Cost Accounting ( Unit -1)

1. What do you mean by cost accounting? Describe the objectives, advantages and limitation of cost
accounting?
Cost accounting examines the cost structure of a business. Cost accounting is mostly concerned with developing an
understanding of where a company earns and loses money, and providing input into decisions to generate profits in the
future.
Cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for three
major purposes: (in) Operational planning and control ;( ii) Special decision; and (iii) Product decision. -Charles T.
Horngren
Chartered Institute Of Management Accountants Costing is the technique and process of ascertaining cost
Cost management describes the approaches and activities of managers in short-run and long-run planning and control
decisions. These decisions increase value of customers and lower costs of products and services Cost management is an
integral part of a companys strategy
Cost accounting process begins with the recording of income and expenditure or the bases on which they are calculated
and ends with the preparation of periodical statements and reports for the purpose of ascending and controlling costs.
COST, COST ACCOUNTING & COST ACCOUNTANCY-:
1. Cost: It is a sacrificed resource to obtain something, costing is a process of determining costs. Cost is commonly
defined as anything which is measurable in terms of money. For example, cost of preparing one pizza which in itself
include various other costs like cost of flour, other ingredients, labor, electricity and other overheads. Just the same
way, cost of production of any product or service can be determined from cost.
2. Cost Accounting: Cost accounting is that part of accounting which is helpful to calculate the cost. In cost
accounting, we deeply study the variable cost, fixed cost, overheads and capital cost. Cost accounting involves
analyzing relevant costing data, interpret it and present various management problems to management. It deals with
classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or
services, the relation of these costs to sales values, and the ascertainment of profitability.
3. Cost Accountancy: It is the application of costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of
information derived there from for purposes of managerial decision making. Thus, cost accountancy is the science, art
and practice of a cost accountant.
It is science because it is a body of systematic knowledge having certain principles which a cost accountant should
possess for proper discharge of his responsibilities. It is an art as it requires the ability and skill with which a cost
accountant is able to apply the principles of cost accountancy to various managerial problems.
OBJECTIVES OF COST ACCOUNTING
Cost accounting aims at systematic recording of expenses and analysis of the same so as to ascertain the cost of each
product manufactured or service rendered by an organization. Information regarding cost of each product or service would
enable the management to know where to economize on costs, how to fix prices, how to maximize profits and so on.
Thus, the main objectives of cost accounting are the following.
1. To analyze and classify all expenditure with reference to the cost of product and operations.
2. To arrive at the cost of production of every unit, job, operation, process, department or service and to develop cost
standard.
3. To indicate to the management any inefficiencies and the extent of various forms of waste, whether of materials, time,
expenses or in the use of machinery, equipment and tools. Analysis of the causes of unsatisfactory results may
indicate remedial measures.
4. To provide data for periodical profit and loss accounts and balance sheets at such intervals, e.g. weekly, monthly or
quarterly as may be desired by the management during the financial year, not only for the whole business but also by
departments or individual products.
5. To reveal sources of economies in production having regard to methods, types of equipment, design, output and
layout. Daily, Weekly, Monthly or Quarterly information may be necessary to ensure prompt constructive action.
6. To provide actual figures of costs for comparison with estimates and to serve as a guide for future estimates or
quotations and to assist the management in their price fixing policy.
7. To show, where Standard Costs are prepared, what the cost of production ought to be and with which the actual costs
which are eventually recorded may be compared.
8. To present comparative cost data for different periods and various volume of output and to provide guidance in the
development of business. This is also helpful in budgetary control.
9. To record the relative production results of each unit of plant and machinery in use as a basis for examining its
efficiency. A comparison with the performance of other types of machines may suggest the necessity for replacement.
10. To provide a perpetual inventory of stores and other materials so that interim Profit and Loss Account and Balance
Sheet can be prepared without stock taking and checks on stores and adjustments are made at frequent intervals.

