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UNIT - 1

Introduction to Management Accounting

Introduction:

Accounting is an ancient art as old as money itself. However the role of

accounting has been changing with the economic and social developments. Over a

period of time new dimensions have been added to the discipline of accounting.

Until recently accounting was regarded merely as an art of recording, classifying

and summarizing transactions and events which are of a financial character. Thus,

accounting can be rightly, termed as a service activity, a descriptive, analytical

discipline, and an Information system.

Accounting:

It involves the collection of recording, classification and presentation of financialdata for the benefit of management and outside agencies such as shareholders,

creditors, bankers and government.

Smith and Ashburne describe it as, Accounting is the science of recording and

classifying business transactions and events, primarily of a financial character, and

the art of making significant summaries, analysis and interpretation of those

transactions and events and communicating the results to persons whom must

make decisions or form judgments.

The word accounting can be classified into three categories.

A) Financial Accounting

B) Cost Accounting ;and

C) Management Accounting.

Financial Accounting:

Financial accounting may be defined as the science and art of recording and

classifying business transactions and preparing summaries of the same fordetermining year end profit or loss and the financial position of the concern. The

main objective of financial accounting is to find out the profitability and to provide

information about the financial position of the concern as a whole.

Objectives of financial accounting:


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A modem accounting system has to accomplish the following four

objectives:

a) To identify financial events and transactions that occurs in an organization;

b) To measure the value of these occurrences in terms of money;

c) To organize the accumulated financial data into meaningful information;

and

d) To analyze, interpret and communicate the information to a board range of

persons and groups, both with in and outside the organizations.

Functions of Financial Accounting:

1) Recording of information: It is not possible to remember each and every

transaction of the business. Accounting is necessary to supplement human

memory. The information is recorded in journal and other subsidiary books.These books are used to record various transactions in such away that the

information is properly classified and analyzed so that the management may

make use of that information.

2) Classification of data: The classification of information means that data of

one nature is placed at one place. This is done in the book called ledger. The

entries relating to different items are brought at on e place so that full

information of these items may be collected under different heads. For

example, we may have accounts called, salaries, rent, interest,advertisement etc.

3) Making summaries: The classified data is used to prepare final accounts,

i.e., Profit and Loss account and Balance sheet. The final accounts are

prepared to find out operational efficiency and financial strength of the

business.

4) Dealing with financial transactions: Only those transactions are recordedwhich are measurable in terms of money. Money is taken as a common

medium and all economic transactions are expressed in monetary terms.


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5) Interpreting financial information: Accounting information is modified in

such a way that it is interpreted by the management for drawing

conclusions. The interpretation part is very important for decision-making.

Limitations of financial accounting:

1) Historical nature: financial accounting is historical, since the data are

summarized only at the end of the accounting period. There is no system of

computing day-to-day cost and also computing pre-determined costs.

2) Not helpful in price fixation: It is not helpful in fixing prices of products.

The cost of a product can be obtained only when all expenses have been

incurred. It is not possible to determine the price in advance.

3) Cost control not possible: It is not possible to control cost as the cost has

already been incurred. There is no technique in financial accounting which

can help to ascertain whether the cost is more or less while the expenses

are being incurred.

4) No performance appraisal: In financial accounting, there is no system ofdeveloping norms and standards to appraise the efficiency in the use of

materials, labour and other costs by comparing the actual performance with

what should have been accomplished during a given period of time.

5) Only actual costs recorded: It records only actual costs figures. The

amount paid for purchasing materials, property or other assets is recorded in

account books. Financial accounts do not record price level changes. The

recorded costs cannot provide correct information or exact value of assets.

6) Fails to supply useful data to Management: It fails to supply useful data

to management for taking various decisions like replacement of labour bymachines, introduction of new products, make or buy, selection of the most

profitable product mix, etc.

Cost accounting:

Introduction:


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Costing is specialized branch of accounting. It has been developed because of

limitations of financial accounts. In the present day it is absolutely necessary that a

business concern should operate its activities with utmost efficiency and at the

lowest cost.

Meaning of cost, costing and cost accounting:

Cost: The costing terminology of the institute of cost and works accountants,

London defines cost as the amount of expenditure incurred on or attributable to a

given thing. Thus cost refers to something that must be sacrificed to obtain a

particular thing.

Costing: It is a systematic procedure of determining the unit cost of product/service.

In the words of Harold j. wheldon, costing is the classifying and appropriate

allocation of expenditure for the determination of the cost of products or services,

and for the presentation of suitably arranged data for purposes of control and

guidance of the management.

Cost Accounting: The costing terminology of I.C.M.A, London defines cost

accounting as the process of accounting for cost from the point of which

expenditure is incurred or committed to the establishment of its ultimate

relationship with cost centers and cost units.

Objectives and Functions of cost accounting:

The main objectives of cost accounting are as follows:

1) Ascertainment of cost: this is the primary objective of cost accounting. In

cost accounting, cost of each unit of production, job, process, or departmentetc., is ascertained. Not only actual costs incurred are ascertained but costs

are also predetermined for various purposes.

2) Cost control and cost reduction: it aims at improving profitability by

controlling and reducing costs. For this purpose, various specialized

techniques like standard costing, budgetary control, inventory control, value

analysis, etc., are used.

3) Guide to business policy: it aims at serving the needs of the management

in conducting the business with utmost efficiency. Cost data provide

guidelines for various managerial decisions like make or buy, selling below

cost, utilization of idle plant capacity, introduction of a new product, etc.


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4) Determination of selling price: It provides cost information on the basis of

which selling prices of products or services may be fixed. In periods of

depression, cost accounting guides in deciding the extent to which the selling

prices may be reduced to meet the situation.

5) Provides a basis for business policy: The objective of cost accounting is

to help the management in the formulation of business policy and I decision-

making. The gross-profit analysis, the cost-volume-profit relationship, the

break-even point of sales, and the differential costing method, etc. help the

management in profit planning and in deciding crucial matters.

Essentials of a Good cost Accounting system:

The essential principles of a good system of cost accounting are as

follows:

1) Suitability: The method of costing adopted, i.e., job or process costing,

should be suitable to the industry and serve the objectives of installing the

system.

2) Specially designed system: A readymade costing system cannot be

suitable for every business. The cost accounting system should be tailor-

made according to the requirements of a business.

3) Support of executives: If a costing system is to be successful, it must be

fully supported by executives of various departments and everyone should

participate in it.

4) Cost of the system: The cost of installing and operating the system should

be justified by the results produced.

5) Clearly defined cost centres: In order to derive maximum benefits from a

costing system, well defined cost centres and responsibility centres should

be identified within the organization.


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6) Controllable costs: Controllable and non-controllable costs of each

responsibility centre should be separately shown.

7) Integration with financial accounts: There should be cooperation and

coordination between cost accounting and financial accounting departments.

In order to avoid duplication of accounts, cost and financial accounts may be

integrated.

8) Continuous education: Well trained and educated staff should be employed

to operate the system. In order to educate the costing staff, written manuals

and meetings etc. should be arranged on a continuous basis.

9) Prompt and accurate reports: The cost accounting department should

prepare accurate reports and promptly submit the same to appropriate level

of management so that action may be taken without delay.

10) Avoid unnecessary details: Resources should not be wasted on

collecting and compiling cost data that is not required. Only useful cost

information should be compiled and used whenever required.

