SCHOOL
OF BUSINESS MANAGEMENT
DEPARTMENT
OF MANAGEMENT
BBA
303
COST
ACCOUNTING
UNIT
I
Cost,
Costing, Cost Accounting and Cost Accountancy
Cost,
costing, cost accounting and cost
accountancy are normally used interchangeably but they are not synonyms of each
other. The meaning of these terms is related and similar but there are differences.
Cost is a sacrificed resource to obtain something, costing is a process of
determining costs, cost accounting is a technique to assist management in
establishing various budgets, standards, etc and cost accountancy is the
practice of costing and cost accounting.
COST
Cost
is commonly defined as ‘sacrificed resource’ for a particular thing. If we buy
a watch for $30, a number of dollars are considered to be the cost of that
watch. Here, 30 dollars are sacrificed to obtain a watch. It is the simplest
example but cost can be of anything which is measurable in terms of money. For
example, the cost of preparing one pizza which in itself include various other
costs like cost of flour, other ingredients, labor, electricity and other
overheads. Just the same way, cost of production of any product or service can
be determined.
COSTING
‘Cost’
is a term whereas ‘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. The real scope of this term can best be
understood in the context of big manufacturing concerns who produce hundreds of
products and spend a lot of money on material, labor and other overheads. The
cost of each product in those organizations requires recording expenses with to
each product or process, classifying expenses like direct material, labor,
overheads etc, allocating direct expenses and suitable apportionment of
overheads to each product for most correct determination of per unit cost of
production of each product.
COST
ACCOUNTING
This
term is of utmost importance for the top management of any business. Cost
Accounting is basically the next step to costing. Cost accounting involves
analyzing relevant costing data, interpret it and present various management
problems to management. The scope of cost accounting involves preparation of
various budgets for an organization, determining standard costs based on
technical estimates, finding and comparing with actual costs, ascertaining the
reasons of by variance analysis etc.
COST
ACCOUNTANCY
This
term is over and above costing and cost accounting. It envisages 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 incomes is also a part of the practice of Cost Accountancy.
Objectives
of Cost Accounting:
The main objectives of cost accounting are as
follows:
1.
To record, analyze, and classify the cost of products and operations with a
view to ascertain the cost per unit of production, also the cost of each
element of expenditure and thereby to determine the selling price of such
products or services.
2.
To help management in its task of cost minimization by facilitating cost
control through standard costing and budgetary control, etc. and enable
management to measure the efficiency of the organization as a whole or
departmentally and also devise means of increasing efficiency.
3.
To provide information to enable management to make such tactical decisions as
the closing down of or continuance of a department, a product mix, make or buy,
etc., and also strategic investment decisions.
4.
To enable management to have frequent review of production, sales and operating
by supplying information at shorter intervals say, daily, weekly, or monthly
about the volumes of units produced, accumulated costs together with appropriate
analysis.
Functions
of Cost Accounting:
More specifically the following may be listed as the
functions of cost accounting:
1.
To ascertain the unit cost of product, service or department and estimate the
net result i.e., cost, profit or loss, for each item of operation, production
or service.
2.
To help construction of budget and budgetary control and standard costing and
develop control systems through analysis and exceptions.
3.
To present and interpret data for managerial decision-making and control and
suggest suitable criteria for choosing among alternative investments, products,
market, etc.
Advantages
of Cost Accounting
The
extent of advantages derived from the cost accounting is based on the type,
adequacy and efficiency of cost accounting system installation.
Moreover,
the management at the maximum should accept the advises given by the cost
accounting system. If so, the following advantages may be available to an
organization.
1. Elimination of Wastes, Losses and Inefficiencies:
A good cost accounting system eliminates wastes, losses and inefficiencies by
fixing standard for everything.
2. Cost Reduction: New and improved
methods of production are followed under cost accounting system. It leads to
cost reduction.
3. Identify the reasons for Profit or Loss:
A good cost accounting system highlights the reasons for increasing or
decreasing profit. If so, the management can take remedial action to maintain
profitability of the concern. There is no possibility of shutting down of any
product or process or department.
4. Advises on Make or Buy Decision: On the basis of
cost information, the management can decide whether make or buy a product in
open market. The management can rightly choose the best out of many
alternatives. Sometimes, spare capacity can be used profitably.
5. Price Fixation: The total cost of a
product is available in the costing records. It is highly useful for price
fixation of a product.
6. Cost Control: Budgets are prepared and standards
are fixed under cost accounting system. The expenses are not permitted beyond
the budget amount. The actual performance is compared with standard to find the
variation. If there is any variation, reasons are find out and the management
can exercise control. Period to period cost comparison also helps cost control.
7. Assist the Government: Government can collect
reasonable tax from the company and exercise price control.
8. Help the Trade Union: Bonus calculation is
very easy to the trade union. Reasonable remuneration is also fixed on the
basis of cost accounting information.
9. Marginal Analysis of Cost: It is done for
facilitating the short-term decisions especially during depression period.
10. Fixation of Responsibility: Responsibility centers
is fixed under cost accounting system. If responsibility is fixed, it becomes
difficult to evade responsibility of performance and leads to effective
performance.
11. Helps to Prepare Financial Accounts:
The information like value of closing materials, work in progress and finished
goods are necessary to prepare financial accounts. This information is supplied
by the costing records and helps to prepare financial accounts without any
further delay.
12. Prevention of Frauds: Introducing cost audit
can prevent frauds. If so, correct and reliable data was available from the
costing records which are highly useful to the government, share holders, the
creditors and the like.
Disadvantages
or Limitations of Cost Accounting
The
limitations or disadvantages of cost accounting are listed below:
1.
Only past performances are available in the costing records but the management
is taking
decision for future.
2.
The cost of previous year is not same in the succeeding year. Hence, cost data
are not highly useful.
3.
The cost is ascertained on the basis of full utilization of capacity. If
capacity is partly utilized, the cost may not be true.
4.
Financial character expenses are not included for cost calculation. Hence, the
calculated cost is not correct always.
5.
In cost accounting, costs are absorbed on pre-determined rate. It leads to over
absorption or under absorption of overheads.
6.
Cost Accounting fails to solve the problems relating to work study, time and
motion study and operation research.
7. Installation
of Cost Accounting System requires the maintenance of
many costing records. If results in heavy expenditure.
8.
Delay in receiving costing information does not result in taking quality
decision by the management.
9.
Rigid Cost Accounting System does not serve all purposes.
General
Principles of cost Accounting
There
are certain cost accounting principles that are very important. Some of the
principles of costing are given below.
- Previous costs
should not be included in any part of the future costing.
- Cost accounting
should cause effective relationship.
- The practice of
farsightedness should be ignored in cost accounting.
- It is preferred
and suggested by every firm to follow the double entry principle. It
simply means keeping two sets of accounting books which will have
transaction records.
- Anomalous cost
should be excluded from cost accounts.
Classification of cost
Costs
can be classified based on the following attributes:
By Nature
In
this type, material, labor and overheads are three costs, which can be further
sub-divided into raw materials, consumables, packing materials, and spare parts
etc.
By Degree of
Traceability of the Product
Direct
and indirect expenses are main types of costs come under it. Direct expenses
may directly attributable to a particular product. Leather in shoe
manufacturing is a direct expenses and salaries, rent of building etc. come
under indirect expenses.
By Controllability
In
this classification, two types of costs fall:
- Controllable - These are controlled by
management like material labor and direct expenses.
- Uncontrollable - They are not influenced by
management or any group of people. They include rent of a building,
salaries, and other indirect expenses.
By Relationship with
Accounting Period
Classifications
are measured by the period of use and benefit. The capital expenditure and
revenue expenditure are classified under it. Revenue expenses relate to current
accounting period. Capital expenditures are the benefits beyond accounting
period. Fixed assets come under category of capital expenditure and maintenance
of assets comes under revenue expenditure category.
By Association with the
Product
There
are two categories under this classification:
- Product cost - Product cost is
identifiable in any product. It includes direct material, direct labor and
direct overheads. Up to sale, these products are shown and valued as
inventory and they form a part of balance sheet. Any profitability is
reflected only when these products are sold. The Costs of these products
are transferred to costs of goods sold account.
- Time/Period base cost - Selling
expenditure and Administrative expenditure, both are time or period based
expenditures. For example, rent of a building, salaries to employees are
related to period only. Profitability and costs are depends on both,
product cost and time/period cost.
By Functions
Under
this category, the cost is divided by its function as follows:
- Production Cost - It represents the
total manufacturing or production cost.
- Commercial cost - It includes
operational expenses of the business and may be sub-divided into
administration cost and selling and distribution cost.
By Change in Activity
or Volume
Under
this category, the cost is divided as fixed, variable, and semi-variable costs:
- Fixed cost - It mainly relates to time
or period. It remains unchanged irrespective of volume of production like
factory rent, insurance, etc. The cost per unit fluctuates according to
the production. The cost per unit decreases if production increases and
cost per unit increases if the production decreases. That is, the cost per
unit is inversely proportional to the production. For example, if the
factory rent is Rs 25,000 per month and the number of units produced in
that month is 25,000, then the cost of rent per unit will be Rs 1 per
unit. In case the production increases to 50,000 units, then the cost of
rent per unit will be Rs 0.50 per unit.
- Variable cost - Variable cost directly
associates with unit. It increases or decreases according to the volume of
production. Direct material and direct labor are the most common examples
of variable cost. It means the variable cost per unit remains constant
irrespective of production of units.
- Semi-variable cost - A specific portion of
these costs remains fixed and the balance portion is variable, depending
on their use. For example, if the minimum electricity bill per month is Rs
5,000 for 1000 units and excess consumption, if any, is charged @ Rs 7.50
per unit. In this case, fixed electricity cost is Rs 5,000 and the total
cost depends on the consumption of units in excess of 1000 units.
Therefore, the cost per unit up to a certain level changes according to
the volume of production, and after that, the cost per unit remains
constant @ Rs 7.50 per unit.
Difference between
Financial accounting and Cost accounting
Both
cost accounting and financial accounting help the management formulate and
control organization policies. Financial management gives an overall picture of
profit or loss and costing provides detailed product-wise analysis.
No
doubt, the purpose of both is same; but still there is a lot of difference in
financial accounting and cost accounting. For example, if a company is dealing
in 10 types of products, financial accounting provides information of all the
products in totality under different categories of expense heads such as cost
of material, cost of labor, freight charges, direct expenses, and indirect
expenses. In contrast, cost accounting gives details of each overhead
product-wise, such as much material, labor, direct and indirect expenses are
consumed in each unit. With the help of costing, we get product-wise cost,
selling price, and profitability.
The following table broadly covers the most
important differences between financial accounting and cost accounting.
|
Point of Differences
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Financial Accounting
|
Cost Accounting
|
|
Meaning
|
Recoding of transactions is part of financial
accounting. We make financial statements through these transactions. With the
help of financial statements, we analyze the profitability and financial
position of a company.
|
Cost accounting is used to calculate cost of the
product and also helpful in controlling cost. In cost accounting, we study
about variable costs, fixed costs, semi-fixed costs, overheads and capital
cost.
|
|
Purpose
|
Purpose of the financial statement is to show
correct financial position of the organization.
|
To calculate cost of each unit of product on the
basis of which we can take accurate decisions.
|
|
Recording
|
Estimation in recording of financial transactions
is not used. It is based on actual transactions only.
|
In cost accounting, we book actual transactions
and compare it with the estimation. Hence costing is based on the estimation
of cost as well as on the recording of actual transactions.
|
|
Controlling
|
Correctness of transaction is important without
taking care of cost control.
|
Cost accounting done with the purpose of control
over cost with the help of costing tools like standard costing and budgetary
control.
|
|
Period
|
Period of reporting of financial accounting is at
the end of financial year.
|
Reporting under cost accounting is done as per the
requirement of management or as-and-when-required basis.
|
|
Reporting
|
In financial accounting, costs are recorded
broadly.
|
In cost accounting, minute reporting of cost is
done per-unit wise.
|
|
Fixation of Selling Price
|
Fixation of selling price is not an objective of
financial accounting.
|
Cost accounting provides sufficient information,
which is helpful in determining selling price.
|
|
Relative Efficiency
|
Relative efficiency of workers, plant, and
machinery cannot be determined under it.
|
Valuable information about efficiency is provided
by cost accountant.
|
|
Valuation of Inventory
|
Valuation basis is ‘cost or market price whichever
is less’
|
Cost accounting always considers the cost price of
inventories.
|
|
Process
|
Journal entries, ledger accounts, trial balance,
and financial statements
|
Cost of sale of product(s), addition of margin and
determination of selling price of the product.
|
Comparison
between cost accounting & Management accounting
Management
accounting collects data from cost accounting and financial accounting.
Thereafter, it analyzes and interprets the data to prepare reports and provide
necessary information to the management.
On
the other hand, cost books are prepared in cost accounting system from data as
received from financial accounting at the end of each accounting period.
The
difference between management and cost accounting are as follows:
|
S.No.
|
Cost Accounting
|
Management Accounting
|
|
1
|
The main objective of cost accounting is to assist
the management in cost control and decision-making.
|
The primary objective of management accounting is
to provide necessary information to the management in the process of its
planning, controlling, and performance evaluation, and decision-making.
|
|
2
|
Cost accounting system uses quantitative cost data
that can be measured in monitory terms.
|
Management accounting uses both quantitative and
qualitative data. It also uses those data that cannot be measured in terms of
money.
|
|
3
|
Determination of cost and cost control are the
primary roles of cost accounting.
|
Efficient and effective performance of a concern
is the primary role of management accounting.
|
|
4
|
Success of cost accounting does not depend upon
management accounting system.
|
Success of management accounting depends on sound
financial accounting system and cost accounting systems of a concern.
|
|
5
|
Cost-related data as obtained from financial
accounting is the base of cost accounting.
|
Management accounting is based on the data as
received from financial accounting and cost accounting.
|
|
6
|
Provides future cost-related decisions based on
the historical cost information.
|
Provides historical and predictive information for
future decision-making.
|
|
7
|
Cost accounting reports are useful to the
management as well as the shareholders and creditors of a concern.
|
Management accounting prepares reports exclusively
meant for the management.
|
|
8
|
Only cost accounting principles are used in it.
|
Principals of cost accounting and financial
accounting are used in management accounting.
|
|
9
|
Statutory audit of cost accounting reports are
necessary in some cases, especially big business houses.
|
No statutory requirement of audit for reports.
|
|
10
|
Cost accounting is restricted to cost-related
data.
|
Management accounting uses financial accounting
data as well as cost accounting data.
|
Comparison
between Financial accounting & Management accounting.
