Notes on Cost and Cost Accounting - B Com PDF Download

1. Notes on Cost and Cost Accounting:

Aspects of Cost:

Costs may be ascertained:

(i) Historically; i.e. after they have been incurred; or

(ii) By predetermined standards combined with subsequent analysis of variances between these standards, and the actual cost incurred; and

(iii) By the use of marginal methods of presentation for either (a) or (b), involving the differentiation between “fixed” and “variable” costs.

In the light of the above definitions we may define Cost Accounting as a process or mechanism by means of which costs of products and services are ascertained with a reasonable degree of accuracy. In a broader view, cost accounting is concerned with the field of responsibility for advising the management in both historical and future costs and, thereby, helping managerial planning, control and decision making.

It provides the management with a variety of information to plan, control and make decisions. The following table gives us the examples of the information provided by a typical costing system and how it is used for different purposes by the management.

The examples provided by the table are not exhaustive. In practice, much more informa­tion is produced and used. The usefulness of costing information is enhanced when the actual results and costs are compared with some target or standard figure.

Need for Cost Accounting:

The following are the purposes of Cost Accounting:

(i) Submission of quotations and tenders: To provide information with the supply of cost data upon which estimates and tenders are based. It provides the scope for price adjustment to meet market conditions, so as to ensure that no orders for supply of products are lost.

(ii) Management tool for identifying and controlling efficiency: It is used as a management tool to indicate to the management inefficiencies of various departments, plants and machinery. The management—through cost analysis—can identify the weak areas of operations and can take proper and prompt action and, thus, can lead the business unit to its desired goal.

(iii) Preparation of budgets and standard costs: It provides data to the management for the preparation of budgets and standard costs. An analysis of variances between budgeted figures and actuals or standard and actuals throw light on the weak areas of business operations and guides the management in taking corrective action to remove the unfavorable cost variances.

(iv) Preparation of Financial Statements: It is used to provide data for the preparation of periodical Profit and Loss Account and Balance Sheet at such intervals as may be desired. It also provides a perpetual inventory of stores and other materials, so that interim financial statements can be prepared without stock taking.

So, an important objective of cost accounting is the creation of useful cost data and information for the purpose of planning and control. They influence and facilitate both short— and long-run decisions.

Cost accounting provides for a basis for operating policies like:

(a) Determination of cost-volume-profit relationship,

(b) Whether it would be economical to buy certain articles or components from outside,

(c) Whether to replace the existing plant and machinery, or

(d) Whether to continue the business or to shut it down.

Thus, there is a direct relationship between information needs of management, cost accounting objectives, and techniques and tools used for the analysis.

Financial Accounting and Cost Accounting:

Financial Accounting is concerned with historical cost. It consists of recording, classifi­cation (ledger) and analysis of the business transactions in a subjective manner. It presents income statements showing the financial result of the business for a particular financial year and a Balance Sheet on a specific date to exhibit the state of affairs of a business unit.

It fails to throw light on the aspects of planning, control and decision making. For these purposes, we need Cost Accounting. To achieve the above objectives Cost Accounting records business expenditures in an objective manner, i.e. according to the purpose for which costs are incurred.

 Cost Accounting and Management:

Cost Accounting provides useful data to management for taking managerial decisions in the following areas:

(i) Establishing business unit’s profit goal;

(ii) Determining departmental goals;

(iii) Measuring and controlling business performance with the help of budgetary control;

(iv) Making decisions about improvements and adjustments in the operation of the business for achieving predetermined business objectives; and

(v) To coordinate the entire organisational efforts and tasks.

In doing so, cost accounting performs the following tasks:

(a) Cost Accounting helps in determination and analysis of costs and income of a business unit. This facilitates comparison of costs of one period with those relating to a different period in order to evaluate the operating efficiency of each division or segment or product.

Control of Materials:

(b) It helps management in controlling cost. In every type of cost accounting, materials and supplies are accounted for—in terms of departments and processes. A rational and scientific system of receiving, handling and issuing materials is strictly observed. The perpetual inventory method is used to control properly the materials in stores. Control of raw materials and of parts follows production until goods are completed.

Control of Wages and Salaries:

Labour cost is controlled through proper accounting for labour by jobs and by operations. In many manufacturing concerns, daily summary reports are prepared to show the number of hours and wage rate for each worker, per job or operation.

In cost accounting, costs are classified into direct and indirect items, indirect costs are generally termed as overheads. Overheads are further classified as controllable and uncontrol­lable items. This classification allows the cost accountant to concentrate his attention on those costs which can be reduced or eliminated.

(c) Curtailment of losses due to seasonal conditions:

In many industries higher costs and lower profits arise due to seasonal changes in activities. The cost accountant may make an attempt to alleviate the situation by presenting figures showing costs and losses that result from irregular employment of labour, plant and machinery.

The cost reports can exhibit the idle time of workers and machinery, cost of storing raw materials and finished products, unabsorbed overhead costs and general decay in the morale of personnel that result from subnormal operations. The use of budgetary control combined with cost accounting may go a long way to bring about stability in industrial activity which will ultimately benefit the shareholders, employers and the society at large.

(d) Cost Accounting and expansion policy:

Every business unit has to face national and international changes that occur frequently due to changes in governments’ political and economic policies. These changes have consid­erable effect on costs. Moreover, the management has to adopt policies to face the ever growing competition, to develop new markets for its products. The cost accountant is required to investigate and to prepare reports to keep the management abreast of the relative advantages and profitability of one policy as compared to others.

(e) Budgeting:

Participation of cost accounting in the formulation and execution of budgets and standards:

Cost information for managerial decision making and planning is the most important justification of a sound cost accounting system.

The following diagram shows the accounting cycle by which information reaches the decision makers:

The use of budget helps the management to correct inefficiencies. It helps to identify the weak areas by making a comparative study of estimated figures with the actuals. Variances are studied carefully and corrective measures are taken in time to avoid wastage and losses.

We may now conclude that cost accounting is so closely linked with management that it becomes difficult to indicate where the work of the cost accountant ends and managerial control begins. In brief, it may be said that:

“Cost accounting is to serve management in the execution of policies and in the comparison of actual and estimated results in order that the value of each policy may be appraised and changed to meet future conditions” –Blocker.

2. Notes on Management Accountancy in Relation to Cost:

The American Accounting Associations’ (AAA’s) Committee on Management Accounting has defined Management Accounting “as the application of appropriate techniques and concepts in processing the historical and projected economic data of an entity to assist management in establishing plans for reasonable economic objectives and in the making of rational decisions with a view towards achieving these objectives. It includes the methods and concepts necessary for effective planning for choosing among alternative business actions and for control through the evaluation and interpretation of performance. Its study involves consideration of ways in which accounting information may be accumulated, synthesized, analyzed and presented in relation to specific problems, decisions and day to day tasks of business management”.

Management Accounting embraces both Financial and Cost Accounting. Management Accounting emphasizes the preparation of reports of an organisation, for its internal users such as Board of Directors, Managing Director and for other top level management for the formulation of business policies.

Thus, management accounting reports attempt to fill the information needs of managers with respect to a specific problem, situation, or decision.

Management Accounting is generally indistinguishable from Cost Accounting. They are closely linked as both of them use common basic data and reports. Cost Accounting largely uses data about production, sales, wages, overheads. Management Accounting uses the same data to prepare budgets, performance reports, control reports for making decisions in different areas.

Gray and Ricketts establish the relationship of Management Accounting with Cost Accounting in the following language:

“The historical data on labour cost might be used to estimate the labour cost for the coming year, to determine the size of work-force needed to meet anticipated production requirements and to estimate the cash requirements to meet weekly pay rolls. This represents the use of cost accounting data to develop managerial accounting data for planning decisions.”

