Unit - 1 : Introduction to Cost Accounting

Structure of Unit:
1.1 Objectives
1.2 Introduction
1.3 Branches of Accounting
1.4 Emergence of Cost Accounting
1.5 Nature
1.6 Advantages
1.7 Importance
1.8 Installation of Cost Accounting System
1.9 Essential of a Good Cost Accounting System
1.10 Methods
1.11 Techniques
1.12 Cost Accounting vs. FinancialAccounting
1.13 Limitations of Cost Accounting
1.14 Summary
1.15 Self Assessment Questions
1.16 Reference Books

1.1 Objectives
After completing this unit, you will be able to:
 To assertion and control cost.
 Determining selling price.
 Facilitating preparation of financial and other statements.
 To reduce cost.
 To provide base for operating policy.

1.2 Introduction
In the initial stages cost accounting was merely considered to be a technique for ascertainment of cost
of products or services on the basis of historical data. In course of time due to competitive nature of
the market, it was realized that ascertainment of cost is not as important as controlling costs. Hence, cost
accounting started to be considered more as a technique for cost control a s compared to cost ascertainment.
Due to technological development in all fields, now cost reduction has also come within the ambit of cost
accounting. Cost accounting is thus concerned with recording, classifying and summarizing costs for
determination of costs of products or services, planning, controlling and reducing such costs and furnishing
of information to management for decision making.

Meaning and Definitions of Cost Accounting

“Cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information
for three major purposes: (in) Operational planning and control ;( ii) Special decision; and (iii) Product
decision.” -Charles T. Horngren

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“Cost accounting is the process of accounting for costs from the point at which the expenditure is incurred
of committed to the establishment of its ultimate relationship with cost units. In its widest sense, it embraces
the preparation of statistical data, the application of cost control methods and the ascertainment of the
profitability of the activities carried out or planned is defined as the application of accounting and costing
principles, methods and techniques in the ascertainment of costs and the analysis of saving and/or excess as
compared with previous experience or with standards.” – Institute of Cost and Management
Accountants of London
“Cost accounting is defined as the application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the ascertainment of profitability. It includes
the presentation of information derived therefore for the purposes of managerial decision making. –Wheldon
Cost accounting thus provides information to the management for decision of all sorts. It serves multiple
purposes on account of which it is generally indistinguishable from management accounting or so-called
internal accounting. Wilmot has summarized the nature of cost accounting as “the analysing, recording,
standardizing, forecasting, comparing, reporting and recommending” and the role of a cost account asthat
of “a historian, news agent and rophet”.

1.3 Branches of Accounting

There are seven branches of accounting:-
a) Financial Accounting: This is called original accounting, whichis mainly confined to the preparation
of financial statement for the various concern parties and financial institutions.
b) Cost Accounting: The process of accounting for cost which begins with the recording of income
and expenditure or the bases on which they are calculated and ends with the preparation of periodicals
statements and reports for ascertaining and controlling cost.
c) Management Accounting: Management accounting is a distinctive form of resource management
which facilitates management’s ‘decision making’ by producing information for managers within
organization.
d) Inflation Accounting: This accounting system do not consider the cost constant at every time
because the price of a commodity change with time to inflation and decline purchasing power of
money.
e) Social Accounting: This deals with the application of double entry system of book keeping to
socio-economic analysis at the preparation, estimation and interpretation of nation and international
income and balance sheet.
f) Value –Added Accounting: In this system income is measured by the value added by a firm in a
particular period. It is the difference between the value of the product and the cost of raw material,
stores and any brought out component used for production.
g) Human Resource Accounting: Human Resource accounting is the measurement of the cost and
value of people for the organization or it is the process of identifying and measuring data about
human resources and communicating this information to interested parties.

1.4 Emergence of Cost Accounting

The Institute of Cost and Works Accountants of India (ICWAI) was established as a company limited by
guarantee for the development of cost accounting in India. The main purpose of this to develop the cost

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accounting as a profession. The maintenance of cost accounting records became mandatory since 1965,
after the addition of Sec.209 (1) (d) in the companies act 1956.
The Institute of Cost and Works Accountants of India has recently issued cost accounting standard (CAS)
1 to 4 also to understand the subject in a better manner as follows :-
CAS 1 - Classification of cost
CAS 2 - Capacity determination
CAS 3 - Allocation and apportionment of overhead
CAS 4 - Cost of production for captive consumption

1.5 Nature
Cost accounting is a practice of cost control which is as follows:-

(a) Cost accounting is a branch of systematic knowledge that is a discipline by itself. It consist its own
principles, concepts and conventions which may vary from industry to industry.

(b) Cost accounting is a science and arts both. It is science because it is a body of systematic knowledge
relating to a wide variety of subject and an art because without the efficiency and experience of cost
auditor it is not possible to use costing techniques efficiently.

1.6 Advantages
A good system of costing is the technique of controlling the expenditure and helps bringing economy in
production, so it serves the needs of a large section of people in the following ways.
(a) Benefits to the Management: The information revealed by cost accounting aims at mainly assisting
the management in decision making and optimizing profits. Besides this there are certain advantages
of cost accounting to the management i.e. it helps in price fixation, in revealing profitable and
unprofitable activities, idle capacity, in controlling cost and also helps in inventory control.
(b) Benefits to the Employees: Cost accounting introduces wage scheme, bonus to the efficient &
sincere employees which in turn increasing productivity, profitability and lowering cost.
(c) Benefits to Creditors: The better management of finance through cost accounting leads to timely
debt servicing by company in the form of repayment of loan and payment of interest. To stay and
grow in competition and for judging soundness of present and perspective borrower and cost
reports give better picture of efficiency profit prospectus and capacity.
(d) Benefits to the Government: Cost accounting enables the Govt. to prepare plans for economic
development of the country, to make policies regarding taxation, excise duty, export, price, ceiling,
granting subsidy etc.
(e) Benefits to Consumers/Public: Cost accounting helps consumers in getting goods of better
quality at reasonable price.

1.7 Importance
Cost accounting gives information and reports to the management in the following ways:-
(a) Control of Material Cost –Cost of material is a major portion of the total cost of a product. It can
be controlled by regular supply of material and spares for production, maintaining optimum level of
funds in stocks of materials and stores.

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(b) Control of Labour Cost: If workers complete their work within the specified time cost of labour
can be controlled.
(c) Control of Overheads: By keeping a strict check over various overheads such as factory,
administrative and selling & distribution, this can be controlled.
(d) Measuring Efficiency: Cost accounting provides information regarding standards and actual
performance of the concern activity for measuring efficiency.
(e) Budgeting: The preparation of the budget is the function of costing department and budgeting is
done to ensure that the practicable course of action can be chalked out and the actual perform
corresponds with the estimated or budgeted performance.
(f) Price Determination: On behalf of cost accounting information, management is enable to fix
remunerative selling price for various items of products and services in different circumstances.
(g) Expansion: The management may be able to formulate its approach to expansion on the basis of
estimates of production of various levels.

1.8 Installation of Cost Accounting System

It is essential to undertake a preliminary investigation installing a suitable system of cost accounting to know
the feasibility of installing cost accounting system to such business.
(a) Essential Conditions: The following conditions are essential for successful functioning of the costing
system:-
(i.) Material control system should be very efficient.
(ii.) The role of cost accounting must be clear.
(iii.) The methods of wage payment must be sound and well designed.
(iv.) The cost report should be printed forms to facilitate quick compilation.
(v.) The cost and financial accounts must be integrated so as to facilitate reconciliation of profit.
(b) Essential Factors for Installing a Cost Accounting System: The following essential factors are
to be considered before installing a cost accounting system :-
(i) Nature of Industry –There is no technique or method of costing that can be applied universally.
The nature of business should be considered while applying the costing techniques.
(ii) Background of Business Unit –The back ground of business unit includes its existence,
position, rate of growth, policy and philosophy of management. It serves as a basis for designing the
cost accounts in respect of necessity, simplicity and investment involved in installing cost account.
(iii) Selling & Distribution Method –The warehousing facility, external transport, market research
and other promotion measures, terms of sale and promotion of orders from customers are to be
considered with regard to distribution process.
(iv) Flexibility and Uniformity – The cost accounting system to be install must be flexible and
uniform in operation and must be capable of adoption to changing conditions and facilitates inter
firm comparison among various firms belonging to the same industry.
(v) Product Range – Range of product must be analyzed in terms of size, models, fashions, area
of market and competitors to determine the method of costing to be selected.
(vi) Organizational Factors – Size and type of organization, levels of management, extent of
delegation and responsibility, extent of departmentalization, availability of modem office equipments

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 and number of managerial and supervisory staff are to be considered while installing cost accounting.
(vii) Area of Control-It must be given top most priority for exercising control over materials when
material control occupies significant are of control.
(viii) Reporting and Use of Electronic Data Processing- The reports of cost data must be
frequent and promptitude, while installing cost accounting system. In modern ere use of electronic
data processing equipments and computers has become a common practice.
(c) Procedure for Installation
(i.) Nature of Business: Nature of the business of organization like capacity of plant, nature of
material and labour, and various processes etc. should be considered before installation of costing
system.
(ii.) Determination of Cost Centers: Nature and no. of cost centers required should be decided
to control cost.
(iii.) Determination of Process: Suitable system or process should be adopted according to the
size of business and nature of product.
(iv.) Nature and Quality of Product: Quality of product, time consumed, and process used etc.
should be considered while installing a costing system.
(v.) Determination of Extent and Way to Control: Extent and way to over material, labour and
over head should be determination.
(vi.) Arrangement for Flow of Cost Data: Proper arrangement should be made for the information
related to cost.
(vii.) Forms: Standardized forms should be used by all foreman and workers.
(viii.) Records to be Maintained: Complete and accurate records should be maintained to carefully
work out.

1.9 Essential of a Good Cost Accounting System

A good cost accounting should possess the following essential features:
i) It should be simple, practical and capable of meeting the business concern requirements.
i) Accurate data should be used by cost accounting system; otherwise it may distort the output of the
system.
iii) To develop a good system of cost accounting necessary co-operation and participation of executives
from various departments of the business is needed.
iv) The cost of installing and operating the system should be result oriented.
v) It should not sacrifice the utility by introducing unnecessary details.
vi) For the introduction of the system a carefully phased programmed should be prepared by using
network analysis.
vii) Management should have faith on costing system and works as a helping hand for its development
and success.

1.10 Methods
Depending upon the nature of the business and the types of its products, numbers of methods of cost
ascertainment are used in practice. The methods of costing are as follows:

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 a) Job Costing: In this system the cost of each job is ascertained separately which is suitable in all
cases where work is undertaken on receiving a customer’s order. Like a printing press, motor work
shop etc.

b) Batch Costing: It is considered as the extension of job costing. It represents a number of small
orders passed through the factory in batch. Each batch here is treated as a separate unit of cost.

c) Contract Costing: It is suitable for the firms which are engaged in the work of construction of
bridges, roads, buildings etc.

d) Single or Output Costing: It is used in the business where a standard production is turned out and
it is desired to find the cost of a basic unit of production.

e) Process Costing: It is a method of costing used to ascertain the cost of a product which may
passes through various processes before completion.

f) Operating Costing: The cost of providing a service is known as operating cost and the methods
to ascertain the cost of such services is known as operating costing.

g) Multiple Costing: In multiple costing, a combination of two or more methods of costing is used in
conjunction to determine the cost of final product. This method is used by the industries where
different components are separately manufactured and subsequently assembled into the finished
product. For e.g.: Motor car, Television, Ships etc.

1.11 Techniques
For ascertaining cost, following techniques of costing are usually used:-
a) Uniform Costing: The practice in which common methods of costing for different undertakings in
the same industry are used is known as uniform costing.

b) Historical Costing: In this technique, ascertainment of cost is done after they have been incurred
but the utility of this technique is limited.

c) Direct Costing: The practice of charging all direct costs to operations, processes or products
leaving all indirect costs to be written off against profit’s in which they arise are called as direct
costing.

d) Absorption Costing: In this all costs, both variable and fixed are charged to production, operations
or processes.

e) Marginal Costing: The method of ascertaining marginal cost by differentiating between fixed and
variable costs. This technique is used to ascertain effect of changes in volume or type of output over
the profits.

f) Standard Costing: The preparation of standard costs and applying them to measure the variations
from actual cost and analyzing the causes of variations with a view to maintain maximum efficiency
in production is known as standard costing.

g) Activity Based Costing: ABC is a system that focuses on activities as fundamental cost objects
and utilizes the cost of these activities as building blocks or compiling the costs of other cost objects.

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1.12 Cost Accounting vs. Financial Accounting
Basis Cost Accounting Financial Accounting
1) Purpose Its main purpose to guide It reveals the final results during
the management for proper the particular period for every
planning, controlling and concern.
decision-making etc.

2) Coverage It deals with expenses related This deals with whole

to or identified with products. organization connected with
manufacturing and also other
activities or areas.
3) Basis This deals with estimated and This deals only with the actual
actual data both. financial transactions and
figures and not on estimation.
4) Scope It is related to a particular It includes all commercial
product or service. translation of organisation
for a particular
period of time.
5) Parties Involved This deals with internal This concern with external
translations between parties as well as external
departments within the transactions.
organisation.
6) Final Statement Only one statement is prepared Profit & Loss A/c and balance
i.e. statement of cost. sheet both are prepared.
7) Valuation of Stock Stock is valued at cost Market value or cost
whichever is lower is
considered as the value of
stock.
8) Nature It does not consider only It is related to the historical
historical records but also records.
predetermined cost.
9) Classification It is clearly classifies the cost In this cost is not classified
into fixed and variable cost. into fixed and variable cost.
10) Legal Generally these accounts are It is required by companies
Requirements kept to meet management act, Income Tax Act, etc. to
requirements. Now it has keep these accounts.
become obligatory.

1.13 Limitations of Cost Accounting

These are the following reasons for which cost accounting is criticized by the different sections of society:
a) Not Reliable: Cost Accounting is based on estimates and so it is not reliable.

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b) Failure of the System: Cost Accounting system has failed to produce desired results in many
concerns. Thus it could be said that this system is at fault.
c) Unnecessary: it is not necessary in Business concern as it involves duplication of work.
d) Inapplicability: Modern methods of cost accounting are not applicable to every type of
industries.
e) Expenses: It is expensive because double set of account books has to be maintained and its
introduction involves considerable amount of expenditure.

1.14 Summary
The techniques and process of accounting for cost begins with recording of Revenue and expenditure
and the basis on which they are calculated and it also includes the presentation of information in the
form of periodical statements and reports for the purpose of managerial decision – making. Cost
Accounts are key to economy in manufacturing and are indispensable to the intelligent and economical
management of the factory. Thus it has come on essential tool of management.