Also to provide the basis for production planning and for avoiding unnecessary wastages or losses of materials and
stores.
ADVANTAGES OF COST ACCOUNTING
1. Fixation of selling price: Generally cost regulates selling price. Cost Accounting determines actual or calculated cost
of production. Adding a margin of profit to the cost, price can be fixed.
2. Preparing estimates:" Cost Accounting accumulates statistical information regarding manufacture and sale. All
expenditure in the factory, office and] sales department can be known in advance and it is possible to make reasonable
estimates for preparing quotations and submitting tenders.
3. Evaluating profitability: The preparation of schedules of comparative cost of different jobs under different conditions of
manufacture is facilitated to detect the profitable method of manufacture. It also reveals unprofitable methods of
manufacture with their causes and remedial measures.
4. Establishes standard: Statistical data regarding cost and income help management to fix standard for different items of
cost and income and to detect variances, if any, for corrections.
5. Controlling and reducing cost: Cost Accounting reveals expenses contributing towards production cost. It also
detects weaknesses of the organization and checks wasteful expenditure of material and labour due to inefficient
workmanship and management.
6. Ascertainment of importance: It helps in ascertaining the degree of importance each element of cost has in the total
cost of production and the scope for economy in operation.
7. Control over financial records: Cost Accounting helps to locate the exact cause of decrease or increase in profit or
loss, reflected by financial accounting to exercise control over them.
8. Inventory Control: It has an efficient store accounting system for effective check on inventories - material, work in
progress, finished goods, stores and spares.
9. Comparison: Installation of uniform costing system helps management to make inter-firm and intra-firm comparison on
various aspects of operation.
10.Aid to Government: It provides data to government for price control, wage fixation and settlement of labour disputes.
11. Decisions and Policies: Cost Accounting provides facts and figures for formulating policy and taking decisions on the
matters like: a. Level of output: Quantity to be produced, b. Make or buy requisite material and assets, c. Acceptance of
special order, c. Replacement of labour with machinery, d. Introduction of new product, e. Replacement or
modernization of old equipment, f. Shut down or continue production during depression,
DISADVANTAGES OF COST ACCOUNTING
1. Based on estimates: Indirect costs are not charged fully to a product or process. It is charged to all the products and
processes on the basis of estimates. Actual cost varies from estimated cost. Due to these limitations, all cost
accounting results are taken as mere estimates.
2. Lack of uniformity: Procedures of cost accounting followed by different organizations are different for different
products. There is no uniformity. There is also possibility of difference in pricing material issues for production. All
these lead to different cost results for the same operation.
3. Many conventions: There are many conventions for classification of costs, pricing of material issues, apportionment
of indirect costs, adoption of marginal or standard cost, etc. These create difficulty in determining the exact cost,
because no one type of cost is suitable for all. Purposes and in all circumstances.
4. Expensive: Cost accounting is expensive. It involves lots of clerical won for maintaining various costing records for
different purposes. For medium and small size concern, the benefit derived from costing system may not justify the
cost involved.
5. Result requires reconciliation: Information and results provided b; financial accounting and cost accounting may be
different for the as activity. This requires reconciliation to find out correctness of the two before taking any decision.
6. Dependent: It is not an independent system of accounting. It depends on other accounting systems.
7. Does not include all items of expense and income: Items of purely financial nature such as interest, financial
charges, discount and loss on issue of shares and debentures, etc. are not taken into consideration in Cost
Accounting.

2. Distinguish between Financial Accounting & Cost Accounting?

Point of Differences

Financial Accounting

Cost Accounting

Recoding of transactions is part of

financial accounting. We make
financial statements through these
transactions. With the help of
financial statements, we analyze
the profitability and financial
position of a company.
Purpose of the financial statement
is to show correct financial
position of the organization.
Estimation in recording of
financial transactions is not used.
It is based on actual transactions
only.

Cost accounting is used to calculate

cost of the product and also helpful in
controlling cost. In cost accounting,
we study about variable costs, fixed
costs, semi-fixed costs, overheads and
capital cost.

Meaning

Purpose

Recording

Controlling

Correctness of transaction is
important without taking care of
cost control.

Period

Period of reporting of financial

accounting is at the end of
financial year.

Reporting

Fixation of Selling
Price

Relative Efficiency

Valuation of Inventory

10 Process
11 Analysis of Profit:

In financial accounting, costs are

recorded broadly.
Fixation of selling price is not an
objective of financial accounting.
Relative efficiency of workers,
plant, and machinery cannot be
determined under it.
Valuation basis is cost or market
price whichever is less
Journal entries, ledger accounts,
trial balance, and financial
statements
Financial Accounting reveals the
profit and loss of the business as a
whole at the end of a trading
period, usually a year.
The total results, at the end of
certain period, as reported by the
financial accountant will not be of
much help to the management for
control and various other purposes

To calculate cost of each unit of

product on the basis of which we can
take accurate decisions.
In cost accounting, we book actual
transactions and compare it with the
estimation. Hence costing is based on
the estimation of cost as well as on the
recording of actual transactions.
Cost accounting done with the
purpose of control over cost with the
help of costing tools like standard
costing and budgetary control.
Reporting under cost accounting is
done as per the requirement of
management or as-and-when-required
basis.
In cost accounting, minute reporting
of cost is done per-unit wise.
Cost accounting provides sufficient
information, which is helpful in
determining selling price.
Valuable information about efficiency
is provided by cost accountant.
Cost accounting always considers the
cost price of inventories.
Cost of sale of product(s), addition of
margin and determination of selling
price of the product.
Cost Accounting discloses the result
of each operation, process and
product.
while the cost accountant reveals the
profit and loss as and when the job or
process is completed which helps the
management in taking prompt and
effective measures.

3.What do you mean by installation of costing system? What are factors need to be considered before installing a
cost accounting system? Explain the practical difficulties involved in installing such a system in a manufacturing
concern?

