Graduate Course

B.Com (Hons) II Year

Paper IX : Cost Accounting

Contents:

Unit 1

Lesson 1: Cost Accounting: An Overview

Lesson 2: Cost Concepts and Classification

Unit 2

Lesson 3: Accounting for Material Cost

Lesson 4: Pricing & Materials

Unit 3

Lesson 5: Labour Cost

Lesson 6 Time-Keeping and Time Booking

Editor
K.B. Gupta

School of Open Learning

University of Delhi
5, Cavalry Lane, Delhi-110007
Session 2007-08 Copies

School of Open Learning

Published by The Executive Director, School of Open Learning, 5 Cavalry Lane,

University of Delhi, Delhi-110007.
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 UNIT 1

LESSON 1

COST ACCOUNTING: AN OVERVIEW

Manisha Verma
HansRaj College
University of Delhi
"A business can be hardly successful over the long-run without effective procedures for treating
costs and revenues
- Peter F. Drucker in Managing the Next Society

LEARNING OBJECTIVES

After studying this chapter, you should be able to understand

1.1 Meaning of Costing and Cost Accounting
1.2 Objectives of Cost Accounting
1.3 Limitations of Financial Accounting
1.4 Relationship with Financial Accounting
1.5 Differences between Financial Accounting and Cost Accounting
1.6 Advantages of Cost Accounting
1.7 Objections to Cost Accounting
1.8 Costing Methods and Techniques
1.9 Installation of Cost Accounting System
1.10 Practical Difficulties in Installation
1.11 Essentials of a Good System

Cost accounting has grown into an exciting discipline. Now it is a re cognized

feature of modern business life. Its also the foundation of a firm's internal information
system. Management is seeing costing as the instrument of productivity, profitability,
and efficiency. Its users of information are no longer simply factory enterprises. Today, it
is universally employed and equally touches merchandising and service organizations.
Over the years, cost accounting as a body of principle and practice has matured into cost
management systems with focus on customer satisfaction and maintaining competitive
position.
1.1 Meaning of Costing and Cost Accounting
The primary purpose of accounting is to provide financial information relati ng to
an economic/business activity. It is concerned with measuring, recording, and reporting
financial information by the management to plan and control the activities of a business as

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well as by others who provide funds or who have various interests in t he operations of an
entity. The accounting system that provides the information to measure product costs and
performance, and control the operations of a firm is called cost accounting.
The Chartered Institute of Management Accountants (CIMA), London has defined costing as,
"the techniques and processes of ascertaining costs. Wheldon has defined costing as, "the
proper allocation of expenditure and involves the collection of costs for every order, job,
process, service or unit." Thus, costing simply means cost finding by any process or technique. It
consists of principles and rules which are used for determining:
(a) The cost of manufacturing a product, e.g., motor car, furniture, chemical, steel, paper,
etc., and
(b) The cost of providing a service, e.g., electricity, transport, education, etc.
The terms `costing' and `cost accounting' are often used interchangeably. Cost
accounting is a formal system of accounting for costs in the books of account by means of
which costs of products and services are ascertained and controlled.
An authoritative definition of cost accounting has been given by CIMA, London as
follows: "the application of costing and cost accounting principles, methods and techniques
to the science, art and, practice of cost control and the ascertainment of profitability. It
includes the presentation of information derived there from for the purposes of managerial
decision making."
Cost accountancy is thus the science, art and practice of a cost accountant. It is a
science in the sense that it is a body of systematic knowledge which a cost accountant should
possess for the proper discharge of his duties and responsibilities. It is an art as it requires the
ability and skill on the part of a cost accountant in applying the principles of cost
accountancy to various managerial problems like price fixation, cost control, etc. Practice
refers to constant efforts on the part of cost accountant in the field of cost accountancy.
Theoretical knowledge alone would not enable a cost accountant to deal with the various
intricacies involved. He should, thus, have sufficient practical training, and exposure to real life
costing dilemmas.
1.2 Objectives of Cost Accounting
The main objectives of cost accounting are as follows:
1. Ascertainment of cost: The primary objective of cost accounting is to determine the
cost of product manufactured or service rendered i.e. both aggregate cost and unit
product costs. For cost ascertainment, various methods are employed in different
industries like job costing, process costing, operating costing etc.

