Cost Accountancy BBA Part II Semester III

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BBA – II S
SEMESTER - III T
As per Revised CBCS Syllabus of
Shivaji University (2020 -21) A
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U
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Dr. Varsha Rayanade N
M.Com., MBA, M.Phil., PhD.
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TABLE OF CONTENTS
1. Introduction to Cost Accounting … …. 3
2. Methods of Costing and Material Management … …. 22
3. Material Costing and Break Even Analysis … …. 40
4. Standard Costing … …. 51
5. Cost Audit … …. 59
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Dr. Varsha Rayanade
BBA Part II Semester III
Cost Accountancy CC-B2
Syllabus Contents
Unit I – Introduction to Cost Accounting

Meaning of Costing, Cost Accounting and Cost Accountancy, Cost Centre, Cost Unit,
Objectives of Cost Accounting, Importance of Cost Accounting, Financial Accounting
vs. Cost Accounting, Limitation of Cost Accounting, Classification of Cost on various
bases, Preparation of Cost Sheet (Practical Problem)
Unit II – Methods of Costing and Material Management
Methods of Costing- Job Costing, Batch Costing, Contract Costing, Service Costing,
Process Costing (Theory), Methods of pricing material issues (FIFO, LIFO, Simple
Average, Weighted Average) (Practical Problems), Inventory Cost Control
Techniques – EOQ (Practical Problems) and ABC Analysis
Unit III – Marginal Costing and Break Even Analysis
Marginal Costing- Meaning, Marginal Cost Equations and Break Even Analysis,
Managerial Applications of Marginal Costing – Make or Buy Decisions, Effect of
changes in Selling Price (Practical Problems)
Unit IV – Standard Costing and Cost Audit
Standard Costing: Meaning, Objectives, Advantages and Disadvantages, Types of
Variances – Material Variances (Practical Problems)
Cost Audit: Nature, Scope, Objectives, Types and Techniques of Cost Audit (Only
Theoretical understanding to be given)
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Unit – I Introduction to Cost Accounting
The term Cost, Costing, Cost Accounting and Cost Accountancy are normally used
interchangeably but they are not synonyms of each other. The meaning of these terms are
related and similar but there are differences.
Cost
Cost is commonly defined as ‘sacrificed resource’ for a particular thing. In business and
accounting Cost can be defined as ‘the monetary value that has been spent on production or
creation of a good or service’. From a seller’s point of view cost is the amount spent to produce
a product or good. If the sellers sold their goods at the same price as it cost them to produce,
then they would break even i.e. they would not lose money nor would they earn any profit.
From the buyer’s point of view, the cost of product can be called as the price i.e. the amount
charged by the seller for the product and this amount could include both the cost to make the
product and the mark up cost added by the seller to make a profit.
In simple words, cost can be said to be anything that is measurable in terms of money. Thus,
the amount of expenditure (actual or notional) incurred on or attributed to a specified article,
product or activity is known as ‘Cost’.
Costing
‘Cost’ is a term while ‘Costing’ is a process for determining the cost. It may be called a
technique for ascertaining the cost of production of any product or service in the business
organization. According to CIMA, ‘An organization’s costing system is the foundation of the
internal financial information system for managers. It provides the information that
management needs to plan and control the organization’s activities and to make decisions
about the future.’
The scope of costing can be understood in context of big manufacturing concern that produces
various products and spends a lot of money on material, labor and other overheads, The cost
of each product manufactured by the concern requires recording expenses with respect to
each product or process classifying expenses like direct material, labor, overheads, etc.,
allocation of direct expenses and suitable apportionment of overheads to each product for
correct determination of per unit cost of production of each product.
Cost Accounting
‘Cost Accounting’ is basically the next step to costing. Cost Accounting involves analyzing
relevant cost data, interpreting it and finally presenting the same to the management. Cost
Accounting is defined as ‘the process of accounting for cost which 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 ascertaining and controlling costs.’
The scope of cost accounting involves the preparation of various budgets for an organization,
determining standard costs based on technical estimates, finding and comparing with actual
costs, ascertaining the reasons by variance analysis, etc.
Cost Accountancy
‘Cost Accountancy’ is over and above costing and cost accounting. It visualizes application of
costing and cost accounting in a business setup. Cost Accountancy facilitates management
with cost control initiatives, ascertainment of profitability and informed decision making. It also
includes determination of selling price for the products, division and unit wise profitability.
Forecasting of expenses and future probable income is also a part of the practice of Cost
Accountancy.
Cost Accountancy is defined as ‘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 for the purpose of
managerial decision making.’
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Objectives of Cost Accounting
The main purpose of developing Cost Accounting was to overcome the limitations of financial
accounting. Hence, in the initial stage the sole objective or function of Cost Accounting was to
ascertain the cost of goods or services produced by the organization. However, over the period
of time Cost Accounting has been successfully applied to different functions of business
activity, due to which there has been an increase in the objectives. Following are some of the
main objectives of Cost Accounting:
a. Ascertainment of Cost: The prime objective of cost accounting is to ascertain the cost of
production of each unit, job, process or service in a scientific way. The ascertainment of
cost includes cost finding, cost recording, cost analyzing and cost reporting. There are two
methods of ascertaining costs viz. a. Post costing, wherein analysis of actual information
as recorded in financial books and b. Continuous costing, which aims at collecting
information about cost as and when the activity takes place so that as soon as a job is
completed the cost of completion is known. Thus, such costs enable the management to
fix or quote the prices of goods and services produced, valuation of inventory and ascertain
the amount of profit earned during a period.
b. Cost Control: the purpose of cost accounting is to utilize the resources of production at an
optimum level. After the costs are ascertained by application of cost accounting principles,
the standard of costs (i.e. material, labor and overhead) required for a product are set for
exercising cost control. These standard costs express what the costs should be for a
product. From time to time, the actual costs of production are computed and compared with
standard costs. In case the actual costs are more than the standard costs then remedial
steps are taken to remove the causes of difference.
c. Cost Reduction: it means achievement of real and permanent reduction in the unit cost of
goods manufactured or services rendered without affecting the suitability or quality of the
product or service. Thus, cost reduction means permanent and genuine savings in the cost
of manufacture, administration, distribution and selling brought by elimination of wasteful
and unessential elements from the design/ technique / process of the product but at the
same time maintaining intact the essential characteristics and quality of the product or
service. Thus, it can be said that cost reduction aims at permanent reduction in the unit cost
which results in saving of costs without affecting utility and quality of the product or service.
d. Determination of Selling Price: generally the purpose of business organizations is profit
making, hence it is therefore necessary that the revenue of the organization is greater than
the costs incurred. Cost accounting provides both the total cost of production as well as
cost incurred at each and every stage of production. Though the selling price of a product
or service is influenced by market conditions which are beyond the control of any business,
with the help of costing data it is still possible to determine the selling price within the
constraints. Hence, accurate cost data is very important as it plays a dominating role in
fixation of selling price of any product or service.
e. Assistance in Managerial Decision Making: One of the main function of management is
to make important decision. The process of decision making is defined as a process of
selecting a course of action out of two or more alternative courses. For making a choice
between different courses of action, it is necessary to make a comparison of the outcomes
which may be arrived under different alternatives. Such a comparison can be made possible
with the help of cost accounting information using which tactical managerial decisions such
as closing down or continuing a department, making or buying a product, a profitable
product mix, utilization of idle capacity, price reduction during recession, etc. can be taken.
f. Evaluation of operating efficiency: cost accounting records the cost of various products,
processes, operations, departments and other cost centres. This enables the management
to do intra-firm comparison and inter- firm comparison and evaluate the operating efficiency
of the various segments of the concern.
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g. Disclosure of wastages: cost accounting reveals the inefficiencies and wastages in
various forms, existing in the different areas of business such as wastages of material,
labor, expenses, idle capacity, idle time, under -utilization of plant and equipment, etc. so
that management can take remedial measures to minimize wastages and maximize the
efficiency.
h. Other objectives:
 To reveal sources of economy in the production process
 To provide an effective system of materials and stores
 To provide necessary data to develop standard costs and exercise the system of
budgetary control
 To assist the special studies and investigations such as pricing of new products and
services, expansion or contraction of projects, change in the methods of production and
distribution, wage compensation plan and other such problems which may arise from
time to time.
Importance of Cost Accounting
a. To the Management:
 It measures the economic performance of the business
 It provides actual cost data in fixing the selling price of the product
 It helps in identifying profitable and non-profitable activities
 It guides in making future production policies
 It provides an independent and reliable check on the accuracy of financial accounts with
the help of reconciliation statement
 It reveals any losses or wastages in the production process
b. To the Employees:
 It enables employees to earn better wages through overtime and incentive wages
 It evaluates the performance of employees and ensures better job security
 It provides higher earnings through time and motion study
c. To the Creditors:
 It provides more information about the financial accounts especially with respect to the
solvency of the business
 It gives an insight of current affairs as well as the future prospects of the business
d. To the Government:
 It helps the Government in formulation of policies regarding price control measures,
import and export policies, wage fixation, fixation of price of certain products, etc.
 It helps in preparation of national economic plan for development
 It helps in assessment of taxes
e. To the Society:
 It provides quality products at lower rates due to application of cost reduction techniques
 It offers employment opportunities in cost accounting departments of a business
organization as cost accountants / cost assistants.
Limitation of Cost Accounting
Like other branches of accounting, cost accounting also has certain limitations. The limitations
of cost accounting are as follows:
 Expensive: cost accounting is expensive because additional staff and systems are needed
for doing activities such as analysis, allocation and absorption of overheads, etc. Therefore,
in case of small firms, the cost of installation of costing system exceeds the benefits derived
from them.
 Duplication of work: as two sets of accounts viz. financial accounts and cost accounts
have to be maintained by the organization, there is duplication of work.
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 Requirement of reconciliation: the results shown by cost accounts differ from those shown
by financial accounts. Therefore, reconciliation statement needs to be prepared for
ascertaining the accuracy of the results.
Financial Accounting vs. Cost Accounting
Financial Accounting is an art of recording all monetary transactions on double entry principle
in a set of books with an ultimate object of preparing Profit & Loss Account and Balance Sheet
of business. The financial accounts are meant for owners, creditors and Government who are
interested in the working results of an organization. Cost Accounting on the other hand, is a
recently developed branch of accounting which is concerned with ascertainment of cost of
products, processes, operations, departments and other segments of a concern and use of
such costs for the purpose of managerial control. Both these accounting systems i.e. financial
and cost accounting make use of the expenditure of the organization but they use it in different
way to serve their respective purpose.
Difference between financial accounting and cost accounting is as follows:
Basis Financial Accounting Cost Accounting
1 Meaning It is an accounting system that It is an accounting system,
captures the records of financial through which an organization
information about the business keeps track of various costs
to shoe the correct financial incurred in production activities
position of the company at a of the business.
particular date
2 Objective To reveal the profitability and To ascertain cost of products,
state of affairs of business to its process, operations,
owners, creditors & government departments, etc. to facilitate
cost control by the management
3 Scope It covers all types of business It covers only items of expenses
transactions like income, that are related to manufacture,
expenses – revenue as well as administration, selling &
capital distribution of goods & services.
4 Information It records the information which It records the information related
Type are in monetary terms to material, labor and overhead
which are used in the production
process
5 Time of Financial statements are Details provided by cost
Reporting generally prepared and reported accounting are frequently
at the end of the accounting prepared and reported to the
period which is normally one management as and when
year. required.
6 Recording of All expenses are recorded in full The expenses are broken down
costs i.e. the total aggregate amount of and recorded as required either
expenditure is recorded in the product-wise, process-wise,
financial accounts operation-wise, element –wise,
etc.
7 Stock Valuation In financial accounts, stocks are Stocks are valued only at cost
valued at cost or market price
whichever is lower.
8 Statutory Maintenance of financial Except for a few type of business
Compulsion accounts and submission of organizations such as
financial reports and returns is automobile, pharmaceutical,
mandatory under Income Tax etc., it is not mandatory to
Act as well as Companies Act maintain cost accounts for all the
business concerns.
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9 Type of cost Only historical costs are Both historical and pre-
used for recorded determined cost are recorded
recording
10 Aid in Decision The financial statements and The cost data generated by the
making reports represent the financial cost accounting assists the
position of the business and are management in tactical decision
not adequate to assist in making
managerial decision making
process
11 Efficiency The financial data is insufficient The cost accounting data helps
evaluation for evaluation of operating in detailed comparison of
efficiency of two firms, operational efficiency of two
departments or between two firms, periods or cost centres.
periods
12 Users It provides information to internal Information provided by cost
as well as external parties like, accounting is used only by
owners/shareholders, internal management of the
management, employees, organization like employees,
creditors, Government, etc. directors, managers,
supervisors, etc.
Cost Unit
It is a unit of product, service or time (or combination of these) in relation to which costs may
be ascertained or expressed. The forms of measurement used as cost units are usually the
units of physical measurement. For eg. In case of steel the cost is expressed per tonne, while
in case of transport service it is expressed per kilometer, etc. The choice of cost unit depends
upon the nature of the product manufactured, methods of production and trade practices.
Thus, cost units are usually the units of physical measurement like number, weight, area,
volume, length, time and value.
Each industry has a unit of its own for measurement of output of finished as well as semi-
finished products. The cost of a product unit is the average cost obtained by dividing the total
cost of the batch or product or process by the number off product units produced. Some of the
forms of measurements commonly used as Cost units in different type of Industries are as
given below:
Sr. Type of Industries Cost Unit Basis
1 Automobile, Electronic products & Number
Gadgets (TV, Fridge, Washing
Machine, Mobile, etc.)
2 Iron & Steel, Cement, Sugar, etc. Tonne
3 Chemicals, Lubricants, Petroleum Litre, Gallon
products, Milk, Water, etc.
4 Transport Kilometer
5 Cable, Rope, Wire, Yarn (cloth) Metre
6 Electricity, Power Kilo-watt hour
7 Fertilizers, food grains Bag of Standard Weight
8 Professional Services Chargeable Hour
9 Construction, Civil Work, Painting Square Metre
10 Cotton & Jute Bales
11 Timber Cubic Metre
12 Cosmetics, Cream Jar or Tubes
Cost Centre
Cost Centre is defined as a location, person or an item of equipment (or group of these) for
which cost may be ascertained and used for the purpose of Cost Control. Cost Centre is a
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segment of a plant or in some cases an entire plant which is treated as a functional unit for
the purpose of applying process overhead. It may be a single work point, such as machine, a
group of work points smaller than a department, a processing department or an entire plant.
The purpose of creating cost centres is to accumulate and control costs by subdivisions of the
plant and distribute them to products in the most equitable manner.
So far as plant is concerned, cost centres fall under two categories viz. productive cost centres
and service cost centres. A productive cost centre is directly engaged in productive activity
and may consist of similar items of equipment. A cost centre based on similarity of operations
is called an operation cost centre. A process consisting of series of operations may constitute
a cost centre called process cost centre. An operation cost centre consists of machines and/or
persons carrying out similar operations while a process cost centre consists of a specific
process of a continuous sequence of operations.
Service cost centre are those cost centres which are not directly engaged in productive work,
but provide services to productive cost centres so that production work may be carried out.
Repairs and maintenance department, steam plant, power plant etc. are examples of service
cost centres. The cost of service cost centres (service departments) are apportioned to
productive costs centres (production department) on equitable basis. Costs of the productive
cost centres together with cost transferred from service cost centres are finally charged to all
cost unit handled by the respective productive cost centres.
There is no prescribed rule for the number of cost centres to be set up or created in a plant.
Closer control and greater accuracy of cost absorption can be achieved by increasing the
number of cost centres.
Classification of Cost
Classification of cost refers to grouping of costs according to their common characteristics.
Some of the important bases of classification of cost are as mentioned below:
a. By nature of elements b. By function
c. By variability or behavior d. By controllability
e. By normality f. By costs for Management Decision Making
a. By nature of elements: this type of classification is useful to determine the total cost. The
elements of cost are as shown in the diagram below:
ELEMENTS OF COST
Material Cost Labor Cost Other Expenses
Direct Indirect Direct Indirect Direct Indirect

Material Material Labor Labor Expenses Expenses
Cost Cost Cost Cost
Overheads
Production or Works Administration Selling Distribution