Installation of cost system

The cost accounting system depends upon the nature of business and the product manufactured. Before a suitable system
of cost accounting is installed it is necessary to undertake a preliminary investigation so as to know the feasibility of
installing cost accounting system to such business. While introducing a system of cost accounts it should be borne in mind
that cost accounting system must suit the business.
There should not be any attempt to make the business suit the system. This means the system must be simple and it must
lead to savings through the control of materials, labour and overheads when compared to expenses incurred in maintaining
it. For the successful functioning of the costing system, the following conditions are essential:
a. There must be an efficient system of material control.
b. A sound and well designed method of wage payment must be set up.
c. The existence of sound basis for collection of all indirect expenses and a basis for its apportionment to various
production departments.
d. The integration of cost and financial accounts to facilitate reconciliation of profit as shown by these two systems of
accounts.
e. The use of printed forms so as to facilitate quick compilation of cost reports.
f. The duties and responsibilities of cost accountant must be made clear.
Factors Considered Before Installing A Cost Accounting System
The following factors are to be considered before installing a cost accounting system:
A. History of business unit: The history of a business unit implies the duration of its existence, position in the industry,
the rate of growth, policy and philosophy of management and the like. The history of business unit serves as the basis
for designing the cost accounts in respect of necessity, simplicity, and investment involved in installing cost accounts.
B. Nature of the industry: The nature of business such as manufacturing, mining, trading, etc. determines the costing
techniques to be applied. Similarly, the type of product manufactured also determines the method of costing that is to
be employed. In other words, there is no all purpose technique and method of costing that can be applied universally.
C. Product range: The range of products manufactured and sold also determines the method of costing to be selected.
Accordingly range of products must be analysed in terms of size, models, fashions, area of market, competitors and
whether the products are made to customers specification or for stocking and selling.
D. Technical considerations : Technical considerations that influence the installation of cost accounts are as follows :
Size and layout of the factory, The existence of production and service departments
Flow of production, Capacity of machines and degree of mechanization
Existence of laboratories, Internal transport and material handling equipments
Production control techniques, Inspection and testing of materials and finished goods.
E. Organizational factors: The problem of installing cost accounting is somewhat difficult in case of an existing
business when compared to new business. However, the existing set up of the organization should be least disturbed
should the need arise. In order to fix up responsibility to the executives it may be necessary to group the departments.
The organizational factors to be considered are: (a) size and the type of organization such as line, line and staff,
functional and committee organization, (b) the levels of management, viz., top level, middle level and bottom level
management, (c) extent of delegation and responsibility, (d) extent of centralization and decentralization, (e) extent of
departmentation, (f) availability of modern office equipments, and (g) number of managerial and supervisory staff.
F. Selling and distribution method : The chief factors to be considered with regard to distribution process are the
warehousing facilities, external transport, market research and other promotional measures, terms of sale and
procurement of orders from customers.
G. Accounting aspects: The factors to be considered in respect of accounting are : (a) number of financial records, (b)
existing forms, (c) registers used, and (d) number of copies required.
H. Area of control to be exercised: The areas where cost control is to be exercised is to be identified so that each
manager may take action relevant to his activities. If material control occupies significant area of control, it must be
given topmost priority for exercising control over materials.
I. Reporting: The cost accounting system to be installed must ensure frequency and promptitude in reporting cost data
to all levels of management. It must also to be pointed out that duplication of reporting is to be avoided. Further, only
those information which are relevant for the management in a particular context alone should be reported.

J. Uniformity: The practice of adopting uniform costing facilitates inter-firm comparison among various firms
belonging to the same industry. Further it also has the benefit of adopting common costing practice if a holding
company has number of subsidiaries.
K. Use of electronic data processing : In modern days it has become a common practice to use electronic data
processing equipments and computers. In this situation it is essential to ensure that the equipment meets the needs of
the system but not the other way round.
L. Practical considerations: The cost accounting system to be installed must be flexible in operation and must be
capable of adaptation to changing conditions. The system must be periodically scrutinised so as to make necessary
changes owing to development in business.
PRACTICAL DIFFICULTIES IN INSTALLING COST ACCOUNTING
In addition to the above problems, a cost accountant will encounter the following practical difficulties at the time of
installation of cost accounting system:

a. Lack of support from management: Wherever costing system is installed. It is essential to seek the support of
various departmental managers. Very often the managers show hostile attitude towards the costing system. They feel
that this system will interfere in their routine work and probably as a means of checking their efficiency. Under such
circumstances it is better to convince them about the utility of costing system for the business as a whole.
b. Resistance by existing accounting staff: Very often the existing accounting staff resist the installation of the cost
accounting system on two grounds. Firstly, they feel that the new system of accounting might lead to excess work.
Secondly, they are afraid of their job security. But this difficulty may be overcome by encouraging them about the
usefulness of cost accounting as a supplement to financial accounts and the generation of more employment
opportunities from the installation of cost accounting system.
c. Non-cooperation from middle and bottom level management: At times the middle and bottom level managers
such as foremen, supervisors and inspectors also fail to extend their wholehearted cooperation fearing additional
work which may be entrusted to them. This problem may be overcome by suggesting them about the simplicity of
the system and the existence of a separate cost accounting department to look after costing matters. However, they
may be required to provide necessary reports concerning their area of activity so as to enable functioning of cost
accounting department efficiently.
d. Lack of trained staff: This was no doubt a problem in olden days. Today this problem is overcome, thanks to the
establishment of The Institute of Cost and Works Accountant of India in our country which offers professional course
in costing and also offers training facilities through various companies to the candidates undergoing the course. In
spite of this facility, it is somewhat difficult to get the competent and experienced staff at the time of installation.
This problem can be overcome by paying attractive salaries to the cost accountants.
e. Heavy expenses in installing and maintaining the system: The setting up of a separate costing department with
staff often poses a problem. In addition to installation, the operating expenses in the form of printing and stationery,
heating and lighting, depreciation and insurance, rent and rates are to be incurred. However, as was mentioned
earlier, the system of cost accounting must be a useful investment, i.e., benefits derived from it must be more than the
investment made on it. If this is not possible, for the time being the system must be discarded.
4. Explain the steps involve in installation of cost accounting systems?
Steps Involved in The Installation Of cost accounting systems
The steps involved in the installation of a cost accounting system are as follows:
1.Determination of objectives: The costing system will be simple if the objective is only to determine cost. It
will have to be elaborate if the objective is to have information which will help the management in
exercising control and taking decisions.
2.studying the existing organization and routine practice: The various matters to be considered in this regard
are the nature of the business, the various operations carried on, extent of responsibility and authority attached to
the various functionaries, the lay-out of the factory with particular reference to the manufacturing department, the
methods of dealing with wastage of materials, the system of time recording and the methods of computing and
paying wages, the system of issuing orders for production to the factory and the method of treating fixed, semivariable and variable overheads.
3.Deciding the structure of cost accounts: This refers to deciding the system of costing based on a thorough
study of the manufacturing process and their ancillary services. The structure of cost accounting should follow

