UNIT 1:

Introduction

Cost is essential not only to fix price but also to ascertain the margin of profit. Knowledge of the
cost determination is also necessary to keep a check on the cost of product/control on wastages,
etc. The accounting used to study the various aspects of cost is known as cost accounting. In this
we will learn about meaning, importance, and limitations etc. of cost accounting.

Meaning and Scope

Cost accounting is the process of determining and accumulating the cost of product or activity.
It is a process of accounting for the incurrence and the control of cost. It also covers
classification, analysis, and interpretation of cost. In other words, it is a system of accounting,
which provides the information about the ascertainment, and control of costs of products, or
services. It measures the operating efficiency of the enterprise. It is an internal aspect of the
organization. Cost Accounting is accounting for cost aimed at providing cost data, statement and
reports for the purpose of managerial decision making. The Institute of Cost and Management
Accounting, London defines “Cost accounting is the process of accounting from the point at
which expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centres and cost units. In the widest usage, it embraces the preparation of statistical
data, application of cost control methods and the ascertainment of profitability of activities
carried out or planned”.
Costing includes “the techniques and processes of ascertaining costs.” The ‘Technique’ refers
to principles which are applied for ascertaining costs of products, jobs, processes and services.
The `process’ refers to day to day routine of determining costs within the method of costing
adopted by a business enterprise.”
Costing involves “the classifying, recording and appropriate allocation expenditure for the
determination of costs of products or services; the relation of these costs to sales value; and
the ascertainment of profitability”.

Scope of Cost Accounting

The terms ‘costing’ and ‘cost accounting’ are many times used interchangeably. However, the
scope of cost accounting is broader than that of costing. Following functional activities are
included in the scope of cost accounting:

1. Cost book-keeping: It involves maintaining complete record of all costs incurred from
their incurrence to their charge to departments, products and services. Such recording is
preferably done on the basis of double entry system.
2. Cost system: Systems and procedures are devised for proper accounting for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the
important function of cost accounting. Cost ascertainment becomes the basis of
managerial decision making such as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors of actual costs
varying from the budgeted costs and fixation of responsibility for cost increases.

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5. Cost comparisons: Cost accounting also includes comparisons between cost from
alternative courses of action such as use of technology for production, cost of making
different products and activities, and cost of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilization of cost information for exercising control.
It involves a detailed examination of each cost in the light of benefit derived from the
incurrence of the cost. Thus, we can state that cost is analyzed to know whether the
current level of costs is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These
reports are primarily for use by the management at different levels. Cost Reports form the
basis for planning and control, performance appraisal and managerial decision making.

Objectives of cost accounting

There is a relationship among information needs of management, cost accounting objectives, and
techniques and tools used for analysis in cost accounting. Cost accounting has the following

1. Determining selling price

The objective of determining the cost of products is of main importance in cost accounting. The
total product cost and cost per unit of product are important in deciding selling price of product.
Cost accounting provides information regarding the cost to make and sell product or services.
Other factors such as the quality of product, the condition of the market, the area of distribution,
the quantity which can be supplied etc., are also to be given consideration by the management
before deciding the selling price, but the cost of product plays a major role.

2. Controlling cost

Cost accounting helps in attaining aim of controlling cost by using various techniques such as
Budgetary Control, Standard costing, and inventory control. Each item of cost [viz. material,
labour, and expense] is budgeted at the beginning of the period and actual expenses incurred are
compared with the budget. This increases the efficiency of the enterprise.

3. Providing information for decision-making

Cost accounting helps the management in providing information for managerial decisions for
formulating operative policies. These policies relate to the following matters:
(i) Determination of cost-volume-profit relationship.
(ii) Make or buy a component
(iii) Shut down or continue operation at a loss
(iv) Continuing with the existing machinery or replacing them by improved and economical
machines.

4. Ascertaining costing profit

Cost accounting helps in ascertaining the costing profit or loss of any activity on an objective
basis by matching cost with the revenue of the activity.