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

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3. Guide for managerial decision making : Cost data provide guidelines for various
managerial decisions like make or buy, keep or replace, accept or reject, continue
or drop a product.
4. Determination of selling price: Cost accounting provides cost information on the basis of
which selling prices of products or services may be fixed.
FINANCIAL ACCOUNTING AND COST ACCOUNTING
Financial accounting aims at presenting a true and fair view of the overall results of
transactions and events which are recorded in the books of accounts in terms of money, and in
accordance with established principles, accounting standards and legal requirements. The
financial statements, comprising the income statement, position statement as well as the funds
flow statement reveal the overall performance and position of the business entity. Such reporting
is hawed on a post mortem examination of past events. Although management has some interest
in the information contained in these statements, the information is of little practical
significance from the point of view of planning, control and decision-making. Cost accounting
was thus evolved to overcome the limitations of financial accounting.
1.3 Limitations of Financial Accounting
In spite of its popularity, financial accounting suffers from the following limitations:
(a) Historical in Nature: Financial accounting is essentially historical in nature. It records
transactions and events which have already occurred. As such, the financial statements
prepared and presented at the end of the accounting period, report on past events as a part
of stewardship function of management. Although, the information is historically
important, it does not provide the management with day-to-day information for
evaluating operational efficiency.

(b) Overall Performance: Financial accounting discloses and reports profitability or

otherwise of the business as a whole. Since it does not classify accounts on the basis of
departments or segments, products, processes and sales territories, it fails to provide
information about costs and profit of these sub-divisions of the organisation.
(c) No Objective Classification: In financial accounting, accounts are classified under two
major groups, viz. personal and impersonal. Such a primary classification made
subjectively, is of little use to management to ascertain costs by products, jobs and
processes.
(d) Distinction between Direct and Indirect Expenses: In the case of financial accounting,
expenses are not classified into direct and indirect, fixed and variable, controllable
and uncontrollable, and assigned to departments, jobs or products. As such, controllable
items of expenses cannot be distinguished from uncontrollable ones for purposes of cost
control and cost reduction.
(e) Material Losses: There being no material control system operating under financial
accounting, there is no safeguard against material losses consequent upon wastage,
pilferage, deterioration and obsolescence of materials.
(f)) Labour Cost Control: In the case of financial accounting, there is no means of comparing

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 the time clocked with the time booked since workers are paid on the basis of hours worked.
Consequently, losses resulting from idle time, evasion of work and loitering cannot be
controlled. Further, labour time is not recorded job-wise. Hence, there is no means of
judging the efficient utilization of labour time and no incentive systems based upon
results can be introduced.
(g) Idle Facilities: Financial accounting does not reveal losses due to idle plant and
equipment. Such losses can neither be analyzed nor controlled.
(h) No Cost Comparison: Financial accounting does not provide data for comparison of
costs of' two periods, two firms, two jobs, departments or processes. As such, it is not
possible to arrive at conclusions regarding the profitability or otherwise of different
products, jobs, departments, processes or sales territories.
(i) Distortion of Trading Results: In financial accounting, the values of closing inventories
are estimated for the purpose of income statement and balance sheet. If the values are
not stated accurately, matching of costs with revenues cannot be done properly.
Consequently, trading results become distorted to the extent of variation in values.
(j) Only Monetary Information: Financial accounting records contain information
relating to transactions and events of a business entity capable of being expressed in terms of
money. There is no place in these records for non monetary information such as quantity of
materials and quality of labour, etc.
(k) Fixation of Product Price: Financial accounting records do not furnish the required
information regarding quantity and costs to enable management to fix the price of
products, jobs and processes or services rendered. Financial accounting also fails to
explain the reason why there is rise or fall in cost of production.
(l) Inventory Levels cannot be fixed: Financial accounting fails to supply the necessary
information to management for fixation of stock levels such as maximum level,
minimum level, ordering level, etc. In the absence of fixation of such levels, investment in
inventories cannot be optimized.
(m) Lack of Data for Decision-making: Decision-making is one of the basic functions of
management of any organisation. However, financial accounting fails to furnish the
required data for such decisions as introduction of a product line, discontinuance of
production of a product or a department, whether to make or buy, equipment
replacement, suitable product-mix, etc.
1.4 Relationship with Financial Accounting
Cost accounting is a branch of accounting in much the same way as financial accounting.
In fact, financial accounting provides the data base for cost accounting. Necessary
information relating to costs is obtained from financial accounting records. As such, cost
accounting and financial accounting are complementary to each other. The similarities
between the two branches of accounting are:
i) Both cost and financial accounting are the branches of accounting.
ii) Both are concerned with recording and reporting accounting
information.

