B. COM. PART-III (SEM-V) B.C.

503
COST ACCOUNTING-I

BOTH MEDIUM
PART-1

LESSON NO. :
Department of Distance Education

UNIT NO. I

1.1 : NATURE OF COST ACCOUNTING

Punjabi University, Patiala

1.2 : ELEMENTS OF COST

(All Copyrights are Reserved)

1.3 : COST AUDIT

1.4 : MATERIAL CONTROL

1.5 : INVENTORY CONTROL AND EVALUATION

Note : Students can download the syllabus from department's

website www.pbidde.org
B.COM. PART-III B.C. 503
COST ACCOUNTING

LESSON NO. 1.1 AUTHOR : DR. J.S. PASRICHA

NATURE OF COST ACCOUNTING

1.1.1 Objective
1.1.2 Introduction
1.1.3 Financial Accounting and its limitations
1.1.4 Definitions
1.1.4.1 Cost
1.1.4.2 Cost Unit
1.1.4.3 Cost Centre
1.1.4.4 Costing
1.1.4.5 Cost Accountancy
1.1.4.6 Cost Accounting
1.1.5 Scope of Cost Accounting
1.1.5.1 Cost Ascertainment
1.1.5.2 Cost Presentation
1.1.5.3 Cost Control
1.1.6 Objectives of Cost Accounting
1.1.6.1 Advantages of Cost Accounting
1.1.6.2 Limitations of Cost Accounting
1.1.7 Methods of Costing
1.1.7.1 Job Costing
1.1.7.2 Process Costing
1.1.7.3 Multiple or Composite Costing
1.1.7.4 Illustration-1
1.1.8 Financial Accounting Vs. Cost Accounting
1.1.9 Installation of Costing System
1.1.9.1 Objectives of Designing
1.1.9.2 Steps in Designing
1.1.9.3 Essentials of a Good Costing System
Self check Exercise
1.1.10 Summary
1.1.11 Answers to self check questions
1.1.12 Glossary
1.1.13 Exercise
1.1.14 Suggested Readings 1
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1.1.1 OBJECTIVE
Cost Accounting is one of the three branches of accounting.i.e (i) Financial
Accounting,(ii) Cost Accounting and (iii) Management Accounting. Each of these has
its own extent and scope. The objective of this Lesson is to enlight the students
with the cost accounting system as a branch of accounting dealing with the
classification, recording, allocation, summarisation and reporting of current and
prospective cost.
1.1.2 INTRODUCTION
The origin of Cost Accounting can be traced to the beginning of 20th century. The
system of large scale production in factories created new problems in accounting.
The amount and varieties of expenditure increased and many new items of cost not
only increased the calculations but also gained prominence. The financial accounting
was exposed of its limitations. It failed to meet the requirements of modern
Industries.
1.1.3 FINANCIAL ACCOUNTING AND ITS LIMITATIONS
Financial Accounting : The definition of accounting given by the chartered Institute
of Management Accountants, London is as given below :
1. “the classification and recording of monetary transactions; and
2. the presentation and interpretation of the results of those transactions in
order to assess performance over a period and the financial position at a
given date; and the monetary projection of future activities arising from
alternative planned courses of action.”
Limitations
The major limitations of financial accounting are explained below:
1. Financial accounting does not give clear picture of operating efficient when
prices are rising or falling on account of inflation or depression. It is possible
that profits may be more or less, not because of efficiency or inefficiericy but
because of inflation or depression,
2. Financial accounting discloses only the net result of the collective activities
of business as a whole. It does not indicate profit or loss of each department,
Job, prices or contract. Thus, exact point of inefficiency remains unreported.
3. In Financial accounting, there is no such system by which accounts are
classified so as to give data regarding costs by department processes, product
in the manufacturing divisions, by units of products lines and sale territories.
4. In Financial accounting costs are not available as an aid in determining
prices of the products and services.
5. It does not provide information for a proper control of materials and supplies,
wages labour and overheads.
B.Com. Part-III 3 B.C. 503

6. In Financial accounting, expenses are not classified as to direct and indirect

items and are not assigned to the products at each stage of production to
show the controllable or uncontrollable items of overhead costs.
7. Financial accounting is mainly historical and tells about the cost already
incurred. It does not provide day to day cost information to the management
for making effective plans for the coming year and the period after that as
financial data are summarised at the end of the accounting period.
8. It does not supply useful data to the management for taking various financial
decisions such as introduction of new products, replacement of labour by
machines.
1.1.4 DEFINITIONS
1.1.4.1 Cost : According to Shilling law, “Cost represents the resources that have
been or must be sacrified to attain a particular objective.’’
1.1.4.2 Cost Unit : “The cost unit is a unit of product or service in relation to
which costs are ascertained.”
1.1.4.3 Cost Centre : “The cost centre is a production or service location, function,
activity or item of equipment for which costs are accumulated.”
1.1.4.4 Costing : “Costing” has been defined as “the technique process of
ascertaining costs”. It involves systems, methods and techniques of
accumulation, classification, analysis and appropriate allocation of expenditure
incurred in respect of a product of service.
1.1.4.5 Cost Accountancy : The term ‘Cost accountancy’, includes costing,
cost accounting, budgetary control, cost control and cost audit.
1.1.4.6 Cost Accounting :
Cost Accounting means “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
therefrom for the purpose of managerial decision-making.”
Thus there exists a distinction between the meaning conveyed by “Cost Accounting”
and “Cost Accountancy”. Therefore, strictly speaking cost accounting is a formal
system of recording, analysing and allotment of costs to cost centres or costs units.
On the other hand, cost accountancy embraces, in addition to cost accounting, the
principles, methods and techniques by means of which cost control is exercised
and the profitability is determined. It involves the system of reporting the data for
management decisions.
1.1.5 SCOPE OF COST ACCOUNTING
From the above it is clear that the scope of cost accounting includes :
1. Cost Ascertainment;
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2. Cost Presentation; and

3. Cost Control.
1.1.5.1 Cost Ascertainment :
Cost Ascertainment refers to :
(i) The collection and analysis of expenses.
(ii) The measurement of production at different stages,
(iii) The linking up of production with expenses.
For the purpose of cost ascertainment. Costing has developed systems, methods,
and techniques, viz.
(1) systems like historical (actual) costs, estimated costs, standard costs
are used for collection of expenses.
(2) methods of costing such as job costing, process costing, output costing
etc. are the instruments of measurement of productions; and
(3) techniques like absorption costing, marginal costing have been evolved
linking up production with expenses.
1.1.5.2 Cost Presentation :
It refers to a system of reporting cost data to various levels of management to suit
their requirements. For managerial purposes, the right and appropriate information
should be made available to the right person who needs them, at right time, and in
a proper form, various printed forms and statements are used for effective reporting.
1.1.5.3 Cost Control :
Cost control is defined as “the guidance and regulation by executive
action of costs of operating an undertaking. Cost control can be ensured through :
(1) setting up standard targets for Expenses and production performance;
(2) comparing the actual with the standards to find out variations, if any;
(3) analysing reasons for such variation; and
(4) taking up corrective action to eliminate the variation and thus bringing
up actual performance to the pre-set standards. In this context
management needs costs data so that responsibility for incurrence of
cost can be identified. The cost concepts covered here are:
(1) Responsibility Cost,
(2) Controllable and Non-Controllable Costs; and
(3) Direct and Indirect Cost.
1.1.6 OBJECTIVES OF COST ACCOUNTING
The following are the main objectives of Cost Accounting : Ascertainment of Cost :
The objective cost accounting is to ascertain the cost per unit of the different
products manufactured by a business concern.
2. Analysis of Cost: The objective of cost accounting is to provide a correct
B.Com. Part-III 5 B.C. 503

analysis of cost both of the process or operation and by different elements of

cost.
3. Identify sources of Wastage : The objective is to disclose sources of
wastage whether of material, time or expense or in the use of machinery,
equipment and tools and to prepare such reports which may be necessary to
control such wastage.
4. Provide required Cost data : The objective is to provide requisite cost
data and serve as a guide for price fixation of products manufactured or
services rendered.
5. Ascertain profitability : The objective is to ascertain the profitability of
each of the products and advise the management as to how these profits can
be maximised is another objective of Cost Accounting.
6. Effective Control : Next objective is to exercise effective control on stocks
of raw materials, work in progress, consumable store and finished goods in
order to minimise the capital locked up in these stocks.
7. Reveal Sources of economy : The objective of cost accounting is to
reveal sources of economy by installing and implementing a system of cost
control for materials, labour and overheads.
8. Advicing Management : To advice management on future expansion
policies and proposed capital projects, is another objective of cost accounting.
9. Organise an effective information system : Here objective is that
different levels of management may get the required information at the right
time, in right form for carrying out their individual responsibilities in an
efficient manner.
10. Supply Useful data to the management to take various financial decisions
such as introduction of new products, replacement of labour by machine etc.
11. To organise cost reduction programmes with the help of different
departmental managers.
12. To provide specialised services of cost audit in order to prevent the errors
and frauds and to facilitate prompt and reliable information to the
management.
1.1.6.1 Advantages of Cost Accounting :
The advantages of Cost Accounting System may be summarised as follows :
1. The Cost Accounting System enables the manufacturer to ascertain the
exact cost of each specific unit of output and the extent to which each
element of expenditure contributes to such cost.
2. It enables the manufacturer to fix selling prices on the basis of cost of
production and thus saves him from losses, which may arise due to injudicious
B.Com. Part-III 6 B.C. 503

fixation of prices without actually looking to the cost of production.

3. It provides a reliable basis upon which tenders’ estimates may be prepared.
4. The profitable and unprofitable project or assignment can be readily disclosed.
5. It assists the manufacturer in ascertaining the importance of each element
of cost or process and in determining where is greater scope of economy ?
6. It facilitates the detection and prevention of wastage, leakage and
inefficiencies.
7. It assists in controlling costs with the application of standard costing and
budgetary control system.
8. Cost Accounting system provides an independent and most reliable check
on the accuracy of financial accounts by means of reconciliation of profits as
shown by cost and financial accounts.
1.1.6.2 Limitations of Cost Accounting :
It is sometimes remarked that cost accounting is not as exact science and there is
no such thing as ‘exact’ of ‘true’ cost. This is because of the fact that there may not
be uniformity in cost ascertained by different cost accountants from the same data.
Disagreement in cost of a product arises on account of different procedures of cost
ascertainment followed by the accountants. Following are certain areas in cost
ascertainment wherein there are varied approaches open and where the cost
accountant has to choose the one which he thinks best :
1. Determination of Expenses entering into Cost of Production : It
includes determination of non-cost items, e.g. whether interest on capital or
cash discount should be considered in calculation or be excluded.
2. Computation of Material Cost or Product Cost: There are different
methods of pricing material such as FIFO, LIFO, average cost method,
standard cost method, etc. The material cost of product differs according to
the method of pricing adopted.
3. Apportionment and Absorption of Overheads : Overheads are
apportioned to cost centres on the basis of floor area, capital value, number
of employees etc. Similarly overheads are absorbed by different methods
such as percentage of direct material cost, percentage of wages, direct labour
hours, machine hours etc.
4. Choice of technique of cost ascertainment : Different costing
techniques like absorption (total) costing, marginal costing are available.
In above cases the cost accountants has to make assumptions and select method
which he deems proper in determination of cost.
(A) The nature of cost data requires for decision-making may differ according to
the purpose for which it is needed. Cost control requires standard cost and
B.Com. Part-III 7 B.C. 503

actual cost to be ascertained currently, whereas for budgeting estimated

costs are necessary.
(B) Costs have no usefulness in themselves; their value depends only upon the
action taken by the management in the light of the information they reveal.
Cost accountant has no powers to take decisions and enforce them. He is a
staff official acting in advisory capacity to the executives to present necessary
information with his expert recommendations on the issue. It is for the
directors and other managerial personnel to take decisions and act on them.
1.1.7 METHODS OF COSTING
Different methods of costing are applied for ascertaining unit cost in different
industries based on the nature of operation and unit of finished product involved.
All these methods have the same general principles but they differ in so far as the
methods used in collecting and presenting cost data are concerned. Basically, there
are three methods of ascertaining costs :
(1) Job costing.
(2) Process costing.
(3) Multiple or Composite costing.
1.1.7.1 Job Costing : is applied to special order type of industry devoted to the
execution of specific orders such as Printing press, house building, ship building
manufacture of heavy electrical machinery, etc. The main objective of job costing is
to ascertain cost and profit or loss in respect of each job, contract or project
undertaken.
The following methods are, included in job costing :
(A) Contract (or Terminal) Costing : This method of costing is employed in
business where separate constructional contracts are undertaken and it is desirable
to ascertain the exact cost of each contract. Contract costing is generally applicable
to the business engaged in building construction, road construction, bridge building,
ship building etc.
(B) Batch Costing : This method of costing is applied to industries where
production is carried on in batches. Under this method, a batch of similar products
is treated as one job and then the batch is divided by total numbers in the batch in
order to arrive at the unit cost of articles produced. Batch costing is generally
employed in industries engaged in biscuit manufacture, toy making, spare parts
manufacture, ready-made garments etc.
1.1.7.2 Process Costing : This method applied to mass production type of
industries engaged in the continuous production of uniform standard products
such as chemicals, oils, textiles, paints, cement, mining, colliery, flour etc. The
objective of process costing is to ascertain the cost of process of operation involved
B.Com. Part-III 8 B.C. 503

in converting raw material into finished products. The following methods are included
in process costing:
(A) Single Output (or Unit Costing) : This method is applied to ascertain
the cost per unit of output where the production is continuous and the units
manufactured are identical or uniform. Single costing is generally adopted where
the manufacturing concern is engaged in producing only one type of product or a
few grades of the same product. The method is commonly used in case of industries
like collieries, brick works, flour mills, quarries, cement mills, iron and steel works,
paper mills etc.
(B) Operating Costing : Operating costing is the system of costing employed
to ascertain the cost of providing or operating a service. This system of costing is
adopted by undertakings which render services rather than manufacture goods
such as railways, road transport, tramways, electricity companies, gas companies,
water works etc.
(C) Operation Costing : Operation costing represents a refinement of process
costing. Under this method, each operation in each process or stage of production
is separately costed. Operation cost generally refer to, conversion cost i.e. cost of
labour and overheads. At the end of each operation the unit operation cost is
ascertained by dividing the conversion cost by output. Thereafter the cost of finished
unit is determined by adding the material cost plus the cost of several operations
through which it passes. This method is suitable to those industries which are
connected with mass production of repetitive nature.
1.1.7.3 Multiple or Composite Costing : Multiple or composite costing is
applied to ascertain the cost of complex products manufactured by a factory, where
no single-system of costing is applicable. Under this method the total cost is
ascertained by aggregating component cost which are collected by both job and
process costing. Multiple costing applies to industries engaged in the production of
bicycle, motorcycles, motor cars, radios, typewriter, engines, machine tools, aero
planes and other complex products.
1.1.7.4 Illustration-I : Specify the method of Costing and the cost unit applicable
to the following industries :
Industries Method Answer Cost Unit
(a) Ship-building Contract Costing a ship
(b) Toy-making Batch costing a batch
(c) Textiles Process costing meter
(d) Sugar Process cost tonne or kg
(e) Cement Unit costing a bag or tonne
(f) Road transport Operating costing km.
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(g) Radio Multiple costing a radio