1.15 Self Assessment Questions

1. “Cost Accounting System is neither unnecessary nor expensive, rather it is profitable
investment”, Comment.
2. Discuss the characteristics of an ideal system of Cost Accounting and differentiate between
cost accounting and financial accounting.
3. Explain different ‘Methods’ and ‘Techniques’ of costing.

1.16 Reference Books

- Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and Management Accounting
( Malik and Co.)
- Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)
- Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD, Jaipur)
- Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)

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Basic Cost Concepts
Structure of Unit:
2.1 Objectives
2.2 Introduction
2.3 Classification of Costs
2.4 Cost Concepts
2.5 Components of Total Cost
2.6 Cost Sheet
2.7 Summary
2.8 Self Assessment Questions
2.9 Reference Books

2.1 Objectives
After completing this unit, you will be able to:
 Define the classification of cost and cost concepts.
 Differentiate between components of total cost and to make cost sheet.

2.2 Introduction
Element is an important area of a product. To estimate correct cost accounting, cost classification and
analysis is being done. This is also necessary to control the cost. In other words elements of cost means
expenditure or cost incurred on resources which are helpful in produce an item, for example material, labour
and expenses. To understand the cost one should know what is expenses and loss.

Cost:

Generally cost maybe explained as the amount of expenditure, actual or notional, relating to a specific thing
or activity such as product, job, service, process etc. It may also be expressed as a sacrifice which may be
defined in the terms of money means it is the amount of resources given up in exchange for some goods and
services. Cost and expenses are different but relative terms.

Where ‘costs’ includes the cost of material and labour in addition to expenses, the term expenses is widely
applied in financial accounts for various types of historical cost. In cost accounting, it is used for costs other
than cost of raw material and wages. To understand the meaning of cost, it is necessary to define the
meaning of expenses.

Expenses:
Generally expenses are called expired costs means those costs which have been used up totally in generating
revenue. They are not capitalised but only shown as expenses in income statement. There are so many
examples of expenses such as costs of goods sold expenses, selling expenses and administrative expenses.
For expenses, there is no need to be paid in cash immediately, even a promise to pay could be made for the
profits received. The manufacturing costs are capitalised in the form of finished goods inventory and when
a sale is incurred, they expire becoming expenses. The cost of unsold stock which was an asset prior, now
converts expenses of cost of goods sold as it has contributed to the generation of revenue.

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Manufacturing expenses may be expressed as cost because this is included in the cost of fished goods stock
which is an asset unless sale is made.

For example, depreciation of a factory machine increases the utility of goods manufactured which are
therefore included in work-in-progress and finished goods inventory.

Selling and administrative expenses, when not included in the cost of finished goods stock, are deemed only
as expenses, not cost (asset) and are deducted from revenues whenever obtained. Similarly, depreciation of
a factory building is a cost but depreciation of an office building is an expense.

The term cost itself is without any significant meaning and therefore, it is always advisable to use it with an
adjective or phrase that will convey the meaning intended such as prime, direct, indirect, fixed, variable,
controllable, opportunity, imputed, sunk, differential, marginal, replacement and the like. Future costs are
also considered in cost accounting but not in financial accounting.

Loss:

To understand the concept of cost, the term ‘loss’ should be defined.

Loss is lost cost. It is applied to define two accounting events. In financial accounting, it is used to describe
a circumstance where expenses exceed revenues for an accounting period, that is, the reverse of net income
(earnings) for the accounting period. On the other hand, a loss arises due to the cost of an asset being more
than the sale proceeds when the asset is sold. This unfavourable event does not arise from a normalbusiness
activity but from non-operating transactions or events. This meaning of loss is used to recognize the reverse
of gain. That is, if no gain is achieved from the cost incurred or it becomes definite that no benefits accrue,
the cost becomes a lost cost, i.e., loss on sale of fixed asset, loss of stock due to fire etc.

2.3 Classification of Costs

There are so many objectives of cost accounting such as planning, decision- making, stock valuation, profit
measurement, control etc. For achieving these objectives, cost should be computed, classified and grouped.
Cost classification may be known as the process of grouping costs according to their general characteristics.
The various cost classifications are as follows:
1 Natural Classification of Cost
(A) Direct Material Cost (B) Indirect Material Cost
(C) Direct Labour Cost (D) Indirect Labour Cost
(E) Direct Expenses Cost (F) Indirect Expenses Cost

2. According to Variation in Production Activity and Quantity

(A) Fixed Cost (B) Variable Cost
(C) Semi-variable/Fixed Cost (Mixed Cost)
3. Degree of changeability to the product
(A) Direct Cost (B) Indirect Cost
4. Degree of Relation with the Product
(A) Product Cost (B) Period Cost

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5. Functional Classification of Cost
(A) Manufacturing Cost (B) Selling and Distribution Cost
(c) Administrative Cost

6. Association with the Accounting Period

(A) Capital Cost (B) Revenue Cost
7. Costs for Decision-Making and Planning
(A) Opportunity Cost (B) Sunk Cost
(C) Relevant Cost (D) Differential Cost
(E) Imputed Cost/Notional Cost (F) Out-of-pocket Cost
(G) Fixed, Variable and Mixed Cost (H) Shut Down Cost
8. Costs for Control
(A) Controllable and Uncontrollable Cost (B) Standard Cost
(C) Fixed, Variable and Mixed Cost
9. Other Costs
(A) Joint Cost (B) Common Cost

1. Normal Classification of Cost

A) Direct Material cost: Material means those items which are applied for manufacturing of a product
and direct material is directly related to production. For example, raw cotton in textiles, crude oil to
make diesel etc. There are so many names of direct materials such as process material, prime cost
material, stores material and construction materials.

Main points for direct material can be summarized as follows:

(1) Direct material specially acquired for a particular Job, order, process or product.
(2) It is integrated part of manufacturing unit.
(3) Value of direct material is comparatively higher than that of other materials.
(4) Material passing from one process to another process.
(5) Primary packing materials e.g. wrapping, cardboard boxes, the glass bottle in production of
syrup etc
(6) It Increases in the same ratio as the increase in production

B) Indirect Material Cost: In the words of C.I.MA., London, “indirect material cost is the material
cost which cannot be allocated but which can be apportioned to or absorbed by cost centres or
cost units’’.

Thus it may be said that indirect cost is the cost which cannot be directly identified to the unit of
output or to the segment of a business activity e.g. oil, grease, consumable stores etc.

C) Direct Labour Cost: Direct labour is known as the wage of those workers who are involved in the
production process whose time can be efficiently and economically traceable to units of products
e.g. wages paid to compositors in a printing press, labour of machine operators and assemblers. It
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 may also be defined as prime labour cost, process labour cost, operating labour cost, manufacturing
wages, Direct wages and productive labour cost. In the words of C.I.MA., London, “direct wages
is that wages which can be allocated to cost centres or cost units.”

D) Indirect Labour Cost: Some workers does not engage directly in conversion of output but contribute
indirectly. Labour is paid for the objective of carrying tasks incidental to goods or service provided.
It cannot be practically traced to particular units of output e.g. wages of store-keepers, foremen,
time-keepers, supervisors, Inspectors etc. In the words of C.I.M.A., London, “Wages which
cannot be allocated but which can be apportioned or absorbed by cost centres or cost units is
indirect wages.’’
E) Direct Expenses Cost: It is also defined as chargeable expenses. These direct expenses are
incurred directly on a particular product, Job or cost units and recognizable with the cost units.
According to C.I.M.A., London, “Direct expenses means, expenses which can be allocated to
cost centres or cost units.”

For example, -
(1) Hiring of a particular tool plant or equipment for job.
(2) Cost of special moulds, designs and patterns.
(3) Fees paid to architects, surveyors and consultants.
(4) Insurance charges on special materials chargeable to a job.

F) Indirect Expenses Cost: Those expenses which cannot be directly, conveniently and fully charged
to cost units are known as indirect expenses In the words of C.I.M.A., London, “Indirect expenses
are expenses which cannot be allocated but which can be apportioned to or absorbed by cost
centres or cost unit” For example, insurance, power, lighting and heating, rent, rates and taxes,
depreciation etc.
2. According to Variation in Production Activity and Quantity:
Costs can be divided into (i) fixed, (ii) variable, and (iii) mixed costs, in terms of their changes in cost
behaviour in relation to variation in output, or activity or volume. Activity can be expressed in anyform such
as units of output, hours worked, sales, etc.
A) Fixed Cost: Fixed cost is a cost which does not vary in total for a given time period in spite of wide
fluctuation in production or volume ofactivity. These costs are also termed as standby costs, capacity
costs or period costs. Few examples explaining the nature of fixed costs are rent, property taxes,
supervising salaries, depreciation on office facilities, advertising, Insurance, etc. Fixed costs are
incurred with the passage of time and not with the production of the product or the job.

Hence, fixed costs are defined in terms of time, such as per day, per month or per year and not in
terms of unit. It is totally illogical to say that remuneration of supervisor in the form of salaryand
perquisites are so much per unit but, it can be said that supervisor’s salary and perquisites are so
much per month.
Fixed costs can be further classified in the following categories
a. Committed costs: Those costs are unavoidable in short-term if the concern has to function. Such
costs are basically incurred to maintain the company’s benefits and physical existence, and over which

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 management has little or no discretion. Few examples of committed costs are plant and equipment
depreciation, taxes, insurance premium, rate and rent charges.
b. Managed costs: Managed costs are related to current activities which must continue to be incurred
to ensure the operating existence of the company e.g., management and staff salaries.
c. Discretionary costs: They are also identified as programmed costs. Discretionary costs result from
special policy decisions, management programmes, new researches etc. Few examples of such costs
are research and development costs, marketing programmes, new system development costs.
The difference between committed and discretionary costs is that it is hard to eliminate or neglect
committed costs in times of low production or decline in business activity, whereas discretionary costs
such as research and development could be reduced to a desirable level.
d. Step costs: Astep cost is fixed for a given amount of production and then rises in a constant amount
at a higher production level. For example, in a manufacturing concern, one supervisor is needed at a
salary of Rs 20,000 p.m. for every 50 workers. So long as 50 workers or less than that are working,
the supervision costs will be Rs. 20,000 p.m. But, as soon as the 51st worker is employed, the cost of
supervision rises by Rs. 20,000 p.m. and will be Rs. 40,000.Up to 100 workers the cost of supervision
remains fixed at Rs. 40,000. But, if more than 100 workers are employed the cost of supervision willgo
up further. The following figure can be used to explain this concept :

B) Variable Cost: Variable Cost is those costs that change directly and accordingly with the production.
There is a fixed ratio between the variation in the cost and variation in the level of output. Direct
materials cost and direct labour cost are the costs which are generally variable costs. For example,
if direct material cost is Rs. 50 per unit, then for producing each extra unit, a direct material cost of
Rs. 50 per unit will be incurred. That is, the total direct material cost increases in direct proportion
to increase in units manufactured. However, it should be highlighted that it is only the total variable
costs that vary as more units are produced; the per unit variable cost remains fixed.
Variable overheads like factory supplies, indirect materials, sales commission, office supplies aresome
other examples of variable costs. If the factory is shut down, variable costs are eliminated. Variable cost
is always revealed in terms of units or percentage of volume; it cannot be stated in terms of time. For
every increase in the units produced there is a proportionate increase in the cost. When production
increases to 3,000 units from a level of 2,000 units, the cost of direct materials increases in direct
proportion at the fixed rate of Rs. 50 per unit. The line of variable cost is shown as linear rather than
curvilinear.

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C) Semi-variable/Fixed Cost (Mixed Cost): Mixed costs are costs made up of fixed and variable
items. They are a combination of semi-variable costs and semi-fixed costs. Because of the variable
element, theyvarywith volume; because of the fixed element, they do not fluctuate in direct proportion
to output. Semi-fixed costs are those costs which remain fixed up to a certain level of production
after which they become variable.
3. Degree of Changeability to the Product
According to this basis, cost may be divided into direct and indirect cost.
A) Direct Cost: it may be defined as the term of direct materials, direct labour and direct overheads.
That means it is a cost which can be directly identified to a unit of output or the segment of a
business operation. It output units are the objects of costing, then direct cost represent cost and
resources that can be traced to or identified with the finished product .
B) Indirect Cost: Indirect costs are those costs which cannot be associated with or chargeable to a
single product because they are incurred for more products. The examples of indirect costs are:
indirect materials (lubricants and scrap materials), salary of factory supervisors (indirect labour),
rent, rates and depreciation (indirect expenses). Indirect costs, often related to as overheads, have
to be apportioned to various products.

Costs also may be direct or indirect with respect to particular firm segments or divisions. That is some cost
which are indirect for a product, may be charged to a segment or department and thus, will be direct costs
for that department. Asegment may mean any one of a number of things, viz. department, division, specific
activity, sales territory etc.

Before classifying the cost into direct and indirect, it is necessary to know whether it is being related with a
product, sales area, department or some other activity. For example, if a salesman simultaneously handles
several products, his salary is an indirect cost for each product, but a direct cost to his sales area or
department.

4. Degree of Relation with the Product

Cost may be divided into product costs and period costs in terms of relation with the product.

A) Product Cost: Generally product costs are identified with the product and merged in inventory
values. In other words, product costs are those costs that are included in the cost of manufacturing
a product. In a manufacturing firm, it is the combination of four elements: (i) direct materials, (i )
direct labour, (iii) direct expenses, and (iv) manufacturing overhead. Thus, product cost is a complete
factory cost. Prior to sale, product costs are deferred as inventories and until the goods are sold,
are shown on the balance sheet as assets. As finished inventory goods is sold, product costs are
transferred from the inventory accounts to the cost of goods sold account thus becoming expenses
and part of the period costs at the time revenue is realised.

B) Period Cost: Period costs are those costs which are not identified with product or activity during
the period in which they are evolved. They are not carried forward as a part of value of stock to the
next accounting period.

