be
1. Natural person like Mr. Ramesh, Mr. Kumar etc,

2. Artificial person like Company – Bajaj Auto limited etc.
Rule for accounting of personal account is –
Debit the receiver, credit the giver
Cost – Costing – Cost accounting –
ICMA London defines - Cost as “The amount of expenditure, actual or notional,

incurred on or attributable to a given thing or activity “
It defines costing as “Technique and process of ascertaining the costs.
It defines cost accountancy as “ Application of costing and cost accounting

principles , methods and techniques to the science, ascertainment of profitability
as well as presentation of information for the purpose of decision making. “
For consumer cost means price, for management cost means expenditure
incurred. Process of ascertainment of cost is costing.
Costing provides analysis of information in such a way that management gets

complete idea about even the smallest item of expense. It helps management for
cost control and cost reduction.
According to Wheldon, costing is the classifying, recording, and appropriately

allocating the expenditure for –
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1. Ascertainment o cost of the product or services, and
2. Presentation of data in such a way so as to enable management to take

decisions
It has been popularly said that, “an estimate is an opening, price is a policy
and cost is a fact.”
Importance of Cost Accountancy –
Costing is relatively younger concept. In present context, the only way left for
many organization, to increase profits, is reduction in costs. Cost reduction
program requires detail collection and analysis of costs. Cost estimation and cost
ascertainment are primary functions of costing
Importance of Costing and cost accountancy can be seen form its following
advantages –
A. Advantages to Management –
1. Knowing cost of product

2. Helps in measuring efficiency
3. Provide suitable information for decision making
4. Provide necessary data for finding variances
5. Guides future prod policies
6. Provides information to decide proper product mix
7. Helps in preparing budgets
8. Helps in price fixation – inland / exports
9. Helps in overall control of operations.
B. Advantages to Employees –
1. Provides data for inefficient areas identification

2. General profitability increases , thereby morale
3. Increases work efficiency , competency
4. Increases chances for better wage structure and payment
policies.
C. Advantages to Government
1. Helps in assessing the tax liability

2. Helps in formulating policies
3. Cost data provides necessary base data for preparing national
plans , industrial policy
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4. Good costing system increases overall efficiency and productivity,

thereby saving in national resources.
D. Advantages to General public
1. Good Product at lesser price / cost

2. Public awareness / competition improves general health of product
or service
Management Accounting –
Introduction :-
The scope of Management Accounting is broader than the scope of cost

accounting. In cost accounting, as we have seen, the primary emphasis is on
cost and it deals with collection, analysis, relevance, interpretation and
presentation for various problems of management. Management Accounting is
an accounting system which will help the Management to improve its effi ciency.
The main thrust of Management Accounting is towards determining policy and
formulating plans to achieve desired objectives of management. It helps the
Management in planning, controlling and analyzing the performance of the
organization in order to follow the path of continuous improvement. Management
Accounting utilizes the principle and practices of fi nancial accounting and cost
accounting in addition to other modern management techniques for effective
operation of a company. In fact there is an overlapping in various areas of cost
accounting and management accounting.
As the name itself indicates it is accounting information prepared for

management decisions. Management accounting is a part of internal reporting
system as in Decision Support system (DSS). For MIS Management accounting
is necessary.
Definition: Management accounting as defined by British Industrial Accountants:

“Presentation of accounting information in such a way as to assist the
management in creation of policy and day to day operations of the undertaking.”
As per Robert Anthony, Management accounting is concerned with accounting

information that is useful to management.
Management accounting is the branch of accounting which deals with presenting

and providing accounting information in such systematic way that it can perform
its managerial functions of planning controlling and decision making in an
effective manner.
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As per ICWAI management accounting is a system of collection and presentation

of relevant economic information relating to an enterprise for planning controlling
and decision making.
Functions of Management Accounting –
Main and primary function of management accounting is to help the management

and guide it to take decisions, framing policies and procedures. This is done with
the help of various accounting data. Following are some basic functions
performed by management accountant –
1. Supply of necessary data – Management accountant should make

intelligent use of financial data to transform it into useful information by
using various techniques like working capital, capital budgeting etc
2. Data changes / modifications – sometimes data collected needs certain

modifications to suit the management requirements before presentation.
3. Analysis and interpretation – As management accountant has to use

various techniques and tools to prepare reports and statements, he is
required to analyze data so that all useful information can be presented to
management. This is done to find profitability, solvency, and liquidity and
cost efficiency. Some techniques used are ratio analysis, fund flow, cash
flow etc.
4. Facilitate overall control – As management accountant covers all

activities of business, it facilitates overall control measures. This is done
with the help of statistical and costing techniques like break even
analysis, decision tree, transportation, assignment, marginal costing,
standard costing etc.
5. Providing qualitative information – Only quantitative data is not useful as

it takes lot of time to analyze. Therefore quantitative information should
be transformed into qualitative information so that management gets the
idea and results more quickly.
6. Assist in planning – Planning is fundamentary and planning problem

arises only when alternative courses of action is to be decided.
Management accounting provides a base to management for taking quick
decisions.
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Nature and features of management accounting:-
Any kind of accounting basically deals with collecting, grouping, summarizing,

and recording of data; related to the business. That means accounting is
basically a communicating or reporting system, to coordinate the collective
decisions for fulfillment of objectives and goals.
Management accounting is a part of internal reporting system as in Decision

Support system (DSS). For MIS Management accounting is necessary.
Various distinguished features of management accounting are as under –
1. It deals with collection of accounting and other data and it analyses,

interpret and communicates all relevant information to management which
are effectively required for planning controlling and decision making
2. It interprets the analyzed data as obtained from the operational and non
operational activities.
3. It provides all necessary information to management to judge
effectiveness of managerial functions.
4. It provides all necessary information to management to judge whether the
performance achieved is towards its goals and objectives.
5. It serves as yardstick for measuring effectiveness of managerial
performance.
6. It acts as a yardstick for measuring level of performance of operational
and non operational activities.
7. It analyzes and interprets the historical data to project the future trend of
different activities
Scope and objectives of Management accounting -
Basically Management accounting aims at serving the top management by

providing useful data and assisting them in better decision making. It is not a
separate division or branch. It uses the tools and techniques of the other
branches like Financial and cost accounting to provide useful information to top
management.
It has a very broad scope; it includes variety of aspects of the business.

Following are some specialized areas of its coverage:
1. Financial accounting – includes recording of all business transactions and

ultimately preparation of final accounts of an enterprise. Final accounts
include balance sheet and profit and loss account which is presented in a
particular format to shareholders of the company. Therefore it is part of
management accounting for external reporting. Final accounts and all
other related annexure are analyzed by management accounting
department.
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2. Cost accounting – Basically aims at cost ascertainment and cost control

measures in an enterprise. Management accountants use the data
generated by Cost accounting department to prepare number of reports
which helps top management to control over the costs and reduction in
overheads. It also helps management to identify in efficiencies in business
and suggest the corrective actions over the same.
3. Forecasting and budgeting – An organization not only need to record the

present transactions but to plan for future activities as well. This is
required to decide about the direction towards which the business is to be
headed. This is done with the help of Budget dept. In many organizations
there is a separate internal budget dept which has many skilled persons to
estimate the future with maximum accuracy. This can also be done with
some statistical techniques.
4. Costing techniques – Management accountants always work in

coordination with other departments including costing dept. Techniques of
standard costing, marginal costing and budgetary controls are normally
used by management accountants to serve the top management in taking
certain critical decisions.
5. Taxation – this department ensures that all the rules and regulations lay
down by various government bodies are properly followed, and various
returns are being submitted. Management accounting supplies all
necessary tax matter details to the management. In addition they also
have to address the queries of taxation authorities.
6. Methods and procedures – Every business wants to standardize the

procedures and methods in all fields to increase the efficiency and profits
of business. For this management accounting helps to design the
standard manuals for each critical activity.
7. Reporting – Management accountant is required to submit various reports

about all the happenings in a company to top management, as and when
required. Also it is required to submit the reports to external bodies like
banks and financial institutions. Reporting can contain financial or non
financial data e.g. man hours spent, machine hours on particular line of
machines etc.
8. Management controls – It covers the area of internal control system. To

achieve this various tools are used so that there is smooth and efficient
flow of work. These control systems helps in locating various deviations at
the early stage so that corrective actions can be taken at right time. It
includes Internal control and internal audit.
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Objectives of Management accounting –
1. Analysis, interpretation of financial data

2. Planning and policy making
3. Decision making
4. Controlling
5. Communicating
6. Coordinating
7. Tax planning
8. Advisory service
Functions of Management Accounting –
Main and primary function of management accounting is to help the management

and guide it to take decisions, framing policies and procedures. This is done with
the help of various accounting data. Following are some basic functions
performed by management accountant –
1. Supply of necessary data – Management accountant should make

intelligent use of financial data to transform it into useful information by
using various techniques like working capital, capital budgeting etc
2. Data changes / modifications – sometimes data collected needs certain

modifications to suit the management requirements before presentation.
3. Analysis and interpretation – As management accountant has to use

various techniques and tools to prepare reports and statements, he is
required to analyze data so that all useful information can be presented to
management. This is done to find profitability, solvency, and liquidity and
cost efficiency. Some techniques used are ratio analysis, fund flow, cash
flow etc.
4. Facilitate overall control – As management accountant covers all activities

of business, it facilitates overall control measures. This is done with the
help of statistical and costing techniques like break even analysis,
decision tree, transportation, assignment, marginal costing, standard
costing etc.
5. Providing qualitative information – Only quantitative data is not useful as it

takes lot of time to analyze. Therefore quantitative information should be
transformed into qualitative information so that management gets the idea
and results more quickly.
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6. Assist in planning – Planning is fundamentary and planning problem

arises only when alternative courses of action is to be decided.
Management accounting provides a base to management for taking quick
decisions.
Role of Management Accountancy in global business

environment
The role of management accounting and financial accounting is quite different

from each other as they have different goals altogether. Management
Accounting measures, analyzes and reports financial and non financial
information that helps managers to take decisions to fulfill the goals of an
organization. Managers use management accounting information to choose,
communicate and implement strategy. They also use management accounting
information to coordinate product design, production and marketing decisions.
Management accounting focuses on internal reporting. The following points
highlight the role played by Management Accounting in the business
organization.
I. Implementing Strategy: Managers implement strategies by translating them