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 iii) Both the sets of accounts use the same basic documents for recording transactions
and events.
iv) Both record transactions and events on the basis of double entry.
v) Both the sets of accounts record information in monetary terms
although cost accounting records contain additional information.
vi) Each of these branches is mutually helpful to the other. While financial accounting
provides basic information for writing up cost records, cost accounting assists
financial accounting in inventory valuation thereby facilitating the preparation of
financial statements.
vii) Both the sets of accounting records furnish the required information to
interested parties.
viii) Each of these branches facilitates performance appraisal in its own way.
ix) Both the sets of accounts are a means of control.
1.5 Differences between the Two
In spite of the above points of similarity between financial and cost accounting, the two
branches of accounting differ from each other in the following respects
(i) Purpose: Financial accounting records disclose profitability or otherwise, i.e., trading
results as well as the financial position of a business. The chief purpose of cost
accounting is to provide detailed cost information to management.
(ii) Nature: Financial accounting is historical in nature. The information provided by the
records is in respect of only monetary transactions and events which have already
occurred and about which nothing can be done. Cost accounting, on the other hand,
focuses not only with past transactions but of the future ones also.
(iii) Legality: Financial accounting is legally necessary, especially in the case of companies.
Even in the case of other forms of business, financial accounting has almost become
mandatory by virtue of the application of other enactments much as the Income Tax Act
and Sales Tax Act. Cost accounting is not legally necessary except for certain specified
industries.
(iv) Reporting: Financial accounting serves the interest of people belonging to different
groups outside the organization such as shareholders, creditors, potential investors, workers,
taxation authorities, financial analyst, government, trade unions. Therefore this branch of
accounting accomplishes only external reporting of financial information. Cost accounting,
however, serves the needs of management and thus accomplishes internal reporting.
(v) Periodicity: Financial accounting reports are prepared on annual basis while cost
accounting reports are prepared on weekly, monthly, quarterly even daily basis
depending on the needs of management.
(vi) Analysis of profit:. Financial accounts reveal the profit or loss of business as a whole
for a particular period. Cost accounts show the detailed cost and profit data for each
product line, department, division, section, process.