Advantages of cost accounting:

1) Cost accounting as an aid to management: It helps the management in

carrying out its functions, i.e. planning, organizing, controlling, decision-

making, budgeting and pricing efficiently by providing cost information to

the management. The importance of costing to the management is as

follows:

a. It provides reliable cost data in regard to materials, labour, overhead

and other expenses.

b. It helps in price fixation.

c. It provides information on which estimates and tenders are based.

d. It helps in channelizing production on right lines.

e. It guides future production policies and thus helps in planning.

f. It helps in determining profitable and unprofitable activities.


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g. It increases efficiency ad reduces wastages ad costs.

h. It helps management in periods of trade depression and competition by

determining actual cost of the product.

i. It provides cost data for comparison in different periods.

j. Costing aids in inventory control.

2)Advantages to Employees: Workers are benefited by introduction of

incentive plans which is an integral part of a cost system. This results not

only in higher productivity but also higher earnings for them.

3)Advantages to creditors, Investors and Bankers: It enables the

creditors, bankers, and investors to judge the financial position ad solvency

of a concern by providing reliable cost data. Cost accounting thus helps

bankers and others in evaluating the performance of a customer. The

various cost reports can be analysed before lending money to a concern.

4)Advantages to the government and the society: It increases the

efficiency of a concern, reduces costs and increases its profits. Thus, it

promotes the overall economic development of the country. Better andcheaper goods are made available to the public. With the reduction in

wastages and increases in profits the revenue of the government in the form

of taxes increased.

Limitations of cost accounting:

1)It is unnecessary: it is argued that maintenance of cost records is not

necessary and involves duplication of work. It is based on the premise that a

good number of concerns are functioning prosperously without any system

of costing. This may be true, but in the present world of competition, to

conduct a business with utmost efficiency, the management needs detailedcost information for correct decision-making.

2)It is expensive: It is pointed out that installation of a costing system is quite

expensive which only large concerns can afford. It is also argued that


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installation of the system will involve additional expenditure which will lead

to a diminution of profits.

3)It is inapplicable: another argument sometimes put word is that modern

methods of costing are not applicable to many types of industry. A costing

system must be specially designed to meet the needs of a business. Only

then will the system work successfully and achieve the objectives for which

it was introduced.

4)It is a failure: the failure of a costing system in some concerns is quoted as

an argument against its introduction in other undertakings. If a system does

not produce the desired results, it is wrong to jump to the conclusions that

the system is at fault. The reasons for its failure should be probed.

Management Accounting:

Introduction:

The term management accounting is of a recent origin. This term was

first used in 1950 by a team of accountants visiting U.S.A under the auspices of

Anglo-American council of productivity. The terminology of cost accountancy had no

reference to the word management accountancy before the report of this study

group.

Meaning and definition:

Management accounting is comprised of two words management and

accounting. It is the study of managerial aspect of accounting. The emphasis of

management accounting is to redesign accounting in such a way that it is helpful to

the management in formation of policy, control of execution and appreciation of

effectiveness. It is that system of accounting which helps management in carrying

out its functions more efficiently.

According to Robert N. Anthony, Management accounting is concerned with

accounting information that is useful to management.

According to Brown and Howard, The essential aim of management accounting

should be to assist management in decision making and control.

Characteristics:

1) Providing Accounting information: The collection and classification of

data is the primary function of accounting department. The information so


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collected is used by the management for taking policy decisions. It involves

the presentation of information in a way it suit managerial needs.

2) Cause and effect analysis: If there is a loss, the reason for the loss is

probed. If there is a profit, the factors directly influencing the profitability are

also studied. The figures of profits are compared to sales, different

expenditures, current assets, interest payables, share capital, etc. so the

study of cause and effect relationship is possible in management accounting.

3) Use of special techniques and concepts: The techniques used include

financial planning and analysis, standard costing, budgetary control, marginal

costing, project appraisal, control accounting, etc. the type of technique to be

used will be determined according to the situation and necessity.

4) Taking important decisions: It supplies necessary information to the

management, which may base its decisions on it. The historical data is

studied to see its possible impact on future decisions.

5) Achieving of objectives: In management accounting, the accounting

information is used in such a way that it helps in achieving organizational

objectives.

6) No fixed norms followed: In financial accounting certain rules re followed

for preparing different accounting books. On the other hand, no specific rules

are followed I management accounting.

7) Concern with forecasting: the management accounting is concerned with

the future. It helps the management in planning and forecasting.

Advantages of management accounting:


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1) Increases Efficiency: Management accounting increases efficiency of

business operations. The targets of different departments are fixed in

advance and the achievement of these goals is tool for measuring their

efficiency.

2) Proper planning: Management is able to plan various operations with the

help of accounting information. The technique of budgeting is helpful in

forecasting various activities.

3) Measurements of performance: The systems of budgetary control and

standard costing enable the measurement of performance. In standard

costing, standards re determined and then actual cost is compared with

standard cost. It enables the management to find out deviations between

standard and actual cost.

4) Maximizing profits: The thrust of various management techniques is to

control cost of production and increase efficiency of each and every

individual in the organization. The steps of controlling cost are able to reduce

cost of production.

5) Improves service to customers: The cost control devices employed inmanagement accounting enable the reduction of prices. All employees in the

concern are made cost conscious. The quality standards are pre-determined.

The customers are supplied god quality goods at reasonable prices.

6) Effective management control: The tools and techniques of management

accounting are helpful to the management in planning, co-ordination and

controlling activities of the cocern. The setting of standard and assessing

actual performance regularly enables the management to have management

by exceptions.

Disadvantages of management accounting:

1) Based on accounting information: The correctness and effectiveness of

managerial decisions will depend upon the quality of data on which these

decisions are based. If financial data is not reliable then management

accounting will to provide correct analysis.


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2) Lack of knowledge: The use of management accounting requires the

knowledge of a number of related subjects. Management should be

conversant with accounting principles, statistics, economic, principles of

management, etc., and only then management accounting can be effectivelyutilized.

3) Intuitive (spontaneous) decisions: Though management accounting

provides scientific analysis of various situations and enables decision taking

based on facts and figures, there is a tendency to make decisions intuitively.

4) Not an alterative to administration: It does not provide an alternative to

administration. The tools and technique of management accounting provideonly information and not decisions. Decisions are to be taken by the

management and their implementation is also done by management.

5) Top heavy structure: The installation of a management accounting system

needs an elaborate organizational system. A large number of rules and

regulations are also required to make this system workable and effective. It is

a costly affair and can be used by big concerns only. Smaller units cannot

afford to use this system because of heavy cost.

6) Personal bias: the interpretation of financial information depends upon the

capability of interpreter as one has to make a personal judgment. There is

every likelihood of personal bias in analysis and interpretation.

Management accounting vs. Cost accounting vs. financial

accounting

Point of difference

Managementaccounting

Cost accounting Financialaccounting

Orientation It is concerned with allsituations includingmonetary and non-monetary economicevents from the pointof view of

It is also concernedwith money as ameasure of economicperformance.

It is concernedwith money as theeconomic resourcei.e. cash.


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management.Scope It is a way of

accounting whichcovers financialaccounting, costaccounting and all

aspects of financialmanagement. It isconcerned withassisting themanagement in itsfunctions as well asevaluating theperformance of themanagement.

It aims at measuringthe economicperformance of thecost centres and themain purpose of cost

accounting is toprovide suitable costdata to measure theeconomic performanceof cost centres.

The financialaspect of the firmis dealt with byway of preparing

Trading A/c, Profit

and Loss A/c andBalance sheet.

Analysis ofperformance

It can be applied formaking the costaccounting morepurposeful andmanagement oriented.Accordingly themanagementaccounting directs itsattention to variousdepartments of thebusiness and reportabout the profitabilityperformance of each ofthe departments in thebusiness.

It is basicallyconcerned withcollection,classification andanalysis of cost data.