into actions. Creating value for customers is an important part of planning and
implementation of strategies. Strategic planning and implementation will include
decisions regarding the design of products, services or processes, research and
development, production, marketing, distribution and customer services. Each of
this area is important for satisfying customers and keeping them satisfied.
Management accounting will help to track the costs of each of the activity
mentioned above. The ultimate target is to reduce costs in each category and to
improve efficiency. Cost information also helps managers make cost benefit
analysis. For example, managers can find out that is it cheaper to buy products
from outside vendors or to do manufacturing in-house? Is it worthwhile to invest
more resources in design and manufacturing if it reduces costs in marketing and
customer service?
II. Supply Chain Analysis: Companies can also implement strategy, cut costs
and create value by enhancing their supply chain. The term ‘Supply Chain’
describes the flow of goods, services and information from the initial sources of
materials and services to the delivery of products to customers regardless of
whether those activities occur in the same organization or in other organization.
Customers expect improved performance from companies through the supply

chain. They expect that the companies should perform all these activities in an
efficient manner so as to reduce costs and also maintain quality of the products
and the products be available easily for them. This is no doubt a daunting task
and the management accounting plays a vital role in ensuring value for money
for the customers. Tools like standard costing and target costing can be used
effectively for cost control and cost reduction and thus ensure reasonable prices
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for customers. A system of budgets and budgetary control will ensure continuous
planning and monitoring various functions and thus provide for introspection.
Continuous improvement in these activities will help in creating value for
customers.
III. Decision Making: One of the important functions of management is decision

making. Management Accounting helps in this crucial area by providing relevant
information to the management. Techniques like marginal costing helps to
generate information, which will be useful for taking decisions. Decisions include
make or buy decisions, adding or dropping a product line, working of additional
shift, shut down or continue operations, capital expenditure decisions and so on.
Decisions based on information are expected to be more rational and objective
rather than subjective.
IV. Performance Measurement: Management accounting helps immensely for

the measurement of performance of the organization. The main aspect of
performance measurement is comparison between the targets and actual. There
are several tools and techniques like budgets and budgetary control, standard
costing and marginal costing, which are used in measuring the actual
performance against the target performance. This will facilitate introspection and
corrective action can be taken for further improving the performance.
Advantages and limitations /disadvantages of Management accounting –
Advantages – Management accounting helps in all functions of management but

planning, organizing, coordinating, motivating, controlling functions are benefited
the most as follows:
1. Planning – Management accounting collects all financial and non financial
data, process it and provides such information to management which
helps in framing policies, programmers, procedures, methods etc that is it
helps in preparation of plans more effectively.
2. Organizing – Means grouping of various activities and division of work into

logical segments called departments by assigning duties and
responsibilities to such department. Management accounting helps in
these functions as it recognizes various cost centers and profit centers
and it also adopts suitable internal control system.
3. Coordinating – Management accounting is a reporting system. It
coordinates the activities of various dept’s like planning, production, sales,
purchase, finance etc by adopting techniques like performance budgets,
performance review meetings of all depts. together.
4. Communication – In any organization communication is important and

significant activity of Management accounting dept as it prepares various
reports, statements by collecting data from various dept and provide
relevant information to all such depts. It facilitates two way
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communications. It is also helpful in designing proper and effective

communication channel.
5. Motivating – Management accounting provides ground for assessment of

various employees’ performance. It provides a medium to calculate
efficiency of employees. This is done with the help of performance review
statements, performance budgets; it helps in promoting, rewarding and
appraisal of employees who work efficiently and effectively.
6. Controlling – This is a feedback activity or function. Management

accounting dept devises various review methods to check how far the
targets or objectives are achieved. This ensures controlling of various
activities in better way.
Disadvantages – Every system has its own drawbacks or disadvantages.

Management accounting is also no exception. Following are some of the
disadvantages-
1. Lack of objectivity – Management accounting is based on some

techniques which might include some presumptions and some basis,
which in reality might not be exact or accurate always. To this extent it
lacks the objectivity.
2. Wide scope and high cost of installation – It covers practically every

activity of an enterprise. It has a very wide scope and therefore it has a
difficulty in implementation of its functions in a way it needs. Also it is
associated with a separate system altogether and therefore it involves a
very high cost of installation of such system. It may not be affordable for
small companies to implement such costly affair.
3. Intuitive decision making – Management accounting helps in future

decision making, which is largely based on intuitions of management.
Therefore it is criticized to have subjectivity and personal touch.
4. Lack of skilled personnel – Management accounting covers almost all

aspects of business and therefore it demands a very highly qualified staff
to perform these functions. Sometimes it becomes difficult to get the
skilled employees all the time.
5. Psychological resistance – Since management accounting calls for a

change in the policies, procedures, methods for better profitability, quality
and reductions in costs, there could be a resistance observed from all
levels of management. People are normally against any change in the
Page 17
environment. In case of any changes recommended by management

accountant, top level management may observe psychological resistance
from middle and lower level managers and employees.
Tools and techniques of Management accounting –
1. Financial statement analysis like ratio analysis, comparative statement,

common size statements, trend analysis
2. Fund flow statement
3. Cash flow statement
4. Costing techniques like marginal, differential costing, standard costing
5. Budgetary control
6. Operational techniques like PERT/CPM, Regression correlation, linear
programming etc
7. Responsibility accounting
8. Managerial reporting
Comparison of Management Accounting with Cost Accounting and

Financial Accounting
Financial accounting and cost accounting is more of an accounting kind of work

where as management accounting is more of analysis and reporting kind of work.
Differentiation between management accounting - Financial Accounting – Cost

accounting is as under –
1. Purpose :
Financial Accounting:
Basically prepared for external users e.g. Govt Shareholders, probable investors,
society at large etc
Management Accounting:
Basically prepared for internal users – management
Cost accounting:
Main purpose is to ascertain costs and cost control
2. Preparation:
Financial accounting:
Mandatory under section 227 of companies act 1956
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Management accounting:
Optional, but preparation enables the management in better decision making
Cost Accounting:
Mandatory under section 233(b) of companies act 1956 for certain companies
mentioned.
3. Principles :
Governed by Accounting standards (A.S) and GAAP (Generally accepted
accounting procedures)
No such principles or procedures
Cost Accounting:
As per guidelines given by Institute of Cost and Works Accountants of India.
4. Audit :
Financial Accounting:
Compulsory under companies act
Management Accounting:
Optional, but many companies are doing this for better control
Cost Accounting:
Compulsory under section 233 b of companies act
5. Scope:
Financial / Cost Accounting:

Narrow in scope
Wide in scope
6. Periodicity:

Prepared at regular intervals
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Reports are generated as and when required.
7. Contents :

Governed by companies act
Not governed by any law
8. Coverage:
Financial accounts cover entire performance of company
Covers segment wise performance
9. Objectivity:

Reports are objective one’s that is completely based on facts and are supported
by various documents
Reports are objective as well as subjective as management accountants use
objective data and facts, and also based on subjective factors like estimates and
projections.
10. Publications:

Reports are required to be published and submitted to Govt Bodies
Reports are internal and need not to be given to outside parties.
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Distinction between Financial Accounting and Cost Accounting
Points Financial Accounting Cost Accounting

Coverage It covers accounts of whole It covers transactions relating to
business relating to particular activities / product /
commercial transactions services
purpose Purpose is external Purpose is internal reporting
reporting only
Statutory Financial Accounts are Cost records are maintained under
requirement prepared under section 211 section 209 (1)(d) of companies
of companies act 1956 act 1956
Nature of It records only historical It records historical as well as
costs costs estimated costs
analysis It discloses profit / loss for It discloses product wise / segment
an organization as a whole wise profitability
Control It does not make use of any It makes use of control techniques
aspect control technique
Pricing Does not help in making Helps in pricing decisions
decision decisions regarding pricing
Efficiency Does not help to evaluate Helps to determine efficiency,
efficiency of business productivity
Break up of Does not reveal break up of Reveals break up of costs into
costs costs like variable / fix , variable, fixed, production,
function wise costs administration, selling and
distribution etc
Reporting Financial accounting report Cost accounting report goes to
goes to shareholders management and GOI
Duration of Periodic – every quarter Continuous reporting to
reporting management
Page 21
Cost Accounting
Cost – Costing – Cost accounting –
ICMA London defines - Cost as “The amount of expenditure, actual or notional,

incurred on or attributable to a given thing or activity “
It defines costing as “Technique and process of ascertaining the costs.
It defines cost accountancy as “ Application of costing and cost accounting

principles , methods and techniques to the science, ascertainment of profitability
as well as presentation of information for the purpose of decision making. “
Objectives of Costing and cost accountancy -
a. Management –
1. To know cost of product

2. To help in measuring efficiency
3. To provide suitable information for decision making
4. To Provide necessary data for finding variances
5. To Guide future production policies
6. To Provide information to decide proper product mix
7. To help in preparing budgets
8. To help in price fixation – inland / exports
9. To help in overall control of operations.
b. Employees –
1. To provide data for inefficient areas identification

2. To increases work efficiency , competency
3. To increases chances for better wage structure and payment
policies.
c. Government
1. To Help in assessing the tax liability

2. To Help in formulating policies
3. To Provide Cost data for preparing national plans , industrial policy
Costs classification in manufacturing industry
Costs means all expenses incurred whether paid or outstanding ,to manufacture
a product or render a service. Meaning of cost differs as per its angle of
measuring – From General consumer cost means a price at which it is
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purchased, whereas from manufacturer point of view, cost means all expenses –
direct or indirect which are incurred to produce any particular item or rendering
any services.
Costs are classified differently as per following-
A. Based on Time –
1. Historical cost – Costs are ascertained after they are incurred

2. Predetermined cost – calculated before they are incurred
3. Standard cost
B. Based on Elements –
1. Material – Direct / Indirect
2. Labour – Direct / Indirect
3. Expenses – Direct / Indirect
C. Based on Behavior – How costs behave