(h) Oil Process costing a litre
(i) Hospital Operating costing Patient, bed
(j) Chemicals Process costing a Jar or litre
(k) Medicines Batch costing a batch
(1) Motor Car Multiple costing a car
(m) Bicycle Multiple costing a cycle
(n) Catering Operating costing a meal
(o) Printing Job costing a job
(p) Aerated water Unit costing a dozen
(q) Dairy Unit costing a dozen
(r) Brewery Unit or Process a bottle or
costing a barrel
(s) Furniture Batch costing a batch
(t) House building Contract costing building
Importance of Cost Accounting to business concern
Cost accounting has many importance. Specially, the following parties are benefitted
from it.
Importance to management :
Management is highly benefitted with the introduction of cost accounting. It helps
to ascertain the cost and selling price of the product. Cost data help management
to formulate the business policies. The introduction of budgetary control and standard
cost would be an aid to analyze cost. Its also helps to find out reasons for profit or
loss. It provides data to submit tender as well. Thus, cost accounting is an aid to
management.
Importance to investors :
Investors can obtain benefit from the cost accounting. Investors want to know the
financial conditions and earning capacity of the business. An investor must gather
information about organization before making investment decision and investor can
gather such information from cost accounting.
Importance of consumers :
The ultimate aim of costing is to reduce the cost of production to minimize the profit
of business. Reduction in the cost is usually passed on the consumers in the form
of lower price. Consumers get quality goods at a lower price.
Importance to Employees :
Cost accounting helps to fix the wages of the workers. Efficient workers are rewarded
for their efficiency. It helps to induce incentive wage plan in business.
B.Com. Part-III 10 B.C. 503

Importance to Government :
Cost Accounting is one of the prime sources to provide reliable data to internal as
well as external parties. It helps government agencies to determine excise duty and
income tax. Government formulates tax policy industrial policy, export and import
policy based on the information provided by the cost accounting.
1.1.8 FINANCIAL ACCOUNTING VS. COST ACCOUNTING
Cost accounting and Financial accounting as we know are two different branches of
accounting and main objective of both of them is to provide information by recording
the business systematically and scientifically so that it ‘may serve the purpose of
the management for policy formulation and of controlling and to provide necessary
protection to the outsides. Both are based on double entry system and their roles
are supplementary. Besides, having some similarities these two are very different
form each other. Some difference are as under :
FINANCIAL ACCOUNTING COST ACCOUNTING
1. It gives information in general 1. It gives information to the
way about the profit and loss management for proper
and financial position of the planning, operation control and
business. decision making.
2. It lays emphasis on the 2. It provides detailed system of
recording aspect without control for materials, labour and
attaching any importance to overhead costs with the help of
control standard costing and budgetary
control
3. It reports operating results and 3. It gives information through cost
financial position usually at the reports to management as and
when end of the year. desired.
4. Financial accounts are the 4. Cost accounting is only a part of
accounts of the whole business, financial accounting and discloses
as they disclose the result of a results of each product, job or
business as a whole. service.
5. The costs are reported in 5. The cost are broken down on a
aggregate in financial accounts. unit basis in cost accounts.
6. Financial accounting is 6. Cost accounts are concerned
concerned with external with internal transactions which
transaction (i.e. transaction do not form the basis of payment
between business concern and or receipt of cash.
third party based on payment
and receipt of cash.)
B.Com. Part-III 11 B.C. 503

7. Monetary information is only 7. Non-monetary information is

used. also used, e.g. units.
8. Stocks are valued at cost or 8. Stocks are valued at cost.
market price which is less.
9. These accounts are kept in 9. These accounts are
generally
such a way as to meet the kept voluntarily to meet the
requirement of Companies Act requirements of management.
and Income Tax Act. But now it is compulsory for
some manufacturing companies to
keep cost records.
1.1.9 INSTALLATION OF COSTING SYSTEM (Designing of a Cost
Accounting System)
A formal system of cost accounting is essential for ascertaining and controlling
costs. And, the requirements of two firms are not alike and the system must be
designed to meet the individual needs to each.
1.1.9.1 Objectives of Designing :
(1) It will aid in planning the future and controlling the present.
(2) It will aid in establishing selling prices.
(3) It will provide a means of costing inventories.
(4) It will compute the cost of sales.
(5) It will measure the efficiency of materials, employees, and machines.
(6) It will furnish data for various other analytical processes.
1.1.9.2 Steps in Designing :
While installing a costing system, the cost accountant should examine certain issues
and take systematic steps in its installation. These steps are :
(1) Organisational structure of the company :
The organization set-up should, therefore, be examined thoroughly, with reference,
to responsibility and authority assigned to the various functionaries. The organization
charts must be prepared in such a manner that highlight the authority and
responsibility relationships between managers, superintendents and departmental
heads, who are responsible for:
(1) Providing detailed information needed for accounting department;
(2) Incurring expenditures for materials, labour and other costs; and
(3) Reporting to those incharge.
(2) Procedures and processes :
The cost accounting system must reflect the manufacturing procedures, processes,
methods, and the marketing and administrative organisation of a particular company.
B.Com. Part-III 12 B.C. 503

(3) Nature of Product :

It is essential to examine the nature of products manufactured, methods and stages
of production cycle; the number of products and quantity manufactured of each
product.
(4) Type of cost information :
The service rendered by the accountant is judged by the prompt presentation of
meaningful costs reports and statements to management. A good costing system of
cost accounting will provide information which helps in decision-making.
(5) Organisation of cost office :
The cost office should be properly organised, and as far as possible, it should be
situated adjacent to the factory so that delay in routing out documents or removal
of discrepancies and doubts is avoided. Normally, the duties of cost office are divided
into following categories:
(i) Stores Accounts.
(ii) Labour Accounts.
(iii) Cost Accounts.
(iv) Cost Control Accounts.
(6) Costing Department and its relationship with other departments:
The costing department is responsible for the presentation of the operating
statements and cost analysis for management action, including areas of inefficiency
and wastage, and relative profitability of products. Costing system should be designed
in such a manner so as to serve these purposes.
(7) Legal requirements and installation of cost :
It is equally important to weight the cost of the system against its advantages.
There are certain requirements imposed on an organisation that necessitate the
establishment of minimum costing system. For example, maintenance of cost audit
records as required under the Companies Amendment Act, 1965, laws like Income
tax, and Securities (Contract) Regulation Act prescribe certain requirement regarding
record keeping and reporting.
1.1.9.3 Essentials of a good costing system :
(1) Simplicity and adaptability
(2) Accurate and speedy statistics
(3) Admit comparisor
(4) Standardisation
(5) Co-ordination
(6) Economical
Self Check Exercise :
Q.1 Discuss the scope of cost accounting.
Q.2 Give in detail varius essentials of good costing system.
B.Com. Part-III 13 B.C. 503

1.1.10 SUMMARY
In comparison, financial accounting does not provide management with detailed
cost and revenue information relevant to its needs. On I lie other hand cost
accounting helps in determination and analysis of costs of departments, processes,
jobs, products, sales territories, sales orders etc. Hence, cosy accounting is a tool
of management, which provides management with detailed records of the costs
relating to products, operations or functions, as it covers classfication analysis and
interpretation of costs.
1.1.11 Answer to self check Questions :
Ans.1 Scope of cost accounting: Cost accounting means “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 therefrom for the purpose of control and decision
making.”
From above definition it is clear that the scope of cost accounting includes :
1. Cost ascertainment.
2. Cost presentation, and
3. Cost Control.
Ans.2 Essential of Good costing system : Give in detail following points :
1. It must be simple.
2. It must be adaptable.
3. It must be accurate.
4. Comparison should be possible.
5. Coordination of various activities must be required.
6. It must be economical
7. It should follow the standards.
1.1.12 GLOSSARY
(1) Costing Techniques of ascertaining cost.
(2) Installation-Starting a new system in an organisation.
(3) Operating costing-System of measuring service cost
(4) Operation costing sytem of measuring cost of each operation.
(5) Job Costing-System of ascertaining cost of specific order.
1.1.13 EXERCISE
(A) Short Questions :
Q.1 Define ‘Cost’, ‘Cost accounting’ and ‘Costing’.
Q.2 How the cost accounting is different from financial accounting ?
Q.3 What are the main objectives of cost accounting system?
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(B) Long Questions :

Q.1 What are the limitations and techniques of costing?
Q.2 Explain how will you go about the task of installing a cost accounting system
in an industry ?
Q.3 Discuss in detail various methods of costing.
Q.4 Differentiate cost Acccounting and Financial Accounting.
1.1.14 SUGGESTED READINGS
1. V.K. Saxana and CD. Vashist, Advanced Cost and Management Accounting
Sultan Chand & Sons, New Delhi,1998.
2. Dr. Manmohan & S.N. Goyal, Principles of Management Accounting
Shakithabhavan Publication, Agra.
3. Barfield, Jessie, Ceily A. Raiborn and Micheal R. Kenny : Cost Accounting,
Traditions and innovations, South Western College Publishing, Cincinnati,
Ohio.
4. Homgren, Charles T George Foster and Srikant M Daliar : Cost Accounting,
a managerial emphasis, Prentice Hall, Delhi.
5. Lall, B.M and I.C Jain : Cost Accounting : Principles and Practice Hall, Delhi.
6. Welsch Glenn A, Ronald W Hilton and Paul N Gorden : Budgeting, Profit
Planning and Control, Prentice Hall, Delhi.
B.COM. PART-III B.C. 503
COST ACCOUNTING

LESSON NO. 1.2 AUTHOR : DR. J.S. PASRICHA

ELEMENTS OF COST
1.2.1 Objective
1.2.2 Introduction
1.2.3 Cost Elements and Cost Classification
1.2.3.1 Classification on the basis of elements
1.2.3.2 Classification on the basis of Functions
1.2.3.3 Classification on the basis of Variability
1.2.3.4 Classification on the basis of Controllability
1.2.3.5 Classification on the basis of Normality
1.2.4 Production Cost and its Composition
1.2.4.1 Total/Absorption Costing approach
1.2.4.2 Variable Costing approach
1.2.4.3 Alternative approach to Production Cost
1.2.5 Cost Sheet
1.2.5.1 Specimen of Simple Cost Sheet
1.2.5.2 Specimen of Typical Cost Sheet
1.2.5.3 Purposes of Cost Sheet
1.2.6 Tender or Quotations
1.2.7 Illustration-I
Self-Check Exercise
1.2.8 Summary
1.2.9 Answers to self check questions
1.2.10 Glossary
1.2.11 Exercise
1.2.12 Suggested Readings
1.2.1 OBJECTIVE
The main objective of this lesson is to introduce the students with the various elements
of cost. The term ‘elements of cost’ has been defined as “the constituent parts of costs
according to the factors upon which expenditure is incurred, namely, material labour
and expenses.” In practice, for different purposes different kinds of information is
required, so, attempt has been made to classify the costs on the basis of elements,
functions, variability, controllability and normality.
1.2.2 INTRODUCTION
Cost refers to the amount of expenditure incurred on, or attributable to a given thing.
15
B.Com. Part-III 16 B.C. 503

Costs which are classified according to factors upon which expenditure is primarily
incurred, namely, materials, wages and expenses are known as elements of cost. Cost
may be basically classified as ‘Direct costs’ and ‘Indirect costs’. Costs which can be
directly identified with cost centres, processes, production units are direct costs. For
Example : Cost of yarn in the manufacture of cloth, wages payable to a worker for
weaving the cloth etc. Costs which can not be identified with cost centres of cost units
but are of a general character are indirect costs. For Example : rent of factory, salary of
the factory manager, salary of a foreman or supervisor etc
1.2.3 COST ELEMENTS AND COST CLASSIFICATION
The elements of cost can be divided into direct cost and indirect cost as follows:
1. Direct Material Cost
2. Direct Labour cost
3. Direct Expenses
4. Overheads
1.2.3.1 Classification on the basis of Elements
1. Direct Material Cost : Direct materials are those materials which can be traced
to a cost object in an economically feasible way. Thus, these materials directly enter
the product and form a part of finished product. For example, timber in furniture
making, cloth in dress making, bricks in building a house. The following are normally
classified as direct materials :
1. All raw materials like jute in the manufacture of gunny bags, pig iron
in foundry, and fruit in canning industry.
2. Materials specifically purchased for a specific job, process or order like
“gum for book binding, starch powder for dressing yarn.
3. Parts or components purchased or produced like batteries for transistor
radios and tyres for cycle.
4. Primary packing materials like cartoon wrapping, cardboard boxes etc.
However in some cases, though the material is a part of the finished product yet it is not
treated as direct material. For example, sewing thread in the dress making and nail in
furniture making. This is because they are used in comparatively small quantities and
it would be futile elaboration to make an analysis of them for the purpose of a direct
charge. Thus, such materials are treated as indirect materials.
2. Direct Labour Cost : Direct labour is all labour expended in altering the
construction composition, confirmation or condition of the product. In simple words,
it is that labour which can be conveniently identified or attributed wholly to a
particular job, product or process or expended in converting raw materials into
finished goods.
Wages of such labour are known as direct wages. Thus, it includes payment made to
B.Com. Part-III 17 B.C. 503

the following groups of labour :