These costs are required to generate revenues but they cannot be directly related with units of
product. Difference of opinion exists regarding whether certain costs should be considered as product
or period costs.
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5. Functional Classification of Costs
Functional classification of costs defines how the cost was applied (manufacturing, administration or selling).
A functional classification expresses that the business performs various functions for which costs are incurred.
In measuring net income, expenses are usually classified by function and grouped under the headings of
manufacture, selling and administrative costs. Manufacturing costs are all production cost incurred to
manufacture the products and to bring them to a saleable condition, including direct materials, direct labour
and indirect manufacturing (or factory overhead) costs. Selling and administrative charges may be assumed
as expenses when incurred or charged to prepaid expense accounts such as prepaid insurance. Functional
classification is also important because it gives an opportunity to the management to calculate theefficiency
of departments performing various functions in the firm.
6. Association with Accounting Period
Costs can also be classified into two major classes on the basis of the accounting period to which they
relate: (i) capital expenditures, and (ii) revenue expenditures.
A capital expenditure provides benefit to future periods and is classified as an asset; a revenue expenditure
is treated to benefit the current period and is classified as an expense; a capital expenditure willflow into the
cost stream as an expense when the asset is applied up or written off. The difference between capital and
revenue expenditures is vital to the accurate matching of costs and revenue and to the right measurement of
periodic net income.
7. Costs for Decision-Making and Planning
A) Opportunity Cost: opportunity cost is the cost of opportunity lost. Opportunity cost is the cost of
choosing one item of action in terms of the opportunities which are given up to carry out that course
of action. Opportunity cost is the profit lost by avoiding the best competing alternative to the one
chosen. The benefit lost is normally the net earnings or profits that might have been earned from the
rejected alternative.
For example, assume that a manufacturer can sell a semi-finished product to a customer for Rs.
5,00,000. He decides, however, to keep it and eliminate it. The opportunity cost of the semi-
finished product is Rs. 5,00,000 because this is the amount of economic resources rejected by the
manufacturer to complete the product. Simultaneously, capital which is invested in plant and
inventories cannot now be invested in shares and debentures that will earn interest and dividends.
The loss of interest and dividend that would be earned is the opportunity cost. Other examples of
opportunity cost are when the owner of a business foregoes the opportunity to employ himself
elsewhere; or a machine used to make Product X is said to have an opportunity cost if the machine
can be sold or if it can also make Product Y.
Opportunity costs help in decision-making and selecting alternatives. Decision-making is selecting
the best alternative which is adopted with the help of opportunity costs. But opportunity costs are
not recorded in an accounting system as they relate to opportunities lost.
B) Sunk Cost: Sunk cost is past or historical cost which has already been incurred. It may be known
as unavoidable cost, it refers to all past costs since these amounts cannot be changed once the cost
is incurred. They are the costs which have been created by a decision in the past and cannot be
altered or neglected by any decision that is made in the future. Examples of sunk costs are the book
values of existing assets, such as plant and equipment, inventory, investment in securities, etc. Except
the possible benefits or losses on sales of any of such assets, the book value is not relevant for
decisions regarding whether to use them or dispose them off.
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 Some accountants make discussion and argument that the total cost of a fixed asset is not the sunk
cost, but sunk cost is the difference between the purchase price of a fixed asset and the net amount
that could be realised from its sale. For example, if a plant has a book value of Rs 10,00,000 and
a scrap value of Rs. 60,000 then the sunk cost is Rs. 9,40,000 (Rs 10,00,000 - 60,000) and not
Rs. 10,00,000 That is, the sunk cost is the difference between book value and scrap value.
C) Relevant Cost: Relevant costs are related to future, which differ between alternatives. Relevant
costs may also be termed as the costs which are influenced and changed by a decision. On the other
hand, irrelevant costs are not influenced bythe decision, whatever alternative is selected. The features
of relevant cost are as follows
(i) Relevant costs are basically future costs, i.e. those costs which are, expected to be charged in
future. Relevant costs therefore, are not past (sunk) costs which have already been incurred and
cannot be altered by a decision.
(ii) Relevant costs are only incremental (additional) or avoidable costs. Incremental costs refer to an
increase in cost between two options. Avoidable costs are those which are not incurred from one
alternative to another.
To take an example, assume a business firm purchased a plant for Rs. 20, 00,000 and has now a
book value of Rs. 2,00,000. The plant had become obsolete and cannot be sold in its present
situation. However, the plant can be sold for Rs. 1,60,000 if some modification is done on it
which did cost Rs. 60,000.
In this example, Rs. 60,000 (modification cost) and Rs. 1,60,000 (sales value) both are relevant
as they reflect future, incremental costs and future revenues a respectively. The firm will have
incremental benefit of Rs. 1,00,000 (Rs. 1,60,000 - Rs. 60,000) on sale of the plant.
Rs 20,00,000 has already been incurred and being a sunk cost is not relevant to the decision,
i.e. whether modification should be done. Similarly, the book value of Rs. 2,00,000 which has
to be written off, whatever alternative future action is chosen is also not relevant because is
cannot be altered by any future decision.
D) Differential Cost: Differential cost is the increase or decrease in total costs between any two
alternatives due to change in activity or a particular management decision.

Differential costs are similar to the additional variable expense charged in respect of the additional
output, plus the increase in fixed costs, if any. This cost day be evaluated by taking the total cost of
production without the additional contemplated outlay and comparing it with the total costs incurred
if the additional output is under consideration.

Differential costs are also named as incremental costs, although technically an incremental cost
should refer only to an increase in cost from one alternative to another; decrease in cost should be
referred to as decremental cost. Differential cost is a broader concept encompassing both cost
increases (incremental costs) and cost decreases (decremental costs) between options.

For example, assume that a company has normal capacity to manufacture 50,000 units of a product;
production beyond that point would require the installation of additional plant and equipment that
would increase the amount of fixed costs. General utilisation of available capacity ranges between
40,000 and 50,000 units. Fixed costs for the range of output and expanded capacity have been
estimated as follows:

10
 Normal capacity Expanded capacity
Number of units 40,000 to 50,000 50,000 to 60,000
Fixed costs Rs. 2,00,000 Rs. 2,50,000
Now assume that the variable cost is Rs. 4 per unit. A statement comparing manufacturing costs at
three different production levels would be as follows:
Number of units
Particulars 40,000 50,000 60,000
Variable costs Rs. 1,60,000 Rs. 2,00,000 Rs. 2,40,000
Fixed costs Rs. 2,00,000 Rs. 2,00,000 Rs. 2,50,000
Total manufacturing cost Rs. 3,60,000 Rs. 4,00,000 Rs. 4,90,000
Average per unit Rs. 9.00 Rs. 8.00 Rs. 8.17
incremental costs - Rs. 40,000 Rs. 90,000
Additional output (units) - 10,000 10,000
Incremental cost per unit - Rs. 4.00 Rs. 9.00
The additional capacity which would be needed to expand actions to 60,000 units would enhance the fixed
costs by Rs. 50,000. The incremental cost of an additional 10,000 units would total Rs. 90,000 or Rs. 9.00
per unit. The average cost of the 60,000 units would be Rs. 8.17 per unit.
The concept of differential costing is vital in planning and decision-making.
It is an important tool in calculating the profitability of alternative choice decisions and helping
management inchoosing the optimum alternative. The differential cost analysis can assist management
in knowing the additional profit that would be earned if idle or unused capacity is used for additional
production or if some extra investments are made by the organization.
E) Imputed Cost / Notional Costs: Imputed costs are those costs which do not involve actual cash
outlay. These costs are not actually incurred in some transaction but which are relevant to the
decision as they pertain to a particular situation. These costs do not enter into traditional accounting
system or in financial records. Interests on internally generated funds, rental value of company-
owned property and salaries of owners of a single proprietorship or partnership are some examples
of imputed costs.
Costs paid or charged are not imputed costs. For example, if Rs. 60,000 is paid for purchase of
raw materials, it is an outlay cost but not an imputed cost, because it would enter into ordinary
accounting systems. When a company uses internally generated funds, no actualinterest payment is
needed. But if the internally generated funds are invested in some projects, interest would have
been earned.
The revenue forgone (loss of interest) reveals an opportunity cost, and thus, imputed costs are
opportunity costs.
F) Out of Pocket Cost: Out of pocket cost involves the cash outflows due to a particular management
decision activity. Non-cash costs such as depreciation are not involved in out-of-pocket costs. This
cost concept is important for management in deciding whether or not a particular project will at

10
 least return the cash expenditures related with the project choosen by management. Similarly
acceptance of a special order for production may necessitate the considerations of out-of-pocket
costs that need not to be charged if the special order proposal is not accepted. Depreciation on
plant and equipment is not relevant in decision-making because no cash goes outside the concern.
G) Fixed, Variable and Mixed Costs: These costs have been defined in the previous classifications.
H) Shut Down Cost: Shut down costs are those costs which have to be arise under all conditions in
the case of stopping manufacture of a product or closing down a department or a division. Shut
down costs are always fixed costs. If the manufacture of a product is stopped, variable costs like
direct materials, direct labour, direct expenses, variable factory overhead will not be incurred.
However, a part of fixed costs (if not total fixed costs) related with the product will be incurredsuch
as rent, watchman’s salary, property taxes etc. Such fixed costs are unavoidable. Some fixed costs
associated with the product become negligible and need not be incurred in case production is
stopped such as supervisor’s salary, factory manager’s salary, lighting, etc. Shut down costs, thus
refer to minimum fixed costs which are incurred in the event of closing down of a department or
division.
8. Costs for Control
A) Controllable and Uncontrollable Cost: Controllable cost is that cost which is subject to direct
control at some level of managerial supervision.
The concept of controllable cost is very significant in cost accounting and contributes to the
achievement of the goals of cost control and responsibility accounting The CIMA, London, explains
controllable cost as ‘a cost which can be influenced by the action of a specified member of an
undertaking’ and a non- controllable cost as ‘a cost which can be influenced by the action of a
specified member of an undertakings’. Basically, a controllable cost is the cost over which a manager
has direct and full decision authority. That is, controllable costs can be controlled (reduced) by a
manager at a given organizational level. Some examples of controllable costs are indirect labour,
lubricants, cutting tools, and power costs incurred in the machine department. Controllable costs
do not reveal that they are 100% controllable. Some costs are partly controllable by a responsibility
centre manager. For example, the cost of raw materials is controlled by the production managers as
well as purchase managers. The production manager controls at quantity level, and the purchase
manager at the price level. Such costs are reported to both of them, but one responsible manager
should be held accountable for those costs which he can control.
The term “controllable cost’’ is different with the terms “variable cost, direct cost’’. Variable costs
change with the output but are not necessarily. For example, factory supplies used for servicing
plant and equipment may vary with the output in the production department, but the production
manager cannot control them.
It is influenced from the two factors: (i) the time period factor, and (ii) the decision-making authority,
can make a cost controllable or uncontrollable. If the time period is long enough all costs can be
controllable and curtailed. Similarly, the decision-making authority affects the cost. If a responsibility
center manager has been delegated the authority to spend the cost, he can control it but all costs can
be said to be controllable by somebody in the concern. The managing director of a company is
responsible for allcosts. But practically, the responsibilityand authority of controlling costs is delegated
to various levels in the concern.

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 B) Standard Cost: Standard costs are those costs which are planned or pre-determined cost estimates
for a unit of output in order to get a basis for comparison with actual costs. It is evaluated at
assuming a particular level of efficiency in utilization of material, labour and indirect services.Standard
costs are used to prepare budgets. Standard cost is a unit concept and indicates standard cost per
unit of output, per labour hour etc. On the other hand, the term budgeted Cost’ is a total concept
and implies total budgeted cost of an item at some activity level or output level such as budgeted
cost of material is Rs 8,00,000 if 8000 units are produced.
C) Fixed, Variable and Mixed Costs: These costs have been explained earlier.
9. Other Costs
A) Joint Cost: Joint costs incur where the processing of a single raw material or production resources
results in two or more various joint products or by-products up to the point of separation
simultaneously. Joint costs relate to two or more products manufactured from a common production
process or element-material, labour, or overhead or any combination thereof, or so locked together
that one cannot be produced without producing the other(s).
Thus, joint cost is the cost of two or more products that are not identifiable as individual types of
products until a particular stage of production known as the split-off point (point of separation) is
reached. For example, kerosene, fuel oil, gasoline and other oil products are derived from crude
oil. Joint costs are total costs incurred upto the point of separation. Joint costs can be apportioned
to different products only by means of some suitable bases of apportionment.
B) Common Cost: Common costs are those which are incurred or charged for more than one product,
job or any other certain costing object. These costs are not easily recognizable with individual
product and therefore are normally apportioned.
Common costs are common to products, processes, functions, responsibilities, customers, sales
territories, costing units and period of time.

2.4 Cost Concepts

There are six basic cost concepts on which cost classification and various cost terms are based, which are
as follows :
1. Concept of Objectivity: This concept helps to give direction to the operations referred to cost
finding, cost analysing, cost recording and cost reporting. This concept requires goal congruence
i.e. cost exercises have to be in harmony with the objectives. Objectives influence cost treatments
and cost strategies which may include internal reporting for operational, external and specific non-
repetitive decisions.
2. Concept of Materiality: This concept that forces exactness must be tempered by good judgement,
if no misrepresentation of product cost is likely to result. For example, overhead may include few
items of direct cost, which may not be as material as to justify tracing them to particular unit of
production. A specific decision may be helpful, but benefits may not be materially sufficient to
implement it. Materiality is determined with reference to nature of firm’s affairs, managerial policies
and competitors’ practices.
3. Concept of Time Span: Allassumptions relating to various cost exercises remain valid only during
related specific time span. The fixed cost statement is relied upon a time span under consideration.
No costs will remain fixed for the whole time. Time span choosed by a firm should be more enough

10
 to permit the procedures to record the related cost, output, labour hours and other factors required
in the interpretation or analysts. If time span is too less, leads and lags in recording the cost data may
be quite hassle. If cost associating to a specific time span activity is recorded to another time span
activity, cost result may turn out to be quite wrong.

4. Concept of Relevant Range of Activity: Relevant range of activity reveals the span of volume
over which the cost behaviour is expected to remain valid. Various cost activities are relied upon on
specific assumptions relating to cost behaviour patterns, which are valid only within the related
range of cost exercise. Afixed cost is fixed only in relation to the relevant range of activity during the
time span.

5. Concept of Relevant Cost and Benefit: This concept is for decision-making objectives. In
appraising alternative courses of action, management should consider only relevant cost and relevant
profits relating to alternatives under consideration. Irrelevant cost and benefits are ignored. The
affects of this concept on operating or cong range capacity decisions are as follows :

(a) Relevant Cost and Profit for Operating Decisions: In operating decisions concentration is
on optimum application of existing capacity. Increment analysis based on differential cost and
differential revenue is based directly on the concept of relevant cost and profit.

(b) Relevant Cost and Profit for Capacity Decisions: Relevant cost and profits to a capacity
decision are varied from the cost and profits relevant to an operating decision. In the long-term, the
concepts of fixed and variable cost are meaningless. In long-term decisions, cost and profits are
evaluated in relation of their influence on cost. A long-term decision must consider time value of
money, the timing of the investment and recovery of cost. The terms out-of-pocket cost and sunk
cost are also considered from this perspective.
6. Concept of Normal and Abnormal Cost: The term normal refers for cost or circumstances
which is in agreement with what is representative, usual or regular. The term abnormal refers for
cost or circumstances which are varied from what is normal, expected or ordinary. Various cost
accounting treatments and strategies are laid down for normal and abnormal cost and circumstances.