the natural production line. The sequence can be simple, analytical or synthetic. The designing of the system
should be such that there is gradual build up of the cost at each significant stage of production as the product
proceeds to c o m p l e t i o n .
4.Determining the cost rates: This entails a thorough study of factory conditions, classification of cost into direct
and indirect, grouping of indirect costs into production, selling, administration etc., treatment of wastes of all
kinds, methods of pricing issues, methods of recovering overheads and calculation of overheads rates. A
complete cost accounting code should be drawn up so that expenditure may be quickly classified in the office as
to both source and c a u s e .
5.Introducing the system: No costing system can be expected to function effectively unless cooperation of
all the officials could be obtained. Before the system is put into effect, the implications of the system should
be explained to all indicating to them the benefits that will accrue to each and to the business as a whole.
However, instead of introducing the complete system, it should be introduced only by stages and the
existing routines and practices should be utilized unless, there are good grounds to supersede them.
6.Organizing the cost office: It is always better that the cost office is situated adjacent to the factory so that delay
in routing out documents or in clearing up discrepancies and doubts is avoided. The costing staff must be allowed
to perform their duties properly. The size of staff would depend on the volume of work involved. The duties of
cost office fall into the following spheres.
Stores accounts.Posting of materials, receipts and stores issues in stores ledgers, preparing material
abstracts.
Labour accounting. Evaluation of time sheets, jobs cards etc., preparing labour abstracts. In some cases
preparation of actual pay rolls.
Cost accounts. Posting of all cost accounts, whether job or process or service accounts.
Cost control. Posting cost control accounts from data supplied from sections (a) and (b) above. Preparation
of special statistical and other information for management for carrying out special investigation and
preparation of periodical trading statements.
7. Relationship of cost office to other department: The cost department should function independently. The cost
accountant being made directly responsible to the General Manager or Managing Director. The costing system
should be designed to serve management at all levels. The cost accountant, therefore, should design his whole
system of records and reports; with this end in view. He must know and understand the problems faced in the
process of production and try to translate them into financial implications so that correct decisions may be
taken.
8. Authority and responsibility should be clearly defined-: if the costing system is to be successful then authority
and reasonability need to be cleared in all respect. Costing systems should be perfect so that it will helps in the
preparation of cost of sales , valuation of inventories , helps in control and management of a company, helps in
measuring the efficiency of 3 Ms ( men, materials and machines).
5. Explain the various methods and techniques of costing?
The general fundamental principles of ascertaining costs are the same in every system of cost accounting, but the methods
of analysis and presenting the costs vary from industry to industry. Different methods are used because business
enterprises vary in their nature and in the type of products or services they produce or render. Basically, there are two
principal methods of costing, namely (i) Job Costing, and (ii) Process costing.
1.
Job costing: It refers to a system of costing in which costs are ascertained in terms of specific jobs or orders
which are not comparable with each other. Industries where this method of costing is generally applied are Printing
Process, Automobile Garages, Repair Shops, Shipbuilding, House building, Engine and Machine construction, etc.
Job Costing includes the following methods of costing:
(a)Contract Costing: Although contract costing does not differ in principle from job costing, it is convenient to treat
contract cost accounts separately. The term is usually applied to the costing method adopted where large scale
contracts at different sites are carried out, as in the case of building construction.
(b)Bach Costing: This method is also a type of job costing. A batch of similar products is regarded as one job and the
cost of this complete batch is ascertained. It is then used to determine the unit cost of the articles produced. It
should, however, be noted that the articles produced should not lose their identity in manufacturing operations.
(c) Terminal Costing: This method is also a type of job costing. This method emphasizes the essential nature of job
costing, ie, the cost can be properly terminated at some point and related to a particular job.