(i) Labour engaged on the actual production of the product or carrying
out of an operation or process.
(ii) Labour engages in aiding the manufacturing way of supervision,
maintenance, tools setting, transportation of material etc.
(iii) inspectors analysis etc. specially required for such production.
The wage paid to supervisors, inspectors etc. though not direct labour, can be treated
as direct labour, if they are directly engaged on specific product or process and the
hours they spend on it can be directly measured without much of an effort. Similarly
where the cost is not significant like the wage of trainees or apprentices, their labour
though directly spend on a product is not Heated as direct labour.
3. Direct Expenses : Direct expenses include all expenditure other than direct
material or direct labour that are specifically incurred for a particular product or
process. Such expenses are charged directly to the particular cost centre as part of
the prime cost. Examples of direct expenses are :
(i) Excise duty, (ii) Royalty, (iii) Architect or Surveyor fees, (iv) Cost of rectifying defective
work, (v) travelling expenses to the site, (vi) Experimental expenses of pilot projects,
(vii) Expenses of designing of drawing of patterns of model, (viii) repairs and
maintenance of plant obtained on hire, (ix) Hire of special equipment obtained for a
contract.
4. Overheads : Overheads may be defined as the aggregate of the cost of indirect
materials, indirect labour and such other expenses including services as cannot
conveniently be charged direct to specific cost units. Thus overheads are all expenses
other than direct expenses. In general terms overheads comprises of all expenses
incurred for or in connection with in the general organisation of the whole or part of
the undertaking i.e. the cosl of operating supplied and services used by the
undertaking and including the maintenance of capital assets.
(B) Indirect Cost :
The main group into which overheads/ indirect costs can be divided are as follows :
(a) Indirect Material Cost
(b) Indirect Labour Cost
(c) Indirect Expenses
(a) Indirect Material Cost : It refers to material cost which cannot be allocated but
which can be apportioned to, or absorbed by cost centres or cost unit e.g. cotton waste,
oil grease used in keeping the machines in running condition.
(b) Indirect Labour Cost : If refers to the cost of remuneration of the employees of
an undertaking which cannot be allocated but which can be apportioned to, or absorbed
by cost centres of cost units, e.g. salary of the factory manager, salary paid to the factory
supervisor etc.
B.Com. Part-III 18 B.C. 503

(c) Indirect Expenses : Expenses which cannot be allocated but which can be
apportioned to or absorbed by cost centres or cost units e.g. Factory rent, depreciation
of plant and machinery, insurance of factory premises, rates taxes etc. are known as
indirect expenses.
1.2.3.2 Classification on the basis of Functions
(a) Factory Overheads
(b) Office and Administration Overheads
(c) Selling and Distribution Overheads
(a) Factory Overheads : Factory overheads includes all the indirect expenses
incurred in the factory in connection with manufacturing operations. Factory overheads
comprises the cost of indirect materials, indirect labour and all other indirect expenses
incurred in running of the works of factory e.g. oil, cotton waste of storekeeper, foremen,
supervisors, factory rent, rates, depreciation of plant and machinery, power and fuel
etc.
(b) Office and Administration Overheads : These include all expenses relating
to-the direction, control and administration of an undertaking. In other words office and
administration overhead refer to general office expenses of administration and control
of business e.g. office rent and rates, office lighting, depreciation of office furniture and
buildings, office stationary, audit fee, director’s remuneration-ibank charges etc.
(c) Selling and Distribution Overheads : These include all indirect expenses
incurred for promoting sales and retaining customers and for delivering an article after
its manufacture to the consumer e.g. cost of advertisement, salaries of salesmen,
commission of sales, rent and rates of the showrooms, carriage outwards, packing
charges, running and maintenance of delivery vans, rent of warehouse etc.
1.2.3.3 Classification on the basis of Variability
According to this classification costs are classified according to the behaviour in relation
to changes in the level of activity or volume of production. On this basis costs are
classified into three groups viz.
(a) Fixed or period costs
(b) Variable or product costs
(c) Semi-variable costs
(a) Fixed or Period Costs : These are commonly described as those which remain
fixed in lotal amount and decreases’per unit as production increases and increases per
unit as production declines. Examples of fixed cost are rent, insurance of factory building,
factory manager’s salary etc. These fixed costs are constant in total amount but fluctuate
per unit as production changes.
(b) Variable or Product Costs : These are those which vary in total in direct
proportion to the volume/output. These cost per unit remain relatively constant with
B.Com. Part-III 19 B.C. 503

changes in production. Thus variable costs fluctuate in total amount but tend to remain
constant per unit as production activity changes. Examples are direct material costs,
direct labour costs, power, repairs etc.
(c) Semi-Variable Costs : These are those which are partly fixed variable. For
example, telephone expenses include a fixed portion of annual charges plus variable
charge according to calls. Thus total telephone expenses are semi-variable. Other
examples of such costs are depreciation, repair and maintenance of building and plants
etc.
1.2.3.4 Classification on the basis of Controllability
Under this, costs are classified according to whether or not these costs are influenced
by the actions of a given member of the undertaking. On this basis it is classified into
two categories :
(a) Controllable Costs.
(b) Uncontrollable Costs.
(a) Controllable Costs : Controllable costs are those which are influenced by the
action of a specified member of an undertaking that is to say, cost which are at least
partly within the control of management. An organisation is divided into a number of
responsibility centres and controllable costs incurred in a particular cost centre can be
influenced by the action of the manager responsible for the centre. Generally speaking,
direct costs include direct material, direct labour and some of the overhead expenses
are controllable by lower level of management.
(b) Uncontrollable Costs : Uncontrollable costs are those which cannot be
influenced by the action of specified member of an undertaking. Most of the fixed costs
are uncontrollable. For example, rent of the building is not controllable and so are
managerial salaries. Overhead costs, which are incurred by one service section and is
apportioned to another which receives the services is not controllable by the latter.
The distinction between controllable and uncontrollable is sometimes left to individual
judgement and is not sharply maintained. It is only in relation to a particular level of
management or an individual manager that we may say whether a cost is controllable
or uncontrollable. A Particular item of cost, which may be controllable from a point of
view of one level of management, may be uncontrollable from another point of view.
This is partly so in case of fixed costs.
1.2.3.5 Classification on the basis of Normality
Under this, costs are classified according to whether these costs are normally incurred
or not at a given level of output in the conditions in which that level of activity is normally
attained. On this basis, it is classified into two categories.
(a) Normal Cost
(b) Abnormal Cost
B.Com. Part-III 20 B.C. 503

(a) Normal Cost : It is the cost which is normally incurred at a given level of output
in the conditions in which that level of output is normally attained. It is a part of cost of
production.
(b) Abnormal Cost : It is the cost which is not normally incurred at a given level of
output in the condition in which that level of output is normally attained. It is not a part
of cost of production and charged to Costing Profit and Loss Account.
1.2.4 PRODUCTION COST AND ITS COMPOSITION
Production cost is the sum total of both direct and indirect costs connected with
production. The official Terminology defines production cost as “Prime Cost plus
absorbed production overhead.”
Cost = Direct Cost + Indirect Cost
or
= Material Cost + Labour Cost + Expense Cost
Production Cost = Prime Cost + Absorbed Production overhead or
Production Cost = Direct Material cost + Direct Labour Cost + Direct
expenses + Indirect Material cost + Indirect Labour
cost + Indirect expenses (all connected with
Production) or
Production Cost = Prime Cost + Overheads/Indirect Cost connected
with production
Thus, direct cost and prime cost are virtually the same and indirect cost and overhead
are also the same.
1.2.4.1 Total/Absorption Costing Approach
The total costing approach is also known as the full costing or absorption costing and
orthodox costing approach. According to this approach, all costs, whether fixed or variable
are treated as product costs.
1.2.4.2 Variable Costing approach
In this approach, product cost includes only variable cost. Fixed cost is transferred in
its entirety, to the Profit and loss account.
1.2.4.3 Alternative approach to Production Cost
Based on the distinction between fixed and variable cost, students can also distinguish
two alternative approaches to production cost.
I: Total Costing Approach II : Variable Costing Approach
Direct Costs : Material - Direct Cost : Material -
Labour - Labour -
Expenses - Expenses -

Prime Cost XXX Prime Cost XXX

B.Com. Part-III 21 B.C. 503

Indirect Cost : Materials - Indirect Costs:Material (Variable) -

Labour - Labour (Variable) -
Expenses - Expenses (Variable) -

Production Cost XXX Production Cost XXX

Selling and Distribution - Variable selling and -
Overhead (total) - Distribution overhead (Variable) -
Administration (total) -

Total Cost XXXX Total Cost XXXX

1.2.5 COST SHEET
Cost Sheet is a statement presenting the items entering into cost of production and
service analysed by their elements, function and even by their behaviour, within the
strict meaning of the term it does not include sales proceeds and profit earned.
Under this system an analysis of the different elements of the cost is made so as to
ascertained the prime cost, factory cost, office cost and total cost.
1. Prime cost is the aggregate of all direct costs, viz. direct material, direct
labour and direct expenses.
2. Works (factory) cost is the total of prime cost and factory overheads.
3. Cost of production is the sum total of works cost and administrative
overheads.
4. Cost of sales is the sum total of cost of production and selling and
distribution overheads.
1.2.5.1 Specimen of Simple Cost Sheet
Total Cost Per unit Cost
Direct Material consumed XXX XX
Direct Wages XXX XX
Direct Expenses XXX XX
(1) Prime Cost XXX XX
Add : Factory (works) overheads XXX XX
(2) Work Cost XXX XX
Add : Administrative Overhead XXX XX
(3) Cost of Production XXX XX
Add : Selling and Distribution overhead XXX XX
(4) Cost of Sales XXX XX

However, the same information in relation to cost, sales and profit may be presented in
the form of a ledger account known as Production or Manufacturing Account. This
B.Com. Part-III 22 B.C. 503

account is debited with the opening stock and all items of cost and credited with sales
revenue and closing stock, so that the balancing figure shows either profit or loss.
1.2.5.2 Specimen of Typical Cost Sheet
Monthly ending ................ Unit Produced ...................
Rs. Total Cost Per Unit
(Rs.) Cost (Rs.)
Direct Material
Opening Stock of material XXX
Add : Purchases of materials XXX
Less: Closing stock of materials XXXX
Material consumed XXX
Direct Wages XXXX XXXX
Direct Expenses XXXX XXXX
(1) Prime Cost XXXX XXXX
Add : Factory (Works) Overheads : XXXX XXXX
Fuel-Power and water (Factory) XXX
Lighting and heating XXX
Indirect Materials XXX
Wages of foremen and other XXX
Indirect labour XXX
Drawing office, works office expenses XXX
Depreciation of Plant, equipment XXX
Depreciation on factory land and building XXX
Factory rent, taxes and insurance XXX
Less: Scrap value of defective work XXX
Add : Work in Progress (opening) XX XXXX
XX
Less: Work in Progress (closing) XXXX
XXX XXXX
Add : Administrative Overheads : XXXX
Office rent, insurance, lighting, clearing XXX
Office salary XXX
Telephone, law expenses, audit fees XXX
Depreciation on office building and
furniture XX
Director’s remuneration XXX
General Manager’s salary XXX
B.Com. Part-III 23 B.C. 503

Printing and Stationery XXX XXXX XXXX

(3) Total cost of Production XXXX XXXX
Add : Opening stock of finished products XXXX XXXX
XXXX XXXX
Less: Closing stock of finished products XXXX XXXX
(4) Cost of goods sold XXXX XXXX
Add : Selling and Distribution Overheads .: XXX
Showroom expenses XXX
Salemen’s salaries and commission XXX
Bad debts XXX
Discount of distributors XXX
Warehouse rent and other expenses XXX
Carriage outwards and delivery expenses XXX
Advertisement XXX XXXX XXXX
(5) Cost of sales XXXX XXXX
Net Profit XXXX XXXX
(6) Selling Price XXXX XXXX

1.2.5.3 Purpose of Cost Sheet

The cost sheet is a statement of all expenses/costs incurred or expected to be incurred
during a given period. It is prepared at convenient intervals such as, weekly, fortnightly,
monthly, quarterly, half-yearly or annually.
A cost sheet serves the following purposes:
1. It discloses the total components by stages and cost per unit of output
during a period.
2. It provide data for planning, production, fixing sale price and submitting
tenders and quotations.
3. It facilitates comparative study of costs with previous costs sheets to
know the cost trends and also with standard cost to check the nation
from actual costs.
4. It enables close watch over the cost for cost control.
Role of Cost Accountant in Organization :
1. First is to maintain cost information on the products the company is producing.
This maintenance includes a constant review of existing standards, noting
changes in processes or products which result in change of cost. The goal of
the cost accounting team is to maintain up-to-date and accurate product
costs. Such information should be based on actual data being produced on
the floor or to original standards and rates that were used to develop the cost at
B.Com. Part-III 24 B.C. 503

the beginning of the period. This is an ongoing assignment which requires

frequent attention and constant focus on what is occurring on the shop floor. In
addition, the job requires the ability to anticipate needs from the management
team related to product costing.
2. Second, cost accountants provide management controls of operations. Many
costing systems are still based on the standard cost method which includes
variance reporting by department, by product, by a person, or by a process.
Such reporting can be utilized to compare standard cost data in relationship
to actual results. In some cases, reporting of such management information
is completed very regularly, may be hourly or may be daily, and issued in
reports to the various management team members. However, other components
may be reported on less frequently. For instance, overhead variance
calculations should probably be done no more frequently than once a month.
These variance calculations are generally done for the purpose of improving
maangement control and usually result in very specialized periodic reporting
to a variety of individuals based solely on their ability to impact or improve
the costing results based on the data that they have been provided to them
from the cost accounts.
3. The third general category of assignments cost accountants frequently work
on are related to specialized projects. I have worked with accounting teams
which were charged with determining the profitability of certain parts, or a
specific manufacturing location. Others have included assignments related
to make vs. buy or outsourcing of a product to a foreign country. In this
particular instance, special assignments included those related to products
previously produced by the company and analyzing costs to determine if it
would be more cost-effective to have these parts produced elsewhere.
1.2.6 TENDER OR QUOTATIONS
Very often a producer in response to an advertisement in 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 manufacturers. The preparation
of tenders require information regarding prime costs, works, administration and selling
overheads and profit of 11n: proceeding period. The manufacturers, has to ascertain
and find out the possible changes in prices of material, rates of wages and other costs.
He has inascertain 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 percentage of estimates i.e. works
B.Com. Part-III 25 B.C. 503

overheads on wages basis and selling and distribution overheads on works cost basis
etc.
1.2.7 ILLUSTRATION-I
Prepare a cost sheet from the following data to find out Profit and Cost per Unit.
Rs.
Raw material consumed 1,60,000
Direct Wages 80,000
factory over heads 16,000
Office overheads (10% of factory cost) —
Selling overheads 12,000
Units Produced - 4000
Unit Sold 3,600
Selling price per unit Rs.100.
SOLUTION :
Cost Sheet of ............... for the period ending.................
Unit Produced 4,000 Per Unit Total
Rs. Rs.
Raw materials consumed 40.00 1,60,000
Direct Wages 20.00 80,000
Prime Cost 60.00 2,40,000
Factory overheads 4.00 16,000
Factory Cost or Production Cost 64.00 2,56,000
Add : Office Overhead *(10% Rs. 2,56,000) 6.40 25,600
Adjustment for finished goods inventory ---- ----
Add : Opening inventory
Less : Closing Inventory
Units Produced 4,000
Unit sold 3,600
Closing inventory 400 28,160
Cost of goods sold (@Rs,.64+6.40) 70.4 2,53,440
Selling overheads (as given) 3.33 12,000
Cost of sales 73.73 2,65,440
Profit (B/F) 26.27 94,560
Sales 3600x100 100.00 3,60,000
Self Check Exercise:
Q.1 Define the term cost. Classify the cost on the basis of its functions and elements.
Q.2 Discuss production cost and its composition under the costing system.
B.Com. Part-III 26 B.C. 503

