Meaning of Costing and Cost Accounting

The Chartered Institute of Management Accountants (CIMA), London has defined costing as, "the techniques and processes of ascertaining costs.” Wheldon has defined costing as, "the proper allocation of expenditure and involves the collection of costs for every order, job, process, service or unit." Thus, costing simply means cost finding by any process or technique. It consists of

principles and rules which are used for determining:

(a) The cost of manufacturing a product, e.g., motor car, furniture, chemical, steel, paper, etc., and

(b) The cost of providing a service, e.g., electricity, transport, education, etc.

The terms `costing' and `cost accounting' are often used interchangeably. Cost accounting is a formal system of accounting for costs in the books of account by means of which costs of products and services are ascertained and controlled.

An authoritative definition of cost accounting has been given by CIMA, London as follows: "the application of costing and cost accounting principles, methods and techniques to the science, art and, practice of cost control and the ascertainment of profitability. It includes the presentation of information derived there from for the purposes of managerial decision making."

Cost accountancy is thus the science, art and practice of a cost accountant.

Objectives of Cost Accounting

The main objectives of cost accounting are as follows:

1. Ascertainment of cost: The primary objective of cost accounting is to determine the cost of product manufactured or service rendered i.e. both aggregate cost and unit product costs. For cost ascertainment, various methods are employed in different industries like job costing, process costing, operating costing etc.

2. Cost control: Cost accounting aims at improving profitability by controlling and reducing costs. For this purpose, various specialized techniques like standard costing, budgetary control, inventory control, value analysis, etc., are used. This objective of cost control and cost reduction is becoming increasingly important in the present scenario because of growing competition in the business world.

3. Guide for managerial decision making : Cost data provide guidelines for various managerial decisions like make or buy, keep or replace, accept or reject, continue or drop a product.

4. Determination of selling price: Cost accounting provides cost information on the basis of which selling prices of products or services may be fixed.

Differences between Financial Accounting and Cost Accounting

In spite of the above points of similarity between financial and cost accounting, the two branches of accounting differ from each other in the following respects

(i) Purpose: Financial accounting records disclose profitability or otherwise, i.e., trading results as well as the financial position of a business. The chief purpose of cost accounting is to provide detailed cost information to management.

(ii) Nature: Financial accounting is historical in nature. The information provided by the records is in respect of only monetary transactions and events which have already occurred

and about which nothing can be done. Cost accounting, on the other hand, focuses not only with past transactions but of the future ones also.

(iii) Legality: Financial accounting is legally necessary, especially in the case of companies. Even in the case of other forms of business, financial accounting has almost become mandatory by virtue of the application of other enactments much as the Income Tax Act and Sales Tax Act. Cost accounting is not legally necessary except for certain specified industries.

(iv) Reporting: Financial accounting serves the interest of people belonging to different groups outside the organization such as shareholders, creditors, potential investors, workers, taxation authorities, financial analyst, government, trade unions. Therefore this branch of accounting accomplishes only external reporting of financial information. Cost accounting, however, serves the needs of management and thus accomplishes internal reporting.

(v) Periodicity: Financial accounting reports are prepared on annual basis while cost accounting reports are prepared on weekly, monthly, quarterly even daily basis depending on the needs of management.

(vi) Analysis of profit:. Financial accounts reveal the profit or loss of business as a whole for a particular period. Cost accounts show the detailed cost and profit data for each product line, department, division, section, process.

(vii) Focus: In Financial accounting focus is on recording, classifying and summarizing the financial transactions .In cost accounting the focus is on cost ascertainment and cost control.

(viii) Format of presenting information: Financial accounting has a single uniform format of presenting information, i.e., Profit and Loss Account, Balance Sheet and Cash flow statement Cost accounting has varied forms of presenting cost information which are tailored to meet the needs of management and thus lacks a uniform format.

(ix) Analysis of cost: In financial accounting, no distinction is made between direct and indirect costs, fixed and variable costs and controllable and uncontrollable costs. In cost accounting, costs are distinguished according to their identification with the cost units (direct and indirect), according to variability (fixed and variable), and according to responsibility (controllable and uncontrollable costs).

(x)

Use of standards: In financial accounting there are no predetermined standards of cost and performance to evaluate the efficiency of operations as regards the use of material, labour and overhead facilities. Cost accounting makes the use of standard costs against which actual costs are compared, variances are calculated and analyzed into their causes that corrective action may be taken.

Advantages of Cost Accounting

Cost accounting provides information that is useful to management in planning, control and decision-making. The main advantages of cost accounting are listed below:

1. It reveals unprofitable activities, losses, and inefficiencies such as wastage of material in the form of spoilage, excessive scrap, and idle time of labour and idleness of plant facilities. Management can take steps to check these wastes and losses.

2. It helps the management in fixation of prices. Accurate cost data can be used as a guide for preparation of quotations and submission of tenders.

3. It provides suitable data and information which helps the management in taking decisions such as make or buy, shut-down or continue selection of most profitable product-mix, acceptance or rejection of a special order, introduction of a new product, etc.

4. Detailed costs of materials, labour and overheads reveal actual and potential sources of cost saving and reduction.

5. Maintenance of time and job records for workers reveals losses incurred due to idle time. Such records assist in taking steps to minimize those losses.

6. Centralization of purchasing is facilitated by the use of cost accounting. This results in economical purchases.

7. A perpetual inventory system which facilitates continuous stock-taking helps in the preparation of interim profit and loss account.

8. Cost accounting lays the basis of standard costing and budgetary control systems. These two techniques help the management in cost control. Variance analysis and comparison of actual performance with budget estimates indicates areas where economies can be achieved.

9. A system of cost accounting provides an independent and reliable check on the accuracy of financial accounts. A reconciliation is made of the profit as shown by cost accounts with that shown by financial accounts.

10.

Installation of uniform costing enables management to make inter-firm comparisons.

COST CONCEPTS AND CLASSIFICATION

According to ICWA of India "Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering of services".

Cost Classifications

Classification is the process of grouping costs according to their common characteristics. It is a systematic placement of like items together according to their common features.

The principal bases on which costs are classified are:

1. Variability (behavioral classification)

2 Functional areas (functional classification)

3. Responsibility (controllable and uncontrollable costs) 4: Traceability/identifiably (direct and indirect costs)

Behavioral Classification

Fixed costs: These are unaffected by variations in the volume of activity. The total fixed costs remain constant over a relevant range of output, while the fixed cost per unit varies with the output. Fixed costs have no particular relation to the volume of activity. These are incurred irrespective of production and sales. These are usually time based. Some typical examples are rent, insurance, taxes and managerial salaries.

Variable cost: These are the costs which vary in direct proportion to changes in volume. They increase or decrease in the same proportion in which the output increases or decreases. The total amount of variable costs tends to change in respect to changes in production volume, but the variable cost per unit stays at the same level for a considerable period of time. The examples of such costs are direct material, direct labour, small tools, commission of salesmen, power.

Semi-variable costs: Also known as `mixed costs'. These costs include both a fixed and a variable component, i.e. these are partly fixed and partly variable. A semi-variable cost often has a fixed element below which it will not fall at any level of output. The variable element in semi-variable costs changes either at a constant rate or in lumps. For example, introduction of an additional shift in the factory will require additional supervisors and certain costs will increase by steps. In the case of a telephone connection, there is a minimum rent and beyond a specified number of calls, the charges very according to the number of calls made. In fact, there is no definite pattern of behaviour of semi variable costs. The examples of such costs are supervision, maintenance and repairs, telephone expenses, light and power, depreciation.

Functional Classification

Costs classified according to managerial functions are accumulated according to the activity performed. The costs of a typical organization may be divided into manufacturing, marketing, administrative and financing groups.

Manufacturing cost: These are related to the production of an item. These are the sum of direct materials, direct labour and factory overhead. In other words, these include all the costs incurred in the factory up to that stage when the goods are ready for dispatch. Examples are:

salaries of factory manager, supervisors and foremen, rent, rates and insurance of the factory, power and fuel used in the factory, depreciation, maintenance and repairs of building, plant, machinery tools, etc.