(d)Operation Costing: This method is adopted when it is desired to ascertain the cost of carrying out an operation in
a department, for example, welding. For large undertaking, it is frequently necessary to ascertain the cost of
various operations.
2.
Process Costing: Where a product passes through distinct stages or processes, the output of one process being the
input of the subsequent process, it is frequently desired to ascertain the cost of each stage or process of production.
This is known as process costing. This method is used where it is difficult to trace the item of prime cost to a
particular order because its identity is lost in volume of continuous production. Process costing is generally adopted in
textile industries, chemical industries, oil refineries, soap manufacturing, paper manufacturing, tanneries, etc.
3.
Unit or single or output or single output costing: This method is used where a single article is produced or
service is rendered by continuous manufacturing activity. The cost of the whole production cycle is ascertained as a
process or series of processes and the cost per unit is arrived at by dividing the total cost by the number of units
produced. The unit of costing is chosen according to the nature of the product. Cost statements or cost sheets are
prepared under which various items of expenses are classified and the total expenditure is divided by total quantity
produced in order to arrive at unit cost of production. This method is suitable in industries like brick-making,
collieries, flour mills, cement manufacturing, etc. this method is useful for the assembly department in a factory
producing a mechanical article e.g. Bicycle.
4.
Operating Costing: This method is applicable where services are rendered rather than goods produced. The
procedure is same as in the case of single output costing. The total expenses of the operation are divided by the units
and cost per unit of services is arrived at. This method is employed in Railways, Road Transport, Water supply
undertakings, Telephone services, Electricity companies, Hospital services, Municipal services, etc.
5.
Multiple or Complete Costing: Some products are so complex that no single system of costing is applicable. It is
used where there are a variety of components separately produced and subsequently assembled in a complex
production. Total cost is ascertained by computing component costs which are collected by job or process costing and
then aggregating the costs through use of the single or output costing system. This method is applicable to
manufacturing concerns producing Motor Cars, Aeroplanes, Machine tools, Type-writers, Radios, Cycles, Sewing
Machines, etc.
6.
Uniform Costing: It is not a distinct method of costing by itself. It is the name given to a common system of
costing followed by a number of firms in the same industry. This helps in comparing performance of one firm with
other.
7.
Departmental Costing: When costs are ascertained department by department, the method is called
Departmental Costing. Usually, for ascertaining the cost of various goods or services produced by the department,
the total costs will have to be analyzed, say, by the use of job costing or unit costing. In addition to the above methods
of costing, mention can be made of the following techniques of costing which can be applied to any one of the above
method of costing for special purposes of cost control and policy making: a) Standard or Predetermined Costs. b)
Marginal Costs
TECHNIQUES-: For ascertaining cost, following techniques of costing are usually used:a) Uniform Costing: The practice in which common methods of costing for different undertakings in the same industry
are used is known as uniform costing.
b) Historical Costing: In this technique, ascertainment of cost is done after they have been incurred but the utility of
this technique is limited.
c) Direct Costing: The practice of charging all direct costs to operations, processes or products leaving all indirect
costs to be written off against profits in which they arise are called as direct costing.
d) Absorption Costing: In this all costs, both variable and fixed are charged to production, operations or processes.
e) Marginal Costing: The method of ascertaining marginal cost by differentiating between fixed and variable costs.
This technique is used to ascertain effect of changes in volume or type of output over the profits.
f) Standard Costing: The preparation of standard costs and applying them to measure the variations from actual cost
and analyzing the causes of variations with a view to maintain maximum efficiency in production is known as
standard costing.
g) Activity Based Costing: ABC is a system that focuses on activities as fundamental cost objects and utilizes the cost
of these activities as building blocks or compiling the costs of other cost objects.

UNIT-2
1.

What are the objective of inventory control / material control? Explain the methods and techniques of inventory control
systems?

Material control / inventory control is a systematic control over purchasing, storing and consumption of materials, so as
to maintain a regular and timely supply of materials, at the same time, avoiding overstocking.
Material control refers to the management function concerned with acquisition, storage, handling and use of materials so
as to minimize wastage and losses, derive maximum economy and establish responsibility for various operations through
physical checks, record keeping, accounting and other devices.
Thus material control is the proper control of material which reduces the cost of production, minimizing the investment of
fund in the purchases of material & increases the profitability of the organization.
ESSENTIALS OF MATERIAL CONTROL
The basic objective of material control is to obtain requisite quantity of material at right price, right quantity, and right
quality and from right source. The detailed objectives of material control are as follows:
1. Regular supply of material: Material control ensures regular supply of material to the factory so the production may
not be held up for want of material.
2. No possibility of overstocking and under stocking: By fixing various stock level as minimum level, maximum level
ordering level over stocking and under stocking of material can be avoided.
3. Minimum Wastage: Proper material management and control reduces wastages of material. Poor stores facilities
result deterioration, obsolescence, pilferage, theft, fire, evaporation etc. which directly affect the profitability of the
organization
4. Getting material at reasonable prices: While purchasing materials, it is seen that it is purchased at reasonable low
prices but the quality is not to be sacrificed in the plan of low prices.
5. Availability of up-to-date information: Up-to-dated and readily material information can be made available to the
management, for planning and decision making. The store keeper can supply information because he keeps up-todated record of the every item of the store under proper system of material control.
6. Adoption of internal check system: Internal check system is the part of material control. Under this system the
employees perform their work on rotational basis by which misappropriation of material is minimized.
7. To enable uninterrupted production: The main object of material control is to ensure smooth and unrestricted
production. Production stoppages and production delays cause substantial loss to a concern.
8. To ensure requisite quality of materials: The quality of finished products depends mainly on the quality of raw
materials used. If quality of the raw materials is not up to desired standards, the end product will not be of desired
quality which affects the sale of the product in the market resulting in loss of profits as well as goodwill of the
concern. It is of vital importance to exercise strict control and supervision over the purchases, storage and handling of
materials.
METHODS AND TECHNIQUES OF INVENTORY CONTROL SYSTEMS
Inventory consists of stock of raw materials, work-in-progress, spare pa consumables for production and finished goods
for sale. Thus, inventory com includes control over raw materials, spare parts, consumables, partly finished goods, and
finished goods. The following are the common techniques of inventory control:
1. Determination of various levels of materials
2. Economic Order Quantity
3. ABC Analysis
4. Perpetual Inventory System
1. DETERMINATION OF VARIOUS LEVELS OF MATERIALS-: The store-keeper plays an important role in
deciding upon the various levels materials. In order to ensure that the optimum quantity of materials is purchased
stocked neither less nor more, the store keeper applies scientific techniques of material management. Fixing of certain
levels for each item of materials in one of techniques.These levels are not permanent but require revision according to
the change in the factors which determine these levels. The following levels are generally fixed.