It indicates theposition of thebusiness as awhole in the finalaccounts preparedfor the purpose ofreporting anoverallperformance ofthe business.

Time factor It concentrates onfuture operations,profitability etc.

It also focusesattention on past andcurrent operations.

Financial accountsfocus attention onpast and currentoperations.

Legalcompulsion

There is no legalcompulsion as such inrespect of amanagementaccounting system andhence a company may

keep the system ofmanagementaccounting voluntarilyto assist themanagement in itsfunctions as well asevaluating theperformance of themanagement.

Cost records aremaintained voluntarilyin order to meet therequirement of themanagement. But nowcompanies act, 1956

has made it obligatoryto keep the costrecords in somemanufacturingindustries.

It becamecompulsory forevery company onaccount of legalprovision.


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Difference between Cost accounting and Financial

accounting

BASIC COST CONCEPT:

Basis Financial Accounting Cost Accounting

Purpose The main purpose of financialaccounting is to prepare profit andloss account and balance sheet forreporting to owners or shareholdersand other outside agencies, i.e.,external users.

The main purpose of costaccounting is to provide detailedcost information to management,i.e., internal users.

Statuaryrequirements

These accounts have to be preparedaccording to the legal requirementsof companies act and income tax act.

Maintenance of these accounts isvoluntary except in certainindustries where it has been madeobligatory to keep cost records

under the companies act.

Analysis ofcost andprofit

Financial accounts reveal the profit orloss of the business as a whole for aparticular period. It does not showthe figures of cost and profit forindividual products, departments andprocesses.

Cost accounts show the detailedcost and profit data for eachproduct line, department, process,etc.

Periodicityof reporting

Financial reports are preparedperiodically, usually on an annualbasis.

Cost reporting is a continuousprocess and may be daily, weekly,monthly, etc.

Controlaspect

It lays emphasis on the recording offinancial transactions and does notattach any importance to the controlaspect.

It provides for a detailed system ofcontrols with the help of certainspecial techniques like standardcosting and inventory control etc.

Format ofpresentinginformation

It has a single uniform format ofpresenting information, i.e., profitand loss account, balance sheet andcash flow statement.

Cost accounting has varied formsof presenting cost informationwhich are tailored to meet theneeds of management and thuslacks a uniform format

Types oftransactions

recorded

Financial accounting records onlyexternal transactions like sales,

purchases, receipts, etc., with outsideparties.

Cost accounting records not onlyexternal transactions but also

internal or inter-departmentaltransactions like issue of materialsby store keeper to productiondepartment.


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Introduction:

The term cost does not have a definite meaning and its scope is extremely

broad and general. Cost accountants, economists and others develop the concept of

cost according to their needs because one complete description of cost to suit all

situations is not possible.

Definition of Cost:

According to the ICMA, London, Cost is the amount of expenditure incurred on

or attributable to, a specified thing or activity or cost unit.

According to the oxford dictionary, cost means The price paid for

something.

Cost Vs. Expenses and Loss:

Often the terms cost and expense are used interchangeably. But cost shouldbe distinguished from expenses and loss.

Expense is defined asan expired cost resulting from a productive usage of

an asset. It is that cost which has been applied against revenue of a particular

accounting period in accordance with the principle of matching costs to revenue. In

other words, an expense is that portion of the revenue earning potential of an asset

which has been consumed in the generation of revenue. Unexpired or unconsumed

part of the cost is recorded as an asset in the balance sheet. Such an unexpired

cost is converted into an expense when it expires while helping to earn revenue. For

example, when a plant is purchased, depreciation on plant (expired cost) is charged

to profit and loss account as an expense and cost of plant remaining after providingdepreciation (unexpired cost) is shown as an asset in the balance sheet.

Loss is defined as reduction in a firms equity, other than from

withdrawals of capital for which no compensating value has been received. A loss

is an expired cost resulting from the decline in the service potential of an asset that

generated no benefit to the firm. Obsolescence or destruction of stock by fire are

examples of loss.

Cost centre:

For the purpose of ascertaining cost, the whole organization is divided into

small parts or sections. Each small section is treated as a cost centre of which cost

is ascertained. A cost centre is defined by CIMA, London as a location, person, or

item of equipment for which costs may be ascertained and used for the purpose of

control. Thus cost centre refers to a section of the business to which costs can be

charged. It may be a location (a department, a sales area), an item of equipment (a


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machine, a delivery van), a person (a salesman, a machine operator) or a group of

these (two automatic machines operated by one workman). The main purpose of

ascertaining the cost of a cost centre is control of cost.

Cost centres are primarily of two types:

a) Personal cost centre: which consists of a person or a group of persons

b) Impersonal cost centre: consists of a location or an item of equipment or

group of these.

From functional point of view, cost centres may be of the following two types:

a) Production cost centre: these are those cost centres where actual

production work takes place. Examples are weaving department in a textile

mill, melting shop in a steel mill, cane crushing shop in a sugar mill, etc.

b) Service cost centre: these are those cost centres which are ancillary to andrender services to production cost centres. Examples are power house, tool

room, stores department, repair shop, canteen, etc.

A cost accountant sets up cost centres to enable him to ascertain the costs he

needs to know. A cost centre is charged with all the costs that relate to it, e.g.,

if a cost centre is a machine, it will be charged with the costs of power, light,

depreciation and its share of rent etc. the purpose of ascertaining the cost of a

cost centre is cost control. The person in charge of a cost centre is held

responsible for the control of cost of that centre.

Cost Unit:

A cost unit goes a step further by breaking up the cost into smaller sub-

divisions, thereby helping in ascertaining the cost of saleable products or services.

A cost unit is defined by CIMA, London as a unit of product or service in

relation to which costs are ascertained. For example, in a sugar mill, the cost per

tone of sugar may be ascertained; in a textile mill the cost per meter of cloth may

be ascertained. Thus a tonne of sugar and a meter of cloth are cost units.

The concept of cost is thus not something definite; care must be taken to qualify it.

A cost accountant is mainly is mainly concerned with the following cost concepts:

1) Concept of objectivity: It is this concept that gives direction ot the

activities related to cost finding, cost analysis, recording and cost reporting.

This concept necessitates goal congruence, i.e., cost exercises have to be in

harmony with objectives. Cost treatments and cost strategies are influences

by objectives, which may include internal reporting for operational decisions,

internal reporting for specific non-repetitive decisions and external decisions.


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2) Concept of materiality: This concept that stress accuracy must be

tempered by good judgment, if no distortion of product cost is likely to result,

for example, overhead may include some items of direct cost, which may not

be as material as to justify tracing them to specific unit of production. Aparticular decision may be useful, but benefits may not be material enough to

implement it. Materiality is determined with reference to nature of companys

activities.

3) Concept of time span: All assumptions relating to different cost exercise

remain valid only during related time span. The statement that cost is fixed,

is based on a time span under consideration. No costs will remain fixed for all

the time. Time span selected by a company should be long enough to permit

the procedures to record the associated cost, output, labor hours and other

factors needed in the analysis. If time span is too short, leads and lags I

recording the cost data may be quite troublesome.

4) Concept of relevant range of activity: Relevant range of activity

represents the span of volume over which the cost behavior is expected to

remain valid. Different cost exercises are based o certain assumptions

relating to cost behavior patterns, which are valid only within the relevant

range of activity. The relevant range of activity may be different between

firms and for individual firm also, it may change from time to time.

5) Concept of relevant cost and benefits: this concept is vital for decision-

making purposes. In evaluating alternative curses of action, management

should consider only relevant cost and relevant benefit relating to

alternatives under consideration. Irrelevant cost and benefits, i.e., costs and

benefits which are not affected by decision under consideration are ignored.