Administrative costs: These include all expenditures incurred in formulating the plans, directing the organization and controlling the operations. A major portion of these costs are policy costs which are of fixed nature and, therefore, uncontrollable. These include salaries paid to management and clerical staff, rent, rates and insurance of general offices, their lighting, heating and air-conditioning, depreciation of office buildings, furniture, machinery, etc.

Selling and distribution costs: Selling Cost: These are incurred to create and stimulate demand and to secure orders. These include salaries, commission and traveling expenses of salesmen and technical representatives and sales managers, advertising, catalogues, price lists, bad debts and collection charges, cost of market research, etc.

Distribution Cost: These are .the costs incurred in moving the goods from the point of production to the point of consumption. These include: warehouse expenses, carriage outwards, depreciation and upkeep of delivery vans, wages of packers, van drivers, etc.

Financing costs: These are costs incurred for raising and using capital, e.g. interest on loans and debentures, commission or brokerage on issue of shares and debentures, discount on the issue of shares and debentures, etc.

Controllability Classification

Costs are also classified in terms of responsibility over them. Responsibility carries the authority of the manager to influence costs-increase or decrease their amount. As such, there are two groups: Controllable anduncontrollable.

Controllable Costs. Costs are said to be controllable when the amount of the cost incurred can be influenced by the action of a specified member (manager or supervisor) of an undertaking.

Uncontrollable Costs. Costs which cannot be influenced by the action of a specified member (manager or supervisor) of an undertaking are known as uncontrollable costs.

The distinction between controllable and uncontrollable costs depends upon a point of reference. An item of cost may be uncontrollable at one level of management but the same item may be controllable at another level of management. Almost all costs are controllable at some level of management. Segregation of costs into controllable and uncontrollable categories will help the management in fixing responsibilities of different executives for unfavourable cost variances. An executive should be held responsible only for those costs which are under his control.

Manufacturing Classification

Costs are also classified as to when they are charged against revenue. The basis as the period benefited by the particular cost. This is essential in matching expenses against revenues in the relevant period. Such a grouping helps management in income measurement for the preparation of financial statements. Here, two categories are product costs and period costs.

Product Costs. These are the costs directly identified with the product. These are the cost of goods produced and kept ready for sale. They are direct materials, direct labour, variable factory overheads. These costs provide no benefit till the product is sold, and are, therefore, inventoried. When the products are sold, the total product costs are recorded as an expense, and is called “cost of goods sold”. It is matched against revenue for the period in which products are sold.

Period Costs. These are not directly related to the product and, therefore, not inventoried. If the period costs benefit only one accounting period, it is called revenue expenditure. If they benefit

two or more accounting periods, they are treated as assets till they are charged as expenditure for the relevant years. Normally, expense of fixed nature like depreciation of assets, insurance premium, rent and rates are treated as fixed costs. These costs represent non-operating items and are related to passage of time and not to the production and sales of the period.

Identification / Traceability Classification.

Costs are classified as direct and indirect costs on the basis of their identification with particular jobs, products or processes.

Direct Cost: It is a cost which can be directly identified with a product, process or department. Materials used and labour employed in manufacturing an article or in a particular process of production, are common examples of direct costs.

Indirect Costs: These costs are not traceable to any particular product, process or department, but are common to different products, processes or departments. Factory manager's salary, factory rent, depreciation of machinery, etc., are typical examples of indirect costs.

Sunk Cost:

It is a cost incurred as a result of decision made in the past which cannot be reversed or altered by any decision in the future. Sunk costs are irrelevant for decision-making. The written down values of assets previously purchased are sunk costs. Let us suppose the management of a company is considering the desirability of replacing an existing machine by a new one. Suppose, an old machine originally costs Rs. 20,000 and it has been depreciated to the extent of Rs. 15000 so far. If it is scrapped (no value being realisable on sale) there will be an accounting loss of Rs. 5000. It would be wrong to recognise this loss as a cost for deciding upon the proposed replacement. The book value of the existing machine is really a sunk cost and the decision to replace or not to replace the machine will not make any difference to its undepreciated value. It is irrelevant to the question of replacing the existing machine. The difference in income which will result from the installation of new machine and expected return on capital investment should be the deciding factor.

Elements of Cost

A cost is composed of three elements, i.e., material, labour and expense. Each of these elements may be direct or indirect.

Material Cost: According to CIMA, London, material cost is "the cost of commodities supplied to an undertaking.” Material cost includes cost of procurement, freight inwards, taxes, insurance, etc., directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refund on account of modvat, sales tax, etc., are deducted in determining the cost of material. Materials may be direct or indirect.

Direct materials: Direct material cost is that which can be conveniently identified with and allocated to cost units. Direct materials generally become a part of the finished product. For example, cotton used in a textile, clay in bricks, leather in shoes, steel in machines, cloth in garments, timber in furniture.

Indirect materials: These are those materials which cannot be conveniently identified with individual cost units. These are minor in importance, such as (i) small and relatively inexpensive items which may become a part of the finished product, e.g., pins, screws, nuts and bolts, thread, etc.,

(ii) those items which do not physically become a part of the finished products, e.g., coal, lubricating oil and grease, sand paper used in polishing, soap, etc.

Labour Cost: According to CIMA, London, labour cost is “the cost of remuneration (wages, salaries, commission ,bonuses etc) of the employees of an undertaking.” It includes all fringe

benefits like P.F.contribution, gratuity, ESI, overtime, incentive bonus, wages for holidays, idle time etc. Labour may be direct or indirect.

Direct labour cost consists of wages paid to workers directly engaged in converting raw materials into finished products. These wages can be conveniently identified with a particular product, job or process. Wages paid to a machine operator, shoe-maker carpenter, weaver, tailor is a case of direct wages.

Indirect labour: It is of general character and cannot be conveniently identified with a particular cost unit. In other words, indirect labour is not directly engaged in the production operations but only to assist or help in production operations. Supervisor, Inspector, Cleaner, Clerk, Peon, Watchmen are examples of indirect labour.

Expenses: All costs other than material and labour are termed as expenses. According to CIMA, London. It is defined as “the cost of services provided, to an undertaking and the notional cost of the use of owned assets.” Expenses may be direct or indirect.

Direct expenses: are those expenses which can be identified with and allocated to cost centres or units. These are those expenses which are specifically incurred in connection with a particular job or cost unit. Direct expenses are also known as chargeable expenses. Hire of special plant for a particular job, Travelling expenses in securing a particular contract, Cost of patent rights, Experimental costs, Cost of special drawings, designs and layouts, Job processing charges, Royalty paid in mining, Depreciation or hire of a plant used on a contract at site are examples of direct costs.

Indirect expenses: All indirect costs, other than indirect materials and indirect labour costs, are termed as indirect expenses. These cannot be directly identified with a particular job, process or work order and are common to cost units or cost centres. Rent and rates, Depreciation, Lighting and power, Advertising, Insurance, and Repairs are examples of indirect expenses.

Direct material + Direct labour + Direct expenses = Prime Cost Indirect material + Indirect labour + Indirect expenses = Overhead

Overheads are divided into three groups as follows:

(a) Manufacturing (works, factory or production) overheads: Such indirect expenses which are incurred in the factory and concerned with the running of the factory or plant are known as manufacturing overheads. Following are a few items of such expenses: Rent, rates and insurance of factory premises, power used in factory building, plant and machinery, etc.

(b) Office and Administrative Overheads. These indirect expenses are not related to factory but they pertain to the management and administration of business. Such expenses are incurred on the direction and control of an undertaking. Examples are: Office rent, lighting and heating, postage and telegrams, telephones and other charges, depreciation of office building, furniture and equipment, bank charges, legal charges, audit fee etc.

(c)

Selling and Distribution Overheads. Indirect Expenses incurred for marketing of a commodity, for securing orders for the articles, despatching goods sold, and for making efforts to find and retain customers, are called selling and distribution overheads. Examples are advertisement expenses, cost of preparing tenders, travelling expenses, bad debts, collection charges, warehouse charges, packing and loading charges, carriage outwards, etc.

Cost Sheet

The statement of cost according to element-wise is known as cost sheet. The preparation of cost- sheet is one of the most important and primary function of cost accounting. The statement discloses the following:

1. Prime cost

2. Work cost

3. Cost of production

4. Total cost

ABC Ltd.