The historical data on labour costs might be compared with the estimated labour costs to determine if labour is being used effectively and efficiently. This represents the use of cost accounting data to develop managerial accounting data for control decisions.

There is an intimate relationship between Cost Accounting and Management Accounting. Management Accounting communicates various information useful to the management for making decisions for the efficient running of the business.

For this purpose, management accounting uses various techniques which include standard costing, marginal costing, uniform costing, budgetary control, break even and cost benefit analysis. In fact, management accounting is an extension of the managerial aspects of cost accounting; it utilizes the principles and practices of both cost accounting and financial accounting in the best interests of the business.

Financial Accounting determines the financial results for a period and the state of affairs on the last day of the period. From this point of view financial accounting may be treated as Stewardship Accounting. Cost Accounting, on the other hand, generates information for controlling operations with a view to maximising efficiency and profit.

So, it may be termed as Control Accounting. Since Management Accounting communicates necessary information to the management for efficient running of the business, it is known as Decision Accounting.

3. Notes on Prerequisites of Costing System:

(i) Determination of objectives:

The objectives for which the costing system is installed are to be determined. In fact, if the objectives are not predetermined and well defined, the costing system will fail to accomplish the desired goal.

(ii) Size layout and nature of the business:

A close study of the size, layout and nature of the business is very much essential to design the costing system. The choice of method of costing largely depends upon the nature of the business.

(iii) Production stages:

Every costing system should follow the production stages because the cost at each stage of production is to be determined. The costing system should be designed in a way so that it can determine the cost at each significant stage.

(iv) Organizational structure of the business:

The organizational set up of the business is to be closely studied. The methods of purchase, receipt of materials, issue and storage of materials should be examined and changes, if required, are to be made so that these departments can feed the costing department with the supply of accurate cost data. The maximum amount of required information should flow to the system.

(v) Easy, simple, economical and flexible:

The system to be introduced should be simple and easy to operate. For this, form and records of original entry should be designed in such a way as to minimise clerical work and expenditure. The cost of the system to be installed should be considered. It should be kept in mind that the installation and operation of the system should be economic.

(vi) Coordination and cooperation:

Various departments that are involved in the system should be well coordinated so that they can function harmoniously and with a sense of cooperation to make the system effective. The benefits that accrue from the system should be explained to various persons concerned and the sense of awareness should be created.

(vii) Cost Control:

The system should be so designed that cost control can effectively be exercised.

(viii) Communication of information:

The costing system should incorporate a suitable procedure for communicating required information with promptness to the various levels of management for making appropriate decisions.

(ix) Interlocking of financial and cost accounts:

The cost and financial accounts could be interlocked into a single integral accounting system. If, that is done, the results of separate sets of accounts could be reconciled by means of control accounts for accuracy.

4. Notes on Classification of Methods of Costing:

A. Classification of Methods on the Basis of Manufacturing Process:

(a) Job Costing:

This is a method of costing by which the cost of a definite job, or of a specific order or a batch of finished products is determined. This method of costing is applied in those business concerns where production is carried out as per specific order.

Under this method, costs are collected and recorded under a specific production order. When an order is received, production control allots a number to it. In job costing all costs of direct materials, direct labour and other direct expenses are directly charged to the specific job or product.

Job cost sheets are used for the accumulation of job costs. The job cost sheets serve a control function. This method is very much popular in enterprises engaged in house building, ship building, production of machinery and repairs. Batch costing, contract costing and composite costing are the other variations of job costing.

(i) Batch Costing:

Batch costing refers to that method of costing which determines the cost of a group of identical products. This method is applied to general engineering factories which produce components in economical batches for subsequent assembly. Batch costing can conveniently be applied to companies engaged in manufacturing radios, televisions, watches, cars, electronic goods, medicines, biscuits, confectionery, etc.

(ii) Contract Costing:

This method of costing is based on the principle of job costing. A specific contract becomes the cost unit. A particular contract is treated as a whole job and the cost of the contract is ascertained. It is also known as Terminal Costing since the job cost is completed with the completion of the work. Contract costing is used in building and civil engineering works, ship building and aircraft manufacture.

(iii) Composite Costing or Multiple Costing:

Under this method of costing, costs for each component or each group of components to be assembled into a final product are ascertained separately. Industries which manufacture radios, televisions, motor car, aircraft, etc. make use of this method of costing.

(b) Process Costing:

Process costing is a system which applies costs to like products that are mass produced in continuous fashion through a series of production steps known as processes. The finished goods of earlier processes become the raw materials of the latte processes.

Costs are identified for each process and charged to that process. Cost of each process is ascertained separately. Chemical industries, oil refineries, gas and electricity generating concerns, textiles, paints, flour, food processing, paper, mining and cement industries etc. make use of this system of costing. Other variations of process costing are: operating cost, operation cost and single or output cost.

(i) Operation Cost:

The cost unit is the ‘operation’ instead of the process. This system is used by the manufacturing concern where methods of production consist of a number of distinct opera­tions. The per unit cost is arrived at the end of each accounting period by dividing the cost of an operation by the number of units completed in the operation centre.

(ii) Operating Cost:

Operating cost is used for finding out the cost of the appropriate cost unit for a particular service. It is used by those organisations which render services such as transport, power house, schools, catering, hospitals, boiler houses etc.

(iii) Single or Output Cost:

This method is employed where production is uniform and consists of a single product or two or three types of similar products. The per unit cost is obtained by dividing the total cost by the total number of units manufactured.

B. Classification on the Basis of Time:

(a) Historical Cost:

These costs represent the cost of actual operational performance. It is a method of costing under which costs are determined after they have been incurred. Historical costs are ‘post-mortem’ costs. Historical data are considered for predicting estimated costs of the alternative actions under consideration.

By making comparisons, one of these alternative actions is selected and the decision is translated into action. So, in a decision-making process, historical costs play an important role.

(b) Predetermined Cost:

(i) Standard Costing:

It is a technique where standard costs are prepared in advance and used. Standard costs are fixed on the historical data. After the production, actuals are compared with the standard costs and variances are identified.

Once the variances are determined, the management finds out the reasons for such variances for taking remedial measures. So, it is a tool in the hands of the management to control cost and ensures accountability, as also efficiency in the use of factors of production. It is an extension of budgetary control. This system of costing is useful in repetitive industries and jobbing industries.

I.C.M.A.’s definition of standard costing summarizes its concept and purposes:

“A pre-determined calculation of how much costs should be under specified working conditions.

It is built up from an assessment of the value of cost elements and correlates technical specifications and the qualification of materials, labour and other costs to the prices and/or wage rates expected to apply during the period in which the standard cost is expected to be used.

Its main purposes are to provide bases for control through variance accounting, for the valuation of stocks and work-in-progress, and in some cases, for fixing selling prices”.

C. Classification for Making Managerial Decisions:

(a) Marginal Costing:

In marginal costing, costs are classified into fixed and variable costs. The fundamental approach of marginal costing is to relate variable costs to cost units; while fixed costs are attributed to the business in general. Variable costs are charged to production; fixed costs will be written off in full in the period to which they are attributable.

Marginal costing assumes that the excess of sale price over variable cost contributes to a fund which will cover the fixed costs and provide the undertaking’s profit. In other words, fixed overhead is not allocated to cost units.

(b) Uniform Costing:

Uniform costing is not a system of costing. This system refers to a system used by several undertakings. They use the same costing principles or practices to enable them to enjoy benefits of a uniform system. This method of costing is useful to make inter-firm comparisons.

(c) Opportunity Costs:

These costs refer to costs which result from the use of material, labour and other facilities, in a particular manner and which have been discarded in favour of an alternative use. In other words, the benefit from resources which has been foregone for not being used in the manner originally planned.