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(vii) Focus: In Financial accounting focus is on recording, classifying and summarizing the
financial transactions .In cost accounting the focus is on cost ascertainment and cost control.
(viii) Format of presenting information: Financial accounting has a single uniform format of
presenting information, i.e., Profit and Loss Account, Balance Sheet and Cash flow
statement Cost accounting has varied forms of presenting cost information which
are tailored to meet the needs of management and thus lacks a uniform format.
(ix) Analysis of cost: In financial accounting, no distinction is made between direct and
indirect costs, fixed and variable costs and controllable and uncontrollable costs. In
cost accounting, costs are distinguished according to their identification with the cost
units (direct and indirect), according to variability (fixed and variable), and
according to responsibility (controllable and uncontrollable costs).
(x) Use of standards: In financial accounting there are no predetermined standards of
cost and performance to evaluate the efficiency of operations as regards the use of
material, labour and overhead facilities. Cost accounting makes the use of standard
costs against which actual costs are compared, variances are calculated and analyzed
into their causes that corrective action may be taken.
1.6 Advantages of Cost Accounting
Cost accounting provides information that is useful to management in planning,
control and decision-making. The main advantages of cost accounting are listed below:
1. It reveals unprofitable activities, losses, and inefficiencies such as wastage of material
in the form of spoilage, excessive scrap, and idle time of labour and idleness of
plant facilities. Management can take steps to check these wastes and losses.
2. It helps the management in fixation of prices. Accurate cost data can be used as a
guide for preparation of quotations and submission of tenders.
3. It provides suitable data and information which helps the management in taking
decisions such as make or buy, shut-down or continue selection of most profitable
product-mix, acceptance or rejection of a special order, introduction of a new product,
etc.
4. Detailed costs of materials, labour and overheads reveal actual and potential sources
of cost saving and reduction.
5. Maintenance of time and job records for workers reveals losses incurred due to idle
time. Such records assist in taking steps to minimize those losses.
6. Centralization of purchasing is facilitated by the use of cost accounting. This results in
economical purchases.
7. A perpetual inventory system which facilitates continuous stock-taking helps in the
preparation of interim profit and loss account.
8. Cost accounting lays the basis of standard costing and budgetary control systems.
These two techniques help the management in cost control. Variance analysis and
comparison of actual performance with budget estimates indicates areas where
economies can be achieved.

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9. A system of cost accounting provides an independent and reliable check on the
accuracy of financial accounts. A reconciliation is made of the profit as shown by cost
accounts with that shown by financial accounts.
10. Installation of uniform costing enables management to make inter-firm comparisons.
1.7 Objections against Cost Accounting
There are objections raised against the introduction of cost accounting.
(i) It is expensive. A cost accounting system involves recording, classification,
analysis, allocation and apportionment of costs and absorption of overheads which
require considerable amount of clerical work.
(ii) It leads to increase in workload. The results shown by the cost accounts differ
materially from those shown by the financial accounts. Preparation of reconciliation
statements frequently is necessary to verify their accuracy. This leads to unnecessary
increase in work load.
(iii) It is unnecessary. Introduction of costing system itself does not control costs or contribute
to operating efficiency of the concern. It gives management information with which to
control costs. If the management is alert and efficient, it can control costs without the aid
of this system. This is, therefore, unnecessary.
The above arguments are untenable. The basic aim of cost accounting is minimizing costs
by avoiding wastes at all stages therefore it, it will be wrong to call it expensive , infact it is a
profitable investment. Differences between results shown by cost accounts and financial
accounts arise on account of over and under-absorption of overheads, methods of material
pricing used and treatment of other incomes. An integrated system of accounts can help in
elimination of these differences. In this age of competition and globalization costing is not
unnecessary, but must for each manufacturer because he must know the exact cost not only of
each article made but also of each process involved in its production so that he may be in a
position to avoid waste and minimise its cost. It is possible only when proper costing records are
maintained. Hence, it is wrong to say that it is unnecessary.
1.8 Costing Methods and Techniques
Methods: The methods of costing refer to the processes employed in the
ascertainment of costs. Several methods have been designed to suit the needs of different industries
.The methods of costing to be applied in a particular concern depends upon the type and nature of
manufacturing activity. .
1 Job Costing is that form of specific order costing under which each job is treated as a cost
unit and costs are accumulated and ascertained separately for each job. It is applied in
those industries where the goods are manufactured against specific orders as per
customers specifications e.g. printing press, repair shop, interior decoration, painting.
2. Contract Costing is that form of specific order costing under which each contract is treated
as a cost unit and costs are accumulated and ascertained separately for each contract e.g.
construction of building, roads, bridges or other construction work..
3. Batch Costing is that form of specific order costing under which each batch is treated as a
cost unit and costs are accumulated and ascertained separately for each batch .It is applied