Generallythese terms are used in reference to normalor abnormalworking situations in cost accounting
discussions.

2.5 Components of Total Cost

1. Prime Cost: It consists costs of direct material, direct labour and direct expenses. It is also known
as basic, first or flat cost.
2. Factory Cost: It comprises of prime cost and in addition, works or factory overheads which
include costs of indirect labour and indirect expenses. This cost is also known as works cost,
production or manufacturing cost.
3. Office Cost: If office and administration overheads are added to factory cost office cost is arrived
at. This is also termed as administration cost or total cost of production.
4. Total Cost: Selling and distribution overheads are added to the total cost of production to get the
cost of sales.
The various components of total cost can be depicted through the help following chart:

10
 Components of Total Cost
Direct Material
Direct Labour Prime Cost or Direct Cost or First Cost
Direct Expenses

Wo rks Cost Plus

Office and Ad mn. Office Cost or Total Cost of Production
Overheads

Office Cost Plus

Selling and Distribution Cost o f sales or Total Cost
Overheads

2.6 Cost Sheet

Cost sheet is an analytical statement of expenses relating to production of an article which informs regarding
total cost, per unit cost and quantity of production.

According to Wheldon, “Cost sheets are prepared for the use of management and consequently, they must
include all the essential details which will assist the manager in checking the efficiency of production.”

In the words of C.I.M.A., London, “Cost sheet is a cost schedule or document which provides for the
assembly of the estimated detailed cost in respect of a cost centre or cost unit”

When cost per unit of production is not necessary to calculate then a statement of cost is prepared to
ascertain total cost and profit or loss on production.

Cost Sheet or Statement of Cost

For the year ending………………
Output units
Particulars Total Cost Cost Per Unit
Rs. Rs.
Direct Materials Consumed ----- ------
Direct Wages ----- ------
Direct Charges or Chargeable Expenses ----- ------
Prime Cost ----- ------
Works Overhead ----- ------
Works Cost ----- ------
Administrative or Office Overhead ----- ------
Cost of Production or Cost of Goods Sold ----- ------
Selling and Distribution Overhead ----- -----
Selling Cost or Total Cost ---- ----
Profit ….% on Cost or Selling Cost ---- ----
Sales ---- ----

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 Production Statement Output units
Particulars Total Cost Cost Per Unit
Rs. Rs.
Raw Materials Consumed ---- ----
(op. stock of R.M.+Purchases + closing stock of R.M.)
Direct Labour or Wages ---- ----
Direct Expenses ---- ----
Prime Cost ---- ----
Works Overhead ---- ----
Add : Opening Work in Progress ---- ----
Less : Closing Work in Progress ---- ----
Works Cost ---- ----
Office Overhead ---- ----
Total Cost of Production ---- ----
Add : Opening Stock of finished goods ---- ----
Less : Closing Stock of finished goods ---- ----
Cost of Production or Cost of Goods Sold ---- ----
Selling and Distribution Overhead ---- ----
Cost of Sales ---- ----
Profit ---- ----
Selling Price ---- ----

Illustration : The following figures have been extracted from the records of a manufacturing company for
the year ending 31st December, 2008. You are required to prepare a statement of cost showing : (a) Cost of
raw materials consumed (b) Prime Cost (c) Factory Cost (d) Cost of production (e) Cost of goods sold (f)
Total cost of goods sold and profit on sales.
Rs.
Stock of Raw Materials (1-1-08) 3,000
Stock of Raw Materials (31-12-08) 2,400
Purchases of Raw materials 14,000
Stock of work-in-progress (1-1-08) 1,000
Stock of work-in-progress (31-12-08) 800
Carriage inward 500
Manufacturing wages 4,000
Other direct expenses 200
Indirect wages 1,000
Experiment expenses 400
Wastage of materials 50
Factory overhead 7,000
Establishment on costs 2,000
Selling overhead 4,000
Distribution overhead 1,000
Stock of finished goods (1-1-08) 1,200
Stock of finished goods (31-12-08) 3,000
Sales 40,00

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Solution:
Statement of Cost
Particulars Rs. Rs.
Purchase of Raw Materials 14,000
Add: Opening Stock of Raw Materials 3,000
Carriage inward 500
17,500
Less: Closing Stock of Raw Materials 2,400
(a) Cost of Raw Materials Consumed 15,100
Add: Direct Wages 4,000
Other Direct Expenses 200
(b) Prime Cost 19,300
Add: Factory Overheads:
Indirect wages 1,000
Experiment Expenses 400
Wastage of Materials 50
Factory Overheads 7,000 8,450
27,750
Add: Opening Stock of WIP 1,000
28,750
Less: Closing Stock of WIP 800
Factory Cost 27,950
Add: Office Overheads:
Establishment on Costs 2,000
Cost of Production 29,950
Add: Opening Stock of Finished goods 1,200
31,150
Less: Clothing Stock of Finished Goods 3,000
Cost of Goods Sold 28,150
Add: Selling Overheads 4,000
Add: Distribution Overheads 1,000
Total Cost of Goods Sold 33,150
Sales 40,000
Net Profit 6,850

2.7 Summary
Cost is a measurement in monetary terms of the amount of resources used for the purpose. Thus the cost

10
can be regarded as the price paid for attaining the objects. The objects may be a product, a service or any
activity. For proper planning, decision making, stock valuation, profit measurement and control in business
cost should be computed, classified and grouped according to their general characteristics.

2.8 Self Assessment Questions

1. Explain the various concepts of ‘Cost’.
2. Define Cost Sheet with Performa.
3. From the following particulars of a manufacturing firm, prepare a statement showing:
(a) Cost of materials consumed
(b) Works cost
(c) Cost of production
(d) Percentage of works overhead to productive wages
(e) Percentage of general overhead to works cost
Rs.
Stock of materials on January 1, 2008 40,000
Purchase of raw materials in January, 2008 11,00,000
Stock of finished goods on 1-1-2008 50,000
Productive wages 5,00,000
Finished goods sold 24,00,000
Works overhead charges 1,50,000
Office and general expenses 1,00,000
Stock of materials on 31-1-2008 1,40,000
Stock of finished goods on 31-1-2008 60,000
Ans.: (a) Rs. 10,00,000 (b) Rs. 16,50,000 (c) Rs. 17,50,000 (d) 30% (e) 6.6%

2.9 Reference Books

- Agrawal, Shah, Mendiratta, Agarwal, Sharma, Tailor — Cost and Management
Accounting ( Malik and Co.)
- Agrawal & Agrawal — Management Accounting (RBD. Jaipur)
- Khan, Jain — Management Accounting (S. Chand & Sons.)
- I. M. Pandey — Management Accounting (S. Chand & Sons.)
- M.R. Agarwal — Managerial Accounting (Garima Publications)
- Jain, Khandelwal, Pareek — Cost Accounting (Ajmera Book depot, Jaipur)
- Oswal, Maheshwari, Modi — Cost accounting. Cost Accounting ( RBD, Jaipur)
- Agrawal, Jain, Sharma, Shah, Mangal — Cost Accounting ( RBD, Jaipur)

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 Material : Purchasing Organization and Control
Structure of Unit:
3.1 Objectives
3.2 Introduction
3.3 Centralized Purchasing
3.4 Decentralized Purchasing
3.5 Purchase Procedure
3.6 Purchase Policy
3.7 Principles of Skillful Buying
3.8 Summary
3.9 Self Assessment Questions
3.10 Reference Books

3.1 Objectives
After going through this unit, you will be able to understand:
 How material constitutes an integral part of the cost of production
 Who purchase the material
 Centralized /decentralized purchasing
 Purchase cycle or purchase procedure
 Different purchase system
 What is purchase order, GRN , Schedule of Quotations, Debit note

3.2 Introduction
Successful operations of any of the business depend to a large extent on the availability of goods and
services of the right quality in the right quantity at the right time, from the right source at theright prices. Out
of three elements of cost (material, labor, overheads), material cost account for nearly 50% of the cost of
production, it is therefore essential to establish suitable procedure for proper control of materials from the
time of placing order with suppliers and vendors until they have been consumed. Material control is a
system which ensures the provision of Five Rights as discussed above in the first two lines of thisparagraph.
Now what is material. Material constitutes an important part of the cost of product. It means all those
supplies and components which are supplied to the organization for the purpose of consumption like
Raw material, components, spare parts, consumables etc depending upon the nature of industry. For
McDonalds potatoes, flour, cheese, butter, vegetables can be stock of raw material.
Who purchases the materials
There are different groups of purchasers who buy materials for different purpose from different sources.
Ist category
Purchasers Who buys Ultimate consumption
IInd category
Middlemen Whole sellers, retailers, agents
IIIrd category
Manufacturers Rawmaterial, components, consumables, machine tools, fuels
packing material
IV category
Governmental agencies and institutions Public utility

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Activity A:
1. Name any three industries where the material function is a board room activity?
Material department can contribute effectively to profits, as purchasing is a spending function and every
rupee saved in buying goes to the profit column. The basic objective of material management is to provide
raw materials timely.

3.3 Centralized Purchasing

Purchase of Material
Purchasing is a specialized activity in a manufacturing concern because it has its bearing on everyvital
factor concerning the manufacture like quantity, quality, cost, efficiency, prompt delivery, and volume of
production. Quality of finished product ultimately depends upon quality of raw materials used in it. High skill
work can of course help in improving the quality of product but it cannot change the character of raw
material, which is base for the end product. A traditional housewife is a pace setter when demand, price,
consumption, source, money, management comes into pictures. The purchases can be
• Centralized
• Decentralized.
It means all the purchases are made at one central point or by one central department. In such a system all
the departments, which requires materials, machines, supplies, components, tools etc. send their purchase
request to the centralized purchasing department and this department takes care of timely supply ofrequired
purchases. This system is useful in multiproduct, multi unit organization where centralized purchase of key
raw materials, which may be common to all products or units, be a very economic proposition.
Benefits of centralized purchasing are as under:
 It can reduce the price: As materials are purchased in bulk, which means economical price due to
lower rate of materials, trade discount, economical transport etc.
 Effective control: Central purchase avoids duplication, overlapping so it helps in exercising effective
control on material function.
 Favourable terms: When material is acquired in bulk there may be more favourable terms with
vendors due to reduced cost and trade discount.
 Specialized staff: The staff at central purchasing department becomes expert and specialized in
purchase function ,their expert knowledge and negotiation skills can help in reducing the cost of
purchase to great extent.
 Clear policy: Centralized purchasing helps in adopting uniform policies, practices which ultimately
helps in reduction of prices at various levels.
Where centralized purchasing practices can be adopted:
Largest central purchasing organisation is the directorate general of supply and disposal, which caters to the
needs of defence, railway and communication. BHEL, also makes centralized purchase of major items like
copper and electrical steel for its various units. 100% centralization can exist only in wishful thinking. It has
following disadvantages: -
 It increases the lead time: If there are too many people from the point supply to point of
consumption, it can increase the lead-time.

10
  Initial cost is too high: Centralized purchase needs a full-fledged department in place, which can
cater to the needs of all the departments.
 Supply of inferior quality: Sometimes inferior quality material is issued for consumption when
there is non-availability of material demanded in the stores.
Centralized purchase, how it can be made more effective: It can be made highly effective if user
departments will take care of the following: -
 Incomplete Specification
 Frequent last minutes changes
 Rejecting good quality in case of surplus
 Accepting bad quality when urgently needed.

3.4 Decentralized Purchasing

Under decentralized purchasing various department units are authorized or made responsible to take decision
independently and directly. In a waythe power to procure material are delegated to the concerned department
or lower levels
The advantages of this system are: -
 Better knowledge - the department which buys the material better knows the requirements of his
department.
 Shorter time of communication-The local decision making system on the spot will shorter the
time of communication.
 Better control-the department may have better liason and the and control on the local purchase
officer.
 It helps in reducing the lead-time due to speedy communication.
No single system can be helpful in achieving the results, so partial centralization for high consumption value
items and leaving the remaining to unit level is desirable to be adopted for better results for the company.
Activity B:
1. Which method of purchase is more suitable for the following industry? Steel industry, confectionery
unit, Pizza hut

3.5 Purchase Procedure

The success of purchase executives depends a great deal on how well they are able to understand the
purchase function. If they have selected right quality, right quantity, right source which can prove to be their
strength or weakness at any critical moment. So there should be production target or budget for theconcern
as a whole. This will help to simplify the work of purchase department. Ingeneral, the major functions of a
purchase dept. may include:
1. Initiating the Purchase
2. Purchase Requisition
3. Deciding Important Factors
4. Studying the Market and Sources of Supply
5. Placing the Purchase Order
6. Follow Up
7. Receiving and Inspecting the Goods
8. Passing Invoices for Payment
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1. Initiating the Purchase
The people who can initiate the purchase of material can be Store keeper, who has to keep his stores in
place. Different department heads, who want to acquire such materials, which do not form part of thestore
list such materials are not usually kept in the store rooms.
2. Purchase Requisition
A form known as purchase requisition is commonly used as a formal request to the Purchase departmentfor
procuring goods and services. It enlists all those articles for which the stock balance has come down to
ordering points.

Purchase Requisition Form

Cost Centre------- Date------

Please Purchase for Department

Item No. Code No. Description Quantit y Remarks

Required

Required By Checked By Approved By

For use of Department Issuing For use of Purchase Department

this requisition
Item No. Quantity Consumption Item No. Purchase Supplier Delivery
in Stock per Day Order No. Date

Store Keeper Purchase Officer

The Purchase Manager places orders for goods as per the requisition received from the storekeeper or the
Department Head. Generally purchase requisition is prepared in triplicate, the original copy is sentto purchase
department, second to the store department and third copy is kept by department who is preparing the
purchase requisition.
3. Deciding Important Factors
It includes deciding upon the following issues.
 What to Purchase?
 When to Purchase?
 How much to Purchase?

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4. Studying the Market and Sources of Supply
After deciding quality, quantity, and the next step is to invite inquiries, tenders or quotations from the
prospective suppliers in prescribed form with all-necessary details
Schedule of Quotations
XYZ Co.Ltd.
Schedule of Quotations
Material Code ------ Date------------

Serial No. Name of Quantity Rate per Time of Quality Other

Party offered Unit Delivery Terms

Initial of Purchase manager--------- Purchase Order No.-----------

Date- -

The tenders received are tabulated in a chart. They are compared on different grounds like quality, quantity.
Regarding sources of supply, purchase department must have full information of various sources of supply
of material, plant and other needs, keeping needs of material requirement of the concern. Records of prices
and quotations should be kept in comparative statement called schedule of quotations. APurchase Manager
is also expected to keep pace with current and expected changes in Government import and industrial
licensing policy, emergence of substitutes, He should also be able to predict trend of market and market
prices, make a bargain on purchases.