So, opportunity cost is the foregone benefit which might have been drawn from the resources had they been used in an alternative manner.

For example, a saving of Rs.50,000 may earn an interest of Rs.6,000 if deposited with a bank for two years or more. Now, this amount is invested in a business for earning profit. Here, the opportunity cost will be the amount of interest, i.e. Rs.6,000 which has been foregone for its alternative use.

(d) Replacement Costs:

This cost refers to the cost of replacement of an asset at current market price. Suppose, the written down value of a particular machine is Rs.30,000. If the machine is bought at current market price, it would cost, say, Rs.35,000. So, the amount of Rs.35,000 is the replacement cost of the machine. In replacement cost, the current market price of an asset or materials is considered but not its original cost or written down cost.

(e) Imputed Costs:

These are notional costs. They do not involve cash outlay. From this point of view, it is similar to opportunity cost. These costs are computed only for the purpose of decision making. They are also used for evaluating the performance of profit centres.

Chart showing the method of costing applicable to industry:

5. Notes on Material Control in Cost Accounting:

Objectives of Material Control:

A good system of material control should have the following objectives:

(i) Supply of the desired quality and quantity shall be ensured for efficient and uninterrupted production.

(ii) Materials should be purchased in economic quantities to enjoy the benefits of economic purchases.

(iii) Materials are to be properly stored to preserve quality and quantity arid to avoid pilferage and obsolescence.

(iv) The investment in materials shall be maintained at lowest level to avoid unnecessary blockage of working capital.

(v) Purchase of materials must be made at the most favourable prices under the best possible terms.

(vi) Issues of materials should be properly authorised and accounted for.

(vii) Materials received should be properly inspected to test the quality of materials.

(viii) Payment should be made only when .payment vouchers have been properly passed by authorised officer.

(ix) Payment should be made for those materials which have been received after proper inspection.

Importance of Material Control:

In an effective cost accounting system there must be a proper system for the control of material from the time an order is placed until the material is issued to production.

Since materials represent an important asset and is the largest single item of cost in almost every manufacturing concern, the success or failure of a concern may depend largely upon efficient materials purchasing, storage, utilisation and proper accounting.

Where materials are not systematically controlled, excess stocks of some items are likely to occur as a result of which unnecessary tying up of capital and loss through obsolescence and deterioration take place. Further more, haphazard buying and lack of control of materials is bound to result in the purchase of material of too good or too poor a quality for the purpose for which it is intended.

An efficient buyer makes a valuable contribution to the success of a business by ordering the right quality and quantity of material at the most favourable price and by ensuring the continuous flow of materials to the production departments.

Efficient material control cuts out losses and forms of wastes. So, incoming materials should be checked against orders to ensure that the correct quantity and quality have been received. Theft, breakage, deterioration, and the use of excessive floor space can be reduced to a minimum by proper controls.

Finally, the most important thing to the cost accountant is that, it is impossible to produce reliable costing information system if the records of material issues are unsatisfactory. So, an efficient purchase officer should know when to purchase, how much to purchase, where to purchase.

Therefore, effective material control is very important in order to:

(i) Provide better quality of goods to the customers at reasonable price by elimi­nating wastage and by reducing cost,

(ii) Produce goods at the maximum efficiency,

(iii) Manage inventories to control investment in inventories,

(iv) Avoid abnormal wastage by exercising direct control, and

(v) Avoid over-stocking of materials by making proper planning of materials and fixation of levels well in advance. The stock should be maintained at such a level so that materials can be supplied to production departments as and when they require. It is also to be seen that working capital is not blocked unnecessarily in stock of materials.

Essentials of Materials Control:

The essentials of materials control from the costing viewpoint can be summarised as follows:

(i) Materials of appropriate quality and specification should be purchased.

(ii) The suppliers of materials chosen should represent an appropriate balance between quality, price and delivery.

(iii) Materials should be properly inspected and received.

(iv) Appropriate storage facilities should be provided to preserve the quality of materials.

(v) There must exist co-ordination and co-operation between the various depart­ments like Purchase, Inspection, Storage, Accounts and Cost.

(vi) Efficient purchase organisation.

(vii) The documentation, accounting systems and controls at each stage should be well designed and effective.

(viii) Planning of requirement of materials is to be done very carefully.

(ix) Well organised system of reporting to management regarding materials pur­chase, storage, utilization, returns, spoilage, defective goods, obsolete stocks and inventory balances should be introduced.

(x) Direct materials used in production should be charged to production on an appropriate and consistent pricing basis.

(xi) Stock taking must be well organised to ensure that sufficient quantities of stock on hand are available when required.

(xii) There must be efficient system of internal checks and internal audit.

Materials control consists of controls at two levels:

(i) Quantity controls and

(ii) Financial controls.

The production department in a manufacturing organisation aims at quantity controls while the finance department aims at keeping the investment on materials at the lowest point. So, in materials control an equilibrium has to be maintained between the two opposite needs.

In the opinion of A. Matz, O. J. Curry and George W. Frank— “A basic objective of good materials control is to be able to place an order at right time from the right source to acquire the right quantity at the right price and quality”.

Inefficient materials control results in loss through misuse, and waste of resources may be caused by many factors like buying the wrong articles, buying materials of inadequate quality, buying too much, buying too little.

Financial loss results from materials stolen, pilfered, spoilage and damage to materials before use, scrap and spoilage during use. All these lead to Ineffective employment of working capital. An inadequate system of material control proves to be costly to the business firm and reduces competitiveness in the market because of high cost of the product.

Advantages of Material Control:

The following are the advantages of material control:

(i) Efficient material control eliminates wastages in course of purchases, storage handling and production;

(ii) It ensures continuous flow of materials for use in production;

(iii) It also facilitates preparation of accurate monthly or periodical statement required for management information;’

(iv) Reduces, to the minimum the working capital locked up in various inventories;

(v) Reduces the risk of fraud and theft; and

(vi) Provides for accountability on the part of those who are involved in the process of material management.

Procedure of Material Control:

In brief, the materials controls procedures include:

(i) Purchasing, Receipt, Storage and issue, Inventory control and associated costing procedures.

(ii) The purchasing function is of paramount importance which aims at buying proper type o materials at competitive price. It aims for an appropriate balance of price, quality and delivery.

(iii) The purchase requisition giving precise details of quantity required, specification, delivery etc. initiates the main purchasing procedures.

(iv) The purchasing procedures consist of search for Supplier, Selection of Supplier, placing of order to the selected supplier and expediting the deliveries.

(v) Goods supplied must be properly received. Before taking delivery of goods they should be verified with reference to Purchase Order, inspected and to be entered in Goods Received Note (GRN).

(vi) The G.R.N. is an acknowledgement of goods received and is used for making payment to supplier.

(vii) Store keeping involves receipt and issue of materials, preservation of materials and storage space organization.

(viii) Materials should be issued to production departments on the basis of Materials Requisition to be issued by a responsible authority of the production department concerned.

(ix) Ideal stock level should be maintained by the stores so that replenishment of stock can take place at an appropriate time. It should see that the production departments do not suffer from dearth of materials.

(x) Stock taking is carried out on a periodic or continuous basis. Continuous stock taking is essential for perpetual inventory systems.

6. Notes on Departments Involved in Controlling Labour Cost:

A. Personnel Department:

Most firms of any size have a Personnel Department which has responsibility for numerous tasks involving labour. The tasks include:

(i) Advertising, recruiting and engaging labour.

(ii) Discharge, transfer and administration of and appraisal of schemes.

(iii) Industrial relations and negotiations with unions to settle industrial disputes.

(iv) Staff development, training and educational schemes including day release, apprenticeships and courses.

(v) Execute the policies, regarding appointment, promotion, wage and incentive systems etc.

(vi) Communication of information to the management on such matters as absenteeism, lateness, labour turnover, normal and overtime worked.