a) Re-order Level

b) Maximum Level

c)

Minimum Level

d) Average Level

a)

b)

c)

d)

e)

2.

Danger Level
Re-order Level: This level is that level of material at which it is necessary to initiate purchase requisition for fresh
supplies. This is normally the point lying between the maximum and the minimum levels. Fresh orders must be placed
before the actual stocks touch the minimum level.
This level is fixed in such a manner that the quantity of materials represented by the difference between the re-order
level and the minimum level will be sufficient to meet the requirement of production till such time as the order
materialises and materials are delivered. The following factors are taken into account for fixing the Re-order level:
Rate of consumption of material, Lead time, i.e., time required to receive the delivery of fresh purchase. Re-order
quantity, Minimum level.
Re-order level can be calculated by applying the following formula:
Re-order level = Minimum level + consumption during period required to get fresh delivery
Another formula for Re-order level is:
Re-order level = Maximum consumption x Maximum Re-order Period
Example 1-: Calculate Re-order level for a material from the following information: Minimum level - 1,000 units
Maximum level - 6,000 units Time required to get fresh delivery - 15 days. Daily consumption of the material - 100
units.
Solution: Re-order level = Minimum Level + Consumption during the period required to get fresh delivery= 1,000
units + (100 x 15) = 2,500 units.
Example 2-: Calculate Re-order Level from the following particulars: Minimum consumption - 80 units' Maximum
consumption - 120 units Re-order period - 10-12 days
Solution: Re-order Level = Maximum consumption x maximum Re-order period = 120 units x 12 = 1,440 units
Maximum Level: The maximum level is that level of stock which can be held at any time. In other words, it is the
level beyond which stock should not be maintained. The purpose is to avoid over-stocking and thereby using working
capital in a proper way. This level is fixed after taking into account the following factors: Rate of consumption, Lead
time, Availability of capital, Storage capacity, Cost of maintaining stores including insurance cost, Nature of
commodity, Possibility of price fluctuation, Possibility of change in fashion, habit, etc., Restrictions imposed by
Govt., local authority or trade associations, Re-order level it, Re-order quantity.
Maximum level can be calculated by applying the following formula:Maximum Level = Re-order level + Reorder Quantity - (Minimum consumption x Minimum Re-order period)
Minimum Level: This is the level below which the stock of an item should not fall. This is known as safety or buffer
stock. An enterprise must maintain minimum quantity of stock so that the production is not hampered due to non
availability of materials. This level is fixed after considering the following factors: Re-order level, Lead time, Rate
of consumption.
The formula for calculating minimum level is: Minimum level = Re-order level - (Normal consumption x Normal
Re-order period)
Average Level: Average level can be calculated by applying the following formula:
Maximum level + Minimum level Average level = ---------------------------------------------- - Or Average level =
Minimum level + of Re-order Quantity.
Danger Level: Usually stock should not be lower than the minimum level. But if for any reason, stock comes down
below the minimum level, it is called danger level. When the stock reaches danger level, it is necessary to take urgent
action on the part of the management for immediate replenishment of stock to prevent stock-out situation. The danger
level can be calculated by applying the following formula:Danger Level = Average consumption x Maximum Reorder period for emergency purchases.
ECONOMIC ORDER QUANTITY (EOQ)
The economic order quantity, known as EOQ, represents the most favorable quantity to be ordered each time fresh
e)

orders are placed. The quantity to be ordered is called economic order quantity because the purchase of this size of
material is most economical. It is helpful to determine in advance as to how much should one buy when the stock
level reaches the re-order level. If large quantities arc purchased, the carrying costs would be large.
On the other hand, if small quantities are purchased at frequent intervals the ordering costs would be high. The
economic order quantity is fixed at such a level as to minimize the cost of ordering and carrying the stock. It is the
size of the order which produces the lowest cost of material ordered.