Overheads Overheads Overheads Overheads
Direct Materials: Materials which are present in the finished product or can be economically
identified in the product are called direct materials. For eg. Cloth in dress making.
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Direct Labor: Labor which can be economically identified or attributed wholly to a cost object
is called direct labor. For eg. Labor engaged in the actual production of the product or in
carrying out the necessary operations for converting the raw materials into finished product.
Direct Expenses: it includes all expenses other than direct material or direct labor which are
specially incurred for a particular cost object and can be identified in an economically feasible
way. For e.g. Hire charges of a special machinery.
Indirect Materials: materials which normally do not form part of the finished product (cost
object) are known as indirect materials. These are:
a. Stores used for maintaining machines and building (cotton waste, lubricants, etc.)
b. Stores used by service departments like power house, boiler house, canteen, etc.
Indirect Labor: labor costs which cannot be allocated but can be apportioned to or absorbed
by cost units or cost centres is known as indirect labor. For eg. Indirect labor includes wages
of supervisors, maintenance workers, etc.
Indirect Expenses: expenses other than direct expenses are known as indirect expenses,
that cannot be directly, conveniently and wholly allocated to cost centres. Factory rent and
rates, insurance of plant and machinery, power, lighting, telephone expenses, etc. are some
examples of indirect expenses.
Overheads: It is the aggregate of indirect material costs, indirect labor costs and indirect
expenses. The main groups into which overheads may be subdivided into the following:
i. Production or Work overheads: indirect expenses which are incurred in the factory for
running of the factory such as factory rent, power and fuel, etc.
ii. Administration overheads: indirect expenses related to management and administration of
business such as office rent, printing and stationery, etc.
iii. Selling overheads: indirect expenses incurred for marketing of a commodity such as
advertisement, sales commission and incentives, etc.
iv. Distribution overheads: indirect expenses incurred towards dispatch and logistics for
transportation of goods. For eg. Packing and Loading expenses, Freight, warehouse
charges, etc.
b. By Function: costs are divided according to the function for which they have been incurred.
It includes the following:
i. Prime Cost
ii. Factory Cost
iii. Cost of Production
iv. Cost of Goods Sold
v. Cost of Sales
c. By variability or behavior: according to this classification costs are classified into three
groups viz. fixed, variable and semi-variable.
i. Fixed Costs: these are the costs which are incurred for a period and which within certain
output and turnover limits, tend to be unaffected by fluctuations in the levels of activity
(output or turnover). They do not tend to increase or decrease with the changes in output.
For eg. Rent, Insurance of factory building remain same for different level of production.
ii. Variable Costs: these costs tend to vary with the volume of activity. Any increase in the
activity results in an increase in the variable cost and vice-versa. For eg. Cost of direct
labor, direct material, etc.
iii. Semi-Variable Costs: these costs contain components of both fixed and variable and are
thus partly affected by fluctuations in the level of activity. Examples of semi variable costs
are gas, electricity, etc.
d. By Controllability: here costs are classified into controllable and uncontrollable costs.
i. Controllable Costs: these are costs which can be influenced by the action of a specified
member of an organization. A business organization is usually divided into a number of
responsibility centres and an executive heads each such centre. Controllable costs incurred
in a particular responsibility centre can be influenced by the action of executive heading
that responsibility centre. For eg. Direct cost comprising direct labor, direct material, direct
expenses and some of the overheads are generally controllable by the shop level
management.
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ii. Uncontrollable Costs: costs which cannot be influenced by the action of a specified member
of an organization are known as uncontrollable costs. For eg. Expenditure of Factory Stores
which is apportioned to a machine shop is not controlled by the machine shop in-charge or
foreman.
e. By Normality: according to this basis cost may be categorized as follows:
i. Normal Costs: it is the cost that is normally incurred at a given level of output under the
conditions in which that level of output is normally attained
ii. Abnormal Costs: it is the cost which is not normally incurred at given level of output in the
conditions in which that level of output is normally attained. It is charged to costing profit
and loss account.
f. By Costs for Management Decision Making: According to this basis cost may be
categorized as follows:
i. Pre-determined Cost: a cost which is computed in advance before production or start of
operation on the basis of specification of all factors affecting cost, is known as pre-
determined cost.
ii. Standard Cost: a pre-determined cost which is calculated from managements expected
standard of efficient operation and the relevant necessary expenditure. It may be used as
a basis for price fixing and cost control through variance analysis.
iii. Marginal Cost: the amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit.
iv. Estimated Cost: the expected cost of manufacture or acquisition generally in terms if a unit
of product computed on the basis of information available in advance of actual production
or purchase. Estimated cost are prospective costs since they refer to prediction of costs.
v. Differential Cost: (incremental and decremental cost) it represents the change (increase or
decrease) in total cost (variable as well as fixed) due to change in activity level, technology,
process or method of production, etc. For eg. If any change is proposed in the existing level
or in the existing method of production, the increase or decrease in total cost or in specific
elements of cost as a result of this decision will be known as incremental cost or
decremental cost.
vi. Imputed Cost: these costs are notional costs which do not involve any cash outlay, interest
on capital, the payment for which is not actually made, is an example of imputed cost. These
costs are similar to opportunity costs.
vii. Capitalized Cost: these are costs which are initially recorded as assets and subsequently
treated as expenses.
viii. Product Cost: these are costs which are associated with the purchase and sale of goods
(in the case of merchandise inventory)
Expenses Excluded from Costs
Expenses relating to capital assets, capital losses and items of pure financial nature do not
form part of cost. Therefore, they are excluded from costs e.g. payment of dividend, income
tax, normal wastage of material, abnormal payments, interest on loan/ capital, preliminary
expenses, discount on issue of shares/ debentures, expenses on issue of share/ debentures,
Preparation of Cost Sheet
Cost Sheet is the statement which shows element wise breakup of cost of production and sale.
There is no standard format of cost sheet. It is prepared in columnar form. Number of columns
may be increased to show total cost and per unit cost for current year, previous year and the
budget for the next year as per requirement. Data recorded in cost sheet is derived from
financial accounting, if separate cost record is not maintained. The condensed form of cost
sheet is given below:
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Cost Sheet
Total Cost Per Unit Cost
Rs. Rs.
Direct Materials XXXX xx
Direct Labor XXXX xx
Other Direct Expenses XXX xx
Prime Cost XXXX xxx
Add: Works Overheads XXX xx
Works Cost XXXX xxx
Add: Administration Overheads XXX xx
Cost of Production XXXX xxx
Add: Selling & Distribution Overheads XXX xx
Total Cost or Cost of Sale XXXX xxx
The detailed cost sheet showing various elements of cost and profit is given below:
Cost Sheet
Opening Raw Material Stock XXX
Add: Materials Purchased XXX
Freight / Carriage Inward XXX
----------
XXXX
Less: Purchase Returns XX
Closing Raw Material Stock XX
-----------
Material Consumed XXXX
Direct Labor XXXX
Other Direct Expenses XXXX
--------
PRIME COST XXXX
Add: Factory Overheads
Indirect Labor XXX
Repairs and Maintenance – factory XXX
Heat, Light and Power XXX
Rates and Taxes XXX
Misc. factory Expenses XXX
Depreciation – Plant & factory building XXX
--------- XXXX
--------
Gross Works Cost XXXX
Add: Opening Stock of Work in Progress XX
Less: Closing Stock of Work in Progress XX
--------
WORKS COST XXXX
Add: Administrative Overheads
Office Salaries and Expenses XXX
Office Rent XXX
Depreciation – Office Building and furniture XXX
Rates and Taxes XXX
-------- XXXX
--------
COST OF PRODUCTION XXXX
Add: Opening Stock of Finished Goods XX
Less: Closing Stock of Finished Goods XX
--------
COST OF GOODS SOLD XXXX
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Add: Selling and Distribution Overheads
Sales Commission XXX
Advertisement & Sales Promotion XXX
Sales – Travel & Conveyance XXX
-------- XXXX
--------
TOTAL COST XXXX
PROFIT XXX
-------
SALES XXXX
=====
Illustration 1:
Determine the Prime Cost from the following details:
Particulars Rs.
Direct Wages 50,000
Direct Expenses 5,000
Opening Stock of Materials 10,000
Materials bought during the period 60,000
Closing Stock of Materials 20,000
Carriage Inward 1,500
Carriage Outward 2,000
Materials returned to Suppliers 1,500
Solution
Cost Sheet
Rs. Rs.
Direct Materials:
Opening Stock of Materials 10,000
Add: Materials bought during the year 60,000
------------
70,000
Less: Materials returned to Supplier 1,500
Closing Stock of Materials 20,000
------------ 48,500
Direct Wages 50,000
Carriage Inwards 1,500
------------
Prime Cost 105,000
=======
Illustration 2:
Compute Works Cost from the following, where indirect wages are 50% of direct wages,
indirect materials are 50% of the direct materials and indirect expenses are 100% of direct
expenses.
Direct Expenses Rs. 10,000
Direct Wages Rs. 30,000
Direct Materials Rs. 10,000
Solution
Cost Sheet
Rs.
Direct Material s 10,000
Direct Wages 30,000
----------
Prime Cost 50,000
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Indirect Materials (50% of 10,000) 5,000
Indirect Wages (50% of 30,000) 15,000
Indirect Expenses (100% of 10,000) 10,000
---------- 30,000
----------
Works Cost 80,000
======
Illustration 3:
Ascertain (i) Prime Cost (ii) Works Cost and (iii) Cost of Production from the undermentioned
figures.
Factory Expenses Rs. 30,000
Administrative Expenses Rs. 20,000
Labor Rs. 25,000
Materials Rs. 35,000
Selling Expenses Rs. 10,000
Solution
Cost Sheet
Rs.
Materials 35,000
Labor 25,000
------------
Prime Cost 60,000
Factory Overheads 30,000
------------
Works Cost 90,000
Administrative Overheads 20,000
------------
Cost of Production 110,000
=======
Illustration 4:
Calculate Prime Cost, Factory Cost, Cost of Production and Profit from the following
particulars:
Particulars Rs. Particulars Rs.
Direct Materials 100,000 Direct Wages 30,000
Wages of Foreman 2,500 Electric Power 500
Lighting – Factory 1,500 Storekeeper’s Wages 1,000
Office 500 Oil and Water 500
Rent – Factory 5,000 Transfer to Reserves 1,000
Office 2,500 Dividend 2,000
Repairs – Factory plant 3,500 Consumable Stores 2,500
Office premises 500 Manager’s Salary 5,000
Deprecation – Factory plant 500 Director’s Fees 1,250
Office premises 1,250 Office Stationery 500
Postage and Telegram 250 Telephone Expenses 125
Travelling Expenses 500 Salesmen’s Salaries 1,250
Warehouse Charges 500 Advertising 1,250
Sales 189,500 Carriage Outward 375
Discount on shares 500 Income Tax 10,000
Solution
COST SHEET
Particulars Rs. Rs.
Direct Materials 100,000
Direct Wages 30,000
------------ 130,000
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Prime Cost 130,000
Wages of Foreman 2,500
Electric Power 500
Storekeeper’s Wages 1,000
Oil & Water 500
Factory Rent 5,000
Repairs to factory plant 3,500
Factory Lighting 1,500
Depreciation – factory plant 500
Consumable stores 2,500
------------ 17,500
Factory Cost 147,500
Add: Administration Overheads
Office Rent 2,500
Office Lighting 500
Repairs to office premises 500
Depreciation on office premises 1,250
Manager’s salary 5,000
Directors’ fees 1,250
Office Stationery 500
Telephone charges 125
Postage and telegrams 250
----------- 11,875
Carriage Outward 375
Salesmen’s Salaries 1,250
Travelling expenses 500
Advertising 1,250
Warehouse charges 500
----------- 3,875
Cost of Sales 163,250
Profit 26,250
Sales 189,500
=======
Note:
a. Transfer to reserves, Income Tax and Dividend are items of appropriation of profit, hence
not considered in the cost sheet.
b. Discount on shares is a non- operating expense item hence it is excluded from cost.
Illustration 5:
From the following information for the month of March, prepare a Cost Sheet to show the
following components: (a) Prime Cost (b) Factory Cost (c) Cost of Production (d) Total Cost.
Direct materials 57,000 Telephone and Postage 200
Factory wages 28,500 Printing and Stationery 100
Factory rent and rates 2,500 Legal Charges 150
Office rent and rates 500 Advertisement 1,500
Plant repairs 1,000 Salesmen’ salaries 2,500
Plant depreciation 1,250 Showroom rent 500
Factory heating & lighting 400 Sales 116,000
Factory manager’s salary 2,000
Office Salaries 1,600
Director’s remuneration 1,500
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Solution
Cost Sheet for the month of March, …………
Particulars Rs. Rs.
Direct Wages 28,500
------------ 85,500
Prime Cost 85,500
Factory rent and rates 2,500
Plant repairs 1,000
Plant depreciation 1,250
Factory heating & lighting 400
------------ 7,150
Factory Cost 92,650
Office salaries 1,600
Director’s remuneration 1,500
Telephone and postage 200
Office rent and rates 500
Printing and stationery 100
Legal charges 150
----------- 4,050
Advertisement 1,500
Showroom rent 500
----------- 4,500
Total Cost (or Cost of Sales) 101,200
Profit 14,800
Sales 116,000
=======
Illustration 6:
A manufacturer presents the following details about the various expenses incurred in
manufacturing:
Raw materials consumed 70,000 Carriage inwards 2,000
Factory rent 2,400 Bad debts 440
Printing & Stationery 620 Legal Expenses 350
Carriage outwards 1,540 Indirect material 560
Power 4,600 Depreciation on furniture 160
Postage expenses 465 Repairs to machinery 1,200
Salesmen’s Salary 3,400 Advertising 500
Direct wages 85,000 General manager’s salary 36,000
Factory manager’s salary 18,000 Depreciation on machinery 1,240
Audit fees 350
Solution
Cost Sheet for the period …………
Particulars Rs. Rs.
Raw materials consumed 70,000
Carriage inwards 2,000
Direct wages 85,000
-----------
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Prime Cost 157,000
Factory Overheads:
Factory rent 2,400
Indirect material 560
Power 4,600
Repairs to machinery 1,200
Depreciation on machinery 1,240
---------- 28,000
-----------
Works Cost 185,000
Administrative Overheads:
Printing 620
Legal Expenses 350
Postage 465
Depreciation on furniture 160
General manager’s salary 36,000
Audit fees 350
---------- 37,945
-----------
Selling Overheads:
Bad debts 440
Carriage outwards 1,540
Salesmen’s salary 3,400
Advertising 500
---------- 5,880
------------
Total cost / Cost of Sales 228,825
=======
Illustration 7:
Prepare a cost sheet of the following data relating to the manufacture of Jeans:
Number of Jeans manufactured during the month – 1800
Direct materials consumed 20,000 Depreciation of machine 500
Direct labor 8,000 Office overheads 8,000
Indirect labor (in factory) 2,500 Office salaries 2,000
Supervision costs (in factory) 1,000 Misc. office expenses 1,000
Factory premises rent 1,600 Selling and distribution
Factory lighting 600 overheads 6,000
Oil for machines 100
Note: a profit margin of 20% on the total cost of goods is expected on the sale of Jeans.
Solution
Cost Sheet for the period …………
Particulars Rs. Rs. Per unit Rs.