‘Accounting’
is a process of systematically identifying, recording, classifying, reporting,
analyzing and interpreting the results thereof to the users of the financial
statement. The two major branches of Accounting are Financial Accounting and Management Accounting. The
former, is an accounting system which gives true and a fair view of the
financial position of the company to various parties. The latter, is an
accounting system which provides both the quantitative and qualitative
information to the managers. Here we are going to discuss about the differences
between Financial Accounting and Management Accounting.
|
BASIS FOR
COMPARISON
|
FINANCIAL
ACCOUNTING
|
MANAGEMENT
ACCOUNTING
|
|
Meaning
|
Financial Accounting is an accounting system that
focuses on the preparation of financial statement of an organization to
provide the financial information to the interested parties.
|
The accounting system which provides relevant
information to the managers to make policies, plans and strategies for
running the business effectively is known as Management Accounting.
|
|
Is is compulsory?
|
Yes
|
No
|
|
Objective
|
To provide financial information to outsiders.
|
To assist the management in planning and decision
making process by providing detailed information on various matters.
|
|
Format
|
Specified
|
Not specified
|
|
Time Frame
|
Financial Statements are prepared at the end of the
accounting period which is usually one year.
|
The reports are prepared as per the need and
requirements of the organization.
|
|
User
|
Internal and external parties
|
Only internal management.
|
|
Reports
|
Summarized Reports about the financial position of
the organization
|
Complete and Detailed reports regarding various
information.
|
Role of a cost
accountant in an organisation
A
cost accountant in a manufacturing organisation plays several
important roles
I.
He establishes a cost accounting department in his concern.
II.
He ascertains the requirement of cost information which
may be useful to organizational managers at different levels of the
hierarchy.
III.
He develops a manual, which specifies the functions to be
performed by the cost accounting department. The manual also contains the
format of various forms which would be utilised by the concern for
procuring and providing information to the concerned officers. It also
specifies the frequency at which the cost information would be supplied to a concerned
executive.
Usually,
the functions performed by a cost accounting department includes -cost
ascertainment, cost comparison, cost reduction, cost control and cost
reporting.
a. Cost
ascertainment, requires the classification of costs into direct and
indirect. Further it requires classification of indirect costs (known as
overheads) into three classesviz., factory overheads; administration
overheads and selling and distribution overheads. Cost accountant suggests the
basis which may be used by his subordinates for carrying out the necessary
classifications as suggested above.
b. Cost
comparison is the task carried out by cost accountant for
controlling the cost of the products manufactured by the concern. Cost
accountant of the concern establishes standards for all the elements of cost
and thus a standard cost of the finished product. The standard cost so
determined may be compared with the actual cost to determine the variances.
Cost accountant ascertains the reasons for the occurrence of these variances
for taking suitable action.
c. Cost
analysis may also be made by cost Accountant for taking decisions
like make or buy and for reviewing the current performance.
d. Cost
accountant also plays a key role in the preparation of cost reports.
These reports help the executives of a business concern in reviewing
their own performance and in identifying the weak areas, where enough control
measures may be taken in future.
In
brief, one may say that there is hardly any activity in a
manufacturing organisation with which a cost accountant is not
directly associated in some form or the other.
Elements
of cost
The following chart shows the various elements of
cost and how they are classified.
The
elements that constitute the cost of manufacture are known as the elements of
cost. Such element of cost is divided into three categories. In a manufacturing
concern, raw materials are converted into a finished product with the help of
labour and other service units. They are Material, Labour and Expenses.
Again,
these elements of cost are divided into two categories such as Direct
Material and Indirect Material, Direct
Labour and Indirect Labour, Direct Expenses and
Indirect Expenses. All direct material, direct labour and direct expenses are
added to get prime cost. Likewise all indirect material, indirect labour and
indirect expenses are added to get overhead.
Again, overhead
is divided into four categories. They are factory
overhead, administration overhead, selling overhead and distribution overhead.
1. Direct
Material: It refers to material out of which a product is to be
produced or manufactured. The cost of direct material is varying according to
the level of output. For example: Milk is the direct material of butter.
2. Indirect
Material: It refers to material required to produce a product but not
directly and does not form a part of a finished product. For example: Nails are
used in furniture. The cost of indirect material is not varying in direct
proportion of product.
3. Direct
Labour: It refers to the amount paid to the workers who are directly
engaged in the production of goods. It varies directly with the output.
4. Indirect
Labour: It refers to the amount paid to the workers who are indirectly
engaged in the production of goods. It does not vary directly with the output.
5. Direct
Expenses: It refers to the expenses that are specifically incurred by
the company to produce a product. A product cannot be produced without
incurring such expenses. It varies directly with the level of output.
6. Indirect
Expenses: It refers to the expenses that are incurred by the
organization to produce a product. But, these expenses cannot be easily found
out accurately. For example: Power used for production.
7. Overhead:
It is the combination of all indirect materials, indirect labor and indirect
expenses.
8. Factory
Overhead: It is otherwise called Production Overhead or Works Overhead.
It refers to the expenses that are incurred in the production place or within
factory premises. For example: Indirect material, rent, rates and taxes of
factory, canteen expenses etc.
9. Administration
Overhead: It is otherwise called Office Overhead. It refers to the
expenses that are incurred in connection with the general administration of the
company. For example: Salary of administrative staff, postage, telegram and
telephone, stationery etc.
10. Selling
Overhead: It refers to all expenses incurred in connection with sales.
For example: Salary of sales department staff, travelers’ commission,
advertisement etc.
11. Distribution
Overhead: It refers to all expenses incurred in connection with the
delivery or distribution of goods
and services from the producer to the consumer.
For example: Delivery van expenses. Loading and unloading, customs duty, salary
of deliverymen etc.
Cost Sheet
Cost
sheet is a statement, which shows various components of total cost of a
product. It classifies and analyses the components of cost of a product.
Previous periods data is given in the cost sheet for comparative study. It is a
statement which shows per unit cost in addition to Total Cost. Selling price is
ascertained with the help of cost sheet. The details of total cost presented in
the form of a statement is termed as Cost sheet. Cost sheet is prepared on the
basis of : 1. Historical Cost 2. Estimated Cost
Historical Cost
Historical Cost sheet is prepared on the basis
of actual cost incurred. A statement of cost prepared after incurring the
actual cost is called Historical Cost Sheet.
Estimated Cost
Estimated
cost sheet is prepared on the basis of estimated cost. The statement prepared
before the commencement of production is called estimated cost sheet. Such cost
sheet is useful in quoting the tender price of a job or a contract.
Importance of Cost Sheet
The
importance of cost sheet is as follows:
·
Cost
ascertainment: The main objective of the cost sheet is
to ascertain the cost of a product. Cost sheet helps in ascertainment of cost
for the purpose of determining cost after they are incurred. It also helps to
ascertain the actual cost or estimated cost of a Job.
·
Fixation
of selling price: To fix the selling price of a product
or service, it is essential to prepare the cost sheet. It helps in fixing
selling price of a product or service by providing detailed information of the
cost.
·
Help
in cost control: For controlling the cost of a product
it is necessary for every manufacturing unit to prepare a cost sheet. Estimated
cost sheet helps in the control of material cost, labour cost and overheads
cost at every point of production.
·
Facilitates
managerial decisions: It helps in taking important decisions
by the management such as: whether to produce or buy a component, what prices
of goods are to be quoted in the tender, whether to retain or replace an
existing machine etc.
Advantages of Cost Sheet:
The main advantages of a cost
sheet are:
(i) It indicates the break-up of
the total cost by elements, i.e. material, labour, overheads, etc.
(ii) It discloses the total cost
and cost per unit of the units produced.
(iii) It facilitates comparison.
(iv) It helps the
management in fixing selling prices.
(v) It acts as a guide
to the management and helps in formulating production policy.
(vi) It enables to
keep control over cost of production.
(vii) It helps the
management in submitting quotations or preparing estimates for tenders.
(viii) It is a simple
and useful medium of communication of costs to various levels of management.
Unit
II
Materials Management: Objectives, Scope
and Functions
Materials
management is concerned with management functions supporting the complete cycle
of material flow, from the purchase and internal control of production
materials to planning and control of work in process, to warehousing, shipping
and distribution of the finished product. An effective materials management
process ensures that the right kinds of materials are at the right place
whenever needed.
Materials
management is concerned with planning, directing and controlling the kind,
amount, location, movement and timing of various flows of materials used in and
produced by the process.
Objectives of Materials Management:
Materials
management objectives are categorized into:
1.
Primary objective
2.
Secondary objectives
1.
Primary Objectives:
“Making
available (supply) of materials in specified quantity and quality at economic
cost and maintaining the continuity of supply. Minimization of investments in
materials and inventory costs, and assuring high inventory turnover.”
2.
Secondary Objectives:
Secondary
objectives help to achieve the primary objectives.
The
secondary objectives can be stated as:
1.
Purchasing the items from a reliable source at economic price.
2.
Reduction of costs by using various cost reduction techniques such as variety
reduction, standardization and simplification, value analysis, inventory
control, purchase research etc.
3.
Co-ordination of the functions such as planning, scheduling, storage and
maintenance of materials.
Scope
of Materials Management:
Materials
management encompasses all the aspects of the materials i.e. material costs,
material supply and material utilization. Materials management is concerned
with material planning and materials control activities.
Integrated
Materials Management:
Materials
required for production purpose are normally procured and stored in the plant
and issued to manufacturing when there is a requisition. Materials are to be
purchased in advance and stored to ensure uninterrupted supply.
There
should be a proper co-ordination and co-operation among different functional
heads of materials department to optimise the operations of materials
management. The materials function to be effective, the objective must be to
maximise materials productivity. An integrated approach to materials management
i.e. materials planning and control must look in to the problem areas in a co-
coordinated manner in order to maximise the effectiveness of materials
management.
An
integrated materials management will result in the following advantages:
a.
Better accountability for materials and material concerned costs.
b.
Better co-ordination within the materials functions and also other functional
areas of business.
c.
Better performance and effectiveness.
d.
Adaptability to automated and computerised systems.
The
important areas to improve materials planning and control are:
1.
Value analysis and purchase price analysis.
2.
Materials planning and control (Inventory Control).
3.
Stores control.
4.
Waste management.
5.
Materials handling.
Irrespective
of the type of the organisation, the basic material related functions performed
at the organisation are:
1.
Purchasing
2.
Inbound traffic from suppliers to company
3.
Receiving
4.
Inventory Control
5.
Production control
6.
In plant storage
7.
Material handling
8.
Packaging and shipping
9.
Outbound traffic
10.
Warehousing and distribution.
Purchasing:
Purchasing
plays a crucial role in the materials management because it is concerned from
input stage up to the consumption in manufacturing. Purchasing functions as a
monitor, clearing house and a pipeline to supply materials needed for
production.
Dr.
Walters defines scientific purchasing as:
“Procurement
by purchase of the proper materials, machinery and equipment and supplies of
stores used in manufacturing of the product, adopted to marketing in the proper
quantity and quality at the proper time and at the lowest price consistent with
quality desired.”
The
basic elements in purchasing are:
1.
The origin of demand for materials and components based upon the requisitions
made to purchase department by user departments with all the details like
descriptions, quantity and quality specifications.
2.
Specifications are checked and verified and purchase plan is made for items
demanded
3.
Selection of source of supply.
4.
Preparation of purchase order by supplier (order acceptance) and acceptance of
terms and conditions.
5.
Follow up to ensure prompt delivery of right quality and quantity of materials.
6.
Incoming inspection of materials (both to check quality and quantity) to ensure
correct material as per specification.
7.
Checking supply invoice against purchase order and goods received and payments
are made.
Methods
of Buying:
Methods
of purchasing will vary according to the nature of demand and the market
conditions.
The
principle methods of buying are:
1.
Purchasing by requirement (Hand to mouth buying).
2.
Purchasing for a specified future period.
3.
Market purchasing.
4.
Speculative buying.
5.
Contract buying.
6.
Group purchasing of small items.
7.
Forward buying.
8.
Hedging.
Source
Selection (Vendor Selection):
The
selection of right source of supply is an important aspect in materials
management. The vendor is to be examined with respect to his capability and
competency to supply right quality of material at right time and at a
competitive price.
The
buyer looks for the following details before a decision regarding vendor
selection is made:
1.
Production Capabilities:
(a)
Capacity to manufacture the products as per the specifications and required
quantities.
(b)
Availability of spare capacity.
(c)
Capability to understand the needs of Buyer Company both technical and
commercial.
2.
Financial Position of the Vendor:
(d)
The type of the company – Private limited, Partnership or Sole proprietorship.
(e)
Company’s capital structure.
(f)
Financial position and profitability of the company since last 3-4 years.
3.
Technical Capabilities:
(g)
Whether the available plant and equipment’s ere in a position to meet the
quality and quantity specifications of the customer.
(h)
Whether there are enough technically skilled and trained people.
(i)
Whether R&D facilities are available.
(j)
What is the market standing of the vendor with respect to quality and delivery
commitments (Reliability of supply).
(k)
Whether he has enough storing and warehousing facilities.
(l)
Quality control procedures – whether an ISO-9000 certified supplier.
4.
Other Conditions:
(m)
Working conditions in the vendor company.
(n)
Industrial relations and bargaining power of unions.
(o)
Possible reasons for interruptions in supply.
Vendor
Relations:
Purchase
department should establish a sound relationship with vendors based on mutual
trust and benefit to ensure smooth supply of materials/parts as per the quality
and quantity required. So, apart from a formal commercial relationship as a
customer, a long lasting and mutually rewarding relationship is to be
established.
A
strategic partnership between the buyer and supplier is defined as a continuing
relationship involving a commitment over an extended time period, an exchange
of information and acknowledgment of risks and rewards of the partnership. A
sound relationship emerges from the proper help and co-ordination on the part
of both buyer and supplier.
The
expectations from buyers include:
a.
Promptness in delivery.
b.
Meets the quality and quantity requirements.
c.
Entertains occasional rush orders.
d.
Flexibility in quantity to be supplied.
e.
Can wait for the bills.
f.
Competitive pricing.
The
expectations from the vendors:
a.
Consistent orders
b.
Prompt payment of the bills.
c.
Extend help during difficulty both financial and technical.
d.
Continuity of orders.
Vendor
Rating (Evaluation of Suppliers):
The
appraisal of the vendor performance is a continues process.
The
vendor can be rated on various characteristics such as:
1.
Delivery (To deliver as on time as per the order).
2.
Quality (To delivery as per specifications).
3.
Price.
4.
Other factors such as capability to meet urgent/rush orders readiness to try
out new designs or new methods etc.
In
vendor rating, one usually gives weightage to these various characteristics and
measures the performance of the vendors periodically on the basis of certain
norms and procedures. Every company should have a formal vendor rating system.
It is not only beneficial to the buyer company but also for the supplier
company. Vendors will get the feed-back based on objective evaluation and can
compare its own performance with that of competitors. It is a fair evaluation since
the rating is based on facts and not on opinions or prejudices. Vendor
Company’s can know their shortcomings and improve upon them.
Generally,
there are three methods of vendor rating:
1.
Categorical plan
2
Weighted point method
3.
Cost ratio method.
Just
In Time (JIT) Purchasing:
Just
in time purchasing is a major component of JIT manufacturing system. The basic
concept of JIT purchasing is to establish agreement with vendors to deliver
small quantities of materials/parts just in time for production. This approach
is quite contrast to traditional approach of bulk buying.
The
features of JIT purchasing are:
a.
Reduced lot sizes
b.
Frequent and. reliable delivery schedules.
c.
Reduced and highly reliable lead times.
d.
High quality level of purchased parts.
The
JIT purchasing aims at a single reliable source for each item and consolidation
of several items from each supplier.
The
reduction of number of suppliers in JIT purchasing has the following
advantages:
1.
Consistent quality
2.
Minimum investment and resources such as buyer’s time, travel and engineering
3.
Focused attention on vendors
4.
Savings on tooling
5.
Establishment of long-term relationship.
For
making JIT work, the following conditions are put on purchasing department:
1.