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5. Facilitating preparation of financial and other statements

Cost accounting helps to produce statements at short intervals as the management may require.
The financial statements are prepared generally once a year or half year to meet the needs of the
management. In order to operate the business at high efficiency, it is essential for management to
have a review of production, sales and operating results. Cost accounting provides daily, weekly
or monthly statements of units produced, accumulated cost with analysis. Cost accounting
system provides immediate information regarding stock of raw material, semi finished and
finished goods. This helps in preparation of financial Statements

Differences between Cost Accounting and Financial Accounting:

After studying financial accounting and cost accounting, you can understand the difference
between these two accounting systems. Therefore, difference between financial accounting and
cost accounting is as follows:

Basis Financial Accounting Cost Accounting

1. Objective It provides information about It provides information of
the financial performance and ascertainment of cost to
financial position of the control of the cost and for
decision making about the
cost.
2. Nature It classifies records, presents It classifies, records, presents,
and interprets transactions in and interprets in a significant
and manner the material, labour
Terms of money. and overheads cost.
3. Recording of the data It records Historical data It also records and presents the
Estimated/budgeted data. It
makes use of both the
historical costs and pre-
determined costs.
4. Users of information The users of financial The cost accounting
accounting information are information is used by internal
shareholders, creditors, management at different
financial analysts and levels.
government and its agencies,
etc.
5. Analysis It shows profit or loss of the It provides the details of cost
organization and profit of each product,
process, job, contracts, etc.
6. Time Period Financial Statements are Its reports and statements are
prepared for a definite period, prepared as and when
usually a year required.
7. Presentation of A set format is used There are not any set formats
Information presenting financial for presenting cost
information. information.

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In spite of the above differences, both financial and cost accounting are in agreement regarding
actual cost data and product costing analysis. Values of stock and cost of goods produced and
sold are the main examples. For the preparation of the position statement, financial accountant
receives the necessary data from the cost accountant.

Importance of Cost accounting

The limitation of financial accounting has made the management to realize the importance of
cost accounting. The importance of cost accounting is as follows:

A. Importance to Management:

Cost accounting provides invaluable help to management. It is difficult to indicate where the
work of cost accountant ends and managerial control begins. The advantages are as follows:

i. Helps in ascertainment of cost

Cost accounting helps the management in the ascertainment of cost of process, product, Job,
contract, activity, etc., by using different techniques such as Job costing and Process costing.

ii. Aids in Price fixation

By using demand and supply, activities of competitors, market condition to a great extent, also
determine the price of product and cost to the producer does play an important role. The
producer can take necessary help from his costing records.

iii. Helps in Cost reduction

Cost can be reduced in the long-run when cost reduction programme and improved methods are
tried to reduce costs.

iv. Elimination of wastage

As it is possible to know the cost of product at every stage, it becomes possible to check the
forms of waste, such as time and expenses etc., are in the use of machine equipment and
material.

v. Helps in identifying unprofitable activities

With the help of cost accounting the unprofitable activities are identified, so that the necessary
correct action may be taken.

vi. Helps in checking the accuracy of financial account

Cost accounting helps in checking the accuracy of financial account with the help of
reconciliation of the profit as per financial accounts with the profit as per cost account.

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vii. Helps in fixing selling Prices

It helps the management in fixing selling prices of product by providing detailed cost
information.

viii. Helps in Inventory Control

Cost furnishes control which management requires in respect of stock of material, work in
progress and finished goods.

ix. Helps in estimate

Costing records provide a reliable basis upon which tender and estimates may be prepared.

B. Importance to Employees

Worker and employees have an interest in which they are employed. An efficient costing system
benefits employees through incentives plan in their enterprise, etc. As a result both the
productivity and earning capacity increases.

C. Cost accounting and creditors:

Suppliers, investor’s financial institution and other moneylenders have a stake in the success of
the business concern and therefore are benefited by installation of an efficient costing system.
They can base their judgment about the profitability and prospects of the enterprise upon the
studies and reports submitted by the cost accountant.

d. Importance to National Economy

An efficient costing system benefits national economy by stepping up the government revenue
by achieving higher production. The overall economic developments of a country take place due
to efficiency of production.