1. Variable
2. Fixed
3. Semi Variable
D. Based on functions
1. Manufacturing
2. Administration
3. Selling and Distribution
4. Research and development
5. Preoperative cost
E. Based on accounting period

1. Capital Expenditure
2. Revenue Expenditure
F. Based on Controllability
1. Controllable
2. Uncontrollable
G. Based on analytical view
1. Opportunity cost
2. Sunk Cost
3. Marginal Cost
4. Differential cost
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H. Other Classification
1. Out of pocket cost

2. Replacement cost
3. Normal cost
4. Conversion cost
5. Avoidable cost
6. Unavoidable cost
7. Value added cost
Relevant Cost –
Relevant costs are costs relevant for a specific purpose or situation. In the
context of decision making relating to a specific issue only those costs which are
relevant are considered. Decision making involves consideration of several
alternative courses of action. In this process, whatever costs are relevant are to
be taken into consideration. In other words, costs which are going to be affected
matter the most and these costs are called as relevant costs .
A particular cost item may be relevant in a decision making and may be irrelevant
in some other decision making situation. For example, present depreciated cost
of machine is relevant in case of decision of its sale but it is irrelevant in case of
decision of its replacement.
Sunk Cost –
Sunk Costs are historical costs which are incurred i.e. ‘sunk’ in the past and are
not relevant to the particular decision making problem being considered. Sunk
costs are those that have been incurred for a project and which will not be
recovered if the project is terminated. While considering the replacement of a
plant, the depreciated book value of the old asset is irrelevant as the amount is a
sunk cost which is to be written off at the time of replacement.
Differential Costs:-
Differential costs are also known as incremental cost. This cost is the difference
in total cost that will arise from the selection of one alternative to the other. In
other words, it is an added cost of a change in the level of activity. This type of
analysis is useful for taking various decisions like change in the level of activity,
adding or dropping a product, change in product mix, make or buy decisions,
accepting an export offer and so on.
Differential Cost is the change in cost due to change in activity from one
level to another.
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Differential Cost is found by using the principle which highlights the points of
differences in costs by adoption of different alternatives. This technique is used in
export pricing, new products and pricing goods sought to be promoted in new
markets, either within the country or outside. The algebraic difference between
the relevant cost at two levels of activities is the differential cost. When the level
of activity is increased, the differential cost is known as incremental cost and
when the level of activity is decreased, the decrease in cost is known as
decremented cost.
Cost Sheet
Cost Sheet is a statement of cost showing the total cost of production and profit
or loss from a particular product or service. A Cost Sheet shows the cost in a
systematic manner and element wise. A typical format of the Cost Sheet is given
below.
Cost Sheet for the period.........................................
Production ............................... units
Particulars Amount (Rs.) Amount (Rs.)
A. Direct Materials Opening Stock

+ Purchases
+ Carriage inwards
- Closing Stock
B. Direct Wages
C. Direct Expenses
I Prime Cost ( A + B + C )
D. Factory Overheads- Indirect materials

Loose Tools
Indirect wages
Rent and Rates (Factory)
Lighting and heating (F)
Power and fuel
Repairs and Maintenance
Drawing office expenses
Research and experiment
Depreciation – Plant ( F )
Insurance – ( F )
Work Manager’s salary
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II. Factory Cost/Works Cost ( I + D )

E. Office and Administrative Overheads
Rent and Rates – office
Salaries – office
Insurance of office building and equipments
Telephone and postage
Printing and Stationery
Depreciation of furniture and office equipments
Legal expenses
Audit fees
Bank Charges
III. Cost of Production ( II + E )

F. Selling and Distribution Overheads
Showroom rent and rates
Salesmen’s salaries and commission
Traveling expenses
Printing and Stationery – Sales Department
Advertising
Bad debts
Postage
Debt collection expenses
Carriage outwards
Depreciation of delivery van
Debt collection expenses
Samples and free gifts
IV. Cost of Sales ( III + F )
V. Profi t/Loss
VI. Sales ( IV + V)
A glance at the above cost sheet will reveal that it works out the total cost of
production/service in a phased manner. In other words, total costs are
segregated into elements like Prime Cost, Factory or Works Cost, Cost of
Production, Cost of Sales and finally the profit/loss is worked out by comparing
the total cost with the selling price. Appropriate adjustments are made for
opening and closing stock of Work in Progress and also opening and closing
stock of finished goods. The format of cost sheet may be suitably changed
according to the requirements of each firm but the basic form remains the same.
Page 26
Cost Control
Cost Control and Reduction:-
One of the important functions of cost accounting is cost control and cost
reduction. Cost control implies various actions taken in order to ensure that the
cost do not rise beyond a particular level while cost reduction means reducing
the existing cost of production. Both these concepts are discussed below.
Cost Control:- As mentioned above, cost control means keeping the expenses
within limits or control. Cost control has the following features.
A. Cost control is a continuous process. It involves setting standards and budgets

for deciding targets of different expenses and constant comparison of actual the
budgeted and standards.
B. Cost control involves creation of responsibilities center with clearly defi ned
authorities and responsibilities.
C. It also involves, timely cost control reports showing the variances between
standard and actual performance.
D. Motivating and encouraging employees to accomplish budgetary goals is also

one of the essential aspects of cost control.
E. Actually cost control not only means monetary limits on cost but it also
involves optimum utilization of resources or performing the same job at same
cost.
Cost Reduction :- Cost reduction means attempts to reduce the costs. For
example, if the present costs are Rs. 1,000 per unit, attempts can be made to
reduce it to bring it down below Rs. 1,000. For doing this, all out efforts will have
to be made for achieving this target. The goal of cost reduction can be achieved
in two ways, first is reducing the cost per unit and the second one is increasing
productivity. Reducing wastages, improving efficiency, searching for alternative
materials, and a constant drive to reduce costs, can effect cost reduction. The
following tools and techniques are normally used for cost reduction.
A. Value analysis or value engineering.
B. Setting standards for all elements of costs and constant comparison of actual
with standard and analysis of variances.
C. Work study
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D. Job evaluation and merit rating
E. Quality control
F. Use of techniques like Economic Order Quantity
G. Classification and codification
H. Standardization and simplification
I. Inventory management
J. Benchmarking
K. Standardization
L. Business Process Re-engineering.
Material Accounting –
Material is one of the important element of cost and it has been observed that in
the total cost structure of a product, material content is about 60 to 65%. The
substantial proportion of material cost in the total cost demands more and more
attention of the management towards this element. The term ‘material’ generally
used in manufacturing concerns, refers to raw materials used for production, sub-
assemblies and fabricated parts. The terms ‘materials’ and ‘stores’ are
sometimes used interchangeably. However, both the terms differ. ‘Stores’ is wider
in meaning and comprises many other items besides raw materials, such as
tools, equipments, maintenance and repair items, factory supplies, components,
jigs, fixtures. Sometimes, finished goods and partly finished goods are also
included within the scope of this item.
Materials mean commodities or substances used in factories or companies for

the sake of converting it into finished goods ready for sale. Material includes raw
material, fabricated parts assemblies and subassemblies.
Store is used in broader sense to mean raw material, tools jigs fixtures patterns
consumables such as cotton wastes dusters cleaning material lubricants, grease
oil etc
Inventory is wider term used to include raw material, work in process, finished
stock, operational items, consumables etc
Materials is classified into two – direct and indirect
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Direct material are the materials which form part and parcel of final product,
they can be either seen in final goods or traced in the product
Examples of direct material –
Raw materials such as cloth in shirt, leather in shoes, fruits in jam etc
Components like tyres and tubes in motor, batteries in transistor etc
Primary packing material such as tube in tooth paste
Indirect material – These materials do not form part in product directly as such.
They are consumed side by side in manufacturing activity such as lubricants, oil
grease consumables cleaning material etc. They are ancillary to production.
There are certain items which form part of the product but still they are regarded
as indirect material because of their negligible value for example, sewing thread
in dress material nails used in furniture glue used in book binding.
Concept and objectives of Materials Control
Material cost constitutes a prime part of the total cost of production of

manufacturing firm. Proper accounting, therefore is required for controlling the
material through purchase control, stores control, issue control and control over
various losses. Material control basically aims at efficient purchasing of materials,
their efficient storing and efficient use or consumption. The following are the
objectives of material control.
a. Material of desired quality should be available when needed for efficient

and uninterrupted production.
b. Material should be purchased only when it is needed and in most
economic quantities.
c. Investment in material is maintained at minimum level consistent with
the operating requirement.
d. Purchasing of material will be made at the most favorable prices under
the best possible terms.
e. Material is stored in such a way that the objective of protection is met
fully and at the same time material is made available easily.
f. Issues of materials are authorized properly and are accounted for
properly.
g. Materials are, at all the time, charged as the responsibility of some
individual.
Importance of material control in manufacturing industry –
Page 29
Material cost ranges from 30-80% in industries and therefore it is very important
to have a strict control over its costs. Material control can be achieved through –
1. Purchase control – scientific purchasing

2. Storage control
3. Issue control
4. Consumption – waste control
Scientific purchasing –
Scientific purchasing is much more than simply buying. It is an executive function

like all other functions of management. In big organizations there is separate
function and department called purchase department. There are 6 R s in
scientific purchasing – Right Quantity, Right Quality, Right Time, Right place of
delivery, Right source of supply and Right price.
Steps under scientific purchase – procedure under scientific purchasing
1. Initiating purchase order