Classifications of cost:

Classification is the process of grouping costs according to their

common characteristics. It is a systematic placement of like items together

according to their common features.

There are various ways of classifying costs. Each classification serves a

different purpose.


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1. Classification into Direct ad Indirect costs: Costs are classified into

direct costs and indirect costs on the basis of their identifiability with cost

units or jobs or processes or cost centres.

Direct costs: these are those costs which are incurred for and conveniently

identified with a particular cost unit, process or department. Cost of raw

materials used and wages of a machine operator are common examples of

direct costs.

Indirect costs: these are general costs and are incurred for the benefit of a

number of cost units, processes or departments. These costs cannot be

conveniently identified with a particular cost unit or cost centre. Depreciation

of machinery, insurance, lighting, power, rent, managerial salaries, materials

used in repairs, etc., are common examples of indirect costs. Depreciation of

machine for stitching a pair of trousers cannot be known and thus it is an

indirect cost.

2. Classification into fixed and variable costs: costs behave differently

when level of production rises or falls. Certain costs change in sympathy with

production level while other costs remain unchanged. As such o the basis of

behavior or variability, costs are classified into fixed, variable and semi-

variable.

Fixed costs: these costs remain constant in total amount over a specific

range of activity for a specified period of time, i.e., these do not increase or

decrease when the volume of production changes. For example, building rent

and managerial salaries remain constant and do not change with change in

output level and thus are fixed costs. But fixed cost per unit decreases when

volume of production increases and vice versa.

Variable costs: these costs tend to vary in direct proportion to the volume

of output. In other words, when volume of output increases, total variable

cost also increases, and when volume of output decreases, total variable cost

also decreases, but the variable cost per unit remains fixed.


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Semi variable and semi fixed costs (mixed cost): These costs include

both a fixed and a variable component, i.e. these are partly fixed and partly

variable. The variable element in semi-variable costs changes wither at a

constant rate or in lumps. For example, introduction of an additional shift in

the factory will require additional supervisors and certain costs will increase

by steps. In the case of telephone connection, there is a minimum rent andbeyond a specified number of calls, the charges vary according to the

number of calls made.

3. Classification into committed and discretionary costs: fixed costs are

further classified into committed costs and discretionary costs. This

classification is based on the degree to which a firm is locked into an asset or

service that is generating the fixed cost.

Committed costs: these are those costs that are incurred in maintaining

physical facilities and managerial set up. Such costs are committed in the

sense that once the decision to incur them has been made, they are

unavoidable and invariant in the short run. For example, salary of the

managing director may represent a committed cost if, by policy, the

managing director is not to be relieved unless the firm is liquidated.

Discretionary costs: these are those costs which can be avoided by

management decisions. Such costs are not permanent. Advertising, research

and development cost and salaries of low level managers are examples of

discretionary costs because these costs may be avoided or reduced in the

short run, if so desired by the management.

4. Classification into product costs and period costs: It is important from

the point of view of profit determination. This is so because product cost is

carried forward to the next accounting period as part of the unsold finished

stock, whereas period cost is written off in the accounting period in which it is

incurred.

Product costs: These are those costs which are necessary for production

and which will not be incurred if there is no production. These consist of

direct materials, direct labour and some of the factory overheads. Product

costs are absorbed by or attached to the units produced.


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Period costs: These are those costs which are not necessary for production

and are incurred even if there is no production. These are written off as

expenses in the period in which these are incurred. Such costs are incurred

for a time period and are charged to profit and loss account of the period.Show room rent, salary of company executives, travel expenses, etc., are

examples of period costs.

5. Classification into Controllable and Non-Controllable costs: From the

point of view of controllability, costs are classified into controllable costs and

non-controllable costs.

Controllable costs: These are those costs which may be directly regulatedat a given level of management authority. Variable costs are generally

controllable by department heads. For example, cost of raw material may be

controlled by purchasing in larger quantities.

Non-Controllable costs: These are those costs which cannot be influenced

by the action of a specified member of an enterprise. For example, it is very

difficult to control costs like factory rent, managerial salaries, etc.

6. Classification into Historical cost and Pre-determined costs: on the

basis of time of computation, costs are classified into historical and pre-

determined costs.

Historical costs: These are those costs which are ascertained after these

have been incurred. Historical costs are thus, nothing but actual costs. These

costs are not available until after the completion of the manufacturing

operations.

Pre-determined costs: These are future cots which are ascertained in

advance of production on the basis of a specification of all the factors

affecting cost. These costs are extensively used for the purpose of planning

and control.


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7. Classification into Normal and Abnormal costs: on the basis f normality

costs may be classified into normal and abnormal costs.

Normal Costs: it may be defined as a cost which is normally incurred on

expect lines at a given level of output. This cost is a part of production.

Abnormal cost: It is that which is not normally incurred at a given level of

output. Such cost is over and above the normal cost and is not treated as a

part of the cost of production. It is charged to costing profit and loss account.

8. Special costs for Management Decision-Making:

There are certain costs which are specially computed for use by

the management for the purpose of decision-making. These costs may not be

recorded in the books of account.

Shut down cost: A cost which will still be required to be incurred even

though a plant is closed or shut-down for a temporary period, for example,

the cost of rent, rates, depreciation, maintenance expenses etc., is known as

shut-down cost.

Sunk cost: A cost which has been incurred in the past or sunk in the past

and is not relevant to the particular decision making, is a sunk cost. If it is

decided to replace the existing plant, the written down book value of the

plant less the sale value of the existing plant, is a sunk cost.

Opportunity cost: It is the value of a benefit sacrificed in favor of an

alternative course of action.

The net selling price, rental value or transfer value which could be obtained

at a point in time if a particular asset or group of assets were to be sold,

hired, or put to some alternative use available to the owner at that time is

the opportunity cost.


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Imputed cost: It is hypothetical cost required to be considered to make

costs comparable. If the owner of the factory charges rent of the factory to

the cost of production to make cost comparable with that of those

undertakings which run production in rented factories, it is an imputed costas the rent has actually not been paid.

Out-of-pocket cost: It is the cost which involves current or future

expenditure/outlay, based on managerial decisions. For example, a company

has its own trucks for transporting goods from one place to another. It seeks

to replace these by employing public carriers of goods. While making the

decision management can ignore depreciation, but not the out-of-pocket

costs in the present situation i.e., fuel, salary to drivers and maintenance

paid in cash.

Replacement cost: This is the cost at which there could be purchased an

asset identical to that which is being replaced. In simple words, replacement

cost is the current market cost of replacing an asset. When the management

considers the replacement of an asset, it has to keep in mind its replacement

cost and not the cost at which it was purchased earlier, for example,

machinery purchased in 1990 at Rs. 10,000 is discarded in 1998 and a new

machinery of the same type is purchased for Rs. 15,000. So the replacement

cost of machinery is Rs. 15,000.

Differential (Incremental cost) costs: It is the increase or decrease in

total cost that results from an alternative course of action. It is ascertained by

subtracting the cost of one alternative from the cost of another alternative.

The alternative choice may arise because of change in method of production,

in sales volume, change in product mix, make or buy decisions, take or refuse

decision, etc.

Marginal cost: It is the additional cost of producing one additional unit.

Marginal cost is the same thing as variable cost. It is a technique of charging

only variable costs to products. Inventory is also valued at variable cost only.

It helps in decisions like make or buy, pricing of products, selection of sales

mix, etc.