COST SHEET FOR THE PERIOD…….

Production-Units

Direct Materials:

Opening stock Purchases Carriage inwards

Less: Closing stock Direct materials consumed Direct wages

Direct expenses

Prime Cost:

Add: Works or Factory Overheads: Indirect materials

Indirect wages

Rent and rates (factory) Lighting and heating Power and Fuel

Repairs and maintenance Cleaning

Drawing office expenses

Cost of research & experiments Depreciation of factory plant Works stationery

State insurance

Total cost (Rs.) Cost per unit(Rs.)

Welfare service expenses Insurance-Fixed assets etc.

-Stock and finished goods

Loose tools-Very small Works manager's salaries etc.

Works or Factory Cost:

Add: Office and Administrative Overheads: Rent and rates

Salaries

Lighting and heating Insurance Cleaning Telephone and postage Printing and stationery

Depreciation of furniture and office Equipments and buildings

Legal expenses Audit fees Bank charges

Cost of Production:

Add: Selling and Distribution Overheads: Showroom rent and rates Lighting and heating

Salemen’s salaries Commission Travelling expenses

Sales printing and stationery Advertising

Bad debts Postage

Depreciation and expenses of delivery vans Debt collection expenses

Carriage freight outwards Samples and other free gifts

ACCOUNTING FOR MATERIAL COST

Meaning of Materials

The term `materials' refer to all commodities supplied to an undertaking. Materials may be direct or indirect.

Direct materials are those materials which can be conveniently identified with and can be directly allocated to a particular product, job or process. Examples : timber in furniture, cloth in garments, milk & cream in ice cream, paper in books, gold/silver in jewellery, bricks & cement in building construction, steel in machines, leather in shoes.

Indirect materials are those materials which cannot be conveniently identified with and cannot directly allocated to a particular product, job or process. Examples :

1. Stores used for maintaining machines such as lubricant oil & grease, cotton waste, consumable stores etc.

2. Stores used by service departments (like power house, boiler house).

3. Materials of small value which can not be conveniently identified with a particular

product, job or process. For example, nails used in furniture, thread used in stitching garments.

Material Control

Material Control involves the planning, organising and controlling the procurement, storage and usage of materials so to as achieve the objectives of efficiency and economy.

Objectives of Material Control

The main objectives of material control are as follows:

1. To avoid the situation of under stocking i.e. to provide continous supply of required materials so that the activities of production and service departments may not be held up.

2. To avoid the situation of over-stocking i.e. to maintain optimum investment in inventory considering the operating requirements and financial resources ,so as , to reduce carrying costs.

3. To ensure the procurement of materials and stores of the required quality at minimum cost from a reliable source.

4. To minimise the total cost (i.e. ordering costs & carrying costs)

5. To avoid wastages and losses during storage and usage.

6. To maintain proper and upto date records of inventory

7. To provide the required information to the management so as to help the management in taking inventory decisions.

Essential Requirements of Material Control

The essential requirements of material control are as follows:

1. Proper Co-ordination - There should be proper co-ordination of all departments involved viz. Purchasing, Receiving, Inspection, Storage, Production, Cost and Finance.

2. Proper Purchase System - There should be proper purchase system to ensure the procurement of materials and stores of the required quality at minimum cost from a reliable source.

3. Proper Storage System - There should be proper storage system to ensure a place for everything and everything in its place and avoidance of losses during storage and minimum storage cost.

4. Proper Issue System - There should be proper system for the issue of materials to ensure that delivery of materials of the required quality in the required quantity at the required time upon requisition to the department making requisition.

5. Perpetual Inventory System - There should be perpetual inventory system so as to determine the quantity and value of each item of materials in stock at any point of time.

6. Continuous Stock Taking System - There should be continuous stock taking system so as to ensure accuracy of perpetual inventory records.

7. Internal Check System - These should be internal check system so that all transactions concerning materials are automatically checked.

8. Proper Budgetary Control System - There should be proper budgetary control system to ensure economy in purchasing and usage of materials and stores.

9. Proper Forms - There should be use of proper forms with regard to Purchase Requisition, Purchase Order, Material Received Note, Material Requisition, Bill of Materials, Material Returned Note, Material Transfer Note, Bin Card, Stores Card etc.

10. Proper Accounting System - There should be proper accounting system so as to determine the cost of materials at time of receipt and consumption.

11. Proper Reporting System - These should be proper reporting system to ensure regular reporting to the management regarding :

(a)

Materials purchased (b) Materials issued (c) Materials in hand (d) Slow-moving and obsolete stock etc.

Inventory Control

Inventory comprises -

(a) Stock of Raw-materials; (b) Stock of Work-in-progress;

Inventory control involves the planning, organising and controlling the purchase and storage of inventory so as to ensure the availability of inventory –(a) of the required quality(b) in the required quantity(c) at the required time(d) at the minimum cost.

Techniques of Inventory Control

The various techniques of inventory control are as follows:

1. ABC Analysis

2. Economic Order Quantity (EOQ)

3. Stock Levels, Minimum Level, Maximum Level, Recorder Level, Re-order Quantity.

4. Inventory Turnover Ratio and review of Slow and Non-moving items.

ABC analysis

ABC analysis is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of the investment involved. It is based on the principle of management by exception i.e. concentrate more on critical areas than others.

Usually all items of stores are classified into 3 categories according to their importance (i.e.

their value and frequency of replenishment during a period) as follows:

Category

Composition

Control

It consist of those items which require large investments(say about 70%of total value of stores) but consistute a small percentage(say

about 10%) of total items of stores.

High degree of control is excerised by use of various techniques such as fixing stock levels like max

level, min level, reoder level, determining EOQ.

It consist of those items which require relatively moderate investments(say about 20%of total value of stores) but consistute relativelymoderate percentage(say about 20%) of total items of stores.

Moderate degree of control is excerised. Orders are placed on periodic review basis.

It consist of those items which require small investments(say about 10%of total value of stores) but consistute a large percentage(say about 70%) of total items of stores.

Lower degree of control is excerised. Orders of large size are placed either after 6 months or once in a year to minimize ordering cost

and to take advantage of bulk purchase.

Advantages of ABC Analysis

The advantages of ABC analysis are the following:

(i) It ensures effective control on costly items (i.e. A category items) which require large investment.

(ii) It saves time and cost by exercising economic systems of control over low value items (i.e. C category items).

(iii) It ensures optimum investment in inventory considering the operational requirements and financial resources with the use of economic order quantities.

(iv) It ensures minimum total cost (i.e. ordering costs and carrying costs) of inventory.

(v) It helps in the maintenance of high inventory turnover rate.

Re-Order Quantity or Economic Order Quantity (E0Q)

Re-order quantity is the quantity for which order is placed when the stock reaches reorder level. It is known as economic order quantity when it is the quantity which is most economical to order. The EOQ refers to the quantity of inventory, at which total of ordering costs and the carrying costs is minimum. At EOQ the ordering costs are equal to carrying costs.EOQ is determined after considering the following factors:

(a) Ordering Costs- The term `Ordering Costs' refer to the costs incurred for acquiring inputs. These costs include -

(i) Cost of placing an order,

(ii) Cost of transportation,

(iii) Cost of receiving goods,

(iv) Cost of inspecting goods.

There is an inverse relationship between order size and ordering cost. Larger the order size, Lower the ordering costs because of fewer orders Smaller the order size , Higher the ordering costs because of more orders

(b) Carrying Costs- The term 'Carrying Costs' refer to the costs incurred in maintaining a given level of inventory. These costs include

(i) cost of storage space,

(ii) cost of handling materials,

(iii) cost of insurance,

(iv) cost of deterioration or obsolescence,

(v) cost of store staff

There is positive relationship between order size and carrying cost.

Larger the order size, higher the carrying costs because of high average inventory. Smaller the order size, lower the carrying costs because of low average inventory.

(c) Annual consumption (usage) of inventory: Importance of EOQ

The EOQ technique solves one of the major problems of the inventory management

i.e. the order quantity problem by answering to the question: “How much inventory should be ordered at a particular point of time?”