2. Exploring sources of supply and selecting supplier
3. Preparing and placing purchase order
4. Follow up of PO
5. Receiving material
6. Inspecting material
7. Checking of supplier invoice and settle account
Centralization and decentralization of purchasing –
Centralize purchase – means purchase by single department called purchase

department headed by purchase manager. When a firm has many plants
producing products from similar materials to be bought from same suppliers,
generally centralize purchasing is done
Decentralize purchasing – under decentralize purchasing separate purchase

departments are established for different plants in different localities
manufacturing different products. This is done for simplicity and for smoothening
activities.
Issue Control : Another important aspect of material control is the issue control.
Material is issued to production and utmost care is to be taken while issuing the
material. The first thing is that without authorization material should not be issued
to any department. A Material Requisition Note is prepared by the department
that is in need of the material and sent to the stores department. It is a written
request made to the stores department for sending the material. In the Material
Requisition Note, the details of the material required such as the quantity, quality,
date by which it is required etc. It is signed by the authorized signatory of the
Page 30
concerned department. On the receipt of this requisition, the stores department

takes action of supplying the required material to the department. While issuing
material care should be taken that exact quantity as per the requirement should
be supplied. If there is surplus material remaining after satisfying the needs of the
concerned department, it should be returned to the stores department. In such
case, Material Return Note should be prepared and sent along with the material.
Similarly if material is transferred from one site to other site without being
returned to the store, it is necessary to prepare Material Transfer Note for
recording the same. Proper documentation is extremely necessary for minimizing
the chances of errors and frauds.
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 fi nd out the consumption value of
the material. However the question is that at what price the issue is to be
charged. Obviously the answer is that the issues should be priced at the same
price at which they are purchased. But it is not practical as it is virtually
impossible to identify the material issued. Hence it is necessary to price the
issues by using certain methods. The various methods of pricing of issues are
given below.
1. First In First Out:- As per this method, material received first is issued
first. Thus the material in stock at the beginning of a period is issued firstly
and then the issues are made according to the dates of purchases made.
This method is quite logical as the sequence of issue is as per the dates of
purchases. However the consumption value will be as per the purchases
made earlier and hence the latest price may not be charged to the
consumption. In case of rising prices it will result in charging lower prices
while in case of falling price it will result in charging higher prices to the
material consumption. The closing stock will be shown at the latest prices
as the material purchased towards the end of the
period will remain the stock.
2. Last In First Out [LIFO]:- The assumption under this method is that the
material which is purchased last is issued fi rst to the production.
Therefore the issue should be charged at the latest prices. The main
advantage of this method is that the issues are priced at the latest prices
and hence consumption value is also the latest. This will make the product
cost more realistic. However, the inventory valuation will be at the older
price as material in balance will be from the earlier batches of purchases.
Valuation 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
Page 31
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 Rs.18, Rs.19 and
Rs.23, the issue will be charged at the average price of the three prices,
i.e. Rs.18 + Rs.19 + Rs.23 = Rs.60/3 = Rs.20. This method is not very
popular because it takes into consideration the prices of different batches
but not the quantities purchased in different batches. In the periods of
price fluctuations this method is useful but if fluctuations are too wide, the
method may not be useful.
Weighted Average Method:- This method takes into consideration the

prices as well as the quantities of materials purchased. Thus weighted
average is computed after each receipt by dividing the total amount by the
total quantity. The issue is charged at prices arrived at according to this
calculation. For example, if three consignments of materials are
purchased at prices of Rs.10, Rs.12 and Rs.11 and the quantities involved
are respectively 1,000, 1,200 and 1,400. The weighted average price will
be calculated as shown below.
Rs.10 _ 1,000 + Rs.12 _ 1,200 + Rs.11 _ 1,400 = Rs.10,000 + Rs.14,400

+ Rs.15,400 = Rs.39,800 / 3,600 = Rs.11.05. The subsequent issue will be
charged at this price. The main advantage of this method is that it evens
out the price fluctuations and reduces the number of calculations to be
made.
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.
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
Profi t and Loss Account. Standard Cost is a predetermined cost and if it is
set accurately, it can be very effective. However revision of standard cost
at regular intervals is required.
Page 32
8. Replacement Cost [Market Price]:- The replacement cost is 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. This
method is not acceptable for standard accounting practices as it refl ects
the price, which has not been paid actually.
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.
10. Base Stock Method:- Under this method, a certain quantity of

materials is always held in stock and any material over and above this
quantity is priced according to any other pricing method like First In First
Out or Last In First Out or any other method. For example, it may be
decided that 500 units will be held in stock and for materials over and
above this FIFO method may be followed. However, this method is not
popular and also not accepted under standard accounting practices as it
would result in stock valuation totally unrealistic.
Thus it will be observed that there are several methods of pricing of issues. Any
one of these can be selected. However care should be taken that once a
particular method is selected, it should be followed consistently year after year
because if frequent changes are made, the results will be not comparable.
Inventory Control: One of the important aspects of the overall material

management is the inventory control. It is necessary to avoid the overstocking as
well as under stocking. For ensuring this, maximum level, minimum level, re-
order level are fixed. Besides this it is essential to take care of the material lying
in the stock. There is huge investment made in the materials and if proper care is
not taken, there will be severe loss. Even though records are maintained in the
stores regarding the receipts and issues, they should be periodically verified with
the physical stock so that chances of errors and frauds are minimized. For
inventory control, the following techniques are used.
a. Perpetual Inventory System: Perpetual Inventory system means

continuous stock taking. CIMA defines perpetual inventory system as ‘the
recording as they occur of receipts, issues and the resulting balances of
individual items of stock in either quantity or quantity and value’. Under
this system, a continuous record of receipt and issue of materials is
maintained by the stores department and the information about the stock
of materials is always available. Entries in the Bin Card and the Stores
Ledger are made after every receipt and issue and the balance is
reconciled on regular basis with the physical stock. The main advantage of
this system is that it avoids disruptions in the production caused by
periodic stock taking. Similarly it helps in having a detailed and more
Page 33
reliable check on the stocks. The stock records are more reliable and
stock discrepancies are investigated and appropriate action is taken
immediately.
b. ABC System: In this technique, the items of inventory are classified

according to the value of usage. Materials are classified as A, B and C
according to their value. Items in class ‘A’ constitute the most important
class of inventories so far as the proportion in the total value of inventory
is concerned. The ‘A’ items constitute roughly about 5-10% of the total
items while its value may be about 80% of the total value of the inventory.
Items in class ‘B’ constitute intermediate position. These items may be
about 20-25% of the total items while the usage value may be about 15%
of the total value. Items in class ‘C’ are the most negligible in value, about
65-75% of the total quantity but the value may be about 5% of the total
usage value of the inventory. The numbers given above are just indicative,
actual numbers may vary from situation to situation. The principle to be
followed is that the high value items should be controlled more carefully
while
items having small value though large in numbers can be controlled
periodically.
c. Just in Time Inventory: This is the latest trend in inventory

management. This principle envisages that there should not be any
intermediate stage like storekeeping. Material purchased from supplier
should directly go the assembly line, i.e. to the production department.
There should not be any need of storing the material. The storing cost can
be saved to a great extent by using this technique. However the
practicality of this technique in Indian conditions should be verified before
practicing the same. The benefits of Just in time system are as follows,
a. Right quantities are purchased or produced at right time.

b. Cost effective production or operation of correct services is
possible.
c. Inventory carrying costs are eliminated totally.
d. The stores function is eliminated and hence there is a
considerable saving in the stores cost.
e. Losses due to breakage, wastage, pilferage etc are avoided.
d.VED Analysis: This analysis divides items into three categories in the
descending order of their criticality as follows.
• ‘V’ stands for vital items and their stock analysis requires more attention.
The reason is that if these items are not available, the resulting stock outs
will cause heavy losses due to stoppage of production. Thus these items
are required to be stored adequately to ensure smooth operation of the
plant.
Page 34
• ‘E’ means essential items. Such items are considered essential for
efficient running but without these items, the system will not fail. Care must
be taken to see that they are always in stock.
• ‘D’ stands for desirable items, which do not affect production immediately
but availability of these items will lead to more efficiency and less fatigue.
• Thus VED analysis can be very useful to capital intensive process
industries. As it analyses items based on their importance and it can be
used for those special raw materials which are difficult to procure.
e. FSND Analysis: Age of the inventory indicates the duration of inventory

in the organization. It shows the moving position of inventory during the
year. This analysis divides the items of inventory into four categories in the
descending order of their usage rate as follows.
I] ‘F’ stands for fast moving items and stocks of such items are consumed
in a short span of time. Stock of fast moving items must be observed
constantly and replenishment orders be placed in time to avoid stock out
position.
II] ‘N’ means normal moving items and such items are exhausted over a
period of time, i.e. say one year. The order levels and quantities for such
items should be on the basis of a new estimate of future demand to
minimize the risks of a surplus stock.
III] ‘S’ indicates slow moving items, existing stock of which would last for
two years or so. These items must be reviewed carefully before
eliminating them.
IV] ‘D’ stands for dead stock which means that there will not be any further
demand for the same. It is necessary to identify these items and if there
cannot be any alternative use for the same, should be eliminated.
Objective of inventory control is to achieve maximum efficiency in production and

sales with minimum investment in inventory. To achieve this, some measures
used are as under –
1. Setting up various stock levels – Maximum, Minimum, Reorder level,

danger level
2. EOQ ( Economic Order Quantity )
3. ABC analysis
4. Kanban system
5. JIT ( Just In Time )
6. Perpetual inventory - Stock verification
Economic Order Quantity: One important question that is to be answered by

the Purchase Manager is how much to purchase at any one time? In other
words, how much quantity is to be ordered at any one point of time? Whether
there are any costs associated with the ordering quantity apart from the purchase
price? 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
Page 35
the carrying cost. We will discuss about these costs. Ordering cost is the cost of
placing an order. In other words, it can be said that when an order is placed, the
company has to incur certain costs at the time of 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. On the other hand, there are certain costs that are called as
carrying costs. The cost of carrying the inventory 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, however their behavior is exactly opposite of
each other. 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 number of orders is 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. In this situation, 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’. This
quantity can be calculated with the help of the following formula.
Economic Order Quantity = Sq root of = 2* U* O/IC
U = Annual demand / annual consumption in units

O = Cost of placing and receiving an order
IC = Carrying cost per unit per annum
The Economic Order Quantity is an important concept as it guides the Purchase