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Conversion cost: This term is used to denote the sum of direct labour and

factory overhead costs in the production of a product. In other words,

conversion cost is the factory cost minus direct material cost. It is the total

cost of converting a raw material into finished product. Appropriate use of

this cost can be made in certain managerial decisions.

Elements of Costs:

A cost is composed of three elements, i.e., materials, labour and expenses.

Each of these elements may be direct or indirect.

1) Material: The substance form which the product is made is known as

material it may be in a raw or a manufactured state. It can be direct as well

as indirect.

a) Direct material: All material which becomes an integral part of thefinished product and which can be conveniently assigned to specific

physical units is termed as Direct materials.

All material or components specifically purchased, produced or

requisitioned from stores.

Primary packing material (ex. Carton, wrapping, cardboard boxes,

etc.)

Purchase or party produced components.

b) Indirect material: All material which is used for purposes ancillary to the

business and which cannot be conveniently assigned to specific physical

units is termed as indirect material. Consumable store, oil and waste,

printing and stationery material, etc., are a few examples of indirect

materials.

2) Labour: For conversion of materials into finished good, human effort is

needed, such human effort is called labour, and labour can be direct as well

as indirect.

a) Direct labour: Labour which plays an active and direct part in the

production of a particular commodity is called direct labour. Direct labour

costs are, therefore, specifically and conveniently traceable to specific


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products. It is also described as process labour, productive labour,

operating labour, etc.

b) Indirect labour: labour employed for the purpose of carrying out tasks

incidental to goods produced or services provided, is indirect labour. Such

labour does not alter the construction, composition or condition of theproduct. It cannot be practically traced to specific units of output. Wages

of store-keepers, foremen, time-keepers, directors fees, salaries of

salesmen etc, are all examples of indirect labour costs.

3) Expenses: Expenses may be direct or indirect.

a) Direct Expenses: These are expenses which can be directly,

conveniently and wholly allocated to specific cost centers or cost units,examples of such expenses are: hire of some special machinery required

for a particular contract, cost of defective work incurred in connection with

a particular job or contract, etc.

b) Indirect Expenses: These are expenses which cannot be directly,

conveniently and wholly allocated to cost centres or cost units, examples

of such expenses are rent, lighting, insurance charges, etc.

4) Overhead: It is to be noted that the term overheads has a wider meaningthan the term indirect expenses. Overheads include the cost of indirect

material and indirect labour besides indirect expenses. Indirect expenses

may be classified under the following three categories:

a) Manufacturing (works, factoryor production) Expenses: such

indirect expenses which are incurred in the factory and concerned with

the running of the factory or plant are known as manufacturing expenses.

Expenses relating to production management and administration are

included therein. Factory overheads include:

Indirect material used in the factory such as lubricating oil,

consumable stores, etc.

Indirect labour such as gate-keepers salary, time-keepers salary,

works managers salary, etc.


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Indirect expenses such as factory rent, factory insurance, factory

lighting, etc.

b) Office and Administrative Expenses: These expenses are not related

to factory but they pertain to the management and administration of

business. Such expenses are incurred on the direction and control of an

undertaking. Office overheads include:

Indirect material used in the office such as printing and stationery

material, broom and dusters, etc.

Indirect labour such as salaries payable to office manager, office

accountant, clerks, etc.

Indirect expenses such as rent, insurance, lighting of the office.

c) Selling and Distribution Expenses: Expenses incurred for marketing of

a commodity, for securing orders for the articles, dispatching goods sold,

and for making efforts to find and retain customers, are called selling and

distribution expenses. Selling overheads include:

Indirect material used such as packing material, printing and

stationery material, etc.

Indirect labour such as salaries of salesmen ad sales manager, etc.

Indirect expenses such as rent, insurance, advertising expenses,

etc.

Methods of costing:

The methods or types of costing refer to the techniques and processes employed

in the ascertainment of costs. Several methods have been designed to suit the

needs of different industries. The method of costing to be applied in a particular

concern depends upon the type and nature of manufacturing activity. Basically,

there are two methods of costing:

1) Job costing or job order costing, and

2) Process costing

All other methods are variations of either job costing or process costing. The

various methods of costing are as follows:


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a. Job order costing: This method applies where work is undertaken to

customers special requirements. Cost unit in job order costing is taken to be

a job or work order for which costs are separately collected and computed. A

job, big or small, comprises a specific quantity of a product or service to be

provided as per customers specifications. Industries where this method is

used include printing repair shops, interior decoration, painting, etc.

b. Contract costing or terminal costing: This is a variation of job costing

and, therefore, principles of job costing apply to this method. The difference

between job and contract is that job is small and contract is big. It is well said

that a contract is a big job and a job is a small contract. The cost unit here is

a contract which is of a long duration and may continue over more than one

financial year. Contract costing is most suited to construction of buildings,

dams, bridges and roads, ship-building, etc.

c. Batch costing: In this method, the cost of a batch or group of identical

product is ascertained and therefore each batch of products is a cost unit for

which costs are ascertained. This method is used in companies engaged in

the production of readymade garments, toys, shoes, tyres and tubes,

component parts, etc.

d. Process costing: this method is used in mass production industries

manufacturing standardized products in continuous processes of

manufacturing. Costs are accumulated for each process or department. Here

raw material has to pass through a number of processes in a particular

sequence to completion stage. In order to arrive at cost per unit, the total

cost of a process is divided by the number of units produced. The finished

product of one process is passed on to the next process as raw material.

Textile mills, chemical works, sugar mills, refineries, soap manufacturing,

etc., may be cited as examples of industries which employ this method.

e. Operation costing: This is nothing but a refinement and a more detailedapplication of process costing. A process may consist of a number ofoperations and operation costing involves cost ascertainment for eachoperation instead of a process. This method provides minute analysis of costsand ensures greater accuracy and better control.


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f. Single, output or unit costing: This method of cost ascertainment is used

when production is uniform and consists of a single or two or three varieties

of the same product. Where the product is produced in different grades, costs

are ascertained grade-wise. As the units of output identical, the cost per unit

is found by dividing the total cost by the number of units produced. This

method is applied in mines, quarries, brick kilns, steel production, flour mills,etc.

g. Operating or service costing: this method should not be confused with

operation costing. It is used in undertakings which provide services instead of

manufacturing products. For example, transport undertaking (road transport,

railways, airlines, shipping companies), electricity companies, hotels,

hospitals, cinemas, etc., use this method. The cost units are passenger-

k8ilometer or tone-kilometer, kilowatts hour, a room per day in a hotel, a seat

per show in a cinema hall, etc. this method is a variation of process costing.

h. Multiple or composite costing: It is an application of more than one

method of cost ascertainment with respect to the same product. This method

is used in industries where a number of components are separately

manufactured and then assembled into a final product. For example, in a

television set manufacturing company, manufacture of different component

parts may require different production methods and thus different methods

of costing may have to be used. Assembly of these components into final

product requires yet another method of costing. Other examples of industrieswhich make use of this method are air-conditioners, refrigerators, scooters,

cars, locomotives, etc.

Techniques of Costing:

These techniques may be used for special purpose of control and policy in

any business irrespective of the method of costing being used there. These

techniques are:

1) Standard costing: This is a very valuable technique of controlling cost. In

this technique, standard cost is pre-determined as target of performance, and

actual performance is measured against the standard. The difference

between standard and actual costs are analysed to know the reasons for the

difference so that corrective actions may be taken.


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2) Budgetary control: A budget is an expression of a firms business plan in

financial form and budgetary control is technique applied to the control of

total expenditure on materials, wages and overheads by comparing actual

performance with planned performance. Thus, in addition to its use in

planning, the budget is also used for control and co-ordination of business

operations.