Activity: C

1 Being Purchase Manager of an emerging business school you have to purchase 150 laptops for
students. Which steps you need to take to purchase the laptops?

5. Placing the Purchase Order/ Supply Order

Deciding on sources of supply, the purchase manager prepares a purchase order, which is request made by
the purchaser to the supplier to deliver certain goods of requisite quality and quantity at the terms and
conditions agreed between them. Apurchase order gives complete details about quantity, quality, specification
of goods, rates approved, place and date of delivery, mode of transport, terms of payment etc. Before
placing the purchase executives or purchase manager needs to check the vendor rating which helps to
decide on a reliable source who will give uninterrupted supply of material.

What is Vendor Rating

A Reliable vendor is the greatest asset of any organization which is must for correct and cordial Buyer-
Seller relations. It is necessary to identify potential and reliable vendors and to maintain up to date records

10
in order to assess their performance. It is essential to compare one vendor’s performance with others in
order to improve the overall reliability and profitability. In order to fulfill the objective of getting a quality
product at minimum cost, It is essential to assess the vendor performance on the basis of price, delivery,
quality and service. The purchase section should maintain a book of vendors and enter all complaints or
faults of them in order to blacklist any supplier for repeated failure.
Purchase Order
XYZ Co. Ltd
To, No.-----
Date
Our Ref.-------
Please supply the following items in accordance with the terms and conditions mentioned
herein.

Item No. Description Quantity Price Per Unit Total Remarks

Value

Delivery at------- Special Instruction

Discount-------- Receipt of this order may please be
Excise Duty-------- acknowledged
Sale Tax------------ For XYZ Co. Ltd.
Freight -
Terms of payment------------ (Signature)
Other particulars----------
( For Office use only )

Acknowledgement received on
Date of Delivery
Challan No:
Date:
6. Follow Up
Follow up of purchase order in essential to keep pace with schedule of supply by the specified date so that
production work should not be interrupted. The purchase manager needs to ensure that material should be
supplied on agreed date.
7 . Receiving and Inspecting the Goods
Generally in large works a separate department known as receiving department receives the supplies and in

10
small under takings, it is done by storekeeper. The delivery note/ advice note sent by supplier is handed
over to receiving officials for checking goods with the advice notes.
If any deficiencies are noted the matter is taken up with the supplier by purchase department. Excess
supplies are either retained or returned to the suppliers. Goods received note is prepared by the receiving
clerk after receiving, inspecting the goods and verifying them with advice note.
Goods Received Note (GRN)

XYZ C o. Ltd. No GRN ---------------

Goods Received Note Date--------------------
From(Supplier)
Goods Quantity No. Of Order Advice Inspection
received Packin g No. Note
Description Code Quantity Remarks
No. rejected

A GRN gives the following details

 Serial number and Date
 Supplier name and address
 Description, Code,
 Quantity of goods received
 Order No.,
 Supplier advice note number
 Inspection report of goods received
 Bin number where this material is to be entered.

8. Passing Invoices for Payment

The invoices received from the suppliers are passed on to the stores accountant who checks the invoice
with the supplier’s quotations, copy of the purchase order and goods received note. The quantity, quality
and rates of materials are checked and verified. After approving the invoices, these are sent to pay/accounts
department for payment to avail cash discounts for prompt payments, if any.
Accounting of Purchases
When the invoices of goods are received by the purchasing department, the purchase order is marked with
the invoice number to process the passing of a invoice. If the invoice is in order the purchasing officer will
sign and pass it to the accounts department, where it will be checked by a clerk as to its accuracy. The
invoice is then entered in the purchase journal. The journal will be posted daily to the purchase ledger and
total purchase for a month willbe entered into purchase account. The cashier will draw a cheque toclear the
creditor’s account.

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 Debit Note
XYZ Co. Ltd.
Debit note
From ------ No.-------
Date
We are debiting your A/C with the value of under mentioned materials for the reasons
stated. Meanwhile we await your instructions.

Description Specification Price Amount

Our Order No. Our GRN No. Your D/N No. Date received

Please remember a debit note is issued when goods are not according to the standard or received in excess
of the order and to be returned. A Credit note may be issued under reverse circumstances.
Activity D:
1. Compare Debit note and credit note

3.6 Purchase policy

There are different systems of purchasing available to the industrial buyers. The system depends on factors
like demand, supply, price, urgency of requirement, vender, type of material, organization culture, power of
delegation, procedures seasonal commodities etc. The basic objective of purchase policy is to buy the
required material in the right quantity from right source at the right time and price to obtain the maximum
value for each rupee spend on material cost.
Large organizations usually have a written purchase policy, which clearly gives guidelines and direction to all
those related.
Different Purchasing System

Cash Hedging
Purchase Tender Stock Less
System Sub Purchase Torward
Contracting Bying

Sub
Contract

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Cash Purchase
In this system payments are made across the counter. Each department head is given some imprest amount
and is authorized to purchase subject to a ceiling value per item. The major reason of purchase of such items
is that, such items are required urgently.
Tender System: This system is generally adopted by government sector organizations; the main purpose is
to procure materials at the most competitive rates and to eliminate the chances of undue favour to any
supplier. Buying should be as impersonal as possible and should foster a spirit of competition. Private sector
organizations adopt this method of purchase for items whose values are very high. Major disadvantage of
this system is longer time for placing an order compared to other systems. Tender are of three types: -
 Open tender
 Limited tender
 Single tender
When an advertisement is given at least three or four leading national newspapers will be called for open
tender system: Limited tender means when quotations are invited only from registered suppliers and
others known sources to the buying organization. The main advantage of this tender is lead time is reduced.
When there is only a single source of material the value of quotation is not very high. There are mainly for
monopoly items.
Sub Contracting
This is most commonly used method of procuring manufactured components for few properly chosen items,
if the buying organization feels that manufacturing cost will be higher compared to subcontracting cost. The
decision to sub contract is based on factors such as capacity utilization, cost of manufacture, andavailability
of technology. Generally the sub contractors are smaller establishments with specialists in the line. Most
important consideration is to ensure whether the subcontractor would be able to meet delivery schedules
and quality requirements. The buying organization must carry out make/buy analysis before deciding upon
subcontracting.
System Contract
In this, the seller becomes the material planner for the buyer. It is long-term contract between thebuyers and
provides for the automatic replenishment. The system is designed to assist both the buyer and the seller.
Regularly consumed low value items are system contracted. The buyer has to be careful in the choice of the
contractor, because the agreement is of long duration. By adopting this system, the buyer can concentrate
on costlier items and items of shortage, leaving other items to system contractor.
Stockless Purchase
Zero stock buying is a system, which largely depends upon sound relations between buyer and seller. If the
seller /vendor has clear idea about the requirements of the buyer he can hold the stock at a convenient
location, from where the buyer can draw from the warehouse according to his needs. As seller has whole
responsibility to hold the stock as per buyer needs, he can charge more for his services. But this increased
price is automatically compensated by decreased carrying cost for the buyer.
Blanket Order
Blanket order is generally entered for row value (ABC) C-class items. It is useful for the purchase of those
items, whose annual requirements cannot be effectively forecasted. The price can be agreed upon or can be
the prevailing market prices at the time of supply. An example of blanket order can be to place anorder for

10
the annual supply of stationery items. The buyer can get quantity discount, as he is placing order for a longer
period. The seller will have to concentrate more on services than on trying to convince the buyers.

Forward Buying

In this, the buyers commit to buy at a future date a contracted quality at contracted price, whatever may be
the ruling market price then. The buyer does so with a speculative interest that the prices will rise in future.
He wants to protect the organization from any future shortage or due increases in price. Forward buying
helps buyers and sellers to ensure themselves against uncertainties arising from frequent changes in the
supply and demand.

Hedging

Hedging is totally different from forward buying .The buyer tries to protect himself in the future by entering
into two transactions, a purchase and a sale in two markets, whose prices move up and down together. But
such perfect conditions do not exist in the market. So hedging is basically a tool for protecting against future
losses due to difference in different markets.

Activity E:
1 After going through different purchase system which system do you think is most suitable
for?
a) Automobile Industry
b) Infrastructure Industry
c) Public sector undertakings

3.7 Principles of Skillful Buying

After going through the purchase cycle, different purchase systems we can say that skillful buying depends
upon skillful handling of five rights which are:

Right Quality

The existence of each organization depends upon its valuable customers and they want quality. For a
purchase executive quality is the key parameter to decide on purchasing. Right quality of raw material is the
base for finished product. Now who decide about the quality of raw material being used, though the
responsibility is of design department but the purchase division being eyes and ears of the organization are
in better position to suggest about sources and alternatives so that the minimum price is paid for maximum
benefit.

Right Quantity

Right quantity means the ideal size of material which should always be available in the stores, so that there
should no interruption due to shortage of raw material and supplies. Excess material and shortage ofmaterial
both the situation are bad for any manufacturing concern .excess stock means blockage of capital, warehousing
cost ,insurance cost, maintenance cost and loss due to obsolescence and spoilage. In case of shortage of
material means cost of men and machines rendered idle, interruption in production will result in delay of
timely supply of goods in the market. So it is very important to decide on right quantity to be ordered, it can
be done with the help of deciding inventory levels and with EOQ technique.

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Right Prices

This is the most difficult parameter for any purchase executive to decide, because high price does not
necessarily means high quality and lowest price need not be the best price .actually right price means which
brings the best ultimate value associated with other factors like quality, quantity, delivery and standards. A
vendor need to adhere to quality ,quantity and time schedule if he is not keep these requirements, though his
prices may be the lower but actual cost to the organization will be more. If the vendor is not ableto maintain
the quality, it will lead to rejections
Right Source
The success of purchase executive depends on how carefully he has selected his suppliers. If the material
does not reach on time or if it is of inferior quality, the organizations production cost will increase due to
increased idle time, increased rejections or high input cost. To decide about the right source the purchase
executive needs to be fully aware about the track record, rating, financial capability of the supplier, delivery
records, capability of handling emergency demands. Sources of material supply should be selected with
extra care as these relations go a long way with the organization
Right Time
Right time means to identify when an order is to be placed. There is always a time gap between placing an
order, procuring them and supplying them to the point of production. This time gap is called lead time
.there is a direct relationship between lead time and inventory longer the lead time more the need of working
capital. Lead time and consumption rate can change any time without prior information a store has to take
of all these uncertain circumstances. The purchase should have right sources or supplier who have proven
track record of timely delivery of materials.
Activity F:
1 As purchase manager of a leading concern add few more skills which a person should have for
skillful buying?

3.8 Summary
Material planning, buying, receiving, inspecting is scientific process which needs to have skills of different
types. An organization needs to decide which method of buying centralized or decentralized is to befollowed
for what type of material. There are so many factors which decide the quality, quantity, price, source and
time of material to be purchased. Material planning is not necessarily a board room activity in different types
of organization it varies depending upon the size, needs, demand of the organization.

3.9 Self Assessment Questions

1 “The purchase department is a profit centre” discuss.
2 How efficient buying can contribute to savings for the organization?
3 Write short note on:
 Stock less purchase
 Tender purchase
 Lead time
 System contract
 GRN
 Purchase order

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4 What is centralization and decentralization in material management? Compare and contrast between
the two.
5 What are the different steps followed by purchase department to fulfill the purchase needs of
the organization?
6 What do you understand by 5R‘s of buying? Discuss.

3.10 Reference Books

- Horngren.T.chareles, Datar.M.Srikant “Cost Accounting a Managerial Emphasis” Pearson
- Gopalakishanan.P., “Purchasing and Material Management”, Tata McGraw-Hill education
pvt Ltd.
- Bhar B.K., “Cost accounting”, Academic publications.
- Jain & Narang, “Cost Accounting”, Kalyani Publications, New Delhi

10
4.1 Inventory Control
4.5.1 Meaning of Inventory and Inventory Control
Inventory means “a schedule of items held at a particular point of time.” Inventory comprises of
stocks of materials, components, work-in-progress, and finished products and stores and spares. The main
objective of inventory control is to achieve maximum efficiency in production and sales with the minimum
investment in inventory. Inventory control refers supervision of supply, storage and accessibility of items of
inventory in order to ensure adequate supplywithout excessive oversupply. Material control is an important
managerial function which is directed to ensure that required quantity and quality of material is provided at
the proper time with the minimum amount of capital.
Inventory control is affected by coordination and control activities relating to planning, sourcing, purchasing,
moving and storing of materials. Inventory control and material control are synonym.
4.5.2 Scope of Inventory Control
1. Production, Planning and Control:
(a) Preparation of detailed schedule of parts and materials required to be produced by purchase or
manufacture in order to realize an outlined production programmed or sales forecast approved by
the top management.
(b) Control of shop loading and other activities to be carried out concurrently to avoid hold- ups in
production.
2. Storage Exercises:
(a) Control on physical handling of parts and materials.
(b) Exercising control on materials in stock to prevent physical deterioration and theft. Etc.
3. Inventory Planning and Control: Control of policies and procedures to regulate systematically
the parts and materials kept in stock.

10
4. External Transport, Control for Efficient Usage of External Transport Activities: These
activities are concerned with the movement of materials from suppliers to the manufacturers and
from the manufacturers to customers.
5. Internal Transport and Material Handling: Control over the efficient use of material transport
and material handling instruments. The internal transport and material handling tools etc. are used
for movement of material from one point to another within the factory.
4.5.3 Advantages of Material Control
(a) It eliminates wastages in use of raw materials and supplies in course of purchase , storage handling
and use.
(b) Reduces the risk of fraud and theft.
(c) Ensures uninterrupted flow of materials of the right quality for use in production.
(d) Facilities preparation of accurate monthly financial statements required for various management
information reports.
(e) Furnishes quickly and accurately the value of material and supplies used in various departments.
(f) Reduces to the minimum the capital locked up in inventories.
(g) Prevents production hold ups by supplying proper quantities at right time. And provides for
accountability on the part of those who are responsible for exercising material management.