1.2.8 SUMMARY
The three important areas in cost accounting are cost ascertainment, cost analysis and
cost control. For cost accounting to be useful in these areas, cost must be accumulated,
classified and grouped in such a manner that total cost and units cost can be determined.
These requirements call for an understanding of the concept of cost and of its appropriate
classification.
1.2.9 Answer to Self Check Questions
Ans.1 Cost means the amount of expenditure incurred on, or attributable to a given
thing.
(A) Functional Classification of cost will cover :
(1) Factory overheads (2) Office and administration Overheads,
(3) Selling and Distribution overheads.
(B) Elementwise classification cost will cover :
(1) Direct materials cost (2) Direct labour cost
(3) Direct expenses and (4) Overheads
Q.2 Production cost is “Prime Cost plus absorbed production overhead”.
Production Cost = Direct material cost + direct labour cost + direct expenses
+ indirect material cost + indirect labour cost + indirect
expenses connected with production.
Explain all these components to discuss the concept of production cost in detail. Thus
direct cost and prime cost are virtually the same, and indirect cost and overhead are
also same.
1.2.10 GLOSSARY
1. Tender- Statement showing prices of products.
2. Cost Sheet- Statement of cost detail.
3. Direct Cost- Cost directly attributable to the product/service.
4. Indirect Cost- Cost which cannot directly attributable to the product or sevice.
5. Semi-Variable Cost - which partly fixed and partly variable.
1.2.11 EXERCISE
(A) Short Questions :-
Q.1 What are the elements of cost ? How these elements can be further analysed ?
Q.2 Distinguish between direct and indirect costs.
Q.3 What do you mean by controllable costs? Give examples.
(B) Long Questions :-
Q.1 What is a cost sheet ‘What are its objectives and advantages ?
Q. 2. How does a production account differ from a cost sheet ?
Q. 3. In a factory, 20,000 units of Product A were manufactures in the month of
July 2009. From the following figures obtained from the costing records,
prepare a cost sheet showing cost per unit.
B.Com. Part-III 27 B.C. 503

Rs.
Opening Stock of raw material 5,000
Purchases 55,000
Closing Stock 10,000
Direct Wages 25,000
Factory overheads 40,000
Office and Administration overheads 20,000
Q.4 From the following particulars, Prepare a statement showing total cost and
profit :
Rs.
Opening stock of raw material 10,000
Closing stock of raw material 8,000
Opening stock of finished goods 15,250
Closing stock of finished goods 10,750
Raw material purchased 75,000
Carriage on raw material 1,500
Direct wages 32,500
Factory Cost 6,000
Office Cost 4,000
Selling expenses 5,250
Sale of scrap 600
Branch office expenses 2,400
Warehouse expenses 1,750
Exhibition expenses 1,250
Profit is to be calculated @ 2% on selling price. Unit produced during the period
were 10,000.
1.2.12 SUGGESTED READINGS
1. V.K. Saxana and CD. Vashist, Advanced Cost and Management Accounting
Sultan Chand & Sons, New Delhi,1998.
2. Dr. Manmohan & S.N. Goyal, Principles of Management Accounting
Shakithabhavan Publication, Agra.
3. Barfield, Jessie, Ceily A. Raiborn and Micheal R. Kenny : Cost Accounting,
Traditions and innovations, South Western College Publishing, Cincinnati,
Ohio.
4. Homgren, Charles T George Foster and Srikant M Daliar : Cost Accounting, a
managerial emphasis, Prentice Hall, Delhi.
5. Lall, B.M and I.C Jain : Cost Accounting : Principles and Practice Hall, Delhi.
6. Welsch Glenn A, Ronald W Hilton and Paul N Gorden : Budgeting, Profit
Planning and Control, Prentice Hall, Delhi.
B.COM. PART-III B.C. 503
COST ACCOUNTING

LESSON NO. 1.3 AUTHOR : KARAMBIR SINGH

COST AUDIT
1.3.0 Objective
1.3.1 Introduction
1.3.2 Objectives of Cost Audit
1.3.3 Who should carry out the cost audit
1.3.4 Disqualifications
1.3.5 Ceiling on number of cost audit
Self Check excrcise-I
1.3.6 Types of cost audit
1.3.7 Cost Audit Programme
1.3.7.1 Preparation of Cost Audit
1.3.7.2 Review of Cost Accounting Records
1.3.7.3 Verification of Cost Statements
1.3.8 Advantages of Cost Audit
1.3.8.1 To Management
1.3.8.2 To Shareholder
1.3.8.3 To Government
1.3.8.4 To Society
1.3.9 Disadvantages of Cost Audit
Self Check Exercise-II
1.3.10 Rights of Cost Auditor
1.3.11 Duties of a cost auditor
1.3.12 Difference between cost audit and financial audit
1.3.13 Cost audit report
1.3.14 General Features of Cost Audit Report
1.3.15 Form of Cost Audit Report
1.3.16 Summary
1.3.17 Answers to self check questions
1.3.18 Glossary
1.3.19 Exercise
1.3.20 Recommended Hooks
1.3.0 OBJECTIVE
Over the years, costing system is being established by the concerns to attain its objectives
28
B.Com. Part-III 29 B.C. 503

relating to cost. The main objective of this lesson is to introduce (1) objectives of Cost
Audit, (2) Ceiling on number of Cost (3) Cost Audit Programme; (4) Cost audit Report;
and (5) Rights, disqualifications, rights and duties of cost auditor.
1.3.1 INTRODUCTION
Cost Audit is the audit of cost records. It is an effective tool of control. It identifies the
weaknesses and inefficiencies at all levels of organization. It gives Assistance to
management in decision making process. According to Institute of Cost and Management
Accountants of England, “Cost audit represents the verification of cost accounts and a
check on the adherence to cost accounting plan.
Thus Cost Audit comprises :
(i) Verification of the cost accounting records such as cost statements, cost data,
cost reports and costing techniques, and
(ii) Checking and examination of these records to ensure that they adhere to the
cost accounting principles, plans and objectives.
When cost audit is introduced under a statute of law it is called statutory cost Audit.
The Institute of cost and works Accountant of India defines statutory cost Audit as, “a
system of audit introduced by the government of India for the review, examination and
appraisal of the cost accounting records and added information required to be maintained
by specified industries”.
1.3.2 OBJECTIVES OF COST AUDIT
The objectives of cost audit are as follows :
1. To verify the adequacy of the books of accounts and records about cost .
2. To detect the Frauds and error of Principle of cost records.
3. To find the accurate value of work-in-Progress and closing finished stock.
4. To verify the total cost of each product, process, operation and job to ensure
that they are accurate.
5. To ensure that cost accounting procedures laid by the management are strictly
followed.
6. To advise the management to adopt alternative course of action.
7. To check whether the company is making optimum use of resources.
8. Help in price fixation and price control.
9. Help to increase productivity of different factors of production.
10. To improve cost consciousness.
1.3.3 WHO SHOULD CARRY OUT THE COST AUDIT
Under section 233 (B) Companies Act, the central government may, if it feels necessary,
direct by an order that an audit of the cost record kept by a company under section 209
(1) (d) shall be conducted by a cost accountant within the meaning of the cost and
works Accountant Act, 1959 in such a manner as may be specified. A firm of cost
B.Com. Part-III 30 B.C. 503

Accountants can also be appointed as cost auditor if all the partners of the-firm are
practicing cost accountant and the firm itself has been constituted with the previous
approval of the central government under the regulation of the cost and works Accountant
Act, I959 Unlike financial audit, cost audit is to be conducted only if the central
government makes an order for a particular year and for a specified company.
1.3.4 DISQUALIFICATIONS
According to the sub-section (3) and (4) of section 226 of companies Act the following
person can not be appointed as cost auditor .
1. A body corporate.
2. An officer or employee of the company.
3. A person who is a partner, as who is in the employment of an officer or employee
of the company.
4 A person who is indebted to the company for an amount exceeding one
thousand rupees or who has given any guarantee, or provided any securities
in connection with the indebtedness of any third person to the company for
an amount already specified.
5. A person who is disqualified on the above grounds as an auditor of any other
body corporate which is the company’s subsidiary or holding company or
another subsidiary or of another subsidiars of its holding company.
6. A person appointed as financial auditor of the company shall not be appointed
to do the cost audit of the same company also an internal auditor cannot be
appointed as the cost auditor to that company.
1.3.5 CEILING ON NUMBER OF COST AUDIT
Section 224 (13) impose a ceiling on the number of audits which is as follows:
(1) In the case of an Individual cost accountant, who is in full time employment
twenty companies, of which not more than ten should have a paid-up share
capital of Rs. 25 lakh or more.
(2) In the case of an Individual cost accountant who is not in full time employment.
There is no limit on the number of companies that such a person can audit.
(3) In the case of a firm of cost accountant.
For every partner of the firm who is not in full time employment maximum number of
companies is twenty. Out of which not more than ten such companies should have a
paid up share capital of Rs. 25 lakh or more.
Self Check Exercise-I
Q.1 Discuss the qualifications and disqualifications of the cost auditor
Q.2 What are the objectives of Cost Audit ?
B.Com. Part-III 31 B.C. 503

1.3.6 TYPES OF COST AUDIT

The following are the main types of cost audit :
1. Cost audit on the behalf of the management :
The object of this type of audit is that the cost data are reliable and serve the purpose of
management in taking important decisions. Cost auditor also help the management in
improving the quality of cost accounting system.
2. Cost audit on the behalf of customer :
In some cases customer insists on a cost auditor to satisfy himself about the correct
ascertainment of cost. This is done in the case of cost plus contracts. The customer do
this to find out the correct cost so that he may be able to pay price on the basis of
correct cost plus an agreed margin of profit.
3. Cost audit on the behalf of government :
Government may appoint a cost auditor in public interest to fix the fair price of any
product, some times government is approached for subsidies or protection etc. before
taking a decision the government may prefer to determine the cost of production on the
basis of cost audit to satisfy itself whether the need is genuine or not.
4. Cost audit on the behalf of trade Association :
Sometime a trade association may appoint a cost auditor to conduct cost audit to
determine minimum price to avoid cut throat competition among its members and to
ascertain comparative profitability of its members.
5. Statutory Cost Audit :
The central government may under section 233-B of Companies Act 1956 order certain
companies to get their cost accounts audited.
1.3.7 COST AUDIT PROGRAMME
There is no standard pattern for cost audit programme. But the cost audit programme
should include all the usual steps that are used by a financial auditor in this audit
programme. Cost audit will be affected by the nature and size of the business, attitude
of the management etc. The cost auditor should draw a cost audit programme which
should be specific to the unit concerned.
A cost audit programme may be divided into the following stages :
1.3.7.1 Preparation of Cost Audit :
Before starting the cost audit, an auditor should acquaint himself with several factors
such as :
1. Cost accounting system used in organisation.
2. Production methods and manufacturing processes.
3. Information, about raw materials and components used in Production.
4. Concessions received from Government, if any.
5. Memorandum on Articles of Association and important points mentioned
therein about costing requirements.
B.Com. Part-III 32 B.C. 503

6. Information about cost records and documents.

7. Cost Accounting Rules or Cost Accounting Manual used in the organisation.
1.3.7.2 Review of Cost Accounting Records :
This will include :
(a) Method of costing in use like process, batch.
(b) Method of accounting for raw materials, stores, wastages etc.
(c) Method of accounting of depreciation.
(d) System of internal auditing.
(e) System of budgetary control.
(f) Basis of allocation and absorption of overhead.
1.3.7.3 Verification of Cost Statements :
This will include the verification of :
(a) Financial ratios
(b) Production data
(c) Cost Statements
(d) Cost of raw material, wages and salaries, stores, power and fuel etc.
(e) Reconciliation with financial books.
1.3.8 ADVANTAGES OF COST AUDIT
The following are the advantages of cost audit.
1.3.8.1 To Management :
(1) Cost Control :
Cost audit helps the management to control different elements of cost like material,
labour and overheads.
(2) Helpful in reducing the prices :
Cost audit increase the efficiency of industries and helps in increasing the production
and reducing the cost of production.
(3) Helpful in increasing profit :
Cost audit indicate the efficiencies and inefficiencies of an organisation and helps in
increasing profit by controlling inefficiencies.
(4) Management by exception :
Management by exception become possible through allocation of responsibilities to
individual managers.
(5) Helpful in Budgetary control and standard costing :
Cost audit helps in budgetary control and standard costing by comparing actual results
with the budgeted results and actual cost with standard cost.
(6) Proper valuation of stocks etc. :
A reliable check on the valuation of closing stock, and work-in-progress helps the
management. Facts about over valuation and under valuation are reported on which
remedial action can be taken.
B.Com. Part-III 33 B.C. 503

(7) Fixing responsibilities :