Manager regarding the quantity to be purchased of a particular material.
However, this concept is based on some assumptions. These assumptions are
as follows.
• The concerned material will be available all the time without any diffi culty.
• The price of the material will remain constant.
• Ordering cost and carrying costs are variable.
• Impact of quantity discounts on the prices is negligible.
Fixation of Level: Another important aspect of material procurement is not to

purchase too much or too little. Similarly the timing of the purchase is also
important. Fixation of levels of materials is done precisely with these objectives in
mind. The following levels of materials are fixed for achieving objectives like
avoiding overstocking, ensuring that the material is ordered at right time and also
avoiding shortage of materials.
Maximum Level : This is the highest level of material beyond which the
inventory of material is not allowed to rise. Obviously this level is fixed with
Page 36
the objective of avoiding overstocking. This level is fixed after taking into
consideration the consumption of material and the re-order period.
Mathematically the level is fixed as under.
Maximum Level = Re-order Level + Re-order Quantity – [Minimum

Consumption Minimum Reorder period]
Minimum Level : This level is fixed with the objective of avoiding shortage
of material. If production is held up due to shortage of material, there will
be huge loss to the company. In order to avoid this, the minimum level is
fixed. Care is taken that the stock does not fall below this level. The
minimum level is fixed in the following manner.
Minimum Level = Ordering Level – [Average rate of consumption _ Re-

order period]
Re-order Level : This level is fixed for deciding the time of placing an
order. If the stock of materials reaches this level, fresh order is placed so
that by the time the material is procured, the level of material may fall up
to minimum level but not below that. This level is fixed in the following
manner.
Re-order Level = Maximum Usage per Period _ Maximum Re-order Period
Average Level : This level is the average of the maximum and minimum
level and computed in the following manner.
Average Level = Maximum Level + Minimum Level / 2
Danger Level : Generally the danger level of stock is indicated below the
safety or minimum stock level. Sometimes, depending on the practices of
the fi rm and circumstances prevailing, the danger level is determined
between the re-order level and minimum level.
Material Losses: One of the main reason of rising material costs is the loss of
material in the production process. It is of paramount importance that there
should be rigid control over the material losses failing which it will be very diffi
cult to keep the material costs in check. The material losses can be categorized
as given below.
Waste:- Waste is a loss of material either in stores or in production due to

reasons like evaporation, chemical reaction, shrinkage, unrecoverable residue
etc. Wastages may be visible or invisible. It is necessary to take steps to control
the material wastage. In cost accounting, the wastage is divided into the following
categories.
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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.
• Wastage can be controlled by adopting strict quality control measures.
Normal allowance of waste can be fi xed with technical assessment and
past experience as well as by identifying the special features of materials.
The causes for abnormal wastages should be studied in detail and
responsibility should be fi xed for wastage. Better material handling
system will also help in controlling the wastage.
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 identifi able 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 Profi t and Loss
Account.
• If scrap value is quite substantial and it is not identifi able with a particular job or
process, the amount will be transferred to factory overhead account after
deducting the selling cost. This will reduce the cost of production to the extent of
the scrap value.
Control of Scrap:- For the control purpose, scrap may be divided into the
following categories.
• Legitimate Scrap:- This is predetermined or anticipated in advance due
to experience in manufacturing operations.
• Administrative Scrap:- This results from administrative decisions, e.g.
change in design of a product or discontinuation of existing product lines.
• Defective Scrap:- This results from poor quality of raw material,
negligent handling of material etc.
• Scrap can be controlled through selection of right type of material,
selection of right type of manpower, determination of acceptable limits of
scrap, and reporting the source of waste.
Spoilage:- Spoilage is the production that fails to meet quality or dimensional

requirements and so much damaged in manufacturing operations that they are
not capable of rectification and hence has to withdraw and sold off without further
processing. Rectification can be done at a cost which may not be economic. If
Page 38
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 Profi t 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.
Labour Accounting
Labour is important element of cost. It is most sensitive and crucial factor of

production. Broadly labour cost comprises of following –
1. Monetary benefits – basic , Dearness allowance , Bonus
2. Deferred Monetary benefits – Contribution to PF, ESI, Gratuity,Pension etc
3. Non monetary – Fringe benefits – Subsidies Food, Housing, canteen
Medical facility etc
Labour cost is divided into direct labour and indirect labour
Direct labour – payment made to all workers directly involved in production of

goods or providing services. For example, wages paid to carpenter, machine
operator. Direct wages is variable cost.
Indirect labour – expenses incurred on those who are not directly involved in
production of goods and services. They cannot be conveniently identified with
production of goods - job, process. Examples – supervisors, administration,
accounts, audit, stores, quality control, time office, general manager etc.
Basic remuneration types-
1. Piece rate system of payment

2. Time based system
3. Bonus – Halsey , Rowan method
4. Indirect methods- profit sharing, co partnership
Page 39
5. Non monetary benefits – working conditions, welfare facilities
Time keeping
Time Keeping – It is a systematic process of recording arrival and departure of

employees in an organization. It means it keeps a record of incoming time and
outgoing time of all workers and staff. It is normally at office gate or factory
gate, for simplicity. Time keeping is set up for achieving following purposes:
1. Calculation of wages to be paid becomes easy

2. Record of normal working and overtime working hours is possible
3. Statutory requirement – Keeping record of all workers is a statutory
requirement
4. It facilitates to introduce incentive system
5. It helps in ascertainment of labour cost of various operations.
6. Primary and secondary distribution of overheads is possible with the
help of time keeping records.
7. It provides a base for any statistical analysis
Methods of Time keeping:
Manual methods – Manual methods can be an attendance register method,

where a simple register is kept at the factory gate which has a record of each
person coming in and going out of the factory along with his identification, his
dept name etc.
Mechanical methods – Now days with the help of computerization, many

mechanical devises are put to use for keeping a record of persons working in
various shifts and at different locations.
Correct recording of time is essential, especially when the payment is made

on the basis of no of hours worked by a person.
Time Booking – Time booking refers to actual utilization of time in the concerned
department, job, and process. Proper accounting of labour cost requires analysis of
time spent by each person on a job. Time booking involves recording of starting time
and ending time of work by every worker in respect of every job. Time booking comes
after time keeping, where these two systems are reconciled at regular intervals. This is
simply because wages calculated on the basis of time keeping should match with the
time recorded on job cards used by different persons. Objectives of time booking are
as under:
1. To ensure that the time recorded as per time keeping record is in
accordance with the time utilized on different jobs as per job card
record.
2. To calculate the labor cost for a particular job or work order
Page 40
3. To ascertain unproductive time, idle time.

4. To know the efficiency and determine the piece rate wages.
Different methods used for time booking – following methods are used for time
booking of individual jobs –
1. Daily time sheet card

2. Job Card
3. Time and job ticket
4. Piece work card
5. Idle time card
Labor Turnover: Labor turnover, which is also called as ‘attrition’ is a major

problem in the modern times. Labor turnover can be defined as, a change in the
labor force as compared to the total labor force. Labor turnover is prevalent in
every industry, however, the proportion of the same changes from industry to
industry. For example, turnover in information technology sector is the highest
today due to ample job opportunities due to the rapid growth of this sector. Labor
turnover should not be very high as it will result into double loss to the
organization, the first one is that an experienced employee will be lost and
secondly new person who is replacing the old one, may not have same
qualifications and experience and till he is accustomed to the new job, his
productivity is bound to be low. Similarly suitable training will have to be given to
him in order to acquaint him with the environment, which will also result in
additional expenditure. Due to these reasons, every organization tries to
minimize the labor turnover. However, some proportion of labor turnover is
actually necessary, as it will bring in fresh ideas in the organization. If labor
turnover is reduced to zero, it will indicate that the employees do not have any
opportunity outside and hence they are surviving. Therefore some degree of
labor turnover is always desirable.
I.II Measurement of Labor Turnover: It is essential for any organization to
measure the labor turnover. This is necessary for having an idea about the
turnover in the organization and also to compare the labor turnover of the
previous period with the current one. The following methods are available for
measurement of the labor turnover.
Additions Method: Under this method, number of employees added during a
particular period is taken into consideration for computing the labor turnover. The
method of computing is as follows.
Labor Turnover = Number of additions/Average number of workers during the
period _ 100
Separations Method: In this method, instead of taking the number of employees

added, number of employees left during the period is taken into consideration.
The method of computation is as follows.
Labor Turnover = Number of separations/Average number of workers during the
period_100
Page 41
Replacement Method: In this method neither the additions nor the separations
are taken into consideration. The number of employees replaced is taken into
consideration for computing the labor turnover.
Labor Turnover = Number of replacements/Average number of workers during
the period _ 100
Flux Method: Under this method labor turnover is computed by taking into
consideration the additions as well as separations. The turnover can also be
computed by taking replacements and separations also. Computation is done as
per the following methods.
Labor Turnover = ½ [Number of additions + Number of separations] /Average
number of workers during the period _ 100
Labor Turnover = ½ [Number of replacements + Number of separations]
/Average number of workers during the period _ 100
Causes of Labor Turnover: Computation of labor turnover and a report of the

same help the management in taking action for minimizing the labor turnover. It
will also be useful if the management finds out the reasons for the labor turnover.
Broadly, causes of labor turnover can be divided into two categories, avoidable
and unavoidable.
Avoidable Causes: These causes include the following.

• Dissatisfaction with the job
• Dissatisfaction with the working hours
• Dissatisfaction with the working environment
• Relationship with colleagues
• Relationship with the superiors like supervisors
• Dissatisfaction with monetary and non monetary incentives
• Other reasons such as lack of facilities like insurance, absence of
promotion chances, lack of
proper training etc.
Unavoidable Causes: These causes include the following.