Reduction in number of suppliers.
2.
Locating the suppliers who are nearby.
The
success of JIT purchasing depends on how well the firm establishes the strategy
of single sourcing. The suppliers should be seen as “Outside” partners who can
contribute to the long run well fare buying firm.
Pricing
of Issues of Materials
1.
First in First out (Commonly Called FIFO):
Under
this method material is first issued from the earliest consignment on hand and
priced at the cost at which that consignment was placed in the stores. In other
words, materials received first are issued first.
The
units in the open ling stock of materials are treated as if they are issued
first, the units from the first purchase issued next, and so on until the units
left in the closing stock of materials are valued at the latest cost of
purchases. It follows that unit costs are apportioned to cost of production
according to their chronological order of receipts in the store.
This
method is most suitable in times of falling prices because the issue price of
materials to jobs or works orders will be high (materials issued from the
earliest consignments which were purchased at a higher rate) while the cost of
replacement of materials will be low.
But
in case of rising prices this method is not suitable because the issue price of
materials to production will be low while the cost of replacement of materials
will be high.
Advantages
of FIFO Method:
1.
The main advantage of FIFO method is that it is simple to understand and easy
to operate.
2.
It is a logical method because it takes into consideration the normal procedure
of utilising first those materials which are received first. Materials are
issued in order of purchases, so materials received first are utilised first.
3.
Under this method, materials are issued at the purchase price; so the cost of
jobs or work orders is correctly ascertained so far as cost of materials is
concerned. Thus, the method recovers the cost price of the materials.
4.
This method is useful when prices are falling.
5.
Closing stock of materials will be valued at the market price as the closing
stock under this method would consist of recent purchase of materials.
6.
This method is also useful when transactions are not too many and prices of
materials are fairly steady.
Disadvantages
of FIFO Method:
1.
This method increases the possibility of clerical errors, if consignments are
received frequently at fluctuating prices as every time an issue of materials
is made, the store ledger clerk will have to go through his record to ascertain
the price to be charged.
2.
In case of fluctuations in prices of materials, comparison between one job and
the other job becomes difficult because one job started a few minutes later
than another of the same nature may be issued materials at different prices,
merely because the earlier job exhausted the supply of the lower priced
materials in stock.
3.
For pricing one requisition more than one price has often to be taken.
4.
When prices rise, the issue price does not reflect the market price as
materials are issued from the earliest consignments. Therefore, the charge to
production is low because the cost of replacing the material consumed will be
higher than the price of issue.
2.
Last In First Out (Commonly Called LIFO) Method:
As
against the First in First Out method the issues under this method are priced
in the reverse order of purchase i.e., the price of the latest available
consignment is taken. This method is sometimes known as the replacement cost
method because materials are issued at the current cost to jobs or work orders
except when purchases were made long ago.
This
method is suitable in times of rising prices because material will be issued
from the latest consignment at a price which is closely related to the current
price levels. Valuing material issues at the price of the latest available
consignment will help the management in fixing the competitive selling prices
of the products. This method was first introduced in the U.S.A. during the
Second World War to get the advantages of rising prices.
Advantages
of LIFO Method:
1.
Like FIFO method, this is simple to operate and is useful when transactions are
not too many and the prices are fairly steady.
2.
Like FIFO, this method recovers cost from production because actual cost of material
is charged to production.
3.
Production is charged at the recent prices because materials are issued from
the latest consignment. Thus, effect of current market prices of materials is
reflected in the cost of sales provided the materials are recently purchased.
4.
In times of rising prices, LIFO method of pricing issues is suitable because
materials are issued at the current market prices which are high. This method
thus helps in showing a lower profit because of increased charge to production
during periods of rising prices and lower profit reduces burden of income-tax.
Disadvantages
of LIFO Method:
1.
Like FIFO, this method may lead to clerical errors as every time an issue is
made, the store ledger clerk will have to go through the record to ascertain
the price to be charged.
2.
Like FIFO, comparison between one job and the other job will become difficult
because one job started a few minutes after another of the same type many bear
a different charge for materials consumed, merely because the earlier job
exhausted the supply of the lower priced or higher priced materials in stock.
3.
For pricing a single requisition, more than one price has often to be adopted.
4.
The stock in hand is valued at price which does not reflect current market
price. Consequently, closing stock will be understated or overstated in the
Balance Sheet.
3.
Average Cost Method:
The
principle on which the average cost method is based is that all of the
materials in store are so mixed up that an issue cannot be made from any particular
lot of purchases and, therefore, it is roper if the materials are issued at the
average cost of materials in store.
Average
may be of two types:
(i)
Simple Arithmetic Average and
(ii)
Weighted Arithmetic Average.
(i)
Simple Average Price:
“A
price which is calculated by dividing the total of the prices of the materials
in the stock from which the material to be priced could be drawn by the number
of the prices used in that total”. (C.I.M.A.)
Simple
average price is calculated by dividing the total of unit purchase prices of
different lots in stock on the date of issue by the number of prices used in
the calculation and quantity of different lots is ignored.
This
method may lead to over-recovery or under-recovery of cost of materials from
production because quantity purchased in each lot is ignored.
(ii)
Weighted Average Price:
“A
price which is calculated by dividing the total cost of materials in the stock
from which the materials to be priced could be drawn by the total quantity of
materials in that stock.” (C.I.M.A.)
The
weighted average price takes into account the price and quantity of the
materials in store.
Advantages
of Average Cost Method:
1.
This method is rational, systematic and not subject to manipulation. It is
representative of the prices that prevailed during the entire period rather
than of the price at the beginning, end, or at one point of issue during the
period because it is based on the average of the material costs of the various
lots available in the store.
2.
Average price method is considered to be the best method when prices fluctuate
considerably because this method tends to smooth out fluctuations in prices.
3.
Issue prices are not to be calculated each time issues are made. Issue prices
are changed only when new lot of materials is received.
4.
This method recovers the cost of materials from production.
5.
This method maintains the issue prices as near to the market prices as
possible.
6.
This method eliminates the necessity for adjustments in stock valuation.
Disadvantages
of Average Cost Method:
1.
The greatest disadvantage of this method is that a fresh rate calculation will
have to be made as soon as a new lot of materials are purchased which may
involve tedious calculations. Thus, there are chances of clerical errors.
2.
Issue price of materials does not represent actual cost price of materials
issued but it represents average cost of materials in stores.
3.
At the time of rising prices, it over-states profit but not as much as FIFO
because average price is lower than the most recent price.
(4)
Closing stock is not valued at current cost.
It
is the average cost method which is mostly used by different organisations
because it satisfies most of the conditions of a good method of valuing
material issues.
4.
Highest In First Out (HIFO) Method:
This
method is based on the assumption that the closing stock of materials should
always remain at the minimum value; so the issues are priced at the highest
value of the available consignments in the store. The method is not popular as
it always undervalues the stock which amounts to creating a secret reserve. The
method is mainly used in case of cost plus contracts or monopoly products as it
is helpful in increasing the price of the contract or products.
Material
Losses in Cost Accounting
Losses
of material during handling, storage or manufacturing are called as material
losses in cost accounting. We could classified material losses
into two parts i.e. normal losses and abnormal losses.
Normal
Losses: Losses which are unavoidable are called Normal
losses. Normal losses of material can not be completely avoided but may be
controlled to a limited extent .These losses are transferred to factory
overheads .Examples of material losses are as follows:
- Losses by
evaporation
- Loss due to
loading and unloading
- Losses due to
breaking the bulk etc.
Abnormal
Losses: Losses that arises due to inefficiency in
operations, carelessness etc. is called as abnormal losses. These losses are
charged to coasting profit and loss account. Examples of
abnormal losses are as follows:
- Breakage
- Fire, accident,
flood etc.
- Improper storage
- Theft
Forms
of Material Losses:
Material
losses could arise in the form of waste, scrape, spoilage and defectives.
Waste:
It comprise of all visible, invisible losses that can not be collected and also
unsalable portion of the collected loss. Examples of waste are dust, smoke,
gases etc.
Scrap: It
represents the unusable loss which can be sold. It is measurable and has a
minor value .Scrap may arise in the form of turning’s, filing etc. from metal;
off-cuts and cut pieces in leather & cloth industry .
Spoilage: Spoilage
is those materials or components which are so damaged in the manufacturing and
operation process that they can not be repaired or reconditioned. Spoiled units
do not attain the quality required and it is not economic to correct them.
Defectives: A
good in which there is a manufacturing fault or defect is called Defective
goods, this fault could be removed by applying additional cost called
rectification cost.
Material
Losses:
Material
losses may take the form of waste, scrap, defectives and spoilage. Problems of
spoilage, waste, defective units and scrap are bound to arise in almost all
manufacturing concerns, so there is usually a difference between the quantity
of the output and the input.
Usually
the quantity of the output is less than that of the input because of waste,
scrap or spoilage. Efforts should be made to reduce the difference between the
quantities of the output and the input so that cost of production may be
reduced.
Methods
of treatment of spoilage, waste etc. and the interpretations given to these
terms vary considerably from one industrial concern to another because of
different situations arising in different concerns. The terms are also loosely
used; for example, waste and scrap may be taken to have the same meaning.
1.
Waste:
Waste
is defined as discarded substances having no values. In many industries, some
waste is inevitable. Such waste may arise due to the inherent nature of
materials, chemical reaction, evaporation, drying, sublimation of goods etc.
Waste can also be in the form of smoke, gas, slag or dust which arises in the
course of a manufacturing process.
Waste
may be invisible or visible. The former type of waste (i.e., waste due to
drying, evaporation etc.) is invisible whereas the latter type of waste (i.e.,
gas, smoke, slag etc.) is visible. Waste has practically no measureable value.
Rather in some industries, the waste instead of realising any value creates a
problem for its disposal incurring further costs. The waste may be normal and
abnormal from the point of view of treatment in costing.
Normal
Waste:
It
is the loss which is unavoidable on account of inherent nature of material.
Some materials such as liquid materials lose their weight due to evaporation.
Similarly, there are some materials (i.e. coal) which are wasted due to loading
and unloading. Materials may be wasted due to breaking the bulk into smaller
parts.
Normal
waste is unavoidable and as such may be reduced to some extent if there is
strict control but cannot be totally eliminated. Such loss can be estimated in
advance on the basis of past experience or chemical data. As waste has
practically no value, its treatment in costing is relatively simple. The normal
process loss is recorded only in terms of quantity.
Abnormal
Waste:
Any
loss caused by unexpected or abnormal conditions such as sub-standard
materials, carelessness, accident etc. or loss in excess of the margin
anticipated for normal process loss should be regarded as abnormal waste.
All
cases of abnormal waste should be thoroughly investigated and steps taken to
prevent their recurrence in future. Responsibility for abnormal wastage should
be fixed on purchasing, storage, production and inspection staff to maintain
standards. Abnormal waste should not be allowed to affect the cost of
production as it is caused by abnormal or unexpected conditions.
Such
loss representing the cost of materials, labour and overhead incurred on the
wastage should he transferred to Profit and Loss Account (Costing Profit and
Loss Account where no integral system of accounting is maintained) and not
added to the cost of production so as to make meaningful comparison of costs of
production of different periods.
2.
Scrap:
Scrap
is discarded material having some values. It represents fragments or remnants
of material that are left from certain type of manufacture. It is a material
loss but has small value without further processing. Examples of scrap are
available in operations like turning, boring, punching, sawing, shavings,
moulding, etc. from metals on which machine operations are carried out; saw
dust and trimmings in the timber industry; dead heads and bottom ends in foundries;
and cuttings, pieces and splits in leather industry.
Such
scrap can be solid because it can be used by other industries by melting in
furnaces. Scrap is always physically available unlike waste which may or may
not be physically present in the form of a residue. Thus scrap is always
visible whereas waste may or may not be visible. Further, waste may not have
any value whereas scrap must necessarily have a value.
There
are three types of scrap, namely:
(a)
Legitimate scrap,
(b)
Administrative scrap,
(c)
Defective scrap.
Legitimate
scrap arises due to the nature of operation like turning, boring, punching etc.
as discussed above. This type of scrap can be pre-determined and efforts should
be made that it should not be more than the pre-determined quantity.
Administrative scrap arises due to administrative action, such as, a change in
the method of production.
Defective
scrap arises because of use of inferior quality of material or bad workmanship
or defective machines. Such type of scrap is abnormal because it arises due to
abnormal reasons.
Treatment
of Scrap:
The
useful methods for the treatment of scrap are as follows:
1.
If realisable value of normal scrap is insignificant (i.e., legitimate scrap
and administrative scrap) it may be credited to Profit and Loss Account like
other income. This method of treatment of scrap is suitable when the scrap is
of very little value and when the market for it is uncertain. This method is
known as treatment by neglect.
This
method is not suitable for effective control over scrap because detailed
records of scrap are not kept and scrap cost is not shown as an element of cost
in the cost sheet. Scrap which is not sold and is in stock is valued at nil for
balance sheet purposes and thus vitiates the valuation of closing stock.
Accounting
of scrap by this method is also inaccurate as there is a time lag between the
sales and the production. There is also a possibility that scrap may arise in
one period but may be accounted (i.e., sold) in another period and thus
distorts the profits of two periods.
2.
The sale value of scrap may be deducted from the cost of materials consumed or
factory overhead. This method is suitable when several production orders are
commenced at a time and it is not possible to find scrap for each other. This
method is, however, not effective in controlling scrap arising in different
processes, jobs or orders.
When
overheads are absorbed on the basis of pre-determined rates, it is more
appropriate to credit an estimated allowance for the scrap instead of the
amount of actual scrap.
The
journal entries for recording the scrap are:
(i)
Dr. Scrap Account (with an estimated allowance) Cr. Factory Overhead Control
Account
(ii)
Dr. Cash/Debtors (Amount realised on sale) Cr. Scrap Account.
Profit
or loss on sale of scrap may be transferred to the Profit and Loss Account at
the end of the year. When scrap is sold on a day-to-day basis and no stock is
maintained, the journal entry is: Dr. Cash/Debtors Account (with realisable
value) Cr. Factory Overhead Control Account
3.
The scrap may be assigned a cost if it can be related to the job which yielded
the scrap. It will help in giving reasonable credit to the jobs which yielded
scraps. This method of treatment is suitable when scraps from the various jobs
widely differ in nature.
4.
It is possible that scrap arising in one job may be used in another job. In
such a case material transfer note for transfer of scrap from one job to
another job should be prepared and credit should be given to the job where
scrap arises and debit should be given to the job for the amount of scrap
transferred to it.
Sometimes,
scrap may be returned to stores when some further processing has to be done
before that can be utilised for other jobs. Job returning the scrap is credited
with the value of the scrap returned to stores.
5.
When the actual scrap is in excess of the pre-determined quantity (i.e., normal
quantity), the cost of the excess scrap is transferred to Costing Profit and
Loss Account after deducting there-from the sale proceeds of such excess scrap.
The valuation of excess scrap is done in the same way as the valuation of
abnormal waste is done.
6.
The cost of defective scraps after deduction there-from the sale a proceeds of
such scrap is transferred to Costing Profit and Loss Account because it is an
abnormal loss.
3.
Defectives:
Defective
products or units are those which do not meet with dimensional or quality
standards and are reworked for rectification of defects by application of
material, labour and/or processing and salvaged to the point of either standard
product or substandard product to be sold as seconds. Therefore, defectives
are that portion which can be rectified at some extra cost of re-operation.