Limitations of Cost Accounting:

Like other branches of accounting, cost accounting is not an exact science but is an art which has
developed through theories and accounting practices based on reasoning and common sense.
These practices are not static but changing with time. Cost accounting lacks a uniform procedure.
There is no stereotyped system of cost accounting applicable to all industries. There are widely
recognized cost concepts but understood and applied differently by different industries. Cost
accounting can be used only by big enterprises.

The limitations of cost accounting are as follows:

 It is expensive because analysis, allocation and absorption of overheads require
considerable amount of additional work.
 The results shown by cost accounts differ from those shown by financial accounts.
Preparation of reconciliation statements frequently is necessary to verify their accuracy.
This leads to unnecessary increase in workload
 It is unnecessary because it involves duplication of work. Some industrial units are
functioning efficiently without any costing system.

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 Costing system itself does not control costs. If the management is alert and efficient, it
can control cost without the help of the cost accounting. Therefore it is unnecessary.

Elements of Cost:

We first classify costs according to the three elements of cost:

a) Materials b) Labour c) Expenses

Direct costs: Direct costs are generally seen to be variable costs and they are called direct costs
because they are directly associated with manufacturing. In turn, the direct costs can include:

 Direct materials: plywood, wooden battens, fabric for the seat and the back, nails,
screws, glue.
 Direct labour: sawyers, drillers, assemblers, painters, polishers, upholsterers
 Direct expense: this is a strange cost that many texts don't include; but (International
Accounting Standard) IAS 2, for example, includes it. Direct expenses can include the
costs of special designs for one batch, or run, of a particular set of tables and/or chairs,
the cost of buying or hiring special machinery to make a limited edition of a set of chairs.

Indirect Costs: Indirect costs are those costs that are incurred in the factory but that cannot be
directly associate with manufacture. Again these costs are classified according to the three
elements of cost, materials labour and overheads.

 Indirect materials: Some costs that we have included as direct materials would be
included here.
 Indirect labour: Labour costs of people who are only indirectly associated with
manufacture: management of a department or area, supervisors, cleaners, maintenance
and repair technicians
 Indirect expenses: The list in this section could be infinitely long if we were to try to
include every possible indirect cost. Essentially, if a cost is a factory cost and it has not
been included in any of the other sections, it has to be an indirect expense. Here are some
examples include: Depreciation of equipment, machinery, vehicles, buildings,
Electricity, water, telephone, rent, Council Tax, insurance
Total indirect costs are collectively known as Overheads.

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COST SHEET – FORMAT

Particulars Amoun Amount

t

Opening Stock of Raw Material ***

Add: Purchase of Raw materials ***

Add: Purchase Expenses ***

Less: Closing stock of Raw Materials ***

Raw Materials Consumed ***

Direct Wages (Labour) ***

Direct Charges ***

Prime cost (1) ***

Add :- Factory Over Heads:

Factory Rent ***

Factory Power ***

Indirect Material ***

Indirect Wages ***

Supervisor Salary
***
Drawing Office Salary
***
Factory Insurance
***
Factory Asset Depreciation
***

Works cost Incurred ***

Add: Opening Stock of WIP ***

Less: Closing Stock of WIP ***

Works cost (2) ***

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Add:- Administration Over Heads:-

Office Rent ***

Asset Depreciation ***

General Charges ***

Audit Fees ***

Bank Charges ***

Counting house Salary ***

Other Office Expenses ***

Cost of Production (3) ***

Add: Opening stock of Finished Goods ***

Less: Closing stock of Finished Goods ***

Cost of Goods Sold ***

Add:- Selling and Distribution OH:-

Sales man Commission ***

Sales man salary ***

Traveling Expenses ***

Advertisement ***

Delivery man expenses ***

Sales Tax ***

Bad Debts ***

Cost of Sales (5) ***

Profit (balancing figure) ***

Sales ***

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Emerging Terms in Cost Accounting:

Life Cycle Costing:

Life-cycle costing is a method of costing that looks at a product’s entire value chain from a cost
perspective. Other types of costing generally look only at the production process, whereas life-
cycle costing tracks and evaluates costing from the research and development phase of a
product’s life, through to the decline and eventual conclusion of a product’s life.