(vii) Welfare, sports and social facilities, safety and medical facilities.

(viii) Manpower planning and forecasting.

In brief, the personnel department has the responsibility to provide an efficient labour-force which is cost effective and to keep labour turnover to a minimum.

B. Engineering Department:

This department helps to maintain control over working conditions, production methods, job performance. It is also responsible for maintaining safety and efficient working conditions. It has to initiate and supervise research and development (R & D) and to make method study, motion study and time study.

Making job evaluation, merit rating and job analysis are the important functions of the Engineering Department.

This department should aim at improving labour efficiency or productivity, thereby cutting down the effective labour cost. The Engineer­ing Department maintains control over working conditions and production methods for each job or process by performing the above functions.

C. Time-Keeping Department:

The function of this department is to maintain the exact time for which each worker has worked.

Proper time-keeping in labour costing and control is very important because of the following reasons:

(a) It accumulates the total number of hours worked by each worker so that his total periodical earnings can be computed.

(b) Absence of proper time-keeping arrangement is sure to create frustration among sincere and punctual employees. This situation will adversely affect the morale of employees resulting in low productivity and production and increased costs.

(c) Certain retirement benefits like pension, gratuity, leave with pay,, provident fund and salary are linked with continuity of service of employees. Attendance records can be immensely helpful and useful in the determination of various retirement benefits and other fringe benefits.

(d) Time-keeping is of paramount importance in the task of apportionment of overhead costs on the basis of labour hours.

(e) Time-keeping records are also useful for analysis purposes.

Time Recording for Piece Worker:

Time recording for workers who are paid on piece rate basis is essential for the following reasons:

(i) Time recording is necessary to ensure discipline in the factory.

(ii) When the workers are guaranteed minimum wages, time recording becomes neces­sary to ascertain the time spent by the workers irrespective of their individual output.

(iii) Time recording is important because it facilitates the preparation of pay roll as a whole and calculation of dearness allowance.

(iv) In fixing up differential wage rates, time recording becomes essential.

(v) Time recording also facilitates the apportionment of overheads on the basis of labour hours.

Objects of Time-keeping:

The main objectives of time keeping function are:

(i) To maintain workers’ activity records to meet statutory requirements;

(ii) To maintain basic data required for the preparation of payroll;

(iii) To generate statistical data to ascertain productivity of labour and to control labour cost;

(iv) To find out the labour cost and to control labour cost;

(iv) To find out the labour cost of a job or product or service;

(v) To maintain discipline in attendance; provide;

(vi) To nationalize basis of overhead distribution in various situations;

(vii) To calculate overhead cost of a job.

D. Payroll Department:

The tasks of preparing pay rolls are complicated as some specified amounts like income tax, professional tax, cooperative loan, contribution to P.F., employees’ contribution to E.S.I, etc. are withheld from the earnings of employees.

There are three major problems that involve the preparation of payrolls:

(a) Allocating labour costs to products, departments;

(b) Accurate computation of earnings and prompt payment to individual employees; and

(c)Computing and remitting withholdings to proper authorities like government, local authority etc. From the view-point of employees, promptness of payments and pinpoint accuracy are the foremost criteria for judging the merits of any payroll system.

The functions of a payroll department is an intermediary function between the time­keeping and the cost accounting departments.

The main functions of pay roll department are:

(i) To compute employees’ wages accurately;

(ii) To make prompt payment to employees;

(iii) To compute the deductions to be made from employee’s earnings under different heads and to remit them to the appropriate authority in time, for example, income tax, professional tax, E.S.I, etc. ;

(iv) To compile labour statistics for management to formulate labour policy;

(v) To maintain a permanent pay roll record for each employee;

(vi) To maintain a record of job classification, department and wage rate for each employee;

(vii) To verify and summarise the time of each worker as shown on the daily time cards.

Payment of Wages:

Due care should be taken for payment of wages to employees to ensure proper payment i.e. right amount to the right persons. In order to maintain a-control to safeguard the payroll against the inclusion of ghost workers or the names of those employees who have already left their jobs, the paymaster should require the identity of each employee at the time of payment of wages by one of the following:

(i) Personal identification by foreman or authority of the department;

(ii) Identification card or badge;

(iii) Signed receipt for comparison with a personal signature on file in the personnel department.

Preparation of Pay Roll:

The preparation of pay roll is the responsibility of the pay roll accounting department. Wages for each worker is calculated in wage sheet or pay roll.

The following documents are used to prepare the pay roll of the workers:

(i) Time cards

(ii) Piece-work cards, and

(iii) Job cards.

Care should be taken at the time of preparing pay roll to avoid errors and frauds. It is to be seen that no wage bill has been drawn in the names of dummy workers.

E. Cost Accounting Department:

This department is responsible for the accumulation and classification of all the cost data of which labour cost is one of the most important elements. There must be a proper coordination and close relationship between cost department and time keeping and pay roll departments.

In the determination of labour cost time keeping and pay roll departments feed the costing department with necessary data in respect of time taken (labour hours) by each worker and his remuneration. Time-keeping is the first function in the labour accounting process.

The pay roll department computes the earnings of each employee after making necessary deductions. The cost accounting department is responsible for the accumulation and classification of all cost information of which labour is one element.

Direct and Indirect Labour:

Direct labour:

The Institute of Cost and Management Accountants (U.K.) defines direct labour cost as “the cost which can be identified with, and allocated to, cost centre or cost units”. In the words of Horngren— “All labour that is physically traceable to the finished goods in an economically feasible manner”.

So, direct labour costs are identifiable with individual units of product or job orders as far as practicable.

Examples:

Wages paid to machine operators and assemblers are treated as direct labour costs.

Indirect Labour:

According to the Institute of Cost and Management Accountants (U.K.) indirect labour costs mean “wage costs other than direct wage costs”. According to Horngren indirect labour refers to that activity of employees which is not possible and economically feasible to trace to any specific products via physical observation.

Otherwise, the indirect labour cost is the cost which cannot be allocated to any specific job but can be apportioned or absorbed by cost centres or cost units.

Examples:

Factory Supervisors’ salary, Storekeepers’ salaries, Foremen’s salaries etc. are examples of indirect labour costs.

Distinction between Direct and Indirect labour cost:

The distinction between direct labour cost and indirect labour cost is very important for the following reasons:

(i) To provide a more accurate product cost;

(ii) To provide a strict control over labour costs because direct labour efficiency can be measured by the number of units completed by direct labour;

(iii) If this distinction is not made, proper allocation of overheads will be erroneous.

Direct labour cost is the cost for employees’ efforts and skills used directly for a product or saleable service. The nature of the work of an employee is to be considered for making a distinction between direct labour and indirect labour.

A machine man’s work is treated as direct labour but while he spends time to repair a machine or to clean it up, his labour for doing so is to be treated as indirect labour because it is not directly connected with production process.

From this view-point, labour activities can be classified into the following categories to draw a line of distinction between direct and indirect labour:

(i) Contribution Activities:

They refer to those activities which are directly connected with the production of goods or services which generate the firm’s income. The costs of these activities are treated as direct labour cost.

(ii) Service Activities:

These activities are those which support contribution activities but do not generate income. All such labour is treated as indirect labour.

(iii) Control Activities:

These are the activities which are necessary to control the employees. They relate to the control or supervision or managerial aspect of the whole show. These activities do not create income for the firm but help to generate income in a better way. All such labour is treated as indirect labour.

Need for distinguishing between direct and indirect labour:

The distinction between direct and indirect labour is essential from costing point of view for the following reasons:

(a) The distinction between direct and indirect labour is important for calculating labour cost accurately which provides a basis for labour control;

(b) It facilitates the measurement of labour efficiency;

(c) Such distinction helps allocation of overheads;

(d) Introduction of incentive schemes for payment of wages becomes feasible and easy; and

(e) It also helps to estimate total labour cost.