Defectives
may arise due to the following reasons:
1.
Sub-standard materials.
2.
Poor workmanship.
3.
Poor maintenance of machines.
4.
Wrong tool setting.
5.
Faulty design of products.
6.
Bad supervision.
7.
Careless inspection.
8.
Poor working conditions.
9.
Lack of control, such as humidity, furnace temperature etc.
10.
Excessive short runs.
Defectives
are bad products which are not totally spoiled and can be rectified or restored
to original or near-original condition at some extra cost of re-operation. The
additional cost of rectifying the defectives is added to the total cost and the
quantity of defectives rectified is added to the quantity of good output
because defective units rectified can be sold as “seconds”. Rectification of
defective units is advisable only when the cost of rectification is low and
more profitable than to sell as spoil 3d units.
Treatment
of Cost of Rectification of Defectives:
Following
methods may be adopted for the treatment of this cost:
1.
If the defective production is identified with a specific job or department,
the cost of rectification is charged to that specific job or department.
2.
If the defective production is not identified with a particular job or
department, the cost of rectification is added to general factory overhead.
3.
If the defective production is due to abnormal reasons, the rectification cost
is transferred to Costing Profit and Loss Account.
Every
possible effort should be made to reduce the number of defectives because they
increase the cost of production. Control of defectives is an operational
correction, so steps should be taken to eliminate the reasons responsible for
defectives. Right from the design stage to the output of the final product
stage, each one should be looked into carefully for avoiding defectives.
Standardisation
of products and operations, comparison of actual performance with standards
laid down in regard to defectives, feedback and reporting and incentive scheme
for minimising defectives will go a long way in reducing the quantity of
defectives.
4.
Spoilage:
Spoilage
refers to production that does not meet with dimensional or quality standards
in such a way that it cannot be rectified economically and is junked and sold
for a disposal value. So it occurs when goods are so damaged in course of
manufacturing process as to become not rectifiable with some additional cost.
Material
used in spoiled units can be used again as material by the same or another
process or product. Spoilage cost is the difference between the cost incurred
upto the point of rejection less salvage value or cost of material used.
Spoilage
arises due to sub-standard materials, poor workmanship, faulty tool setting,
poor maintenance of machines, bad supervision and careless inspection.
Spoilage
should not be confused with scrap. Scrap arises at the initial stages of
production operations whereas spoilage takes place more towards the finishing
production stages with larger loss of added value to the cost of material used.
Spoilage
can be of two types:
(1)
Normal spoilage and
(2)
Abnormal spoilage.
According
to Charles T. Horngren, “Normal spoilage is what arises under efficient
operating conditions; it is an inherent result of the particular process and is
thus uncontrollable in the short run.
Abnormal
spoilage is spoilage that is not expected to arise under efficient operating conditions;
it is not an inherent part of the selected production process”. Abnormal
spoilage can be controlled because it arises as a result of inefficient
operating conditions.
Normal
spoilage is planned spoilage that management is willing to accept and is
controllable by higher level of management which determines the nature of
products and processes. On the other hand, abnormal spoilage can be controlled
by first-line supervision which can exert influence over inefficiency.
Treatment
of Cost of Spoilage:
The
treatment of cost of spoilage depends upon the nature of spoilage. If the
spoilage is normal, the cost is borne by good units of output. In case of
abnormal spoilage, cost of spoilage is transferred to Costing Profit and Loss
Account. When, however, the normal spoiled units are used again as raw material
in the same manufacturing process, no separate treatment becomes necessary.
If
they are used for another process, job or order, a proper credit should be
given to the process job or order giving rise to the spoilage keeping in view
the utility value of the spoilage to the process, job or order for which the
same is used.
Control
of Wastage, Scrap, Defectives and Spoilage:
Every
effort should be made to reduce the cost of production by exercising control on
wastage, scrap, defectives and spoilage.
Following
steps may be taken in this direction:
1.
Reports relating to the wastage, scrap, defectives and spoilage should be
prepared in time to locate the reason responsible for the wastage etc. An
immediate corrective action should be taken on the basis of the reasons
responsible for the loss.
2.
Wastage, scrap, defectives and spoilage should be standardised by following
standard costing system. It should be seen that actual wastage, scrap, etc.
should be within normal limits allowed.
3.
Good quality of materials should be used. Better the quality of materials less
is the wastage, scrap and spoilage.
4.
Control of wastage, scrap, defectives and spoilage should start with the
designing of the products. The type of materials that will result in the
minimum wastage, scrap, defectives and spoilage are decided at the designing
stage. Better quality of equipment should be used to get better return, so type
and shape of equipments to be used for manufacturing process should be decided
at the designing stage.
5.
Properly trained personnel should be employed to reduce the quantum of wastage,
scrap, defectives and spoilage.
Unit III
Labor
cost
Labor
cost represents human contribution. Labor cost is sensitive in nature. The
reason is that the labor cost is fully based on the human behavior i.e. labor
behavior.
The control
of labor costs requires the control of the labor behavior. Therefore,
the management should study human behavior, performance of labor, time and
motion study, labor
turnover, labor approach in order to control the labor cost.
Labor
cannot be stored for future reference. It is very much similar to the
perishable nature of materials. Some materials may lose its quality and not
used for the purpose of production. Such materials will be waste one. Likewise,
once labor is lost, the same cannot be recovered and not effectively used in
the days to come.
If
labor is kept idle, the management should pay remuneration or wages for such
idle time. Hence, the management incurred two losses. They are loss of labor
working hours and monetary loss. Hence, the management is very keen in the
control of labor cost.
Classification
of Labor Cost
The
labor cost may be classified in the following ways.
1.
Direct Labor Cost
Direct
Labor cost is that portion of salary or wage, which can be identified
with and charged to a single unit cost of production.
Characteristics
of Direct Labor Cost:
The
direct labor cost has the following characteristics.
- It has direct
relationship with the product or process or cost unit.
- It can be measured
quantitatively.
- It is sufficiently
material in amount.
2.
Indirect Labor Cost
It
is not identifiable within the production of goods and services even though
directly incurred. These costs are incurred in the production place. Sometimes,
some cost
center may render service to the production departments or production
activities. Such cost centers purchase, engineering and time keeping.
3.
Controllable Labor Cost
A
labor cost can be controlled by the management during production period and
even during absence of production. A standard time and time rate may be fixed
and request the labor to complete the job or order within such time. If so, the
labor cost can be controlled to some extent.
4.
Non-Controllable Labor Cost
A
labor cost, which cannot be easily controlled by the management. A job or order
can be completed by a group of labors. The efficiency of such group of labors
differ in nature. A labor can use his/her efficiency in full as per the
prevailing environment in the product place. If so, the cost cannot be
controlled by the management.
Information
required for Labor cost control
The
following information is required for labor cost control effectively
1.
Cost of recruitment of labor.
2.
Training cost of workers.
3.
Labor Turnover.
4.
Idle Time.
5.
Over Time.
6.
Shift Work.
7.
Labor Efficiency.
8.
Number of workers.
9.
Wastage.
10.
Spoilage.
11.
Wages Paid.
Methods
or ways of Labor cost control
The
management to control the labor cost effectively may exercise the following
ways.
1.
Proper production planning.
2.
Fixing of standard time.
3.
Fixing of clear-cut wage structure.
4.
An agreement with workers.
5.
Preparation of labor budgets i.e. Labor Cost Budget and Labor Hours Budget.
6. Performance
reports of labor.
7.
Fixing of specific incentive payment.
Control
over Labor Costs
Labor
costs constitute a significant portion of the total cost of a product. Labor
cost may be excessive due to inefficiency of labor, high labor turnover, idle
time and unusual overtime work, inclusion of bogus workers in the wages sheet
and many other related factors.
Inefficiency
of labor is also a cause of excessive material and overhead costs. Therefore,
economic utilization of labor is a need of the present day industry to reduce
the cost of production of the products manufactured or services rendered.
Management
is interested in labor costs on account of the following:
1.
To use direct labor cost as a basis for increasing the efficiency of workers ;
2.
To identify direct labor cost with products, orders, jobs or processes for
ascertaining the cost of every product, order, job or process ;
3.
To use direct labor cost as a basis for absorption of overhead, if percentage
of direct labor cost to overhead is to be used as a method of absorption of
overhead ;
4.
To determine indirect labor cost to be treated as overhead; and
5.
To reduce the labor turnover.
Hence,
control of labor costs is an important objective of management and the
realisation of this objective depends upon the cooperation of every member of
the supervisory force from the top executive to the foreman.
From
functional point of view, control of labor costs is affected in a large
industrial concern by the co-ordinated efforts of the following six
departments:
1.
Personnel Department,
2.
Engineering Department,
3.
Rate or Time and Motion Study Department,
4.
Time-keeping Department,
5.
Pay-roll Department, and
6.
Cost Accounting Department.
Meaning
of systems of wages payment
The
success of a concern largely depends upon the efficiency of labor and the
efficiency of labor is considerably affected by the amount of wages paid to
them. Some personal are of the view that the profit of a concern can be
maximized only by reducing the wages rates payable to be workers. But this view
is not correct. It should be remembered that low-paid workers' are
usually inefficient that leads to wastage of materials, less economic use
of tools, frequency breakdown of machinery and loss of time as a result of
which the cost of production goes up, reasonable and fair wage rates allowed
ultimately lead to more economic use of machines, tools, materials and time.
Therefore, the importance of the method of wages of wages payment should never
be under-estimated.
Method
or system of wages payment must possess the following characteristics:
•
Should be simple to operate and easy to understand.
•
Should guarantee a minimum wage to every worker.
•
Should be acceptable to the employer and the employee.
•
Should be flexible enough so the changes may be made according to the
requirements.
•
Should ensure the establishment of industrial peace.
The
principle methods of wages payment are as follow:
1.
Time rate system
2.
Piece rate system
3.
Incentive wage system (payout plan)
- Piece rate system
In
this method, wages are paid to the employees after completion of work. Under
it, a worker is paid on the basis of output. Not the time by him to perform the
work. This is one of the simplest and most commonly used systems of wages
payment. In this system, the wage rate is expressed in terms of per unit of
output, per job or per work-order. This amount of wages payable to a workman
under this method is to be calculated as follows:
Total
wages = total output x wages rate per unit of output
=output
units x unit rate
=actual
yield x unit or piece rate
This
system is suitable in the following cases:
•
Where a work is of a repetitive natures.
•
Where the measurement of work is simple.
•
Where the quality and accuracy of output is not very important.
•
Where strict supervision is not possible.
Advantages
of piece rate system
The
main advantages of piece rate systems are as follows:
a.
Simplicity: just like time rate system, the
piece rate system is also simple to operate and easy to understand. It does not
involve tedious calculations.
b.
Incentive to workers: This system provides an increase
to the workers to work hard as the wages are paid on the basis of quantity of
output not on the basis of time. So efforts and rewards are correlated.
c.
Ascertainment of accurate labor cost: since the wages
are paid on the basis of output, the exact cost of labor per unit of output or
job can be considerable.
d.
No payment for idle time: under piece rate system, any
payment is made to the workers for the idle time as a result of which the cost
of supervision is not considerable.
e.
Proper care and use of machine and tools: the
workers rake proper care of their machine and tools since breakdown of machine
and tools means decrease in output resulting in less remuneration to them.
Disadvantages
of piece rate system
This
system has the following disadvantages:
a.
Less attention to quality: as the payment of wages
is made on the basis of output, the workers, in order to maximize their output,
work with sense of hurry, which may affect the quality of the output adversely.
b.
Inefficient use of machine and materials: since the
wages are paid on the basis of quantity of output, an excursive wastage of
materials and frequent breakdown of machinery may be caused by the workers due
to their efforts to obtain maximum output.
c.
No guarantee of minimum wages: since there is
direct relationship between quality of output and wages, the workers suffer if
they fail to work efficiently. There is no guarantee of minimum daily wages o
workers.
d.
Dissatisfaction among inefficient workers: the
inefficient workers, who work slowly, become dissatisfied by reason of lower
wages as compared to the wages paid to their efficient counterparts.
e.
Adverse effect on worker's health: the worker may try to
abnormally to earn more which has an adverse effect on their health and efficiency.
So, this method is not accepted by trade union.
Under
this system, the amount of remuneration or the total wages payable to the
workers depends on the time for which he is employed. This is simple and common
method of wages payment. In this method, the workman is paid an hourly, daily,
monthly or yearly rate rat of wages.
Thus
the worker is paid on the basis of time and not on his performance or unit of
output. The amount of wages payable to a workman under this method is to be
calculated as follows:
Total
wages = actual time take x time rate
Or,
total wages = total hours worked x wages rate per hour.
This
method is suitable to be applied in the following circumstances:
•
Where the quality of work is more important than production.
•
Where the volume of production is not within the control of labor.
•
Where it is difficult to fix the unit of output.
•
When it is volume of production is not within the control of labor.
•
The nature of work is such that there is no basis for incentive plan.
•
Where the amount of output cannot be accurately measured, counted and
standardized.
Advantages
of time rate system
This method is widely used even at the present time on account of the following advantages:
a. Simplicity: it is very easy to understand and simple to calculate the earnings of worker under this method.
b. Guarantee of minimum wages: it guarantees a minimum wages to the workers.
c. Quality production: since this amount of wages is not linked with the quantity of output, this method ensures production of better quality due to the careful attention of the workers.
d. Unity among workers: under this method, all workers falling under a particular category are paid at equal rate without any consideration of their quantity of output. It encourages a feeling of equality among workers on account of which this method is also favored by trade unions.
e. Economical: it involves less clerical work and detailed records are not necessary. Since the output is not the criteria for determination of wages, tool and materials are handled carefully. Wastage are also minimized.
This method is widely used even at the present time on account of the following advantages:
a. Simplicity: it is very easy to understand and simple to calculate the earnings of worker under this method.
b. Guarantee of minimum wages: it guarantees a minimum wages to the workers.
c. Quality production: since this amount of wages is not linked with the quantity of output, this method ensures production of better quality due to the careful attention of the workers.
d. Unity among workers: under this method, all workers falling under a particular category are paid at equal rate without any consideration of their quantity of output. It encourages a feeling of equality among workers on account of which this method is also favored by trade unions.
e. Economical: it involves less clerical work and detailed records are not necessary. Since the output is not the criteria for determination of wages, tool and materials are handled carefully. Wastage are also minimized.
Disadvantages
of time rate system
This method has the following disadvantages:
a. No incentive to the efficient workers: This system lacks incentive to efficient workers since all works are paid equally and no distinction is made between efficient and inefficient workers. So efforts and rewards are not correlated.
b. Go-slow policy: the workers, in order to earn higher wages for overtime work, may try to perform the worker slowly which leads to increase in labor cost per unit.
c. Dissatisfaction among the efficient workers: the efficient workers are paid wages at the rate equal to these payable ton inefficient workers, which creates dissatisfaction among the efficient workers.
d. Payment for idle time: under this method, idle time of the workers is also paid that increase the cost of production.
e. High cost of supervision: since there is no direct link between quantity of output and wages, wastage of time on the part of the workers is common, the avoidance of which requires considerable supervision leading to increase costs.