This approach to costing makes sense for several reasons. First of all, most of a product’s costs
are committed before the product is in the production phase. This means that the majority of
control management can exert over production and other costs is during the design phase of the
product’s life-cycle.

Life-cycle costing also looks at product costs post-sale. Examples of this type of cost are
warranties, customer service, marketing, and distribution costs. Where most types of costing
systems focus on cost control, life-cycle costing focuses on reducing costs throughout a
product’s life.

Activity-based costing (ABC)

It is a costing methodology that identifies activities in an organization and assigns the cost of
each activity with resources to all products and services according to the actual consumption by
each. This model assigns more indirect costs (overhead) into direct costs compared to
conventional costing.

With ABC, an organization can soundly estimate the cost elements of entire products and
services. That may help inform a company's decision to either:

 Identify and eliminate those products and services that are unprofitable and lower the
prices of those that are overpriced
 Identify and eliminate production or service processes that are ineffective and allocate
processing concepts that lead to the very same product at a better yield (process re-
engineering aim).

In a business organization, the ABC methodology assigns an organization's resource costs

through activities to the products and services provided to its customers. ABC is generally used
as a tool for understanding product and customer cost and profitability based on the production
or performing processes. As such, ABC has predominantly been used to support strategic
decisions such as pricing, outsourcing, identification and measurement of process improvement
initiatives.

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Back flush accounting:

Back flush accounting is a certain type of "postproduction issuing", it is a product costing

approach, used in a Just-In-Time (JIT) operating environment, in which costing is delayed until
goods are finished. Standard costs are then flushed backwards through the system to assign costs
to products. The result is that detailed tracking of costs is eliminated. Journal entries to inventory
accounts may be delayed until the time of product completion or even the time of sale, and
standard costs are used to assign costs to units when journal entries are made. Back flushing
transaction has two steps: one step of the transaction reports the produced part which serves to
increase the quantity on-hand of the produced part and a second step which relieves the
inventory of all the component parts. Component part numbers and quantities-per are taken from
the standard bill of material (BOM). This represents a huge savings over the traditional method
of a) issuing component parts one at a time, usually to a discrete work order, b) receiving the
finished parts into inventory, and c) returning any unused components, one at a time, back into
inventory. Back flush accounting is inappropriate when production process is long and this has
been attributed as a major flaw in the design of the concept. It may be also be inappropriate if the
bill of materials does not only contain piece goods but also many parts with more or less variable
consumption.

Materials Cost Control

Materials cost is one of the important elements of cost of product or unit. It constitutes a
substantial proportion of the total cost of production. For material cost control purposes, it is
very essential to know the important aspects of material, material control and material purchase
control.
Materials: The term 'materials' refers to all commodities or components which are consumed in
the process of manufacture. The materials may be classified into Direct Materials and Indirect
Materials.
Direct Materials: Direct Materials form part of the finished products. They can be easily
identified with a particular cost unit. For example, cotton used in textile mills, timber used in
furniture industries.
Indirect Materials: Indirect materials indirectly used for conversion from raw materials into
finished products. They cannot be easily identified with a particular cost unit. For example, spare
parts, tools, nails, lubrications etc.
Materials are further classified on the basis of the nature which have to be used such as:
(a) Raw Materials, e.g., rubber, timber, steel etc.
(b) Components, e.g., instruments
(c) Consumable stores, e.g., cotton waste, brushes
(d) Maintenance Materials, e.g., spare parts
(e) Tools, e.g., jigs and fixtures

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Materials Control

Materials control may be defined as the systematic control over the procurement, storage and
usage of materials so as to maintain an even flow of materials and at the same time avoiding
excessive investment in inventories.