Activity D:

1. Discuss about inventory control in reference of various five industries.

2. Discuss advantages of inventory control.

4.2 Techniques of Inventory Control

The techniques or the tools commonly applied to effect control over the inventory are following:
Techniques of inventory control:
1. Setting of Various Stock Levels.
2. ABC Analysis.
3. Two Bin System.
4. Establishment of System of Budgets.
5. Use of Perpetual Inventory Records and Continuous Stock Verification.
6. Determination of Economic Order Quantity.
7. Review of Slow and Non-moving Materials and Stock Items.
8. Use of Control Ratios.
Structure of Unit:

5.1 Objectives
5.2 Introduction
5.3 Pricing of Incoming Material
5.4 Material Cost
5.5 Pricing of Outgoing Material
5.6 Material Losses
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5.7 Consumption of Materials
5.8 Summary
5.9 Self Assessment Questions
5.10 Reference Books

5.1 Objectives
After completing this unit, you will be able to:

 Understand the various methods of pricing material issues.

 Evaluate different methods of pricing material issues.
 Understand the procedure of pricing of incoming material.
 Understand the various types of material losses, their control techniques and treatments in cost
accounting.
 Understand the monitoring of consumption of materials.

5.2 Introduction
In previous unit, we have studied about material issue procedure, storage of material, inventory control and
its techniques. But beyond this study there are many aspects which have equal importance in accounting for
materials. These aspects are pricing of incoming materials, pricing of outgoing materials, materiallosses and
monitoring of consumption of materials. Without knowledge of these aspects a cost accountant cannot fulfill
objectives of cost accounting. In this unit, we will discuss in detail all aforesaid contents of material cost
accounting.

5.3 Pricing of Incoming Material

In order to determine the accurate value of material issued for various production activities or jobs, it is
necessary to determine the true actual cost of the material purchased. The invoice of material purchased
from the market sometime contain items such as trade discount, quantity discount, freight, duty, insurance,
cost of containers, sales tax, excise duty, cash discount etc and determination process becomes more
difficult when various type of materials have been purchased from a common supplier and joint expenses
were to bring the material to store. Under such a situation, following points should be taken care off:

1) The general principle is that all costs incurred up to the point of procuring and storing materials
should include in the cost of materials purchased.

10
 2) The amount of trade discount, quantity discount and excise duty (under MODVAT credit scheme)
are credit items hence deducted from the invoice of material purchased.

3) The transport charges (carriage and freight), sales tax, insurance, cost of containers, customs and
excise duty (without MODVAT credit) should be included in the invoice cost of materials.
4) The cash discount is considered as financial gain, so it is keep outside the area of material cost.
5) In case of containers are returnable, their resale value should also taken in the invoice price of
material to ascertain the cost of material purchased correctly.
6) If common expenses incurred, these expenses should be divided either on the basis of purchase
price of material, quantity of material or number of material.
7) The cost should also be inflated by an estimated percentage for wear and tear, scrap and damages
also.
The cost of material purchased so determined, may be used for the entry of martial in the stores ledger.
Activity A:
1. Write items which are added in pricing of incoming materials.
2. Write items which are excluded from pricing of incoming materials.
Illustration - 1:
An invoice in respect of a consignment of chemicals Aand B provides the following information:
Rs.
Chemical A: 10,000 lbs. at Rs. 10 per lb. 1,00,000
Chemical B : 8,000 lbs. at Rs. 13 per ib. 1,04,000
Sales tax @ 10% 20,400
Railwayfreight 3,840
——————
Total Cost 2,28,240

Shortages are noticed 500 lbs. in chemical A and 320 lbs. in chemical B, due to normal breakages. You are
required to determine the rate per lb. of each chemical, assuming a provision of 2% for further deterioration.
Solution:

Statement of computation of effective quantity of each chemical available for use

Chemical A Chemical B
lbs. lbs.
Quantity purchased 10,000 8,000
Less: shortage due to normal breakages 500 320
9500 7680
Less: Provision for deterioration 2% 190 53.6
Quantity available 9310 7526.4

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 Statement showing the computation of rate per lb. of each chemical
Chemical A Chemical B
Rs. Rs.
Purchase price 1,00,000 1,04,000
Add: Sales tax (10% 10,000 10,400
Railway freight (in the ratio of
Quantity purchased i.e. 5:4) 2133 1707
Total Cost 1,12,133 1,16,107

Rate per lb. A:

Rate per lb. B:

Illustration - 2:
At what price, per unit would part no. B 32 will be entered in the stores ledger, if the following invoice was
received from a supplier:
Invoice Rs.
200 units of Part No.B 32 @ Rs. 1000
Less: 20 % discount 200
800
Add: Excise duty @ 15 % 120
920
Add: Packing charges (5 non-returnable Boxes) 50
970
Notes:
(1) A 2% discount will be given for payment in 30 days.
(2) Document substantiating payment of excise duty is enclosed for claiming MODVAT credit.
Solution:
200 units at cost after trade discount Rs. 800
Add: Packing charges Rs. 50
Total cost of 200 units Rs. 850

Cost per unit = = Rs. 4.25

5.4 Material Cost

“The material cost is the cost of commodities supplied to an undertaking” -I.C.M.A.
Material cost is following two types:
1) Direct Material Cost.
2) Indirect Material Cost.

10
1) Direct Material Cost:
Direct materials cost is the cost of those materials which enter into and form part of the product such as
timber in furniture making; clay in brick making; cement, stones etc. in building and yarn for clothproducing
etc. It includes the following:
a) Material specially purchased for requisitioned for a specific or a particular job, process, or work
order & used therein;
b) Material passing for one process or operation to the other, for instance, in the process costing the
finished product of a process becomes the direct materials for the next or the succeeding process;
c) The primary packing materials such as cartoons for the biscuit packing etc.

The materials cost the above is directly identified with jobs, products or cost units and is allocated to them.
According to I.C.M.A. “Materials cost which can be identified with and allocated to cost centers or cost
units”. Direct materials are also known as ‘process materials’, ‘prime cost materials’ or ‘productive materials’.

2) Indirect Materials Cost:

According to I.C.M.A indirect materials cost is “materials cost which can’t be allocated but which can be
apportioned to or absorbed by, cost centers or cost units”.

Indirect materials cost is the cost of those materials which do not form part of the product but which help
the production, for example:
a) Lubricating oil, fuel, cotton waste etc., required for operating and maintaining plant & machinery;
b) Small tools;
d) Stores use for repairs and maintenance;

Items for small values like threads, gum, nails etc, though forming part of the product and thus reckoned as
direct materials are treated as indirect materials for the reason that it is difficult to calculatethe cost per unit
of the material. The threads or gums in book binding, nails used in shoes etc. are the examples.

5.5 Pricing of Outgoing Material

5.4.1 Pricing of Issue of Materials

Material issued from stores should be priced at the value at which they are carried in stock but there can be
a situation where the material may have been purchased at different times and at different prices with varying
discounts, taxes etc. Because of this the problem arises as to how the material issues to production are to be
valued. There are several methods for tackle this situation. The cost accountant should select the proper
method based on following factors:
1. The frequency of purchases, price fluctuations and its range.
2. The frequency of issue of materials, relative quantity etc.
3. Nature of cost accounting system.
4. The nature of business and type of production process.
5. Management policy relating to valuation of closing stock.

Several methods of pricing material issues have been evolved in an attempt to suitably answer the problem.
These methods may be grouped and explained as follows:

10
1. Cost Price Methods:
(a) Specific price method.
(b) Fist – in first – out method.
(c) Last in – first – out method.
(d) Base stock method.
2. Average Price Methods:
(e) Simple average price method.
(f) Weighted average price method.
(g) Periodic simple average price method.
(h) Periodic weighted average price method.
(i) Moving simple average price method.
(j) Moving weighted average price method.
3. Market Price Methods:
(k) Replacement price method.
(l) Realizable price method.
4. Notional Price Methods:
(m) Standard price method.
We may now briefly discuss all the above methods:
(a) Specific Price Method- This method is useful, specially when material are purchased for a specific job
or work order, and as such these material are issued subsequently to that specific job or work order at the
price at which they are purchased to use this method, It is necessary to store each lot of materialseparately
and maintain its separate account. The advantages and disadvantage of this method are :
Advantages:
1- The cost of material issued for production purposes to specific job represent actual and correct
cost.
2- This method is best suited for non-standard and specific products.
Disadvantage: This method is difficult to operate, specially when purchases and issues are numerous.
(b) First –in – First Out Method (FIFO): It is a method of pricing the issues of materials. Under this
method, the materials first received in the store are the first issued. In other words, the order inwhich the
materials are received in the store are first issued at their cost price in the same order or the items longest in
stock are issued first. Thus each issue of material only recovers the purchase price which does not reflect
the current market price.
This method is considered suitable in times of failing price because the material cost charged to production
will be high while the replacement cost of materials will be low. But in the case of rising prices, if this method
is adopted, the charge to production will be low as compared to the replacement cost of materials (as in the
current period) in future without having additional capital resources.
The advantages and disadvantages of the method may be stated as follows:
Advantages:
1. It is simple to understand and simple to operate.

10
 2. Material cost charged to production represents actualcost with which the cost of production should
have been charged.
3. In the case of falling prices, the use of this method gives better results.
4. Closing stock of material will be represented very closely at current market price.
5. The old material is issued first. Thus, there remains no possibility of loss of material due to spoilage
or obsolescence.
Disadvantages:
1. If the price fluctuates frequently, this method may lead to clerical error.
2. Since each issues of material to production is related to a specific purchase price, the cost charged
to the same job are likely to show a variation from period to period.
3. In the case of rising prices, the real profits of the concern being low, they may be inadequate to meet
the concern’s demand to purchase raw materials at the ruling price.
Illustration - 3:
Prepare store ledger account as per FIFO method from the following data:
Receipt of Materials Rate Materials Issued
Date Units per unit Date Units
Rs.

April 1, 2008 opening balance 1,000 5 April 4,2008 3,000

April 3, 2008 5,000 6 April 6,2008 2,000
April12, 2008 3,000 5 April 15,2008 1,500
The weekly stock taking on April 7, 2008 showed on shortage of 150 units.
Solution:
Store Ledger Account

Receipts Issues Balance +

Date Units Rate Amount Units Rate Amount Units Rate Amount
2007 Rs. Rs. Rs. Rs. Rs. Rs.
Apr.1 ― ― ― ― ― ― 1,000 5 5,000
Apr.3 5,000 6 30,000 ― ― ― 1,000 5 35,000
5,000 6
Apr.4 ― ― ― 1,000 5
2,000 6 17,000 3,000 6 18,000
Apr.6 2,000 6 12,000 1,000 6 6,000
Apr.7 150 6 900 850 6 5,100
Apr.12 3,000 5 15,000 ― ― ― 850 6
3,000 5 20,100

Apr.15 850 6 8,350

650 5 2,350 5 11,750
 Wastage is treated as abnormal.

(c) Last – in – First Out Method (LIFO): It is a method of pricing the issues of materials. This method is
based on the assumption that the items of the last batch (lot) purchased are the first to be issued. Therefore,
under this method the price of the last batch (lot) is used for pricing the issues, until it is exhausted, and so
on. If however, the quantity of issue is more than the quantity of the latest lot than earlier (lot) and its price
will also be taken into consideration.

10
During inflationary period or period of rising prices, the use of LIFO would help to ensure that the cost of
production determined on the above basis is approximately the current one. This method is also useful
specially when there is a feeling that due to the use of FIFO or average methods, the profits shownand tax
paid are too high.

The advantages and disadvantages of LIFO method are as follows:

Advantages:

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

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

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

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

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

Disadvantages:

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

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

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

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

5. The closing stock is priced at a very old price which does not show the correct position of the
business.

Illustration - 4:

With the help of the following particulars, prepare stores account showing issue of materials on the basis
of Last in, First out:

Purchases Issues

August 3,2008 750 kg @ Rs. 2.00 August 19,2008 850 kg

August 18,2008 350 kg @ Rs. 2.10 August 26,2008 450 kg

August 25,2008 600 kg @ Rs. 2.20 August 29,2008 510 kg

August 28,2008 500 kg @ Rs. 2.30 August 30,2008 150 kg

10
 Solution:
Stores Ledger Account
Receipts Issues Balance
Date Kg Rate Amt. Kg Rate Amt. Kg Rate Amt.
2008 Rs. Rs. Rs. Rs. Rs. Rs.
Aug.3 750 2.00 1,500 ― ― ― 750 2.00 1,500
Aug.18 350 2.10 735 ― ― ― 750 2.00 1,500
350 2.10 735
Aug.19 ― ― ― 350 2.10 735
500 2.00 1,000 250 2.00 500
Aug.25 600 2.20 1,320 ― ― ― 250 2.00 500
600 2.20 1,320
Aug.26 450 2.20 990 250 2.00 500
150 2.20 330
Aug.28 500 2.30 1,150 ― ― ― 250 2.00 500
150 2.20 330
500 2.30 1,150
Aug.29 ― ― ― 500 2.30 1,150 250 2.00 500
10 2.20 22 140 2.20 308
Aug.30 ― ― ― 140 2.20 308
10 0 2.00 20 240 2.00 480

(d) Base Stock Method: Aminimum quantity of stock under this method is always held at a fixed price as
reserve in the stock, to meet a state of emergency, if it arises. This minimum stock is known as base stock
and is valued at a price at which the first lot of materials is received and remains unaffected by subsequent
price fluctuations.
Thus, this is more a method of valuing inventory than a method of valuing issued because, with the base of
stock valued at the original cost some other method of valuing issues should be adopted. The quantity in
excess of the base stock may be valued either on the FIFO or LIFO basis. This method is not an independent
method as it uses FIFO or LIFO. Its advantages and disadvantages therefore will depend upon the use of
the other method viz., FIFO or LIFO.
(e) Simple Average Price Method: Under this method, materials issued are valued at average price,
which is calculated by dividing the total of all units rate by the number of unit rate.

Material issue price   Total of unit prices of each purchase

Total number of purchase

This method is useful under the following circumstances:

1. When the materials are received in uniform lots of similar quantity, otherwise, it will give wrong
results.
2. When purchase prices do not fluctuate considerably.

Advantage:
1. It is simple to understand and easy to operate.
2. The method is a mixed form of market price and cost price.
3. Due to calculation of average of different purchase prices, the tendency of equality in different rates
is arrived at.