This method has the following disadvantages:
a. No incentive to the efficient workers: This system lacks incentive to efficient workers since all works are paid equally and no distinction is made between efficient and inefficient workers. So efforts and rewards are not correlated.
b. Go-slow policy: the workers, in order to earn higher wages for overtime work, may try to perform the worker slowly which leads to increase in labor cost per unit.
c. Dissatisfaction among the efficient workers: the efficient workers are paid wages at the rate equal to these payable ton inefficient workers, which creates dissatisfaction among the efficient workers.
d. Payment for idle time: under this method, idle time of the workers is also paid that increase the cost of production.
e. High cost of supervision: since there is no direct link between quantity of output and wages, wastage of time on the part of the workers is common, the avoidance of which requires considerable supervision leading to increase costs.
- Incentive wages payment plan
To
remove the defects of both time rate and piece rate systems of wages payment,
incentive plans have been developed. Under these plans, the advantages of time
and piece-wages system are combined, and incentives are provides to workers to
work hard. The characteristics of these plans are as follows:
i. Incentives by way of bonus and other are given to efficient works for time saved.
ii. A standard time is fixed and the worker is to perform the given work within the standard time. The standard time is set after making time studies for the performance of specific job.
The incentive is compromise between the two extremities, on the one, if the workers are paid according to time, hey a nothing if time is saved and on the other hand, if they are paid on the basis of piece rate, employers get nothing, if time is saved. Under incentive plans, the employer as well as the workers shares the benefit of time saved, and both labor and overtime costs are reduced.
The incentive plans should be selected according to the nature of work and other circumstances. It should be accepted by the management as well as labor otherwise it does not function successfully. The payment of wages may be made according to any of the following plans:
i. Incentives by way of bonus and other are given to efficient works for time saved.
ii. A standard time is fixed and the worker is to perform the given work within the standard time. The standard time is set after making time studies for the performance of specific job.
The incentive is compromise between the two extremities, on the one, if the workers are paid according to time, hey a nothing if time is saved and on the other hand, if they are paid on the basis of piece rate, employers get nothing, if time is saved. Under incentive plans, the employer as well as the workers shares the benefit of time saved, and both labor and overtime costs are reduced.
The incentive plans should be selected according to the nature of work and other circumstances. It should be accepted by the management as well as labor otherwise it does not function successfully. The payment of wages may be made according to any of the following plans:
Individual
bonus plan
According
to individual bonus plan, the bonus of each worker is calculated separately.
Some methods of calculating wages under individual bonus plan are discussed
below:
a.
Halsey premium plan
This
plan was originated by F.A. Haley. Under this scheme, an hourly rate is
guaranteed to all workers. A standard time is fixed unit, job or operation on
the basis of time and mention studies and the worker is paid the agreed hourly
rate of wages for the actual time taken plus a fixed percentages of bonus on
the time saved. The amount of bonus or premium payable to the workers in
one-half of the wages of the time saved.
Requirements
for calculating total wages or total earning of the worker under. Halsey
premium plan are:
ST
= standard time or normal time allowed
TT
= time taken
SR
= standard time rate of wages
Time
saved (TS = ST –TT)
Advantages
of Halsey premium plan
The
advantages of Haley premium plan are mentioned below:
i.
It is simple to understand and operate.
ii.
Every worker is guaranteed minimum wages and even the inefficient worker feel
secured.
iii.
It encourages efficiency among worker by inducing them to finish their job
before the standard time.
iv.
The benefit from the time saved is shared equally by have employer and the
workman.
v.
Generally workers do not oppose this method of wages, payment as it rewarded
time saved rather than increase output.
Disadvantages
of Halsey premium plan
The
disadvantages of Halsey premium plan are mentioned below:
i.
Workers are paid only half of the wages on the time saved. So the worker may
oppose this method.
ii.
The worker may perform to work in hurry by neglecting the quality of output to
save time and earn higher bonus.
iii.
The standard time fixed for finished a job may not be scientific.
b.
Rowan premium plan
This
plan was originated by David rowan. This plan guarantees an hourly rate to all
workers. A worker is paid the fixed rate per hour for the actual time spent on
the job plus a premium or bonus based on the time saved. The amount of premium
or bonus is not a fixed percentage of the wages of time saved but it various
according to the extent of the time saved. The amount of bonus or premium
payable under this plan depends on the percentage of time saved by the workers.
The bonus is calculated the such percentage out of the basis wages.
Formula
for to calculated total wages or total earning of the worker under, Rowan
premium plan:
Basis
wages = time taken x standard time rate = TT x SR
Bonus
= time saved/ standard time
Total
wages under rowan plan = basis wages = bonus = TT x SR = TS/SR
Effective
wages rate under rowan plan = total wages/TT
Advantages
of rowan premium plan
The
advantages of rowan premium plan are mentioned below:
i.
This plan guarantees minimum wages and provides incentive for efficiency.
ii.
It does not induce to rush through work for increase bonus earning because the
bonus increase at a decreasing rate with higher levels of efficiency. Thus, an
automate check for limiting production of inferior quaintly of goods is
ensured.
iii.
The per unit fixed cost decrease with the increase in production
iv.
The per unit fixed cost decrease with increase in production
v.
Under this method, the per unit cost decrease due to decrease in per unit labor
cost.
Disadvantages
of Rowan premium plan
The
disadvantages of Rowan premium plan are mentioned below:
i.
As the bonus is to be shared by employees and employees, it is not welcomed by
employees. They expect full benefit for their extra efficiency.
ii.
The calculation earnings under this method is comparatively complicated and
time consuming.
iii.
The preparation of Lanzhou budget and estimated product labor cost are made
difficult by the varying labor costs under this plan.
iv.
Payment under this plan is much less than that under the Halsey plan by way of
bonus below 50% of the time saved.
Why
rowan plan is better than Halsey plan?
•
In the Halsey plan, bonus is usually set at 50% of the
time saved. It does not serve as a strong incentive. On the other hand under
the Rowan plan, bonus is that proportion of the wages of the time taken which
the time save bears to the standard time; it serves as a strong incentive for
increasing the efficiency.
•
In the Rowan plan, the quality of work is not
affected much. The worker is not induced to rush through the work because bonus
increases at a decreasing rate at higher levels of efficiency. In the Halsye
plan. A worker is induced to rush through the because he get extra wages for
every 50% of the time saved.
•
The effective labor rate per hour in the Rowan plan is
higher up to 50% of the time saved and falls there after whereas in the Halsey
plan, the effective labor rate per hour up to 50% of the time saved and can be
double thereafter. Usually, worker are not able to save more than 50% of the
time allowed, so worker prefer the Rowan plan for earning more wages
Overhead:
Definition, Importance and Classification
Cost
pertaining to a cost centre or cost unit may be divided into two portions
direct and indirect. The indirect portion of the total cost constitutes the
overhead cost which is the aggregate of indirect material cost, indirect wages
and indirect expenses. CIMA defines indirect cost as “expenditure on labor,
materials or services which cannot be conveniently identified with a specific
saleable cost per unit.”
Indirect
costs are those costs which are incurred for the benefit of a number of cost
centers or costs units. Indirect cost, therefore, cannot be conveniently
identified with a particular cost centre or cost unit but it can be apportioned
to or absorbed by cost centres or cost units.
Broadly
speaking, any expenditure over and above prime cost is known as overhead. In
general terms, overheads comprise all expenditure incurred for or in connection
with the general organisation of the whole or part of the undertaking i.e. the
cost of operating supplies and services used by the undertaking including the
maintenance of capital assets. The terms ‘burden’, ‘supplementary costs’, ‘on
costs’, ‘indirect expenses’ are used interchangeably for overhead.
Importance
of Overhead Costs:
In
various five-year plans, industrialisation was given due importance. The result
is that a large number of establishments have grown up both in the public and
private sectors for mass production for which use of improved and costlier and
special type of machines has become absolutely necessary. With the increasing
trend towards plant automation, heavy expenditure is being incurred which
cannot be charged directly to any particular unit and can be called as cost
common to all units of production.
Overhead
expenses being a significant proportion of the total cost have assumed an added
importance and require analysis for purposes of cost ascertainment and control
by function and for guidance in certain managerial decisions by the extent of
the variability with production.
Overhead
costs cannot be allocated but have to be suitably apportioned and then absorbed
by suitable methods. The cost accountant is required to pay so much attention
to the accounting of overhead cost as prudence choice of various bases used for
apportionment and absorbing the overheads in the cost of products has to be
made by him.
Are
High Overhead Costs an Indication of Inefficiency?
These
days we find that overhead expenses are increasing in every organisation. Some
people may have the feeling that high overhead costs are an indication of
inefficiency. But this is not correct.
High
overhead costs do not indicate inefficiency if it is accompanied by:
(i)
Large scale production or mass production;
(ii)
Increase in efficiency and productivity of labor;
(iii)
Less human efforts will be required because of automatic machines but more
machine expenses will have to be incurred;
(iv)
More depreciation, maintenance expenditure and similar other items because of
more use of machinery;
(v)
Improved methods of managerial control like work study, production control, cost
and management accountancy techniques may reduce the direct cost but will
increase the overhead costs.
Classification
of Overhead Costs:
Cost
classification is the process of grouping costs according to their common
characteristics and establishing a series of special groups according to which
costs are classified.
Thus,
it involves two steps:
i)
The determination of the class or groups in which the overhead costs are
subdivided,
(ii)
The actual process of classification of the various items of expenses into one
or the other of the groups.
The
method to be adopted for the classification of overhead costs depends upon the
type and size of the business, nature of the product or services rendered and
policy of the management.
The
various classifications are:
(i)
Functional classification,
(ii)
Classification with regard to behaviour of the expenditure,
(iii)
Element-wise classification,
(iv)
Classification according to nature of expenditure.
A
concern may adopt one or more of the above classifications. For example, the
overhead expenses in a concern may be first divided according to functions i.e.
manufacturing, administration, selling and distribution groups. The expenses
pertaining to one group say manufacturing may further be classified into fixed,
variable and semi-variable.
Each
of these groups may then be grouped into the elements i.e. indirect material,
indirect labor and indirect expenses and under each element, the expenses may
be further subdivided according to their nature i.e. depreciation, salary,
repairs and maintenance etc.
I.
Functional Classification of Overhead:
When
overhead expenses are classified with reference to major activity divisions of
a concern, it is called functional classification of overhead. This
classification is necessary for the segregation of the cost of each of the
principal functional division of the concern and for having separate methods of
accounting and control for the diverse nature of expenses in each division.
The
main groups forming the basis of the classification are:
(a)
Manufacturing Overhead,
(b)
Administration Overhead,
(c)
Selling Overhead,
(d)
Distribution Overhead, and
(e)
Research and Development Expenses
II.
Classification with Regard to Behaviour of Expenditure:
Under
this overheads are classified with reference to their tendency to vary with
production/sales volume or activity level. Some expenses vary directly with the
rise and fall in output, some remain constant in spite of change in the level
of activity of the concern whereas there are some other items which are
constant only upto a certain level and then change their character to become
variable or which vary with volume of output but less than proportionately.
Based
on this behaviour, the expenses may be classified into:
(a)
Fixed overhead,
(b)
Variable overhead,
(c)
Semi-variable or Semi-fixed overhead.
This
classification is not absolute but is one of convenience. All costs are
variable in the long run. This classification is important for cost control and
decision making.
(a)
Fixed Overhead:
Fixed
overhead cost (also called period cost and policy cost) is the cost which
accrues in relation to the passage of time and which, within certain limits
tends to be unaffected by fluctuations in the level of activity. These expenses
remain fixed in total amount with increases or decreases in the volume of
output or productive activity for a given period of time. Fixed overhead cost
per unit decreases as production increases and increases as production
declines.
Examples
of fixed expenses are rent of building, storage space etc., depreciation of
plant and machinery, depreciation of buildings, pay and allowances of space
etc., depreciation of plant and machinery, depreciation of buildings, pay and
allowances of directors, managers, secretaries, accountants etc., office
expenses, like stationery and postage etc., bank charges, legal expenses,
salaries of the works manager, interest on capital, if included in costs.
Fixed
overhead costs are not always wholly fixed in nature:
If
a concern increases its capacity, it has to go in for additional equipment and
buildings and appoint some more staff to meet the changed requirements of
production. It will result in more fixed overhead expenses.
Fixed
overhead costs remain constant only within the limit of plant capacity and any
appreciable change in plant capacity affects the fixed overheads. The
definition that fixed overheads remain constant in spite of increase or
decrease in the level of activity will hold true only in short period during
which no appreciable change in capacity occurs.
Fixed
overheads have to be incurred during a particular period whether there is more
or less production or no production at all. Fixed overhead expenses are thus
period costs representing a constant amount of expenditure during a particular
period. Sometimes, they are also termed as shutdown or stand-by costs.
Fixed
overhead costs are constant in total amount during an accounting period but
fluctuate per unit as production changes. The fixed overhead cost per unit
decreases with increase in production as the same amount is spread over a
larger number of units. On the other hand, it increases when production falls
either due to capacity remaining unused or due to inefficiency in production.
Fixed
overhead falls under the category of non-controllable cost from the management
control point of view as there is practically no scope of reduction of the
amount of expenditure by the action of any executive once certain facilities
are installed. However, it is desirable to have most effective utilisation of
plant capacity in order to reduce the fixed cost per unit to the minimum.
(b)
Variable Overhead:
It
is a cost which tends to follow (in the short-term) the level of activity.
Variable overheads costs vary in total in direct proportion to the volume of
output. These costs per unit remain relatively constant with changes in
production. Thus variable costs fluctuate in total amount in direct proportion
to the volume of output but tend to remain constant per unit as production
activity changes. Examples are indirect material, indirect labor, spoilage,
tools, defective work loss, lubricants, idle time, lighting and heating
expenses and commission to salesmen.
The
variable overhead costs seldom reveal the characteristic of perfect variability
i.e. an expenditure which varies directly with variation in the volume of
output. They simply tend to vary rather than vary directly in direct proportion
to output.
We
come across three types of variable overhead expenses in actual practice:
(i)
A 100% variable expenses. For all production the variable expenditure per unit
of production is constant.
(ii)
The expenses per unit of production are lower at lower ranges of output but
gradually increase as production goes up.
(iii)
The expenses per unit of production are more at lower ranges of output but
gradually decrease with the increase in production,
(c)
Semi-variable Cost (also called mixed cost or semi fixed cost) is a cost,
containing both fixed and variable elements and which is thus partly affected
by fluctuation in the level of activity. These costs are partly fixed and
partly variable. For example, telephone expenses include a fixed portion of
annual charge plus variable charge according to calls, thus the total telephone
expenses are semi-variable.
Similarly
if the salesmen are entitled for a fixed salary plus a commission beyond a
certain level of sales, salesmen compensation is a semi-variable overhead
having a fixed element constant at all the levels and a variable element which
comes into operation after a specified level of sales is achieved.
Semi-variable
overheads are of two types:
(a)
The first type shows semi-variable costs where variable element operates at all
the levels as shown in the graphs given below:
(i)
Semi-variable Costs:
Variable
element operates at all the levels.
(b)
The second type shows semi-variable costs where variable element comes into
operation after a certain level of activity level as shown in the graph given
above:
(ii)
Semi-variable Costs:
Variable
element comes into operation after a certain range. These costs are the costs
which increase in steps. These remain constant over various small ranges of
output, but increase by discrete amounts as activity moves from one range to
the next. Examples are canteen staff wages, supervisor’s salary etc.