Objectives of Stores Control

The following are the objectives of stores control:

1. To receive materials and store them properly.
2. To ensure proper production and preservation of materials.
3. To make sure proper classification and codification of materials.
4. To provide proper information to the management about stock of materials.
5. To ensure good housekeeping and effective material handlings.
6. To assist in verification and provision of supporting information for effective
purchase action.
7. To minimize obsolescence of materials adopted through effective control
measures.
8. To ensure the optimum investment in materials to avoid overstocking or under
stocking of materials.
9. To maintain proper records about materials, receipts, issues and balances.
10. To issue materials as per specifications.
11. To make sure of the availability of all types of materials.
12. To ensure proper utilization of floor space.

Essentials of Material Control

Effective materials control is required for the following essentials to be considered:

 Systematic planning for requirement of materials.

 Essentials for co-ordination and co-operation among different departments.
 Fixing of stock level is essential for avoiding overstocking.
 Floor space is required for smooth handling of materials.
 Proper filing system should be adopted.
 Proper codification and classification of materials as per specifications.
 Perpetual inventory system should be adopted for verification of materials in stock.
 Proper planned storage control and issue.
 Systematic procedure should be adopted for materials, receipts and issues.
 Qualified personnel required to manage the materials functions effectively.
 Appropriate system of internal auditing should be adopted.

Advantages of material control:

The following are the advantages of materials control :

 It ensures continuous flow of production.

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 There is maximum utilization of stores resources.

 It facilitates economy of buying.
 It ensures optimum investments in inventories.
 There is possibility of reduction of loss of theft, leakage, obsolescence etc.
 It minimizes cost of materials during purchase, storage and issue of materials.
 It facilitates effective information system to management.

Material is main current asset of business which is needed for finished product. It also has big
proportion in total cost. These two points attract businessman to control the material, so that
supply of stock should be continue without any delay and also it should be at optimum level
without any over-stocking problem. For this, cost accountant has to use following techniques for
controlling the material or inventory.

1. Stock levels

In this technique of material control, we study and control by calculating different level of
quantity of stock. With our past records, we have the data of normal usage, maximum usage,
minimum usages, re-order quantity and minimum and maximum period and its mid will be
average period. With this data, we can find following stock level

a) Re-ordering level

It is the level of stock quantity between minimum and maximum level and material order was
sent for getting fresh stock.

Formula

maximum usage of stock X maximum delivery period

b) Minimum level

It is the minimum balance, which must be maintained in hand at all times, so that there is no
stoppage of production due to non availability of inventory.

Formula

Re-order level - ( Normal usage X average period )

c) Maximum level

It shows maximum quantity which should be in the stock, if we buy more, it means we are

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wasting money.

formula

re-order level X re-order quantity - ( minimum usage X minimum period )

d) Average Stock Level

This is the average of minimum and maximum level and it can be calculated by adding minimum
level and maximum level and divided by 2.

Formula

minimum level + maximum level / 2

e) Danger level

It is the level at which normal issues of the raw material inventory are stopped and emergency
issues are only made.

Formula

average consumption X lead time for emergency purchases

2. ABC Analysis:

ABC analysis is that technique of material control in which we divide our material into three
categories and investment is done according to the value and nature of that category’s materials.
After this, we control of material according to their level of investment. We need not to control
all the categories but we have to control those materials which are in a category.

A category materials and its control

In these category materials, we include 10% of total material, but its cost will be high, so its
investment requirement will also be very high and it may be 70% of total investment in
inventory. Store keeper should make safe these materials from any wastage, because its price or
demand is very high. Store keeper also keeps its economic order quantity and tries to decrease
misuse of money in this category.

A category which will also require special attention due to the “large amount of money” they
represent. A small “mistake” in managing the few A Category materials may cost a lot to your
company.

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B category materials and its control

In this category, there are many normal materials can be included which are needed for
production. Store keeper can classify 20% of material and we need 20% of total investment in
this type of inventory for buying. But its control is also necessary, because without this,
production may be delay. So, store keeper should not ignore its control and for continuing
supply, storekeeper should maintain its minimum, maximum and re-order level.