• Personal betterment
• Retirement
• Death
• Illness or accident
• Change in locality
• Termination
• Marriage
• National service
• Other reasons like lack of residential facilities, family commitments,
attitude etc.
Page 42
Cost of Labor Turnover: For an organisation, labor turnover results into a cost.
If labor turnover is very high, it will result in high cost and hence efforts should be
made to prevent the same. The costs of the labor turnover can be grouped into
the following categories, preventive and replacement. These are explained
below.
Preventive Costs: It is said that preventions is always better than cure. Same
thing is applicable in case of labor turnover. It is always better to prevent the
labor turnover rather than taking action after it has taken place. The costs
incurred for preventing the labor turnover are known as preventive costs. These
costs are as follows.
Cost of personnel administration which includes expenditure incurred in
maintaining good relationships between the management and the workers.
Cost of medical services incurred for improvement in medical facilities and also
for motivating the employees.
Expenditure incurred on welfare measures like sports facilities, transport,
housing, cultural activities, canteens etc.
Certain schemes like pension, gratuity schemes and other post retirement
benefits.
Replacement Costs: These costs are incurred for removing the effect of the
labor turnover and include the following costs.
Cost of recruitment and training of new workers

Loss of output due to delay in recruiting new workers
Loss due to inefficiency of new workers.
Cost of increased spoilage
Cost of tool and machine breakage.
The preventive costs should be collected under different standing order numbers
and are apportioned to different departments in proportion to the number of
persons engaged in each department.
Replacement costs arising on account of fault of a particular department, such

replacement costs may be charged directly to that department. If however, the
labor turnover is due to shortsighted policy of the management the cost is
collected as an overhead item and is apportioned to departments on the basis of
number of persons engaged in each department.
Overheads - Classifications, Allocation, Apportionment, Absorption
Page 43
Overheads comprise of indirect materials, indirect employee costs and indirect

expenses which are not directly identifiable or allocable to a cost object in an
economically feasible way.
Any items of overheads arising out of abnormal situation in business activity

should not be treated as overheads. They are charged to Costing Profit and Loss
Account. Items not related to business activities such as donation, loss / profit on
sale of assets etc are also not to be treated as overheads.
Collection of Overheads - Collection of overheads means the pooling of indirect

items of expenses from books of account and supportive/ corroborative records
in logical groups having regards to their nature and purpose.
Overheads are collected on the basis of pre-planned groupings, called cost

pools. Homogeneity of the cost components in respect of their behavior and
character is to be considered in developing the cost pool. Variable and fixed
overheads should be collected in separate cost pools under a cost centre. A
great degree of homogeneity in the cost pools are to be maintained to make the
apportionment of overheads more rational and scientific. A cost pool for
maintenance expenses will help in apportioning them to different cost centers
which use the maintenance service.
ICMA, London defines Overheads as “Aggregate of indirect material, indirect

labour and indirect expenses. Overheads are also known as burden ,
supplementary , on cost etc The word indirect indicates that the expenditure can
not be directly allocated to a product , unit or service , but can only be allocated
or apportioned to cost centers from where it gets absorbed to the product. Thus
in short overheads are common costs, which are incurred to run, continue the
business activity.
Examples of overheads are – staff salaries , telephone exp , electricity

expenses , Office rent , godown rent , printing and stationery , advertisement ,
sales promotion expenses , canteen , stores , maintenance etc.
Cost information relating to any type of overhead is important and useful in

performance of managerial functions like planning, decision making, control etc.
Overheads can be classified into following 4 types:
1. Element wise classification – Under this overheads are classified as per

elements of costs like material, labour and expenses. So we have –
a) Indirect material such as consumables, stores and spares,

cleaning materials, soaps, detergents hand gloves, soldering
rods. Nails , cloth etc
Page 44
b) Indirect labour such as payment made to supervisor’s sales

representatives, sweepers, watchman, all office staff etc.
c) Indirect expenses such as depreciation, office rent, office
salaries, and telephones telex fax, canteen, taxes travelling
expenses etc.
2. Functional wise classification – Overheads can be classified as per

functions like –
a) Production overheads like factory rent , light, depreciation ,

works salaries , time keeping booking exp , security exp ,
factory canteen , coal, gas used as consumable items etc
b) Administration overheads like office rent, office salary, office
printing stationery, director’s remuneration office equipment,
bank charges. office telephone etc
c) Selling and distribution expenses like godown rent , salesman
salaries , depot expenses bad debts , advertisement sales
promotion etc
d) Research and development expenses like expenses incurred on
new design , formula , survey etc
3. Behavior wise classification – All overheads can be classified as per their

variability with volume of production. Some expenses vary directly with the
volume of production such as direct material, labour etc. These are termed
as variable overheads. Some expenses do not vary with the volume of
overheads such as salary, depreciation, rent etc. These are called as fixed
overheads. While some expenses vary proportionately or in some part,
which are called as semi variable or semi fixed. Therefore, under behavior
classification we have 3 types of overheads such as –
a) Variable overheads
b) Fixed overheads
c) Semi variable / semi fixed overheads
4. Classification according to controllability
a) Controllable overheads
b) Uncontrollable overheads
Allocation of overheads – Allocation of overheads is assigning a whole item of

cost directly to a cost centre.
An item of expense which can be directly related to a cost centre is to be

allocated to the cost centre. For example, depreciation of a particular machine
Page 45
should be allocated to a particular cost centre if the machine is directly attached

to the cost centre.
Apportionment of overhead - Apportionment of overhead is distribution of

overheads to more than one cost centre on some equitable basis.
When the indirect costs are common to different cost centers, these are to be
apportioned to the cost centers on an equitable basis. For example, the
expenditure on general repair and maintenance pertaining to a department can
be allocated to that department but has to be apportioned to various machines
(Cost Centers) in the department. If the department is involved in the production
of a single product, the whole repair & maintenance of the department may be
allocated to the product.
Examples of basis of primary distribution of some items of production overheads
Item of Cost Basis of Apportionment
Power (H.P. rating of Machines x hours x LF

Fuel *
Jigs, tools & fixtures Consumption rate x hour
Crane hire charges Machine hours or Man hours
Supervisors’ salary & fringe Crane hours or weight of materials
benefits handled
Labour welfare cost Number of employees
Rent & rates Number of employees
Insurance Floor or Space area
Depreciation Value of fixed asset
Value of fixed asset
* LF = Motor Load Factor
Primary and Secondary distribution of overheads
Primary Distribution – A departmental distribution summary of overheads

expenses is prepared by allocation of directly identifiable expenses and
apportionment of common items on some suitable basis. Primary distribution of
overheads consist of assigning of overheads to several departments with the
object of ultimately all units produced should absorbed all related overheads.
While making primary distribution of overheads, clear distinction between
production and service dept need not be made since it hardly makes any
difference.
Secondary distribution - It consist of redistribution of total costs of each

service departments to production departments and other service dept if
required.Main purpose here is to allocate / apportioned costs of service dept to
Page 46
prod dept so that all overheads of service dept will get absorbed by units
produced. There are certain service dept like canteen, general stores etc which
gives the services to prod dept as and when required. If one service dept give the
service to more than one prod or service dept then, the expenses of that service
dept will be proportionately distributed on some appropriate basis. Secondary
distribution is helpful in following manner –
1. In determining cost of final product produced
2. To determine the effect of certain management decisions on total cost of
particular dept or cost centre
3. It provides motivation among employees of producing dept to take up
service dept activities.
There should be proper basis to apportion or reapportion overheads of service
dept to prod dept. for example, canteen exp to be distributed on no of employees
under each prod dept., store dept expenses to be redistributed on no of
requisitions received from each prod dept. and so on.
Different methods of secondary distribution -
There are basically two methods of redistribution of service dept overheads to

prod and other dept. these are –
1. Non reciprocal basis

2. Reciprocal basis
Under Non reciprocal basis method, cost of each service dept is allocated to
production dept and other service dept. The cost of most serviceable dept is first
apportioned to other service and production departments then the next service
dept overheads are apportioned to the remaining dept and so on. This process
continues till last service dept overheads are apportioned to only production
depts...
Reciprocal method: -
In this case, there is overlapping of services rendered by one service dept to

other and vice versa. For example, maintenance dept gives service to stores
dept and store dept also in turn give service to maintenance dept. In such case
exact distribution is difficult to calculate. This creates a vicious circle. In such
case, there are following methods to be applied:
1. Simultaneous equation method where total true cost of service dept is

ascertained first with the help of simultaneous equation.
2. Repeated distribution method where the costs of one service dept is

distributed among other prod and service depts. , again the costs of those
service dept is redistributed to prod dept and also the first service dept.
Page 47
This process continues till very small or negligible amount remained to be

distributed. The process repeats and therefore called as repeated
distribution method.
3. Trial and error method - This method is to be followed when the question
of distribution of costs of service cost centers which are interlocked among
them arises. In the first stage, gross costs of services of service cost
centers are determined and then in the second stage, costs of service
centers are apportioned to production cost centers. Steps to be followed :-
The proportion at which the costs of a service cost centre to be distributed to

production cost centers and other service cost centers is determined.
Cost of first service cost centre is distributed to the other service centers in the
proportion of service they received from the first as assessed in step (i).
In the next step, total cost of second service cost centre so arrived has to be
distributed to the other service centers in the proportion of service they received
from the second as assessed in step (i).
Similarly, the cost of other service cost centres are to be apportioned to the
service cost centres.
This process as described in (iii) and (iv) is to be continued till the figures
remaining undistributed in the service cost centers are negligibly small.
At the last, total cost of service cost centers to be distributed to production cost
centers.
Absorption of overheads - Absorption of overheads is charging of overheads

from cost centers to products or services by means of absorption rates for each
cost center which is calculated as follows:
Total overheads of the cost centre