Following are the assumptions of EOQ:

1. Prior knowledge of Annual Usage (consumption) of inventory

2. Constant rate of usage

3. Constant ordering costs

4. Constant carrying costs, and

5. Zero lead-time/delivery period

EOQ may be determined by any of the following three methods:

(a) Graphical Method

(b) Tabular Method

(a) Graphical Method: The optimum quantity of inventory which should be ordered at a point of time is determined after achieving a trade off between ordering cost and carrying cost.

Cost (Rs)

Limitations of EOQ Technique

EOQ Order Size Q X

1. Expected annual usage may not be same as the actual due to unusual at unexpected demand for inventory.

2. Rate of usage may not be constant due to unusual and unexpected demand for inventory.

3. Ordering and carrying costs may not be constant due to fluctuations in the costs of various components comprising costs.

4. Lead-time may not be constant due to reason beyond supplier's control.

Stock Levels

Setting of various stock levels is one of the techniques of inventory control. The main purpose of setting various stock levels is to avoid the situation of under stocking and over stocking. These levels are not permanent but need revision according to the changes in the factors which determine these levels.

Maximum Stock Level: Maximum Stock Level is that level of stock above which the stock in hand should not normally be allowed to exceed. It is the largest quantity of a particular material which may be held in the store at any time. The objective of fixing the maximum stock level is to

avoid the costs of overstocking such as — Cost of storage, cost of investment in stock Cost of insurance, risk of obsolescence etc.

Maximum Stock Level is computed with the help of following formula:

Maximum Stock Level = Reorder Level + Reorder Quantity –( Minimum Consumption x

Minimum Reorder Period)

Minimum Stock Level : Minimum Stock Level is that level of stock below which the stock in hand should not normally be allowed to fall. It is the lowest quantity of a particular material which must be held in the store at all times. The objective of fixing the minimum stock level is to avoid the costs of understocking such as cost of stoppage of production due to shortage of materials like cost of idle labour, cost of idle plant & machinery etc.

Minimum Stock Level is computed with the help of following formula:

Minimum Stock Level= Reorder Level – (Normal Consumption x Normal Re-Order Period) Re-order level

Re-order level is that level of stock at which fresh order should be placed for replenishment of stock. It is fixed somewhere between maximum and minimum levels in such a way that fresh supplies are received in such a way that fresh supplies are received just before the minimum level is reached. It is the level at which purchase requisition should be made out for fresh supplies.

The objective of fixing Re-order Level is to determine when the fresh order should be placed for replenishment of stock.

Reorder Level is computed with the help of following formula:

Reorder Level= Maximum Consumption x Maximum Reorder Period

= Minimum Level + ( Normal Consumption x Normal Reorder Period ) Average Stock Level: Average Stock Level indicates the average stock held by the organisation.

This level of stock may be computed by using any one of the following formula:

Average Stock Level = Minimum Level + ½ Reorder Quantity

Or Maximum Level + Minimum Level

Danger level: Danger level is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made on special requisition approved by the competent authority .When stock reaches this level an urgent action is required for the fresh supplies of materials. It is generally below the minimum level. However some enterprises treat minimum level as danger level whereas some others fix the danger level above the minimum level but below the reorder level .Fixing danger level below the minimum level is meant for taking urgent corrective action whereas fixing it above the minimum level is for preventive action. The object of fixing danger level (below minimum level) is to determine when an urgent action is required for fresh supplies of materials.

Danger Level = Average Consumption x Maximum Reorder Period For Emergency Purchases.

Inventory Turnover Ratio

Inventory Turnover Ratio is one of the techniques of inventory control. It expresses the relationship between the cost of material consumed and the average stock held. The objective of computing the Inventory Turnover Ratio is to determine the efficiency with which inventories are maintained. In other words, the objective is to find out –

(a) Fast Moving Stock i.e. stock in great demand

(b) Slow Moving Stock i.e. stock in low demand

(d) Obsolete Stock i.e. stock no longer in demand

Inventory Turnover Ratio is computed with the help of following formula:

Inventory Turnover Ratio = Cost of materials consumed during a period = …..times

Cost of average stock held during the period

where, Cost of Materials Consumed= Opening Stock +Purchases-Closing Stock Average stock= ½ (opening stock + closing stock)

Average no of days for which an average inventory is held = 365 days

Inventory Turnover

It indicates the speed with which the inventory is consumed. In general, a high ratio indicates fast moving stock and a low ratio indicates slow moving stock. However, too high ratio and too low ratio call for further investigation. A too high ratio may be the result of a very low inventory levels which may result in frequent stock-outs and thus the firm may incur high stock-outs. On the other hand, a too low ratio may be the result of excessive inventory levels, slow-moving or dormant or obsolete inventory and thus, the firm may incur high carrying costs. Thus, a firm should have neither a very high nor a very low stock turnover ratio, it should have a satisfactory level. To judge whether the ratio is satisfactory or not, it should be compared with its own past ratios or with the ratio of similar firms in the same industry or with industry average.

On the basis of Inventory Turnover Ratio, the management may take the necessary corrective action such as -(a) Decision as to how to prevent the under-stocking of fast moving stock items. (b) Decision as to how to prevent the over-stocking of slow moving stock items. (c) Decision as to whether to retain or scrap the dormant stock items. (d) Decision as to scrapping or discard of obsolete stock items.

Just in Time (JIT) Purchasing

Just in time purchasing means purchase when required only or purchase immediately before use. CIMA, London defines , JIT purchasing as “matching receipts of materials closely with usuage so that raw materials inventory is reduced to near zero level .” The man objective of JIT purchasing is to minimize the carrying costs, storage costs, material handling costs, spoilage, obsolescence etc. An essential requirement of JIT purchasing is to enter into long term agreements with suppliers to deliver the materials even in smaller quantity timely as and when required. The effect of JIT purchasing is that the issue price of materials is likely to be closer to market prices.

Advantages of JIT Inventory Management

JIT inventory management boosts a company’s ROI by lowering inventory carrying costs, increasing efficiency and decreasing waste.

Waste Reduction: The JIT inventory management model eliminates overordering and excess of all kinds.

Reduce Obsolete Inventory and Dead Stock: Low inventory levels significantly reduce the risk of inventory going unsold and sitting in the warehouse obsolete.

Reduce Defective Product Loss: Defective inventory items are easier to identify and fix when production levels are low, which reduces scrap costs.

Improved Efficiency: JIT eliminates the costs that come with extra raw materials, unneeded inventory and product storage.

Raise Inventory Turnover Ratios: Greater efficiency brings higher inventory turnover.

Minimal Inventory Obsolescence: The high inventory turnover rate keeps items from sitting in your facility for too long and becoming obsolete.

Minimize Raw Materials on Hand: Receiving deliveries in the smallest possible quantities — sometimes multiple times per day — virtually eliminates raw material inventories.

Local Sourcing: When suppliers are located near a company's production facility, the shortened distances contribute to timely deliveries. On-time, reliable delivery of goods reduces the need for safety stock.

Greater Productivity: JIT enhances productivity by reducing the time and resources involved in manufacturing processes.

Faster Product Turnaround: Manufacturers can more quickly produce products.

Shorter Production Runs: With JIT, manufacturers can deliver new products more quickly and easily.

Simplify Change Orders: Having less raw material stock to draw down before product changes makes it easier to implement engineering change orders to existing products.

Smoother Production Flow: JIT can eliminate bottlenecks and delays across the entire production process.

Shorter Production Cycles: JIT shortens manufacturing time, which decreases lead times for customers.

Reduce Product Defects: Production mistakes can be spotted faster and corrected, which results in fewer defective products.

Shorter Production Runs: Fast equipment setup times reduce production runs, lowering investment in finished goods.

More Functional Production Cells: Employees walk individual parts through the processing steps in a work cell, which reduces scrap levels. Cell models also eliminate work-in-process queues that build up at more specialized workstations.

Compressed Operations: Arranging production work cells near each other limits the amount of work-in-process inventory moving between cells.

Lower Costs: Receiving goods on an as-needed basis reduces inventory costs.

Reduce Working Capital: The low inventory levels that come with JIT limit the amount of working capital needed. Lower Holding Costs: Inventory holding costs (like those for warehousing) are minimal because less space is used. Lower Cash Investment: Companies invest less cash in inventory because JIT doesn’t require having a lot of stock on hand.

