DM Notes Mim Jbims 12 13

Cost and management Accounting MHRDM-MIM - JBIMS
COST: MEANING AND ITS ELEMENTS

The term cost means the amount of expenses [actual or notional]
incurred on or attributable to specified thing or activity. As per Institute of
cost and work accounts (ICWA) India, Cost is measurement in monetary
terms of the amount of resources used for the purpose of production of
goods or rendering services.
Elements of cost
Cost of production/manufacturing consists of various expenses incurred
on production/manufacturing of goods or services. These are the
elements of cost, which can be divided into three groups: Material,
Labour and Expenses.
COST SHEET: MEANING AND ITS IMPORTANCE
Cost sheet is a statement, which shows various components of total cost
of a product. It classifies and analyses the components of cost of a
product.
Previous periods data is given in the cost sheet for comparative study. It is
a statement, which shows per unit cost in addition to Total Cost. Selling
price is ascertained with the help of cost sheet. The details of total cost
presented in the form of a statement are termed as Cost sheet. Cost sheet
is prepared on the basis of:
1. Historical Cost
2. Estimated Cost
Historical Cost
Historical Cost sheet is prepared on the basis of actual cost incurred. A
statement of cost prepared after incurring the actual cost is called
Historical Cost Sheet.
Estimated Cost
Estimated cost sheet is prepared on the basis of estimated cost. The
statement prepared before the commencement of production is called
estimated cost sheet. Such cost sheet is useful in quoting the tender price
of a job or a contract.
Importance of Cost Sheet
The importance of cost sheet is as follows:
_ Cost ascertainment
The main objective of the cost sheet is to ascertain the cost of a product.
Cost sheet helps in ascertainment of cost for the purpose of determining
cost after they are incurred. It also helps to ascertain the actual cost or
estimated cost of a Job.
Private & Confidential
Page 1
By Dinesh Makani

_ Fixation of selling price
To fix the selling price of a product or service, it is essential to prepare the
cost sheet. It helps in fixing selling price of a product or service by
providing detailed information of the cost.
_ Help in cost control
For controlling the cost of a product it is necessary for every
manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in
the control of material cost, labour cost and overheads cost at every
point of production.
_ Facilitates managerial decisions
It helps in taking important decisions by the management such as:
whether to produce or buy a component, what prices of goods are to be
quoted in the tender, whether to retain or replace an existing machine
etc.
COMPONENTS OF TOTAL COST
The Components of cost are shown in the classified and analytical form in
the cost sheet. Components of total cost are as follows:
_ Prime Cost
It consists of direct material, direct wages and direct expenses. In other
words Prime cost represents the aggregate of cost of material
consumed, productive wages, and direct expenses. It is also known as
basic, first, flat or direct cost of a product.
Prime Cost = Direct material + Direct Wages + Direct expenses
Direct material means cost of raw material used or consumed in
production.
It is not necessary that all the material purchased in a particular period is
used in production. There is some stock of raw material in balance at
opening and closing of the period. Hence, it is necessary that the cost of
opening and closing stock of material is adjusted in the material
purchased.
Opening stock of material is added and closing stock of raw material is
deducted in the material purchased and we get material consumed or
used in production of a product. It is calculated as:
Material Consumed = Material purchased + Opening stock of material
Closing stock of material.
Page 2
By Dinesh Makani

Illustration 1
Calculate prime cost from the following particulars for a production unit:
Rs.
Cost of material purchased
30,000
Opening stock of material
6,000
Closing stock of material
4,000
Wages paid
3,000
Rent of hire of a special machine for production 5,000

Solution:
Details
Amount
(Rs.)
Direct Material: Material Consumed

Opening stock of material
Add: Material Purchased
6,000
30,000
Material available for consumption

Less: Closing stock of material
36,000
4,000
Material consumed
32,000
Direct Labour: Wages
3,000
Direct Expenses: Rent of hire a special machine

Prime cost
5,000
40,000
Factory Cost
In addition to prime cost it includes works or factory overheads. Factory
overheads consist of cost of indirect material, indirect wages, and indirect
expenses incurred in the factory. Factory cost is also known as works cost,
production or manufacturing cost.
Factory Cost = Prime cost + Factory overheads
Page 3
By Dinesh Makani

Illustration 2
Calculate factory cost from the following particulars:
Rs.
Material consumed
60,000
Productive wages
20,000
Direct Expenses
5,000
Consumable stores
2,000
Oil grease/Lubricating
500
Salary of a factory manager
6,000
Unproductive wages
1,000
Factory rent
2,000
Repair and Depreciation on Machine
600
Solution:
Statement showing Factory cost
Details
Amount
(Rs.)
60,000
Direct Labour: Productive wages
20,000
Direct Expenses
5,000
Prime cost
85000
Page 4
By Dinesh Makani

Add: Factory overheads
Indirect Material:
Consumable stores
2,000
Oil grease/lubricants
500
2,500
Indirect Labour:
Unproductive wages
1,000
Salary of a factory Manager
6,000
7,000
Indirect Expenses:
Factory rent
2,000
Repair and Depreciation on Machine
600
Factory cost
2,600
97,100
TOTAL COST AND COST SHEET

If office and administrative overheads are added to factory or works cost,
total cost of production is arrived at. Hence the total cost of production is
calculated as:
Total Cost of production = Factory Cost + office and administration
overheads
Illustration 4
From the following information calculate the total cost of production
Rs.
Direct material
90,000
Direct Labour
32,000
Direct Expenses
9,000
Factory overheads
25,000
Office and administration overheads
18,000
Page 5
By Dinesh Makani

Solution:
Statement showing total cost of production
Details
Amount
(Rs.)
90,000
Direct Labour: Productive wages
32,000
Direct Expenses
9,000
PRIME COST
1,31,000
Factory overheads
25,000
FACTORY COST
1,56,000

TOTAL COST OF PRODUCTION
18,000
1,74,000
Cost of goods sold

It is not necessary, that all the goods produced in a period are sold in the
same period. There is stock of finished goods in the opening and at the
end of the period. The cost of opening stock of finished goods is added in
the total cost of production in the current period and cost of closing stock
of finished goods is deducted. The cost of goods sold is calculated as:
Cost of goods sold = Total cost of production + Opening stock of
Finished goods Closing stock of finished goods
Illustration 5
From the following information calculate the cost of goods sold.
Rs.
Total Cost of Production
1,22,000
Opening stock of finished goods
12,000
Closing stock of finished goods
16,000
Page 6
By Dinesh Makani

Solution:
Cost of goods sold = Cost of Production + Opening stock of Finished
goods - closing stock of Finished goods
Cost of goods sold = Rs.1,22,000 + 12,000 16,000 = Rs.1,18,000
Total Cost i.e., Cost of Sales
If selling and distribution overheads are added to the total cost of
production, total cost is arrived at. This cost is also termed as cost of Sales.
Hence the total cost is calculated as:
Total Cost = Cost of Goods sold + Selling and distribution overheads
Illustration 6
From the following information calculate the total cost.
Rs.
Direct material
1,60,000
Direct Labour
52,000
Direct Expenses
19,000
Factory overheads
45,000
28,000
Selling and distribution overheads
33,000
Solution:
Statement showing total cost
Details
Amount
(Rs.)
Direct Material:
1,60,000
Direct Labour:
52,000
Direct Expenses
19,000
PRIME COST
2,31,000
Factory overheads
45,000
FACTORY COST
2,76,000

TOTAL COST OF PRODUCTION
Total cost = cost of sales
28,000
3,04,000
33,000
3,27,000
Page 7
By Dinesh Makani