Cost audit helps in fixing responsibilities of a particular person, group of persons for
irregularities or non compliance of rules and regulations of the company.
1.3.8.2 To Shareholder :
Cost audit ensure the shareholders, that they will get a fair return on their investment.
It explore to the shareholders that proper records regarding income and expenses,
purchase and sale are maintained.
1.3.8.3 To Government :
(i) Cost audit helps the government to focus its attention on inefficient unit,
(ii) Cost audit helps in fixation of prices of essential commodities,
(iii) Where the government enter into a cost-plus contract it helps to fix a reasonable
price.
(iv) It helps the government to settle trade disputes.
1.3.8.4 To Society :
Cost audit helps in increasing efficiency of the company and reduces the price of product
and provides the goods to the consumer at a fair price and of good quality.
1.3.9 DISADVANTAGES OF COST AUDIT
Disadvantages of cost audit are as follows :
1. By making cost audit compulsory restriction on companies will increase and it
will disturb the normal working of companies.
2. Most of the working of cost accountant and financial accountant are the same
and cost audit leads to duplication of work.
3. Cost audit is expensive and increase the cost of product. But it is wrong to say
that cost audit will interfere in the working of the management rather it helps
the management to achieve their objectives. Cost auditor also helps the
management to reduce cost by bringing in their knowledge inefficiencies
and wasteful expenditures.
Self Check Exercise-II
Q. 1 Discuss the various types of cost audit.
Q. 2 Discuss the various stages of cost audit programme.
1.3.10 RIGHTS OF A COST AUDITOR
The cost auditor enjoys the same powers as an auditor under section 227:
(I). The rights of a cost auditors are as follows :
1. He has a right of access at all times to the books of accounts and vouchers of
the company.
2. He is entitled to require from the officers of the company such information
and explanations as he may consider necessary for the performance of his
duties.
B.Com. Part-III 34 B.C. 503

3. He has a right to get all facilities and assistance from the company to perform his
duties.
1.3.11 DUTIES OF A COST AUDITOR
The duties of a cost auditor are as follows :
1. He is liable to the company if he does not perform his duty properly or is guilty of
gross negligence or fraud.
2. He owes a legal responsibility to third party who might mislead by his audit
certificate and acted in reliance thereon.
3. He is bound to answer any query or clarification required by the central
government on the audit report submitted by him.
4. He should not disclose any confidential information acquired during his work.
1.3.12 DIFFERENCE BETWEEN COST AUDIT AND FINANCIAL AUDIT
1. Cost audit is the verification of cost accounts. Cost auditor gives his opinion that
the cost records prescribed by law have been maintained or not and on the
other hand financial audit is the verification of the financial account as to whether
balance sheet and profit and loss account exhibit a true and fair view of the
state of affairs of the concern.
2. Cost audit is product oriented as compared to financial audit which is
organization oriented.
3. A cost auditor should be a cost accountant appointed by the board of directors
while a financial auditor is appointed by the shareholders and should be a
chartered accountant.
4. Cost auditor reports to management while the financial auditor reports to
shareholders.
1.3.13 COST AUDIT REPORT
A report is a formal statement usually made after an enquiry, examination or review of
specified matters under report and includes the reporting auditors opinion thereon.
Cost audit report is the end product of audit of cost accounts. Under section 233 (B) of
the companies act 1956, the cost auditor has to submit his report to the central
government and also to send a copy of the report to the company. The company within
30 days from the date of receipt of the copy of the report furnish to the central government
the whole information and explanation on every reservation or qualification contained
in the cost audit report. Cost auditor is bound to answer any query or classification
required by the central government on the audit report.
1.3.14 GENERAL FEATURES OF COST AUDIT REPORT
The cost auditor has to submit in his report whether :
(1) All information and explanation required for the purpose of cost audit are obtained
or not.
B.Com. Part-III 35 B.C. 503

(2) Whether proper cost accounting record as required under section 209(1) (d) of
the companies act are maintained or not. ,
(3) The books and records give information required by the companies act 1956
in the manner so required.
(4) Books and records give a true and fair view of cost or not.
Time Limit for submission of report
The cost auditor shall send his report referred in sub rule (1) of rule (4) to the central
government and to the concerned company within 182 days from the end of the
company’s financial year to which the cost audit report relates.
Penalties :
If default is made by any cost auditor to send his report to the central government and
to the concerned company, he shall be punishable with fine upto five hundred rupees.
If the company and every officer therefore fails to provide required cost accounting
records, books and papers within 90 days.
From the end of the financial year of company every officer who is in default shall be
punishable with fine which may extend to five hundred rupees.
1.3.l5 FORM OF COST AUDIT REPORT [Section 2(C) and rule (4)]
The cost auditor has to submit his audit report in the following form.
I/We——————————having been appointed as cost auditor(s), under section 233-
B of the companies act, 1956 of---------—(name of the company), have examined the
books of accounts as prescribed under clause (d) of sub-section (1) of section 209 of
the said act and other relevant record for the year ended———————(financial
year) relating to——————————(name of product) maintained by the company
and report, subject to my/our comments under the heading “auditors observations
and conclusions” contained in the Annexure to this report, that——
(a) I/We/have/have not obtained all the information and explanations which to
the best of my/our knowledge and belief were necessary for the purpose of
this audit.
(b) Proper cost accounting records as required under clause (d) of Section 209 of
the company act 1956 have/have not been kept by the company.
(c) Proper returns adequate for the purpose of my/our cost audit, have/have not
been received from branches not visited by me/us.
(d) The said books and records give/do not give the information required by the
Companies Act, 1956 (1 of 1956) in the manner so required.
(e) In my/our opinion the company’s cost, accounting records have/have not
been properly kept so as to give a true and fair view of the cost of production,
processing, manufacturing or mining activities as the case may be.
(f) The cost statements in respect of product under reference as specified in Annexures/
B.Com. Part-III 36 B.C. 503

Proformance of Schedules 1 and II of the cost Accounting Records (-----)

Rules duly audited by me/us are/are not kept in the company.
The matter contained in the annexure to this report form part of this report, which is
also subject to my/our observation made therein.
COST AUDITOR(S)
Dated this............day of.....................
Annexure to Cost Audit Report.
The salient part of annexure are as follows :
1. General Information :
This includes:
- Name and address of the company
- Name and address of the cost auditors.
- Reference No. .............. and date of government order under which the
audit report is conducted.
- Financial year of the company for which accounts are audited.
- Location of the factory.
- Date of incorporation of the company and its status.
- A copy of Annual Report along with audited profit and loss account
and balance sheet in respect of the company’s financial year for which
the reports rendered shall be enclosed with the cost audit report.
2. Cost Accounting System :
Briefly describe the cost accounting system and comment on its adequacy or otherwise
to determine correctly the cost of production of the product.
3. Financial Position :
A number of figures and ratios are to be given like (1) Net worth (2) Profit (3) Capital
employed (4) Net sale (5) Operational Profit (6) Value addition (7) Ratios. The figures of
capital employed, Profit and net sales are to be given for the company and for the
product under reference.
4. Production :
The following information is to be given for each type of product under reference and for
each factory.
1. Licensed capacity, registered capacity
2. Installed capacity
3. Actual production, Production capacity enhanced by leasing.
4. Percentage of production in relation to installed capacity.
5. Process of Manufacture : A brief note regarding the... process of manufacture
of the product alongwith a flow chart shall be given.’
6. Raw Material : The consumption of major raw material should be shown both
B.Com. Part-III 37 B.C. 503

in term of value and quantity. The consumption of major raw material should be shown
alongwith the standard requirements.
7. Power and Fuel : The quantity, rate per unit and total cost for each major
form of power and fuel used in production should be shown and actual physical
consumption per unit of production should be compared with standards if any with
the preceding two years consumption.
8. Wages and Salaries : Wages and salaries paid to all employees should be
showing separately the direct labour cost on production, indirect labour cost on
production, employee cost of administration and selling and distribution cost. The
average number of workers employed should be mentioned.
9. Repair and Maintenance : The expenditure per unit on stores and spares,
labour charges should be shown.
10. Depreciation : The method of depreciation adopted by the company e.g.
straight line, diminishing balance etc. and the basis of allocation of depreciation should
be stated. The depreciation if any, provided on the amount of revalued assets shall not
form part of cost of production.
11. Overheads : The amount of each overhead should be shown separately like
factory overheads, administration overheads, selling overhead, and distribution
overheads. The basis of allocation and apportionment of the common overheads should
be stated. The basis of absorption of overheads to cost centers should also be stated.
12. Sales : In respect of each type of product sold, sales in quantity, net sale
realization and average sale realization per unit should be shown where the product
is sold at different prices in accordance with government policy, quantity and value
of sale at different prices should be shown separately.
13. Abnormal Non-recurring Costs : If there were any abnormal features
affecting Production during the year e.g. strikes, lockouts, major breakdowns in the
Plant, substantial power cuts, serious accidents etc. they shall, wherever practical, be
briefly mentioned indicating their effect on the unit cost of production.
14. Auditor’s observation and conclusions : The cost auditor shall report
on :-
(a) matters which appear to him to clearly wrong in principle or apparently
unjustifiable.
(b) cases where the company’s funds have been used in a negligent or inefficient
manner.
(c) factors which could have been controlled but have not been done resulting in
increase in the cost of production.
(d) the adequacy of otherwise of budgetary control system, if any, in vogue in the
company.
B.Com. Part-III 38 B.C. 503

The cost auditor shall suggest measures for improvements in performance, if any, in
respect of the following :
(a) rectification of general imbalance in production facilities.
(b) fuller utilisation of installed capacity.
(e) concentration on areas offering scope for cost reduction, increased
productivities.
(d) improved inventory policies.
The cost auditor may give his other observations and conclusions, if any, irelevant to
the cost audit. If the auditor wants to give qualified report he shall indicate the extent to
which he has to qualify the report and the reason there of.
1.3.l6 SUMMARY
Cost Audit is mainly a preventive measure. It serves as a guide for policy formulation
and decision making in addition to being a barometer of performance. Although
government has made it a statutory obligation to have cost audit in a few type of
industries. But in the coming years, it will be the competition driven market which will
drive the cost audit. In the competition driven market, cost audit will be an important
tool in bringing out inefficiencies and thus improving probability.
1.3.17 ANSWERS TO SELF CHECK QUESTIONS
Self Check Exercise-I
Ans.1 Qualifications and disqualifications of the cost auditor : The cost
audit shall be conducted by a cost accountant within the meaning of cost and works
accoutants Act, 1959.
Disqualifications : A body corporate, officer or employee of a company, a person
who is indebted to the company, a person appointed as financial auditor of the company,
a partner who is in the employment of an officer or employee of a company, and a
person who is disqualified on the above grounds as an auditor of any other body
corporate which is the compnay is subsidiary or holding company or another subsidiary/
subsidiaries of its holding company are disqualified to appoint as cost auditor.
Ans.2 Objectives of Cost Audit :
1. Verify books of accounts / records.
2. Detect grounds and error of principle.
3. Valuation of stock
4. Verify total cost of each product, process, operation or job.
5. Ensure follow up of cost accounting procedures.
6. Highlight alternative course of action.
7. To make optimum use of resources.
8. Price fixation and price control.
9. Increase productivity.
10. Improve cost consciousness.
B.Com. Part-III 39 B.C. 503

Self Check Exercise-II

Ans. Various types of cost audit are as given below :
1. Cost audit on the behalf of management.
2. Cost audit on the bahalf of customer.
3. Cost audit on the behalf of government.
4. Cost audit on the behalf of trade association.
5. Statutory cost audit etc.
Ans.2 Following are the stages of cost audit programme
1. Preparation of cost audit plans.
2. Review of cost accounting records.
3. Verification of cost statements.
4. Preparation of cost audit report.
1.3.18 GLOSSARY
1. Financial Audit : Verification of Financial accounts (i.e. Profit
and loss account and balance sheet)
2. Cost Audit Report : A formal statement reporting auditors
opinion about cost and expenditure.
3. Cost : The amount of expenditure incurred on,
or attributable to a given thing.
4. Cost Accounting : A system which is installed to ascertain,
system record, measure and presentation of cost
data.
5. P & L A/c : Profit and Loss Account
6. B/S : Balance Sheet
1.3.19 EXERCISE
(A) Short Questions :
Q.1 Define Cost audit and its objectives.
Q.2 Distinguish between Cost Audit and Financial Audit.
Q.3 What do you mean by Cost Audit Programme ?
(B) Long Questions :
Q. 1 Explain the provisions of Companies Act, 1956 and the cost audit (report) rules,
1996 relating to statutory cost audit.
Q.2 “The cost audit report contains significant information which would help to
assess and improve the operational efficiency of a concern.” Discuss the
statement with reference to the matters to be reported by a cost auditor in his
report.
Q.3 Discuss the matters to be reported under the head ‘Auditors’ observations and
conclusions under Para 14 of the Annexure to the cost audit (reports) rules.
B.Com. Part-III 40 B.C. 503

1.3.20 RECOMMENDED BOOKS

1. V.K. Saxana and CD. Vashist, Advanced Cost and Management Accounting
Sultan Chand & Sons, New Delhi,1998.
2. Dr. Manmohan & S.N. Goyal, Principles of Management Accounting
Shakithabhavan Publication, Agra.
3. Barfield, Jessie, Ceily A. Raiborn and Micheal R. Kenny : Cost Accounting,
Traditions and innovations, South Western College Publishing, Cincinnati,
Ohio.
4. Homgren, Charles T George Foster and Srikant M Daliar : Cost Accounting, a
managerial emphasis, Prentice Hall, Delhi.
5. Lall, B.M and I.C Jain : Cost Accounting : Principles and Practice Hall, Delhi.
6. Welsch Glenn A, Ronald W Hilton and Paul N Gorden : Budgeting, Profit
Planning and Control, Prentice Hall, Delhi.
Note : This lesson has been written with the financial assistance of D.E.C.
B.COM. PART-III B.C. 503
COST ACCOUNTING

LESSON NO. 1.4 AUTHOR : DR. J.S. PASRICHA

MATERIAL CONTROL
OBJECTIVES
The following objectives are covered under this lesson :-
1. To study the need and essentials of material control system.
2. To study the various types of purchasing system and process of purchasing
materials.
3. To study the codification system of material.
STRUCTURE OF THE LESSON
1.4.1 Introduction
1.4.2 Material Control
1.4.2.1 Needs of Material Control
1.4.2.2 Objectives of Material Control
1.4.2.3 Essentials of Material Control
1.4.3 Purchasing of Material
1.4.3.1 Centeralised Purchasing
1.4.3.2 Purchasing Procedure
1.4.3.3 Just-in-time Purchasing
Self Check Exercise
1.4.4 Codification of Materials
1.4.4.1 Benefits of Codification
1.4.4.2 Methods of Codification
1.4.5 Summary
1.4.6 Answers to self check questions
1.4.7 Glossary
1.4.8 Exercise
1.4.9 Suggested Readings
1.4.1 INTRODUCTION
Material is the basic substance used in the process of Production. The cost of material
has been defined as “The cost of commodities supplied to an undertaking.’ It includes
raw materials, spare parts and components, factory supplies and packing materials. It
may be direct or indirect. Direct and Indirect materials are distinguished on the basis of
identification or traceability of an item of material to the cost unit or cost centre. Oil,
grease, cotton waste, etc. are those items of materials that cannot be traced to the
finished product. 41
B.Com. Part-III 42 B.C. 503