3) Marginal costing: In this technique, separation of cost into fixed and

variable is of special interest and importance. It regards only variable costs

as the cost of the products. This technique is used to study the effect on

profit of changes in volume or type of output.

4) Total absorption costing: It is a traditional method of costing whereby

total costs are charged to products. This is in complete contrast to marginal

costing where only variable costs are charged to products. Although until

recently, this was the only technique employed by cost accountants, but now

a days it is considered to have only a limited application.

5) Uniform costing: This is not a separate technique or method of costing like

standard costing or process costing. It simply denotes a situation in which a

number of firms adopt a uniform set of costing principles. It helps to compare

the performance of one firm with that of other firms and thus, to derive the

benefit of anyones better experience and performance.

Management Process and Accounting:

The chief objective of management accounting is to serve management by

providing information for decision-making. It is pertinent here to understand the

management functions, that management accounting serves:

1) Planning: It is the process of setting goals and allocating resources to

achieve those goals. The purpose of a plan is to anticipate future needs oropportunities that require specific steps to be taken now or in the near future

example, investment in new facilities to increase capacity and the

development of new products or markets. The planning process of

management answers to such questions as what does the firm desire and

when and how are the objectives to be accomplished.


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2) Control: It involves a comparison of actual performance with plans so that

deviations from plan can be identified and corrective action taken. It is

through control process that management comes to know, whether or not the

objectives under long-range plan are likely to be achieved. If objectives are

not likely to be achieved, the control process provides response for the

review of companys objectives and long-range plans.

3) Organizing: This is the process that involves establishment of the

framework, within which activities are to be performed and the designation of

who should perform these activities. This involves departmentalization by

establishment of divisions, departments, sections, branches, and so on.

Management accounting performs a staff function. It provides line managers

and other staff managers with a specialized information service, which assist

them in decision-making planning and control activities.

4) Co-ordinating: It is necessary to coordinate and harmonizes the activities of

a company so as to facilitate its working and its success. Co-ordination

process results in the following advantages:

Each department will work in harmony with others.

Each department will know the specific role that it has to play

in accomplishment of organizational objectives.

Sequential arrangement of activities is so governed thatoverlapping and wastage of labour is avoided.

5) Motivating: It means influencing human behavior in such a manner that

participants identify with the objective of the organization. When workforce is

motivated, decisions taken harmonize with the objective. A good manager is

one, who motivates the subordinate to strive to achieve the target set by the

top management.

Cost control and cost reduction:

Cost control:


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The cost control is the function of keeping costs within prescribed limits.

According to C.I.M.A., cost control is the regulation by executive action of the cost

of operating an undertaking, particularly where such action is guided by cost

accounting. Cost control is based on the principle of predetermination of costs andachieving these costs levels so that inefficiencies and wastages may be reduced. In

other words, cost control is compelling actual costs to conform to planned costs.

This involves:

a) Predetermining or preplanning costs.

b) Comparing the actual costs with planned costs.

c) Taking action to correct divergencies.

Among the techniques used for cost control, the two most popular are

Budgetary control and Standard costing.

Cost reduction:

Often cost reduction is confused with cost control. Cost reduction is defined by

C.I.M.A. as the achievement of real and permanent reduction in the unit cost of

goods manufactured or services rendered without impairing their suitability for use

intended. This definition reveals the following characteristics of cost reduction:

a) Cost reduction must be real say, through increase in productivity.

b) Cost reduction must be permanent- temporary reductions in cost due to

windfalls, change in tax rates, changes in market prices, etc., do not come in

the purview of cost reduction.

c) Cost reduction must not impair the suitability of products or services for the

intended use.

In the other words, cost reduction should not be at the cost of essential

characteristics of the products or services. The cost reduction is, therefore,

the term used for planned and positive approach to the improvement of

efficiency. It can be viewed in many ways, such as increasing productivity,

elimination of waste, improvement of product design, better technology and

techniques, incentive schemes, new layouts and better methods, etc. if the


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cost reductions are not based on sound reasons, like improved methods, then

very quickly the costs will grow back to their original size.

UNIT II

COST ANALYSIS AND CONTROL

Overheads:

Meaning and definition:

Overhead is the aggregate of indirect material cost, indirect labour cost

and indirect expenses which cannot be conveniently identified with and

directly allocated to a particular cost centre and cost object in an

economically feasible way. It is also known as indirect cost.

The CIMA of UK has defined overhead as the aggregate of indirect

materials cost, indirect wages and indirect expenses.

In the words of wheldon, overhead may be defined as the cost of

indirect materials, indirect labour and such other expenses, including

services, as cannot conveniently be charged direct to specific cost units.

Alternatively, overheads are all expenses other than direct expenses.

Advantages of overhead:

1) Calculates the full cost of outputs or activities

2) Manage and control costs

3) Reports to internal and external stakeholders

How to reduce overhead expenses?


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1) Advertising, as well as research and development, are often the first

activities to be cut because they can be reduced almost instantly.

2) We can also cut staff cost by restricting overtime or cutting staff hours.

3) We can reduce overheads, by delaying purchases of new equipment,

although this is a temporary measure.

4) Leasing new equipment rather than buying it outright.

5) Renegotiating your contracts with suppliers.

Steps for the distribution of overheads:

1) Classification of overheads.

2) Collection of overheads.

3) Allocation of overheads.

4) Apportionment of overheads.

5) Re-apportionment of service departments overheads.

6) Absorption of overheads.

Collection of overheads:

Collection of overhead involves the act of recording individual items of cost in

the records kept for the purpose. Each document must have the correct cost centre

code as well as the correct cost accounts number. The following source documentsare used for the collection of overheads.

1) Invoices: These invoices relate to the services provided to the organization

by outside firms. Invoices are documents based on which payments are

made. The payments made are booked to expenses in financial accounts.

Collections of indirect expenses are done through these invoices.

2) Stores requisitions: The stores requisitions for indirect materials form the

basis of accounting for indirect materials. These documents have the costcentre code which denotes the name of the cost centre requisitioning the

materials and the account head where the materials issued should be

booked.


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3) Subsidiary records: provisions have been made in the accounts for certain

expenses in the expectation of further cash payment. These provisions are

made in subsidiary records. Thus, outstanding rent, outstanding salaries are

examples.

4) Wages analysis books/ wages abstract sheet: the wages analysis book

shows the different control accounts. These accounts are to be for the

purpose of booking indirect wages and salaries.

5) Estimation from financial accounts: there are certain expenses which arecharged over a number of accounting periods. This includes pre-paid

expenses of previous periods which have been apportioned. The collections

of these expenses are directly made from the financial accounts.

Allocation of overhead:

Cost allocation is the process of identifying overheads to production or service

cost centre for which such overheads are directly incurred or charged. For example,

wages paid to maintenance staff, as revealed by the wages analysis booked, can be

allocated direct to the maintenance service cost centre. Again, indirect material

cost can be allocated to various cost centers based on stores requisitions.

Allocation means charging the full amount of overheads cost to a cost centre,

e.g., to a department, to a process, etc. It has been defined as the allotment of

whole items of cost to cost centres or cost units. Allocation depends on the nature

of cost. If a particular item of cost can be easily identified to a particular cost centre,

it is allocated. For example, salary of a foreman in a production department can be

easily identified and allotted to this department.

Format of statement showing the allocation of overheads

Statement showing the allocation of overheads

Items of overheadsallocated

Production department Service department

P1 P2 S1 S2


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Direct materialDirect wages

Direct expensesIndirect materialIndirect wages

-----

-----

-----

-----

Total overheads allocated - - - -

Apportionment of overheads:

Apportionment is the allotment of proportions of items of cost to cost centres or

cost units. Where an item of cost is common to various cost centres, it is allotted to

different cost centres proportionately on some equitable basis. For example, rent of

factory building is not allocated but apportioned to various departments on some

suitable basis, i.e., area occupied by departments concerned.