Sales
If the profit margin is added to the total cost, sales are arrived at. Excess of
sales over total cost is termed as profit. When total cost exceeds sales, it is
termed as Loss.
Sales = Total Cost + Profit
Sometimes profit is calculated on the basis of given information in
percentage of cost or sales. In such a situation, the amount is assumed
100 in which the percentage is calculated. Then the Profit is calculated in
the following ways:
Case 1
If Cost is Rs.10,000 and profit on cost 10%. Assume the cost is Rs.100 and
profit on cost is Rs.10. Hence Profit on cost of Rs.10,000 is
10,000 10/100 = Rs.1,000
Thus the sales value is Rs 11000 (10,000 + 1000)
Case 2
If Cost is Rs.10,800 and profit on sales price is 10%. Assume sales price is
Rs.100. cost price is Rs.90 [i.e. Rs.100 Rs.10]. When profit on cost of Rs.90 is
Rs.10. Hence profit on cost of Rs.10,800 is
10,800 10/90 = Rs.1,200
10,800 + 1200 = 12,000 sales value
Case 3
If sales price is Rs.12,100 and profit on cost is 10%. Assume Cost price is
Rs.100. Sales price is Rs.110 [i.e.100 + 10]. If sales price is Rs.110, profit is
Rs.10. Profit on sales price of Rs.12,100 is
12,100 10/110 = Rs.1,100 profit
Page 8
By Dinesh Makani

Illustration 7
From the following information, calculate the value of goods sold.
Rs.
Total Cost of Production
1,45,000
Opening stock of finished goods
22,000
Closing stock of finished goods
6,000
25,000
Profit
22,000
Solution
Statement showing Sales
Details
Amount
(Rs.)
Total cost of production
1,45,000
Add: Opening stock of finished goods
22,000
1,67,000
Less Closing stock of finished goods
6,000
Cost of Goods sold
1,61,000
25,000
Total Cost
1,86,000
Profit
22,000
Sales
2,08,000
Page 9
By Dinesh Makani

There is no prescribed format of a Cost sheet. It may change from industry
to industry. A specimen format of a Cost Sheet is given as under:
Particulars
Total (Rs.)
A. Materials Consumed:
Purchases
..............
Add: Opening Stock of Raw material
..............
Expenses on Purchases
..............
Less: Closing Stock of Raw Material
..............
Direct Material consumed
..............
..............
B. Direct Labour (Wages)
..............
C. Direct Expenses
..............
D. Prime Cost (A + B + C)
..............
E. Factory/Works Overheads
..............
Add: Opening Stock of Work-in-Progress
..............
Less: Closing Stock of Work-in-Progress
..............
F. Works/Factory Cost (D + E)
..............
G. Office and administration overheads
..............
H. Total Cost of Production (F + G)
..............
Add: Opening Stock of finished Goods

Cost of Goods available for sale
..............
..............
Less: Closing Stock of finished Goods
..............
I. Cost of production of goods Sold or cost of good sold
..............
J. Selling and Distribution Overheads
..............
K. Total Cost (I + J) = Cost of Sales
..............
L. Profit
..............
M. Sales (K + L)
..............
Preparation of cost sheet
Page 10
By Dinesh Makani

The various components of cost explained above are presented in the
form of a statement. Such a statement of cost consists of prime cost, works
cost, cost of production of goods; cost of goods sold, total cost and sales
and is termed as cost sheet.
The Preparation of a cost sheet can be understood with the help of
following illustration:
Illustration 8
From the following information, prepare a cost sheet for period ended on
31st March 2009.
Rs.
Opening stock of raw material
12,500
Purchases of raw material
1,36,000
Closing stock of raw material
8,500
Direct wages
54,000
Direct expenses
12,000
Factory overheads
100% of direct wages
Office and administrative overheads
20% of works cost
26,000
Cost of opening stock of finished goods
12,000
Cost of Closing stock of finished goods
15,000
Profit on cost 20%
Page 11
By Dinesh Makani

Solution:
Cost sheet
Details
Amount
(Rs.)
Direct Material: Material consumed
12500
Opening stock of raw material
136000
Add: Purchases
148500
Less: Closing stock of raw material
8500
1,40,000
Direct wages
54,000
Direct expenses
12,000
Prime cost
2,06,000
Factory overheads: 100% of direct wages
54,000
(i.e. 100 x 54000

100
Works cost
Office and administrative overheads
2,60,000
20% of works cost, (2,60,000 20/100
52,000
Total cost of production
3,12 000
Add: opening stock of finished goods
12,000
Cost of Goods available for sale
3,24,000
Less: Closing stock of finished goods
15,000
Cost of goods sold
3,09,000
26,000
Total Cost = cost of sales
3,35,000
Profit (20% On Cost i.e. 3,35,00 20/100)
67,000
Sales
4,02,000
Page 12
By Dinesh Makani

Illustration 9
The following information is given to you from which you are required to
prepare Cost Sheet for the period ended on 31St march 2009:
Consumable material:
Rs.
Opening stock
20,000
Purchases
1,22,000
Closing stock
10,000
Direct wages
36,000
Direct Expenses
24,000
Factory overheads
50 % of direct wages
20% of works cost
Selling and distribution expenses
Rs.3 per unit sold
Units of finished goods

In hand at the beginning of the period (Value Rs. 12500)
500
Units produced during the period
12,000
In hand at the end of the period
1,500
Find out the selling price per unit if 20% profit on selling price. There is no
work-in-progress either at the beginning or at the end of the period.
Page 13
By Dinesh Makani

Solution:
Cost Sheet for the period ended on 31st March 2009 (output 12000 units)
Particulars
Total cost
Cost Per Unit
Material Consumed:
Opening Stock
20000
Add: Purchases
122000
142000
Less: Closing Stock
10000
Cost of R.M. consumed
132,000
132000
11.00
Direct wages
36000
3.00
Direct Expenses
24000
2.00
Prime Cost
192000
16.00
50% of Direct Wages (i.e. 12000 1.50)
18000
1.50
Works/Factory overheads
210000
17.50
20% of works cost
42000
3.50
Total Cost of production
252000
21.00
Factory Overheads
Office overheads
Add: Opening stock of finished goods

(500 units @ 25)
12500
Cost of goods available for sale (12000 + 500)
264500
Less: Closing stock of Finished goods @ 21per
31500
Unit (1500 units)

Cost of goods sold (12500 1500 = 11000 units)
233000
21.18
Add: Selling & Distribution overheads @ per unit
330001
3.00
Cost of Sales
266000
24.18
Add: Profit 20% On S. P. i.e. 25% of cost of sales
66500
6.04
332500
30.22
Sales (266000 X 25/100)
Page 14
By Dinesh Makani
Components of Total Cost
Prime Cost = Direct material + Direct Wages + Direct expenses works/

factory cost;
Factory Cost = Prime cost + Factory overheads
Cost of production/office cost = Factory Cost + office and administration

overheads
Cost of production of goods sold = Cost of Production + Opening stock of

Finished goods closing stock of finished goods
Total Cost = Cost of Production of goods sold + Selling and distribution

overheads
Sales = Total Cost + Profit
Page 15
By Dinesh Makani
CONTRACT COSTING
Contract costing is A form of specific order costing; attribution of costs to
individual contracts
A contract cost is Aggregated costs of a single contract; usually applies to
major long term contracts rather than short term jobs
Features of long term contracts
contract costing situations, we tend to mean long term and large
contracts: such as civil engineering contracts for building houses, roads,
bridges and so on. We could also include contracts for building ships, and
for providing goods and services under a long term contractual
agreement.
contract costing, every contract and each development will be
accounted for separately; and does, in many respects, contain the
features of a job costing situation.
is frequently site based.
Features of a Contract
The end product
The period of the contract
The specification
The location of the work
The price
Completion by a stipulated date
The performance of the product
Collection of Costs
Desirable to open up one or more internal job accounts for the collection
of costs. If the contract not obtained, preliminary costs be written off as
abortive contract costs in P&L In some cases a series of job accounts for
the contract will be necessary:
to collect the cost of different aspects
to identify different stages in the contract
Page 16
By Dinesh Makani
Special features
Materials delivered direct to site.
Direct expenses
Stores transactions.
Use of plant on site
Two possible accounting methods:
1. Where a plant is purchased for a particular contract & has little
further value to the business at the end of the contract
2. Where a plant is bought for or used on a contract, but on
completion of the contract it has further useful life to the business
Alternatively the plant may be capitalised with Maintenance and running
costs charged to the contract."
Worked example
Contract ABC started on 1 July 2008. Costs to 31 December 2008, when
the company's accounting year ends, are derived from the following
information.
direct materials issued from store
40000
materials returned tos tore
1000
direct labour
36000
plant issued, at book value 1 July 2008
50000
written down plant value as at 31 December, 2008 30000
materials on site, 31 December, 2008
3000
overhead costs
5000
As at 31 December, 2008, certificates had been issued for work valued at
Rs.100,000 and the contractee had made progress payments of Rs.70,000.
The company has calculated that more work has been done since the
last certificates were issued, and that the cost of the work done but not
yet certified is Rs.14,000. The final contract price is Rs.175,000 and the
estimated total cost of the contract is Rs.130,000.
Prepare the contract account
Page 17
By Dinesh Makani