1.4.2 MATERIAL CONTROL

The material being the biggest cost factor, affords a wide scope for saving in costs.
Therefore a costing system has to provide for a proper control over material and stores.
Material control is defined as “a systematic control over purchasing, Storing and
consumption to materials so as to maintain a regular and timely supply of materials, at
the same time, avoiding overstocking.” It can be achieved by systematically organising
and standardising the procedures and activities relating to :
(1) Purchase
(2) Receipt and inspection
(3) Storing
(4) Issuing and
(5) Record keeping
1.4.2.1 Needs of Material Control
Material control aims at achieving saving in material cost, improvement in material
handling, increased production and larger profits. It ensures :
1. Timely availability of required quantity of material resulting in smooth and
continuous flow of production.
2. Purchases of stores appropriate quality at reasonable price.
3. Minimum capital investment in the inventory by fixing stock levels and
avoiding over stocking.
4. Economy in buying and holding expenses by evolving an ideal order
quantity for each item.
5. Prevention of leakage, deterioration, wastage of materials by arranging
suitable storage facilities and by fixing allowable limits of such losses in storing
as well as manufacturing.
6. Minimisation of risk due to spoilage, obsolescence, theft pilferage by
enforcing slock control measures and physical verification of stock.
7. Maintenance of appropriate stock records which furnish the data relating to
stores quickly and accurately.
1.4.2.2 Objectives of Material Control
The various objectives may be enumerated as follow .
(a) Procurement of materials and stores from suppliers at the lowest price, consistent
with the standard specification as to quality and timely delivery;
(b) Avoidance of production hold-up for want of materials;
(c) Maintenance of even flow of control;
(d) Prevention of excessive investment in material stock;
(e) Avoidance of losses occasioned by deterioration due to evaporation, dryage
careless handling of materials and supplies, pilferage, obsolescence etc; and
B.Com. Part-III 43 B.C. 503

(f) Making available, accurate and reliable information about the different items of
materials and stores for proper planning and control.
1.4.2.3 Essentials of Material Control
Material control embraces all aspects of material management viz. buying, receiving
and inspecting, storing, consumption and accounting. It should be organized keeping
in mind the following requirements :
1. There should be co-operation and co-ordination among the departments
dealing with materials viz, purchase, receiving, inspection, production
planning and control departments (drawing office), stores and shops.
2. All items in the stores should be codified.
3. All purchases must be centralised and must be made through an expert
purchase manager.
4. Receiving and inspection procedure should be chalked out. Material not
ordered or not in accordance with the specification should be rejected.
5. Standard forms for requisitions, purchase order, issues and for transfer of
material from one job to other job, should be used.
6. The storage of material should be well-planned to avoid losses from theft,
carelessness, damage, deterioration, evaporation and pilferage.
7. Procedures for issue and transfer are to be standardised and applied.
8. Minimum, maximum and re-ordering levels for each type of material should
be fixed to ensure that there is no shortage of material and that there is no
overstocking.
9. Ordering quantity for each type of material should be fixed to reduce the ordering
cost and carrying cost of materials.
10. Adequate records to control materials during production should be
maintained to ensure that there is minimum possible wastage.
1 I. Stores control measures like ABC analysis, perpetual inventory system,
stock verification etc. should be introduced.
12. Communication system should be geared to facilitate quick and prompt
reporting in printed forms of the data concerning inventory transaction.
13 A system of internal check should be introduced to ensure that all
transactions involving materials are checked by authorised and
independent persons.
1.4.3 PURCHASING OF MATERIAL
Effective material control demands a good deal of attention to be paid to activities and
procedures relating to purchasing of materials as it has considerable influence on cost,
quality of the product, prompt delivery, volume of production and efficiency of
manufacture. Efficient buying procedure enhances competitive strength of business
B.Com. Part-III 44 B.C. 503

through reduction in material order, in cost of storage and buying and also through
reduced wastage. It builds up goodwill because of better quality output and timely
delivery.
Thus, if the size of business concern permits there should be a separate purchasing
department and the responsibility for purchasing all types of materials should be
entrusted to this department. The head of this department is usually known as the
‘Purchase manager’.
1.4.3.1 Centeralised Purchasing
For efficient buying a Centralised Purchase Department should be established under
an expert officer for purchasing all the requirements of a undertaking. Centralised
purchasing :
1. Ensures better controlled purchases and benefits of expert knowledge of the
Buyer (i.e. Purchase Manager).
2. Avoids excessive and reckless buying by several persons.
3. Enables buying in bulk to obtain trade discount, concession on packing and
transport charges, regular supply and favourable treatment from the suppliers.
4. Eliminates possibility of overstocking and locking up of capital in the stock,
of materials. On the other hand, limitation of centralised purchasing are :
(a) Delay in getting materials;
(b) High cost of maintaining a central purchase department;
(c) Chances of wrong purchases owing to lack of proper co-ordination and
communication between purchase department and requisitioning
department; and
(d) Inability in taking advantages of local buying by branches;
Local buying by branches have certain merits, viz, quick delivery, contacts with local
sellers, saving in transportation, octroi and insurance expenses. But it may lead to reckless
buying by, several persons, overstocking, more capital blocked in inventory, loss of
economies of large-scale buying and week control over purchasing function. However,
where purchasing quantity is small and/or urgent and immediate supply of materials is
needed, local buying may advantageously be resorted to.
Thus, it is evident that centralised purchasing is advantageous. But if the industrial
undertaking consists of a number of works or plants which are situated for apart,
centralised purchasing may be inconvenient and in such a case, local or decentralised
purchasing should be allowed if materials and supplies are required urgently or better
terms can be secured from local supplies or the purchases involved are of small value.
1.4.3.2 Purchasing Procedure
The sole function of the purchase department is “to buy and supply the material and
stores, required for various departments (including tools equipment and stationeries)
B.Com. Part-III 45 B.C. 503

of right quality, in right quantity, at right time and at right price”. This responsibility
involves the determination of what to buy, time, quantity, price of buying and supplier
from whom purchases are to be made.
To carry out this responsibility, the purchasing department follows the procedures
outlined below:
(1) Determination of Purchase Budget.
(2) Receiving the purchase requisition.
(3) Determination of quantity to be purchased.
(4) Exploring the sources of supply and choosing the suppliers.
(5) Placing orders.
(6) Receiving and Inspecting Materials.
(7) Checking and Passing of Bills for Payment.
(8) Return of Materials to suppliers.
(1) Determination of Purchase Budget :
Generally, purchase manager, with the help of production planning department, prepare
a purchase budget in the beginning of the year. This budget guides him in knowing
what he has to buy, what should be the quality, size and quantity and also when he has
to buy.
Apart from budget, the Bill of Materials (also called as specification of Materials] prepared
by drawing office, is also helpful in knowing the requirements of the company for which
the purchase manager has to buy.
(2) Receiving Purchase Requisition :
Purchase of material is initiated through purchase requisition. Guided by stock position,
the storekeeper usually initiates ‘Purchase Requisition’ (i.e. indent) for materials required
to replenish the stock of an item. These are ‘regular’ purchase requisitions. In case
special items are required for a job, departmental head may send a special (also called
as occasional) purchase requisition.
A purchase requisition is a formal request to buy materials. It is usually a printed form
with columns meant for description, quantity, size and grade of materials required. It
must be authorised by a responsible officer like works manager, departmental head or
storekeeper. It is prepared in three copies, for ruting to :
(i) The Purchase Department
(ii) Production control department, and
(iii) For retaining one for record.
B.Com. Part-III 46 B.C. 503

Specimen of Purchase Requisition

Date Regular Date of which material is
No. Occasional required
To be filled by Requisition For Purchase department’s use
Sr. No. Description Code No. Qty. Purchase Supplier Remarks

Sd. Sd. Sd.

Requisitioner Approved by Purchase Manager

(3) Determination of Quantity :

Now the buyer; has to determine the quantity of purchase. Larger order has the merits
of obtaining more trade discounts, less ordering cost, economy in packaging and transport
expenses, credit facilities, regular supply and other concessions from the suppliers.
But it involves more capital, increased storage space and expenses, possibility of loss
due to obsolescence and price fall etc. The merits and demerits are reverse in case of
small order quantity. Therefore, considering both aspects, an ideal quantity of buying is
determined which is known as “ordering quantity”.
(4) Exploring the Sources of Supply and Choosing the Supplier :
A source of supply material must be selected after the receipt of the purchase requisition.
The purchase department usually maintains for every group of materials a list of the
supplier’s names and addresses. Quotations may be invited from these suppliers by
issuing tenders to them. On receipt of the quotations form the suppliers, a comparative
statement of various quotations received should be prepared and the desirable suppliers
should be selected.
While selection the supplier to whom order is to be given for the purchase of materials,
the purchase department should keep in mind: (i) manufacturing capacities, (ii) reliability
of the supplier, (iii) financial condition of the supplier, (iv) the management of the supplier
firm, (v) price quotes, (vi) quantity for which price quoted is applicable, (vii) terms of
payment, (viii) terms of delivery, and (ix) specification to which the products are
manufactured. All the other factors being the same, the purchase price should be the
B.Com. Part-III 47 B.C. 503

lowest price at which a particular material is to be purchased. Thus, the supplier from
whom material is purchased should be dependable and capable of supplying materials
of uniform quality at right time at reasonable price. The purchase officer should keep in
mind all the criteria given above in making a choice of supplier.
The Purchase Manager will obtain necessary information form, schedule of quotations,
past records, catalogues, buyers, guides and other books.
There should be periodic evaluation of suppliers and those whose performance is found
to be bad in regard to quality delivery time, sales policies and competitive prices, should
be removed from the list of suppliers. In future quotations should not be invited from
such suppliers till their performance is found good.
(5) Placing an Order :
After choosing the supplier, the purchase department, prepares a purchase order for
the supply of stores. The order is the written authorisation to the supplier to supply the
particular material or materials. It is the evidence of the contract between the buyer
and the supplier that binds both the buyers and suppliers to the terms under which
the order is placed. Moreover, it is the document which gives authority to the receiving
department to receive the materials ordered for and to the accounts department to
accept the bill from the supplier for payment.
The number of copies of the purchase order to be prepared varied from organisation to
organisation.
(a) The original copy is sent to the supplier.
(b) One copy is sent to the receiving department.
(c) One copy is sent to the person who initiated the purchase
requisition.
(d) One copy is sent to the accounting department.
(e) The last copy is retained by the purchase department for further
reference. A purchase form of the purchase order is given as below :
Purchase Order
No ................ Dated ................ Purchase Requisition No.
To (Suppliers)
Your quotation niimber .............. dated ............. has been accepted.
Please supply the following items of store in accordance with the instructions
mentioned therein and terms and conditions listed on the reserve of this purcahse order.
B.Com. Part-III 48 B.C. 503

Sr. No. Description Code No. Qty. Purchase Supplier Remarks

Terms of Delivery
Terms
Packing and Despatch instructions
Discount Allowed
Purchase Officer

There should be a regular follow-up of the purchase order placed so that materials may
be received in time. Enquiries should be made at regular intervals at the delivery date
agreed upon. Suitable remedial measures may be taken or alternative sources of supply
may be tapped if they face any difficulty in supplying the materials at the promised
delivery dates.
(6) Receiving and Inspecting Materials :
In small and medium sized manufacturing concerns, function of receipt and inspection
of materials are to be performed by the stores department. But in case of large
manufacturing concerns, generally a separate receiving Department is set up. The main
functions of Receiving Department are to receive the materials, to check for their quality
and quantity and to arrange movements of materials within the factory. In case of large
manufacturing concerns, sometimes specialised staff is attached to the Receiving
Department for testing the quality of materials. The Receiving Department, after receiving
the materials, will prepare a Goods Received Note.
Specimen of Goods Received Note
G.R. Note No................. Date ................Inspection Report No: .......................................
Purchase Order No..............Date................ Deliver Note No..........Date............................
Received form.................goods mentioned as under :
Sr.No. Code No. Description Qty. Price Amount Remarks

Sd. Sd. Sd. Sd.

Receiver by Checked by Storekeeper Store Ledger Clerk
B.Com. Part-III 49 B.C. 503

(7) Checking and Passing of Bills for Payment :

When the invoices received from the supplier, it is sent to the stores accounting section
to check both the authenticity, as well as the arithmetical accuracy. The quantity and
price mentioned in the invoice are checked with reference to stores received note and
the purchase order respectively. The arithmetical accuracy of the invoice is also checked
and verified. Having thus verified all respects of the invoice, the stores accounting
section certifies and passes (he invoice for payment and on this basis, the cashier can
make the payment.
(8) Return of Materials to Suppliers :
If the goods received are not according to the standard or are in excess of the quantity
ordered, they are to be returned to the supplier. In such as case a Debit Note is prepared
in quadruplicate. The copies are to be sent to the supplier, Accountant and Purchasing
Department respectively, the fourth copy is retained by the receiving Department for
future reference.
1.4.3.3 Just-In-Time Purchasing
‘Just-in-time’ is said to be the managerial philosophy of elimination of waste. It is directed
towards production or procurement of products or components as they are required by
the customer or for use rather than for stock. It seeks to eliminate inventory holding
costs.
Official Terminology defines Just-in-time purchasing as, a purchasing system in which
material purchases are contracted so that the receipt and usage of material, to the
maximum extent possible, coincide
Thus, under this system, receipt and usage i.e. supply and demand for every item of
material arc made to coincide. Necessary arrangements are made with limited number
of suppliers by entering into long-term contracts for the supply of materials as and
when required. Stocks of materials are thus avoided.
Self Check Exercise
Q.1 Discuss the steps involved in the purchase procedure of material.
Q.2 What do you mean by condification? Also discuss in detail various methods
of codification.
1.4.4 CODIFICATION OF MATERIALS
Codification means assigning a code, symbol or alphabet or a number to, different
materials for each identification, e.g. 6" steel screw may be codified as “SS6” and Brass
screw of 3" may be denoted as “BS3”.
In giving “codes” the materials, their nature, quality, size, weight, measurement should
be borne in mind. A good code system should be simple, definite, elastic and easy to
memorise.
B.Com. Part-III 50 B.C. 503