Necessity
of Classification for Overhead into Fixed and Variable:
The
necessity (or advantages) for classifying the overhead into fixed and variable
arises from the following:
(а)
Fixation of Selling Price:
This
distinction is helpful in determining the price policy of a concern. Sometimes,
different prices are charged for the same article in different markets to meet
varying degrees of competition. However, the lowest selling price of an article
in any market should atleast cover prime cost plus variable overheads. The
corresponding fixed overheads may or may not be recovered if it is not
practical to do so. Such fixed overheads may be recovered from sales in more favorable
markets.
If
the selling price in a market does not cover the variable overheads, it is
better not to sell goods in that market. Similarly, in times of trade
depression, it will be profitable for a manufacturer to sell his goods below
the total cost, provided the selling price is in excess of variable cost. In
this way he can recover a part of his fixed expenses and thus minimize his
loss.
(b)
Framing the Flexible Budget:
Segregating
the fixed overhead from the variable overhead will be helpful in framing the
flexible budget for various levels of capacity utilization. The behavior of the
cost will also be forcefully brought out.
(c)
Effective Cost Control:
Fixed
expenses are incurred by management decisions and as such can be controlled by
the top management while the variable expenses can be controlled by the lower
levels of management. By segregating these, the lower levels of management will
know the types of expenditure which is within their control.
(d) Helps
Management Decisions:
In
management decisions regarding the utilization of capacity, this segregation
will be found useful. After all the concept of fixed or variable expenditure is
in relation to a particular rate of output. For example, supervisory salary may
have to be doubled, if a new shift is to be started.
In
such cases, the management has to see whether the production of the second
shift will be able to bear such an increase in the cost of production Similarly
decisions like fixation of price during depression, for export, for some
special order or the extra amount to be spent if an additional activity is
undertaken or an alternative course is adopted, can be taken easily after
classification of expenses into fixed and variable.
(e) Marginal
Costing and Break-even Charts:
For
the technique of marginal costing, preparation of break-even charts and study
of cost-volume-profit relationship, segregation of cost into fixed and variable
is quite essential.
(f) Method
of Absorption of Overheads:
Different
methods may be adopted for determination of absorption rates for fixed and
variable overheads. The fixed overhead rate serves as a measure of utilisation
of the facilities while the extent of idle capacity is indicated by under
absorption.
In
short, classification of overhead into fixed and variable is highly helpful to
the management for the efficient running of the factory. It is not only helpful
for cost finding but also for cost control and managerial decision-making.
The
classification of costs into fixed and variable is not perfect as it is based
on one assumption that costs are influenced only by volume is not true. But
there are many other factors which influence costs as production specification,
product mix, method of production, technology, plant and equipment,
productivity, organisation structure, management policies and price indices
etc. Moreover the linearity assumption is far from the actual reality.
III.
Element-wise Classification:
This
classification of overhead is done according to the nature and source of
expenditure and follows naturally from the definition of overhead.
According
to this classification, the total expenses are broken up into:
(i)
Indirect Materials;
(ii)
Indirect Labor; and
(iii)
Indirect Expenses
IV.
Classification of Overhead According to Nature of Expenses:
In
order to have effective analysis of the expenses in detail, each of the
manufacturing, administration, selling and distribution overhead cost is
classified into smaller sub-divisions so that expenses of similar nature can be
grouped together under one head. This is achieved through Standing Order
Numbers or Syllabus of Work Order Numbers and Cost Account Numbers. It may be
made clear that standing order numbers are conventionally applied to factory
overheads headings whereas cost account numbers are customarily applied to
administration, selling and distribution and research development expenses.
The
compilation of numbers is similar in both types of numbers. These numbers are so
called as they are listed on a permanent type of schedule or manual. Each
standing order number denotes particular type of expenditure so that items of
expenses of similar nature when incurred are suitably classified in one of
these. A schedule or manual is maintained in the factory for enlisting all the
standing order numbers.
There
is a positive need for having separate standing order numbers for fixed and
variable overheads especially when departmental overheads are charged to
products separately for fixed and variable overheads. Thus, there are two
rates, one for fixed and the other for variable overhead.
Separate
rates are used for the following four reasons:
1.
Fixed costs being policy costs may not be recovered from costs under certain
circumstances (as depression) but variable costs are to be recovered fully
under normal circumstances.
2.
Responsibility centres at higher management level are for controlling fixed
costs but variable cost overheads responsibility centres are at shop level.
3.
Different bases may have to be adopted (sometimes labor hour basis or direct
material cost basis) for recovering overheads from cost.
4.
Marginal cost may be applied with benefit to have vital managerial basis.
The
number of standing order numbers in a factory will depend on the size of
factory, types of expenses and the extent of control necessary. A large variety
or a number of types of expenditure in a factory will have larger number of
standing orders. For better control it is desirable to have smaller sub-division
of the expenses.
The
essential requirements for an effective system of standing order numbers are:
1.
These numbers should be clearly defined in order to understand the
classification and correctly classify each item of expense.
2.
No ambiguity should be there as the schedule or manual for which suitable
remarks against the standing order numbers to assist in properly classifying
each item of expenses is necessary.
3.
System of standing order numbers should be according to the needs of the
concern. It should not be too detailed in order to avoid increased cost of
clerical labor. The classification should not be too broad so as to lose its
clarity and become useless for control purposes.
4.
Code should be used for each heading as it helps to find items in a convenient
way avoiding confusion and ultimately facilitating the collection of overheads.
Allocation
and Apportionment of Overhead to Cost Centres
When
all the items are collected properly under suitable account headings, the next
step is allocation and apportionment of such expenses to cost centres. This is
also known as departmentalisation of overhead. Departmentalisation of
production overheads is the process of identifying production overhead expenses
with different production/service departments or cost centres. It is done by
means of allocation and apportionment of overheads among various departments.
Thus,
it involves:
(i)
Allocation and apportionment of overheads among production and service
departments and
(ii)
Reapportionment of service departments overheads among production departments.
A
factory is administratively divided into sub-divisions known as departments for
running it smoothly and efficiently. This sub-division is done in such a manner
that each department represents a division of activity of the concern such as
repairs department, power department, tools department, stores department, cash
department, cost department etc.
Following
factors must be taken into consideration while organising a concern into a
number of departments:
(i)
Every manufacturing process is divided into its natural divisions in order to
maintain natural flow of raw materials from the time of the purchase till its
conversion into finished goods and sale.
(ii)
For ensuring smooth flow of production, the sequence of operations is taken
into consideration while determining the location of the various departments.
(iii)
For physical control on production and maintaining efficiency of the concern,
division of responsibility must be taken into consideration while organising
departments. Division of responsibility as far as possible should be clear,
without ambiguity and dual control.
Types
of Departments:
In
a manufacturing concern, there are three types of departments:
(a)
Manufacturing or producing departments
(b)
Service departments
(c)
Partly producing departments.
(а)
Producing Departments:
A
department where actual process of manufacturing is carried on is called
manufacturing or producing department. It covers direct manufacture and is
engaged in converting raw materials into finished goods by performing some
manual and/or machine operations on any part of the product.
The
number of such departments and their number will depend upon the nature of
industry, type of work performed and the size of the factory. For example, in
Steel Rolling Mill, Hot Mill, Cold Mill, Pickling Shop, Annealing Shop,
Hardening, Polishing and Grinding are the producing departments.
(b)
Service Departments:
Service
department is an auxiliary and is not directly engaged in production though its
existence is very essential for smooth and efficient running of production
departments. Such departments are not directly engaged in the conversion of raw
materials into finished goods. Such departments (as electricity or repairs and
maintenance) render a particular type of service for the benefit of other
departments.
The
number of departments in a factory and the names to be assigned to them depends
upon size of the factory, nature of industry and the nature of service
rendered. The service departments, common to most concerns are stores, cost
office, personnel department, planning and progress department, tool room,
hospital and dispensary, machine maintenance and electrical maintenance section
etc.
(c)
Partly Producing Departments:
A
department may normally be a service department but sometimes does some
productive work, so it becomes partly producing department. For example, a
carpentry shop which is mainly responsible for the repairs and upkeep of sundry
fixtures and fittings may occasionally be required to manufacture packing boxes
for direct charge to outturn, will be a partly producing department.
Allocation
of Overhead Expenses:
Allocation
is the process of identification of overheads with cost centres. An expense
which is directly identifiable with a specific cost centre is allocated to that
centre. So it is the allotment of whole item of cost to a cost centre or cost
unit or refers to the charging of expenses which can be identified wholly with
a particular department. For example, the whole of overtime wages paid to the
workers relating to a particular department should be charged to that
department.
Similarly,
the cost of repairs and maintenance of a particular machine should be charged
to that particular department wherein the machine is located. Power, if
separate meters are provided at each cost centre and fuel oil for boilers are
other examples of allocation. So, the term allocation means the allotment of
the whole item without division to a particular department or cost centre.
Apportionment
of Overhead Expenses:
Cost
apportionment is the allotment of proportions of items to cost centres or cost
units on an equitable basis. The term refers to the allotment of expenses which
cannot identify wholly with a particular department. Such expenses require
division and apportionment over two or more cost centres or units.
So
cost apportionment will arise in case of expenses common to more than one cost
centre or unit. It is defined as the allotment to two or more cost centres of
proportions of the common items of cost on the estimated basis of benefit
received. Common items of overheads are rent and rates, depreciation, repairs
and maintenance, lighting, works manager’s salary etc.
Bases
of Apportionment:
Suitable
bases have to be found out for apportioning the items of overhead cost to
production and service departments and then for reapportionment of service
departments costs to other service and production departments. The basis
adopted should be such by which the expenses being apportioned must be measurable
by the basis adopted and there must be proper correlation between the expenses
and the basis.
Therefore,
the common expenses have to be apportioned or distributed over the departments
on some equitable basis. The process of distribution is usually known as
‘Primary Distribution’.
Following
are the main bases of overhead apportionment utilised in manufacturing
concerns:
(i)
Direct Allocation:
Overheads
are directly allocated to various departments on the basis of expenses for each
department respectively. Examples are: overtime premium of workers engaged in a
particular department, power (when separate meters are available), jobbing
repairs etc.
(ii) Direct
Labor/Machine Hours:
Under
this basis, the overhead expenses are distributed to various departments in the
ratio of total number of labor or machine hours worked in each department.
Majority of general overhead items are apportioned on this basis.
(iii) Value
of Materials Passing through Cost Centres:
This
basis is adopted for expenses associated with material such as material
handling expenses.
(iv) Direct
Wages:
According
to this basis, expenses are distributed amongst the departments in the ratio of
direct wages bills of the various departments. This method is used only for
those items of expenses which are booked with the amounts of wages, e.g.,
workers’ insurance, their contribution to provident fund, workers’ compensation
etc.
(v) Number
of Workers:
The
total number of workers working in each department is taken as a basis for
apportioning overhead expenses amongst departments. Where the expenditure
depends more on the number of employees than on wages bill or number of labor
hours, this method is used. This method is used for the apportionment of
certain expenses as welfare and recreation expenses, medical expenses, time
keeping, supervision etc.
(vi) Floor
Area of Departments:
This
basis is adopted for the apportionment of certain expenses like lighting and
heating, rent, rates, taxes, maintenance on building, air conditioning, fire
precaution services etc.
(vii) Capital
Values:
In
this method, the capital values of certain assets like machinery and building
are used as basis for the apportionment of certain expenses.
Examples
are:
Rates,
taxes, depreciation, maintenance, insurance charges of the building etc.
(viii) Light
Points:
This
is used for apportioning lighting expenses.
(ix) Kilowatt
Hours:
This
basis is used for the apportionment of power expenses.
(x)
Technical Estimates:
This
basis of apportionment is used for the apportionment of those expenses for
which it is difficult, to find out any other basis of apportionment. An
assessment of the equitable proportion is carried out by technical experts.
This is used for distributing lighting, electric power, works manager’s salary,
internal transport, steam, water charges etc. when these are used for
processes.
Principles
of Apportionment of Overhead Costs:
The
determination of a suitable basis is of primary importance and the following
principles are useful guides to a cost accountant:
(i) Service
or Use or Benefit Derived:
If
the service rendered by a particular item of expense to different departments
can be measured, overhead can be conveniently apportioned on this basis. Thus,
the cost of maintenance may be apportioned to different departments on the
basis of machine hours or capital value of the machines, rent charges to be
distributed according to the floor space occupied by each department.
(ii) Ability
to Pay Method:
Under
this method, overhead should be distributed in proportion to the sales ability,
income or profitability of the departments, territories, basis of products etc.
Thus, jobs or products making higher profits take a higher share of the
overhead expenses. This method is inequitable and is not generally advisable to
relieve inefficient units at the cost of efficient units.
(iii) Efficiency
Method:
Under
this method, the apportionment of expenses is made on the basis of production
targets. If the target is exceeded, the unit cost reduces indicating a more
than average efficiency. If the target is not achieved, the unit cost goes up,
disclosing thereby the inefficiency of the department.
(iv)
Survey Method:
In
certain cases it may not be possible to measure exactly the extent of benefit
wick the various departments receive as this may vary from period to period, a
survey is made of the various factors involved and the share of overhead costs
to be borne by each cost centre is determined.
Thus,
the salaries of foreman serving two departments can be apportioned after a
proper survey which may reveal that 30% of such salary should be apportioned to
one department and 70% to the other department. The cost of lighting, when not
metered, may similarly be apportioned on a survey of the number and wattage of
light points and the hours of use in each cost centre.
Advantages
of Departmentalization of Overhead Expenses:
Departmentalisation
of overhead expenses has the following advantages:
1.
Allocation and apportionment of overhead expenses to the respective departments
facilitate control of overhead cost by means of budgets predetermined.
2.
Apportionment of service department cost to production and other service
departments facilitates control of the uses made of the services rendered to
respective departments.
3.
Absorption of overhead costs in the products produced by departmental overhead
rates facilitates ascertainment of cost as the overhead costs of the respective
departments are taken into consideration in determining the overhead rates.
4.
The basis used in the predetermination of the departmental overhead rates may
be used for control of actual basis in comparison to the quantity
predetermined.
5.
Analysis of under or over absorption of overhead discloses the reasons for
variances which indicate the remedial measures to be taken.
6.
For working out correctly the cost of work-in-progress. If the overhead is not
departmentalized, the cost of work-in-progress will be loaded with a proportion
of overhead of all the departments including those in which the product is yet
to be processed.
Unit IV
Unit
or Output Costing
One operation costing method of costing by units of
production and is adopted where production is uniform and a continuous affair,
units of output are identical and the cost units are physical and natural. The
cost per unit is determined by dividing the total cost during a given period by
the number of units produced during that period.
This method of costing is generally adopted where an
undertaking is engaged in producing only one type of product or two or more
products of the same kind but of varying grades or quality. The industries
where this method of costing is used are dairy industry, beverages, collieries,
sugar mills, cement works, brick works, paper mills etc. In all these cases,
work is a natural unit of cost e.g., a tonne of coal, a quintal of sugar, a
tonne of cement, 1,000 bricks, 1 kg of paper and soon.