Solution
Contract account
Dr
Cr
Materials
40000
materials returned
1000
Labour
36000
plant issued at book value
50000
Overheads
5000
plant c/d
30000
materials c/d
3000
cost of worjk done not certified
14000
cost of work certified
83000
131000 131000
Work certified account
turnover (profit and loss)
contratee account
Contractee account
work certified
cash (progress payment)
balance c/d
100000
100000
100000
70000
30000
100000 100000
Estimating profit
In the early stages, no profit will be accounted for; and in an exam
question, the profit taking method may be GIVEN.
Total anticipated profit
contract price
175000
costs incurred (14,000 + 83,000)
97000
estimated costs to complete (130,000 - 97,000) 33000 130000
Estimated profit
45000
Estimated degree of completion
Page 18
By Dinesh Makani
Therefore, profit to date:

Sales basis = Rs.45,000 * 57.14% = Rs.25,714.29
cost basis = Rs.45,000 * 74.62% = Rs.33,576.92
Consider what the accountant's concept of conservatism might have to
say about these calculations.
Completing the profit and loss account:
turnover - value certified 100000
profit (sales basis)
25715
cost of sales
74285
costs incurred 97000
cost of sales 74285
WIP
22715
Balance sheet disclosure
Cost of sales
74285
cost of work done 97000
-22715
If this is negative, it is WIP, otherwise it is a provision for liabilities and
charges or creditors
Reconciliation of WIP:
value certified
100000
cost of work certified
83000
apparent profit to date
17000
profit recognised
25715
cost of work done but not certified 14000
-22715
Page 19
By Dinesh Makani

Attributable Profit
That part of the total profit reflecting that part of the work performed at
the accounting date, attributable profit not be recognised until the
outcome of contract be assessed with reasonable certainty.
Terminology
Calculation of attributable profit

Taking total costs to date & total estimated further costs to completion,
also the estimated future costs of rectification & guarantee work, and any
other future work to be undertaken under the terms of the contract. Profit
accounted for needs:
1. to reflect the proportion of the work carried out at the accounting
date;
account any known inequalities of profitability in various stages of
contract for certainty of profit
Illustration
M/s New Century Builders have entered into contract to build an office
building complex for Rs.480 lakhs. The work started in April 1997 and it is
estimated that the contract will take 15 months to be completed. Work
has progressed as per schedule and the actual cost charged till March
1998 was as follows.
Page 20
By Dinesh Makani

Particulars
Material
Labor
Hire charges for equipment and other expenses
Establishment charges
Amt in Lakhs
112.20
162
36
32.40
The following information is available:

Particular
Amt in lakhs
Material in hand 31st Mar 1998
10.50
Work certified (of which Rs 324 lakhs have been paid) as 400.00
on 31stMarch 1998
Work not certified as on 31st March 1998
7.50
As per Management estimates, the following further expenditure will be
incurred to complete the work.
Materials : Rs. 10.50 lakhs
Labor: Rs.16.00 lakhs
Sub-contractor: Rs 20.00 lakhs
Equipment hire and other charges: Rs 3.00 lakhs
Establishment charges: Rs 6.90 Lakhs
You are required to compute the value of work in progress as on March
31st, 1988 after considering a reasonable margin of profit and show the
appropriate accounts. Make a provision for contingencies amounting to
5% of the total costs
Page 21
By Dinesh Makani
PROCESS COSTING
PROCESS COSTING IMPORTANCE: In process costing, particular attention is given to (a) cost relating to the
process, i.e., both direct and indirect cost, (b) period for which cost for the
process is collected, (c) complete units in the process at the end of the
period and (e) determining unit cost of the process for the period.
USE OF PROCESS COSTING: Process coasting is useful for industries with following characteristics:
(a) Continuous and mass production
(b) Loss of identity of production against a particular order.
(c) Homogeneous products
(d) Production involves different process and output of one process
forms input of another process.
(e) Other uses: bottling companies, canning plants, packing, breweries
and industries involved in processing milk products.
Process Costing under different inventory costing methods.
The effect of using FIFO method, LIFO method and average method will
be differentiates on cost per unit of the process.
FIFO METHOD. : It is also referred to as First-in-First out method of inventory costing. Under
FIFO method it is presumed that units are completed in the order of
introduction to the process. Units at the beginning are completed first.
Then, newly introduced units are completed. Only after this, work is done
on closing inventory. According to this method, it is assumed that cost
incurred is used
(a) First to complete the units already in process,
(b) Then to complete the newly introduced units,
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By Dinesh Makani

(c) For the work done to bring closing inventory to given stage of
completion.
If units completed are more than units representing opening inventory, it is
presumed under FIFO method that all unfinished units in opening inventory
have been completed. When FIFO method of inventory costing is
followed, units completed during the period are divided in two categories
for the purpose of statement of equivalent production:
(a) Work done for completing opening work in process,
(b) Newly introduced units completed during the process,
LIFO METHOD. : It is also referred to as Last-in-First-out method of inventory costing. It is
presumed under LIFO method that cost incurred is used:
(a) First to complete newly introduced units.
(b) Then to complete units already in process.
If there is closing work in process, it is supposed in LIFO method that units
which represent opening inventory, remain in closing work in process at
the end of the period, because units representing opening inventory are
attended to in the last. If units under closing inventory are more than units
under opening inventory, it will be presumed that all units, which
represented opening work in process, remain in closing work in process
at the end of period.
Under FIFO method work completed is divided into two categories i.e. (i)
units lying under opening work in process but completed during the
period and, (ii) newly introduced units completed during the period.
When LIFO method is followed closing inventory is divided into two
categories i.e.,
(i) Units, which represent opening work in process, but are lying under
closing work in process at the end of the period.
(ii) Newly introduced units lyibg in closing stock.
Page 23
By Dinesh Makani

Difference between Job Order Costing & Process
JOB ORDER COSTING / CONTRACT PROCESS COSTING
COSTING
1
It is used in industries where production Process Costing is used in continuous

is carried on according to specific job and mass production industries
order.
producing like units of standard
specification.
Cost is collected for each individual Cost is collected according

job worked.
process and departments
Items of prime cost can be traced with Items of prime cost cannot be
job order.
traced with a particular order due to
continuous production.
Job cost is computed, when the job is Process cost is computed at the end
completed
of the cost period
There is no transfer of work from one Costs of one process are transferred
job to another job, till it is necessary to to cost of next process, until goods
transfer surplus work or excess are completely manufactured.
production.
The cost of each unit in production is The total cost for production during
separately identified
the period is specified over units
produced, as the separate identity
of units is lost due to continuous
production. This process cost per unit
represents average cost per unit for
the period.
The basis of cost collection is job order Cost is collected by period i.e., on
or batch.
time basis.
There may or may not be work-in- There is always some work in progress
progress at the end of accounting at the beginning as well as at the
period.
end of the period
Page 24
By Dinesh Makani
to

1) Example: Following information is available regarding process A for the
month of Dec. 2008
Production record
Units
Units in process on 30th November 2008 (50% complete)
10000
New units started in process during the month

20000
30000
Production report shows the following results:
Units completed
25000
Units in Process on 31dt December 2008 (80% complete)

5000
Loss in process
Nil
30000
Cost Record
Work in progress as on 1st Dec.2008:
Rs.
Material
3600
Labour
5000
Overhead
2800
Cost for December 2008:

Material
7200
Direct Labour
16000
Overhead
15200
Total Cost to be accounted for

49800
Prepare:
(a) Statement of equivalent production
(b) Statement of cost for each element.
(c) Statement of apportionment of cost.
(d) Process cost account under following circumstances:
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By Dinesh Makani