C category materials and its control

There is no need to control this type of material but normal care is needed for keeping this
material in right position before using it for production. Its quantity is of 70% of total quantity
but cost is 10% of total investment in inventory. So, overstocking can increase store cost and
interest on capital. So, purchase should be in hand.

The A segments represent approximately 70% of the total spend within a category - High
attention

- The B segments represent the following 20% of the total spend within a category - Normal
attention

- The C segments are the remaining (most of the time several segments) which Represents the
final 10% of the total spend - Low attention

3. Economic Order Quantity:

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Economic order quantity is the level of inventory that minimizes the total inventory holding
costs and ordering costs. It is one of the oldest classical production scheduling models The EOQ
model is a continuous replenishment system, which means that inventory is checked upon every
withdrawal to see if that withdrawal will cause the inventory level to fall below the restocking
level. If so, an order is immediately place for the EOQ number of units. This is also known as a
fixed order quantity model because the quantity ordered (EOQ) does not change unless the
parameters of the model change.

Assumptions:

 T he ordering cost is constant.

 The rate of demand is known, and spread evenly throughout the year.
 The lead time is fixed.
 The purchase price of the item is constant i.e. no discount is available
 The replenishment is made instantaneously; the whole batch is delivered at once.
 Only one product is involved.

4. inventory storage techniques:

Perpetual inventory system and periodic inventory systems are the two systems of keeping
records of inventory.

In perpetual inventory system, merchandise inventory and cost of goods sold are updated
continuously on each sale and purchase transaction. Some other transactions may also require an
update to inventory account for example, sale/purchase return, purchase discounts etc. Purchases
are directly debited to inventory account whereas for each sale two journal entries are made: one
to record sale value of inventory and other to record cost of goods sold. Purchases account is not
used in perpetual inventory system.

In periodic inventory system, merchandise inventory and cost of goods sold are not updated
continuously. Instead purchases are recorded in Purchases account and each sale transaction is
recorded via a single journal entry. Thus cost of goods sold account does not exist during the
accounting period. It is determined at the end of accounting period via a closing entry.

Differences between Perpetual and Periodic System

Following are the main differences between perpetual and periodic inventory systems:

 Inventory Account and Cost of Goods Sold Account are used in both systems but they
are updated continuously during the period in perpetual inventory system whereas in
periodic inventory system they are updated only at the end of the period.

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 Purchases Account and Purchase Returns and Allowances Account are only used in
periodic inventory system and are updated continuously. In perpetual inventory system
purchases are directly debited to inventory account and purchase returns are directly
credited to inventory account.
 Sale Transaction is recorded via two journal entries in perpetual system. One of them
records the sale value of inventory whereas the other records cost of goods sold. In
periodic inventory system, only one entry is made.
 Closing Entries are only required in periodic inventory system to update inventory and
cost of goods sold. Periodic inventory system does not require closing entries for
inventory account.

Methods of Inventory Valuation:

1. First in First Out Method:

First-in-First out Method (FIFO) - It is a method of pricing the issues of materials, in he order in
which they are purchased. In other words, the materials are issued in the order in which they
arrive in the store or the items longest in stock are issued first. Thus each issue of material only
recovers the purchase price which does not reflect the current market price. This method is
considered suitable in times of falling price because the material cost charged to production will
be high while the replacement cost of materials will be low. But, in the case of rising prices, if
this method is adopted, the charge to production will be low as compared to the replacement cost
of materials. Consequently, it would be difficult to purchase the same volume of material (as in
the current period) in future without having additional capital resources. The advantages and
disadvantages of the method may be stated as follows:

Advantages:
1. It is simple to understand and easy to operate.

2. Material cost charged to production represents actual cost with which the cost of production
should have been charged.

3. In the case of falling prices, the use of this method gives better results.

4. Closing stock of material will be represented very closely at current market price.

Disadvantages:
1. If the prices fluctuate frequently, this method may lead to clerical error.

2. 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.