1.4.4.1 Benefits of Codification

Following are the benefits of Codification :
(i) Easy identification of material.
(ii) EIimination of chances of wrong issue of materials.
(iii) Saving of time in material handling.
(iv) Secrecy of materials used.
(v) Facility of preparation of “Bill of Materials”, “Materials Requisitions”
and “Purchase Requisitions”,
(vi) Brevity and comprehensiveness in stores list.
(vii) Essential for Merchandised Accounting.
1.4.4.2 Methods of Codification
1. Alphabetical Method : An alphabet is used to identify a particular material
for instance ‘A’ for coal. ‘B’ for belts etc. The method is simple but lacks Flexibility and
expansion. The combination of two or more alphabets may be used to lend flexibility
to some extent.
2. Mnemonic Method : This method is an improvement over simple alphabetical
method. Here, the material is given that alphabet which indicates the first sound of
its name, e.g. copper wire may be coded as CW. It is called a mnemonic system as it
assists memory in remembering code words.
3. Numerical Method : Under numerical method a number is assigned to each
item. The numbering may be straight or in blocks. Straight numbering means giving
separate number to each item, whereas under the latter method a particular class of
items is given in block numbers e.g.
Straight Numbering Block Numbering
Code Steel Nuts Nos. 1-10
Steel Nuts 1/2 01 -do- 1/2 cm 01
do 3/4 02 -do- 3/4 cm 02
do 1 cm 03 -do- 1 cm 03
do 1.5 cm 04 -do- 1.5 cm 04
Brass Nuts ‘1/2 cm 05 Brass Nuts Nos. 11 20
do 1 cm 06 -do- 1/2 cm 11
do 1.5 cm 07 -do- 1.5 cm 12
Now a days, a variation in this method, viz, decimal system has gained more popularity
especially on account of its flexibility. An item is given full number, its grade, colour,
size etc. are indicated by decimal figures. Suppose an automobile concern uses two
types of screw and it has given the following code numbers :
Screw-94, brass-3, Steel-5, and sizes 1/2 cm as 12, 1/3 cm as 13, 1/4 cm as 14, 3/8
as 38 on. Now the coding of the following item will appear as under :
B.Com. Part-III 51 B.C. 503

Code
Screw of brass 1/2 cm 94.312
Screw of brass 1/3 cm 94.313
Screw of brass 3/8 cm 94.538
Screw of brass 1/4 cm 94.514
The numerical method is also simple, capable of expansion to pay limit. II does not
create confusion in identification but as code number cannot be remembered an
elaborate index is necessary.
Alphabetical-cum-Numerical Method :
Under this method, the principal underlines in both the above methods have been
combined advantageously for the coding e.g. aluminium wire of 1/2 cm. May be coded
as AW 12.
1.4.5 SUMMARY
With a view of promoting specialisation consequent upon division of labour, material
control is organised, in modern times. By the creation of a number of departments,
each department comes under a separate functional head, to perform each function of
material control independently. The framework of material control is known as
organisation of material control. This framework consists of interrelated functions in
connection with materials and supplies. These functions involved in material control
are co-ordinated in such a way as to achieve the objectives of material control.
1.4.6 ANSWER TO SELF CHECK EXERCISE
Ans.1 Following are the steps involved in purchasing procedure of material:
1. Receipt of purchase requisition
2. Selection of supplier
3. Preparation, placement and follow up of purchase order
4. Receipt of materials
5. Inspection of materials
6. Return of rejected materials
7. Checking and passing of purchase invoices for payment
8. Making payment to supplier.
Ans.2 Assigning a code, symbol, alphabet or a number to different materials for each
identification is known as codification.
Methods of codification :
1. Alphabetical Method
2. Mnemonic Method
3. Numerical Method
4. Alphabetical-cum-numerical Method
B.Com. Part-III 52 B.C. 503

1.4.7 GLOSSARY
1. Inventory Raw, semi-finished or finished stock.
2. Codification of material - Assigning a code, symbol or number.
3. JIT - Just in time purchasing.
4. Mnemonic method- One method of codification.
5. Purchase requisition - A formal request to buy materials
1.4.8 EXERCISE
(A) Short Questions :
Q.1 Give the meaning of term “material control.” What are its objectives ?
Q.2 What is meant by centralised purchasing.
Q.3 What is meant by Just-in-time Purchasing.
(B) Long Questions :
Q.1 Describe the various benefits and methods of codification of material.
Q.2 Briefly explain the procedure followed for the purchase of materials.
1.4.9 SUGGESTED READINGS
1. V.K. Saxana and CD. Vashist, Advanced Cost and Management Accounting
Sultan Chand & Sons, New Delhi,1998.
2. Dr. Manmohan & S.N. Goyal, Principles of Management Accounting
Shakithabhavan Publication, Agra.
3. Barfield, Jessie, Ceily A. Raiborn and Micheal R. Kenny : Cost Accounting,
Traditions and innovations, South Western College Publishing, Cincinnati,
Ohio.
4. Homgren, Charles T George Foster and Srikant M Daliar : Cost Accounting, a
managerial emphasis, Prentice Hall, Delhi.
5. Lall, B.M and I.C Jain : Cost Accounting : Principles and Practice Hall, Delhi.
6. Welsch Glenn A, Ronald W Hilton and Paul N Gorden : Budgeting, Profit
Planning and Control, Prentice Hall, Delhi.
B.COM. PART-III B.C. 503
COST ACCOUNTING

LESSON NO. 1.5 AUTHOR : DR. J.S. PASRICHA

INVENTORY CONTROL AND EVALUATION

OBJECTIVES
The main objective of the lesson is to give an idea about :
1. Methods of Inventory Control;
2. Methods of valuation of material; and
3. Methods to Control the waste, scrap, defectives and spolige.
STRUCTURE OF THE LESSON
1.5.1 Introduction
1.5.2 Standard Procedure of material issue
1.5.3 Methods of Inventory Control
1.5.3.1 ABC Method
1.5.3.2 Perpetual Inventory System
1.5.3.3 Inventory Turnover Ratio
1.5.4 Valuation of Material (Pricing of Material)
1.5.4.1 Cost Price Methods
1.5.4.2 Average Price Methods
1.5.4.3 Notional Price Methods
1.5.4.4 Specific Price Methods .
1.5.5 Pricing of returns
Self Check Exercise
1.5.6 Wastage,. Scrap, Defective work and spoilage
1.5.7 Control over Waste, Scrap, Spoilage and Defectives
1.5.8 Summary
1.5.9 Answers to self check Questions
1.5.10 Glossary
1.5.11 Exercise
1.5.12 Suggested Readings
1.5.l INTRODUCTION
Another department charged with the function of material control is the stores
department. Materials are received into the stores department after inspection. This is
held by the stores department until it is demanded by the user departments. The
material cost depends upon not merely the purchase price of materials, but also
their issue price. The general principle of valuing purchases is, “all cost of whichever
53
B.Com. Part-III 54 B.C. 503

nature incurred up to the point of placing materials and supplies in a condition suitable
for issuance from the stock room should comprise the cost value of materials.”
1.5.2 STANDARD PROCEDURE OF MATERIAL ISSUE
Materials are kept in store so that the storekeeper may issue whenever these are
required by the production departments. A standard procedure of material issue
from stores should be developed keeping in view the following points :
1. Material should be issued only against authorisation (e.g. Material
Requisition).
2. Issuing of material should take the least possible time so that there should
not be inconvenience or interruption in production process.
3. Material should be kept at accessible and definite place to enable quick issue.
4. Proper system of classification of materials should be adopted for avoiding the
issue of wrong materials.
5. Persons who come to take materials should not be allowed to while away the
time under lame excuses.
6. Every issue should be recorded immediately in proper records like Bin Card,
Stock Register.
7. Material issued should be priced and entered into the Stores Ledger by Costing
Department and not by stores personnel.
8. Unauthorised persons should not be allowed to deal with the stocks.
1.5.3 METHODS OF INVENTORY CONTROL
The cost of material is the most important element of the cost, so it is necessary that
effective physical control is exercised over the materials lying in stores in “order to
avoid loss of materials by theft, pilferage etc. A few methods are available for this purpose
which are as follows :
1.5.3.1 ABC Method
ABC analysis is a technique followed for the purpose of exercising control on materials
according to their value. Under this method all items of materials are classified into
three categories A, B and C according to their value.
I. Category ‘A’ consists of material which constitute 5% to 10% of the total items in
the store and represent 70% to 85%, of total store value;
II. Category ‘B’ the item constituting 10% to 20% of the total items and 10% to 20% of
the store value;
III. Category ‘C’ the items constituting 70% to 85% of the total items and representing
5% to 10% of the store value.
Items under Category ‘A’ must be closely controlled by all steps, while in respect of
items under category ‘C elaborate control procedures are not necessary ABC analysis
of materials is also known as Always Better Control Method or Proportional Parts Value.
B.Com. Part-III 55 B.C. 503

Advantages of ABC Analysis :

1. It ensures closer control over costly items in which considerable amount of
capital is locked up.
2. It leads to reduction in carrying costs.
3. It enables to keep enough safety stock for ‘C’ items.
4. It enables to maintain high stock turnover rate.
1.5.3.2 Perpetual Inventory System
The Institute of Cost and Management Accounting London, has defined the perpetual
inventory system as “a system of records maintained by the controlling department,
which reflects the physical movement of stocks and their current balance.”
In simple, it involves (a) maintenance of Bin Card and Stores Ledger which shows goods
received, issued and stock on hand at any time; (b) continuous stock taking to compare
the actual stock with stock shown by Bin Card and Stores Ledger.
Under continuous stock taking system, a permanent stock taking team is appointed.
This team daily verifies the physical stock of different items selected at random. The
differences found between the Actual Stock and Bin Card balance are noted and an
enquiry for finding out causes is made.
Adjustment of differences between Book Stock and Actual Stock :
If the discrepancy is due to clerical error, the Bin Card or Stores Ledger are adjusted to
rectify the mistake. But the difference, especially shortage of actual stock, may be due
to several reasons, the reasons may be divided into two categories;
(1) Avoidable (2) Unavoidable Causes :
(1) Avoidable
1. Pilferage, theft.;
2. Misplacement of materials.
3. Careless materials handling.
4. Short or excess issue due to negligence or wrong measures.
Unavoidable Causes :
1. Evaporation, shrinkage.
2. Deterioration of perishable items.
3. Variation in weight, length due to climatic conditions.
4. Loss in weight and quantity due to seasoning, curing and storing.
5. Loss in bulk breaking (i.e. issuing in small quantities of materials brought in bulk).
Advantages of Perpetual Inventory System :
1. This system ensures a detailed and reliable checking of stores items in a
methodical manner without interfering in any way with the routine work of
the factory.
2. It obviates the necessity of physical stock taking at the end of financial year.
B.Com. Part-III 56 B.C. 503

3. It assists in the detection and immediate rectification of clerical errors in the

stock records.
4. In case of serious discrepancies, it gives rise to thorough investigation into
their causes and prevents the reoccurrence of similar irregularities.
5. It facilitates preparation of periodic Profit and Loss A/c and the balance Sheet.
6. Perpetual checking by surprise, prevents employees from playing mischief
with stores materials.
7. Stock level can be revised from time to time to avoid or overstocking of a
material.
8. It facilitates proper planning of production programmes, framing buying
policies, accepting new order etc., as ready information of stock position is
available.
Drawbacks of Perpetual Inventory System :
1. The system is expensive and a small concern cannot adopt it.
2. The information about actual stock of a particular day may not be available.
Only book figures are available.
1.5.3.3 Inventory Turnover Ratio (Material Turnover Ratio)
Inventory turnover ratio is also one method of exercising material control. It is the ratio
which the value of materials consumed during a period bears to the average stock held
during that period. It can be calculated as under :
Value of Materials consumed during the period
Inventory turnover Ratio =————————————————--------------------
Value of Average Stock held during the period
Average stock is the half of the total of opening and closing stock. The material turnover
can also be expressed in terms of day by formula :
Days during the period
Material Turnover in days = ------------------------------------
Material Turnover Ratio
The objective of Inventory Turnover Ratio is to ascertain the speed of movement of
particular item. A high ratio indicates that the item is fast moving and investment in it is
minimum. A lower ratio denotes that the item is not consumed in more quantity it is
going out zero demand and had led to overstocking. Such slow moving materials should
be disposed off as early as possible.
Of course, this rule cannot be applied to machinery spare parts, which are stored for
repairing machinery and equipment. In this case, lower rate of turnover would indicate
efficiency of machinery and equipment.
1.5.4 VALUATION OF MATERIAL (PRICING OF MATERIAL)
Material issued to production has to be valued in Costing Department for the purpose
of accounting. This is known as material pricing. Pricing becomes a little difficult because
B.Com. Part-III 57 B.C. 503

of different prices at which material might have been purchased in a particular period.
There are different methods for pricing of material value. The method to be used in a
particular manufacturing concern depends upon the nature of materials and the nature
of business itself. A very careful choice has to be made to the methods of valuing the
material issues because it influences the cost of the jobs and the value of the closing
balances of material in the stores. It is important to note that whatever method of pricing
the material issues is followed; the actual issue of materials will always be from the
earliest consignment. The important methods used for Pricing material issues are as
follows :
1.5.4.1 Cost Price Method
1 FIFO 2 LIFO 3 H1FO 4 N1FO
1. First-in-First-out Method (FIFO) :
Under this method it is assumed, that issue of materials have been made out of the
earliest consignment on hand. The issues of materials therefore, are charged out at the
price as was paid for the lot out of which the issues have been made. In other words in
this case items on the debit side of stores account (receipts column) are exhausted in
chronological order.
Merits : This method has following merits :
(a) Since it is an actual cost method, it recovers entire material cost from
production without any over or under recovery,
(b) It appears logical as the material bought earlier is used for earlier jobs.
(c) Stock is valued at recent purchase prices, and hence it closely represents
current market price.
(d) This method is useful where the items are bulky, slow moving and costly,
because it is easy to identify units belonging to a particular purchase lot.
Demerits :
(a) Calculation becomes complicated when prices fluctuate.
(b) During the period of price fluctuation material cost charges to job vary,
therefore comparison between jobs becomes difficult,
(c) When prices decline, jobs (production) are charged at earlier higher prices,
with the result that quotations are less competitive, understated and profit
margin is reduced.
(d) When prices start rising, profits are inflated creating income tax difficulties.
This method is most suitable in times of falling prices because the issue price
of materials to jobs or work 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.
B.Com. Part-III 58 B.C. 503