(i) When, material is introduced at the beginning of the process
(ii) When material is continuously introduced throughout the process
(iii) When material is introduced at 30% stage of processing.
(iv) When material is introduced at the end of process
2) Example: - from the following information for May 2009 relating to SV
Company Ltd.
Prepare process cost accounts for process III: Opening stock in process III
1000 units at Rs 14400
Transfer from Process II
42600 units at Rs 330800
Direct material added in Process III
Rs. 160720
Direct wages
Rs. 79240
Production Overhead
Rs. 39620
Units Scrapped
2200 units
Transferred to process IV
37800 units
Closing stock
3600 units
Degree of Completion:
Opening stock
Closing stock
scrap
Material
70%
80%
100%
Labour
50%
60%
80%
Overhead
50%
60%
80%
There was a normal loss of 5% production and units scrapped were

sold at Rs.3 each.
Page 26
By Dinesh Makani
3) Example: Product Zenu is made by three sequential process, II, III, and I.
In process III a by-product arises and after further processing in process XY,
at a cost of Rs. 2 per unit, by-product, XYZ is produced. Selling and
distribution expenses of Re.1 per unit are incurred in marketing XYZ at a
selling price of Rs.9 per unit.
Process I
Process II Process
III
Standard provided for
Normal loss in process of input, of
10%
5%
10%
Loss in process, having a scrap value, per unit, of Rs.1
Rs. 3
Rs. 4
For the month of Apr 1990 the following data are given:
Output, in units
Process I
Process II
Process III
Process XY
8800
8400
7000
420
Costs
Rs.
Direct materials:
20000
Rs.
Of Zenu
of XYZ
Rs.
Total Rs.
20000
Introduced (10000 units)

Direct Material added
6000
Direct Wages
Direct Expenses
12640
5000
4000
23200
6000
6200
41840
10000
4080
21000
14280
Budget production overhead for the month was Rs.84000

Absorption is based on a percentage of direct wages.
There are no stocks at the beginning of end of the month.
You are required, using the information given, to prepare accounts for
(a) Each process, I, I I, III;
(b) Process XY
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By Dinesh Makani
STANDARD COSTING
Def: A predetermined cost which is calculated from managements
standards of efficient operations and the relevant necessary
expenditure. They are the predetermined costs on technical estimate of
material labor and overhead for a selected period of time and for a
prescribed set of working conditions. In other words, a standard cost is a
planned cost for a unit of product or service rendered.
Advantages
Standard costing is a management control technique for every activity. It
is not only useful for cost control purposes but is also helpful in production
planning and policy formulation. It allows management by exception. In
the light of various objectives of this system, some of the advantages of
this tool are given below:
1. Efficiency measurement-- The comparison of actual costs with
standard costs enables the management to evaluate performance
of various cost centers. In the absence of standard costing system,
actual costs of different period may be compared to measure
efficiency. It is not proper to compare costs of different period
because circumstance of both the periods may be different. Still, a
decision about base period can be made with which actual
performance can be compared.
2. Finding of variance-- The performance variances are determined by
comparing actual costs with standard costs. Management is able
to spot out the place of inefficiencies. It can fix responsibility for
deviation in performance. It is possible to take corrective measures
at the earliest. A regular check on various expenditures is also
ensured by standard cost system.
3. Management by exception-- The targets of different individuals are
fixed if the performance is according to predetermined standards.
In this case, there is nothing to worry. The attention of the
management is drawn only when actual performance is less than
the budgeted performance. Management by exception means
that everybody is given a target to be achieved and management
need not supervise each and everything. The responsibilities are
fixed and every body tries to achieve his/her targets.
4. Cost control-- Every costing system aims at cost control and cost
reduction. The standards are being constantly analyzed and an
effort is made to improve efficiency. Whenever a variance occurs,
the reasons are studied and immediate corrective measures are
undertaken. The action taken in spotting weak points enables cost
control system.
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By Dinesh Makani

5. Right decisions-- It enables and provides useful information to the
management in taking important decisions. For example, the
problem created by inflating, rising prices. It can also be used to
provide incentive plans for employees etc.
6. Eliminating inefficiencies-- The setting of standards for different
elements of cost requires a detailed study of different aspects. The
standards are set differently for manufacturing, administrative and
selling expenses. Improved methods are used for setting these
standards. The determination of manufacturing expenses will
require time and motion study for labor and effective material
control devices for materials. Similar studies will be needed for
finding other expenses. All these studies will make it possible to
eliminate inefficiencies at different steps.
Limitations of Standard Costing
1. It cannot be used in those organizations where non-standard
products are produced. If the production is undertaken according
to the customer specifications, then each job will involve different
amount of expenditures.
2. The process of setting standard is a difficult task, as it requires
technical skills. The time and motion study is required to be
undertaken for this purpose. These studies require a lot of time and
money.
3. There are no inset circumstances to be considered for fixing
standards. The conditions under which standards are fixed do not
remain static. With the change in circumstances, if the standards
are not revised the same become impracticable.
4. The fixing of responsibility is not an easy task. The variances are to
be classified into controllable and uncontrollable variances.
Standard costing is applicable only for controllable variances.
After setting the standard and standard costs for various elements of cost,
the next important step is to compute variance for each element of cost.
Variance is the difference between standard cost and actual cost. In
other words it is the difference between what the cost should have been
and what is the actual cost. Element wise computation of variance is
given in the following paragraphs.
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By Dinesh Makani

A) Material Variance
Material Cost variance
Material price variance
Material usage variance
Material Mix Variance
Material yield variance
(A) MATERIAL COST VARIANCE =

(STANDARD UNIT X STANDARD PRICE) (ACTUAL UNIT X ACTUAL PRICE)
(B) MATERIAL PRICE VARIANCE =

(STANDARD PRICE ACTUAL PRICE) X ACTUAL QUANTITY
(C) MATERIAL (QUANTITY) USAGE VARIANCE =

(STANDARD QUANTITY ACTUAL QUANTITY) X STANDARD PRICE
(D) MATERIAL MIX VARIANCE =

(REVISED STANDARD QTY ACTUAL QTY) X STANDARD PRICE.
Revised Standard Qty =
Total weight of actual mix
/ Total weight of standard Mix X Std qty of material in question
(D) MATERIAL YIELD VARIANCE =

(TOTAL ACTUAL YIELD TOTAL STD YEILD) X STD YIELD RATE .
Where Std yield rate = Std cost of Std mix / Net Std output
(ii) Where actual mix differ from standard mix. The following formula is used in this situation.
Material yield variance = (Actual yield Revised std yield) X Std yield rate
Where Std yield rate = Std cost of revised Std mix / Net Std output
Page 30
By Dinesh Makani

B) LABOUR VARIANCE
Labour Cost variance
Labour Rate or price variance
Labour efficiency or usage variance
Labour Mix Variance
Idle time variance
(A) LABOUR COST VARIANCE =

(ACTUAL HOURS X ACTUAL RATE) (STANDARD HOURS X STANDARD RATE)
(B) LABOUR RATE OR PRICE VARIANCE =

(STANDARD RATE ACTUAL RATE) X ACTUAL HOURS
(C) LABOUR EFFICIENCY OR USAGE VARIANCE =

(STANDARD HOURS ACTUAL HOURS) X STANDARD RATE
(C) IDLE TIME VARIANCE =

IDLE TIME VARIANCE = IDLE HOURS X STANDARD RATE
(D) LABOUR MIX VARIANCE OR GANG COMPOSITION VARIANCE=

(LABOUR MIX VARIANCE =(REVISED STD MIX OR TIME ACTUAL MIX OR
TIME)*STD.
Revised Standard Mix or Time =
Total time of actual mix of workers / Total time of standard Mix of workers X Std time
of the respective category of workers
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By Dinesh Makani

C) OVERHEAD VARIANCE
STANDARED FIXED OVERHEAD RATE=
BUDGETED FIXED OVERHEAD / NORMAL VOLUME
STANDARED VARIABLE OVERHEAD RATE =
BUDGETED VARIABLE OVERHEAD / NORMAL VOLUME
OVERHEAD VARIANCE
Variable overhead cost variance