3. In the case of rising prices, the real profits of the concern being low, they may be inadequate
to meet the concern's demand to purchase raw materials at the ruling price.

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2. Last in First Out Method:

Last-in-First out method (LIFO) - It is a method of pricing the issues of materials. This method is
based on the assumption that the items of the last batch (lot) purchased are the first to be issued.
Therefore, under this method the price of the last batch (lot) is used for pricing the issues, until it
is exhausted, and so on. If however, the quantity of issue is more than the quantity of the latest
lot than earlier (lot) and its price will also be taken into consideration. During inflationary period
or period of rising prices, the use of LIFO would help to ensure that the cost of production
determined on the above basis is approximately the current one. This method is also useful
specially when there is a feeling that due to the use of FIFO or average methods, the profits
shown and tax paid are too high.

Advantages:

1. The cost of materials issued will be either nearer to and or will reflect the current market price.
Thus, the cost of goods produced will be related to the trend of the market price of materials.
Such a trend in price of materials enables the matching of cost of production with current sales
revenues.

2. The use of the method during the period of rising prices does not reflect undue high profit in
the income statement as it was under the first-in-first-out or average method. In fact, the profit
shown here is relatively lower because the cost of production takes into account the rising trend
of material prices.

3. In the case of falling prices profit tends to raise due to lower material cost, yet the finished
products appear to be more competitive and are at market price.

4. Over a period, the use of LIFO helps to iron out the fluctuations in profits.

5. In the period of inflation LIFO will tend to show the correct profit and thus avoid paying
undue taxes to some extent.

Disadvantages:

1. Calculation under LIFO system becomes complicated and cumbersome when frequent
purchases are made at highly fluctuating rates.

2. Costs of different similar batches of production carried on at the same time may differ a great
deal.

3. In time of falling prices, there will be need for writing off stock value considerably to stick to
the principle of stock valuation, i.e., the cost or the market price whichever is
lower.

4. This method of valuation of material is not acceptable to the income tax authorities.

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3. Weighted Average Method:

This method is like weighted average price method, except that the calculations of issue prices
are made periodically (say, a month). The rate so arrived is used for the issues made during that
period and also for valuing the inventory at the end of the period.

Advantages

1. This method is superior to the periodic simple average price method as it takes into
account the quantities also.

2. It overcomes or evens out the effect of fluctuations.

3. in addition to above, the method also possesses all the advantages of the simple weighted
average price method.

Disadvantages

1. This method is not suitable for job costing because each job is to be priced at each stage of
completion.

Material losses:

Losses of materials may arise during handling, storage or during process of manufacture. Such
losses or wastages are classified into two categories- normal loss and abnormal loss.

Normal loss: this is that loss which has necessarily to be incurred and thus is unavoidable:

Examples:

 Loss by evaporation incase of liquid materials.

 Loss due to loading or unloading of material in case if coal and other materials of such
nature.
 Loss due to breaking the bulk. When materials are purchase in large quantity and issued
to production in small lots, some difference is likely to arise.

Normal losses of material cannot be completely eliminated but may be controlled to a limited
extent.

Abnormal loss:

This is that loss which arises due to

inefficiency in operations, bad luck , mischief etc.,

Examples:

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 Theft or pilferage
 Breakage
 Fire, accident, flood etc.,
 Use of inaccurate weighing instruments
 Improper storage resulting in deterioration of materials.

In the case of normal losses, an alternative method is used to price per unit of material so as
to cover the normal loss. It can be understood with the help of the example considered.

Suppose 1,000 metres of gunny cloth are purchased at 2 per metre. It is expected that 1% would
be the normal loss due to issues being made in small lots. The inflated price would be 2.02 p.
i.e., (2,000 for 990 metres). The rate of 2.02 per metre of gunny cloth covers the cost a normal
loss as well.

Accounting and control of waste, scrap, spoilage and defectives

Waste

The portion of basic raw materials lost in processing having no recoverable value. Waste may be
visible - remnants of basic raw materials - or invisible; e.g., disappearance of basic raw materials
through evaporation, smoke etc. Shrinkage of material due to natural causes may also be a form
of a material wastage.