Example :
Prepare a stores ledger account for materials ‘X’ showing the issue of material on
FIFO method of valuation for April, 2015 from the information below :
April 2015 Quantity Rate Per Unit
1st Opening balance 500 units Rs. 20
8th Issues 300 units
16th Purchases 800 units Rs. 22
18th Issues 400 units
25th Issues 300 units
26th Purchases 400 units Rs. 25
28th Issues 600 units
Stores Ledger
Date Receipts Issues Balance Remarks
2012 Ref. Qty. Rate Amt. Ref. Qty. Rate Amt. Qty. Rate Amt.
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
April 1 500 20 10000
8 300 20 6000 200 20 4000
16 800 22 17600 200 20 4000
800 22 17600
18 200 20 4000
200 20 4000 600 22 13200
25 300 22 6000 300 22 6600
26 400 25 10000 300 22 6600
400 25 10000
300 22 6600
28 300 25 7500 100 25 2500

2. Last-in-first-out method (LIFO)

Under this method, it is assumed that issues of materials have been made out of the
latest consignment or latest purchases. Materials are issued at cost and the price of
the latest consignment is used for pricing the materials issued.
Merits :
1. Since materials are charged at recent price, cost of production reflects current
market trend, and the quotation prices are competitive.
2. Being an actual cost method, it ensures complete recovery of material and cost
from production.
B.Com. Part-III 59 B.C. 503

Demerits :
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 this record to ascertain
the price to be charged.
2. Like FIFO, comparison between one job and the other job will become difficult.
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.
The method is suitable in time of rising prices because materials are issued at the
current market prices which are high.
Using the same example given under FIFO method, the position or stores ledger under
L1FO method shall be as follows :
Solution :
Date Receipts Issues Balance Remarks
2012 Ref. Qty. Rate Amt. Ref. Qty. Rate Amt. Qty. Rate Amt.
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
April 1 500 20 10000
8 300 20 6000 200 20 4000
16 800 22 17600 200 20 4000
800 22 17600
18 200 22 8800 200 20 4000
400 22 8000
25 300 22 6600 200 20 4000
100 22 2200
26 400 25 10000 200 20 4000
100 22 2200
400 25 10000
28 400 25 10000
100 22 2200
100 20 2000 100 20 2000

3. Highest-in-First-out Method (HIFO) :

Under this, method, issues are priced at the highest value of the available consignment
in the store. The main object of this method is to ensure that stock values are kept at
lowest possible level but this method has not been adopted widely.
This method is based on the assumption that the closing stock of materials should
always remain at the minimum value so that the issues priced at the highest value of
the available stock in the store. This method is not popular as it always undervalues
B.Com. Part-III 60 B.C. 503

the stock which amounts to creat 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 of products. . -
4. Next-in-First-out Method (NIFO) :
Under this, method, issues are made at the next price i.e., the price of material which
has been ordered but not, yet been received. In other words, issues of material are
priced at the latest/price at which the company has been committed, even though the
materials have not yet been actually received. The main object of this method is to
value issues at an actual price which is as close as possible to the market price but this
method has not been adopted widely.
This method is based on the assumption that the closing stock of the materials should
always remain at the minimum value, so that the issues are priced at the highest value,
of the available consignments in the store. The method is not popular as it always
under values the stock which amounts to create 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.
1.5.4.2 Average Price Methods
1. Simple average price method
2. Weighted average price method
All average cost methods claim certain common merits over actual cost methods viz.
easy in calculation, smoothening effect of price fluctuations and better comparison
between jobs. Main demerit of those methods is that materials are charged to the jobs
at an average price which is not actual cost of purchase of materials. This results in
over or under recovery of materials cost from production.
Different methods of average cost valuation have been explained below :
1. Simple Average Price Method
The price under this method is calculated by dividing the total of prices of materials in
the stock from which materials are issued, by the number of prices entering in the
calculation. For the purpose of calculation the issues are presumed to have been done
in chronological order and quantities of purchase are ignored.
It is simple to operate and gives good results when prices are stable. But it leads to
profit or loss due over or under charging of material cost to production. Moreover,
the valuation of closing stock is not stock.
Example: From the following transactions recorded in respect of materials ‘X’
used in factory, prepare stores ledger by pricing the issues at simple average
method.
B.Com. Part-III 61 B.C. 503

April 2015 Quantity Rate Per Unit

3rd Purchases 400 units Rs. 2.10
15th Purchases 500 units Rs. 2.10
20th Issues 500 units
26th Purchase 600 units
28th Issues 900 units
(a) Simple Average Method
Stores Ledger
Date Receipts Issues Balance Remarks
2012 Ref. Qty. Rate Amt. Ref. Qty. Rate Amt. Qty. Rate Amt.
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
April 1
3 400 2.10 840 400 2.10 840
15 500 2.20 1100 900 1940
20 500 2.15 1075 400 865
26 600 2.50 1500 1000 2365
28 900 2.35 2115 100 250

Note : Calculation of average price

I. 15th April : = Rs. 2.15

II. 26th April : = Rs. 2.35

2. Weighted Average Price

This method considers quantity of materials stock for calculating the issue price.
Whenever fresh supply is received, the price is calculated by dividing total cost of stock
(including fresh supply) by quantity in stock.
Total Cost of Stock
Weighted Average Price =
Quantity in Stock
B.Com. Part-III 62 B.C. 503

Weighted Average Price Method Stores Ledge r

Date Receipts Issues Balance
2015 Ref. Qty. Rate Amt. Ref. Qty. Rate Amt. Qty. Rate Amt. Remarks
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
April 1
3 400 2.10 840 400 2.10 840
15 500 2.20 1100 900 2.16 1940
20 500 2.15 1080 400 2.16 860
26 600 2.50 1500 1000 2.36 2360
28 900 2.36 2124 100 2.36 236

Note : Calculation of Weighted Average Price :

I. 15th April = = Rs. 2.16

II. 26th April = = Rs. 2.36

1.5.4.3 Notional Price Methods

1. Inflated Price Method
2. Market Price Method
3. Standard Price Method
1. Inflated Price Method
This method is applied where the materials are subject to normal wastage which is
unavoidable. In order to cover the loss arising due to normal wastage, the materials
issue are priced at an inflated rate. For example, if 100 units of a certain material are
purchased at Rs. 38.80 per-unit and it is expected that there shall be a no final wastage
of 5 units, 95 units of the material shall be used at an inflated price of Rs. 40 per unit
(Rs. 3800 % 95).
This method is quite specific and reasonable but involves excessive clerical labour.
2. Market price Method
Under this method, the material issues are priced at market price ruling at the date of
issues or at the replacement price. The actual cost of the material is ignored under this
method.
This method is suitable for giving quotation and competitive basis. It also indicates the
buying efficiency, in that the excess of market price charged to the issues over their
purchase denotes efficient buying and vice-versa. Not being an actual cost method, it
leads to profit or loss in charging materials to production. Moreover, it is not easy to
maintain upto date list of revealing market prices.
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3. Standard Price Method

Under this method, the material are priced at standard price or fixed price The standard
issue price is fixed for a definite period say for a month, quarter or year after considering
all factors affecting prices.
Standard Price can be of two types :
I. Basic standard: It is fixed for long period to facilitate perspective planning.
II. Current standard : It is fixed for short period, flexible to accommodate the
permanent change likely to take place in the cost of materials. This method
possesses the advantage of simplicity, as calculations are minimise and is
generally used when market fluctuations are few.
1.5.4.4 Specific Price Method :
When- materials purchased for specific job or work order, they should be issued to the
specific job or work order at their actual cost. This method is used where job costing is
in operation and the actual material issued can be identified.
1.5.5 PRICING OF RETURNS
Materials returned in the original condition may be valued by anyone of the following
two methods :
(I) At the same price at which it was issued :
The returned material is valued at the original price at which, it was issued. This price
is ascertained from the original material requisition. This method of pricing of returns is
most desirable because the values of the credit given on the return and the original
debit given on issue to the production order concerned are identifiable and no further
adjustment is needed. The returned material may be kept apart and may be issued
according to the specific price method at the original price or the returned materials
may be treated as a new entry. After treating the returned materials as a new purchase.
It will be issued according to the method of pricing of issue prevalent in the organisation.
(II) At the Current Price of Issue :
According to this method, the returned material is priced at the rate at which any
materials requisition, placed on the date would have been priced. In other words, pricing
of returns will not be done at the original price. This method is not popular as it will
need adjustment in production order on account of different rates being applied on
returns.
Scraps, wastes, defectives, etc. do not posses the same value as the original material. So
these- are valued separately and then entered in the Bin Card and Stores Ledger. Thus,
pricing of scraps, wastes and defective is made according to their value and credit is given
to the production order, which returned such scraps, wastes and defectives.
Self Check Exercise:
Q.1 Enumerate the factors which influence the selection of a particularly method
of pricing the issues of material from stores.
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Q.2 Distinguish between (1) waste and scrap (2) scrap and spoilage.
1.5.6 WASTAGE, SCRAP, DEFECTIVE WORK AND SPOILAGE
Wastage : “Waste is the portion of a basic raw material lost in processing, having no
recovery value”, It is a complete loss. A percentage of normal wastage is standardised for
the purpose of exercising control over it and this normal waste may be spread over good
units by inflating their cost proportionately. If waste is abnormal, or in excess of fixed
limit, the excess amounl may be debited to costing Profit and Loss Account.
Scrap :
“Scrap is the incidental residue from certain types of manufacture usually of small
amount and low value, recoverable without processing.”
Defectives :
“Defectives are that portion of production which may be rectified at an extra expenditure,”
(i) If it is due to inherent defect in production process, and identifiable to a
job or process, it may be charged to specific job.
(ii) If it is due to abnormal circumstances it is debited to costing profit and
loss account.
Spoilage :
“Spoilage refers to that portion of production which is damaged beyond rectification
and as such can be sold out as ‘Second’ or ‘Third’ quality goods without further processing.
The cost of work spoiled as determined by accumulating material, labour and overhead
expenses incurred upto the point of rejection.
1.5.7 CONTROL OVER WASTE, SCRAP, SPOILAGE AND DEFECTIVES
Since it is impossible to eliminate waste, scrap, spoilage and defective it is imperative
to follow a rigid procedure of control to keep them down. The control procedure should
recognise the following essentials :
(a) Setting Standards or Normal Limits :
Standards are to be established in respect of scrap, waste, spoilage and defectives
having regard to the nature of manufacturing process, quality of raw materials and
workmanship and working conditions of plant and equipment.
(b) Reporting :
Standard forms printed in different colours are to be used for prompt and accurate
reporting. These reports should clearly furnish information such as the name of the
department, number of cost centre, date and report number, actual waste, scrap etc.,
in both quantity and percentage, normal limit, the difference between, the actual and
the standard costs calculated, the causes for difference and the action to be taken,
(c) Remedial Action :
Where the reports show deviation of actuals from standards, the reasons should be carefully
studied and immediate corrective steps must be taken. These steps may be :
B.Com. Part-III 65 B.C. 503

(1) To repair the machinery and equipment.

(2) To replace the parts scrapped.
(3) To return the defective materials to suppliers.
1.5.8 SUMMARY
In a manufacturing concern, inventory is classified as (a) Raw materials, Work-in-Progress,
and (c) Finished goods. The particular items included in each classification depend on
the particular firm, that what would be classified as raw material or finished goods. The
previous lesson gives requirements of material control by covering main areas, that is,
ordering, purchasing, receipt, storage and issues of material, and the present lesson is
focusing on the important methods followed in pricing of issue of materials, such as,
cost price methods, average price methods, notional price methods and specific price
methods.
1.5.9 ANSWERS TO SELF CHECK QUESTIONS
Ans1. Sel ec t i o n o f a Pr i c i n g M et h o d : The choice of a method of selection may
be based on the following considerations :
1. The method of costing used.
2. The frequency of receipts and issues.
3. The extent of price fluctuations.
4. The extent of work involved in recording, issuing and pricing materials.
5. Whether cost of materials used should reflect current or historical conditions?
6. Whether issues can be identified with purchased costs?
7. Policy of management regarding the valuation of closing stock.
8. Method being adopted by other firm inthe same industry.
Ans.2 (1) Difference betwen waste and scrap :
(i) Scrap always visible whereas waste may be visible or invisible.
(ii) Scrap has always recoverable value but waste has no recoverable value.
(2) Difference between Scrap and Spoilage :
(i) Scrap involves loss of materials only while spoilage involves not
only the loss the materials but also of labour and overheads
incurred upto the stage where the spoilage has occurred.
(ii) Scrap has relatively low value but the value of spoilage may vary
from low to high.
(iii) Scrap arises as a result of the processing of materials while
spoilage occurs to defect in materials or processes.
1.5.10 GLOSSARY
1. FIFO - First in first out method
2. LIFO - Last in first out method
3. HIFO - Highest value material first out
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4. NIFO - Next in first out method

5 Blanket rate - A single rate for all non-specific cost put together.
1.5.11 EXERCISE
(A) Short Questions
Q.l Write short notes on :-
(a) ABC analysis
(b) Average Stock level
Q.2 The treatment of Scrap and defectives.
Q.3 Define LIFO method.
(B) Long Questions :
Q.1 On 1st March 2015, there are 1500 units of materials at Rs. 12 per unit in
stock. The following transactions were made during the month :
March 2 Issued 200 units
,, 4 Purchased 1,000 units @ Rs. 15 p.u.
,, 5 Issued 1,200 units
,, 6 Purchased 600 units @ Rs. 20 p.u
,, 7 Issued 650 units
,, 7 Returned to store 100 units
form issued of 2 march,
,, 9 Purchased 300 units at Rs. 25 p.u.
,, 13 Issued 250 units
,, 17 Issued 300 units
Prepare stores Ledger account by FIFO and L1FO methods.
Q.2 What is Inventory Control ? Give various methods of valuation of inventory in details.
Q.3 What is meant by perpetual Inventory System ? Describe its advantages and
Disadvantages.
1.5.12 SUGGESTED READINGS
1. V.K. Saxana and CD. Vashist, Advanced Cost and Management Accounting
Sultan Chand & Sons, New Delhi,1998.
2. Dr. Manmohan & S.N. Goyal, Principles of Management Accounting
Shakithabhavan Publication, Agra.
3. Barfield, Jessie, Ceily A. Raiborn and Micheal R. Kenny : Cost Accounting,
Traditions and innovations, South Western College Publishing, Cincinnati,
Ohio.
4. Homgren, Charles T George Foster and Srikant M Daliar : Cost Accounting, a
managerial emphasis, Prentice Hall, Delhi.
5. Lall, B.M and I.C Jain : Cost Accounting : Principles and Practice Hall, Delhi.
6. Welsch Glenn A, Ronald W Hilton and Paul N Gorden : Budgeting, Profit
Planning and Control, Prentice Hall, Delhi.