Variable overhead expenditure variance
variable overhead efficiency variance
fixed overhead variance
Fixed overhead expenditure variance

Fixed overhead volume variance
Fixed overhead efficiency variance
Fixed overhead capacity variance
Calendar variance
Seasonal variance
(A) VARIABLE OVERHEAD COST VARIANCE:

VARIABLE OVERHEAD COST VARIANCE = STANDERED OVERHEAD COST
RECOVERED ACTUAL OVERHEAD COST
(a) Variable overhead expenditure variance:

Based on rate per hour Variable overhead expenditure variance = (Std variable overhead absorption rate per hr
X Actual hrs worked) Actual Variable Overhead.
Based on rate per unit Variable overhead expenditure variance = (std variable overhead absorption rate per
unit - actual variable rate per unit) X Actual Output.
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By Dinesh Makani

(b) Variable overhead efficiency variance:
Variable overhead efficiency variance= (Actual Hrs Std hours for actual output) X Std
variable overhead absorption rate
Or = (Std Qty of output Actual qty of output) X Std rate per unit.
(B) FIXED OVERHEADS VARIANCE:

Fixed overheads variance= (Std Hrs for Actual output X Std fixed overhead rate) X
Actual Fixed Overheads
(a) Fixed overhead expenditure variance: = (budgeted Qty X Std fixed Oh. rate per unit)
Actual fixed Oh
= (Budgeted fixed Overheads Actual fixed
Overhead)
(b) Fixed Overheads volume variance = (Actual Qty Budgeted Qty) X Standard rate
Of fixed Oh volume variance = (std hrs for Actual production Actual hrs worked) X Std
fixed Oh rate
(c) Fixed Overheads efficiency variance = (Actual Qty of production STD Qty of
production for Actual
capacity) X Std fixed Oh absorption rate
per unit
or
(STD Hrs for Actual production Actual Hrs Worked) X Std fixed Oh rate
(d) Fixed Overheads Capacity variance = (STD Qty of production Revised budgeted
Qty of production) X Std fixed Oh rate per unit
or
(STD Hrs for Actual production Actual Hrs of the period) X Std fixed Oh rate per unit.
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By Dinesh Makani

(e) Calendar Variance = (STD Unit Revised budgeted unit) X Std fixed Oh rate per
unit
or
(Std number of working days or Hrs Possible number of working days or Hrs) X Std.
Fixed Oh rate per day or Hour.
Calendar Variance = (Budgeted Hrs Actual Hrs) X Std rate.
Page 34
By Dinesh Makani

What Is Inventory?
Inventory is defined as assets that are intended for sale, are in process of
being produced for sale or are to be used in producing goods.
Beginning Inventory + Net Purchases - Cost of Goods Sold
(COGS) = Ending Inventory
How Do We Value Inventory?
The accounting method that a company decides to use to determine the
costs of inventory can directly impact the balance sheet, income
statement and statement of cash flow
There are five basic approaches to valuing inventory
1. Standard: Under the Standard costing method approach, both

inventory and the cost of goods sold are based on the standard
fixed cost assigned to the items within the item manager at the time
of reporting.
2. First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based
upon the cost of material bought earliest in the period, while the
cost of inventory is based upon the cost of material bought later in
the year. This results in inventory being valued close to current
replacement cost. During periods of inflation, the use of FIFO will
result in the lowest estimate of cost of goods sold among the three
approaches, and the highest net income.
3. Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based
upon the cost of material bought towards the end of the period,
resulting in costs that closely approximate current costs. The
inventory, however, is valued on the basis of the cost of materials
bought earlier in the year. During periods of inflation, the use of LIFO
will result in the highest estimate of cost of goods sold among the
three approaches, and the lowest net income.
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By Dinesh Makani

4. Weighted Average: Under the weighted average approach, both
inventory and the cost of goods sold are based upon the average
cost of all units currently in stock at the time of reporting. When
inventory turns over rapidly this approach will more closely resemble
FIFO than LIFO.
5. Average: Under the average approach, both inventory and the

cost of goods sold are based upon the average cost of all units
received in stock.
If prices are rising, each of the accounting methods produces the
following results:
FIFO gives us a better indication of the value of ending inventory

(on the balance sheet), but it also increases net income because
inventory that might be several years old is used to value the cost of
goods sold. Increasing net income sounds good, but remember
that it also has the potential to increase the amount of taxes that a
company must pay.
LIFO isn't a good indicator of ending inventory value because the

left over inventory might be extremely old and, perhaps, obsolete.
This results in a valuation that is much lower than today's prices. LIFO
results in lower net income because cost of goods sold is higher.
Average cost produces results that fall somewhere between FIFO

and LIFO.
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By Dinesh Makani
BUDGET & BUDGETORY CONTROL

A budget is a plan expressed in quantitative, usually monetary term,
covering a specific period of time, usually one year. In other words a
budget is a systematic plan for the utilization of manpower and material
resources.
In a business organization, a budget represents an estimate of future costs
and revenues. Budgets may be divided into two basic classes: Capital
Budgets and Operating Budgets.
Capital budgets are directed towards proposed expenditures for new
projects and often require special financing. The operating budgets are
directed towards achieving short-term operational goals of the
organization, for instance, production or profit goals in a business firm.
Operating budgets may be sub-divided into various departmental of
functional budgets.
The main characteristics of a budget are:
1. It is prepared in advance and is derived from the long-term strategy
of the organization.
2. It relates to future period for which objectives or goals have already
been laid down.
It is expressed in quantitative form, physical or monetary units, or both.
Different types of budgets are prepared for different purposed e.g. Sales
Budget, Production Budget, Administrative Expense Budget, Raw-material
Budget etc. All these sectional budgets are afterwards integrated into a
master budget, which represents an overall plan of the organization.
ADVANTAGES OF BUDGETS
A budget helps us in the following ways:
1. It brings about efficiency and improvement in the working of the
organization.
2. It is a way of communicating the plans to various units of the
organization. By establishing the divisional, departmental, sectional
budgets, exact responsibilities are assigned. It thus minimizes the
possibilities of buck passing if the budget figures are not met.
3. It is a way or motivating managers to achieve the goals set for the
units.
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By Dinesh Makani

4. It serves as a benchmark for controlling on-going operations.
5. It helps in developing a team spirit where participation in budgeting
is encouraged.
6. It helps in reducing wastage and losses by revealing them in time for
corrective action.
7. It serves as a basis for evaluating the performance of managers.
8. It serves as a means of educating the managers.
BUDGETARY CONTROL
No system of planning can be successful without having an effective and
efficient system of control. Budgeting is closely connected with control.
The exercise of control in the organization with the help of budgets is
known as budgetary control. The process of budgetary control includes:
1. Preparation of various budgets.
2. Continuous comparison of actual performance with budgetary
performance.
3. Revision of budgets in the light of changed circumstances.
A system of budgetary control should not become rigid. There should be
enough scope of flexibility to provide for individual initiative and drive.
Budgetary control is an important device for making the organization.
More efficient on all fronts. It is an important tool for controlling costs and
achieving the overall objectives.
Budget Controller
Although the chief executive is finally responsible for the budget
programme, it is better if a large part of the supervisory responsibility is
delegated to an official designated as Budget Controller or Budget
Director. Such a person should have knowledge of the technical details of
the business and should report directly to the president or the Chief
Executive of the organization.
Fixation of the budget period
Budget period mean the period for which a budget is prepared and
employed. The budget period depends upon the nature of the business
and the control techniques. For example, a seasonal industry will budget
for each season while an industry requiring long periods to complete work
will budget for four, five or even larger number of year. However, it is
necessary of control purposes to prepare budgets both for long as well as
short periods.
Page 38
By Dinesh Makani