While determining the economic order quantity, the following three cost factors are taken into consideration: (i) The
cost of the material ii) The inventory carrying cost iii) The ordering cost
Carrying costs are the costs of holding the inventory in the stores. These are:
Rent for the storage space. 2. Salaries and wages of the employees engaged in store keeping department. 3. Loss due
to pilferage and deterioration. 4. Insurance charges. 5. Stationery used in the stores .6. Loss of interest on the capital
locked up in materials.
Ordering costs are the costs of placing orders for the purchase of materials. These are:
Salaries and wages of the employees engaged in purchasing department., Stationary, postage, telephone
expenses, etc. of the purchasing department., Depreciation on equipments and furniture used by the
purchasing department.. Rent for the space used by the purchasing department.
Determination of Economic Order Quantity:
The economic order quantity is determined by using the following formula:

Assumptions in the Calculation of Economic Order Quantity:

1. Quantity of the item to be consumed during a particular period is known with certainty.
2. The pattern of consumption of material is constant and uniform throughout the period.
3. Cost per unit is constant and known and quantity discount is not involved.
4. Ordering cost and carrying cost are known and they are fixed per unit and will remain constant throughout the period.
3. ABC Analysis

ABC analysis is a type of analysis of material dividing in three groups called A-group items, B-Group items
and C-group items For the purpose of exercising control over materials. Manufacturing concerns find it
useful to divide materials into three categories. ABC is said to connote Always Better Control. The
basis of analyzing the annual consumption cost (or usage cost) goes after the principle
MANY,

VITAL FEW TRIVIAL

and the criterion used here is the money spent and not the quantity consumed. The following Exhibit

brings out clearly the concept of ABC Analysis. An analysis of the annual consumption of materials of any
organization would indicate that a handful of top high value items (less than 10 per cent of the total number)
will account for a substantial portion of about 70 per cent of total consumption value.

10% of total number of items carries 70% of value. - "A" group items
Similarly, a large number bottom items (over 70 per cent of the total number of items) account for only
about 10 percent of the consumption value.
70% of total number of items accounts for only about 10% of consumption value - "C"-group items.
Between these two extremes will fall those items the percentage number of which is more or less equal to
their consumption value.
20% of total number of items accounts for only about 20% consumption value - "B" group items.
Items in the top category are treated as "A" category items. Items in the bottom category are called as "C"
category items and the items that lie between the top and the bottom are called "B" category items. Such an
analysis of materials is known as ABC analysis or Proportional parts value analysis. On the basis of physical
quantities and value of arterials used, the following table illustrates the above classification:
After the items of materials are classified into A, B and C category, control can be
exercised in a selective manner as follows:
1. Greater care and strict control should be exercised on the items of category 'A' as any loss or breakage or wastage
of any item of this category many prove to be very costly. Economic order quantity and re-order level should be
carefully fixed for such category of items.
2. Moderate and relaxed control is required for the items of category 'B'.
3. There is not much need for exercising control over the items of category 'C' Periodic or annual verification is
required for this category of materials.
4. PERPETUAL INVENTORY
Perpetual inventory as a system of records maintained by the controlling department, which reflects the physical
movements of stocks and their current balance. Bin cards and the stores ledger help the management in maintaining this
system as they make a record of the physical movements of the stock on the receipts and issues of the materials and also
reflect the balance in the stores.
Thus, it is a system of ascertaining balance after every receipt and issue of materials through stock records to facilitate
regular checking and to avoid closing down the firm for stocktaking.
The following are the advantages of the perpetual inventory system:
1.

It avoids the disruption of production for physical checking of all items of stores at the end of the year.

2.

The preparation of Profit and Loss Account and Balance Sheet is possible without physical verification of stock.

3.

A detailed and more reliable control on the materials in store is obtained.

4.

As the work of recording and continuous stocktaking is carried out systematically and without undue haste, the figures
are more reliable.

5.

Continuous stocktaking will make the storekeeper and the stores accountant more vigilant in their work and they will
try to keep the records accurate and up-to-date.

6.

Planning of production can be done without any fear of shortage as the management is constantly informed of the
stores position.

Q 2. Discuss

different methods of pricing of issue of material?