7. Notes on Classification of Overhead Costs:

i. Function-Wise Classification:

Classification of overhead expenses on a functional basis is done with reference to the various activities of a concern. The main groups consist of:

(a) Manufacturing overhead costs

(b) Office and Administration overhead costs

(c) Selling overhead costs 

(d) Distribution overhead costs

(a) Manufacturing Overhead Costs:

Manufacturing Overhead Costs = Indirect Materials used in factory + Indirect or unproductive wages paid for the factory + Indirect expenses incurred in the factory:

In the words of W. M. Harper: “Overheads incurred in production i.e. overhead incurred within the four walls of the factory proper” are known as Production Overheads.

Students are to note that production overhead is also known as factory overhead or works overhead or production overhead.

Production overhead includes the following indirect expenses:

Factory rent, rates and taxes;

Lighting, heating, power and fuel; depreciation, repairs and insurance for factory assets;

State Insurance, retirement pension premiums, wages of indirect workers; salaries and related costs of production management;

Indirect materials and materials of little individual value used in production – screws, nails, bolts, nuts etc.;

Carriage inwards on materials purchased;

Normal wastage of materials;

Canteen and Welfare expenses;

Tool room expenses, production control and progress department expenses;

Oil, rags and other factory supplies.

(b) Office and Administration Overhead Costs:

Cost of Indirect materials used, indirect remuneration paid to the office and administra­tive staff and indirect expenses incurred in office management are the constituent factors of office and administration overhead costs.

It is the sum total of those costs of general management, and of secretarial, accounting and administrative services, which cannot be directly related to the production, marketing, research and development functions of the enterprise.

Office and .administration overhead costs include the following:

Office rent, rates and taxes and insurance.

Office lighting, heating and cleaning.

Repairs to office buildings, furniture and fittings and equipment.

Salaries, overtime, bonus of office staff, printing and stationery used in the office.

Salaries of administrative directors and other managerial personnel.

Audit fees, legal charges and bank charges.

(c) Marketing, Selling and Distribution Overhead Costs:

Marketing Cost has been defined by the I.C.M.A., London, as “the Cost incurred in publicizing and presenting to customers the products of the undertaking in suitably attractive forms and at acceptable prices, together with the costs of all relevant research work, the securing of orders and, usually, delivery of the goods to customers. In certain cases, after-sales service and/or order processing may also be included”.

Sometimes it becomes useful in most businesses to subdivide the marketing cost into selling, publicity and distribution costs. Marketing overhead costs include the following indirect materials, labour costs and indirect expenses incurred in connection with marketing the products:

Selling:

Salaries, commissions and travelling expenses of technical representatives and sales engineers and salesmen.

Bad debts written-off.

Maintenance and administration costs of Sales Offices.

Publicity:

Cost of advertisement, Cost of printing catalogues, price lists, Cost of maintenance of showrooms, Salaries of showroom personnel, Stationery used in showrooms, Cost of participation in industrial exhibitions.

(d) Distribution Overhead Cost:

Carriage outwards,

Cost of packing materials,

Packing charges,

Costs of running and maintaining of delivery vehicles,

Costs of maintenance of warehouse.

Research and Development Costs:

They include the following expenses:

Salaries of Laboratory technicians, Work-study engineers, Research Associates etc.

Cost of raw materials used in research.

Depreciation of Laboratory Equipment.

Cost of technical journals.

Patent fees.

Subscriptions for Research Association etc.

ii. Element-Wise Classification:

Under this method total indirect expenses are classified as:

(a) Indirect materials;

(b) Indirect labour and

(c) Indirect expenses.

These have been discuss and earlier.

iii. Behaviour-Wise classification:

Overhead costs can be classified into:

(a) Fixed;

(b) Variable; and

(c) Semi-variable costs.

(a) Fixed Costs:

Definition:

Fixed Costs are those which remain fixed and do not vary with the increase or decrease in volume of output for a given period of time.

Examples:

Rent of building, Property taxes, Management salaries, Building depreciation, Salaries of Works Managers, Supervisors, Accountants, Stationery, Printing etc.

(b) Variable Costs:

Definition:

Variable Costs refer to those costs which do vary with the change in the level of production. This type of cost tends to vary in direct proportion to changes in the volume of output.

Examples:

Indirect labour; Indirect material; Power and Fuel; Lighting ; Power ; Repairs and Maintenance ; Tools and Spares ; Overtime pay etc.

(c) Semi-variable Costs:

Definition:

Costs that contain both fixed and variable elements, which are, therefore, partly affected by fluctuations in the volume of output or turnover are known as semi-variable costs. These costs remain fixed in total amount over a relatively short range of variation in output and then are abruptly changed to a new level of production.

Examples:

Normal maintenance of buildings, salaries and wages of administration, stationery and postage, wages of service department, wages of supervisors etc.

iv. Control-Wise classification:

Costs may also be classified as:

(a) Controllable and

(b) Uncontrollable costs.

Controllable costs refer to those costs which can be controlled effectively if proper managerial control is exercised. Uncontrollable costs are those which are beyond the control of the management. They are bound to occur.

8. Notes on Contract Costing:

Features of Contract Costing:

The following features are common to most contract costing system:

(a) Higher proportion of direct costs:

Because of the self contained nature of most site operations, many items of indirect expenses can be identified specifically with a contract and, thus, can be charged directly. For example, telephones installed on site, site power usage, site vehicles, transportation design and planning salaries are charged directly to contract account.

(b) Low indirect costs:

For most contracts, the only item of indirect cost would be a charge for Head Office expenses. This forms a very small portion of the total cost of contract and is absorbed on some overall basis, such as a percentage of total contract cost.

(c) Surplus Materials:

All materials bought for a contract would be charged directly to the contract. At the end of the contract, the contract account would be credited with the cost of materials not used. If the materials are transferred to any other contract the new contract account is to be debited.

(d) Difficulties of Cost Control:

There exists frequently major problems of cost control concerning materials usage and losses, pilferage, labour supervision and utilisation, damage to and loss of plant and tools etc. because of the scale of some contracts and the size of the site.

(e) Materials:

Materials purchased or supplied from the stores shall be debited to contract account. Materials returned to stores and amount received from sale of materials will appear on the credit side. The accruing profit or loss being the difference between cost and sale price is transferred to Profit & Loss Account.

When the materials are transferred from one contract to another or from one site to another to avoid transportation, expenses in returning them to central stores and issuing them again, contract receiving the materials is debited with the cost of such materials and contract transferring the materials is credited. Normal wastage of materials and store should be charged to the contract at a price at which they are priced out.

(f) Wages:

All workers employed at the contract site shall be treated as direct labour and, as such, wages paid to them should be debited to Contract Account.

(g) Contract Plant:

Plant includes cranes, trucks, excavators, mixers and lorries. The usual ways in which cost of plant is dealt with are as follows:

A. When plant is purchased:

The following two methods are in common use:

(i) Charge new plant at cost to the contract. When the plant is no longer required and is transferred to another contract, the original contract is credited with the depreciated value of the plant. In this way the contract bears the charge of depreciation.

(ii) Where plant is moved frequently from contract to contract, each contract is charged a daily or weekly rental.

B. When Plant is leased:

The leasing charges are charged directly to the contract.

Note:

Whatever method is followed, the ordinary running costs like fuel, repairs and insurance, would be charged direct to the Contract Account.

Profit on Incomplete Contracts:

A contract may take more than one financial year for its completion. In such a case problem arises as to how much profit shall be credited to P & L A/c. It becomes necessary to compute profit on partly completed contract and take credit for a part of it in the accounts at the year end.