Budget Procedures
Having established the budget organization and fixed the budget period,
the actual work or budgetary control can be taken upon the following
pattern:
STEPS IN BUDGETARY CONTROL
1. Organization for budgeting
2. Budget manual + Theory
"A document which sets out, inter alias, the responsibilities of the persons
engaged in, the routine of and forms and records required for budgetary
control."
The budget manual is a written document or booklet that specifies the
objectives of budgeting organization and procedures. Following are some
of the important matters covered in a budget manual:
3. A statement regarding the objectives of the organization and how
they can be achieved through budgetary control.
4. A statement regarding the functions and responsibilities of each
Executive by designation both regarding preparation and
execution of budgets.
5. Procedures to be followed for obtaining the necessary approval of
budgets.
6. The authority of granting approval should be stated in explicit terms.
7. Whether one, two or more signatures are to be required on each
document
8. Should also be clearly stated.
9. Timetable for all stages of budgeting.
10. Reports, statements, forms and other records to be maintained.
11. The accounts classification to be employed. It is necessary that the
framework within which the costs, revenues and other financial
amount are classified must be identical both in accounts and the
budget departments.
There are many advantages attached to the use of budget manual. It is a
formal record defining the functions and responsibilities of each
executive.
The methods and procedures of budgetary control are standardized.
There is synchronization of the efforts of all which result in maximization of
the profits of the organization.
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By Dinesh Makani

Making a forecast
Consideration of alternative combination of forecasts:
Alternative combinations of forecasts are considered with a view to
contain the most efficient overall plan so as to maximize profits. When the
optimum -profit combination of forecasts is selected, the forecasts should
be regarded as being finalized.
Sales budget
Past sales figures and trend. The record of previous experience forms the
most reliable guide as to future sales as the past performance is related to
actual business conditions. However the other factors such as seasonal
fluctuations, growth of market, trade cycles etc., should not be lost sight
of salesmen's estimates. Salesmen are in a position to estimate the
potential demand of the customers more accurately because they come
in direct contact with the customers. However, proper discount should be
made for over-optimistic or too conservative estimates of the salesmen
depending upon their temperament.
Plant Capacity. It should be the endeavor of the business to ensure proper
utilization of plant facilities and that the sale budget provides an
economic and balanced production on the factory.
General trade prospects. The general trade prospects considerable affect
the sales. Valuable information can be gathered in this connection from
trade papers and magazines.
Orders on hand. In case of industries where production is quite a lengthy
process, orders on hand also have a considerable influence in the
amount of sales.
Proposed expansion of discontinuance of products. It is affects sales and
therefore, it should also be considered.
Seasonal fluctuations. Past experience will be the best guide in this
respect. However, efforts should be made to minimize the effects of
seasonal fluctuations by giving special concessions or off-season discounts
thus increasing the volume of sales.
Potential market. Market research should be carried out for ascertaining
the potential market, for the company's products. Such an estimate on
the basis of expected population growth, purchasing power of consumers
and buying habits of the people.
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By Dinesh Makani

Availability of material and supply. Adequate supply of raw materials and
other supplies must be ensured before drafting the sales programme.
Financial aspect. Expansion of sales usually require increase in capital
outlay also, therefore, sales budget must be kept within the bounds of
financial capacity.
Production budget
Inventory policies. Inventory standards should be predetermined as that
neither there is a shortage nor over-stocking of goods.
Sales requirements. The quantity of goods to be sold would decide to a
great extent how much is to be produced. Therefore, this budget
depends upon the sales budget.
Production stability. For reduction of costs, stability in employment and
better utilization of plant facilities, the production should be evenly
distributed throughout the year. In case of seasonal industries, since it is
not possible to have stable levels of production or inventory, an effort
should be made to have the optimum balance between the two.
Plant capacity. How much can be produced depends upon the
available plant capacity. There must be sufficent capacity to procede
the annual requirements and also to meet seasonal high demands.
5. Availability of material and labour. Adequate and timely supply of raw
material and labour should have an important effect on the planning of
production.
6. Time taken in production process. The production should commence
well in time deeping in view how much time it would take in the factory to
translate the raw materials into finished goods.
Capital Expenditure Budget

The budget provides a guidance as to the amount of capital that may be
Needed for procurement of capital assets during the budget period. The
budget is prepared after taking into account the available productive
capacitates, probable reallocation of existing assets and possible
improvement in production techniques. If necessary separte budgets may
be prepared for edach item o assets, such a building budget, a plnat and
equipment budget etc.
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By Dinesh Makani

Cash budget
The cash budget can be prepared by any of the following methods;
1. Receipts and payments method
2. The adjusted profit and loss method
3. The balance sheet method.
1. Receipts and payments method : In case of this method the cash
receipts from various sources and the cash payments to various agencies
are estimated. In the opening balance of cash , estimated cash receipts
are added and From the total, the total of estimated cash payments are
deduted to find out the closing balance.
2. The adjusted profit and loss method : In case of this method the cash
budget is prepared on the basis of opening cash and bank balances,
projected profit and loss account and the balances of the various assests
and liabilities.
3. The balance sheet methos : With the helop of budget balances at the
end except cash and bank balances, a budgeted balance sheet can be
prepared and the balancing figure would be the estimated closing cash/
bank balance.
Thus under this method, closing balances other than cash/bank will have
to be found out first to be put in the budgeted balance sheet. This can be
done by adjusting the anticipated.
Research and Development Budget
Research and development costs are to be incurred so that the products
or the methods of the concern do not become out of date. The research
and development budget is a forecast of all such expenses.
Zero-Based Budgeting ZBB
A method of budgeting in which all expenses must be justified for each new
period. Zero-based budgeting starts from a zero base and every function within
an organization are analyzed for its needs and costs. Budgets are then built
around what is needed for the upcoming period, regardless of whether the
budget is higher or lower than the previous one.
ZBB allows top-level strategic goals to be implemented into the budgeting
process by tying them to specific functional areas of the organization, where
costs can be first grouped, then measured against previous results and current
expectations.
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By Dinesh Makani

Advantages of zero-based budgeting
1.
2.
3.
4.
5.
6.
7.
8.
9.
Efficient allocation of resources, as it is based on needs and benefits.

Drives managers to find cost effective ways to improve operations.
Detects inflated budgets.
Useful for service departments where the output is difficult to identify.
Increases staff motivation by providing greater initiative and responsibility
in decision-making.
Increases communication and coordination within the organization.
Identifies and eliminates wasteful and obsolete operations.
Identifies opportunities for outsourcing.
Forces cost centers to identify their mission and their relationship to
overall goals.
Disadvantages of zero-based budgeting

1. Difficult to define decision units and decision packages, as it is timeconsuming and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D department
is threatened whereas the production department benefits.
3. Necessary to train managers. Zero-based budgeting must be clearly
understood by managers at various levels to be successfully implemented.
Difficult to administer and communicate the budgeting because more
managers are involved in the process.
4. In a large organization, the volume of forms may be so large that no one
person could read it all. Compressing the information down to a usable
size might remove critically important details.
5. Honesty of the managers must be reliable and uniform. Any manager that
exaggerates skews the results.
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By Dinesh Makani
MARGINAL COSTING AND ABSORPTION COSTING

Marginal costing is formally defined as:
The accounting system in which variable costs are charged to cost units
and the fixed costs of the period are written-off in full against the
aggregate contribution. Its special value is in decision-making.
(Terminology.)
The term contribution mentioned in the formal definition is the term given
to the difference between Sales and Marginal cost. Thus
MARGINAL COST =
VARIABLE COST DIRECT LABOUR

+
DIRECT MATERIAL
+
DIRECT EXPENSE
+
VARIABLE OVERHEADS
Marginal cost means the cost of the marginal or last unit produced. It is
also defined as the cost of one more or one less unit produced besides
existing level of production. In this connection, a unit may mean a single
commodity, a dozen, a gross or any other measure of goods.
For example, if a manufacturing firm produces X unit at a cost of 300 and
X+1 units at a cost of 320, the cost of an additional unit will be 20, which
are marginal, cost. Similarly if the production of X-1 units comes down to
280, the cost of marginal unit will be 20 (300280).
The marginal cost varies directly with the volume of production and
marginal cost per unit remains the same. It consists of prime cost, i.e. cost
of direct materials, direct labor and all variable overheads. It does not
contain any element of fixed cost, which is kept separate under marginal
cost technique.
Contribution may be defined as the profit before the recovery of fixed
costs. Thus, contribution goes toward the recovery of fixed cost and profit,
and is equal to fixed cost plus profit (C = F + P).
In case a firm neither makes profit nor suffers loss, contribution will be just
equal to fixed cost (C = F). This is known as break-even point.
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By Dinesh Makani