Format of statement showing the apportionment of overheads

Statement showing the apportionment of overheads

Items of overheads

apportioned

Basis of

apportionment

Production

department

Service

department

LightingDepreciationInsuranceRent, rates, and

TaxesRepairsStores overheadsEmployeesinsurance chargesStaff welfare

expenses

No. of light pointsAsset valueAsset valueFloor areaFloor areaDirect materialDirect wagesNo. of workersNo. of workers

P1---------

P2---------

S1---------

S2---------

Total overheadsapportioned

- - - -

Distinguish between Allocation and Apportionment

Allocation Apportionment


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1.

Allocation may be defined as theallotment of whole items of cost tocost centres or cost units.

Apportionment may be defined as theallotment of proportions of items ofcost to cost centres or cost units.

2.

Allocation deals with whole itemsof costs.

Apportionment deals with proportionsof items of cost.

3.

Allocation is a direct process Apportionment may be made onlyindirectly and for which suitable basesare to be selected.

4.

Overheads should always beallocated, as far as possible

If an overhead cannot be allocated, it isapportioned.

5.

It include indirect wages, overtimeand idle time cost, power (whensub-meters are installed indepartments), depreciation ofmachinery, supervision, etc.

It include fire insurance, lighting andheating, time keeping expenses,canteen expenses, medical and otherwelfare expenses, etc.

Overheads should always be allocated, as far as possible. If an overhead cannot

be allocated, it is apportioned. This involves finding some basis of apportionment

that will enable the overhead to be equitably shared between various production

and service departments.

Production and service department:

A production department is one that engages in the actual manufacture of theproduct by changing the shape, form or nature of material or by assembling the

parts into finished product. Examples are melting shop, weaving department,

spinning department, grinding department, etc.

A service department, on the other hand, is one rendering a service that

contributes in an indirect manner to the manufacture of the product but which does

not itself change the shape, form or nature of material that is converted into the

finished product. Examples are labour welfare department, purchasing department,

accounting department, canteen, etc.

Apportionment of service department costs (secondary distribution):

Once the overheads have been allocated and apportioned to production and service

departments and totaled, the next step is to re-apportion the service department

costs to production departments. This is necessary because our ultimate object is to

charge overheads to cost units, and no cost units pass through service

departments. Therefore, the costs of service departments must be charged to

production departments.


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There are various methods of apportionment of service department overheads

a) Apportionment to production department only

b) Apportionment to production as well as service departments.

Apportionment to production department only:

Here the total amount of each service department is distributed to only

production department. Some of the important bases of apportionment of service

department overheads are given below:

Service department Basis of apportionment

Purchases department Value of materials purchased, No. of

orders placed

Time office personnel department No. of employees, wages paid, labour

hours

Canteen labour welfare No of employees, wages paid

Accounts office No. of employees, No. of time cards

handled

laboratory Testing laboratory hours, Units of output

Maintenance department No. of hours worked in each department

Apportionment to production as well as service departments:

Quite often, a service department renders service not only to production

department but also to other service departments. For example, maintenance

department looks after not only the plant and machinery of production department

but also the equipment of other service department like power-house, material

handling, etc. Similarly power-house supplies electricity not only to production

department but also to other service departments like canteen, maintenance

department, etc. this type of inter-service department apportionment may be either

on Reciprocal basis or Non-Reciprocal basis.

Apportionment on Non-Reciprocal basis (Step-Ladder method):

This method is used when service department renders services to other

service departments, but does not receive services of the other service

departments, i.e., when service departments are not inter-dependent.


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Apportionment on reciprocal basis:

This method is used when service departments are mutually dependent. This

means a service department not only provides its services to other service

departments but also receives services of other service departments. For example,

boiler house and pump room are the two service departments. Boiler house has todepend upon pump room for supply of water and pump room has to depend upon

the boiler house for supply of steam power for driving the pump. Thus both boiler

house and pump room depend upon each other for their services.

The following methods may be used for apportionment of overhead costs on a

reciprocal basis:

a) Simultaneous equation method: This method is to be adopted to take

care of secondary distribution of cost of service cost centres to production

cost centres with the help of mathematical formulation and solution. It

involves the following steps:

Step 1: calculate the total costs of each service department by forming and

solving simultaneous equations.

Step 2: Re-apportion the total costs of each service department only to

production department on the basis of given percentages.

X = a+bYandY =a+bX

b) Repeated distribution method: This method involves the following steps:

Step 1: Apportion the costs of first service department over other servicedepartments and production departments on agreed percentages.

Step 2: Apportion the costs of second service department plus the share

received from s1 over other departments on agreed percentages.

Step 3: Apportion the costs of third service department plus the share

received from s1 and s2, over other departments on agreed percentages.

Step 4: Repeat this process of distribution again beginning with S1 until the

total costs of the service departments are exhausted or reduced to too small

figure. The small figure should be apportioned over production departments

and not over other service departments.

c) Trial and error method: this method is to be followed when the question of

distribution of costs of service cost centres which are interlocked among

themselves, arises. In the first stage, gross costs of services of service cost

centres are determined and then in the second stage, costs of service centres

are apportioned to production cost centres.


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Step 1: The proportion at which the costs of a service cost centre to be

distributed to production cost centres and other service cost centres is

determined.

Step 2: Cost of first service cost centre is distributed to the other service

centres in the proportion of service they received from the first as assessedin step (1).

Step 3: In the next step, total cost of second service cost centre so arrived

has to be distributed to the other service centres in the proportion of service

they received from the second as assessed in step(1).

Step 4: Similarly, the cost of other service cost centres are to be apportioned

to the service cost centres.

Step 5: this process as described in (3) and (4) is to be continued till the

figures remaining undistributed in the service cost centres are negligibly

small.

Step 6: At the last, total cost of service cost centres to be distributed to

production cost centres.

Absorption of factory overhead:

After the allocation, apportionment and re-apportionment of overheads to

production departments is complete, the total overhead cost of production

department will consist of:

a) Its own expenses, e.g., indirect materials, indirect wages, etc.

b) Share of the costs of service departments re-apportioned to it.

c) Share of the costs of service department re-apportioned to it.

This gives the total overheads cost of each production department. The total

cost of production department is then to be absorbed by the products

manufactured in the respective production departments. This is known as

absorption.

The absorption of overheads is the last step in the distribution plan of

production overheads. It is the process of charging to the product or output ofthe production department, all the overhead expenses which have been

allocated and apportioned to it. The purpose behind absorption is that overheads

should be absorbed in the cost of the output of the given period. Absorption of

overhead is also known as recovery or application of overheads.

Steps in absorption of overheads:


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There are two steps in the absorption of overheads:

i) Computation of overhead absorption;

ii) Application of theses rates to cost units.

Computation of overhead absorption rate:

Absorption rates are computed for the purpose of absorption of overheads in

costs of the cost units. There are mainly six methods for determining absorption

rates, by dividing the total amount of overheads of the department by the number

of units in the base, such as number of cost units, machine hours, labour hours,

direct labour cost, and prime cost, etc.

Overhead absorption rate = Total overhead of cost centre or department /

Total units of base used

Percentages on direct materials: In this method overheads are absorbed on thebasis of direct materials consumed in producing the product. A percentage of

factory overheads to the total value of materials consumed are determined.