Direct labor 8,000
------------ 28,000
Prime Cost 28,000 28.00
Indirect labor 2,500
Supervision costs 1,000
Factory rent 1,600
Factory lighting 600
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Oil for machines 100
Depreciation of machines 500
------------ 6,300 6.30
Factory Cost 34,300 34.30
Office overheads 8,000
Office salaries 2,000
Misc. expenses 1,000
----------- 11,000 11.00
Cost of Production 45,300 45.30
Add: Selling and Distribution Overheads 6,000 6.00
Total Cost (or Cost of Sales) 51,300 51.30
Profit @ 20% on Total Cost 10,260 10.26
Sales 61,560 61.56
======= =====
Illustration 8:
From the following particulars of manufacturing company for the year ended 31.3.2020,
prepare a cost sheet showing cost of production.
Rs.
W.I.P at the beginning at Prime Cost 51,000
Manufacturing Expenses 15,000
---------- 66,000
W.I.P at the closing at Prime Cost 45,000
Manufacturing Expenses 9,000
---------- 54,000
Stock of raw materials at the beginning 225,000
Purchase of raw materials 477,000
Direct labor 171,000
Manufacturing expenses 84,000
Closing stock of raw materials 204,000
Solution
Cost Sheet for the year ended 31.03.2020
Rs. Rs.
Raw Materials:
Add: Opening Stock 225,000
Purchases 477,000
-----------
702,000
Less: Closing Stock 204,000
Raw Materials Consumed ----------- 498,000
Direct Labor 171,000
-----------
669,000
Add: W.I.P at the beginning 51,000
-----------
720,000
Less: W.I.P at the closing 45,000
-----------
Prime Cost 675,000
Manufacturing Expenses:
Related to opening W.I.P 15,000
Add: Related to current year 84,000
----------
99,000
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Less: Related to closing W.I.P 9,000
---------- 90,000
-----------
======
Illustration 9:
JK manufacturing company submits the following information on 31.3.2019
Sales for the year 137,500
Inventories at the beginning of the year
Finished goods 3,500
W.I.P 2,000
Purchase of material 55,000
Material inventory:
At the beginning of the year 1,500
At the end of the year 2,000
Direct labor 32,500
Factory overheads were 60% of direct labor cost
Inventories at the end of the year
W.I.P 3,000
Other expenses for the year:
Selling expenses – 10% of sales
Administrative expenses – 5% of sales
Prepare Statement of Cost
Solution
Cost Sheet of JK for the year ended 31.03.2019
Rs. Rs.
Opening Stock of Raw Material 1,500
Add: Purchase of Material 55,000
---------
56,500
Less: Closing Stock of Raw Material 2,000
--------- 54,500
Direct labor 32,500
-----------
Prime Cost 87,000
Factory overheads (60% of 32,500) 19,500
-----------
Gross Works Cost 106,500
Add: Opening Stock of W.I.P 2,000
-----------
108,500
Less: Closing Stock of W.I.P 3,000
-----------
Works Cost 105,500
Administrative Overheads (5% of 137,500) 6,875
-----------
Add: Opening Stock of finished goods 3,500
-----------
115,875
Less: Closing Stock of finished goods 4,000
-----------
Cost of goods Sold 111,875
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Selling Overheads (10% of 137,500) 13,750
-----------
Cost of Sales/ Total Cost 125,625
Sales 137,500
-----------
Profit 11,875
======
Illustration 10:
From the account books of M/s. VN Enterprises, the following details are extracted for the year
ending on 31st March, 2018:
Stock of material - opening 94,000 Repairs to plant 21,200
Stock of material – closing 100,000 Factory – rent, rates, taxes 6,000
Direct wages 119,200 Office – rent, rates, taxes 3,200
Material purchases 416,000 Salesmen Travel expenses 6,200
Indirect wages 8,000 Salesmen’s salaries 16,800
Administrative Staff Salary 20,000 Depreciation - Plant 14,200
Freight Inward 16,000 Depreciation - Furniture 1,200
Freight Outward 10,000 Directors’ fees 12,000
Cash discounts allowed 7,000 Electricity – Factory 24,000
Bad debts 9,400 Fuel for Boiler 32,000
General Charges 12,400 Manager’s salary 24,000
The manager’s time is shared between the factory and office in the ratio 20:80. For the
aforementioned details you are required to prepare (a) prime cost (b) factory overheads (c)
Administrative overheads and (d) total cost.
Solution
Cost Sheet of JK for the year ended 31.03.2018
Rs. Rs.
Opening Stock of Raw Material 94,000
Add : Purchase of Raw Material 416,000
Freight Inward 16,000
-----------
526,000
Less: Closing Stock of Raw Material 100,000
----------- 426,000
Direct Wages 119,200
-----------
Prime Costs 545,200
Factory overheads:
Indirect Wages 8,000
Repairs to plant 21,200
Factory – Rent, rates and taxes 6,000
Depreciation – plant 14,200
Electricity – factory 24,000
Fuel for Boiler 32,000
Manager’s salary (20%) 4,800
-----------
Factory Overheads 110,200
----------- 110,200
-----------
Works Cost 655,400
Administrative Overheads:
Administrative Staff Salary 20,000
Freight outward 10,000
Office – Rent, rates and taxes 3,200
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Depreciation – furniture 1,200
Directors’ fees 12,000
General charges 12,400
Manager’s salary (80%) 19,200
----------
Administrative Overheads 78,000
---------- 78,000
-----------
Selling & Distribution Overheads:
Bad debts 9,400
Salesmen Travel Expenses 6,200
-----------
Selling & Distribution Overheads 32,400
---------- 32,400
------------
Total Cost 765,800
=======
Exercise 1.
Following the following details ascertain (i) Prime Cost (ii) Works Cost and (iii) Cost of
Production (iv) Cost of Goods Sold.
Raw material consumed Rs.115,000
Wages paid to workers Rs. 45,000
Factory expenses Rs. 50,000
Office Salaries & Expenses Rs. 75,000
Advertisement & Selling Expenses Rs. 15,000
Exercise 2.
Calculate Prime Cost, Factory Cost, Cost of Production and Profit from the following:
Raw Materials 30,000 Plant Manager Salary 20,000
Labor wages 24,000 Freight Inward 1,000
Factory Rent 5,000 Factory Repairs 7,500
Factory Electricity & Power 3,250 Telephone Expenses 500
Office Salaries 12,500 Office Rent 2,500
Depreciation – plant 2,000 Printing & Stationery 250
Postage & Courier charges 500 Godown Rent 1,500
Salesmen’s Salary 7,500 Sales Commission 1,000
Exercise 3.
Prepare a cost sheet showing cost of production, from the following details:
Rs.
Opening stock of raw materials 25,000
Closing stock of raw materials 14,000
Raw material purchases 77,000
Direct labor 20,000
Manufacturing expenses 34,000
Opening work in progress 12,000
Closing work in progress 9,000
Exercise 4.
From the following data pertaining to manufacture of plastic cans, prepare a cost sheet along
with per unit cost. The number of plastic cans manufactured during Oct., 2019 were 2000
Direct materials consumed 36,000 Direct labor 15,000
Factory power & fuel 6,000 Factory expenses 7,000
Plant repairs & maintenance 2,000 Office salaries 4,600
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Office light expenses 400 Office rent 1,800
Warehousing expenses 500 Selling expenses 500
Salesmen’s salary 2,500 Bad debts 1,200
Exercise 5.
Prepare cost sheet for OK industries from following information for the year ending 31.3.2019
a. Sales for the year 275,000
b. Opening Stock:
Raw materials 3,000
W.I.P 4,000
c. Purchase of material 110,000
d. Direct labor 70,000
e. Factory overheads were 50% of direct labor cost
f. Closing Stock:
Raw materials 4,000
W.I.P 6,000
g. Other expenses for the year:
Selling expenses – 5% of sales
Administrative expenses – 10% of sales
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Unit II – Methods of Costing and Material Management
Methods of Costing:
Every industry is different and the nature of these industry differs. Some industries are simple
and produce only one product for e.g. Tiles making, while some industries may produce one
product but it may really be an assembly of numerous components like a car. Further, some
industries may be involved in production of one homogeneous product which involves many
distinct stages and processes such as edible (vegetable) oil. In some cases, the manufacturing
process may be resulting in by-products, for e.g. molasses and ethanol are by-product of sugar
manufacturing process. While some concerns undertake work as per the requirement of
customer for e.g. printing of stationery.
The exact method to be employed to ascertain cost per unit, therefore depends on the nature
of the industry. The following are some of the principal methods of costing:
a. Job Costing: in this case the cost of each job is ascertained separately. This method of
costing is used when production is not highly repetitive and in addition consists of distinct
jobs so that the material and labor costs can be identified by the particular job. It is suitable
in all cases where work is undertaken on receiving a customer’s order like car workshop
undertaking repair of car, printing press undertaking jobs as per customer’s requirement,
etc. A factory may also produce different types of goods against order or production may
be undertaken against a ‘stock’ order i.e. for keeping the goods in stock for ready supply
as per customers’ requirement. In all these cases the best option costing results can be
obtained by giving distinct job number to each order and opening separate account to which
all expenditure related to that job are charged. As a result of this, ascertaining cost of a
particular job becomes simpler.
b. Batch Costing: it is considered to be extension of job costing and is practiced where jobs
are arranged in different batches. A batch may represent a number of small orders passed
through the factory in a batch. Each batch here is treated as a unit of cost and thus
separated accounted in cost records. Here, cost per unit is determined by dividing the cost
of batch with the number of units produced in the batch. For eg. a factory produces 5000
rims of bicycle at one time then the cost incurred for production of the same is called as
batch costing. This type of costing is suitable for general engineering companies and
pharmaceutical industries.
c. Contract Costing: Contract refers to an assignment to carry out an activity. Contract
costing is not different from job costing – a contract is a big job while job is a small contract.
The term contract is applied where large scale works are undertaken and carried out as per
terms of agreement. This type of costing is suitable for firms engaged in the construction of
road, bridges, buildings, dams, etc. Here the cost of each contract is ascertained
separately. Contract costing is also known as terminal costing.
d. Unit (Single or output) Costing: in cases where products can be expressed in identical
quantitative units and where manufacture is continuous, this type of costing is applied.
Generally, it best suited for single product, as in the case of brick making, flour mills, paper
mills, brewery, etc. wherein, only one type of product is produced. The cost per unit of
output or production is ascertained and the amount of each element constituting such costs
is determined.
e. Process Costing: here the cost of completing each stage of work is ascertained, like the
cost of making pulp and cost of making paper from pulp. Process costing aims at calculating
the cost at each stage through which a product passes in its production process. This
system of costing is suitable for extractive industries such chemicals, paints, soaps, etc.
f. Operational Costing: this is further refinement of process costing. This system is
employed in industries where mass or repetitive production is carried out. Generally, many
operations are necessary to make an article for eg. if steel cupboards have to be made,
then steel sheets have to be cut into strips as per required size, then they shall be shaped
as per design, welding, fitting of handles, accessories shall be done and then it will be
painted and polished. Each one of these is operation and it is possible to find out the cost
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of each operations separately. The cost of cupboard can be ascertained by adding the cost
of all these operations. If this is done, it is known as operational costing. The procedure of
costing is broadly the same as process except that in this case cost unit is an operation
instead of a process.
g. Service Costing or Operating Costing: it refers to the computation of the total operational
cost incurred on each unit of intangible product (i.e. such products which do not have
physical form & which cannot be touched) for eg. Courier, Transport, Electricity, etc. These
intangible products i.e. services can be in the form of internal services that are carried out
by industries as supporting activities for the manufacturing of goods or in the way of external
services that are offered as significant product to the customers by the service sector
companies. Service costing is an essential concept since every service organization needs
to ascertain its business overheads. The system of ascertaining the cost would be similar
to that of single or output costing. Further, operating cost may also make use of operation
cost for e.g. a coaching class may ascertain the cost of (i) tutors salary (ii) classroom rent,
electricity, etc. (iii) preparation of study material (iv) conducting and assessment of exam
and (v) providing counselling services.
h. Multiple Costing: it is combination of two or more methods of costing methods mentioned
above. Under this system, the costs of different sections of production are combined after
finding out the cost of each and every part manufactured. The system of ascertaining cost
in this way is applicable when a product comprises many parts which are assembled to
manufacture the product. For eg. a company manufactures bicycles including its
components; then the costing of parts of bicycle shall be done by job or batch costing while
the cost of assembling of bicycle will be done by single or output costing method. This whole
system of costing is known as multiple costing.
The following table summarizes the various methods of costing applied in different industries:
Nature of Output Method Cost Example of
Industry
As per Customer Job Costing For each order/ Automobile
Specification job/ assignment Service Station
Batch wise processing Batch Costing For each batch Pharmaceutical
Companies
Execution of work Contract Costing For each contract Construction
Companies
Similar units of single Unit ( single or output) For entire activity Beverages ( Cold
product Costing but averaged for drinks), Mineral
output Water
A series of processes Process or For each process Chemical
Operational costing or operation Industries
Rendering Services Service or Operating For each service Hospitals, Courier
Costing
Multiple variety of Multiple Costing Combination of Automobile
activities and process any methods Industry
for one product
Methods of pricing material issues (FIFO, LIFO, Simple Average, Weighted Average)
Materials are purchased at different times and at different prices, due to which pricing of
materials issued from stores becomes very crucial for ascertaining costs. The frequent
changes in the prices of materials and fluctuation in business cycle and frequency at which
materials are issued to production make things complicated. However, in order to price the
materials that are to be sent to production, some methods are adapted. Some of the important
methods for pricing materials are as follows:
I. Actual Cost Methods II. Average Cost Methods III. Other Methods
a. First In First Out (FIFO) a. Simple Average a. Standard Price
b. Last In First Out (LIFO) b. Weighted Average b. Inflated Price
c. Base stock c. Periodic Simple Average c. Market Price
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d. Periodic Weighted Average
Before the methods are discussed, it is important to note that, whatever method for valuing or
pricing material issues is followed, the actual issue of material will always be on the basis of
first in first out i.e. the actual issue of material generally takes place from the earliest
consignment.
First In First Out (FIFO) or At Cost Method: it is a method of pricing the issues of materials,
in the order in which they are purchased. In other words, the materials are issued in order in
which they arrive in the stores. This method assumes that materials are issued from the oldest
supply. Thus, new material entering the stores are put in the end of the line and the ones at
the start of the line that have been in stores for longer time are issued immediately. For eg. if
75 units of material X were received on 10th Jan., 2020 at a cost of Rs.10 per unit and if on
16th Jan., 2020 another 50 units of material X were received at a cost of Rs.12 per unit and if
on 18th Jan. 2020 100 units of material X are issued, then the cost of 100 units of material X
will be Rs.1050 (75 units at Rs.10 = Rs.750 and 25 units at Rs.12 = Rs.300 i.e.750+300).
Therefore, under this method the price of materials issued is exactly the same as paid and
hence, the cost of jobs or products will be accurately known at least with respect to materials.
This also results in the inventory being valued close to current replacement cost.
This method is more suitable when (i) materials are subject to deterioration (ii) when inventory
items do not move very fast and (iii) when the prices of materials purchased are not changing
constantly.
Advantages:
(i) Simple to understand and easy to operate
(ii) Material cost charged to production represents the actual cost with which the cost of
production should have been charged.
(iii) Suitable for slow moving materials
(iv) When prices are falling, this method gives better results
(v) Closing stock of material is reflected very close to the current market price.
Disadvantages:
(i) If the prices fluctuate frequently, calculation becomes difficult.
(ii) The issue prices do not reflect the current prices
(iii) Since each issue of material to production is related to a specific purchase price, the costs
charged to the same job are likely to show a variation from period to period.
(iv) When prices rise, the real profit of the concern being low and may be inadequate to meet
the concern’s demand to purchase material at the prevailing prices.
Last In First Out (LIFO) Method: this method of pricing the issue of materials, assumes
disposal of the newest inventory first. According to this method, material units issued should
carry the cost of the most recent purchase, although the physical flow of material may be
different. This method believes that the most recent cost is most significant in matching cost
with revenue in the income determination procedure. As per LIFO the objective is to charge
the cost of current purchase to work in process and to leave the oldest costs in the inventory.
For eg. if 75 units of material X were received on 10th Jan., 2020 at a cost of Rs.10 per unit
and if on 16th Jan., 2020 another 50 units of material X were received at a cost of Rs.12 per
unit and if on 18th Jan. 2020 100 units of material X are issued, then the cost of 100 units of
material X will be Rs.1100 (50 units at Rs.12 = Rs.600 and 50 units at Rs.10 = Rs.500
i.e.600+500). Thus, the cost of material issued is more close to the current costs.
Advantages:
(i) Materials consumed are priced in a systematic and realistic manner
(ii) The most recent costs are charged against current production and sales
(iii) In case of falling prices, profit tends to rise due to lower material rate, yet the finished
products appear to be more competitive and are at market price.
(iv) Over a period of time, LIFO helps to iron out the fluctuations in profit
(v) In time of inflation, LIFO will tend to show the correct profit and thus avoid paying undue
taxes to some extent.
Disadvantages:
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(i) When frequent purchases are made at highly fluctuating rates, calculation become
complicated.
(ii) Inventories may look to be of insignificant value, as these inventories are priced at older
or perhaps the oldest prices.
(iii) Costs of different similar batches of production carried on at the same time may differ a
great deal.
(iv) This method of valuation of material is not acceptable by the Income tax authorities.
Simple Average or Average Cost Method: under this method, material issues are priced at
the rate, which is the simple average of the purchase price of the various consignments in
stock at the time of issue of materials. The average price is calculated by dividing the total of
all unit rates of the materials in the stores by the number of unit rates of price.
Total unit prices of each purchase
Material issue price = Total number of purchases
For e.g., on the date of issue of a material, there are three consignments in stock as follows:
50 units purchased @ Rs.6 per unit
6+7+8 21
Material issue price = 3 = 3 = Rs.7 per unit
Advantages:
(i) It gives fairly accurate results, when the quantities of purchases are uniform and prices
are stable.
(ii) It is easy to operate and reduces clerical work.
(iii) Distortion of cost is not much.
(iv) Smoothens out price variation in narrow margins
Disadvantages:
(i) It gives absurd results when prices fluctuate and when quantities of purchases vary widely.
(ii) Since, issue are not charged at actual cost it gives rise to profit or loss on materials.
(iii) It does not take into consideration the quantities of purchases
(iv) Price needs to be calculated at every time while issuing the material.
Weighted Average Method: this method gives consideration to the quantity of material and
price of the material purchased while determining the material issue price. As per this method,
the material issued are price at the rate, which is obtained by dividing the total cost of material
in the stock at the time of issue, by the total quantity of material in the stock. The weighted
average is calculated as follows:
Total cost of material purchased
Material issue price = Total quantity of material purchased
For e.g., on the date of issue of a material, there are three consignments in stock as follows:
300+140+80 520
Material issue price = 80 = 80 = Rs.6.50 per unit
Advantages:
(i) It smoothens the price fluctuations, if at all it is there due to material purchases.
(ii) Inventory is valued at only one rate.
(iii) Issue price need not be calculated for each issue unless new lot of material is received.
(iv) It is acceptable to income tax authorities
(v) Issue price is much close to market price
Disadvantages:
(i) If receipts are many, this method requires lots of calculation.
(ii) Material cost does not reflect actual cost price and therefore, a profit or loss will arise out
of such pricing method.
(iii) Inventory in hand i.e. the stock does not represent current market values.
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FIFO - Illustrations:
1. Prepare a Stores Ledger on FIFO method
2019
Mar., 1 Opening balance is 400 units at Rs.4 per unit
Mar., 6 Purchased 600 units at Rs.6 per unit
Mar.,12 Issued 900 units
Mar.,18 Purchased 500 units at Rs.8 per unit
Mar.,28 Purchased 200 units at Rs.10 per unit
Solution
Stores Ledger
Receipts Issues Balance
Date Particulars
Qty Rate Amount Qty Rate Amount Qty Rate Amount
(units) ( Rs.) ( Rs.) (units) ( Rs.) ( Rs.) (units) ( Rs.) ( Rs.)
1.03.19 Balance b/d 400 4 1600
6.03.19 GRN no. 600 6 3600 400 4 1600
600 6 3600
12.03.19 MRN no. 400 4 1600
500 6 3000 100 6 600
18.03.19 GRN no. 500 8 4000 100 6 600
500 8 4000
24.03.19 MRN no. 100 6 600
450 8 3600 50 8 400
28.03.19 GRN no. 200 10 2000 50 8 400
200 10 2000
31.03.19 MRN no. 50 8 400
175 10 1750 25 10 250
( Note : GRN – Goods Receipt Note MRN – Material Requisition Note )
Stock at the end of the month i.e. as on 31st March, 2019 is 25 units at Rs. 250
2. Prepare a stores ledger from the following particulars for the month of July, 18 under FIFO method
of pricing issues.
Qty. in units Rate per unit (Rs.)
July, 1 Opening Stock 300 9.70
3 Purchases 250 9.50
4 Issues 400
20 Issues 210
29 Issues 100
Solution
Stores Ledger
Date Particulars
July, 18
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
1 Balance b/d 300 9.70 2910
3 GRN no. 250 9.80 2450 300 9.70 2910
250 9.80 2450
4 MRN no. 300 9.70 2910
100 9.80 980 150 9.80 1470
15 GRN no. 300 10.05 3015 150 9.80 1470
300 10.05 3015
20 MRN no. 150 9.80 1470
60 10.05 603 240 10.05 2412
25 GRN no. 150 10.30 1545 240 10.05 2412
150 10.30 1545
29 MRN no. 100 10.05 1005 140 10.05 1407
150 10.30 1545
Stock at the end of the month i.e. as on 31st July, 2018 is 290 units at Rs. 2952
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3. Following are the details of receipts and issues of stores in a factory during Feb., 2020.
Feb., 1 Opening Balance 500 kg @ Rs.25
Feb., 8 Issue 250 kg
Feb., 13 Receipts 200 kg @ Rs.24.50
Feb., 14 Refund from Work Order 15 kg @ Rs.24
Feb., 20 Receipts 240 kg @ Rs.24.37
Issues are to be priced on the principles of FIFO. Further, a shortage of 5 kg of material was
noticed on 15th Feb., 2020. Write out the complete store ledger in respect of the above for the
month of Feb., 2020.
Solution
Stores Ledger
Date
GRN Qty Rate Amount GIN Qty Rate Amount Qty Rate Amount
Feb., 20 no. Kg Rs. Rs. no. Kg Rs. Rs. Kg Rs. Rs.
1 500 25.00 12500
8 250 25.00 6250 250 25.00 6250
13 200 24.50 4900 250 25.00 6250
200 24.50 4900
14 15 24.00 360 250 25.00 6250
200 24.50 4900
15 24.00 360
15 5* 25.00 125* 245 25.00 6125
200 24.50 4900
15 24.00 360
16 180 25.00 4500 65 25.00 1625
200 24.50 4900
15 24.00 360
20 240 24.37 5849 65 25.00 1625
200 24.50 4900
15 24.00 360
240 24.37 5849
24 65 25.00 1625
200 24.50 4900
15 24.00 360
24 24.37 585 216 24.37 5264
th
Stock at the end of the month i.e. as on 29 Feb., 2020 is 216 units at Rs. 5264
* Note : Shortage of 5 kg is shown under material issue and is valued @ Rs.25 as per FIFO
4. Prepare Stores Ledger account as per FIFO method from the following information:
1st Jan., Opening Stock 200 pieces @ Rs.2 each
5th Jan., Purchases 100 pieces @ Rs.2.20 each
2nd Jan., Issues 150 pieces
7th Jan., Issues 100 pieces
Solution
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Stores Ledger
Date
Jan., no. Pieces Rs. Rs. no. Pieces Rs. Rs. Pieces Rs. Rs.
1 200 2.00 400
2 150 2.00 300 50 2.00 100
5 100 2.20 220 50 2.00 100
100 2.20 220
7 50 2.00 100
50 2.20 110 50 2.20 110
10 150 2.40 360 50 2.20 110
150 2.40 360
12 50 2.20 110
50 2.40 120 100 2.40 240
20 180 2.50 450 100 2.40 240
180 2.50 450
28 100 2.40 240
100 2.50 250 80 2.50 200
Stock at the end of the month i.e. as on 31th Jan., is 80 pieces at Rs. 200
5. Prepare Stores Ledger as per first in first out method for pricing of issue of materials
Date Units Rate
April 1, 2017 Opening Balance 1000 Rs.5
April 3, 2017 Received 5000 Rs.6
April 4, 2017 Issued 3000
April 8, 2017 Received 3000 Rs.5
The weekly physical stock taking on April 7, 2017 showed a shortage of 100 units
Solution
Stores Ledger
Date
Apr.,17 no. Units Rs. Rs. no. Units Rs. Rs. Units Rs. Rs.
1 1000 5 5000
3 5000 6 30000 1000 5 5000
5000 6 30000
4 1000 5 5000
2000 6 12000 3000 6 18000
6 2000 6 12000 1000 6 6000
7 100 * 6 600 900 6 5400
8 3000 5 15000 900 6 5400
3000 5 15000
9 900 6 5400
1100 5 5500 1900 5 9500
Stock at the end is 1900 units valued at Rs. 9500
* Note : Shortage of 100 units is shown under material issue @ Rs.6 as per FIFO
LIFO - Illustrations:
1. Prepare a stores ledger under LIFO method
1st Dec., 2015 Opening Stock is 500 units at Rs.6 per unit
4th Dec., 2015 Issued 300 units
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8th Dec., 2015 Purchased 600 units at Rs. 9 per unit
14th Dec., 2015 Purchased 500 units at Rs.10
19th Dec., 2015 Purchased 500 units at Rs.12 per unit
22nd Dec., 2015 Issued 600 units
26th Dec., 2015 Purchased 250 units at Rs.14 per unit
Solution
Stores Ledger
Date
Dec. 15 no. Units Rs. Rs. no. Units Rs. Rs. Units Rs. Rs.
1 500 6 3000
4 300 6 1800 200 6 1200
8 600 9 5400 200 6 1200
600 9 5400
14 500 10 5000 200 6 1200
600 9 5400
500 10 5000
15 500 10 5000 200 6 1200
600 9 5400
16 250 9 2250 200 6 1200
350 9 3150
19 500 12 6000 200 6 1200
350 9 3150
500 12 6000
22 500 12 6000
100 9 900 200 6 1200
250 9 2250
26 250 14 3500 200 6 1200
250 9 2250
250 14 3500
30 250 14 3500
100 9 900 200 6 1200
150 9 1350
2. From the following receipts and issues of material during the month of April, 2017 prepare
stores ledger account according to LIFO method.
April, 1 Received 500 units @ Rs.10 per unit
April, 8 Issued 300 units
On 1st April, stock in hand was 200 units valued @ Rs.9 per unit.
Solution
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Stores Ledger
Date
Apr. 17 no. Units Rs. Rs. no. Units Rs. Rs. Units Rs. Rs.
1 200 9 1800
1 500 10 5000 200 9 1800
500 10 5000
5 250 11 2750 200 9 1800
500 10 5000
250 11 2750
8 250 11 2750
50 10 500 200 9 1800
450 10 4500
10 400 12 4800 200 9 1800
450 10 4500
400 12 4800
13 250 12 3000 200 9 1800
450 10 4500
150 12 1800
20 100 11 1100 200 9 1800
450 10 4500
150 12 1800
100 11 1100
28 100 11 1100
150 12 1800
150 12 1800 200 9 1800
300 10 3000
3. The following transactions occur in the purchase and issue of material:
Jan., 19 purchased 100 units at Rs.5 each
Feb., 4 purchased 25 units at Rs.5.25 each
Feb., 12 purchased 50 units at Rs.5.50 each
Feb., 12 issued 80 units
Mar., 6 purchased 50 units at Rs.5.50 each
Mar., 20 issued 80 units
Mar., 27 purchased 50 units at Rs.5.75 each
Complete the Stock Account showing the balance on 31st March by using LIFO method
Stores Ledger
Date
no. Units Rs. Rs. no. Units Rs. Rs. Units Rs. Rs.
Jan. 19 100 5.00 500.00 100 5.00 500
Feb. 4 25 5.25 131.25 100 5.00 500
25 5.25 131.25
Feb. 12 50 5.50 275.00 100 5.00 500.00
25 5.25 131.25
50 5.50 275.00
Feb. 12 50 5.50 275.00
25 5.25 131.25
5 5.00 25.00 95 5.00 475.00
Mar., 6 50 5.50 275.00 95 5.00 475.00
50 5.50 275.00
Mar., 20 50 5.50 275.00
30 5.00 150.00 65 5.00 325.00
Mar., 27 50 5.75 287.50 65 5.00 325.00
50 5.75 287.50
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Closing stock as on 31st March, is 115 units, valued at Rs. 612.50
4. Following is the extract of record of receipts and receipt of sulphur in a factory during Apr.,18
1 Opening balance is 500 tonnes at Rs.100 per tonne
3 Issue 70 tonne
4 Issue 100 tonne
8 Issue 80 tonne
13 Received 200 tonne at Rs.95 per tonne
14 Return from department 15 tonne
16 Issue 180 tonne
20 Received from supplier 240 tonne at Rs.95 per tonne
24 Issue 300 tonne
26 Issue 115 tonne
27 Return from department 35 tonne
Issues are to be priced on LIFO principle.
Stores Ledger
Date
April, 18 no. Tonne Rs. Rs. no. Tonne Rs. Rs. Tonne Rs. Rs.
1 500 100 50000
3 70 100 7000 430 100 43000
4 100 100 10000 330 100 33000
8 80 100 8000 250 100 25000
13 200 95 19000 250 100 25000
200 95 19000
14 15 95 1425 250 100 25000
215 95 20425
16 180 95 17100 250 100 25000
35 95 3325
20 240 95 22800 250 100 25000
275 95 26125
24 275 95 26125
25 100 2500 225 100 22500
25 320 95 30400 225 100 22500
320 95 30400
26 115 95 10925 225 100 22500
205 95 19475
27 35 95 3325 225 100 22500
240 95 22800
28 100 95 9500 225 100 22500
340 95 32300
Closing stock as on 30th March, is 565 units, valued at Rs. 54,800
5. A.K & Co. furnish the following details of store transactions for the month of Oct., 2019.
Prepare stores ledger on LIFO method.
01.10.19 Opening Balance 25 units valued at Rs.162.50
04.10.19 Issues 8 units
06.10.19 Receipts 50 units @ Rs.5.75
10.10.19 Material returned to supplier 10 units
15.10.19 Receipts 25 units @ Rs.6.10
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19.10.19 Received replacement from supplier 10 units
20.10.19 Material returned by department 5 units
22.10.19 Transfer of Material from one job.
to another job in the department 5 units
29.10.19 Transfer of material from one dept.
to another department 5 units
31.10.19 Shortage in stocktaking 2 units
Stores Ledger
Date
Oct, 19 no. Units Rs. Rs. no. Units Rs. Rs. Units Rs. Rs.
1 25 6.50 162.50
4 8 6.50 52.00 17 6.50 110.50
6 50 5.75 287.50 17 6.50 110.50
50 5.75 287.50
7 12 5.75 69.00 17 6.50 110.50
38 5.75 218.50
10 10 5.75 57.500 17 6.50 110.50
28 5.75 161.00
12 15 5.75 86.25 17 6.50 110.50
13 5.75 74.75
13 13 5.75 74.75
7 6.50 45.50 10 6.50 65.00
15 25 6.10 152.50 10 6.50 65.00
25 6.10 152.50
17 10 6.10 61.00 10 6.50 65.00
15 6.10 91.50
19 10 5.75 57.50 10 6.50 65.00
15 6.10 91.50
10 5.75 57.50
20 5 6.10 30.50 10 6.50 65.00
20 6.10 122.00
10 5.75 57.50
26 10 5.75 57.50 10 6.50 65.00
20 6.10 122.00
31 2 6.10 12.20 10 6.50 65.00
18 6.10 109.80
Closing stock as on 31stOct., 2019 is 28 units, valued at Rs.174.80
a. Material received as replacement from supplier is treated as fresh supply
b. Entries for transfer of material from one job / dept. to another job/ dept. are book entries for
adjusting cost for respective jobs/ depts. And have no effect on the stores stock.
Simple Average Method - Illustrations:
1. Prepare a stores ledger account and enter the following transactions adapting simple
average method of pricing issues.
Feb., 1 Opening balance 50 units @ Rs.3 per unit
Feb., 5 Issued 20 units
Feb. ,7 Purchased 50 units @ Rs.4 per unit
Feb., 19 Purchased 75 units @ Rs.5 per unit
Feb., 21 Received back 10 units issued on 9th Feb.
Feb., 26 issued 60 units
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Stores Ledger
Date
Feb., Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
1 50 3.00 150.00
5 20 3.00 60.00 30 3.00 90.00
7 50 4.00 200.00 80 290.00 See (Note a)
9 35 3.50 122.50 45 167.50 See (Note b)
19 75 5.00 375.00 120 542.50 See (Note c)
20 20 4.50 90.00 100 452.50 See (Note d)
21 10 3.50 35.00 110 487.50 See (Note e)
26 60 4.17 250.20 50 237.30 See (Note f)
Closing stock at the end is 50 units, valued at Rs.237.30
** a. Balance Qty = 80 (30+50) & Amount= Rs. 290 (90+200)
b. Rate = Rs. 3.50(3+4)/2; Balance Qty. = 45 (80-35) Amount = Rs.167.50 (290-167.50)
c. Balance Qty = 120 (45+75) Amount.= Rs.542.50 (167.50+375)
d. Rate = Rs.4.50 (4+5)/2; Balance Qty. = 100 (120-20) Amount = Rs.452.50 (542.50-90)
e. Balance Qty = 110 (100+10) Amount = Rs. 487.50(452.50+35)
f. Rate = 4.17 (4+5+3.5)/3; Balance Qty.= 50 (110-60) Amount= Rs.237.30 (487.50-
250.2)
2. The following transactions took place in stores during the month of Oct., 2018.
Receipt:
1.10.18 Opening Stock 200 units @ Rs.7 per unit
3.10.18 Purchased 300 units @ Rs.8 per unit
13.10.18 Purchased 900 units @ Rs.8.60 per unit
23.10.18 Purchased 600 units @ Rs.7.60 per unit
Issues:
5.10.18 Issued 400 units
Prepare Stores Ledger account using Simple Average method for material pricing.
Stores Ledger
Date
Oct., 18
1 200 7.00 1400.00
3 300 8.00 2400.00 500 3800.00
5 400 7.50 3000.00 100 800.00
13 900 8.60 7740.00 1000 8540.00
15 600 8.30 4980.00 400 3560.00
23 600 7.60 4560.00 1000 8120.00
25 600 8.10 4860.00 400 3260.00
Closing stock at the end is 400 units, valued at Rs.3260
3. Prepare stores ledger using simple average method
1st Dec., Opening Stock is 500 units at Rs.2 each
rd
3 Dec., Purchased 400 units at Rs.2.50 each
5th Dec., Issued 600 units
7th Dec., Purchased 800 units at Rs.3.00 each
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12th Dec., Returned from production material issued on 5th Dec., 20 units
17th Dec., Purchased 400 units at Rs.4.00 each
Stores Ledger
Date
Dec., Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
1 500 2.00 1000.00
3 400 2.50 1000.00 900 2000.00
5 600 2.25 1350.00 300 650.00
7 800 3.00 2400.00 1100 3050.00
9 500 2.75 1375.00 600 1675.00
12 20 2.25 45.00 620 1720.00
17 400 4.00 1600.00 1020 3320.00
25 600 3.08 1848.00 420 1472.00
Weighted Average Method - Illustrations:
1. Following is one week record of receipts and issues of a certain material in a factory:
01.03.20 Opening Balance 50 tons @ Rs.10 per ton
03.03.20 Issued 30 tons
04.03.20 Received 60 tons @ Rs.10.125 per ton
06.03.20 Received back material 10 tons issued on 26.02.20 @ Rs.9.94 per ton
Stores Ledger
Date
Mar.,20 Tons Rs. Rs. Tons Rs. Rs. Tons Rs. Rs.
1 50 10.00 500.00
3 30 10.00 300.00 20 10.00 200.00
4 60 10.13 607.50 80 10.09 807.50
5 25 10.09 252.34 55 10.09 555.16
6 10 9.94 99.40 65 10.07 654.56
7 40 10.07 402.80 25 10.07 251.75
Closing stock at the end is 25 tons, valued at Rs.251.75
2. Prepare a stores ledger account showing receipts and issues, pricing the material issued
on the basis of weighted average method from the following particulars:
Date Details Kg. Rate per kg. (Rs.)
June 2, Received 2000 10
6 Received 300 12
9 Issued 1200
10 Received 200 14
11 Issued 1000
22 Received 300 11
30 Issued 200
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Stores Ledger
Date
June Kgs. Rs. Rs. Kgs. Rs. Rs. Kgs. Rs. Rs.
2 2000 10 20000 2000 10.00 20000
6 300 12 3600 2300 10.26 23600
9 1200 10.26 12313 1100 10.26 11287
10 200 14 2800 1300 10.84 14087
11 1000 10.84 10836 300 10.84 3251
22 300 11 3300 600 10.92 6551
30 200 10.92 2184 400 10.92 4367
Closing stock at the end is 400 Kgs., valued at Rs.4367
3. XYZ is a manufacturing unit whose details of store receipts and issues for the month of
April, 2017 are as given below. Prepare their stock ledger using weighted average method
of valuing the issues.
April 1 Opening Stock is 2000 units at Rs.2.50 each
April 3 Issued 1500 units to production
April 4 Received 4500 units at Rs.3 each
April 8 Issued 1600 units to production
April 9 Returned to stores 100 units by production dept. (from the issue of April 3)
April 16 Received 2400 units at Rs.3.25 each
April 19 Returned to the Supplier 200 out of quantity received on April, 4
April 24 Issued to production 2100 units
April 28 Issued to production 2800 units
Stores Ledger
Date
Apr., 17 Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
1 2000 2.50 5000
3 1500 2.50 3750 500 2.50 1250
4 4500 3.00 13500 5000 2.95 14750
8 1600 2.95 4720 3400 2.95 10030
9 100 2.50 250 3500 2.94 10280
16 2400 3.25 7800 5900 3.06 18080
19 200 3.00 600 5700 3.07 17480
20 1000 3.50 3500 6700 3.13 20980
24 2100 3.13 6576 4600 3.13 14404
27 1200 3.75 4500 5800 3.26 18904
29 2800 3.26 9126 3000 3.26 9778
4. Prepare a stores ledger using weighted average method:
Date Particulars Quantity Rate per unit
1.10.18 Opening Balance 200 units Rs.3
3.10.18 Purchases 300 units Rs.4
13.10.18 Purchases 1000 units Rs.4.50
23.10.18 Purchases 600 units Rs.3.80
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Stores Ledger
Date
Oct., 18 Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
1 200 3.00 600
3 300 4.00 1200 500 3.60 1800
5 400 3.60 1440 100 3.60 360
13 1000 4.50 4500 1100 4.42 4860
15 700 4.42 3093 400 4.42 1767
23 600 3.80 2280 1000 4.05 4047
25 600 4.05 2428 400 4.05 1619
5. The store ledger account for material A, in a manufacturing company shows the following
data for the quarter ended 30th Sept.
Date Receipts Issues
Qty.(kgs) Rate/ kg Qty.(kgs)
Jul. 1 Bal. b/d 1600 2.00
Jul. 9 3000 2.20
Jul. 13 1200
Aug. 5 900
Aug. 17 3600 2.40
Aug. 24 1800
Sept. 11 2500 2.50
Sept. 27 2100
Sept. 29 700
Physical verification of stock on 30th Sept., showed actual stock of 3800 units. You are
required to prepare store ledger under weighted average method.
Stores Ledger
Date
Kgs Rate Amount Kgs Rate Amount Kgs Rate Amount
Jul. 1 1600 2.00 3200
Jul. 9 3000 2.20 6600 4600 2.13 9800
Jul. 13 1200 2.13 2557 3400 2.13 7243
Aug. 5 900 2.13 1917 2500 2.13 5326
Aug. 17 3600 2.40 8640 6100 2.29 13966
Aug. 24 1800 2.29 4121 4300 2.29 9845
Sept. 11 2500 2.50 6250 6800 2.37 16095
Sept. 27 2100 2.37 4970 4700 2.37 11124
Sept. 29 700 2.37 1657 4000 2.37 9468
Sept. 30 200 2.37 473 3800 2.37 8994
Inventory Cost Control Techniques
Economic Order Quantity (Reordering Quantity)
Economic Order Quantity (EOQ) is the size of the order that gives maximum economy in
purchasing any material and ultimately contributes towards maintaining the material at the
optimum level and at the minimum cost. In other words, it is the ideal quantity of a material to
be purchased at a time. In other words, it is the ideal quantity of a material to be purchased at
a time. The quantity is fixed in such a way that carrying cost and ordering cost are minimized.
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Carrying cost refers to the cost of holding the materials in the store. Ordering costs refers to
the cost of placing orders for the purchase of materials.
EOQ is the quantity to be ordered at one time is known as ‘ordering quantity’ and should be
determined with good care. EOQ is essentially an accounting formula that determines the
point at which the combination of order costs and inventory carrying costs is the least. The
result is the most cost-effective quantity to order. In case of purchase, this is known as the
order quantity while in case of manufacture it is known as the production lot size.
EOQ is the number of units that a company should add to its inventory with each order to
minimize the total costs of inventory such as holding costs, order costs and shortage costs.
EOQ is used as a part of continuous review inventory system, in which the level of inventory
is monitored at all times and a fixed quantity is ordered each time the inventory level reaches
a specific reorder point.
How to calculate EOQ:
Where C = Consumption of the Material in units during the year/ annual usage of Material
O = Ordering Costs i.e. cost of placing one order including cost of receiving material
I = Inventory Carrying Cost of holding one unit of material per annual in the stores
Example:
Annual usage: 6000 units
Cost of materials per unit: Rs.20
Cost of placing and receiving one order: R.60
Annual carrying cost of one unit: Rs.2
Illustrations – EOQ
1. Calculate EOQ from the following:
a. Consumption during the year – 600 units
b. Price per unit – Rs.20
c. Ordering cost Rs.12 per order
d. Carrying cost 20%
C = 600 units, O = Rs.12, I = 20% of price i.e. 20 x 20 ÷ 100 = Rs.4
2. A company requires 50,000 units of a product during the next year. The cost of processing
an order is Rs.20 and the carrying cost per unit is Rs.0.50 per year. Please calculate EOQ.
3. A company purchases certain spares from supplier for manufacturing engines. The annual
requirement ix 12,000 units and the cost of placing an order is Rs.100, while the carrying
cost per annum is Rs.15 per unit. Compute the EOQ for the company.
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4. A company uses 50,000 units of an item per annum costing Rs.1.20 per unit. Each order
costs Rs.45 and the storage cost is 15% of the annual inventory value.
Working Note:
Cost of Storage per unit = 15% of annual inventory value.
i.e. 15% of Rs.60,000 (50,000 unit @ Rs.1.20) = Rs.9,000
Therefore cost of storage per unit = Rs.9,000 ÷ Rs.50,000 = Rs.0.18 per unit
Alternatively, Storage Cost per unit can be computed as follows:
15% of Rs.1.20 (i.e. price or cost per unit of material) = Rs.0.18 per unit
5. Compute EOQ from the following information:
Annual demand = 5000 units
Unit price = Rs.20
Order cost = Rs.16
Storage rate = 2% p.a.
Interest rate = 12% p.a.
Obsolescence rate = 6% p.a.
Working Note:
Carrying Costs = Storage rate - 2% + Interest rate – 12% + Obsolescence rate – 6% = 20%
Thus, carrying costs = 20% of unit price of material i.e. Rs.20 = Rs.4 per unit
ABC Analysis
ABC analysis is a system for inventory control used throughout materials and distribution
management. In business terms, ABC analysis is used to define an inventory categorization
technique often used in materials management. It is also known as selective inventory control.
ABC analysis can be used for wide range of inventory items such as manufactured products,
components, spare parts, finished goods, unfinished goods, etc.
ABC analysis is a part of inventory management, in which items included in the inventory are
classified into three different categories. It is thus a system of categorization, using three
classes of which each class has a differing management control. The ‘ABC’ in ABC analysis
as known as ABC Classification refers to three classes or categories used in the system. The
first ‘A’ is the category for items that are outstandingly important or critical to a business. The
second ‘B’ is the classification for items of average or medium importance. And finally,
category ‘C’ is designated for relatively unimportant items. As a basis for a control scheme
each class ought to be handled in a different way.
ABC analysis is similar to the Pareto principle also known as the 80/20 rule. Under this rule,
in terms of consumption, 80 percent of the value of inventory would be held in about 20 percent
of the items. By using this principle, categories B and C would make up the remaining 80
percent of the items, perhaps B with 30 percent and C with 50 percent.
ABC codes
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a. ‘A class’ inventory will typically contain items that account for 80% of total value, or
20% of total items.
b. ‘B class’ inventory will have around 15% of total value or 30% of total items.
c. ‘C class’ inventory will account for the remaining 5% of total value or 50% of total items.
Another breakdown of ABC classes
A - approximately 10% of items or 66.6% of value
B - approximately 20% of items or 23.3% of value
C - approximately 70% of items or 10.1% of value
Under this system, materials are classified into three categories in the order of their respective
values. Materials that are costly are grouped into ‘A’ category. Materials that are moderate in
value are grouped into ‘B’ category and materials that are cheap are grouped into ‘C’ category.
In other words, high priced materials are grouped into the ‘A’ category, medium – priced
materials are grouped into the ‘B’ category and low – priced materials are grouped into the ‘C’
category.
Materials in the A category form a small part of the total inventory. Utmost care should be
taken in storing and using these materials. Materials in the B category form a medium part of
the total inventory. Moderate care and control needs to be exercised in storing and using these
materials. Materials in C category form a large part of the total inventory. Such materials need
not be given much importance as such.
Category % of items % of cost
A 8 75
B 25 20
C 67 5
Total 100 100
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Unit III – Marginal Costing and Break Even Analysis
Marginal costing is a ‘principle whereby marginal cost of cost units are ascertained. Only
variable costs are charged to cost units, the fixed costs attributable to a relevant period being
written off in full against the contribution for that period’. Marginal costing is basically
concerned with the determination of product cost, which consists of total costs minus fixed
costs for e.g., direct material, direct labor, direct expenses and variable overheads.
Marginal costing is the ascertainment of marginal costs and the effect of changes in volume
or type of output by differentiating between fixed costs and variable costs. Marginal costing is
not a method of costing such as job costing, process costing and operating costs, etc., but it
is a special technique concerned with effect of fixed overhead on the profitability of a business.
It brings out the relationship between the cost, volume of output and profit.
Marginal cost is defined as the amount at any given volume of output by which aggregate
costs are changed if the volume of output is increased or decreased by one unit. It is the sum
total of prime cost plus variable overheads plus variable portion of semi-variable overheads.
Marginal cost is also termed as variable cost, direct cost, activity cost, volume cost or out of
pocket cost. Fixed cost is also called time cost and period cost. It is a fixed amount irrespective
of the level of capacity achieved. In marginal costing technique, profit is measured by
contribution less fixed overheads which include the fixed portion of semi-variable overheads
also. Semi-variable overheads are segregated and the variable portion is added to the variable
overheads and fixed amount is added to the fixed overheads. Variable costs vary directly with
output and cost per unit is the same. Fixed costs remain the same regardless of the level of
output and vary only with time.
Basic terms used in Marginal Costing:
(a) Fixed Costs: those costs which do not normally change up to the full capacity of firm.
Those costs which are incurred irrespective of the actual activity. Those costs which are
fixed in total but variable per unit.
(b) Variable Costs: those costs which vary in direct proportion to the output or sales. Those
costs which vary in total but remain constant per unit.
(c) Semi-variable costs/ semi-fixed expenses: semi-variable costs refer to these expenses
that do not change within the limits of a small range of activity but may change when the
output reaches a new level. Such an increase or decrease in expenses is not in proportion
to the output.
(d) Contribution: it is the difference between sales and variable costs.
C = S - V or C= FC+P or C – FC =P or C = S x P/V ratio
where, S= Sales, V= Variable Cost, FC = Fixed Cost, P = Profit, C = Contribution
(e) Break- even point: it is the point at which there is neither profit nor loss. In other words, it
is at this point that the contribution is equal to fixed expenses.
(f) Margin of safety: it is the difference between total sales and the sales at break- even point
(BEP). It can be expressed in percentage as well as in value. The size of the margin of
safety shows the strength of a business. Larger the margin of safety stronger is the
business and vice versa.
(g) Profit Volume (P/V) Ratio: the P/V ratio is the relationship between contribution and sales
value. It is expressed as a percentage value. The P/V ratio is considered to be an
indication of the profitability of business. An improvement in P/V ratio leads to an
improvement in profitability.
Important formulae used in marginal costing:
(a) Contribution = sales – variable costs (C = S-V)
= Fixed Assets + Profit (C = F+P)
= sales x P/V ratio (C = S x P/V ratio)
(b) P/V ratio =
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(c) BEP =
(in units)
Or
(d) BEP =
(in rupees)
Or
Break-even volume X Selling price per unit
(e) Margin of Safety (in units) =
(f) Margin of Safety (in Rupees) =
Or Actual Sales – Break-even Sales
(g) Required Sales for a given profit (in units) =
(h) Profit when sales are given = Sales x P/V ratio = Fixed cost
(i) Sales when profit is known =
Illustrations
1. From the following information, find contribution and profit:
Sales = Rs.12,000
Fixed cost = Rs.4,000
Variable cost = Rs.7,000
Solution
Contribution = Sales – Variable cost
i.e. Rs.12,000 – Rs.7,000 = Rs.5,000
Contribution = Fixed cost + Profit
i.e.Rs.5,000 = Rs.4,000 + P
Rs.5,000 – Rs.4,000 = P
Rs.1,000 = P ( profit)
2. From the following information find the amount of profit earned during the year using
marginal cost technique:
Fixed Cost = Rs.520,000
Variable costs = Rs.12 per unit
Selling price = Rs.16 per unit
Output level = 150,000 units
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Solution
i.e. (150,000 x Rs.16) – (150,000 x Rs.12)
= Rs.24,00,000 – Rs.18,00,000
= Rs.600,000
Contribution = Fixed cost + Profit
i.e. Rs.600,000 = Rs.520,000 + Profit
= Rs.600,000 – Rs.520,000 = Profit
∴ Profit = Rs.80,000
3. Calculate Break-Even Point (BEP) from the following particulars:
Variable cost per unit =Rs14
Fixed Expenses = Rs.75,000
Selling price per unit = Rs.20
Solution
BEP (in units) =
Selling price – variable costs = contribution per unit