The concept of contribution is very useful in marginal costing. It has a fixed
relation with sales. The proportion of contribution to sales is known as P/V
ratio, which remains the same under given conditions of production and
sales.
The principles of marginal costing
The principles of marginal costing are as follows.
a. For any given period of time, fixed costs will be the same, for any
volume of sales and production (provided that the level of activity is
within the relevant range). Therefore, by selling an extra item of
product or service the following will happen.
Revenue will increase by the sales value of the item sold.
Costs will increase by the variable cost per unit.
Profit will increase by the amount of contribution earned from
the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by
the amount of contribution earned from the item.
c. Profit measurement should therefore be based on an analysis of
total contribution. Since fixed costs relate to a period of time, and
do not change with increases or decreases in sales volume, it is
misleading to charge units of sale with a share of fixed costs.
d. When a unit of product is made, the extra costs incurred in its
manufacture are the variable production costs. Fixed costs are
unaffected, and no extra fixed costs are incurred when output is
increased.
Features of Marginal Costing
The main features of marginal costing are as follows:
1. Cost
Classification
The marginal costing technique makes a sharp distinction between
variable costs and fixed costs. It is the variable cost on the basis of
which production and sales policies are designed by a firm
following the marginal costing technique.
2. Stock/Inventory
Valuation
Under marginal costing, inventory/stock for profit measurement is
valued at marginal cost. It is in sharp contrast to the total unit cost
under absorption costing method.
3. Marginal
Contribution
Marginal costing technique makes use of marginal contribution for
marking various decisions. Marginal contribution is the difference
between sales and marginal cost. It forms the basis for judging the
profitability of different products or departments.
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By Dinesh Makani

Advantages and Disadvantages of Marginal Costing Technique
Advantages
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of
varying charges per unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some
proportion of current years fixed overhead.
4. The effects of alternative sales or production policies can be more
readily available and assessed, and decisions taken would yield the
maximum return to business.
5. It eliminates large balances left in overhead control accounts which
indicate the difficulty of ascertaining an accurate overhead
recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary
allocation of fixed overhead, efforts can be concentrated on
maintaining a uniform and consistent marginal cost. It is useful to
various levels of management.
7. It helps in short-term profit planning by breakeven and profitability
analysis, both in terms of quantity and graphs. Comparative
profitability and performance between two or more products and
divisions can easily be assessed and brought to the notice of
management for decision making.
Disadvantages
1. The separation of costs into fixed and variable is difficult and
sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal
operating volume and this shows that no advantage is gained by
marginal costing.
3. Under marginal costing, stocks and work in progress are
understated. The exclusion of fixed costs from inventories affect
profit, and true and fair view of financial affairs of an organization
may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of
fluctuating output on fixed overhead. Marginal cost data becomes
unrealistic in case of highly fluctuating levels of production, e.g., in
case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on
the actuals and as such there may be under or over absorption of
the same.
6. Control affected by means of budgetary control is also accepted
by many. In order to know the net profit, we should not be satisfied
with contribution and hence, fixed overhead is also a valuable item.
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By Dinesh Makani

A system, which ignores fixed costs, is less effective since a major
portion of fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may
vary. Thus, the assumptions underlying the theory of marginal
costing sometimes becomes unrealistic. For long term profit
planning, absorption costing is the only answer.
MARGINAL COSTING PRO-FORMA
Rs
Rs
xxxxx
Sales Revenue
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost)
xxxx
Add Production Cost (Valued @ marginal cost) xxxx
Total Production Cost
xxxx
Less Closing Stock (Valued @ marginal cost)
(xxx)
Marginal Cost of Production
xxxx
Add Selling, Admin & Distribution Cost
xxxx
Marginal Cost of Sales
(xxxx)
Contribution
xxxxx
Less Fixed Cost
(xxxx)
Marginal Costing Profit
xxxxx
OBSERVATION
Sales Marginal cost = Contribution ......(1)
Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal
cost equation as follows:
Sales Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit
projection and has a wider application in managerial decision-making
problems.
The sales and marginal costs vary directly with the number of units sold or
produced. So, the difference between sales and marginal cost, i.e.
contribution, will bear a relation to sales and the ratio of contribution to
sales remains constant at all levels. This is profit volume or P/V ratio. Thus,
Page 47
By Dinesh Makani

P/V Ratio (or C/S Ratio) = Contribution (c)
Sales (s)
......(4)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)
Or, Sales = Contribution
P/V ratio
......(6)
1. Contribution
Contribution is the difference between sales and marginal or variable
costs. It contributes toward fixed cost and profit. The concept of
contribution helps in deciding breakeven point, profitability of products,
departments etc. to perform the following activities:
Selecting product mix or sales mix for profit maximization

Fixing selling prices under different circumstances such as trade
depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application

The ratio of contribution to sales is P/V ratio or C/S ratio. It is the
contribution per rupee of sales and since the fixed cost remains constant
in short term period, P/V ratio will also measure the rate of change of
profit due to change in volume of sales. The P/V ratio may be expressed
as follows:
P/V Sales Marginal cost of sales
ratio
=
Sales
Contribution
Sales
Changes in contribution
Changes in sales
Change in profit
Change in sales
A fundamental property of marginal costing system is that P/V ratio

remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio
helps in determining the following:
Breakeven point
Profit at any volume of sales
Sales volume required to earn a desired quantum of profit
Profitability of products
Processes or departments
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By Dinesh Makani

The contribution can be increased by increasing the sales price or by
reduction of variable costs. Thus, P/V ratio can be improved by the
following:
Increasing selling price

Reducing marginal costs by effectively utilizing men, machines,
materials and other services
Selling more profitable products, thereby increasing the overall P/V
ratio
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither
profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of
fundamental marginal cost equation, P/V ratio or contribution per unit.
a. Using Marginal Costing Equation
S (sales) V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S
V=F
By multiplying both the sides by S and rearranging them, one gets the
following equation:
S BEP = F.S/S-V
b. Using P/V Ratio
Contribution at BEP Fixed cost
=
P/ V ratio
P/ V ratio
Thus, if sales is 2,000, marginal cost 1,200 and fixed cost 400, then:
Sales S BEP =
Breakeven point =
400 x 2000
2000 - 1200
= 1000
P/V ratio
= 2000 1200 = 0.4 or 40%
800
So, breakeven sales = 400 / 0.4 = 1000
Similarly,
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By Dinesh Makani

c. Using Contribution per unit
Breakeven point =
4.
Margin of Safety (MOS)
Fixed cost
= 100 units or 1000
Contribution per unit
Every enterprise tries to know how much above they are from the
breakeven point. This is technically called margin of safety. It is calculated
as the difference between sales or production units at the selected
activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or
projected) and the breakeven sales. It may be expressed in monetary
terms (value) or as a number of units (volume). It can be expressed as
profit / P/V ratio. A large margin of safety indicates the soundness and
financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs,
increasing volume of sales or selling price and changing product mix, so
as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity Sales Profit at selected activity
at BEP =
P/V ratio
Margin of safety (sales) x
Margin of safety is also presented in ratio or 100 %
percentage as follows:
Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength
of a business. If it is large, there can be substantial falling of sales and yet
a profit can be made. On the other hand, if margin is small, any loss of
sales may be a serious matter. If margin of safety is unsatisfactory, possible
steps to rectify the causes of mismanagement of commercial activities as
listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to
have higher margin of safety in order to strengthen the financial
health of the business. It should be able to influence price, provided
the demand is elastic. Otherwise, the same quantity will not be sold.
b. Reducing fixed costs
c. Reducing variable costs
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By Dinesh Makani

d. Substitution of existing product(s) by more profitable lines e.
Increase in the volume of output
e. Modernization of production facilities and the introduction of the
most cost effective technology
Problem 1
A company earned a profit of 30,000 during the year 2009-10. Marginal
cost and selling price of a product are 8 and 10 per unit respectively. Find
out the margin of safety.
Solution
Margin of safety =
P/V ratio =
Profit
P/V ratio
Contribution x 100
Sales
Problem 2
A company producing a single article sells it at 10 each. The marginal cost
of production is Rs.. 6 each and fixed cost is Rs.. 400 per annum. You are
required to calculate the following:
Profits for annual sales of 1 unit, 50 units, 100 units and 400 units
P/V ratio
Breakeven sales
Sales to earn a profit of Rs.. 500
Profit at sales of Rs.. 3,000
New breakeven point if sales price is reduced by 10%
Margin of safety at sales of 400 units
Solution Marginal Cost Statement