Overhead rate = factory overhead/ direct material X100

Percentage on direct wages: This is another simple and easy method. In this

method percentageof factory overhead to direct labour cost is computed as follows:

Overhead rate = factory overhead/direct labour cost X100

Percentage on prime cost: This method takes into consideration both direct

materials and direct wages for the absorption of overhead. Overhead rate in thismethod is calculated by dividing the factory overhead by the prime cost.

Overhead rate = factory overhead / prime costX100

Direct labour hour rate: The direct labour hour rate is the overhead cost of a

direct worker working of one hour. This rate is determined by dividing the overhead

expenses by the total number of direct labors hours.

Overhead rate = factory overhead/direct labour hoursX100

Advantages:

a) It gives due consideration to time factor.

b) It is most suitable where labour constitutes the major factor of production.


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c) This rate is not affected by the method of wage payment, i.e., time rate or

piece rate method.

Disadvantages:

a) Additional records of labour (i.e., time spent on different jobs) must be

maintained if this method is to be used. This may add to the cost of clerical

work.

b) This method does not take into account factors other than labour.

Machine hour rate:

This method is applicable where work is performed mainly on machines. A

separate rate is usually computed for each machine or a group of similar machines.

Machine hour rate means the cost of running a machine for one hour. This

rate is obtained by dividing the amount of factory overheads chargeable to amachine by the number of machine hours. Overhead charge to a job is made on the

basis of number of machine hours worked on that job.

Machine hour rate = factory overhead for machine X/no. of machine hours

Computation of machine hour rate: The following steps are taken for the

computation of machine hour rate:

The factory overheads are first apportioned to departments as

discussed earlier under allocation and apportionment.

Overheads of the department are further apportioned to differentmachines or group of machines. For this purpose each machine or a

group of machine is treated as a cost centre or a small department.

Bases of apportionment of different expenses are given here.

Specific overheads like power, depreciation, etc., should be directly

allocated to the machine.

The overheads relating to the machine should be divided between

Fixed or standard charges, variable charges.

The working hours of the machine are estimated for the period.

Overheads pertaining to the machine are totaled and divided by the

number of machine hours. The resultant figure will be machine hour

rate. The time required for setting the machine should be deducted

from the total working hours.

Bases of apportionment of different expenses to machines


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Items of expenses Basis of apportionment

Rent and rates Ratio of floor area occupied by eachmachine

Insurance Insured value of each machine

Supervision Estimated time devoted by thesupervisor to each machine

Lighting No. of light points used for the machines,of floor area occupied by each machine

Depreciation Capital values or machine hours or both

Repairs and maintenance Capital values or machine hours

Lubricating oil and other consumablestores

Capital values or machine hours

Advantages:

a) It is a scientific and accurate method of absorption of factory overheads.

b) It gives due consideration to time factor and thus produces more equitableresults.

c) This is an ideal method where production is carried out on machines.

d) When separate rates are calculated for fixed and variable overheads, the cost

of idle machines can be measured without difficulty.

Disadvantages:

a) This method can be used only in those departments where work is done bymachines.

b) It is quite difficult to estimate total machine hours in advance.

c) This method requires the maintenance of detailed records about machinetime taken by various jobs. This increases the clerical cost.

Rate per unit of production: It is the simplest of all the methods. The total

overheads of a department are divided by the number of units produced to give anoverhead rate per unit of output.

Overhead rate = factory overheads/units produced

This method can be used only where one product of uniform size, quality andstandard is being produced. For example, mining, brick laying, foundries etc.


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Unit III

Costing for specific industries

Introduction:

The profit of every business organization depends upon their selling price forthe product. The determination of selling price is done through the process ofidentifying the cost of that product which is known as costing for the product.

Under costing the role of unit costing is an inevitable tool for the industriesnot only to identify the volume of costs incurred but also to determine the rationalprice.

Unit costing:

It is a method of cost ascertainment, which is used in those industries whereproduction is uniform and continuous and production consists of a single product.

This is also known as output costing or single costing. Examples of industries inwhich this method is commonly used are cement, steel, sugar, paper, brick works,quarries, breweries, dairies, etc.

Cost sheet:In order to ascertain cost of products, a statement known as cost sheet is

prepared periodically as the production is uniform and cost units are identical, thecost per unit is the average cost. It is ascertained by dividing the total cost by thenumber of units produced.

Definition:

Cost sheet is a document that provides for the assembly of the detailed costof a cost centre or cost unit.

Cost sheet is a periodical statement of cost designed to show the various

elements of costs of goods produced like prime cost, factory cost, and total cost.

Advantages:

1. It is helpful in revealing the total cost and cost per unit of goods produced.

2. It acts as a guide to management in fixation of selling prices and quotation oftenders.


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3. It provides a comparative study of the cost of current period with that ofprevious year.

4. It discloses the break-up of total cost into various elements of cost.

Job costing:

The ultimate aim of every business organization is to earn profits bycustomer satisfaction, customer loyalty. To fulfill these specific requirements ofcustomer, every firm is expected to determine the cost of the job, to fix therighteous price.

To find out the cost of the job, the firm should adopt job order costingwhich is one of the costing methods, meant for calculating the cost of a particular

job.

Definition:

It is a costing system for attaining the cost control and performancethrough the available source of cost information of a specific job.

It is cost ascertainment method used in job order industries like printingpress, interior decoration, general engineering etc.

Objectives:

1. Ascertaining the cost of each job separately.

2. Helps identifying the job that are profitable.

3. Provides the basis for determining the cost of similar jobs undertaken infuture.

4. Helps management in controlling cost by comparing actual cost withestimated cost.

Procedure: It contains the following steps

i. Job number: This is first step of job costing where an individual job numbermust be assigned to each job for identification and future references.

ii. Production order: The production control department prepares a productionorder thereby authorizing to start the work on the job. Generally the orders

are of various colours to distinguish between various departments.

iii. Job cost sheet: This is a unique accounting document prepared by theaccountant after receiving job production order. It consists of the costinformation regarding material, machinery and labour. These are not madefor specified periods but they are made out for each job regardless the timetaken for its completion.

Process costing:


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All companies will not produce their finished products in single step. Someorganizations manufacture the product through many stages of production. Suchsystem is known as process of production.

In these organizations the output of one process will become the input ofanother process. Costing procedure for these organizations gives rise to process

costing.

Definition:

Process costing is technique that is used in those organizations where theproduction aspects take place in several steps

If the cost of a product are ascertained by compiling of various stages ofproduction cost of that product, such costing technique is known as process

costing. Examples are textile mills, sugar industry, chemical industry, oil refining,paper industry, food processing, soap industry etc.

Characteristics:

1) Production is continuous, final product results from a sequence of processes.

2) Costs are accumulated process-wise.

3) The products are standardized ad homogeneous.

4) The cost per unit is average cost.

5) The finished product of one process will become the opening material ofanother process.

6) The sequences of operations are pre-determined.

7) Some loss of material is unavoidable.

8) Processing of raw material gives rise to by-products.

9) The finished product will be derived only from the final stage of production.

Distinguish between Process costing and job costing

Process costing Job costing

1. Costs are compiled process-wise andcost per unit is the average cost, i.e.the total cost of the process divided bythe number of units produced.

Costs are separately ascertained foreach job, which is cost unit.

2. Production is of standardized productsand cost units

Production is of non-standard itemswith specifications and instructions


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from the customers.

3. Production is for stocks. Production is against orders fromcustomers.

4. Costs are computed at the end of a

specified period.

Costs are calculated when a job is

completed.

5. The cost of one process is transferredto the next process in the sequence.

Cost of a job is not transferred toanother job but to finished stockaccount.

6. On account of continuous nature ofproduction, work-

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