i.e. Rs.20 – Rs.14 = Rs.6 (contribution per unit)
∴ BEP = Rs.75,000 ÷ Rs.6 = 12,500 units
BEP ( in Rupees) = Break-even volume X Selling price per unit
∴ 12,500 x Rs.20 = Rs.250,000 ( BEP in Rupees)
4. From the given details, calculate – (a) BEP in Rupees and in units (b) No. of units to be sold
to earn profit of Rs.60,000
Selling Price Rs.20 per unit
Variable Cost Rs.14 per unit
Fixed Cost Rs.792,000
Solution
Contribution = Selling Price – Variable cost i.e. Rs.20 – Rs.14 = Rs.6 per unit
P/V ratio = Contribution per unit ÷ Selling price x 100
= Rs.6 ÷ Rs.20 x 100 = 30%
(a) BEP (units) = Fixed costs ÷ Contribution per unit
i.e. Rs.792,000 ÷ Rs.6 = 132,000 units
BEP (Rs.) = Fixed costs ÷ P/V ratio
i.e. Rs.792,000 ÷ 30% = Rs. 26,40,000
alternatively, BEP ( Rs.) can also be calculated as per below:
BEP ( in Rupees) = Break-even volume X Selling price per unit
∴ 132,000 x Rs.20 = Rs.26,40,000
(b) Units to be sold to earn profit of Rs.60,000
Sales = Fixed cost + Profit ÷ P/V
i.e. Sales = Rs.792,000 + Rs.60,000 ÷ 30%
= Rs.852,000 ÷ 30% = 28,40,000
5. From the following find out - (a) P/V ratio (b) Sales required to Break even (c) Sales
to earn a profit of Rs.320,000.
Selling Price – Rs.80 per unit
Variable cost – Material Rs.20
- Labor Rs.14
- Variable Overheads are 100% of direct labor cost
Fixed expenses Rs.128,000
Solution
Contribution = Selling Price – Variable cost i.e.Rs.80 – Rs.48 (Rs.20+Rs.14+Rs.14) = Rs.32
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= Rs.32 ÷ Rs.80 x 100 = 40%
i.e. Rs.128,000 ÷ 40% = Rs. 3,20,000
BEP (units) = Fixed costs ÷ Contribution per unit
i.e. Rs.128,000 ÷ Rs.32 = 4,000 units
Sales to earn profit of Rs.320,000
i.e. Sales = Rs.128,000 + Rs.320,000 ÷ 40%
= Rs.448,000 ÷ 40% = 11,20,000
6. Fixed cost - Rs.13,000
Variable cost - Rs.15,000
Total cost - Rs.28,000
Net profit - Rs.2,000
Net sales - Rs.30,000
From the above information find out:
(a) BEP
(b) Profit when sales are Rs.50,000
(c) Sales when profit is Rs.10,000
Solution
i.e.Rs.30,000 – Rs.15,000 = Rs.15,000
P/V ratio = Contribution ÷ Sales x 100
i.e. Rs.15,000 ÷ Rs.30,000 x 100 = 50%
(a) BEP = Fixed costs ÷ P/V ratio
i.e. Rs.13,000 ÷ 50% = Rs.26,000
Profit = Sales x P/V ratio – Fixed cost
i.e. Rs.50,000 x 50% - Rs.13,000 = Rs.25,000 – Rs.13,000 = Rs.12,000
Therefore, profit will be Rs.12,000 when sales are Rs.50,000.
(c) Sales when profit is Rs.10,000
i.e. Sales = Rs.13,000 + Rs.10,000 ÷ 50%
= Rs.23,000 ÷ 50% = 46,000
7. Following data is given:
Fixed cost Rs.14,,000
Selling price Rs.10 per unit
Variable cost Rs.7 per unit
What will be the profit when Sales are (a) Rs.60,000 (b) Rs.100,000
Solution
Contribution = Selling Price – Variable cost i.e.Rs.10 – Rs.7 = Rs.3
= Rs.3 ÷ Rs.10 x 100 = 30%
(a) Profit when sales are Rs.60,000
i.e. Rs.60,000 x 30% - Rs.14,000 = Rs.18,000 – Rs.14,000 = Rs.4,000
i.e. Rs.100,000 x 30% - Rs.14,000 = Rs.30,000 – Rs.14,000 = Rs.16,000
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8. The price and cost structure of a product in a company are as follows:
Selling price Rs.30 per piece
Variable cost Rs.9 per piece
Fixed cost are:
Manufacturing Rs.225,000 p.a.
Administrating Rs.36,000 p.a.
Selling Rs.39,000 p.a.
a. Compute BEP in units
b. Compute BEP in value (Rs.)
c. In order to earn a profit of Rs.60,000 what should be the level of sales in Rupees?
Solution
= Rs.21 ÷ Rs.30 x 100 = 70%
i.e. Rs.300,000 ÷ Rs.21 = 14,286 units
(b) BEP (Rs.) = Fixed costs ÷ P/V ratio
i.e. (Rs.225,000+Rs.36,000+Rs.39,000) ÷ 70%
i.e. Rs. 3,00,000÷ 70% = Rs.428,571 or Rs. 428,580 (14286 units x Rs.30)
(c) Sales to earn profit of Rs.60,000
i.e. Sales = Rs.300,000 + Rs.60,000 ÷ 70%
= Rs.360,000 ÷ 70% = 5,14,286
9. You are given the following data for the year 2013 for ABC Co. Ltd.
Particulars Amount %
Variable costs 600,000 60
Fixed costs 300,000 30
Net Profit 100,000 10
___________________ _______
Total Sales 10,00,000 100