Reduce Large Raw Material Spends: In JIT, businesses order raw material when needed, so cash is available for other uses that could be more valuable to the company.

Reduce Labor Costs: Labor expenses are lower since the number of person-hours required to fulfill orders is usually fewer than full-time production.

Improve Quality: A flexible workforce can focus on making quality products with lower defect rates. Better outcomes increase customer satisfaction and reduce the cash outlay for production.

Reduce Work-in-Progress Goods: Fewer items moving on the shop floor allows teams to focus on building high- quality products.

Less Damage: Since minimal inventory is on hand, storage-related accidents decline.

Certified Quality: Suppliers guarantee quality in advance. So, deliveries go straight to production areas instead of being held in receiving to await inspection.

To support these goals, you can invest in new technology or update existing solutions that will link your system with your suppliers to coordinate the delivery of parts and materials.

PRICING OF MATERIALS

Actual Cost Method - Where materials are purchased specially for a specific job, actual cost of materials is charged to that job. Such materials will normally be stored separately and issued only to that particular job.

First in First out Method (FIFO) - Under this method materials are issued out of stock in the order in which they were first received into stock. It is assumed that the first material to come into stores will be the first material to be used. CIMA defines FIFO as "a method of pricing the issue of material using, the purchase price of the oldest unit in the stock”.

Advantages

(i) It is easy to understand and simple to price the issues.

(ii) It is a good store keeping practice which ensures that raw material leave the stores in a chronological order based on their age.

(iii) It is a straight forward method which involves less clerical cost than other methods of pricing.

(iv) This method of inventory valuation is acceptable under standard accounting practice.

(v) It is a consistent and realistic practice in valuation of inventory and finished stock.

(vi) The inventory is valued at the most recent market prices and it is near to the valuation based on replacement cost.

Disadvantages

(i) There is no certainty that materials which have been in stock longest will be used, if they are mixed up with other materials purchased at a later date at different prices.

(ii) If the price of the materials purchased fluctuates considerably it involves more clerical work and there is possibility of errors.

(iii) In a situation of rising prices, production cost is understated.

(iv) In the inflationary market there is a tendency to under pricing of material issues and in deflationary market there is a tendency to overprice such issues.

(v) Usually more than one price has to be adopted for a single issue of materials.

(vi) It makes cost comparison difficult of different jobs when they are charged with varying prices for the same materials.

This method is more suitable where the size of the raw materials is large and bulky and its price is high and can be easily identified in the stores separately. This method is useful when the frequency of material receipts is less and the market price of the material are stable and steady.

Last in First out Method - Under this method most recent purchase will be the first to be issued. The issues are priced out at the most recent batch received and continue to be charged until a new batch received is arrived into stock. It is a method of pricing the issue of material using the purchase price of latest unit in the stock.

Advantages

(i) Stocks issued at more recent price represent the current market value based on the replacement cost

(ii) It is simple to understand easy to apply.

(iii) Product cost will tend to be more realistic since material cost is charged at more recent price.

(iv) In times of rising prices, the pricing of issues will beat a more recent current market price.

(v) It minimies unrealized inventory gains and tends to show the conservative profit figure by valuation of inventory at value before price rise and provides a hedge against inflation.

Disadvantages

(i) Valuation of inventory is not acceptable in preparation of financial accounts.

(ii) It is an assumption of a cost flow pattern and is not intended to represent the true physical flow of materials from the stores.

(iii) More than one rates may have to be adopted for an issue.

(iv) It renders cost comparison between jobs difficult.

(v) It involves more clerical work and some times valuation may go wrong.

(vi) In times of inflation, valuation of inventory under this method will not represent the current market prices.

Simple Average Cost Method -Under this method all the materials received are merged into exist existing stock of materials,their identity being lost. The simple average price is calculated without any regard to the quantities involved. The simple average cost is arrived at by adding the different prices paid during the period for the batches purchased by dividing the number of batches.

This method is not popular because it takes into consideration the prices of different batches but not the quantities purchased in different batches. This method is used when prices do not fluctuate very much and the stock values are small in value.

Weighted Average Cost Method - It is a perpetual weighted average system where the issue price is recalculated every time after each receipt taking into consideration both the total quantities and total cost while calculating weighted average price.

.~_ _

Material Losses

Waste: Waste is the portion of basic raw material lost in processing, having no recoverable value. Waste may occur due to evaporation, breaking the bulk, loading and unloading, leakage, inefficient handling, fire, etc. It may be visible or invisible, for example, gases, dust, smoke and unsaleable residues. The effect of waste is to increase the unit cost of production, since total cost is spread over a smaller number of good units.

Scrap. Scrap is defined as the incidental residue from certain types of manufacture usually of small amount and low value recoverable without further processing.

LABOUR COST

Meaning of Labour

Labour is the physical or mental effort expended, in manufacturing a product. Labour cost is the price paid for using human resources. The compensation to employees who work in production represents labour cost.

Labour Turnover

Labour turnover is the rate of displacement of personnel employed in an organisation. A high labour turnover is a sign of instability of labour. It results in low morale with the attendant costs associated with demoralised staff. It is important that labour turnover is kept-as low as possible. The low labour turnover rate is an indication of.

1. Well managed organization.

2. Higher preventive costs being incurred by the management for the satisfaction of employees.

3. Strong and well organised trade union exerting considerable influence over the management.

4. Considerable state regulatory control over the policy of the management in respect of employment and retrenchment.

5. Absence of alternative avenues for better employment and

6. Widespread unemployment as in India.

Labour turnover arises because of various factors including dissatisfaction with job, low rate of wages, unsatisfactory working conditions, and non-availability of adequate basic amenities. The causes of labour turnover may be sub-divided into:

1. Personal causes;

2. Avoidable causes, and

3. Unavoidable causes.

(i) Personal causes. These causes induce or compel workers to leave their jobs purely on personal grounds, including the following:

1. Change of job for betterment.

2. Premature retirement due to ill health and old age.

3. Domestic responsibilities to look after old parents.

4. Discontentment over the job and working environment.

5. Marriage, especially female workers or later on childbirth.

6. During seasons of festivals, marriage or harvesting, the workers in the cities leave for home in large batches.

(ii) Avoidable causes. These include:

1. Low wages in the present organisation and the worker may look for higher wages elsewhere,

2. Dissatisfaction with job,

3. Bad working conditions,

4. Long and odd working hours,

5. Unsatisfactory relationship with the supervisors,

6. Bad relationship with the fellow workers,

7. Lack of adequate recreational facilities,

8. Inadequate housing, medical facilities,

9. Unfair methods of promotion and lack of promotional avenues,

10. Lack of planning and foresight on the part of management, seasonal nature of industry, non availability of raw materials, power, etc.

(iii) Unavoidable causes. These include:

1. Seasonal nature of business,

2. Change in the plant location,

3. Shortage of raw material; power; slack market for the product,

4. Accident or illness rendering workers permanently incapable to work,

5. Dismissal or discharge due to insubordination, negligence, inefficiency, etc.,

6. Marriage, specially in case of women workers.

Effect of Labour Turnover : The higher rate of labour turnover results in increased cost of production. This is due to:

1. Increased cost of new recruitment and training,

2. Interruption of production,

3. Decrease in production due to inefficiency and inexperience of newly recruited workers,

4. The new workers are more accident prone and are liable to cause more damage to machinery, tools than old employees,

5. Losses due to wastage, spoilage and defectives,

6. Increased number of accidents causing loss of output and increase in medical expenses and cost of repairs.

7. Lack of cooperation and coordination between old and new employees resulting in fall in output and increased cost of production.

Methods of Remuneration (Systems of Wage Payment)

There are two basic methods of labour remuneration: (a) Time Rate System; and (b) Piece Rate System.

In addition, there are a number of incentive plans to induce workers to work hard so as to produce more and earn more.

Time Rate System

Under time rate system, workers are paid according to the time for which they work Payment may be on hourly basis; daily basis or monthly basis. In this system consideration is given to the quantity and quality of work done. When payment is made on hourly basis, total wages payable are calculated as follows:

Wages = No. of hours worked x Rate per hour

For example, if a worker is paid at the rate of Rs. 25 per hour, his wages for a day of 8 hours will be: 8 hours x Rs. 25 = Rs. 200. Though this is the oldest system of wage payment, it is still commonly used these days.