Particulars
Amount
Units produced
1
Sales (units * 10)
10
Variable cost
6
Contribution
(sales4
VC)
Fixed cost
400
Profit (Contribution
-396
FC)
Amount
50
500
300
Amount
100
1000
600
Amount
400
4000
2400
200
400
1600
400
400
400
-200
1200
Page 51
By Dinesh Makani

Profit Volume Ratio (PVR) = Contribution/Sales x 100 = 0.4 or 40%
Breakeven sales (Rs.) = Fixed cost / PVR = 400/ 40 x 100 = 1,000
Sales at BEP = Contribution at BEP/ PVR = 100 units
Sales at profit 500
Contribution at profit 500 = Fixed cost + Profit = 900
Sales = Contribution/PVR = 900/. 4 = 2,250 (or 225 units)
Profit at sales 3,000
Contribution at sale 3,000 = Sales x P/V ratio = 3000 x 0.4 = 1,200
Profit = Contribution Fixed cost = 1200 400 = 800
New P/V ratio = 9 6/9 = 1/3
Sales at BEP = Fixed cost/PV ratio =
400
1/3
= 1,200
Margin of safety (at 400 units) = 4000-1000/4000*100

(Actual sales BEP sales/Actual sales * 100)
Page 52
75
By Dinesh Makani
DECISION MAKING
Cost accounting has long been used to help managers understand the
costs of running a business. Modern cost accounting originated during the
industrial revolution, when the complexities of running a large scale
business led to the development of systems for recording and tracking
costs to help business owners and managers make decisions.
In the early industrial age, most of the costs incurred by a business were
what modern accountants call "variable costs" because they varied
directly with the amount of production. Money was spent on labor, raw
materials, power to run a factory, etc. in direct proportion to production.
Managers could simply total the variable costs for a product and use this
as a rough guide for decision-making processes.
Some costs tend to remain the same even during busy periods, unlike
variable costs, which rise and fall with volume of work. Over time, the
importance of these "fixed costs" has become more important to
managers. Examples of fixed costs include the depreciation of plant and
equipment, and the cost of departments such as maintenance, tooling,
production control, purchasing, quality control, storage and handling,
plant supervision and engineering. In the early twentieth century, these
costs were of little importance to most businesses. However, in the twentyfirst century, these costs are often more important than the variable cost
of a product, and allocating them to a broad range of products can lead
to bad decision making. Managers must understand fixed costs in order to
make decisions about products and pricing.
For example: A company produced railway coaches and had only one
product. To make each coach, the company needed to purchase Rs.60
of raw materials and components, and pay 6 laborers Rs.40 each.
Therefore, total variable cost for each coach was Rs.300. Knowing that
making a coach required spending Rs.300, managers knew they couldn't
sell below that price without losing money on each coach. Any price
above Rs.300 became a contribution to the fixed costs of the company. If
the fixed costs were, say, Rs.1000 per month for rent, insurance and
owner's salary, the company could therefore sell 5 coaches per month for
a total of Rs.3000 (priced at Rs.600 each), or 10 coaches for a total of
Rs.4500 (priced at Rs.450 each), and make a profit of Rs.500 in both cases.
Decision making in today business is one of most difficult work of
manager. Decision making is the process to select best alternative out of
different alternative for solving business problems. A prudent cost
accountant can use different techniques of cost accounting and make it
the best tool of decision making in business.
Page 53
By Dinesh Makani
We can see most common problems in business like to fix the price of
product, to reduce the cost of product and to increase overall profitability
of business.
Cost accounting provides cost sheet, statement of material and labour
Page 54
By Dinesh Makani

utilization and some other reports like budget which can be used
immensely for comparing the standard cost. After this, businessman can
decide best price of products. We can also compile the following
information of cost accounting which can be used for business decision
making.
1. Cost Sheet
Cost Sheet is very helpful to find the cost of each unit. By comparing it
with previous year or previous month's cost sheet, manager can take the
decision regarding reducing the cost of product.
If our costs are increasing which has been shown in cost sheet , then
manager can identify the place of production or sales where company is
wasting its money. After this, manager to reduce the wastage by using
quality product techniques, to drop useless production processes and also
standardization of raw material.
2. Labour Cost Reports
Labour cost reports are helpful to reduce labour turnover and idle time
cost. In the off season, some of workers are free and doing nothing. This
time can be calculated from statement of time utilization of each worker
in production purpose and by studying its statement, manager can take
decisions to transfer some of workers to other busy departments for
effective utilization of human resources for business purposes.
3. Overhead Utilization Reports
These reports are helpful to pay only genuine overheads and distribute it
on the product according to valid basis. These reports are helpful to
calculate the correct cost of overhead and to control indirect expenses
of business.
Following are the techniques of Cost Accounting which can be used for
decision making process in business:
[*] Marginal Costing :
To solve the linear programming problems, we need to linear variables. In
marginal cost, we have two variables and both production level and
variable cost are linears. So by creating their relationship, we can decide
the production level by maximizing our profitability or minimizing our cost.
In other words, we can find equilibrium production point under marginal
costing technique.
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By Dinesh Makani

[*] Analysis of Variance :
To reduce the deviation after study the analysis of variance in cost
accounting.
[*] Cost Benefit Analysis or Break Even Point Analysis
To purchase the fixed assets at minimum cost after studying cost benefit
analysis of cost accounting. We can also use this tool for production
purposes also. We can check the level of production where total cost is
equal to total revenue and this level will be break even point. We must
produce up to this level for securing our business from losses. So,
it indicates our business to decide best.
[*] Activity Base Costing
In ABC costing we calculate the each unit's total cost on the basis of
different activities. It reduce indirect cost after assigning it on product
directly.
Eventually, cost accounting is helpful to check each and every point of
business where money is misusing and due to this our cost is increasing. By
reducing this cost, cost accounting is helpful to increase the return on
investment.
Page 56
By Dinesh Makani

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Cost and management Accounting MHRDM-MIM - JBIMS

COST: MEANING AND ITS ELEMENTS

Cost and management Accounting MHRDM-MIM - JBIMS

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Closing stock of material

Rent of hire of a special machine for production 5,000

Direct Material: Material Consumed

Material available for consumption

Direct Labour: Wages

Direct Expenses: Rent of hire a special machine

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Salary of a factory manager

Repair and Depreciation on Machine

Direct Material: Material Consumed

Direct Labour: Productive wages

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Salary of a factory Manager

Repair and Depreciation on Machine

TOTAL COST AND COST SHEET

Office and administration overheads

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Direct Material: Material Consumed

Direct Labour: Productive wages

Office and administration overheads

Cost of goods sold

Closing stock of finished goods

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Office and administration overheads

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Opening stock of finished goods

Closing stock of finished goods

Selling and distribution overheads

Total cost of production

Add: Opening stock of finished goods

Less Closing stock of finished goods

Cost of Goods sold

Selling and distribution overheads

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS

Add: Opening Stock of Raw material

Less: Closing Stock of Raw Material

Direct Material consumed

B. Direct Labour (Wages)

Add: Opening Stock of Work-in-Progress

Less: Closing Stock of Work-in-Progress

G. Office and administration overheads

H. Total Cost of Production (F + G)

Add: Opening Stock of finished Goods

Less: Closing Stock of finished Goods

I. Cost of production of goods Sold or cost of good sold

J. Selling and Distribution Overheads

K. Total Cost (I + J) = Cost of Sales

Preparation of cost sheet

Private & Confidential

Cost and management Accounting MHRDM-MIM - JBIMS