Find out P/V ratio and BEP
Solution
Contribution = Sales – Variable cost i.e.Rs.10,00,000 – Rs.600,000 = Rs.400,000
= Rs.400,000 ÷ Rs.10,00,000 x 100 = 40%
BEP = Fixed costs ÷ P/V ratio
i.e. Rs.300,000 ÷ 40% = Rs.750,000
10. A company produces a single article and sells it at Rs.10 each. The marginal cost of
production is Rs.6 and fixed cost is Rs.400 p.a. Calculate: (a) P/V ratio (b) BEP (Rs.)
(c) Sales to earn profit of Rs.500 (d) Profit at sales of Rs.3000
Solution
(a) P/V ratio = Contribution ÷ Selling price x 100
= Rs.4 ÷ Rs.10 x 100 = 40%
(b) BEP (Rs.) = Fixed costs ÷ P/V ratio
i.e. Rs.400 ÷ 40% = Rs.1,000
(c) Sales to earn profit of Rs.500
Sales = Fixed cost + Profit ÷ P/V i.e. Sales = Rs.400 + Rs.500 ÷ 40%
= Rs.900 ÷ 40% = Rs.2,250
(d) Profit at sales of Rs.3000
Profit = Sales x P/V ratio – Fixed cost i.e. Rs.3,000 x 40% - Rs.400
= Rs.1,200 – Rs.400 = Rs.800
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11. The sales and profit during two years were:
Year Sales (Rs.) Profit (Rs.)
2016 150,000 20,000
2017 170,000 25,000
You are required to calculate:
(a) BEP (b) P/V (c) Sales required to earn profit of Rs.40,000
(d) Profit made when sales are 250,000 (e) Variable cost (f) Margin of safety for 2017
Solution
For computing BEP we need to know P/V, hence P/V ratio is ascertained first
(a) P/V = i.e. = = 25%
(b) BEP = Fixed costs ÷ P/V ratio