Time wage system is suitable for the following type of situations:

(i) Where quality of work is more important than quantity, e.g., high class tailoring.

(ii) Where output cannot be measured in quantitative terms, e.g., in the case of indirect workers like watchman, cleaners and sweepers, etc.

(iii) Where output is beyond the control of the worker, e.g., in process industries the flow of work is regulated by the speed of conveyor belt or where the work of a worker is dependent on the work of other workers.

(iv) Where work is being done on a small scale so that close supervision is possible.

(v) Where the worker is a learner or an apprentice.

Advantages:The main advantages of time rate system are:

(i) Simplicity. The system is simple and calculation of wages is easily understood by workers.

(ii) Security to workers. Workers are assured of a certain amount of wages payable if there is stoppage of work due to power failure, machine breakdown, etc. This gives a sense of

security to workers.

(iii) Quality of work. As this method does not give weight to the quantity of work done, workers can concentrate on the quality of goods produced thus the quality of work under this method is better.

(iv) Accepted by trade unions. Trade unions mostly favour this method because it treats all workers alike and no distinction is made between efficient and inefficient workers.

(v) Economical. Under this method, no detailed records are required to be maintained regarding the work done by workers. This results in saving of clerical costs. Moreover workers avoid over-speeding and cause less damage to plant and machinery and materials. This also results in economy.

Disadvantages: The main disadvantages are:

(i) No incentive. It offers no positive inducement to workers to improve performance as it does not distinguish between efficient and inefficient workers.

(ii) Low quantity. When workers are-paid on time basis, they tend to be slow in work. This results in lower production quantity.

(iii) Extra supervision costs. Under this method, extra supervision is needed so that workers do not waste time. Appointment of additional supervisors increases cost

(iv) Costing difficulties. From costing point of view, it creates difficulties in the calculation of labour cost per unit because the output is constantly, fluctuating

(v) Idle time. Workers waste a lot of time resulting in increase in idle time.

Piece Rate System

Wages under this system are paid according to the quantity of work done. A rate is fixed per unit of production and wages are calculated by the following formula

Wages = Rate per unit x No. of units produced

For instance, if rate per unit is Rs. 17 and during a day a worker has completed 10 units, then his wages will be Rs. 17 x 10 units = Rs. 170.

This method does not give any consideration to the time taken by the worker completing the work. Only quantity of work is taken into account for calculating wages. ,

Suitability of piece rate system Conditions under which piece rates may be useful employed are:

(a) Where production. is standardised and repetitive in nature.

(b) When the aim is continuous maximum production.

(c) Where the output of workers can be measured.

(d) Where workers continue at the same job for long periods.

(e) Where the standard time required to complete a job can be measured accurately.

Advantages: Piece rate system has the following advantages:

1. Incentive to efficient workers: As remuneration is in proportion to the worker effort, the method provides a strong incentive to work more.

2. Increase in production: Each worker tries his best to produce more to earn higher wages. This results in increase in production.

3. Lower Cost: On account of increase in production, fixed cost per unit is reduced resulting in higher profit.

4. Equitable: This system is more equitable than time rate system because wages are paid according to the efficiency of each worker.

5. Decrease in supervision : Strict supervision is not necessary because the workers interested in maximising their earnings through the maximization of output.

6. Simplifies costing: As wages are paid at a rate per unit, this method simplifies cost ascertainment because labour cost per unit is known in advance.

7. Simple and easy: This method is simple and is easily understood by the workers.

Disadvantages : Piece rate system suffers from the following limitations:

1. Poor quality of work: This method lays too much emphasis on quantity of production and ignores quality of work. In order to maximise their wages, workers try to produce more and more without caring for the quality of production.

2. No security of wages: This system does not guarantee a minimum wage to a worker If a worker is not able to complete his day's work, for any reason, he is paid less, thus earnings of workers are uncertain.

3. Misuse of materials and equipment: In the greed to produce more, workers may of materials and damage to plant and machinery.

4. Injurious to health of workers: In an effort to earn more wages, workers try to work excessively and with speed. This proves injurious to the health of workers.

5. Opposed by trade unions: Piece rate system is generally opposed by trade unions because it creates inequality in the wages of workers. Slow and inefficient workers feel jealous of the higher wages of their fellow workers. .

6. Difficulties in fixing piece rate: Fixing equitable piece rate is quite a difficult task and may require considerable amount of work in the form of time studies.

7. Unsuitable in certain cases: This method does not suit where work is of artistic and refined nature.

TIME-KEEPING AND TIME BOOKING

Time-Keeping Department

Time-keeping forms a most valuable link in a harmonious labour-management relationship. Most companies have a separate time-keeping department accumulating the total numbers of hours worked for each employee. It embraces two functions:

l. Time-keeping, i.e. recording of time of workers for purpose of attendance and wage calculations.

2. Time-booking, i.e. reporting of each worker's time for each department, operation and job for the purpose of cost analysis and apportionment of labour costs between various jobs and departments.

Purposes of Time-Keeping

Recording of time is essential for the following purposes:

1. Preparation of pay rolls, where the workers are paid on time basis.

2. Meeting the statutory requirements.

3. For internal administration, like increments, pension, provident fund, gratuity and leave benefits.

4. For proper distinction between direct and indirect costs, normal time and overtime, and regular and late comers.

5. For overhead rates, if based on labour hours.

6. For enforcing regularity, discipline and ensuring daily requirement of labour force in the factory.

Methods of Time-Keeping or Recording

The following are the usual methods of recording attendance of workers at the gate of a factory:

1. Manual Methods:

(a) Attendance Register, and (b) Disc or Token system.

2. Mechanical Methods:

(a) Time Recording Clock, and (b) Dial Time Recorders.

Manual methods.

(i) Attendance Register Method (Hand-Written Record): Under this method, a register, with necessary column like name, identity no. of the employee and arrival and departure time is maintained.

(ii) Disc or token or check method: Under this method, each worker is allotted a metal disc or token bearing his identification. On each disc the name and number of the worker is engraved or painted. all the tokens or discs are hung on a board serially before the arrival time of the workers as soon as a worker reports for duty on the appointed time , he removes his/her disc from the board and puts into a box. Immediately after the scheduled time for entering into the premises of the factory the board is removed and a list is prepared of all such discs or tokens not collected and dropped into the box by the workers. The late-comers collect their discs and hand over personally to the time-keeper. The list of late-comers is prepared separately. The tokens not removed from the board represent the absentee workers. This method may be adopted with some variations such as: (a) the discs or tokens instead of dropping into the box by the workers at the gate of the factory are deposited in the respective departments. Factories may adopt either of these methods, convenient to them keeping in view the number of workers and the distance between gate and the work point. With the help of

these- lists the time-keeper records the attendance in the register known as Muster Roll for the purpose of pay rolls.

Although these methods are simple and economical, yet they are open to many abuses. The disadvantages are:

1. A worker may remove the disc of his fellow-worker to ensure his presence who is either late or absent.

2. There is no certainty that the exact arrival time of the workers has been recorded. The timekeeper marking the attendance may commit errors deliberately or through carelessness and this may result in many disputes.

3. The time-keeper may include the dummy or ghost workers in the muster roll that cannot be easily detected except by a surprise check by some responsible officials.

The manual methods of recording attendance of the workers, therefore, cannot be taken as being foolproof.

Idle Time

Idle time is that time for which the worker has been paid, without giving any production to the employer. Idle time normally results from poor production scheduling and lack of sales order. It is necessary to identify the reasons for the idle time, otherwise it would be difficult for the management to exercise effective control over the labour costs. The idle time normally arises due to normal and abnormal causes:

(i) Normal causes: Whatever precautions may be taken, some idle time is inherent in every situation. Normal causes for which idle time arises are:

1. Time lost between factory gate and place of work. 2.Time taken in picking up the work for the day.

3 The interval between one job and another.

4. The setting-up time for the machine.

5. Time taken for personal needs, and

6. Time lost due to normal fatigue

If the time lost is. due to the above-mentioned reasons, it is known as normal idle time.