Collection
of Costs:
The cost in such industries is collected under the
following headings:
(i)
Material:
As there will be only one product and the process of
manufacture is also simple, the raw material, if any, is directly charged to
the production of the period in total. The items of stores issued for
maintenance and other purposes are analysed by cost centres through the
requisition slips. Normal loss of material is adjusted by inflating the issue
price of materials.
(ii)
Labour:
The labour costs are collected periodically through
payrolls which are prepared separately for each section of the work. The
purpose of such analysis is only to localise the cost to specific cost centres
or to departmental managers, so that the cost can be effectively controlled.
Labour—direct and indirect—should be identified separately. The direct labour
cost is collected separately and forms a part of prime cost whereas indirect labour
is charged to the factory overheads.
(iii)
Overheads:
These are classified into three broad categories:
factory overheads, administration overheads and selling and distribution
overheads. These are usually charged at a predetermined rate.
Tenders
or Quotations:
Very often a producer in response to an
advertisement in the press is required to submit a tender or to quote prices
for the supply of the commodities he produces or for completing a job. A tender
has to be prepared very carefully as the receipts of orders depend upon the
acceptance of quotations or tenders supplied by the manufacturer. The
preparation of tenders requires information regarding prime cost, works,
administration and selling overheads and profit of the preceding period.
The manufacturer has to ascertain and find out the
possible changes in prices of material, rates of wages and other costs. He has
to ascertain the amount of variable, semi-variable and fixed overheads on the
basis of past experience. He must also have a reasonable amount of profit by
taking into consideration the market condition.
In preparation of estimates or tenders, overheads
are generally not given. They are estimated as percentages i.e. works overheads
on wages and administration, selling and distribution overheads on works cost
basis.
Importance
of output costing
A cost sheet is used to determine total and unit
cost of a product under the unit cost method. The followings are the
importance;
- Simple: This
method is very simple and easy to understand.
- Determination
of cost: It helps to determine the total and unit cost if production for a
given period of time.
- Fixation
of selling price: It helps to determine the selling price of the
product.
- Elements
of cost: It provides the detail information of the cost under different
heading incorporating step-wise cost as well as total cost.
- Comparison:
It facilitates to compare the current cost with the previous period.
- Corrective
measures: It enables to find out the causes of variation if any and take
corrective measures.
- Tender sheet: It
helps in the preparation of tender sheet for submitting tender price with
fair degree of accuracy and reliability.
- Decision
making: It facilitates for making different types of decisions and
formulation policy of the manufacturing concern.
Limitation of unit costing
- Cost
sheet is very importance method for determining the unit cost or total
cost of production.
- Not
applicable for heterogeneous products: manufacturing concerns engaged
in manufacturing different types of product cannot apply this method.
- Not
applicable for service sector: Services oriented concern like school,
college, and hospital cannot apply this method.
Operating
Costing: Definition, Unit and Classification
IMA defines the method “Operating costing applies
where standardized services are provided by an undertaking’.
Such undertakings are: transport concern (shipping,
air, railways and motor transport etc.), catering establishments (hotels,
hostel, canteen etc.) and public utility undertakings like gas, electricity,
steam generating, hospitals, theatres, schools, laundries etc. In many
factories utility services like motor transport, power house, hospital and
canteen are departmentally run divisions which provide services to the
producing departments of the factory.
Operating costing is used by concern running diverse
nature of activities, the cost system is obviously different from that for
manufacturing concerns. In this system a suitable cost-unit is adopted, which
is not a job or process but is related to service rendered e.g. ton-kilometer,
passenger-kilometer of transport services, unit of electricity or kilowatt
hour, cubic meter of gas etc.
Unit
of Cost:
It is quite important to find out a proper unit of
cost in case of operating cost so that the cost per unit can be ascertained. In
certain cases the unit is obvious. For example in case of hospital it will be
bed, in case of water works it will be 1000 litres, in case of electricity it
will be a unit or kwh and in case of a retail store it will be the sale per Rs.
100 In case of transport concerns, however, the unit is likely to be composite.
It may be a passenger-km. or ton-km signifying the effort which is made in
carrying a passenger one kilometre or a ton of goods one km. Following are
composite units based on two or more factors.
Classification
of Cost:
Operating costs are classified and accumulated under
the following three heads:
(a) Fixed or Standing Charges:
These are expenses which are more or less fixed in
nature. For example in case transport service garage charges, insurance, taxes,
license and depreciation are standing cost. In case of Hospital the
depreciation pertaining to the cost of building, equipment, beds, beds
insurance etc. are fixed charges. These expenses are constant and are incurred
irrespective of the extent of service.
(b) Maintenance Charges:
These are costs of semi-variable nature and include
expenditure on repairs, maintenance, tyres, tubes, accessories and spares.
(c) Running or Operating Charges:
These are variable cost. For example in case of
hospital, the cost of medicine, diet, laundry etc. will represent the running
charges. In case of transport service petrol or diesel, lubricating oil, wages
of driver or cleaner are operating or running charges.
Features
of Operating Costing
The
basic features of operating costing are presented below.
1.
Uniform service is provided to all the customers.
2.
The costs are classified into fixed and variable.
3.
The fixed
and variable cost classification is necessary to ascertain the cost of
service and the unit cost of service.
4.
There is no physical stock of article if an undertaking renders a service.
5.
If a cost center is operating for an undertaking, there is no sale of service
but render the service. In other words, if a cost center is operating for
public, it sells its service to the public.
6.
The cost unit may be simple in certain cases or composite or compound in other
cases like transport undertakings.
7.
Total costs are averaged over the total amount of service rendered.
8.
The costs are collected from the authentic documents like daily log sheet,
operating cost sheet, boiler house cost sheet, canteen cost sheets etc.
9.
Operating cost is the cost of rendering service.
10.
Operating costing is the method of ascertaining costs.
11.
The productive enterprises can quote prices by ascertaining cost data.
Application
of Operating Costing
Operating
costing is applied by an organization, which provides service to the public as
a whole instead of manufacturing an article, and sells the same. For example,
Transport undertaking electricity, theatre, hospitals, schools and the like.
Similarly, the same type of an organization or cost center renders service to
production departments. For example, Electricity, powerhouse, canteen and the
like.
The
service cost in operating cost should be find out to understand whether an
organization or cost center render services to others or sell the services to
the general public. If the services are sold, the operating expenses and the
extent of services rendered are taken into consideration to find out the service
cost. On the other hand, if the services are sold, the service expenses
should be apportioned to the production department on a suitable basis.
Generally,
the basis may be the extent of service availed by the production departments.
It may also become necessary to compare the cost of such a service with the
cost of an outside service for deciding whether it is profitable to buy a
service from outside rather than make the same available from within an
organization.
Objectives
of Operating Costing
The
objectives of operating costing are listed below:
1.
To supply the information through which the efficiency in rendering service is
improved.
2.
To provide a basis for fixing accurate quotation and fare.
3.
To ensure that the services are provided in proper time.
4.
To control the fuel consumption and its expenses.
5.
To ensure that the service equipments are properly maintained.
6.
To provide cost comparison between own service and alternative service i.e.
hiring.
7.
To compare the cost of one service center with another.
8.
To determine the apportionment
cost if the services are provided within an organization.
9.
To decide the price that can be charged for use of vehicle.
10.
To control the cost of maintenance and repairs.
11.
To select efficient and suitable routing of vehicles to reduce the costs to
production departments that uses the service.
12.
To avoid the under utilization of capacity and idle time of the work force.
13.
To absorb the fixed costs proportionately and systematically that is allocated
to the units of services.
Process
Costing: Meaning, Features and Definitions
‘Process
costing is a method of costing used to ascertain the cost of production of each
process, operation or stage of manufacture where processes are carried on
having one or more of the following features:
(i)
Where the product of one process becomes the material of another process or
operation,
(ii)
Where there is simultaneous production at one or more process of different
products, with or without by product,
(iii)
Where, during one or more processes or operations of a series, the products or
materials are not distinguishable from one another, as for instance, when
finished products differ finally only in shape or form’.
Principles
of Process Costing
The
principles of process costing are briefly presented below.
1.
The whole factory operation is divided into several operations or production
centers, each performing standard operations.
2.
All the items of process costing i.e. materials, labour and overheads are
collected in process wise.
3.
The records are maintained in process wise as the number of units produced, the
total costs incurred and the cost per unit.
4.
The total cost of one process is transferred to next process along with the number
of units transferred to next process for further processing.
5.
The cost per unit is calculated by dividing the number of units produced in a
process into the total costs incurred for processing the same number of units
in a specified period.
6.
Likewise, the cost of finished product is calculated by dividing the total
production cost into the number of units produced.
Thus,
in the process cost accounting system, the cost is determined for completed
production and work-in-progress also.
Features
of Process Costing
The
process costing has the following features.
1.
The production is carried on continuously and passing two or more processes.
2.
Only homogeneous products are produced.
3.
The production will be stopped if the plant and machinery is shut down for
repairs.
4.
The management has clearly defined process cost
centers and the accumulation of costs such as cost of material, cost
of labour and overheads by the cost centre.
5.
The accurate accounting records are maintained in process wise as the number of
units produced completely, the number of units partly produced and total costs
incurred.
6.
The finished product of one process becomes the raw material of the next
process or operation and so on until the final product is obtained.
7.
Some losses may arise in all the processes due to avoidable and unavoidable
reasons. Such losses may be normal and/or abnormal.
8.
Accounting treatment of normal losses and abnormal losses are studied in this
method of costing.
9.
Sometimes, abnormal gain is also available in certain processes.
10.
Accounting treatment of such abnormal gain is also studied in this method of
costing.
11.
Sometimes, goods are transferred from the process to next process at transfer
price instead of cost price.
12.
The transfer price is compared with market price to know the level of
efficiency or losses occurring in a particular process.
13.
All the input units cannot be converted into finished products in all the
processes for a specified period. Some may be in process. At the same time, the
calculation of effective unit rate is carried on in this method of costing.
Therefore, accurate average cost is obtained.
14.
Sometimes, more than one product is produced. All the products are having equal
value and importance. If so, these products are called joint product.
15.
In certain cases, more than one product is produced. One product has more value
and gets more important than others. If so, more value product is main product
and less value product is by-product.
16.
Main product may not require any further processing. But, by-products may
require further processing before they can be sold.
17.
Both main product and by-products are valued under this method of costing.
18.
Joint cost is apportioned to both main product and by-products on suitable
basis.
19.
A main product of one firm may be a by-product of another firm.
20.
Output is uniform. Hence, the cost per unit of production can be ascertained
only by averaging the expenditure incurred during a particular period.
21.
Work in progress is converted into finished products through the cost of
equivalent production.
Objectives
of Process Costing
The
chief objectives of process costing are listed below.
1.
To determine the unit cost.
2.
To determine the method of allocation of manufacturing costs incurred during a
given period.
3.
To allocate the accumulated materials, labour and factory overhead costs to
process cost centers.
4.
To express incomplete units in terms of completed units.
5.
To give accounting treatment to process losses such as waste, scrap, defective
goods and spoiled goods.
6.
To differentiate the main product from by-product and joint product.
7.
To give accounting treatment to joint product and by-product.
8.
To calculate the cost of main product accurately.
Application
of Process Costing
Generally,
an industrial unit follows the process costing system where there are at least
two production processes. In other words, the industrial units, which are
following single production process, can apply operation-costing system instead
of process costing system
Moreover,
an industrial unit can apply operation costing system instead of process
costing system even though these industrial units are not able apply process
costing system and having at least two production processes.
The
following are the examples of industries where process costing is applied.
Chemical
works, Steel, Soap making, Oil refining, Box making, Textiles, Distillation
process, Rubber, Paper mills, Paints, Beer, Coke works, Ink and Varnishing,
Meat products factory, Milk diary, Biscuit works, Food products, Canning
factory.
Process
costing deals with the flow of units and costs through several stages or
operations. As such, when the homogeneous products are produced through
continuous process, a process costing system is usually appropriate.
Contract costing:
Meaning, Features & Procedure
Contract
Costing is otherwise called as terminal costing. It is one of the methods
of Job Costing. Contract costing is also prospered just like job costing. A
separate number is allotted to each contract and records are also maintained
for each contract separately. The cost
unit is each contract
account.
The
contract costing method is used mostly by builders, civil contractors, ship
builders, and construction and mechanical engineering firms. Generally, the
contract is undertaken at the site of contract i.e. customer and according to
the specifications of customer. More over, the period inquired to complete a
contract is fairly long time or usually more than one year.
The
main purpose of preparing contract account is the ascertainment of cost of each
contract separately and profit on each contract.
Features
of Contract Costing
The
following are the features of contract costing.
1.
A contract is undertaken according to the specific requirements of customers.
2.
Generally, the duration of a contract is long period.
3.
The contract is undertaken only at the site of the customer.
4.
Contract work mainly consists of construction activities.
5.
The specific order costing principles are applied in contract costing.
6.
The size of a contract is usually large or bigger than jobs.
7.
It requires a long time to complete a contract.
8.
Each contract is an independent one, quite distinct from another.
9.
A distinctive number is assigned to each contract to differentiate the contract
from one another.
10.
A separate account is maintained and prepared for each contract to find out the
profit earned from each contract separately.
11.
If a contract is not completed at the end of the accounting period, only a
portion of profit is transferred to profit and loss account on the basis of
stage of completion of a contract.
12.
There is no problem of under
absorption and over absorption of overheads.
13.
Every conceivable expenditure is charged to the concerned contract.
14.
If the materials, plants and other inputs are transferred from one contract to
another, the transfer may be affected by giving debit and credit to the
respective contracts.
15.
The proportion of indecent costs to total cost of a contract is very small.
16.
A contractor may appoint a sub — contractor(s) for the execution of the work of
the main contract.
17.
The contractee i.e. the customer pays money only on the basis of the work
certified by the architect, engineer or surveyor.
18.
Escalation clause may be incorporated in the agreement of the contract. It so,
the contractor is protected from any rises in the prices of materials, labour
and other inputs.
Procedure
of Contract Costing
In
contract costing, most of the expenses are direct in nature as in the form of
materials, labour, expenses, plant, sub-contract charges and the like. Only a
small portion of amount is charged as overheads which are apportioned on
suitable basis. Accounting treatment of costs of contract costing is briefly
explained below.
1. Materials
The
value of materials used is debited in the concerned contract account. Materials
may be specifically purchased from the open market, issued from the stores,
transfer from other contracts or supplied by the contractee himself. If
materials are returned to stores, the value of materials is credited in the
concerned contract account.
Sometimes,
materials may be transferred from one contract to another. If so, the value of
materials is debited in the receiving contract account and credited in the
transferring contract account. Whenever the materials are purchased from the
open market, the values of materials are debited in the concerned contract
account.
Similarly,
if materials are issued from stores, the concerned contract account is debited
and the stores control account is credited. Sometimes, some materials may be
stolen or destroyed by fire, the value of materials is credited in the
concerned contract as stores account and the same is transferred to profit and
loss Account.
2. Labour
Generally,
the contract is carried on only at the site of the contractee i.e., customer
not within the company premises. Hence, labour is engaged at site to work on
the contract. The amount
paid to workers is wages which is directly debited in the concerned
contract account. The details of information regarding wages are obtained from
the records of time sheet and wages
sheet. Equitable base method is usually adopted to apportion the wages of
supervisors working on two or more contracts.
Likewise,
the overheads are
also apportioned on suitable basis. The accrued wages and outstanding expenses
are calculated at the end of the accounting period and debited in the concerned
contract account.