As Fixed costs is not known the same shall be ascertained as given below:
Contribution = Sales x P/V ratio i.e. 150,000 x 25% = 37,500
Contribution = Fixed cost + Profit i.e. 37,500 = Fixed cost + 20,000
∴ 37,500 – 20,000 = Fixed cost i.e. 17,500
Hence, BEP = 17,500 ÷ 25% = 70,000
(c) Sales to earn profit of Rs.40,000
i.e. Sales = Rs.17,500 + Rs.40,000 ÷ 25%
= Rs.57,500 ÷ 25% = 230,000
(d) Profit made when sales are 250,000
Profit = Sales x P/V ratio – Fixed cost i.e. Rs.250,000 x 25% - Rs.17,500
= Rs.62,500 – Rs.17,500 = Rs.45,000
(e) Variable cost = ?
Contribution = Sales – Variable cost i.e. 37,500= 150,000 – Variable cost
∴ Variable cost = 150,000 – 37,500 = 112,500
(f) Margin of Safety for 2017
Sales – Break-even sales i.e.170,000 – 70,000 = 100,000
12. JK Enterprises furnishes you the following income information:

Particulars First Year Second Year
Sales 810,000 10,26,000
Profit earned 21,600 64,800
From the above you are asked to compute the following assuming all cost remain same in
both years:
(a) P/V (b) Fixed Cost (c) Profit / Loss when sales are 648,000 (d) Sales to earn
profit of Rs.108,000
Solution
(a) P/V ratio = i.e. = = 20%
(b) Fixed Cost = ??

Contribution = Sales x P/V Ratio i.e. 810,000 x 20% = 162.000
Contribution = Fixed cost + Profit i.e. 162,000 = Fixed cost + 21,600
∴ 162,000 – 21,600 = Fixed cost i.e. 140,400
(c) Profit / Loss when sales are 648,000
Profit = Sales x P/V ratio – Fixed cost i.e. Rs.648,000 x 20% - Rs.140,400
= Rs.129,600 – Rs.140,400 = (-) Rs.10,800 i.e. Loss of Rs.10,800
(d) Sales to earn profit of Rs.108,000
i.e. Sales = Rs.140,400 + Rs.108,000 ÷ 20%
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= Rs.248,400 ÷ 20% = 12,42,000
13. GK ltd. has been offered a choice to buy one out of two machine A and B. You are required
to compute BEP for each machine. The relevant data is given below:
Particulars Machine A Machine B
Annual Output (units) 10,000 units 10,000 units
Fixed cost Rs.30,000 Rs.16,000
Profit at above level of production Rs.30,000 Rs.24,000
The market price of the product is expected to be Rs.10 per unit.
Solution
Machine A
Contribution = Fixed Cost + Profit i.e. Rs.30,000 + Rs.30,000 = Rs.60,000
Contribution per unit = 60,000 ÷ 10,000 (output) = Rs.6 per unit
P/V ratio = Contribution ÷ Selling price x 100 i.e. Rs.6 ÷ Rs.10 x 100 = 60%
BEP ( units) = Fixed costs ÷ Contribution per unit i.e. Rs.30,000 ÷ Rs.6 = 5,000 units
BEP (sales) = = Fixed costs ÷ P/V ratio i.e. Rs.30,000 ÷ 60% = Rs.50,000
Machine B
Contribution = Fixed Cost + Profit i.e. Rs.16,000 + Rs.24,000 = Rs.40,000
Contribution per unit = 40,000 ÷ 10,000 (output) = Rs.4 per unit
P/V ratio = Contribution ÷ Selling price x 100 i.e. Rs.4 ÷ Rs.10 x 100 = 40%
BEP ( units) = Fixed costs ÷ Contribution per unit i.e. Rs.16,000 ÷ Rs.4 = 4,000 units
BEP (sales) = = Fixed costs ÷ P/V ratio i.e. Rs.16,000 ÷ 40% = Rs.40,000.
From the above it is suggested that GK ltd should buy Machine B as it has lower break-
even as compared to Machine A.
14. A plant is operating at 60% capacity. The fixed cost for operating the plant amounts to
Rs.60,000 and the variable costs are Rs.75,000. The sale proceeds of the product is
Rs.150,000. Find the Break Even Point and the % capacity of plant to earn profit of
Rs.40,000.
Solution
Contribution = Sales – Variable cost i.e.Rs.150,000 – Rs.75,000 = Rs.75,000
= Rs.75,000 ÷ Rs.150,000 x 100 = 50%
BEP = Fixed costs ÷ P/V ratio
i.e. Rs.60,000 ÷ 50% = Rs.120,000
Sales to earn profit of Rs.40,000
i.e. Sales = Rs.60,000 + Rs.40,000 ÷ 50%
= Rs.100,000 ÷ 50% = 2,00,000
15. Royal Plastics sells five different type of buckets with identical purchase cost and selling
price. The company is trying to find out the profitability of opening another store which will
have the following expenses and revenues:
Selling Price Rs.30.00 per unit
Variable cost Rs.19.50 per unit
Salesman’s commission Rs. 1.50 per unit
Annual Fixed Expenses are: Amount
Rent Rs. 60,000
Salaries Rs.200,000
Advertising Rs. 80,000
Other fixed expenses Rs. 20,000
Total Fixed Cost Rs.360,000
You are required to:
(a) Calculate annual BEP in units and value
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(b) Determine the profit or loss if 35,000 buckets are sold
(c) In order to earn a profit of Rs.90,000 what should be the level of sales (Rs.)
Solution
Contribution = Selling Price – Variable cost
=.Rs.30 – Rs.21 (i.e.Rs.19.50+Rs.1.50) = Rs.9
= Rs.9÷ Rs.30 x 100 = 30%
i.e. Rs.360,000 ÷ Rs.9 = 40,000 units
i.e. Rs. 3,60,000÷ 30% = Rs.12,00,000
(b) Profit / Loss when 35,000 buckets are sold
Sales = Sales Quantity x Selling price per unit i.e. 35,000 x Rs.30 = Rs.10,50,000
Profit = Sales x P/V ratio – Fixed cost i.e. Rs.10,50,000 x 30% - Rs.360,000
= Rs.315,000 – Rs.360,000 = (-) Rs.45,000 i.e. Loss of Rs.45,000
(c) Level of Sales to earn profit of Rs.90,000
i.e. Sales = Rs.360,000 + Rs.90,000 ÷ 30%
= Rs.450,000 ÷ 30% = 15,00,000
Exercise
1. From the following information, find contribution and profit:
Sales = Rs.25,000
Fixed cost = Rs. 5,000
Variable cost = Rs.20,000
2. Following information is given:

Selling price per unit Rs.5.00
Marginal Cost per unit Rs.3.50
Fixed cost Rs.10,000
Calculate –
a. Break-even point in units
b. Profit from sale of Rs.40,000
3. Find out – (a) BEP in units and value (b) amount of sales to earn a profit of Rs.60,000
from the following information:
Sales - Rs.10,000 units @ Rs.20 per unit
Variable cost @ Rs.10 per unit
Fixed cost - Rs.80,000
4. AXN Co. has given the following data regarding their product ‘A’
Selling Price Rs.50 p.u.
Material cost Rs.20 p.u.
Labor cost Rs.10 p.u.
Fixed cost for production are as below:
Manufacturing overheads Rs.175,000 p.a.
Administrative overheads Rs. 45,000 p.a.
Selling overheads Rs. 40,000 p.a
Compute the following:
a. BEP in units
b. BEP in value (Rs.)
c. What is the expected level of sales if profit of Rs.50,000 is desired.
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5. A product is sold at a price of Rs.120 per unit and its variable cost is Rs.80 per unit. The
fixed expenses of the business are Rs.80,000 per year. Find
a. BEP in Rs. and units
b. Profit made when sales are 240.
Managerial Applications of Marginal Costing