The amount of profit that is to be credited to Profit & Loss A/c depends upon the fact that how far the contract has advanced i.e. the stage of completion it has reached.

The computation of profit is done in the following ways:

(i) Profit should be considered in respect of work certified only. Work uncertified should always be valued at cost.

(ii) For contract which has been taken just in hand or which has not advanced far or 1/4th has been completed, no profit should be taken to the credit of Profit and Loss A/c. This is because it would be too early to forecast or estimate profit with a reasonable degree of accuracy.

(iii) In case of a contract which is covered by Architect’s certificate, profit is computed by deducting the cost of contract from work certified. A portion of this notional profit is taken to new Profit & Loss Account and the balance of notional profit is carried forward as profit in suspense. Conventionally, 1/3 or — 2/3rds of profit is credited to Profit and Loss Account.

If less than 50% but more than 25% of contract is completed then the portion of profit to be taken to the credit of profit and loss account is computed as follows:

1/3 x Notional profit x (Cash received ÷ Work certified)

But, where more than 50% but less than 75% of contract is completed then Profit is computed for taking to Profit and Loss Account:

2/3 x Notional Profit x (Cash received ÷ Work certified).

(iv) Where the contract is almost complete, an estimated total profit is ascertained by deducting the total cost and additional expenditure to be incurred to complete the contract from the contract price. The Profit and Loss Account should be credited with that proportion of total estimated profit on a cash basis, which the work certified bears to the total contract price.

The formula is as follows:

Estimated total profit x (Value of work certified ÷ Contract price):

(v) If there is any loss, the total loss should be transferred to Profit and Loss Account by crediting the Contract Account.

Profit & Loss Account Dr.

To Contract Account

The Costing Entries:

A separate account will be maintained for each contract with the object of finding out the overall Profit or Loss of the contract.

To do this, a proforma of a contract account is shown on the next page:

9. Notes on Process Cost:

The Elements of Process Cost:

The elements of Cost of a Process consist of:

(i) Material Cost;

(ii) Cost of Labour;

(iii) Direct Expenses; and

(iv) Production Overhead.

An account is maintained for each process to which all costs of material, labour, direct expenses and overhead are debited.

(i) Materials:

Materials required for production are issued to the first process. The finished goods of first process are passed to the next process, each process merely performs some operation on the material passed from the earlier process. The finished goods of Process I become the raw materials of Process II and so on.

There are some systems where extra or new materials may be needed and added to the finished goods passed from earlier process and this may continue until completion. The method to be followed depends upon the nature of the product.

Whatever method is followed, sufficient supply of raw materials should be assured to meet production needs. It is to be seen that production does not come to a halt due to paucity of raw materials.

(ii) Labour:

Both direct and indirect wages paid to direct workers and indirect workers like super­visory staff are debited to the Process Account. However, where workers are engaged in more than one process, the gross wages are distributed to each process on the basis of time spent on each process. Generally, the cost of direct labour forms a very small part of the cost of production in industries that adopt process costing.

(iii) Direct Expenses:

Direct expenses which can easily be directly allocated to a particular process are known as direct expenses. Examples of such expenses are cost of design, cost of electricity, depreciation and hire charges of equipment. These expenses are debited to Process Account.

(iv) Production Overhead:

In process costing the overhead element forms a major part of total cost. So, great care should be taken to ensure that each process is charged with a reasonable share of overhead. Overheads are to be apportioned where they cannot be directly allotted and actual overhead in respect of a particular process should be charged or’ debited to the Process concerned.

Overhead may be recovered at a predetermined rates and charged to the Process. Having discussed the elements of cost we now proceed towards the preparation of Process Account where there is no process loss.

 The following steps are involved in costing procedure:

(i) Debit the cost of basic raw materials to the first process account showing both quantity and amount.

(ii) Debit costs of other materials, direct labour and direct expenses pertaining to each process.

(iii) Debit each process account with production overheads as given or on some equitable basis.

(iv) Credit the process account with realisable value of scrap.

(v) Ascertain the total cost of the process and calculate average cost per unit.

(vi) If the whole output of a process has been transferred to the next process, the total cost may be shown on the credit side as transfer to next process and the same shall be shown on the debit side of the next process account.

(vii) If a portion of the output has been earmarked for sale or has been sold show its cost as transfer to stores and the balance as transfer to the next process. It should be noted that when a portion of output has been sold, the process account should credited only with its cost and not the sale value.

(viii) The cost of containers used for packaging the finished goods should be debited to the last process account.

(ix) The total cost of the last process shall be transferred to Finished Stock Account

Treatment of Process Losses, Scrap and Wastage:

In the course of production through different processes, some losses are bound to occur. The quantity and weight of the process output will be-less than the quantity, weight or volume of the materials input.

This may happen due to various reasons:

(i) Evaporation, residuals,

(ii) Unavoidable handling, breakage and spoilage losses.

So, it is imperative that accurate records are to be maintained to have control over materials. The cost department must be kept informed of the losses through the medium of scrap tickets, materials credit notes and loss reports. This information is essential for ascertainment of actual cost of the final product.

Materials which have been processed and later on are found to be defective and scrapped have surely incurred their share of labour cost and overhead cost up to the point of rejection. More defective and scrapped materials mean financial loss to the concern.

Classification of Process Loss:

Process losses may be classified as:

(i) Normal Process Loss and

(ii) Abnormal Process Loss.

(i) Normal Process Loss:

This type of loss is caused by the factors like evaporation, pilferage and which is inherent in large scale production. This loss cannot be avoided but sure to occur. This loss may not be a total loss but may often include scrap and waste. The amount of normal process loss is reduced by selling the scrap and waste.

(ii) Abnormal Process Loss:

Abnormal Process Loss is caused by unexpected or abnormal conditions. The causes are substandard materials, accidents, carelessness. Moreover, it may happen sometimes that the percentage of wastage or loss may exceed the predetermined percentage of normal wastage or loss.

So, any wastage exceeding the normal wastage is termed abnormal wastage or loss. All abnormal losses must be thoroughly investigated, and, where necessary, all possible steps should be taken to prevent its occurrence in future.

Treatment of Normal and Abnormal Loss in Process Costing:

(i) Normal Process Losses:

Normal Loss is normally expressed as a percentage of the quantity of output. Loss arising out of normal wastage is absorbed in the cost of good units i.e. it becomes the part of total cost and surely, increases the total cost of output.

If any value can be recouped from the sale of imperfect articles or materials then the amount so realised shall be credited to relevant Process Account which will reduce the cost of output of that process.

(ii) Abnormal Process Losses:

Abnormal loss or wastage is not treated as a part of production cost or total cost. Its value is credited to the concerned Process A/c and debited to Costing Profit & Loss Account.

The value of abnormal loss is calculated with the help of the following formula:

A separate account is opened for abnormal losses to which is debited the cost of materials, labour and proportionate overhead incurred by the wastage. Since the value of abnormal loss is not treated as a part of cost of production it is written off to the Costing Profit and Loss Account.

Treatment of Abnormal Gain in Process Costing:

Abnormal Gain arises when the actual loss is smaller than estimated loss. According to Wheldon, “sometimes the actual loss in a process is smaller than was expected, in which case an abnormal gain results”. The value of abnormal gain is calculated at the rate at which the effective output would have been valued if normal wastage had taken place according to expectation.

Relevant Process Account is debited with the value of Abnormal Gain and Abnormal gain A/c is credited by Process A/c. The Abnormal Gain A/c is debited with the Scrap Sales A/c and the balance is written off to Profit and Loss A/c.

Abnormal Gain = Normal Loss – Actual Loss

Value of Abnormal Gain

In motor transport undertaking most of the data required for computation of cost and cost control purpose are obtained from Daily Log Book. The Log Book should be filled up by the driver of the vehicle furnishing necessary details of trips made by vehicle during a specified period of time—usually on daily basis.