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Disadvantage:
1. Materials issue cost does not represent actual cost price. Since the materials are issued at a price
obtained by averaging cost prices, a profit or loss may arise from such type of pricing.
2. In case the prices of material fluctuate considerably, this method will give incorrect results.
3. The prices of materials issues used are determined by averaging prices of purchases without giving
consideration to the quantity. Such a price determination is unscientific.
4. It becomes difficult to calculate the average again and again.
Illustration - 5:
From the following information, write the stores ledger account based on ‘Simple Average Method’ of
pricing issues:
May 2008 Receipts May 2008 Issues
12 Purchased 400 unit @ Rs. 59 per unit 3 140 units
14 Refund of surplus from a work order 4 250 units
30 units @ Rs. 58 per unit 8 210 units
20 Purchased 480 units @ Rs. 62 per unit 16 350 units
25 Purchased 640 units @ Rs. 60 per unit 24 608 units
28 Refund of surplus from a work order 24 26 524 units
Units (issued on 3 May)
31 Received from supplier 150 units @ Rs. 64 per unit
Opening balance on May 2008 1,100 units @ Rs. 60 per unit.
Solution:
Stores Ledger Account
Receipts Issues Balance
Date Qty. Rate Amount Qty. Rate Amount Qty. Amount
May2008 Rs. Rs. Rs. Rs. Rs.
1 — — — — — — 1,100 66,000
3 — — — 140 60 8,400 960 57,600
4 — — — 250 60 15,000 710 42,600
8 — — — 210 60 12,600 500 30,000
12 400 59.00 23,600 — — — 900 53,600
14 30 58.00 1,740 — — — 930 55,340
(Refund)
16 — — — 350 591 20,650 580 34,690
20 480 62.00 29,760 — — — 1,060 64,450
24 — — — 608 59.752 36,328 452 28,122
25 640 60.00 38,400 — — — 1,092 66,522
26 — — — 524 61.003 31,964 568 34,558
28 24 60 1,440 — — — 592 35,998
31 150 64 9,600 — — — 742 45,598

1. 60595859
3
2. 60595862 59.75
4
3. 6260 61
2

(f) Weighted Average Price Method: This method gives due weights to quantities purchased and the
purchase price, while, determining the issue price. The average issue price here is calculated by dividing the
total cost of materials in the stock by total quantity of materials prior to each issue.

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 Material issue price   Total of unit prices of each purchase
Total quantity of purchase

The advantages and disadvantages of this method are:

Advantages:
1. It smoothens the price fluctuations if at all it is there due to material purchases.
2. Issue prices need not be calculated for each issue unless new lot of materials is received.
3. This method is scientific and argumentative because under this method, the total cost of the
material available in the bin is provided by the total quantity of material. In fact, after reaching
the bin, the new and old material mix up, i.e., there remains no separate existence in the bin, of the
material separately purchased on the different dates.
4. As regards calculation work, this method is simple because the issue price once calculated continues
till the new material is purchased.
5. This method is a mixed form of market price and cost price.
6. In this method, the balance of the closing stock is shown at appropriate price which can be
used in financial accounts also.
Disadvantage:
1. Material cost does not represent actual cost price and therefore, a profit or loss will arise out
of such a pricing method.
2. If the material is purchased again and again at short intervals, the calculation work increases.
3. As the material is issued at average price, the production cost cannot be correctly estimated.
Illustration 6:
From the following particulars, prepare stores Ledger for the month January 2008 showing material issue
prices on the Weighted Average Price Method:
Receipts of Materials Issues of Materials
Date Units Rate per unit (Rs.) Date Units
Jan.1, 2008 500 2 January 1, 2008 400
Jan.10, 2008 200 3 January 15, 2008 100
Jan.18, 2008 400 4 January 22, 2008 200
Jan.28, 2008 300 5 January 31, 2008 300
Jan.29, 2008 Returns 10 units (issued on 15 Jan.)
th

2 units loss was revealed on January 28 during stock verification.

Solution:
Stores Ledger Account

Receipts Issues Balance +

Date Units Rate Amt. Units Rate Amt. Units Rate Amt.
2008 Rs. Rs. Rs. Rs. Rs. Rs.
Jan. 1 500 2 1,000 400 2 800 100 2 200
Jan.10 200 3 600 ― ― ― 300 2.67 800
Jan.15 — ― ― 100 2.67 2.67 200 2.67 533
Jan.18 400 4 1,600 ― ― ― 600 3.555 2,133
Jan.22 ― ― ― 200 3.555 711 400 3.555 1,422
Jan.27 300 5 1,500 ― ― ― 700 4.174 2,922
Jan.28 ― ― ― 2(loss)* ― ― 698 4.186 2,922
Jan.29 10 2.67 26.70 ― ― ― 708 4.165 2,948.70
Jan.31 ― ― ― 300 4.165 1249.5 408 4.165 1,699.20
* Assumed as Normal wastage.

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(g) Periodic Simple Average Price Method: This method is similar to simple average price method
except that the average price is calculated at the end of the concerned period. In other words, theprice paid
during the period for different lots of materials purchased are added up and the total is divided by the
number purchases made during the period. The rate so computed is the used to price all the issues made
during the period, and also for valuing the closing inventory of the period.
Advantages:
1. It is simple to operate, as it avoids calculation of issue price after every receipt.
2. This method can usefully be employed in costing continuous processes where each individual order
is absorbed into the general cost of producing large quantities of articles.
Disadvantages:
1. This method cannot be applied in jobbing industry where each individual job order is to be priced
at each stage of its completion.
2. This method is unscientific as it does not take into consideration the quantities purchased at different
prices.
3. This method also suffers from all those disadvantages of simple averages cost method.
(h) Periodic Weighted Average Price Method: This method is like weight average price method, except
that the calculations of issue prices are made periodically (say, a month). The rate so arrived is used for the
issues made during that period and also for valuing the inventoryat the end of the period.
Advantage:
1. This method is superior to the periodic simple average price method as it takes into account the
quantities also.
2. It overcomes or events out the effect of fluctuations.
3. In addition to above, the method also possesses all the advantages of the simple weighted average
price method.
Disadvantage:
This method is not suitable for job costing because each job is to be priced at each stage of completion.
(i) Moving Simple Average Price Method: Under this method, the rate for material issues is determined
by dividing the total of the periodic simple average prices of a given number of periods by the numbers of
periods. For determining the moving simple average price, it is necessary to fix up first period to be taken
for determining the average.
Suppose a six monthly period is decided upon and moving average rate for the month of June is to be
calculated. Under such a situation, we have to make a list of the simple average prices from January to
June, add them up, and divide the total by six. To calculate the moving average rate for July, we have to omit
simple average rate pertaining to January and add the rate relating to July and divided the total bysix.
Advantage: This method evens out price fluctuations over a longer period, thus stabilizing the charges to
work-in-progress. Thus the cost of production will be stable to a significant extent.
Disadvantage: A Profit or loss arises by the use of moving simple average cost.
(j) Moving Weighted Average Price Method: Under this method, the issue, rate is calculated by dividing
the total of the periodic weighted average price of a given number of periods by the number of periods.
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(k) Replacement Price Method: Replacement price is defined as the price at which it is possible to
purchase an item, identical to that which is being replaced or revalued. Under this method, materials issued
are valued at the replacement cost of the items.
This method pre-supposes the determination of the replacement cost of materials at the time of eachissue;
viz., the cost at which identical materials could be currently purchased. The product cost under this method
is at current market price, which is the main objective of the replacement price method.
This method is useful to determine true cost of production and to value material issues in periods of rising
prices, because the cost of material considered in cost of production would be able to replace the materials
at the increased price.
Advantage: Product cost reflects the current market prices and it can be compared with the selling price.
Disadvantage: The use of the method requires the determination of market price of material before each
issued of material. Such a requirement creates problems.
(l) Realizable Price Method: Realizable price means a price at which the material to be issued can be
sold in the market. This price may be more or may be less than the cost price at which it was originally
purchased. Like replacement price method, the stores ledger would show profit or loss in this method too.
(m) Standard Price Method: Under this method, materials are priced at some predetermined rate or
standard price irrespective of the actualpurchase cost of the materials. Standard cost is usually fixed after
taking into consideration the following factors:
a. Current prices,
b. Anticipated market trends, and
c. Discount available and transport charges etc.
Standard prices are fixed for each material and the requisitions are priced at the standard price. This
method is useful for controlling material cost and determining the efficiency of purchase department. In the
case of highly fluctuating prices of materials, it is difficult to fix their standard cost on long-term basis.
Advantages:
1. The use of the standard price method simplifies the task of valuing issues of materials.
2. It facilitated the control of materialcost and the task of judging the efficiency of purchase department.
3. It reduced the clerical work.
Disadvantages:
1. The use of standard price does not reflect the market price and thus results in a profit or loss.
2. The fixation of standard price becomes difficult when prices fluctuate frequently.
5.4.2 Valuation of Returns and Shortages
(a) Valuation of Materials Returned to the Vendor: Materials which do not meet quality, dimensional
and other specifications and are considered to be unfit for production are usually returned to the
vendor. These materials can be returned to the vendor before they are sent to the stores. In case
materials reach store and are noticed to be below standard quality, then also they can be returned
to vendor.
The price of the materials to be returned to vendor should include its invoice price plus freight,
receiving and handling charges etc. Strictly speaking, the materials returned to vendor should be
returned at the stores ledger price and not at invoice price. But in practice invoice price is only

10
 considered, the gap between the invoice price and ledger price is charged as overhead. In stores
ledger the defective or sub-standard materials are shown in the issue column at the rate shown in the
ledger, and the difference between issue price and invoice cost is debited to an inventory adjustment
accounts.
(b)Valuation of Materials Returned to Stores: When materials requisitioned for a specific job or
work-in progress are found to be in excess of the requirement or are unsuitable for the purpose,
they are returned to the stores. There are two ways of treating such returns.
1. Such returns are entered in the receipt column at the price at which they were originally
issued, and the materials are kept in suspense, to be issued at the same price against the next
requisition.
2. Include the materials in stock as if they were fresh purchases at the original issue price.
(c) Valuation of Shortages during Physical Verification: Materials found short during physical
verification should be entered in the issue column and valued at the rate as per the method
adopted, i.e. FIFO or any other.
5.4.3 Selection of Pricing Methods
Several methods of charging price of materials issues have been discussed in detail. The question is as to
which out these methods is best one. It is a fact that no one method can be suitable for all business or
industry. No hard and fast rule or procedure has been laid down to select a method of pricing issues of
material. However, the ultimate choice of a method of selection may be based on the following considerations.
(a) The method of costing used and the policy of management.
(b) The frequency of purchases and issues.
(c) The extend of price fluctuations
(d) The extent of work involved in recording, issuing and pricing materials
(e) Whether cost of materials used should reflect current or historical conditions.
(f) Type of business or industry.
Activity B:
1. Which method of pricing of material do you think is the most suitable? Why?
5.4.4 Treatment of Normal and Abnormal Loss or Materials
Whichever method may be adopted for pricing materials, certain differences between the book balanceand
the value of physical stock are bound to occur. These differences, which may be a gain or loss, should be
transferred to inventory adjustment account pending investigation. If, after investigation, they areregarded
as normal, they should be transferred to Overhead ControlAccount; if abnormal they should be written off
to the Costing Profit and Loss account.
In the case normal losses, an alternative method is used to price per unit of material so as to cover the
normal loss. It can be understood with the help of the example considered. Suppose 1,000 meters of gunny
cloth are purchased at Rs. 2 per meter. It is expected that 1% would be the normal loss due to issues being
made in small lots. The inflated price would be Rs. 2.02 p. i.e., (Rs. 2,000 for 990 meters). The rate of Rs.
2.02 per meter of gunny cloth covers the cost a normal loss as well.

5.6 Material Losses

There is various types of losses possible in subject of material such as waste, scrap, spoilage, anddefectives.
We are going to be discussing in detail their meaning, precautions and treatments.

10
5.5.1 Waste
“The portion of basic raw materials lost in processing having no recoverable value.” Waste may be
visible – bits and pieces of basic raw materials – or invisible; e.g., disappearance of basic raw materials
through evaporation, Smoke etc. Shrinkage of material due to natural causes may also be a form of a
material wastage.
In case of normal Wastage -Normal waste is absorbed in the cost of net output.
In Case of Abnormal Wastage -The abnormal waste is transferred to the costing Profit and loss Accounts.
For effective control of waste, normal allowances for yield and waste should be made from past experience,
technical factors and special features of the material process and product. Actual yield and waste should be
compared with anticipated figures and appropriate actions should be taken where necessary. Responsibility
should be fixed on purchasing, storage, maintenance, and production and inspection staffto maintainstandards.
A systematic procedure for feedback or achievement against laid down standards should be established
5.5.2 Scrap
“It has been defined as the incidental residue from certain types of manufacture, usually of small
amount and low value, recoverable without further processing.” Scrap may be treated in cost accounts
in the following ways:-
(1) When the scrap value is negligible: It may be excluded from costs. In other words, the cost of
scrap is borne by good units and income scrap is treated as other income.
(2) When the scrap value is not identifiable to a particular process or job: The sales value of
scrap net of selling and distribution cost, is deducted from overhead to reduce the overhead rate. A
variation of this method is to deduct the net realizable value from material cost.
(3) When scrap is identifiable with a particular job or process and its value is significant: The
scrap account should be charged with full cost. The credit is given to the job or process concerned.
The profit or loss in the scrap account, on realization, will be transferred to the costing profit and
loss account.
Control of scrap really means the maximum effective utilization of raw material. Scrap control does not,
therefore, start in the production department; it starts from the stage of product designing. Thus the most
suitable type of materials, the right type of equipment and personnel would help in getting maximumquantity
of finished product from a given raw material.
A standard allowance for scrap should be fixed and actual scrap should be collected, recorded and reported
indicating the cost centre responsible for it. Aperiodical scrap report would served the purpose where two
or more department or cost centers are responsible for a scrap; the reports should be routed through the
department concerned.
5.5.3 Spoilage
“It is the term used for materials which are badly damaged in manufacturing operations and they
cannot be rectified economically and hence taken out of process to be disposed of in some manner
without further processing.” Spoilage may be either normal or abnormal
In case of normal spoilage:
Normal spoilage (i.e. which is inherent in the operation) costs are included in costs either charging the loss
due to spoilage to the production order or by charging it to production overhead so that it is spread over all
products. Any value realized from spoilage is credited to production overhead account, as the case may be.

10
In case of abnormal spoilage
The cost of abnormal spoilage (i.e. arising out of causes not inherent in manufacturing process) is charged to
the costing profit and loss account. When spoiled work is the result of rigid specification, the cost of spoiled
work is absorbed by good production while the cost of disposal is charged to production overhead

To control spoilage, allowance for normal spoilage should be fixed and actual spoilage should be compared
with standard set. Asystematic procedure of reporting would help control over spoilage. Correctiveactions
should be taken by responsible department, if any.

5.5.4 Defectives

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

recovery of loss from defective units – In the case of articles that have been defected, it is necessary to
take steps to reclaim as much of the loss as possible. For this purpose:
1. All defective units should be sent to a place fixed for the purpose;
2. These should be dismantled;
3. Goods and serviceable parts should be separated and taken into stock;
4. Parts which can be made serviceable by further work should be separated and sent to the workshop
for the purpose and taken into stock after the defects have been removed; and
5. Parts which cannot be made serviceable should be collected in one place for being melted or sold.