3. Direct Expenses
The
direct expenses are debited in the concerned contract account as and when they
are incurred. Examples of direct expenses are hire charges paid for the plant
procured from outside, sub-contractor’s charges, architect’s fees, electricity,
insurance and the like.
4. Plant and Machinery
The
plant and machinery is treated in two ways. Under first method, the full value
of plant and machinery is debited in the concerned contract account if the
plant and machinery is specifically purchased for the contract. At the end of
contract, the plant and machinery may be sold out in the market if it is not
required further. If so, the sale proceeds are credited in the concerned
contract account.
Sometimes,
the plant and machinery may be required further, if so, the depreciated value
or revalued amount of plant and machinery is credited in the concerned contract
account. The net effect is that the contract account is debited with the amount
of depreciation.
Under
second method, the contract account is debited with the amount of depreciation
of plant and machinery. The plant and machinery may be purchased specifically
from the open market or issued from the stores. The amount of depreciation is
calculated on the basis of daily use or hourly basis. Sometimes, a plant is
procured on hire basis, if so, only hourly charges are debited in the contract
account.
5. Overheads
Indirect
costs cannot be directly charged to any contract account. These costs are
apportioned to all the contract accounts only on the suitable basis. These are
called as overheads. The term overheads includes payment made to engineers,
supervisors, architects, managers, store keeper, central office, administrative
expenses like staff salaries, telephone expenses, postage, rent, stationery,
advertisement expenses etc.
Job
Costing: Meaning, Advantages and Limitations
Job
costing is a method of costing applied in industries where production is
measured in terms of completed jobs. Industries where job costing is generally
applied are Printing Press. Automobile Garage, Repair workshops, Ship Building,
Foundry and other similar manufacturing units which manufacture to customers’
specific requirements.
Job
costing is a method of costing whereby cost is compiled for a job or work
order. The production is against customer’s orders and not for stock. The cost
is not related to the unit of production but is a cost for the job, e. g
printing of 5000 ledger sheets, repairs of 50 equipment’s, instead of printing
one sheet or repair of one equipment.
The
elements of cost comprising Prime Cost viz. direct materials, direct labour and
direct expenses are charged directly to the jobs concerned, the overhead
charged to a job is an apportioned portion of the departmental overhead.
Advantages
of Job Order Costing:
(i)
Profitability of each job can be individually determined.
(ii)
It provides a basis for estimating the cost of similar jobs which are to be
taken in future.
(iii)
It provides the detailed analysis of the cost of material, labour and overheads
for each job as and when required.
(iv)
Plant efficiency can be controlled by confining attention to costs relating to
individual jobs.
(v)
Spoilage and defective work can be identified with a specific job and
responsibility for the same may be fixed on individuals.
(vi)
By adopting pre-determined overhead rates in job costing, we can get all
advantages of budgetary control.
(vii)
Job costing is essential for cost-plus contract where contract price is
determined directly on the basis of cost.
Limitations
of Job Order Costing:
(1)
It is expensive to operate as it requires considerable detailed clerical work.
(2)
With the increase in the clerical work the chances of errors are increased.
(3)
Job order costing cannot be efficiently operated without highly developed
production control system. The job costing requires intricate factory
organization system.
(4)
The costs as ascertained are historical as they compiled after incidence and
therefore does not provide control of cost unless it is used with standard
costing system.
Batch
Costing: Meaning, Need and Types
Batch
costing is a form of specific order costing. Job costing refers to costing of
jobs that are executed against specific orders whereas in batch costing items
are manufactured for stock. A finished product may require different components
for assembly and may be manufactured in economical batch lots.
When
orders are received from different customers, there are common products among
orders; then production orders may be issued for batches, consisting of a
predetermined quantity of each type of product. Batch costing method is adopted
in such cases to calculate the cost of each such batch.
Cost
per unit is ascertained by dividing the total cost of a batch by number of
items produced in that batch. In order to do that a Batch Cost Sheet is
prepared. The preparation of Batch Cost Sheet is similar to that of Job Cost
Sheet. This method is mainly applied in biscuits manufacture, garments
manufacture, spare parts and component manufacture, pharmaceutical enterprises
etc.
Types
of Costs in Batch Costing:
There are two types of costs involved in Batch
Costing:
(i)
Set up costs
(ii)
Carrying costs.
If
the batch size is increased, set up cost per unit will come down and the
carrying cost will increase. If the batch size is reduced, set up cost per unit
will increase and the carrying cost will come down. Economic Batch quantity
will balance both these opponent costs.
Difference
Between Job Costing and Batch Costing:
In
case of job costing, work is undertaken as an identifiable unit and cost of
each job is ascertained separately. Such a method of costing is suitable in
case of motor workshop, printing press and where manufacture of products is
according to customers’ specific requirements.
Batch
costing is extension of job costing. Job costing refers to costing of jobs that
are executed against specific orders whereas in batch costing items are
manufactured for stock. In batch costing a batch may represent a number of
small orders passed through the factory in batches. Each batch is treated as a
unit of cost and is separately costed. Cost per unit is ascertained by dividing
the total cost of the batch by number of items produced in that batch.
Integral
Accounting: Advantages, Principles and Essential Features
Integrated
(or Integral Accounts) is the name given to a system whereby cost and financial
accounts are kept in the same set of books. Obviously then there will be no
separate set of books for costing and financial purposes. According to CIMA,
‘It is a system in which the financial and cost accounts are interlocked to
ensure that all relevant expenditure is absorbed into the Cost Accounts’.
Integrated
Accounts will have to afford full information required for costing as well as
for financial accounts. In other words, information and data should be recorded
in such a way as to enable the firm to ascertain the cost (together with the
necessary analysis) of each product, job, process, operation or any other
identifiable activity.
It
should be possible to ascertain marginal cost, variances, abnormal losses and
gains; in fact, all information that management requires from a system of
costing for doing its work properly. It should also be possible to have
accounts to see that the firm maintains full control over its assets and
liabilities and to enable the firm to prepare the Profit and Loss Account and
the Balance Sheet as required by law or for income-tax purposes at the end of
each year.
Usually,
financial accounts require expenditure and revenue to be recorded according to
its nature rather than the benefit derived from it. Thus all salaries paid are
recorded together. But for costing purposes, there must be detailed analysis
functionally, that is, according to the identifiable unit of cost
classification of expenses. Integrated Accounts record transactions so as to be
able to collect and analyses information both ways.
Advantages
of Integral Accounting:
1.
There is no need to reconcile the profit ascertained by the cost accounts with
that of financial accounts since only one profit and loss account is prepared
from the information recorded in the cost accounts.
2.
There is no duplication of recording and effort as in non-integral system and
as such this system is simple and economical.
3.
This system tends to co-ordinate the functions of different sections of the
Accounts Department since all efforts are integrated and directed towards
achievement of one aim that is providing a high level of efficiency.
4.
The accounting procedures can be simplified and the system can be centralised
with the object of achieving a greater control over the organisation.
5.
The system creates conditions which are eminently suitable for the introduction
of mechanised accounting.
6.
There is no possibility of overlooking any expense under the system.
7.
As cost accounts are posted straight from the books of original entry, there is
no delay in obtaining the data.
8.
There is automatic check on the correctness of the cost data. It ensures that
all legitimate expenditure is included in Cost Accounts and reliable and proved
data is provided to the management for its decisions.
9.
Integrated accounting widens the outlook of the accountant and his staff and
they can take broader view of things.
10.
From psychological point of view, it shows the complimentary status of cost and
financial accountant which need to be considered as separate watertight
compartments.
Principles
of (or Pre-Requisites for) an Integral Accounting System:
Following principles should be taken into
consideration while designing such a system:
1.
The degree of integration must be determined. Some undertakings find it
satisfactory merely to integrate upto the stage of prime cost or factory cost
while other concerns integrate the whole of the records in which cost and
financial accounts cannot be distinguished.
2.
The degree of integration will determine the classification of expenditure. The
expenditure is classified here according to function as office expenses,
selling expenses etc. and not according to nature. However, control accounts
are maintained for each element of cost. A suitable coding system should be
available to serve the accounting purposes of financial and cost accounts.
3.
Full details of items posted to the control accounts are supplied to the cost
office at convenient intervals. This information is then dealt with by the cost
office in accordance with the system of costing in force.
4.
The amount of detail recorded in the ledger is usually kept to a minimum, full
information regarding each department or process being contained in tabulators
prepared by the cost office. These tabulations are sometimes referred to as
third entries to emphasise that they are not part of double entry system.
5.
For preparation of interim accounts, there must be an agreed routine for
treatment for accruals, prepaid expenses and other necessary adjustments.
6.
There should be perfect co-ordination between the staff responsible for the
financial and cost aspects to ensure an efficient processing of accounting
documents.
7.
A suitable coding system must be made available so as to serve the accounting
purposes of financial and cost accounts.
Essential
Features of Integral Accounting:
Following are the essential features of an integral
accounting system:
1.
This system records financial transactions not normally required for cost
accounting besides recording internal costing transactions. That is why
accounts for capital expenditure, sundry debtors and creditors, share capital,
cash and bank transactions, prepayments and accruals are opened.
2.
Stores transactions are recorded in the Stores Control Account. This account is
debited with the cost of stores purchased, corresponding credit being given to
cash or sundry creditors depending whether the purchase is made for cash or on
credit.
3.
Wages Control Account is debited with the wages paid, contra credit is taken in
Cash or Bank Account.
4.
Overhead expenses are debited to the Overhead Control Account, corresponding
credit being given to Cash or Bank Account or the sundry creditors.
5.
Transactions relating to material, labour and overheads are posted in the
Stores, Wages and Overhead Control Account after making suitable cost analysis
and at the end of the period transfer of the totals is made to the
Work-in-Progress Account by crediting various control accounts. The day to-day
cost analysis made for this purpose is known as making third entry. These
entries do not mean entries in the same sense as entry of transactions in the
ledger but such entries are simply a sort of cash analysis.
6.
All advance payments are credited and accruals debited to the respective
control accounts by contra entries in the prepayments and accrual accounts.
7.
Capital Asset Account is debited and respective control accounts are credited
in the process of cost analysis for capital expenditure.
Non-Integral
Accounting System
Non-integral system is a system of accounting under
which two separate sets of account books are maintained—one for cost accounts
and the other for financial accounts. In other words, cost accounts are
maintained separately from financial accounts.
Since separate ledgers are maintained for cost and
financial accounts in this system, the cost accountant is responsible for
recording of the cost accounting transactions and the financial accountant is
responsible for financial transactions.
Non-integral system of accounting is also known as
non-integrated system or Inter-locking system or Cost Ledger Accounting system.
CIMA, London defines Non-integral system as a system in which the cost accounts
are distinct from financial accounts, the two sets of accounts being kept
continuously in agreement by the use of control accounts or made readily
reconcilable by other means.
Basic
Features of Non-Integral System:
(i) Separate ledgers are maintained for cost and
financial accounts.
(ii) Like financial accounting, it is also based on
double entry system.
(iii) There are no personal accounts because cost
accounts do not show relationship with outsiders.
(iv) Cost accounts are concerned with impersonal
accounts i.e., real and nominal accounts.
(v) In real accounts, only stocks are shown in cost
accounts.
(vi) Transactions affecting the nominal accounts are
recorded separately in detail. Thus cost accounting department is concerned
mainly with the ascertainment of income and expenditure of business,
(vii) Under this system one main ledger (i.e., Cost
Ledger) and various subsidiary ledgers are maintained,
(viii) Since the system is not properly integrated,
some items may appear in financial ledgers only, while some other items appear
only in cost ledger,
(ix) The profit or loss disclosed by the two sets of
accounts for a particular period will never be the same and as such a
reconciliation of costing profit or loss with that of financial accounts is
essential.
Ledgers
under Non-Integral Accounts:
(a) The principal financial ledgers are:
(i) General Ledger:
It contains all real, nominal and personal accounts
except trade debtors and trade creditors account.
(ii) Debtors Ledger:
It has personal accounts of trade debtors.
(iii) Creditors Ledger:
It has personal accounts of trade creditors.
(b) The principal cost ledgers are:
(i) Cost Ledger:
It is the principal ledger in cost books which
controls all other ledgers in the costing department. It contains all
impersonal accounts and is similar to General Ledger of financial accounts.
(ii) Stores Ledger:
It is a subsidiary ledger. It contains all stores
accounts.
(iii) Work-in-Progress Ledger:
It is a subsidiary ledger. It contains a separate
account for each job in progress. Each such account is debited with the
materials costs, wages and overheads chargeable to the jobs and credited with
the cost of work completed. The balance in this account shows the cost of
uncertified work.
(iv) Finished Goods Ledger:
It is a subsidiary ledger. It contains accounts of
completely finished goods and jobs. The cost ledger is made self-balancing by
opening a control account for each of the above subsidiary ledgers.
BBA
303
Cost
accounting
Important
Questions
Unit
I
1. How does cost accounting help in the planning and
control of operations of a business enterprise? And also differentiate between
cost accounting and financial accounting.
2. Write short note on:
(i) Types of costing
(ii) Advantages and limitations of cost accounting
3. What are the elements of cost? What is the basis
of classification of cost?
4. Following information has been obtained from the
records of a manufacturing concern:
1-1-2015 31-12-2015
Stock
of raw material 30,000 35,000
Work-in-process 15,000 20,000
Stock
of finished goods 43,700 54,000
Indirect
Wages 9,720
Sales 3,25,000
Factory
rent and rates 7,830
Office
Salaries 15,030
General
Expenses 13,500
Office
rent 2,000
Rent
of showroom 1,200
Purchase of Raw
material 1,20,000
Productive wages 90,000
Plant Repair 3,420
Depreciation on plant 8,360
Factory lighting 7,380
Salesman’s Salaries 7,650
Prepare cost sheet.
5. What is cost sheet? Explain its preparation.
Unit
II
6. List out the broad objectives of material
control. Explain the important requirements to attain these objectives.
7. Discuss the functions and advantages of a
Centralized Purchasing Department of a manufacturing concern.
8. From the following information, find out the
value of closing stock of product A on the basis of First-in, First out method:
Date Particulars Units Rate
1 Opening
stock 50 2
3 Receipts 400 2
14 Receipts 250 2.10
15 Issues 300 --
20 Receipts 400 2.30
21 Issues 600 ---
23 Receipts 700 2.20
28 Issues 450 ---
31 Issues 220 ---
9. State the functions of the purchase department in
any factory.
10. What is the procedure of the treatment of
material losses in any manufacturing organization?
Unit
III
11. Critically examine the advantages and
disadvantages of time wage system.
12. Give the classification of labor cost. What are
the various methods of wage payment?
13. How the labor cost can be controlled in any
organization?
14. Enumerate the different classification of
overheads. Explain briefly the meaning of the terms of fixed, semi variable and
variable overhead cost giving one example of each.
15.
Distinguish between allocation, apportionment and absorption of
overheads.
Unit
IV
16. What are the main features of unit costing? Give
its advantages and limitations.
17. Describe briefly the objectives of process
costing and also discuss the application of process costing.
18. Write note on:
(i) Advantages and limitations of job order costing
(ii) Types of cost in batch costing
19. What are the features, principles and advantages
of Integral accounting?
20. Define non integral accounting system. What are
the ledgers prepared under this system?
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