Overhead absorption Rate = _____________________________
Total quantum of base
The base (denominator) is selected on the basis of type of the cost centre and its
contribution to the products or services, for example, machine hours, labor hours,
quantity produced etc.
Overhead absorbed = Overhead absorption rate x units of base in product or

service
Page 48
Under / over absorption of overheads –
Absorption of overheads into a unit cost is based either on actual rate or

predetermined rate. Under actual absorption rate, costs are fully absorbed and
there will be no difference between overheads absorbed and overheads actually
incurred. However, in case the overheads are absorbed on predetermined rate,
the actual overheads might be different than the overheads absorbed, and
therefore, the question of under / over absorption comes.
In case the predetermined rate is Rs.2 per machine hour and actual machine
hours run are 5000, overhead absorption will be 2 * 5000 = 10,000/-
Under absorption – In this the overheads absorbed are less (under) than actual
overheads. That is, overhead absorbed are 10,000 and actual overheads are
suppose Rs.12, 000 there is under absorption of 2,000/-
Over absorption – In this case actual overheads are less than the overheads
absorbed, that is if actual overheads are only 8,000/- there will be over
absorption of 2,000/-
Causes of under / over absorption –
1. Because of error in estimation, total overheads absorbed might be less or

more than actual overheads.
2. Actual volume of output may vary in actual.
3. Actual hours worked may be less or more due to some reasons
4. Work in progress might be charged differently in actual
5. Seasonal fluctuation in actual
6. Some un anticipated factor in actual so as to cause actual expenses more
or less
Decision Making Tools
Page 49
Marginal costing
Marginal costing is not a distinct method of costing like Job costing or process
costing. But it is a special technique used for managerial decision making. It is
used as a tool to interpret cost data to measure profitability, to decide best
product mix, to decide about make or buy etc marginal costing can be used in
conjunction with different methods of costing like job, batch, process etc.
Under marginal costing technique cost ascertainment is made on the basis of

nature of cost, cost behavior. Under conventional method the classification is
based on functional basis.
Marginal costing is ascertainment of marginal cost and of effect on profit of

changes in volume by differentiating between fixed and variable cost.
Marginal cost – it is amount at any given volume of output by which the

aggregate variable costs are changed if the volume of output is increased or
decreased by one unit. In actual practice this is measured by total variable cost
attributable to one unit.
Marginal cost can precisely be the sum of prime cost and variable overheads . In
other words it is nothing but the total variable cost.
Application / advantages of Marginal Costing in following areas –
1. Cost Control
2. Profit planning
3. Evaluating performance
4. Decision making –
a. Make or Buy
b. Product mix
c. Pricing
d. Expand or not to expand – capital investment
e. Alternative use of excess / existing capacity
f. Problem of Limiting / key factor
Limitations / Disadvantages
1. Separation of costs into fixed and variable presents technical difficulties

2. Stock of Finished goods and WIP is understated / under valued
3. Profit under stated
4. Sales are seasonal and fluctuate invariably. And therefore, monthly
statement prepared on marginal costing does not represent true picture
5. Marginal costing does not present full information. It does not reveal the
extensive use of resources, replacement of labour force etc.
Page 50
6. With the increased automation and technology, major portion , that is fixed
costs are not considered in marginal costing technique
Various concepts in Marginal costing-
1. Differentiating Variable and fixed costs

2. Bifurcating Semi variable cost in variable and fixed part
3. Contribution
4. P/V ratio or C/S ratio
5. Break Even Point ( BEP )
6. Margin of safety ( MOS )
Some examples of Decisions taken on the basis of Marginal costing technique –
1. Make or buy
2. Plant Shut down or continue
3. Product mix
4. Capacity utilization
5. Running additional shift – single / double
6. Closing of business / product line
7. Increase / decrease S.P
8. Profitability of different divisions
9. Sharing of corporate expenses
Important Formulae
1. Contribution ( C ) = Excess of S.P over V.C
( C ) = S.P – V.C
S.P = Selling Price, V.C = Variable Cost
2. Contribution - Fixed Cost = Profit
3. Fixed Cost = Contribution – Profit
4. S.P - V.C - F.C = Profit
5. V.C + F.C = Total Cost

Variable Cost Per Unit remains Constant or Same,
However It Changes in total as Volume changes
Page 51
Fixed cost in Total remains Constant or Same ,
However it Increases / Decreases per unit as per Volume

changes
Variable Cost includes = Direct Material , Direct Labour ,

Variable Overheads
6. P/V Ratio = Contribution Per Unit

---------------------
S.P Per unit
OR
Contribution Rs .
----------------------
Sales Rs
OR
Change in Profit
---------------------
Change in sales
7. B E P ( Units ) = Fixed Cost

-----------------
Contribution per unit
8. B E P ( Rs.) = Fixed Cost

-----------------
PV Ratio ( % )
OR
B E P ( Units ) * S.P per unit
9. Margin of Safety = Sales ( Actual / Budgeted )

Less Break Even sales
Or
MOS = Profit / PV ratio
Page 52
10. Contribution = Sales * PV Ratio
11. Sales = Contribution

-----------------
PV Ratio
Effect of following on BEP
Increase in S.P BEP Decreases , PVR Increases
Decrease in S.P BEP Increases , PVR Decreases
Increase in F.C BEP Increases , PVR same
Decrease in F.C BEP Decreases , PVR same
Increase in V.C BEP Increases , PVR Decreases
Decrease in V.C BEP Decreases , PVR Increases
Budget and Budgetary Control
Budget - A budget is defined as “ A quantitative plan of action that aids in

co ordination and control of acquisition and utilization of resources over a given
period of time.
It is quantitative expression of management plans. It is a formal
expression of policies, plans, objectives and goals laid down in advance. There is
master budget for the enterprise as a whole, composed of numerous functional
budgets like sales, manufacturing budget, admin, finance budget. The process
of preparing budget is known as budgeting.
 Budgetary Control:-
There has also to be execution of budgets. Comparison between budget

figures and actual performance should be made.
Budgetary control is one of technique of managerial control. Budgetary
control is establishment of budget relating to responsibilities and continuous
comparison of actual with budgetary results
Budgetary control involves three steps:
1. Preparation of budgets
2. Continuous comparison
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3. Revision of plans in the light of changed circumstances.
 Advantages of budgetary control:-
1. Budgets are an effective means of controlling the activities of an

enterprise. Budget provides targets to measure the performance and
take necessary remedial action.
2. Budgetary control co ordinates various activities.
3. It saves executive time and attention by emphasizing the exception
principle. The executives need to concentrate their attention on off
budgeted performance only.
4. It helps to fix responsibility once the budget is drawn with the consent
of the man in charge of particular activity, it becomes his responsibility
to see that actual are in conformity with the budget.
5. Reduction of wasteful expenditure is possible.
6. Actions are likely to be based on study and careful consideration.
7. Budget provides data for preparing quotations and filling tenders.
They provide data for fixing overhead recovery rates.
8. Cost variance will reveal the weakness that exists.
9. Sound management principles, delegation and responsibility are
recognized.
10. Budget enables a concern to stabilize production.
Flexible budget – Flexible budget is defined as a budget which, by recognizing

the difference between fixed, variable and semi variable, is designed to change
in relation to level of output. Flexible budget has been developed with an
objective of changing the budget figures with the corresponding change in
capacity, level of output.
Need for flexible budget arises in following situations:

1. Where sales are difficult to predict
2. Where company is introducing new products frequently
3. Where capacity utilization varies very often
Flexible budget as effective tool for budgetary control:
1. Flexible budget prepared for each dept can be compared with the actual
figures, and a close control can be set up than the fixed budget.
2. It assists in evolving the effects of various levels of activities on bottom line

that is profit.
3. It helps in determining various factory overheads in minute
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4. It is most helpful in ever changing, dynamic marketing situation.
5. It especially avoids passing the buck. Since it clearly defines the budget at
all possible level of activities and constraints, it establishes responsibilities
very clearly and therefore no body can pass on the responsibility to
someone else.
6. It also helps in following principle of management by exception.
7. Flexible budget keeps enough space for changes that happen frequently
and thereby it helps to have continuous review of performance at any
given point of time.
Standard Costing
Standard Cost -
It is a predetermined calculation of how much costs should be incurred to

produce a standard product or render service under specific working condition.
Standard costing is a technique which uses standard for costs and revenues for
the purpose of control through variance analysis.
Standard cost is therefore,
1. Predetermined cost
2. Incurred during specific period
3. Under specific working conditions
Standard cost therefore is predetermined before production commences so that it

can be compared with the actual and the variance is calculated for control
purpose.
Advantages of standard costing-
Apart from providing basic yardsticks for performance measurement, standard

costing facilitates the principle of management by exception. Management can
throw the attention only on adverse variances on priority so that it can get
controlled. Lot of time and money can be saved if a company has a good
standard costing system. Following are some of the advantages of standard
Costing –
1. Provides a base for motivating to attain favorable variances
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2. Provides an opportunity for continuous appraisal of methods , schedules ,

programmes
3. It is easy to operate
4. Standard costing provide an aid to budgeting
Following are limitations / disadvantages of standard costing

1. Costly affair – Setting up of standard cost requires huge exercise and
needs manpower to study in detail each and every operation. High skill
and proficiency is needed, and so costs go up for standard setting
2. Difficult to classify variances
3. Difficult to adopt in changing scenarios
Controlling through standard costing –
1. Setting up of standards
2. Measuring performance
3. Calculating variances
4. Interpretation of variances
5. Finding causes of variances
6. Correcting measures to reduce variances
7. Follow up
Variance is the difference between standard cost and actual cost. It can be
Favorable or Adverse Variance. It is calculated for –
1. Material
2. Labour
3. Overheads
4. Sales
Variance Formulae
 Material Variances
1. Material Cost Variance ( MCV ) =

Standard Cost – Actual Cost
2. Material Price Variance

( Std Price – Actual Price ) * Act Qty
3. Material Quantity Variance

( Std Qty – Act Qty ) * Std Price
4. Material Mix Variance

( Revised std Mix Qty – Act Mix Qty ) * S.P
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5. Material Yield Variance

( Std Mix Qty – Rev Std Mix Qty ) * S.P
 Labour Variances
1. Labour Cost Variance ( LCV ) =