Control: When defectives are found, the inspector willmake out the defective work Report, giving particulars
for the department, process or job, defective units, normal and abnormal defectives, cost of rectification
etc. On receipt of the defective work report, it may be decided to rectify the defective work; all cost of
rectification are collected against the rectification work order, precaution will be taken to see that number of
defectives is within normal limits.

Defectives are generally treated in two ways: either they are brought up to the standard by incurring further
costs on additional material and labour or where possible, they are sold as inferior products (seconds) at
lower prices. The following illustration is given to explain the accounting procedure followed in either case.

Total expenses of manufacture Rs. 5,000

Out put Good: 450 units
Defective: 50 units
Cost of rectifying defectives Rs. 50

Cost per unit of production =

If the defectives are not rectified but sold as ‘second’s say, @ Rs. 8 each then cost of goods produced will
be ;

10
Distinction between spoilage and defectives: The difference between spoilage and defective is that
while spoilage cannot be repaired or reconditioned, defectives can be rectified and transferred, either back
to standard production or to seconds.
Treatment of spoilage and defectives in Cost Accounting – Under Cost Accounts normal spoilage
costs i.e., (which is inherent in the operation) are included in cost either by charging the loss due to
spoilage to the production order or charging it to production overhead so that it is spread over all
products.
Any value realized from the sale of spoilage is credited to production order or production overhead
accounts, as the case may be. The cost of abnormal spoilage (i.e. arising out of causes not inherent in
manufacturing process) is charged to the costing profit and loss accounts. When spoiled work is the
result of rigid specifications the cost of spoiled work is absorbed by good production while the cost
of disposalis charged to production overheads. The problem of accounting for defective work is theproblem
of accounting of the costs of rectification or rework.
The possible ways of treatment are as below:
1- Defectives that are considered inherent in the process and are identified as normal can be recovered
by using the following methods:
a. Charged to good products – The loss is absorbed by good units. This method is used when
‘seconds’ have a normal value and defectives rectified into ‘seconds’ or ‘first’ are normal;
b. Charged to general overhead – when the defectives caused in one department are reflected
only on further processing, the rework cost are charged to general overhead;
c. Charged to the department overheads – If the department responsible for defectives can
be identified then the rectification costs should be charged to that department;
d. Charged to costing profit and loss accounts – If defectives are abnormal and are due to
causes beyond the control of organization, the rework cost should be charged to costing
profit and loss account.
2- Where defectives are easily identifiable with specific jobs, the work costs are debited to the
job.
Procedure for the control of spoilage and defectives – To control spoilage, allowance for a normal
spoilage should be fixed up and actualspoilage should be compared with standard set. Asystematic procedure
of reporting would help control over spoilage. Aspoilage report (as below) would highlight the normal and
abnormal spoilage, the department responsible, the causes of spoilage and the corrective action taken if
any.
Spoilage Report
Units/Deptt.No……………………. Date…………
Production order no…………….....
Units Units Normal Spoilage Abnormal Spoilage Cost of Reason Action
Produced Spoiled Qty. % Qty. % Abnormal Spoilage taken
Spoilage
Rs.

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Control of defectives may convert the following two areas:
(a) Control over defectives produced
(b) Control over reworking costs.
For exercising effective control over defectives produced and the cost or reworking, standards, for normal
percentage of defectives and reworking costs should be established. Actual performance should be compared
with the standards set. Defective work report should be fed back to the respective centres of control.
5.5.5 Losses Due to Obsolete Stores
Obsolescence is defined as “the loss in the intrinsic value of assets due to its supersession,” Materials
may become obsolete under any of the following circumstances:
(1) Where it is a spare part or a component of a machinery used in manufacture and that machinery
becomes obsolete ;
(2) Where it is used in the manufacture of a product which has become obsolete;
(3) Where the material itself is replaced by another material due to either improved quality or fall in
price.
In all three cases, the value of the obsolete material held in stock is a total loss and immediate steps should
be taken to dispose it off at the best available price. The loss arising out of obsolete materials on abnormal
loss does not form part of the cost of manufacture.
Losses due to obsolescence can be minimized through careful precaution and reduced stocking of spares,
etc. Stores records should be continuously gone through to see whether any item is likely to become
obsolete. There will be such probability if an item has not been used for a long time. (This does not apply to
pare parts of machines still in use).
Activity C:
1. Discuss about various types of material losses.
2. Write treatment of various types of material losses.

5.7 Consumption of Materials

Any product that is manufactured in a firm entails consumption of resources like material, labour etc. The
management for planning and control must know the cost of using these resources in manufacturing. The
consumption of materials takes place say when the material is used in the manufacture of the product.

It is important to note that the amount of materials consumed in a period by a cost object need not be equal
to the amount of material available with the concern. For example, during any period the total of raw
material stock available for use in production may not be equalto the amount of materials actuallyconsumed
and assigned to the cost object of the production. The difference between the material available andmaterial
consumed represents the stock of material at the end of the period.

5.6.1 Identification of Materials:

For the identification of consumption of materials with products of cost centre’s the followings points should
be noted:

1. It is required that the concern should follow coding system for all materials so that each materialis
identified by unique code number.

10
 2. It is required that each product of a cost centre should be given a unique code number so that the
direct material issued for production of particular product of a cost center can be collected against
the code number of that product.

However, it may not be possible to allocate all materials directly to individual product of a cost
centre e.g. maintenance materials, inspection and testing materials etc. The consumption of these
materials are collected for cost centre and then charge to indicial product by adopting suitable
overhead absorption rate of cost center.

Overhead absorption rate of cost centre =

(E.g. labour hrs. or machine hrs.)

3. Each issue of materials should be recorded. One way of doing this is to use a material requisition
note. This note shows the details of materials issued for product of cost centre and the cost center
which is to be charged with cost of materials.

4. A material return note is required for recording the excess materials returned to the store. This note
is required to ensure that original product of cost centre is credited with the cost of materials which
was not used and that the stock records are updated.

5. A material transfer note is required for recording the transfer of materials from one product of cost
centre to other or from one cost centre to other cost centre.

6. The cost of materials issued would be determined according to stock valuation method used.

5.6.2 Monitoring Consumption of Materials

For monitoring consumption of materials a storekeeper should periodically analyses the various materials
requisitions, material return notes and material transfer notes. Based on this analysis, a materialabstract or
material issue analysis sheet is prepared, which shows at a glance the value of material consumed in
manufacturing each product. This statement is also useful for ascertaining the cost of materialissued for each
product.

The material abstract statement serves a useful purpose. It in fact shows the amount of material to be
debited to various products & overheads. The total amount of stores debited to various products & overheads
should be the same as the total value of stores issued in any period.

5.8 Summary
Methods of pricing of issue of materials

FIFO – The materials received first are to be issued first. Material left as closing stock will be at the price
of latest.

LIFO – The materials purchased last are to be issued first. Closing stock is valued at the oldest stock price.
Wastage – portion of basic raw material lost in processing having no recoverable value.
Scrap -The incidentalmaterial residue coming out certain manufacturing operations having low recoverable
value.
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Spoilage – Goods damaged beyond rectification to be sold without further processing.
Defectives – Goods which can be rectified and turned out as good units by the application of additional
labour or other services.

5.9 Self Assessment Questions

1. Write the procedure of valuation of incoming materials.
2. Discuss in brief various methods of issue of materials.
3. Discuss the various types of material wastages. How they treated in accounting.
4. Distinguish between spoilage and defectives in manufacturing company. Discuss their treatment
in cost accounting.
5. Distinguish between waste, scrap, defectives and spoilages.
6. Write advantages and disadvantages of LIFO and FIFO method.

Practical Problems for Self Evaluation

1 The following purchases and issues of tin were made during the month of May 2010.
Received
Date Quantity Unit Cost Amount
1-5-2010 150 1.50 225
10.5.2010 450 1.60 720
25-5-2010 600 1.70 1,020
Issued
Date Quantity
12-5-2010 120
18-5-2010 225
28-5-2010 350
There was no “opening stock”. Compute the inventory value on 31st May, 2010 by LIFO method.
(Ans. 505 Units of Rs. 818)
2. Draw a stores ledger card recording the following transaction that took place in a month under
FIFO & LIFO methods:
2011
1st Jan Opening stock 200 pieces @Rs. 2 each
5th Jan Purchases 100 pieces @Rs. 2.20 each
10th Jan. Purchases 150 pieces @Rs. 2.40 each
20th Jan Purchases 180 pieces @Rs. 2.50 each
2nd Jan Issues 150 pieces
7th Jan. Issues 100 pieces
12th Jan Issues 100 pieces
28th Jan Issues 200 pieces

(Ans. Stock LIFO 80 units of Rs. 172 and FIFO 80 units of Rs. 200)

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3. Prepare a stores Ledger account from the following transactions assuming that the issue of stores
have been priced on the principle of “last-in-first-out”& “First-in-first-out” also.
2011
Jan.1 Received 1,000 units at Rs. 20 per unit
Jan.10 Received 260 units at Rs. 21 per unit
Jan.20 Issued 700 units
Feb.4 Received 400 units at Rs. 23 per unit
Feb.21 Received 300 units at Rs. 25 per unit
Mar.16 Issued 620 units
Apl.12 Issued 240 units
May 10 Received 500 units at Rs.22 per unit
May 25 Issued 380 units
(Ans. Stock LIFO 520 units of Rs. 10,640 and FIFO 520 units of Rs. 11,500)

4 The following transactions took place in respect of a material item:

Receipts Rate Issue

Quantity Rs. Quantity
2-3-2006 200 2.00
10-3-2006 300 2.40
15-3-2006 250
18-3-2006 250 2.60
20-3-2006 200

Prepare a priced Ledger sheet, pricing the issues at-

(a) Simple average rate :
(b) Weighted average rate
(Ans. Stock (a) 300 units of Rs. 720, (b) 300 units of Rs.726)
5 Record the following transactions in stores Ledger, pricing materials issues by (a) FIFO, (b) LIFO
and (c) Average price methods. Show the balance of inventory after each transaction:
May1 Balance 50 units @ 25P. per units
May 1 Ordered 200 units, expected May 6, purchase order 55.
May 2 Issued 25 units, requisition No. 101 Dept.A
May 4 Ordered 100 units, expected May 8, purchase order 65.
May6 Received 200 units, purchase order 55 @ 30P. per unit
May 7 Issued 75 units, requisition 105, Production Order 313.
May 8 Returned to stock room 5 units from Dept. A requisition 101

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 May 10 Received 75 units, purchase order 65@ 38P. per unit
May 12 Ordered 50 units, Purchase Order 77, Expected May20
May 15 Issued 80 units, Requisition 125, Production Order 328.
May 18 Received 25 units, balance of Purchase Order 65@ 38P. per unit
May 21 Issued 30 units, Requisition 130, Dept.B
May 23 Returned to vendor 10 units from Purchase Order 65, received May 18.
May 25 Received 50 units, Purchase Order 77@ 25P. Per unit.
May 27 Freight on Purchase Order 77, Rs. 12.
May 29 Issued 60 units, Requisition 140, production Order 354.

(Ans. Stock FIFO 75 units @ 38P.+50 units @49P.=125 units of Rs. 53; LIFO 25 units@
25P.+100 units@ 30.=125 units of Rs. 36.25; Weighted Av. Method 125 units of Rs. 46.63)

6 Show the stores ledger entries as they would appear when using.
(a) The weighted Average Method.
(b) The LIFO method.
Of pricing issues, in connection with the following transactions:
April Units Value
1. Balance in hand b/f 300 600
2. Purchased 200 440
4. Issued 150
6. Purchased 200 460
11.Issued 150
19.Issued 200
22. Purchased 200 480
27. Issued 250

(Ans. (a) 150 units of Rs. 342, (b) 150 units of Rs. 300)

7 Set up a “Stores Ledger” form and enter the following transactions adopting the weighted average
method of pricing out issues:
2010
August 1 Opening Balance -50 units@ Rs. 3 per unit.
August 5 Issued out to production: 2 units.
August 7 Purchased 48 units @ Rs. 4 per unit.
August 9 Issued out 20 units to production
August 19 Purchased 76 units @ Rs. 3 per unit.
August 24 Received back into stores 19 units out of 20 units issued on 9th August, 2006
August 27 Issued to production 10 units.
(Ans. Stock 161 units of Rs. 527.70)
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8 The following is a history of the receipts and issues of materials in a factory, during February.2006
Feb. 1 Opening balance 500 units @ Rs. 25.00
Feb. 3 Issued 70 units
Feb. 4 Issued 100 units
Feb. 8 Issued 80 units
Feb.13 Received from vendor 200 units @ Rs.24.50
Feb.14 Refund of surplus from a work order 15 units @ Rs. 24.00
Feb 16 Issued 180 units
Feb.20 Received from vendor 240 units @ Rs. 24.37
Feb.24 Issued 304 units
Feb.25 Received from vendor 320 units @ Rs. 24.31
Feb. 26 Issued 112 units
Feb.27 Refund of surplus from a work order 12 units @ Rs. 24.50
Feb. 28 Received from vendor 100 units @ Rs. 25.00
Feb. 29 Returned to vendor 50 units
The store verifier of the factory noted that on 15th he had found a shortage of 5 units and on the 27th
anothershortage of 8 units.

W rite out the complete stores Ledger Account in respect of the above material using (i) first-in-first-out and
(ii) last-in-first-out principles.

(Ans. Stock FIFO 478 units Rs. 11,693; LIFO 478 units of Rs. 11,812)

5.10 Reference Books

- Prof. M.L. Agarwal & Dr. K.L. Gupta, 2010, Cost Accounting, First Edition, Sahitya Bhawan
Publication.

- P.C. Tulsian, 2006, Cost Accounting, First Edition, TMH.

- D.M.Wilson, 2009, Cost Accounting, First Edition, Himalaya Publication House.

- Dr. M.N.Arora, 2009, Theory & Practices of Cost, First Edition, Himalaya Publication House.

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  Understand the margin of safety with respect Break even sales.

e unrealistic assumptions:
1. Exact and accurate classification of cost into fixed and variable is not possible. Fixed costs vary
beyond a certain level or output. Variable costs per unit are constant and it varies in proportion to
the volume.
2. Constant selling price is not true.
3. Detailed information cannot be known from the chart. To know all the information about fixed cost,
variable cost and selling price, a number of charts must be drawn.
4. No importance is given to opening and closing stocks.
5. Various product mixes on profits cannot be studied as the study is concern.
- Agarwal

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