(ii) Abnormal causes : Idle time may also arise, due to abnormal factors.

1. Temporary lack of work.

2. Breakdown of machinery.

3. Power failure.

4. Non-availability of raw materials, and

5. Strikes, lockouts, floods, fires etc.

Idle Time and Idle Capacity

Idle capacity means that plant and machinery is available for utilisation but is not fully used due to normal or abnormal reasons.

Overtime

Over and above the normal working hours, if a worker spends more time on the job, it is generally known as overtime. .

OVERHEAD COST

Meaning of Overheads

Indirect costs refer to overhead costs. Such costs cannot be conveniently identified with a particular product, process or department. It consists of those costs, which the cost accountant is unable or unwilling to allocate to particular cost units. These are common costs like rent, repairs, and salaries, which are incurred for the benefit of a number of cost unit or centres. Thus indirect expenditure of any kind is indicated by overhead and in other words, it is called overhead. Overhead is the aggregate of all indirect materials cost, indirect labour cost and indirect expenses, including services, which cannot be conveniently identified to a specific cost centre or cost object or product.

The following are the some of the authoritative definitions of overheads are reproduced below:

ICMA,

London

“Overhead is the aggregate of indirect materials, indirect wages and indirect expenses.”

CIMA,

London

“Expenditure on labour, materials or services which cannot be economically identified with a specific saleable cost unit.”

Classification of Overheads

Classification of overheads refers to the process of grouping the overhead cost into different class/group on the basis of some common characteristics. The classification can be summarized as follows:

Classification of Overheads on the Basis of Function

Ø PRODUCTION OVERHEADS

These overhead includes all indirect cost which have been incurred in connection with production of a manufactured commodity. These consist of indirect material, indirect labour and indirect expenses incurred from the stage of procurement of materials till completion of the finished good. It is also known as, factory overheads, manufacturing overheads, works overheads, factory cost or works cost etc. They are the expenses incurred in maintaining and operating a manufacturing division of an organization. Unlike direct material and direct labour, production overheads are an invisible part of the finished product. They consist of:

Indirect Material

(i) Cost of consumable stores and supplies such as cotton waste, lubricating oil etc.

(ii) Cost of stationery, printing, postage used in the works

Indirect Labour

(i) Salary paid to store-keepers, works manager, departmental superintendents, supervisor, clerical staff of the factory etc.

(ii) Overtime wages

(iii) Wages for normal idle time

(iv) Contribution to provident fund, leave pay, maternity pay of factory employees

Indirect Expenses

(i) Rent, rates and taxes of factory building

(ii) Power and fuel

(iii) Cost of training new employees

(iv) Lighting and heating charges of the factory

(v) Factory telephone expenses

(vi) Repairs, insurance, depreciation of factory building, plant and machinery and factory furniture

Ø ADMINISTRATION OVERHEADS

These represent all those expenses associated with formulating the policy, directing the organization and controlling the operations (including secretarial accounting and financial control) of an undertaking, which are not related directly to production, selling, distribution, research or development activity. These costs are of a general nature and not directly related to other functions namely production, sales and distribution. These represent the aggregate of material cost, labour cost and expenses incurred by administration department for general management of an organization. These overheads are also known as office overheads or general overheads. It generally consists of the following costs:

Indirect

Material

(i) Cost of printing, postage & stationery used in Administration department

(ii) Cost of dusters, brushes etc. for cleaning

Indirect Labour

(i) Salary paid to office staff

(ii) Salary and allowances or fees of managing director, whole time director, general manager, finance manager, accounts manager, secretary and other staff working in the office

(iii) Remuneration of auditors and legal advisors

(iv) Counting house salaries

Indirect Expenses

(i) Office rent, rates and taxes

(ii) Repairs, insurance & depreciation of office building, equipment and furniture

(iii) Office lighting, heating and cleaning

(iv) Administration office telephone expenses

(v) Bank charges

(vi) Trade subscription

(vii) Sundry office expenses

Ø SELLING OVERHEADS

Selling overheads are the cost of seeking to create and stimulate demand and of securing orders. It comprises the cost to products of distributors for soliciting and recurring orders for the articles or commodities dealt in and of efforts to find and retain customers. These represent the aggregate of material cost, labour cost and expenses incurred by sales department for the sales management to sell the product of an organization. These all costs are in nature of indirect costs. It consists of the following costs:

Indirect Material

(i) Cost of printing, postage and stationery used in sales department

(ii) Cost of catalogues, price lists etc.

Indirect Labour

(i) Salary of sales director, sales manager, salesmen, sales officer and other staff working in sales department

(ii) Commission to selling agents

Indirect Expenses

(i) Advertising, bad debts and debt collection charges

(ii) Rent, rates, insurance & taxes of sales office/showroom

(iii) Repairs, insurance & deprecation of sales office building, equipment and furniture

Ø DISTRIBUTION OVERHEADS

Distribution overhead is the expenditure incurred in the process which begins with making the packed product available for dispatch and ends with the making the reconditioned returned empty package, if any, available for re-use. It includes expenditure incurred in transporting articles to central or local storage. It also comprises expenditure incurred in moving articles to and from prospective customer as in the case of goods on sale or return basis. In other words, Distribution overheads comprise all expenditures incurred from the time product is completed in the factory till it reaches its destination or customer. It represents the aggregate of material cost, labour cost and expenses incurred in connection with distribution department. It consists of the following costs:

Indirect Material

(i) Cost of packing

(ii) Cost of printing, postage and stationery used in distribution department

(iii) Cost of oil, grease etc.

Indirect Labour

(i) Salary of staff working in distribution department

(ii) Salary of driver of distribution vehicle

Indirect Expenses

(i) Rent, rates and taxes of distribution office

(ii) Repairs, insurance and depreciation of distribution office building, delivery van etc.

(iii) Freight and carriage outwards

(iv) Running expenses of delivery vans

1.4.1 Classification of Overheads on the Basis of Element

Ø INDIRECT MATERIALS

Indirect material costs are the cost of materials which cannot conveniently be allocated and identified to a particular cost centre or cost object in an economically feasible way but can be apportioned to or absorbed by a particular cost centre or cost object. Examples of indirect material are:

· Consumable stores

· Stationery

· Coal

· Lubricants

· Tools

Ø INDIRECT LABOUR

Indirect labour costs are the cost of labours (wages) which cannot conveniently be allocated and identified to a particular cost centre or cost object in an economically feasible way but can be apportioned to or absorbed by a particular cost centre or cost object. Examples of indirect labour are:

· Salary of General Manager

· Salary of Accountants

· Salary and commission of Salesmen

· Salary and wages of Supervisors, Foremen and Operators

· Wages of sweeper

Ø INDIRECT EXPENSES

Indirect expenses are the expenses other than of the nature of indirect material or indirect labour, which cannot conveniently be allocated and identified to a particular cost centre or cost object in an economically feasible way but can be apportioned to or absorbed by a particular cost centre or cost object. Examples of indirect expenses are:

· Power, lighting and heating

· Advertising expenses

· Rent, rates and insurance

· Sundry expenses like legal charges audit fees etc.

· Depreciation, repairs and maintenance

· Welfare expenses like canteen, medical, recreation service etc.

1.4.2 Classification of Overheads on the Basis of Controllability

Ø CONTROLLABLE OVERHEADS

Controllable overhead costs are indirect costs which the management of a manufacturing concern can keep under its control, as they are influenced by its decisions. Therefore those overheads which can be influenced by the management decisions are called controllable overheads. The examples of controllable overheads are indirect materials, power expenses and lighting expenses.

Ø UNCONTROLLABLE OVERHEADS

Uncontrollable overhead costs are indirect cost which are beyond the control of the management are known as uncontrollable overheads. The management cannot influence such expenses by its decisions and implementing proper policies, therefore, they are uncontrollable. The examples of uncontrollable overheads are managerial salary, factory rent, office salaries, depreciation, and legal expenses.

1.4.3 Classification of Overheads on the Basis OF Normality

Ø NORMAL OVERHEADS

Normal overheads refer to those overheads costs which are expected to be incurred at a given level of output. These overheads are unavoidable and uncontrollable. This cost is a part of cost of production.