Standard Cost – Actual Cost
2. Labour Rate Variance

( Std Rate – Actual Rate ) * Act Hours paid
3. Labour Efficiency Variance

( Std Hours – Act Hours worked ) * Std Rate
4. Labour Idle Time Variance

( Idle Hours * Std Rate )
5. Labour Mix Variance

( Rev Std Mix Hrs – Act Mix Hrs ) * Std.Rate
6. Labour Yield Variance

( Std Mix Hrs – Rev Std Mix Hrs ) * Std.Rate
Reasons for Material Price Variance -
o Fluctuations in market prices

o Changes in Vendor
o Variations in transportation cost
o Fraud in purchasing
o Change in purchasing policy
Reasons for Material Usage Variance -
o Fluctuations in demand
o Lack of skill in labour
o Defective machinery
o Non accounting of material returns
o Incorrect standards
Reasons for Material Mix Variance -
o Shortage of particular material
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o Use of substitute
o Defective material
o Non purchase of right quality material
o Inefficiency in prod dept
Reasons for Labour Rate Variance -
o Employment of more skilled labour

o Shortage of proper labour
o Payment of extra allowance
o Change in wage scales
o Change in wage payment system
Reasons for Labour Efficiency Variance -
o Efficiency / inefficiency of workers

o Quality of good material
o Power / machine failure
o Poor working conditions
Short Notes -
1. Labour turn over
Almost in all organizations it is found that the names of workers and staff keep
on changing. This is due to retirement, retrenchment or new avenues found by
persons. Therefore composition of total labour force keeps on changing
continuously. This feature of changing the jobs is known as labor turnover.
Term labor turnover as defined by Dale as – Percentage of change in the

composition of labour force during a particular period.
The percentage of this labour turnover varies from industry to industry and by
location.
Some times it becomes necessary to have some percent of labour turnover

since it brings new blood in the business, reduces monotony of work force.
However, when the percent of labour turnover exceed beyond a limit, it
creates a serious problem. It results into disturbing the routine work, rumors
etc.and finally results into low productivity, increase in production cost.
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2. Break even point
Break even Point (BEP) is a point at which there is no loss and no

profit. That means, at that particular level of activity, total cost is exactly
equal to total sales value and therefore, there is no profit or loss. Break
even indicates that sales and costs are even that is equal.
In a business concern some costs are fixed while some vary with the
output, they are variable. Total cost comprised of fixed and variable. At
break even point the total cost is just match with the sales value. That
means by producing the units of break even, a firm neither gain profit
nor it incur any loss. The sales below break even point will attract
losses; where as the sales beyond BEP will give profits to the business.
Following chart will explain the same.
Assumptions of BEP –
1. Fixed cost remains constant at all levels of output

2. Costs can be classified into variable and fixed
3. Selling price remain same at all level
4. Market is sufficient to absorb entire output
Uses of BEP-
1. It determines the minimum no of units to be produced and sold to
avoid losses.
2. It gives idea to management about the profits earned at given

level of output.
3. It suggests sales mix.
4. It gives impact of changes in s.p / v.c / f.c on profits.
5. It helps to prepare budgets
3. FIFO / LIFO
FIFO stands for First In First out. It is a method used for issue of
material and value of closing inventory. It is used in perpetual inventory
system. The method assumes that the material received first are used
or issued first for consumption. And therefore whatever stock remained
in stores is from the latest arrival of material. Therefore the stocks will
be valued at latest prices.
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LIFO stands for last in first out, which is exactly opposite to FIFO.
Under LIFO , material received last is assume to be used first, and
therefore , whatever stock remained in stores is out of first purchased
that is oldest. Under LIFO, consumption is at current prices and stock is
valued at lesser costs in the period of inflation.
4. Key / limiting factor
Key or limiting factor is the factor or element which is crucial or

important to be considered while determining the production capacities
or sales capacities. Organization faces many constraints while
operating. The constraints may be a labour force, machine capacity or
machine hours, limited or scares raw material etc. These are known as
“key “, that is important / VIP factors. This is because unless we have
sufficient factors to produce, we can not proceed further and therefore
the product which gives more amount of contribution or in effect profit
(with the key factor consideration) will be selected as a priority, than the
other products.
Key factors can be - limited raw material, plant capacity to produce,

skilled labour.
5. Sunk Cost / Opportunity costs
Sunk cost is one that has been already incurred and can not be avoided
by decision taken in the future. As it refers to past costs, it is called as
unavoidable cost. The national Association of Accountants defines the
sunk cost as “ An expenditure for equipment or productive resources
which has no economic relevance to the present decion making
process. This cost is not useful for future decision making as all past
costs are irrelevant. It has also been defined as the difference between
the purchase price of an asset and its salvage value
Opportunity cost is the cost of selecting one course of action and the
loosing of other opportunities to carry out that course of action. It is the
amount that can be received if the assets are utilized in its next best
alternative. It is the benefit lost by rejecting the best competing
alternative to the chosen one. “The benefit lost is usually the net
earning or profit that might have been earned from the rejected
alternative.” Example of opportunity cost is –
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Capital is invested in plant and machinery. It can not be now invested in

shares or debentures. Lost of interest and dividends that would be
earned is the opportunity cost.
6. Idle time
Idle time refers to that portion of hours paid which are not utilized for
productive purposes. This is reflected in the time card, as the hours are not
booked in job or work order, and during which time the worker remains idle.
Idle time can be classified into normal and abnormal idle time. Normal idle
time represents inevitable loss of labour hours arising out of the following
situations –
1. Time lost between factory gate and place of work, tea break, lunch
break, etc.
2. Time lost in setting the machine, tools, change – over from one job to
another, fatigue, etc.
3. Time lost in power – failure, machine break down, waiting for material,
etc.
Out of the above causes some are inherent in the process and controllable to
a great extent. While time lost due to external causes such as general power
failure are uncontrollable in the hands of the management. Thus, it is possible
to identify normal idle time, and any loss of time beyond the normal allowed
hours shall be called abnormal idle time, such as,
1. Excessive machine – break down

2. Excessive internal power failure
3. Excessive waiting time for material, instructions etc.
4. Too much time to rectify defectives.
5. Strike, lock out, fire, floods, etc.
7. Master Budget
As the name itself indicates it a master of all budgets. It comprises of two

elements –
1. Summarized profit and loss account and
2. Balance sheet.
When all the subsidiary budgets have been prepared, and finalized, all
these are summarized into one single budget, which is known as master
budget or comprehensive budget. It is the end product of budgeting
activity.
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It is a summary plan of all proposed operations developed by

management. It summarizes in a single page, about sales, cost of sales,
gross profit, admin expenses, net profit before interest, depreciation and
taxes, all important ratios, important sources and application of funds for
a particular period.
It incorporates all functional budgets at one shot. Once it is prepared and

approved by budget committee, it is sent to board of directors for their
approval. Once Master budget is approved it is then compared with the
actual performance every month.
8. P V Ratio
It is a Profit – Volume – Ratio which expresses the relation ship between

Contribution and sales. It is expressed as % of contribution to sales.
Formula for calculation of PV Ratio is = Contribution / sales * 100.
It is also calculated as change in profit / change in sales * 100. It

indicates the rate at which the business is earning profit. High ratio
indicates high earnings. It is helpful while calculating break even point,
profit at given value of sales etc.
9. Margin Of Safety ( MOS )
It is excess of present sales or any given sales from Break even sales. It
indicates the strength of business. High MOS indicates that even if sales
are dropped drastically, it will not incur losses. On the other hand, a small
Margin of safety will indicate a danger situation since a fall in sales would
result in losses, because very thin MOS means that the sales are just
above BEP, therefore if sales are dropped largely, there will be loss
because the sales will fall below BEP. Formula to calculate MOS is =
Profit / PV Ratio, Sales – Break even sales. In case a company has low
MOS, following steps will have to be taken immediately –
1. Increase S.P.
2. Increase level of activity
3. Reduce Costs
4. Substitute existing product by highly profitable product
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Study Material Accounting

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Study Material Accounting

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SEM – I - STUDY MATERIAL ON ACCOUNTING

Accounting is the art of recording, classifying and summarizing in a significant

Financial accounting refers to – Collection, classification, recording and

Book Keeping is nothing but keeping books of accounts. It is a system by which

Accountancy is concerned with formulation of principles to be followed in

Objectives of book keeping / Why Book keeping –

Primary objective of book keeping is to enable the businessman to know the

1. Amount of profits earned or loss suffered by business for a particular

1. Amount due to his creditors

Basic Terms used in Accounting

1. Transaction – It is an event, recognition of which gives rise to an entry in

2. Voucher – represents a document which serves an as evidence of

3. Entry – it is recording of transaction in books of accounts. It is based on

4. Goods – These are the commodities in which a proprietor deals with.

5. Profit or loss – Excess of Income over expenses is Profit whereas,

6. Assets – The entire property possessed by or owing to a person /

a. Whether it is cash or bank

7. Liability – It refers to debt or amount due from business to others either

8. Net worth – It is also called as proprietary fund. It is the amount of fund

9. Contingent liability – these are the liabilities which are dependent on

11. Drawings – It is the amount withdrawn by the proprietor from business in

14. Capital expenditure – It is the expenditure incurred to yield the benefit

15. Revenue expenditure – it is day to day expenditure – for example, salary

16. Deferred revenue expenditure – the expenditure is revenue expenditure

17. Trade discount – It is the allowance allowed by manufacturer or whole

18. Cash discount – It is the concession allowed by seller to buyer to

22. Goodwill – It is an intangible asset having realizable value. It is cost of

Difference between cash discount and trade discount

1. Trade discount is reduction in list price granted by supplier on business

Different accounting Concepts and conventions -

Accounting concepts are necessary assumptions or conditions on which

1. Business entity concept – Business is treated as separate entity from its

started the business. Therefore the capital becomes a liability for a

2. Money measurement concept – In Accounting, everything is recorded in

5. Realization concept – According to this assumption, profit is recorded

6. Accrual concept - The accrual system is a method whereby revenue and

1. Conservatism – It refers to policy of playing safe game. All prospective

2. Materiality – Every accountant should attach importance to material

3. Consistency – Comparison of one accounting period with that of another

Different types of accounts

There are basically three types of accounts. These are –

Rule for accounting of real account is –

Debit what comes in, Credit what goes out

Nominal account – These comprises of all accounts of expenses losses incomes

Rule for accounting of nominal account is –

Personal account – A Person can be

1. Natural person like Mr. Ramesh, Mr. Kumar etc,

Rule for accounting of personal account is –

Debit the receiver, credit the giver

Cost – Costing – Cost accounting –

ICMA London defines - Cost as “The amount of expenditure, actual or notional,

It defines costing as “Technique and process of ascertaining the costs.

It defines cost accountancy as “ Application of costing and cost accounting

Costing provides analysis of information in such a way that management gets

According to Wheldon, costing is the classifying, recording, and appropriately

1. Ascertainment o cost of the product or services, and

2. Presentation of data in such a way so as to enable management to take

Importance of Cost Accountancy –

1. Knowing cost of product

1. Provides data for inefficient areas identification

1. Helps in assessing the tax liability

4. Good costing system increases overall efficiency and productivity,

D. Advantages to General public

1. Good Product at lesser price / cost