A specimen of Log Book is given below:

The above log sheet helps the management to avoid unnecessary or duplicate trips, to avoid under-utilization of capacity by low burdening or over-utilization of extra loading and to avoid waste or idle running capacity.

Selection of Unit:

In transport costing, a composite cost unit such as passenger kilo-meter or ton kilo-metre is usually adopted. The main advantage of selecting of a composite unit cost is that it takes into account both the number of passengers or weight of goods carried and distance covered. 

At present many organisations provide facilities for canteen to workers. The workers are provided with food at subsidized prices. It may be considered a service by the company.

The following are the main items of costs relating to canteen costing:

(a) Provisions:

Provisions will include items like meat, fish poultry egg, tea, coffee, milk, flour, rice, soft drinks etc.

(b) Labour:

Labour will include:

Wages and salaries of canteen staff such as cooks, waiters, kitchen assistants, supervisors etc.

(c) Services:

It will include steam, gas, electricity, power, light and water.

(d) Consumable Stores:

They will include items like linen, cutlery, crockery, glass wares, mops, washing up clothes, dustpans, cleaning materials and brushes

(e) Overheads:

Overhead charges will include rent, rates, insurance, depreciation.

Receipts:

The receipts will consist of:

(i) Subsidy received from company,

(ii) Sale of coupons.

11. Notes on Integrated Accounting System:

Meaning of Integral Accounts:

A single book-keeping system which contains both financial and cost accounts is termed an integral accounting system.

This system contains two types of account:

(i) Simple accounts and

(ii) Control accounts.

The former represent assets, liabilities etc.; while each of the latter forms a connecting link with a subsidiary ledger in which the detailed composition of the control account balance is recorded.

In fact, this system tends to merge cost and financial accounting to form one inseparable accounting function and precisely, integrated accounting is a system of recording both financial and costing transactions in one integrated set of books.

Features of Integrated Accounting System:

The essential features of integrated system are as follows:

(i) The integrated system records financial items not required for cost accounting. For examples – Accounts for capital expenditure, Sundry Debtors and Creditors, share capital, cash and bank balances, prepaid expenses and accruals are opened.

(ii) Store transactions are recorded in the Stores Control Account. For store purchased Store Control Account is debited and credited to Cash/Bank/Creditors Account.

(iii) Payment of wages is debited to Wage Control Account. Similarly, for overhead expenses incurred Overhead Control Account is debited and Sundry Creditors/ Cash/Bank Account is credited.

(iv) At the end of the accounting period, the total of Wages Control A/c, Stores Control A/c and Overhead Control A/c is transferred to Work-in-Progress Account. The entry is:

Work-in-Progress Control A/c Dr.

To Stores Control A/c

To Wages Control A/c

To Overhead Control A/c

(v) All accruals are debited and advance payments are credited. While capital expendi­ture is separated in the process of Cost analysis and debited to Capital Assets Account.

Advantages of Integrated Accounting System:

The following are the advantages of integral accounting system:

(a) Duplication in accounting and analysis can easily be avoided.

(b) Since the need for maintaining of separate sets of financial and Cost accounts ledgers is absent, preparation of reconciliation statement is not required.

(c) There is an automatic check on the correctness of the cost data, which creates confidence in the management.

(d) Centralisation of accounting function leads to economy.

(e) As Cost accounts are posted immediately from the original entries, there is no delay in obtaining cost data.

12. Notes on Reconciliation of Cost and Financial Accounts:

Introduction to Reconciliation of Cost and Financial Accounts:

Cost accounts are maintained independent of financial accounts. The two accounts have a different order of recording revenue and expenses. In cost accounting expanses are analysed and recorded in objective form while in financial accounting expenses are recorded in the books of accounts in subjective form.

As a result, there occurs a difference between profit shown by Cost accounting and that of financial accounting. Therefore, it becomes imperative to reconcile two accounts which enables to test the reliability of cost accounts.

Need for Reconciliation of Cost and Financial Accounts:

In a manufacturing concern both financial and cost accounting are maintained. Naturally, two sets of accounts disclose profit which will not agree with each other. Profit disclosed by the financial accounting does not agree with the profit disclosed by the cost accounting. But this does not happen when a manufacturing company uses an integrated accounting system i.e. no separate cost and financial accounts are maintained.

So, when cost and financial accounts are maintained separately and independently of each other, profit disclosed by one system tends to differ from that of the other accounting systems. This difference in profit creates problems and the need of reconciling the accounting systems arises to arrive at one profit figure.

Reasons for Disagreement between Reconciliation of Cost and Financial Accounts:

Disagreement between Cost and Financial accounts generally arises due to the following factors:

i. Items that are included only in financial accounts:

The following items of purely financial nature are included in financial accounts but not in cost accounts:

(a) Interest received on bank deposits

(b) Profit on sale of assets

(c) Rents receivable

(d) Interest and dividend on investments

(e) Loss on sale of Assets

(f) Loss on sale of investment

(g) Interest paid on Bank Loan, Debentures

(h) Damages payable

(i) Payment of income-tax

(j) Payment of dividend

(k) Transfer to Reserves

(l) Creation of provisions

(m) Donations

(n) Writing off fictitious Assets like Preliminary expense, Discount on issue of shares, debentures

(o) Writing of intangible fixed assets like Goodwill, Patent Rights etc.

ii. Under or over-absorption of overhead expenses:

In cost accounts overheads are absorbed at predetermined rates which are based on past data. On the other hand, in financial accounts the actual amount of expense incurred is only considered. Hence difference arises.

iii. Adoption of different bases for stock valuation:

In financial accounts stocks are valued either at cost or at market value whichever is less. But in cost accounts stock of materials are issued to production departments at cost by using FIFO, LIFO, Simple Average, Weighted Average method. This leads to a difference.

iv. Bases of Depreciation:

The methods of charging depreciation and the rates may be different which surely leads to difference:

13. Notes on Cost Volume Profit Analysis:

Definition of Cost Volume Profit Analysis:

Profit of an undertaking depends upon a large number of factors, the most important of which are cost of manufacture, volume of sales and selling prices of products sold. The three factors of cost volume and profit are interlinked and interdependent.

As we know, profit depends upon sales; selling price; to a great extent; depends upon cost; volume of sales depends upon volume of production which, in turn, is related to cost. In cost-volume-profit analysis an attempt is made to measure variation in cost with variation in volume.

Cost-Volume-Profit analysis is the analysis of three variables, viz., cost, volume and profit, that seek to explore the relationship existing amongst costs, revenues, activity levels and the resulting profit. Profit, as a variable, is a reflection of a number of internal and external conditions which exert their influence on sales, revenue and costs.

Revenue depends upon selling prices, costs, volume of sales, demand, competition etc. Although none of these can be singled out as the most important, the volume is considered to be a dominant factor. This is probably because changes in volume are more frequent, take place rapidly and are outside the purview of management control.

Further, Costs rarely vary in direct proportion to the volume and hence, a small change in the volume may have a more than proportionate effect on profits than the other factors. It is thus, the volume which is perhaps the largest single factor that influences cost. Therefore, there exists an intimate relationship amongst costs, volume and profit.

The cost-volume-profit analysis is an extension of marginal costing and makes use of the principles of marginal costing. It is important tool of short-term planning and is more relevant where the proposed changes in the level of activity are relatively small. Therefore, it is very much useful in making short-run decisions.

Importance of Cost Volume Profit Analysis:

The relationship between cost, volume and profit makes up the profit structure of an undertaking. This analysis may be useful for profit planning, cost control and decision making.