Ø ABNORMAL OVERHEADS

Abnormal overheads refer to those overheads costs which are not expected to be incurred at a given level of output. These overheads are avoidable and controllable. This cost is not a part of cost of production. In fact, such costs are charged to costing profit and loss account. For example, cost of abnormal idle time.

1.4.4 Classification of Overheads on the Basis of Behaviour

Ø VARIABLE OVERHEADS

Variable overhead costs are those costs which vary in direct proportion to the volume of output

i.e. total variable overheads decrease as the production volume decreases and vice versa. Variable overheads per unit remain same. Examples are indirect material, indirect labour, salesmen’s commission, power etc. Variable overhead changes in total but its incidence on unit cost remains constant.

Suppose, for a manufacturing unit variable overheads per unit is Rs. 20. It will remain fixed and does not change with the changes in the volume of output. This can be observed from the following scenario:

Ø SEMI-VARIABLE OVERHEADS

These overhead costs are partly fixed and partly variable. That is why they are termed as semi- variable overheads because they consist of both kind of element i.e. fixed and variable.

Ø FIXED OVERHEADS

Fixed overheads comprise of those expenses which do not change with the change in the volume of production upto a given range. Fixed overheads have two characteristics:

(i) Total fixed overheads do not vary with the change in the volume of production upto a given range.

(ii) Fixed overhead cost per unit varies with the change in the volume of production i.e. fixed overheads per unit decreases as the production increases and vice versa.

Allocation of Overheads

According to the Chartered Institute of Management Accountants, London, cost allocation is “that part of cost attribution which charges a specific cost to a cost centre or cost unit”. Allocation of overheads is the process of charging the full amount of overheads to particular a cost center or cost unit. Thus, it is a direct process of identifying overheads to the cost units or cost center.

For example, electricity charges can be allocated to various departments if separate meters are installed, indirect materials can be easily allocated to various departments in which they are incurred.

Statement showing the allocation of overheads

Items of overhead	Production Department			Service Department
Items of overhead	A	B	C	D	E
Direct Material	-	-	-	XXX	XXX
Direct Wages	-	-	-	XXX	XXX
Direct Expenses	-	-	-	XXX	XXX
Indirect Material	XXX	XXX	XXX	XXX	XXX
Indirect Wages	XXX	XXX	XXX	XXX	XXX
Total Overheads allocated	XXX	XXX	XXX	XXX	XXX

Apportionment of Overheads (Primary Distribution)

Apportionment refers to the distribution of overheads among departments or cost centres on an equitable basis. In other words, apportionment involves charging a share of the overheads to a cost centre or cost unit. CIMA, London has defined it as “that part of cost attribution which

shares costs among two or more cost centres or cost units in proportion to the estimated benefit received, using a proxy”. Apportionment is done in case of those overhead items which cannot be directly allocated to a particular department. Wherever possible, the overheads are to be allocated. However, if it is not possible to charge the overheads to a particular cost center or cost unit, they are to be apportioned to various departments on some suitable basis.

For example, if separate meters are installed in every department, the electricity expenses can be allocated to various departments. However if separate meters are not installed, electricity expenses will have to be apportioned to the departments on some suitable basis like number of light points.

BASIC PRINCIPLES OF APPORTIONMENT OF OVERHEADS:

Overheads are to be apportioned on following two principles:

(i) Cause and

(ii) Benefits received

Re-Apportionment of Service Department Costs (Secondary Distribution of Overheads)

Once the overheads have been allotted and apportioned to production and service department, the next step is re-distribution of overheads of service department to production department on some suitable basis. It is necessary, as our ultimate goal is to charge the total overhead costs to cost unit and no cost unit passes through service departments.

(1) Re-apportionment on non-reciprocal basis (step-ladder method):

This method is used when a service department renders services to the production and other service department but does not receive services of the services department. The following steps involved in this method:

(a) The service departments are arranged in descending order on the basis their serviceability to production and service department.

(b) Apportion the cost of first service department which serves the maximum number of services to all the production and other service departments.

(c) Apportion the cost of next largest service provider department to all the production and other service departments (excluding the first service department)

(d) This process continues till the cost of last service department is apportioned.

(e) In the end, the cost of last service department is apportioned only to the production departments.

(2) Re-apportionment on reciprocal basis:

This method recognizes the fact that where two or more service departments render services to each other, each department receiving such services should be charged for the cost of

services rendered by the other. This means a service department not only provides its services to other service departments but also receives services of other service departments. For example, power house provides power to maintenance department and maintenance department provides services power house. Re-apportionment of service department costs on reciprocal basis can be by using any one of the following method:

(a) Simultaneous Equation Method: In this method, total cost of each service department is apportioned to production department only by forming and solving simultaneous equation.

X = a+bY Y = a+bX

Where, X denotes the total cost of service department X Y denote the total cost of service department Y

a denotes cost of a service department before re-apportionment

b denotes share of cost of one service department to be distributed to other service department

(b) Repeated Distribution Method: Following steps are followed to apportion the cost of service department:

(i) Apportion the cost of first service department to production department and other service department in given percentages. After distribution at this level, the account of service department will be closed.

(ii) Apportion the cost of second service department (plus apportioned cost received in step 1) to production department and other service department in given percentages.

(iii) Apportion the cost of next service department (plus apportioned cost received from previous steps) to production department and other service departments in given percentages.

(iv) The above procedure should be followed till the value of all service departments become negligible small. In the end, the small figures left should be apportioned to production department only.

Thursday, 1 December 2022

Meaning of Costing and Cost Accounting

Objectives of Cost Accounting

Differences between Financial Accounting and Cost Accounting

Advantages of Cost Accounting

COST CONCEPTS AND CLASSIFICATION

Cost Classifications

Behavioral Classification

Functional Classification

Controllability Classification

Manufacturing Classification

Identification / Traceability Classification.

Sunk Cost:

Elements of Cost

Cost Sheet

Direct Materials:

Prime Cost:

Works or Factory Cost:

Cost of Production:

ACCOUNTING FOR MATERIAL COST

Material Control

Objectives of Material Control

Essential Requirements of Material Control

Inventory Control

Techniques of Inventory Control

ABC analysis

Re-Order Quantity or Economic Order Quantity (E0Q)

Limitations of EOQ Technique

Stock Levels

Maximum Stock Level = Reorder Level + Reorder Quantity –( Minimum Consumption x

Minimum Stock Level= Reorder Level – (Normal Consumption x Normal Re-Order Period) Re-order level

Danger Level = Average Consumption x Maximum Reorder Period For Emergency Purchases.

Just in Time (JIT) Purchasing

Material Losses

LABOUR COST

Labour Turnover

Methods of Remuneration (Systems of Wage Payment)

Time Rate System

Piece Rate System

TIME-KEEPING AND TIME BOOKING

Purposes of Time-Keeping

Methods of Time-Keeping or Recording

1. Manual Methods:

2. Mechanical Methods:

Manual methods.

Idle Time

Idle Time and Idle Capacity

Overtime

OVERHEAD COST

Classification of Overheads

Classification of Overheads on the Basis of Function

Ø PRODUCTION OVERHEADS

Ø ADMINISTRATION OVERHEADS

Ø SELLING OVERHEADS

Ø DISTRIBUTION OVERHEADS

1.4.1 Classification of Overheads on the Basis of Element

Ø INDIRECT MATERIALS

Ø INDIRECT LABOUR

Ø INDIRECT EXPENSES

1.4.2 Classification of Overheads on the Basis of Controllability

Ø CONTROLLABLE OVERHEADS

Ø UNCONTROLLABLE OVERHEADS

1.4.3 Classification of Overheads on the Basis OF Normality

Ø NORMAL OVERHEADS

Ø ABNORMAL OVERHEADS

1.4.4 Classification of Overheads on the Basis of Behaviour

Ø VARIABLE OVERHEADS

Ø SEMI-VARIABLE OVERHEADS

Ø FIXED OVERHEADS

Allocation of Overheads

Apportionment of Overheads (Primary Distribution)

(i) Cause and

Re-Apportionment of Service Department Costs (Secondary Distribution of Overheads)

(2) Re-apportionment on reciprocal basis:

Advanced Financial Management