Following are some of the applications of Marginal Costing which are helpful to the
management:
a. Profit Planning: marginal costing helps in planning the profit of the organization as well as
planning the future operations in such manner to maximize profits or to maintain a specified
level of profit. Absorption costing does not show the correct effect of change in sales price,
variable costs or product mix on the profits of an organization; but this is possible with the
help of marginal costing.
b. Evaluation of performance of an Organization: Different products, departments,
markets, etc. have different profit earning potentialities. Marginal cost analysis is very useful
for evaluating the performance of the different sectors of an organization. Performance can
be evaluated better if distinction is made between fixed and variable expenses. Thus it
becomes possible to identify and select a product, department, market or sales division
contributing high over those whose contributions are less if fixed expenses remain constant.
c. Fixation of Selling Price: although selling prices are controlled more by the market
conditions and other economic factors than by decisions of management, fixation of selling
prices is one of the most important functions of management. Marginal costing plays a vital
role in helping the management in this task.
d. Selection of suitable product mix: When a company manufactures more than one
product; one of the common problem faced by management is identification of product mix
that gives maximum profits. An ideal or best product mix is said to be the one that yields
the maximum contribution. Thus, the products that give maximum contribution are retained
and their production is increased and the production of products that give less contribution
over others are reduced or stopped all together. The effect of sales mix can also be seen
by comparing the P/V ratio and BEP. A new sales mix is favorable if it increases the P/V
ratio and reduces the BEP.
e. Maintaining a desired level of Profit: a business is run to earn profits, therefore
management is interested in achieving and maintaining the desired level of profits. Making
use of marginal costing technique, management can ascertain the volume of sales needed
to attain the desired level of profit.
f. Comparing alternative methods of production: marginal costing is useful in comparing
alternative methods of production. The method that gives greatest contribution (assuming
fixed expenses remain same) is adapted by the management.
g. Make or Buy decisions: while deciding between alternative course of action such as make
or buy, the management makes use of marginal cost techniques and chooses that
alternative action that gives the greatest contribution as it is considered to be more
beneficial and profitable than the other alternative action.
Illustrations on Make or Buy
1. A mobile manufacturing company finds that it costs Rs.625 to make inbuilt microphone for
each handset, the same is available in the market at Rs.485 with an assurance of
continuous supply. The breakdown of cost is as follows:
Materials Rs.275 each
Labor Rs.175 each
Other variables Rs. 50 each
Depreciation and other fixed costs Rs.125 each
Total cost Rs.625 each
Should the company make or buy the inbuilt microphone?
Solution
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Variable Cost = Total cost – Fixed cost i.e. Rs.625 – Rs.125 = Rs.500
Market price = Rs.485
Variable Cost – Market Price = Rs.500 – Rs.485 = Rs.15
From the above it can be seen that there is an saving or profit of Rs.15 each, in case the
inbuilt microphone is purchased from the market. Assuming the fixed cost remains the
same and is added to the market price the cost of each component is lower than the cost
of manufacture. Hence it is advisable to procure the product from outside.
2. An engineering company finds that the cost of making part no.1017 in its workshop is Rs.8.
The same part is available in the market for Rs.6.60 with assured continuous supply. The
cost data to make the part is as follows:
Material Rs.2
Direct labor Rs.3
Other variable costs Rs.1
Fixed cost allocated Rs.2
Total cost Rs.8
(a) Should the part be made or bought?
(b) Will your answer be different if the market price is Rs.5.60?
Show your calculations clearly
Solution
To make a decision regarding whether to make or buy the part, the fixed cost may be ignored
as it is not so relevant in this context. But the variable costs need to be considered. In this
case, the variable cost to make a part is Rs. 6 (i.e. 2+3+1).
(a) Variable Cost – Market Price = Rs.6 – Rs.6.60 = (-) Rs.0.60
The company should continue to produce the part if the part available in the market
costs Rs.6.60 because the production of every part will give the company a contribution
of Rs.0.60 paise as the market price of the said part is higher than the variable cost.
(b) Variable Cost – Market Price = Rs.6 – Rs.5.60 = Rs.0.40
The company should not manufacture the part if it is available in the market for Rs.5.60
because the company shall be incurring an additional cost of Rs.0.40 per part as
compared to the market price of the same, if the company is producing the same.
Therefore, it is advisable for the company to procure the part for Rs. 5.60 each from the
market.
3. Techno star Ltd. produces 20,000 units of Part no. 143 every month and uses it in assembly
of Air conditioner. Its cost structure is as given below:
Variable cost Rs.10
Fixed cost Rs.8
Total cost Rs.18
It is proposed to obtain the part from open market @ Rs.15 per unit. It is possible to do
one of the following:
(a) Hire out the idle facilities at Rs.35,000 per month
(b) Produce product X using the idle facilities. 5000 units per month can be produced at a
variable cost of Rs.40 each, which can be sold at Rs.55 per unit. Interest on investment
may be ignored.
You are required to advise the management on the aforesaid options and help in arriving
at the correct decision whether to make or buy.
Solution
(a) Cost of purchase of 20,000 units @ Rs.15 = Rs.300,000
Less: Income from hiring idle facilities = Rs. 35,000
Therefore, effective cost of outside purchase of part no.143 = Rs.265,000
Less: Variable cost of making 20,000 units @ Rs.10 = Rs.200,000
Excess cost for outside purchase of part no.143 = Rs. 65,000
Advise: This part should not bought from outside. The company should continue to
manufacture the same in their factory.
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(b) Sale value of product to be produced using idle facilities (5000 @ Rs.55) = Rs.275,000
Less: Variable cost of the product (5000 @ Rs.40) = Rs.200,000
Net Contribution from idle facilities (Rs.275,000 – Rs.200,000) = Rs. 75,000
Cost of purchase of 20,000 units (20,000 @ Rs.15) = Rs.300,000
Less: Income from using idle facilities * = Rs. 75,000
Effective cost of outside purchase of part no.143 = Rs.225,000
Less: Variable cost of making 20,000 units @ Rs.10 = Rs.200,000
Excess cost for outside purchase of part no.143 = Rs. 25,000
Advise: This part should not bought from outside. The company should continue to
manufacture the same in their factory.
* Note: As facilities become idle only when outside purchase is made, contribution from idle
facilities have to be reduced from the price offered to obtain the effective cost of purchase.
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Unit IV – Standard Costing
Meaning
Standard costing is a technique which uses standards for costs and revenue for the purpose
of control through variance analysis. A standard is a predetermined measurable quantity set
in defined conditions against which actual performance can be compared, usually for an
element of work, operation or activity. It is a tool for planning budgets, managing and
controlling costs and evaluating cost management performance. It aims at increasing
efficiency in performance through setting up standards. Standard costing is also known as
‘variance analysis’ as it studies
Standard costing involves the setting of predetermined cost estimates in order to provide a
basis for comparison with actual costs. A standard cost is a planned cost for unit of product or
service rendered. Standard costing is universally accepted as an effective instrument for cost
control in industries.
Although the term budgeted and standard costs are sometimes used interchangeably,
budgeted costs normally describe the total planned costs for a number of products. Usually,
budgetary control is operated with a system of standard costing because both systems are
interrelated but they are not interdependent.
With the use of standard costing the organization achieves the objectives in a planned and
systematic manner. Standard costing can be used in Direct costing, Absorption costing, Job
costing or Process costing. It is not a method of costing but a system which can be fitted in
any method.
Definitions
The Institute of Cost and Management Accountants (ICMA), London defines standard costing
as “the preparation and use of standard costs, their comparison with actual cost and the
analysis of variances to their causes and points of incidence”.
According to Wheldon, Standard costing, “is a method of ascertaining the costs whereby
statistics are prepared to show:
i. The standard cost;
ii. The actual cost;
iii. The difference between these costs which is termed as ‘variance’. “
W. Bigg States that Standard costing, “discloses the cost of deviations from standards and
clarifies these as to their causes, so that management is immediately informed of the sphere
of operations in which remedial action is necessary.”
Thus from the above definitions it becomes clear that standard costing involves:
i. Ascertainment and use of standard costs;
ii. Recording the actual costs;
iii. Comparison of actual costs with standard costs in order to find out the variance;
iv. Analysis of variance;
v. Appropriate action if necessary, after analysis of the variance,
Objectives of Standard Costing
(a) To provide a formal basis for assessing performance and efficiency.
(b) To control costs by establishing standards and analysis of variances.
(c) To enable the principle of “management by exception’ to be practiced at the detailed
operational level.
(d) To assist in setting budgets.
(e) The standard costs are readily available substitutes for actual average unit costs and can
be used for stock and work in progress valuations, profit planning and decision making
and as a basis of pricing where ‘cost plus’ systems are used.
(f) To assist in assigning responsibility for nonstandard performance in order to correct
deficiencies or to capitalize on benefits.
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(g) To motivate staff and management
(h) To provide a basis for estimating
(i) To provide guidance on possible ways of improving performance.
Advantages of Standard Costing:
(a) Cost Control: Standard costing is universally recognized as a powerful cost control system.
Controlling and reducing costs becomes a systematic practice under standard costing.
(b) Elimination of Wastage and Inefficiency: wastage and inefficiency in all aspects of the
manufacturing process are curtailed, reduced and eliminated over a period of time if
standard costing is continuously operational.
(c) Norms: Standard costing provides the norms and yard sticks with which the actual
performance can be measured and assessed.
(d) Locates Sources of Inefficiency: It pin points the areas where operational inefficiency
exists. It also measures the extent of the inefficiency.
(e) Fixing Responsibility: Variance analysis can determine the persons responsible for each
variance. Shifting or evading responsibility is not easy under this system.
(f) Management by Exception: The principle of management by exception can be easily
followed because areas are highlighted by negative variances.
(g) Improvement in Methods and Operations: Standards are set on the basis of systematic
study of the methods and operations. As a consequence, cost reduction is possible
through improved methods and operations.
(h) Guidance for Production and Pricing Policies: Standards provide valuable guidelines to
the management in the formulation of pricing policies and production decisions.
(i) Planning and Budgeting: Budgetary control is far more effective in conjunction with
standard costing. Being predetermined costs on scientific basis, standard costs are also
useful in planning the operations.
(j) Inventory Valuation: Valuation of stocks becomes a simple process by valuing them at
standard cost.
Disadvantages of Standard Costing:
(a) Cost of Implementation: Since standard costing involves high degree of technical skill,
hence it is costly. The, small organizations with limited financial resources therefore find it
difficult to introduce and implement this system.
(b) Variation in Price: One of the chief problems faced in the operations of the standard costing
system is the precise estimation of likely prices or rate to be paid.
(c) Varying Levels of Output: if the standard level of output set for pre-determination of
standard costs is not achieved, the standard costs are said to be not realized.
(d) Changing Standard of Technology: In case of industries that have frequent technological
changes affecting the conditions of production, standard costing may not be applicable.
(e) Applicability: it cannot be used in those organizations where nonstandard products are
produced. If the production is undertaken according to the customer specifications, then
each job will involve different amount of expenditures.
(f) Difficult to set Standard: the process of setting standard is a difficult task, as it requires
technical skills. The time and motion study is required to be undertaken for this purpose.
These studies require a lot of time and money.
(g) Problem in fixing Responsibility: the fixing of responsibility is not an easy task. The
variances are to be classified into controllable and uncontrollable variances. Standard
costing is applicable only for controllable variances.
(h) Constant Change in Standards: Standards are always changing since conditions of the
business are also changing dynamically. So standards need to be revised in order to make
them comparable with actual results. But such revision of standards creates many problem
particularly in case of inventory adjustment.
(i) Morale and Motivation of Employees: Standards are either too liberal or rigid since the
same are based on average past results, attainable good performance or theoretical
maximum efficiency. So, if the standards are very high it will have an adverse affect on the
morale and motivation of employees.
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Variance
Variance can be defined as the difference between the budgeted or expected cost or income
for an activity and the actual costs or income for the activity. In standard costing and budget
control, variance constitutes the difference between the budgeted costs and the actual costs
for an activity.
Types of Variances
The variances are classified on the following basis:
A. On the basis of Elements of Cost:
i. Material Cost Variance
ii. Labor Cost Variance
iii. Overhead Variance
B. On the basis of Controllability:
i. Controllable Variance
ii. Uncontrollable Variance
C. On the basis of Impact:
i. Favorable Variance
ii. Unfavorable Variance
D. On the basis of Nature:
i. Basic Variance
ii. Sub- Variance
Material Variance
It is the difference between the standard cost of materials used for the actual output and the
actual cost of materials used. According to ICMA London, “It is the difference between the
standard cost of direct materials specified for the output achieved and the actual cost of direct
materials used”.
Material variance can be analyzed as follows:
a. Material cost variance (MCV)
b. Material price variance (MPV)
c. Material usage / quantity variance (MUV)
d. Material mix variance (MMV)
e. Material yield (sub-usage) variance (MYV)
Material Cost Variance
Material Price Variance Material Usage Variance
Material Mix Variance Material Yield Variance Material Usage other

causes Variance
The formulae for above mentioned variance are as follows:

MCV= [standard quantity(SQ) x standard price(SP)] – [Actual quantity(AQ) x Actual price (AP)]
MPV= AQ x [standard price (SP) – actual price (AP)]
MUV= SP x (SQ – AQ)
MMV= SP x (SQ – AQ) or [revised SP x (RSQ) – AQ]
MYV= Standard output price (SOP) x [actual yield (AY) – standard yield (SY)]
Illustrations
1. Calculate Material Price Variances of Products X and Y
Product X Product Y
Standard Price (per unit) Rs.100 Rs.160
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Actual Price (per unit) Rs.120 Rs.150
Units produced 600 units 500 units
Solution
Material Price Variance (MPV) = AQ (SP – AP)
Product X = 600 (100 – 120) = 600 x (-20) = 12,000 (Adverse)
Product Y = 500 ( 160 -150) = 500 x 10 = 5000 (Favorable)
2. From the following data calculate: (a) Material Cost Variance (b) Material Price Variance
Standard Actual
Material cost per unit (Rs.) 5 6
Quantity (units) 50 45
Solution
= (50 x 5) – (45 x 6) = 250 – 270 = (-) 20 ( Adverse)
= 45 x (5-6) = 45 x (-) 1 = (-) 45 (Adverse)
3. Calculate – (a) Material Cost Variance (b) Material Price Variance (c) Material Usage
Variance
Standard Actual
Quantity (Kgs.) 40 48
Rate per Kg. (Rs.) 10 12
Solution
= (40 x 10) – (48 x 12) = 400 – 576 = (-) 176 ( Adverse)
= 48 x (10-12) = 48 x (-) 2 = (-) 96 (Adverse)
MUV= SP x (SQ – AQ)
= 10 x (40 - 48) = 10 x (-) 8 = (-) 80 (Adverse)
4. The standard cost card shows the following details relating to materials needed to produce
1 kg. of groundnut oil.-
Quantity of groundnut required – 3 kg.
Price of groundnut - Rs. 2.50 per kg.
Actual production data:
Production during the month - 1000 kg
Quantity of groundnut used – 3500 kg
Price of ground nut – Rs.3.00 per kg
Calculate – (a) MCV (b) MPV (c) MUV
Solution
Standard Quantity (SQ) =1000 kg x 3 kg = 3000 kg
(a) MCV = Standard cost – Actual Cost
i.e. (3000 x 2.50 ) – ( 3500 x 3) = 7500 – 10,500
= Rs.3000 (Adverse)
(b) MPV = AQ x [standard price (SP) – actual price (AP)]
= 3500 x (2.50 - 3.00) = 3500 x (-) 0.5 = (-) 1750 (Adverse)
(c) MUV= SP x (SQ – AQ)
= 2.50 x (3000 - 3500) = 2.50 x (-) 500 = (-)1250 (Adverse)
5. AFX Company furnishes the following information:
Standard: Material for 70 kg. finished product 100 kg.
Price of material Re.1 per kg.
Actual: Output - 210,000 kg.
Material used - 280,000 kg.
Cost of material - Rs.252,000
Calculate : (a) MCV (b) MPV (c) MUV
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Solution
Standard Quantity for actual output (SQ) = 210,000 kg x 100 kg ÷ 70 kg = 300,000 kg
(a) MCV = Standard cost – Actual Cost
i.e. (300,000 x 1 ) – ( 280,000 x 0.90) = 300,000 – 252,000
= Rs.48,000 (Favorable)
(Working Note – Actual Price (AP) = Rs.252,000 ÷ 280,000 kg = Re.0.90 per kg)
(b) MPV = AQ x [standard price (SP) – actual price (AP)]
= 280,000 x (1.00 - 0.90) = 280,000 x 0.10 = 28,000 (Favorable)
(c) MUV= SP x (SQ – AQ)
= 1.00 x (300,000 – 280,000) = 1.00 x 20,000 = 20,000 (Favorable)
Check MCV = MPV + MUV i.e. 28,000 (F) + 20,000 (F) = 48,000 (F)
6. Calculate: (a) MPV (b) MUV (c) MCV (d) MMV (e) (MYV from the following data:
Material Standard Std. weight per Actual usage for Actual price
price unit of output output of 36 units
A Rs.10 2 72 Rs.12
B Re.1 4 108 Re.1
C Rs.5 3 126 Rs.4
Solution
(a) MPV = AQ x [standard price (SP) – actual price (AP)]
A = 72 x (10 – 12) = 72 x (-) 2 = 144 (A)
B = 108 x (1 -1) = 108 x 0 = 0
C = 126 x (5 – 4) = 126 x 1 = 126 (F)
MPV = 144 (A) +0 + 126 (F) = 18 (A)
(b) MUV = SP x (SQ – AQ)
A = 10 x ( (2 x 36) – 72) = 10 x (72-72) = 10 x 0 = 0
B = 1 x ((4 x 36) -108) = 1 x (144 – 108) = 1 x 36 = 36 (F)
C = 5 x ((3 x 36) – 126) = 5 x ( 108 – 126) = 5 x 18 = 90 (A)
MUV = 0+36 (F) + 90 (A) = 54 (A)
(c) MCV = MPV + MUV
A = 144 (A) + 0 = 144 (A)
B = 0 + 36 (F) = 36 (F)
C = 126 (F) + 90 (A) = 36 (F)
MCV = 144(A) + 36 9F) + 36 (F) = 144 (A) + 72 (F) = 72 (A)
i.e. 18 (A) + 54 (A) = 72 (A)
(d) MMV = SP x (RSQ) – AQ
Standard Quantity (SQ) required for 36 units
A = 2 x 36 = 72 units
B = 4 x 36 = 144 units
C = 3 x 36 = 108 units
Total = 324 units
Actual Quantity (AQ) for 36 units (given) = 72+108+126 = 306 units
RSQ for A = 306 ÷ 324 x 72 = 68 units
RSQ for B = 306 ÷ 324 x 144 = 136 units
RSQ for A = 306 ÷ 324 x 108 = 102 units
MMV = SP x (RSQ) – AQ
A = 10 x (68- 72) = 40 (A)
B = 1 x (136 – 108) = 28(F)
C = 5 x (102 – 126) = 120 (A)
MMV = 40 (A) + 28 (F) + 120 (A) = 132 (A)
(d) MYV = SC (Standard output for Actual Mix – Actual Output)
A = 2 x 10 = 20
B=4x1 = 4
C = 3 x 5 = 15
Total = 39
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Actual Weight per unit = 306 ÷ 9 (i.e.2+4+3) = 34
MYV = 39 x (34 – 36 ) = 39 x 2 = 78 (A)
7. From the following data calculate material variance
Raw Material Standard Actual
X 40 units @ Rs.50/unit 50 units @ Rs.50/unit
Y 60 units @ Rs.40/ unit 60 units @ Rs.45/unit
Total 100 units 110 units
Solution
(a) MPV = AQ x [standard price (SP) – actual price (AP)]
X = 50 x (50 – 50) = 50 x 0 = 0
Y = 60 x (40 - 45) = 60 x (-)5 = 300 (A)
(b) MUV = SP x (SQ – AQ)
X = 50 x ( (40 – 50) = 50 x (-) 10 = 500 (A)
Y = 40 x (60 - 60) = 40 x 0 = 0
(c) MCV = MPV + MUV
= 300 (A) + 500 (A) = 800 (A)
(d) MMV = SP x (RSQ – AQ)
Calculation of RSQ:
X = 40 ÷100 x 110 = 44 units
Y = 60 ÷100 x 110 = 66 units
MMV for X = 50 x (44 – 50) = 50 x (-)6 = 300 (A)
MMV for Y = 40 x (66 – 60) = 40 x 6 = 240 (F)
MMV = 300 (A) + 240 (F) = 60 (A)
8. Calculate : MCV, MPV and MUV from the data given below:
Material Standard Actual
A 500 6.00 3,000 400 6.00 2,400
B 400 3.75 1,500 500 3.60 1,800
C 300 3.00 900 400 2.80 1,120
Total 1200 1300
(-)10%
Normal
Loss 120 220 ( Less: Actual loss)
Net Total 1080 5,400 1080 5,320
Solution
MCV = Standard Cost (SC) – Actual Cost (AC)
= 5,400 – 5,320 = 80 (F)
MPV = AQ x [standard price (SP) – actual price (AP)]
A = 400 x ( 6.00 – 6.00) = 400 x 0 = 0
B = 500 x (3.75 – 3.60) = 500 x 0.15 = 75 (F)
C = 400 x (3.00 – 2.80) = 400 x 0.20 = 80 (F)
MPV = 0+75 (F) + 80 (F) = 155 (F)
MUV = SP x (SQ – AQ)
A = 6.00 x (500 -400) = 6.00 x 100 = 600 (F)
B = 3.75 x (400 – 500) = 3.75 x (-) 100 = 375 (A)
C = 3.00 x (300 – 400) = 3.00 x (-) 100 = 300 (A)
MUV = 600 (F) + 375 (A) + 300 (A) = 75 (A)
Check
MCV = MPV + MUV = 155 (F) + 75 (A) = 80 (F)
9. From the data given herein below, calculate Material variance for products P & Q
Product Standard Standard Actual Quantity Actual Price
Quantity (units) Price (units)
P 840 1.60 880 1.80
Q 1800 3.90 1680 4.20
Solution
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For product P:
MCV = Standard Cost – Actual Cost = (SQ x SP) – (AQ x AP)
= (840 x 1.60) – (880 x1.80) = 1,344 – 1,584 = 240 (A)
MPV = AQ x ( SP – AP) = 880 x (1.60 – 1.80)
= 880 x 0.20 = 176 (A)
MUV = SP ( SQ – AQ) = 1.60 x (840 – 880)
= 1.60 x (-) 40 = 64 (A)
Check MCV = MPV + MUV = 176 (A) +64 (A) = 240 (A)
For product Q:
MCV = Standard Cost – Actual Cost = (SQ x SP) – (AQ x AP)
= (1800 x 3.90) – (1680 x 4.20) = 7,020 – 7,056 = 36 (A)
MPV = AQ x ( SP – AP) = 1680 x (3.90 – 4.20)
= 1680 x 0.30 = 504 (A)
MUV = SP ( SQ – AQ) = 3.90 x (1800 – 1680)
= 3.90 x 120 = 468 (F)
Check MCV = MPV + MUV = 504 (A) + 468 (F) = 36 (A)
10. Techno Chemicals manufactures a chemical named CKF by mixing three raw materials.
For each batch of 100 kg of CKF, 125 kg of raw material is used. In April 2019, 60 batches
were prepared to produce an output of 5600 kg of CKF. The Standard and actual
particulars for April, 2019 are as given below. Calculate Material Variances
Mix (%) Price per kg. Mix (%) Price per kg.
A 50 Rs.20 60 Rs.21
B 30 Rs.10 20 Rs.8
C 20 Rs. 5 20 Rs.6
Solution
Basic Calculation:
One Batch of CKF product is of 100 kg.; and
One Batch of CKF product of 100 kg requires total 125 kg of Raw material (A+B+C)
Standard output in April, 2019 is 60 batches i.e. 6000 kg ( 60 batch x 100 kg)
Actual output in April, 2019 of 60 batches as given is 5600 kg
Standard for 6000 kg. output:
Material Mix (%) Quantity (125kg @100kg for 1 batch)
A 50% of 125 62.50 % for 6000 kg (i.e. 60 batch of CKF) = 3750 kg
B 30% of 125 37.50 % for 6000 kg (i.e. 60 batch of CKF) = 2250 kg
C 20% of 125 25.00 % for 6000 kg (i.e. 60 batch of CKF) = 1500 kg
Total Raw material = 7500 kg
Actual for 5600 kg. output:
Material Mix (%) Quantity (125kg @100kg for 1 batch)
A 60% of 125 75.00 % for 6000 kg (i.e. 60 batch of CKF) = 4500 kg
B 20% of 125 25.00 % for 6000 kg (i.e. 60 batch of CKF) = 1500 kg
C 20% of 125 25.00 % for 6000 kg (i.e. 60 batch of CKF) = 1500 kg
Total Raw material = 7500 kg
Kg. Rate Amount Kg. Rate Amount
A 3750 Rs.20 Rs. 75,000 4500 Rs.21 Rs. 94,500
B 2250 Rs.10 Rs. 22,500 1500 Rs.8 Rs. 12,000
C 1500 Rs. 5 Rs. 7,500 1500 Rs.6 Rs. 9,000
Total 7500 Rs.105,000 Rs. 115,000
Standard cost of actual output = 105,000 ÷ 6,000 x 5,600 = Rs.98,000
Material cost variance (MCV) = Standard cost – Actual Cost
= 98,000 – 115,000
= 17,500 (A)
Material price variance (MPV) = AQ x (SP – AP)
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A = 4500 x (20 – 21) = 4500 x (-)1 = 4500 (A)
B = 1500 x (10 – 8) = 1500 x 2 = 3000 (F)
C = 1500 x (5 – 6) = 1500 x (-)1 = 1500 (A)
MPV = 4500 (A) + 3000 (F) + 1500 (A) = 3000 (A)
Material usage variance (MUV) = SP ( SQ – AQ)
A = 20 x (( 3750 ÷ 6000 x 5600) – 4500)
= 20 x (3500 – 4500) = Rs.20,000 (A)
B = 10 x (( 2250 ÷ 6000 x 5600) – 1500)
= 10 x (2100 – 1500) = Rs.6,000 (F)
C = 5 x (( 1500 ÷ 6000 x 5600) – 1500)
= 5 x (1400 – 1500) = Rs.500 (A)
MUV = 20000 (A) +6000 (F) + 500 (A) = 14500 (A)
Check MCV = MPV + MUV = 3000 (A) + 14500 (A) = 17500 (A)
11. For making 10 kg. Floor Adhesive, the standard material requirements is:
Material Quantity (kg) Rate per kg (Rs.)
A 8 6.00
B 4 4.00
During December, 1000 kg of floor adhesive were produced. The actual consumption of
materials is as under:
. Material Quantity (kg) Rate per kg (Rs.)
A 750 7.00
B 500 5.00
Calculate (a) Material Cost Variance (b) Material Price Variance (c) Material Usage
Variance
Solution
Basic Calculation:
Material Standard for 1000 kg Actual for 1000 kg
Qty. Rate Amount Qty. Rate Amount
Kg. Rs. Rs. Kg. Rs. Rs.
A 800 6 4,800 750 7 5,250
B 400 4 1,600 500 5 2,500
Total 1200 6,400 1250 7,750
Material Cost Variance (MCV) = Standard cost – Actual Cost
= 6,400 – 7,750
= 1,350 (A)
Material price variance (MPV) = AQ x (SP – AP)
A = 750 x (6 – 7) = 750 x (-) 1 = 750 (A)
B = 500 x (4 – 5) = 500 x (-) 1 = 500 (A)
MPV = 750 (A) + 500 (A) = 1250 (A)
Material usage variance (MUV) = SP ( SQ – AQ)
A = 6 x (800– 750)
= 6 x 50 = Rs.300 (F)
B = 4 x (400 – 500)
= 4 x (-)100 = Rs.400 (A)
MUV = 300 (F) + 400 (A) = 100 (A)
Check, MCV = MPV + MUV = 1250 (A) + 100 (A)
1350 (A) = 1350 (A)
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Unit V – Cost Audit
Cost Audit
Cost Audit is an audit process for verifying the cost of manufacture or production on the basis
of accounts as regards utilization of material or labor or any other items of cost, maintained by
the company. In simple words the term cost audit means a systematic and accurate verification
of the cost accounts and records and checking adherence to the objectives of the cost
accounting. Thus, cost audit can be said to be a critical review undertaken for verifying the
correctness of cost accounts and to check that cost accounting principles and planning have
been efficiently followed.
Cost Audit has been defined by the Chartered Institute of Management Accountants (CIMA)
of London as “the verification of cost accounts and a check on the adherence to the cost
accounting plan”.
According to Smith and Day, the term cost audit means “detailed checking of the costing
system, techniques and accounts to verify their correctness and to ensure adherence to the
objective of cost accounting”.
In the words of R W Dobson, “Cost audit is the verification of the correctness of cost accounts
and of the adherence to the cost accountancy plans.”
From the above definitions, it can be said that cost audit is the detailed checking as well as
the verification of the correctness of costing techniques, systems and cost accounts. In any
manufacturing concern or in an service organization, it is generally felt necessary to compute
the correct cost, so as to charge the customers correctly.
Nature and Scope of Cost Audit
The cost audit is conducted in addition to the financial audit. However, unlike financial audit,
cost audit is to be conducted only if the Central Government makes an order for a particular
year and for a particular company.
As per the Section 233B of Company Law 1956, there is the provision for cost audit. Under
this section, cost audit is compulsory for all the public and government companies which are
associated with the processing and production. If there aggregate value of net worth exceeds
5 crores or total sale exceeds 20 crores the cost audit is must.
The scope of cost audit extents to the verification and checking of the following areas:
a. Services: utilization of power, fuel, water, steam and electricity and that of material, labor
and other costs like overhead allocated to the service department.
b. Wages and Salaries: maintenance of employment and attendance records, overtime and
idle time records, allocation of wages and salaries among various departments and those
connected with the capital work.
c. Overhead: the overheads like production, administration, selling and distribution should be
allocated on a reasonable basis. The cost auditor ensures a fair and equitable distribution
of overheads between various departments, reconciliation of the cost records with that of
financial records, overhead recovery rates and basis for allocation of cost between fixed
and variable costs.
d. Depreciation: maintenance of fixed assets registers with quantitative details, situation,
method of calculating depreciation, allocation of depreciation in respect of the common
assets.
e. Production: daily production reports, summaries from daily to monthly, monthly to yearly
and comparison with past records and budgeted targets including abnormal losses, work
in progress, etc.
f. Work in Progress: maintenance of records viz., job cards, work order, cost ledger, etc. and
their valuation method.
g. Stock Verification: inventory records for stock- both finished and unfinished products,
spares and stores, tools, machinery spares, etc. their values, issue procedure and
balances.
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h. Utilization of Capacity: plant utilization and capacity utilization are not considered in detail
in financial audit. However, in cost audit the cost auditor’s examination covers aspects
such as total available hours, standard hours, planned hours and actual hours worked;
Practical capacity, standard capacity, expected capacity and actual capacity utilized.
Besides, the cost auditor’s examination covers various other aspects like royalty payments,
company policies with regard to inventory management, productivity, internal control, internal
audit, cost reduction, bottlenecks in production process inter - company transactions, etc.
Hence, from the practical point of view the scope of cost audit is much wider than financial
audit.
Objectives of Cost Audit:
The following are the objectives of cost audit
A. Prospective Aspects:
i. Proper ascertainment and control of costs
ii. Detection of errors, omission and commission and check on its repetition
iii. Verifying that cost accounts are correctly maintained in conformity with accepted cost
accounting principles adopted in the industry.
iv. Ensuring that the cost account routine laid down is properly carried out.
B. Constructive Aspects:
i. Whether the existing procedures are adequate and effective for the management to
make decisions.
ii. Whether the projected expenditure could give optimum results.
iii. Whether money invested in one type of business can be more profitably invested in
another business.
iv. Whether return on capital employed is adequate and could it be bettered.
Thus the above objectives can be summed up as mentioned below:
i. To verify the arithmetical accuracy of cost data and cost books.
ii. To ensure that cost accounting principles are strictly adhered in preparing cost
accounts.
iii. To check whether pre-determined norms and concepts of cost accounting are followed
properly.
iv. To make available all data relating to cost records to the management for decision
making
v. To detect errors and frauds
vi. To make internal control more effective
Advantages of Cost Audit:
To the Management
a. Cost audit helps in detection of errors and frauds.
b. The management gets accurate and reliable data for decision making
c. It helps in cost control and cost reduction
d. It facilitates the system of standard costing and budgetary control
e. It helps management in inter –unit/ firm comparison
f. It enables management to identify loss making propositions
To the Government
a. Cost audit ensures efficient functioning of the industry which helps in nurturing healthy
competition amongst different companies.
b. It helps in identification of sick units and enables Government to make relevant decisions.
c. It helps in fixing prices in the case of essential commodities and check undue profiteering.
d. It enables to take decisions as to granting of subsidies, incentives and protection to various
industries.
e. It helps to take decision as to levies, duties and taxes.
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To the Society
a. Cost audit enables the Government to fix prices of essential commodities. Thus
safeguarding the interests of the society.
b. Cost audit enables the Government to keep a check on undue profiteering by
manufacturers and also avoid artificial price hike due to monopolistic tendencies.
To the Shareholders
a. Due to cost audit loss making product lineage of a company can be identified and the
losses incurred that has affected the overall profitability of the company can be
ascertained. This will thus help the shareholders and the management to take remedial
measures for make optimum utilization of resources.
b. Cost audit ensures that the shareholders get fair return on their investments.
Disadvantages
a. Expensive: conducting a cost audit can be expensive as the company has to appoint an
independent qualified professional for doing the cost audit.
b. Time Consuming: the process of cost audit is lengthy and time consuming that requires
devotion of employees.
c. Uncertainty: as the major part of the process involves estimating there’s possibility of
numerical figures being wrong and incorrect. Therefore, cost auditor relying on such
documents may give an inaccurate report.
d. Dependency: as costing is not an independent system of accounting, it depends on other
accounting system.
Types of Cost Audit
The types of Cost Audit are classified in two different manners. The summarized manner of
classifying types of Cost Audit is as under:
a. Efficiency Audit
b. Propriety Audit
c. Statutory Audit
a. Efficiency Audit: this audit is directed towards the measurement of effective execution of
corporate plans. It is concerned with the utilization of resources in an economic and most
remunerative manner to achieve the objectives of the concern. For eg. effective utilization
of capital of an organization can be gauged by determining the return on capital employed.
b. Propriety Audit: this audit is concerned with executive actions and plans that have bearing
on the finance and expenditure of the company. The cost auditor needs to judge whether
the planned expenditure is designed to give optimum results.
c. Statutory Audit: It is an compulsory audit that needs to be done by virtue of law with respect
to certain specified establishments. The main aim of this type of audit is to help
Government in ascertaining the relationship between costs and prices.
A more detailed manner of classifying types of cost audit is as mentioned below:
a. Cost Audit to Assist the Management
b. Cost Audit on behalf of the Government
c. Cost Audit on behalf of Customer
d. Cost Audit on behalf of Trade Associations
e. Cost Audit on behalf of Tribunals
f. Cost Audit under Statute
a. Cost Audit to Assist Management: the main objective of these type of cost audit is to make
available accurate and prompt information to management to assist them in making critical
decisions. The aim of this audit is to ensure that the management receives accurate and
timely details related to cost. The cost auditor in such type of audit is expected to suggest
the management ways of reducing cost of production, elimination or reduction of wastages
and losses and ways to make improvement in the cost accounting plan.
b. Cost Audit on behalf of the Government: the Government may appoint a cost auditor, for
the following mentioned purposes:
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i. to ascertain correct cost specific units when the Government is approached for
protection or financial help.
ii. To determine the accurate cost of the contract given to private firm under cost-plus
basis.
iii. To fix reasonable price of certain items of production to prevent undue profiteering.
c. Cost Audit on behalf of Customer: at times, the cost audit may be undertaken on behalf of
a customer when he agrees to pay the price for a certain product on ‘cost-plus’ basis. The
customer in such a case gets cost accounts of the product concerned audited to establish
correct cost so that he may be able to pay the price based on correct cost plus an agreed
margin of profit.
d. Cost Audit on behalf of Trade Associations: trade associations also may appoint a cost
auditor to conduct cost audit, some time to:
i. To ascertain comparative profitability of its members
ii. To determine the minimum price to avoid cut throat competition among its members
iii. To maintain prices at a certain level to prevent undue profiteering by any members
e. Cost Audit on behalf of Tribunals: sometimes the labor tribunal may direct the audit of
accounts to settle issues related to wages, bonus, share in profit, etc. Similarly, the Income
tax and/ or Sales tax tribunals may direct the audit of cost accounts to make correct and
proper assessment.
f. Cost Audit under Statute: the Central Government may under section 233-B of the
Companies Act, 1956 order that certain classes of companies which are required to
maintain proper records regarding materials consumed, labor and other expenses under
section 209 are required to get their cost audited. The aim of such type of audit is that the
Government wants to ascertain the relationship between cost and prices.
Techniques of Cost Audit
The techniques or methods employed through a cost auditor in the performance of his job are
identical to those used by a financial auditor. These techniques or methods of cost audit can
be summarized as follows:
1. Vouching means checking or inspection of documentary proof substantiating the
transaction. By vouching the cost auditor not only sees that the transaction is properly
supported but also verifies that the transaction is correctly authorized, recorded and
entered in the books of accounts or cost records. For e.g. in case of issue of material, the
cost auditor will ensure that there is an appropriate material demand slip against which the
said material has been issued and the same has been correctly recorded in the books.
2. Check marks or tick marks with specific color pen or pencil are made by the cost auditor
to indicate checking or verification activity of particular record are carried out by him. At
times rubber stamp may also be used by the cost auditor for this purpose.
3. Random Sampling technique may be used by the cost auditor instead of cent percent
audit, if he is satisfied with the system of internal control and internal checks. The degree
of such test checking by the auditor shall depend entirely on the satisfaction level of the
auditor.
4. During the course of cost audit, the auditor shall take notes of all material facts noticed by
him for which clarifications and explanations have to be sought from the concerned
officials. Further, he shall also be reporting about specific errors or defects, if any in the
system that were noticed by him while conducting the audit.
5. In order to make proper assessment about the cost accounting system and the internal
control and checks deployed by the management, the cost auditor gets feedback of
specific questionnaire framed by him with respect to significant elements of cost such as
material, labor, etc.
62
Dr. Varsha Rayanade

Cost Accountancy BBA Part II Semester III

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Cost Accountancy BBA Part II Semester III

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C

1. Introduction to Cost Accounting … …. 3

2. Methods of Costing and Material Management … …. 22

3. Material Costing and Break Even Analysis … …. 40

Unit I – Introduction to Cost Accounting

Material Cost Labor Cost Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Production or Works Administration Selling Distribution

Particulars Rs. Rs. Per unit Rs.

C = 600 units, O = Rs.12, I = 20% of price i.e. 20 x 20 ÷ 100 = Rs.4

(b) P/V ratio =

(e) Margin of Safety (in units) =

(f) Margin of Safety (in Rupees) =

Or Actual Sales – Break-even Sales

(g) Required Sales for a given profit (in units) =

(i) Sales when profit is known =

Selling price – variable costs = contribution per unit

Total Sales 10,00,000 100

(a) P/V = i.e. = = 25%

(b) BEP = Fixed costs ÷ P/V ratio

12. JK Enterprises furnishes you the following income information:

(b) Fixed Cost = ??

2. Following information is given:

Managerial Applications of Marginal Costing

Material Price Variance Material Usage Variance

Material Mix Variance Material Yield Variance Material Usage other

The formulae for above mentioned variance are as follows:

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