In Case of Normal Wastage

Normal waste is absorbed in the cost of net output.

In Case of Abnormal Wastage

The abnormal waste is transferred to the Costing Profit and Loss Account.
For effective control of waste, normal allowances for yield and waste should be made from past
experience, technical factors and special features of the material process and product. Actual
yield and waste should be compared with anticipated figures and appropriate actions should be
taken where necessary. Responsibility should be fixed on purchasing, storage, maintenance, and
production and inspection staff to maintain standards. A systematic procedure for feedback of
achievement against laid down standards should be established.

Scrap:

It has been defined as the incidental residue from certain types of manufacture, usually of small
amount and low value, recoverable without further processing.

Scrap may be treated in cost accounts in the following ways:-

 When the scrap value is negligible: It may be excluded from costs. In other words, the
cost of scrap is borne by good units and income scrap is treated as other income.
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 When the scrap value is not identifiable to a particular process or job: The sales value of
scrap net of selling and distribution cost, is deducted from overhead to reduce the
overhead rate. A variation of this method is to deduct the net realizable value from
material cost.
 When scrap is identifiable with a particular job or process and its value is significant:
The scrap account should be charged with full cost. The credit is given to the job or
process concern. The profit or loss in the scrap account, on realization, will be transferred
to the Costing Profit and Loss Account. Control of scrap really means the maximum
effective utilization of raw material. Scrap control does not, therefore, start in the
production department; it starts from the stage of product de-signing. Thus the most
suitable type of materials, the right type of equipment and personnel would help in
getting maximum quantity of finished product from a given raw material.

A standard allowance for scrap should be fixed and actual scrap should be collected, recorded
and reported indicating the cost centre responsible for it. A periodical scrap report would serve
the purpose where two or more departments or cost centers are responsible for the scrap; the
reports should be routed through the departments concerned.

Spoilage:

It is the term used for materials which are badly damaged in manufacturing operations, and they
cannot be rectified economically and hence taken out of process to be disposed of in some
manner without further processing. Spoilage may be either normal or abnormal.

In case of normal spoilage:

Normal spoilage (i.e., which is inherent in the operation) costs are included in costs either
charging the loss due to spoilage to the production order or by charging it to production overhead
so that it is spread over all products. Any value realized from spoilage is creditedSunday, July
14, 2024 to production order or production overhead account, as the case may be.

In case of abnormal spoilage:

The cost of abnormal spoilage (i.e., arising out of causes not inherent in manufacturing process)
is charged to the Costing Profit and Loss Account. When spoiled work is the result of rigid
specification, the cost of spoiled work is absorbed by good production while the cost of disposal
is charged to production overhead. To control spoilage, allowance for normal spoilage should be
fixed and actual spoilage should
be compared with standard set. A systematic procedure of reporting would help control over
spoilage. A spoilage report should highlight the normal and abnormal spoilage, the department
responsible, the causes of spoilage and the corrective action taken, if any.

Defectives:

It signifies those units or portions of production which can be rectified and turned out as good
units by the application of additional material, labor or other service.

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For example, some mudguards produced in a bicycle factory may have dents; or there may be
duplication of pages or omission of some pages in a book. Defectives arise due to sub-standard
materials, bad-supervision, bad-planning, poor workmanship, inadequate-equipment and careless
inspection. To some extent, defectives may be unavoidable but usually, with proper care it
should be possible to avoid defect in the goods produced.

Reclamation of loss from defective units

- In the case of articles that have been spoiled, it is necessary to take steps to reclaim as much of
the loss as possible. For this purpose:
 All defective units should be sent to a place fixed for the purpose;
 These should be dismantled;
 Goods and serviceable parts should be separated and taken into stock;
 Parts which can be made serviceable by further work should be separated and sent to the
workshop for the purpose and taken into stock after the defects have been removed; and
 Parts which cannot be made serviceable should be collected in one place for being
melted or sold. Printed forms should be used to record quantities for all purposes
aforementioned.

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