The main objectives of cost-volume-profit analysis are discussed below:

(i) Profit Planning:

In Profit planning it becomes essential to know the relationship between cost, volume and profit. The most important feature of cost-volume-profit analysis is the manner in which it relates cost, selling price and volume and enables calculation to be made to show the effect of change in these on profit. Accordingly, the management can plan profit with reference to cost – volume – profit analysis.

(ii) Preparation of Flexible Budget:

Cost – volume – profit analysis is of special help in the preparation of flexible budget that indicates cost and profit at various levels of activity.

(iii) Decision Making:

Cost – volume – profit analysis is very much useful in making decisions like make or buy, pricing, selection of a product mix, selection of the best channel of distribution, and selection of best method of production.

(iv) Cost Control:

In the area of cost control, cost – volume – profit analysis is of great assistance to the management. The effect on cost of changes in volume can be evaluated for the purpose of reviewing profits achieved and cost incurred.

14. Notes on Standard Costing:

Introduction to Standard Costing:

The concept of ‘Control’— a third and final link of managerial process—means the process of ensuring accomplishment of plan. This involves not only action to implement the plan but also the measurement of performance in comparison with the specified plan or some other standards, the communication of results to the appropriate authorities for taking corrective measures in time.

Standard costs are predetermined costs and are used as a measure with which the actual cost as ascertained are compared. Standard costing seeks to measure the efficiency of performance and identify weakness in performance, if any, at an early stage so that appropriate managerial measures can be taken to remove the weakness for effective cost control.

In standard costing, cost of a product or service is known in advance and deviations from actual are used for effective cost control purpose.

Meaning of Standard Cost:

Standard cost may simply be defined as ‘predetermined cost’. More formally, a standard cost may be defined as a predetermined calculation of how much costs should be under specified working conditions.

The I.C.M.A. summaries the concept and purpose of standard dost as:

“A predetermined calculation of how much costs should be under specified working condition.”

It is built up from an assessment of the value of cost elements and correlates technical specifications and the quantification of materials, labour and other costs to the prices and / or wage rates expected to apply during the period in which the standard cost is expected to be used.

Its main purposes are to provide bases for control through variance accounting, for the valuation of stocks and work in progress, and, in some cases, for fixing selling prices.

The price and quantity are the two constituents of cost elements for which standards are specified. The production engineer specifies the quantity of materials to be required and the purchasing manager sets a standard price for the materials on the basis of current prices.

Time department will set the labour times and wage rates will be set according to the type of labour required and anticipated average rates. Direct expenses will be assessed and overhead absorption rates will be calculated as appropriate. Standards are set before the commencement of a period and should cover all aspects of production.

Advantages of Standard Costing:

The introduction of a system of standard costing may offer the following advantages:

(i) The setting of standards leads to economics by determining best materials and methods.

(ii) Actual performance may easily be compared with the predetermined standards. Showing separately the favourable or unfavorable variance.

(iii) A detailed analysis of variance enables the management to investigate the causes of inefficiencies of labour, of the use of materials and of the operation of plant and machineries.

(iv) A target of efficiency can be set for the employees to reach and the sense of cost consciousness is thereby stimulated.

(v) Since variances can be calculated, the operation of the principle ‘management by exception’ becomes possible.

(vi) Gains and losses arising out of market fluctuations in prices of raw materials, as distinct from variations due to manufacturing conversion are revealed.

(vii) Standard costs provide a valuable aid to the management in fixing up prices and formulating policies.

(viii) The effects of variations in the price and use of materials, the ratio of labour wages to other expenses and the volume of production are demonstrated at short intervals.

(ix) It is a management tool for having effective cost control.

(x) Costing procedures can be made simple.

(xi) It facilitates the evaluation of stock and optimizes the use of plant facilities, current assets and working capital.

(xii) Since attention is focused on the variances, weak areas can be identified, as a result, management can take corrective and prompt actions on right spots.

(xiii) Better allocations and utilization of resources are possible due to critical study of all the operations, methods in respect of production, sales and administration.

(xiv) A properly developed standards costing system with full participation and involvement creates a positive and cost effective attitude through all levels of management.

(xv) Standard costing facilitates the integration of accounts so that reconciliation between cost accounts and financial accounts may be avoided.

Limitations of Standard Costing:

The standard costing suffers from the following limitations:

(i) It does not become effective without Budgetary Control.

(ii) Cost of its installation is very high.

(iii) Its effectiveness depends upon the efficiency of historical costing. It becomes effective only when historical costing periodically supplements it.

(iv) In volatile conditions with rapidly changing methods, rates and prices, stand­ards become quickly out of date and, thus, lose their control and motivational effects. This may cause resentment and loss of goodwill.

(v) It may not be appropriate to the business to which it is applied.

(vi) A badly conceived standards costs may yield inaccurate and misleading results and, therefore, may not enjoy the confidence of the users of this system.

Applicability of Standard Costing:

Standard costing in practice is a detailed process and requires considerable development work before it becomes a useful management tool for taking managerial and economic decisions. It can gainfully be used in a variety of costing situations like batch and mass production, process manufacture, transport.

However, the greatest benefit can be gained when the manufacturing method involves a substantial degree of repetition. Its major application in practice is in organisation involved in mass production and/or repetitive assembly work.

Types of Standard:

There are different types of standard which are discussed below:

(i) Ideal Standard:

This is the standard which can be attained under the most favourable conditions possible. In other words, ideal standards are based on perfect performance. It is assumed that there is no wastage, no idle time, no inefficiencies or other imperfec­tions in the manufacturing process. But it is very difficult to attain such standards in practice.

(ii) Expected Standard:

This is the standard which may be anticipated to be attained during a future specified budget period. Expected standards are based on expected performance. In setting these standards, a reasonable allowance is made for wastage’s and other inevitable lapses. It is more realistic than ideal standard. This type of standard is best suited from cost control point of view.

(iii) Basic Standard:

This is a standard which is established for use unaltered over a long period of time. Basic standards are set up for some base year and is not changed as material prices and labour rates change. It is suited for those items of expenses which are fixed in nature. But basic standard is of no practical importance from cost control point of view.

(iv) Normal-Standard:

This standard is based on average performances of the past. They are attainable under normal conditions. If there is stability in the past performances, such standards may be useful from cost ascertainment point of view. But, for cost control, it is not so much effective.

Introduction of Standard Costing System in a Factory:

Standard costing is a system of cost accounting which makes use of predetermined standard costs relating to each element of cost—material, labour and overhead. It is basically a technique of accounting which compares the standard cost of each product or service with the actual cost to determine the efficiency of the operations.

So, that any remedial measure may be taken quickly. It is the most effective method for controlling performance and cost.

While introducing a standard costing system in a factory, the following preliminary steps are required:

(i) Review of Existing System of Costing:

Before introduction of standard costing system, it is important to review the existing system of costing with special reference to existing forms and records.

(ii) Study of Technical Aspect:

It is essential to study the technical aspects because standard costing must be based on actual conditions in the factory. Technical aspects involve methods of production, different processes or stages of production, normal and abnormal losses and gains and input-output relations etc.

(iii) Organisation Chart:

Lines of authority and responsibility should clearly be defined so that responsibility may be assigned as and when required.

(iv) Allocation and Apportionment of Overhead:

The existing methods and policies in respect of allocation and apportionment should be reviewed in the background of standard costing principles.

(v) Staff Training:

The staff concerned with the working of standard costing system should be properly trained up.

(vi) Existing Controls:

The existing control techniques like internal control, budgetary control should also be reviewed to avoid overlapping.

(vii) Type of Standard:

Setting up Standard costs for material, labour and overheads is a complicated task. So, an in-depth study should be made to determine the type of standard to be established.

(viii) Standard Cost Manual:

Standard cost manual should be prepared that should clearly define various terms and procedures to be used. This may provide a good guide to the staff.