Material price usually refers to the price quoted and accepted in the purchase orders. Materials are issued from
the stores to work orders based on the material requisition. But stock of materials consists of different
consignment received at different dates and prices with varying discounts, taxes etc. Because of this the
problem arises as to how the material issues to production are to be valued, there are several methods for tackle
this situation. The cost accountant should select the proper method based on following factors:
1. The frequency of purchases, price fluctuations and its range.
2. The frequency of issue of materials, relative quantity etc.
3. Nature of cost accounting system.
4. The nature of business and type of production process.
5. Management policy relating to valuation of closing stock.
Several methods of pricing material issues have been evolved in an attempt to suitably answer the problem.
A. Actual Price Method (or) Cost Price Method-: (1) First In First Out (FIFO). (2) Last In First Out (LIFO).
(3) Specific Price Method. (4) Base Stock Method. (5) Highest in First out (HIFO).
B. Average Cost Method-: (1) Simple Average Method. (2) Weighted Average Method. (3) Periodic Simple
Average Method. (4) Periodic Weighted Average Method.
C. Standard Price Method
D. Inflated Price Method.
E. Market Price Method (or) Replacement Price Method.
1. First in First out Method (FIFO): It is a method of pricing the issues of materials. Under this method,
the materials first received in the store are the first issued. In other words, the order in which the materials
are received in the store are first issued at their cost price in the same order or the items longest in stock are
issued first. Thus each issue of material only recovers the purchase price which does not reflect the current
market price.
This method is considered suitable in times of failing price because the material cost charged to production
will be high while the replacement cost of materials will be low. But in the case of rising prices, if this
method is adopted, the charge to production will be low as compared to the replacement cost of materials (as
in the current period) in future without having additional capital resources.
The advantages and disadvantages of the method may be stated as follows:
Advantages-:
a) It is simple to understand and simple to operate.
b) Material cost charged to production represents actual cost with which the cost of production should have
been charged.
c) In the case of falling prices, the use of this method gives better results.
d) Closing stock of material will be represented very closely at current market price.
e) The old material is issued first. Thus, there remains no possibility of loss of material due to spoilage or
obsolescence.
Disadvantages:
a) If the price fluctuates frequently, this method may lead to clerical error.
b) Since each issues of material to production is related to a specific purchase price, the cost charged to the
same job are likely to show a variation from period to period.
c) In the case of rising prices, the real profits of the concern being low, they may be inadequate to meet the
concerns demand to purchase raw materials at the ruling price.
2. Last in First out Method (LIFO): It is a method of pricing the issues of materials. This method is
based on the assumption that the items of the last batch (lot) purchased are the first to be issued. Therefore,
under this method the price of the last batch (lot) is used for pricing the issues, until it is exhausted, and so
on. If however, the quantity of issue is more than the quantity of the latest lot than earlier (lot) and its price
will also be taken into consideration.
During inflationary period or period of rising prices, the use of LIFO would help to ensure that the cost of
production determined on the above basis is approximately the current one. This method is also useful

specially when there is a feeling that due to the use of FIFO or average methods, the profits shown and tax
paid are too high.
The advantages and disadvantages of LIFO method are as follows:
Advantages:
1. The cost of materials issued will be either nearer to and or will reflect the current market price. nThus,
the cost of goods produced will be related to the trend of the market price of materials. Such a trend in
price of materials enables the matching of cost of production with current sales revenues.
2. The use of the method during the period of rising prices does not reflect undue high profit in the income
statement as it was under the FIFO or average method. In fact, the profit shown here is relatively lower
because the cost of production taken into accounts the rising trend of material prices.
3. In the case of falling prices profit tends to raise due to lower material cost, yet the finished products
appear to be more competitive and are at market price.
4. Over a period, the use of LIFO helps to level out the fluctuations in profits.
5. In the period of inflation LIFO will tend to show the correct profit and thus avoid paying undue taxes to
some extent.
Disadvantages:
1. Calculation under LIFO system becomes complicated and burdensome when frequent purchases are
made at highly fluctuating rates.
2. Costs of different similar batches of production carried on at the same time may differ a great deal.
3. In time of falling prices, there will be need for writing off stock value considerably to stick to the
principle of stock valuation, i.e., the cost or the market price whichever is lower.
4. This method of valuation of material is not acceptable to the income tax authorities.
5. The closing stock is priced at a very old price which does not show the correct position of the business.
3. Simple Average Price Method: Under this method, materials issued are valued at average price, which is
calculated by dividing the total of all units rate by the
number of unit rate.
This method is useful under the following circumstances:
1. When the materials are received in uniform lots of
similar quantity, otherwise, it will give wrong results.
2. When purchase prices do not fluctuate considerably.
Advantage:
1. It is simple to understand and easy to operate.
2. The method is a mixed form of market price and cost price.
3. Due to calculation of average of different purchase prices, the tendency of equality in different rates is
arrived at.
Disadvantage:
1. Materials issue cost does not represent actual cost price. Since the materials are issued at a price
obtained by averaging cost prices, a profit or loss may arise from such type of pricing.
2. In case the prices of material fluctuate considerably, this method will give incorrect results.
3. The prices of materials issues used are determined by averaging prices of purchases without giving
consideration to the quantity. Such a price determination is unscientific.
4. It becomes difficult to calculate the average again and again.

4. Weighted Average Price Method: This method gives due weights to quantities purchased and the
purchase price, while, and determining the issue price. The average issue price here is calculated by
dividing the total cost of materials in the stock by total quantity of materials prior to each issue.

The advantages and disadvantages of this method are:

Advantages:
1. It smoothens the price fluctuations if at all it is there due to material purchases.
2. Issue prices need not be calculated for each issue unless new lot of materials is received.
3. This method is scientific and argumentative because under this method, the total cost of the material
available in the bin is provided by the total quantity of material. In fact, after reaching the bin, the new
and old material mix up, i.e., there remains no separate existence in the bin, of the material separately
purchased on the different dates.
4. As regards calculation work, this method is simple because the issue price once calculated continues till
the new material is purchased.
5. This method is a mixed form of market price and cost price.
6. In this method, the balance of the closing stock is shown at appropriate price which can be used in
financial accounts also.
Disadvantage:
1. Material cost does not represent actual cost price and therefore, a profit or loss will arise out of such a
pricing method.
2. If the material is purchased again and again at short intervals, the calculation work increases.
3. As the material is issued at average price, the production cost cannot be correctly estimated.