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 in those industries where the similar articles are produced in definite batches e.g.
readymade garments, toys manufacturing industries, tyres and tubes, spare parts and
components, pharmaceutical industries.
4. Process Costing is a method of costing under which all costs are accumulated for each
stage of production and the cost per unit of product is ascertained at each stage of
production. It is applied in those industries where manufacturing activity is carried
on continuously by means of two or more processes and output of one process
becomes the input of the following process till completion. e.g. paper industries,
chemical industries, textile industries, sugar industries.
5. Unit /Single /Output Costing is applied in those industries where only one product
or a few grades of the same product are produced and production involves only a
single process or operation and production is uniform and continuous and units of
output are identical e.g. cement industry, steel industry, floor mills industry,
bricks making industry.
6. Operating /Service Costing it is used to ascertain the cost of providing services
incase of those undertakings which render services and are not engaged in the
manufacture of tangible products e.g. road transport, railways, airlines, hotels,
hospitals, electricity, cinemas.
7. Multiple /Composite Costing It involves the application of two or more methods of
costing in respect of same product. It is used in industries where number of
components are separately produced and then assembled in a final product e.g.
bicycle, motor cycle, scooter, T.V., air conditioners, cars, refrigerators.
Techniques: The techniques of costing are not alternatives to the methods of costing.
These are the different ways of analyzing and presenting costs for the purpose of
controlling costs or making managerial decisions irrespective of method of costing being
used. Some of the popular techniques of costing are as follows:
1. Standard costing: This is a very valuable technique of controlling cost. In this technique,
standard cost is pre-determined as target of performance, and actual performance is
measured against the standard. The difference between standard and actual costs is
analyzed to know the reasons for the difference so that corrective actions may be taken.
2. Budgetary control: A budget is an expression of a firm's business plan in financial form.
Budgetary control is a technique applied to the control of total exp enditure on
materials, wages and overheads by comparing actual performance with the budgeted
performance. Thus, in addition to its use in planning, the budget is a control and co-
ordination of business operations.
3. Marginal costing: In this technique, separation of costs into fixed and variable is of
special interest and importance. This is so because marginal costing regards only
variable costs as the cost of the products. Fixed cost is treated as period cost and no
attempt is made to allocate or apportion these cost to cost centres or cost units. It is
transferred to costing profit and loss account of period. This technique is used to study
the effect on profit of changes in volume of output.
4. Total absorption costing: It is a traditional method of costing whereby total costs (fixed
and variable) are charged to products. This is in complete contrast to marginal costing

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 where only variable costs are charged to products.
5. Uniform costing: It is the practice of using the same costing principles or practices by a
number of firms in the same industry. It helps in inter firm comparisons, fixation of price,
cost reduction and in seeking tax relief or protection from government.
1.9 Installation of Cost Accounting
All cost accounting systems reflect the same principles and purposes, although their
application may vary with circumstances out of necessity. Accordingly, the cost accounting
system proposed to be installed should be designed to suit the nature of the business.
Further, the system should be simple, and the expenses of operating it should be
commensurate with the expected benefits.
The preliminary considerations governing the design and installation of a cost accounting
system are:
(a) Nature of Business: The system sought to be designed and introduced, should suit the
nature of business. Accordingly, it is necessary to be thoroughly acquainted with the
technical aspects and the methods of production. If the business engaged in is the
production of goods, it should further be seen whether it produces a s ingle product
on a mass scale, or a multi-product concern producing more than one product, or a
jobbing type of business, a process type or an assembly unit.
(b) Nature of Organisation: It is equally necessary to study the layout, nature and size
of the organisation. Since the system to be designed should suit the organisation, the
existing types of authority relationship, the number of layers and the extent of
authority and responsibility should also be studied.
(c) Methods and Procedures: The methods of manufacture and the procedures existing for
purchase, receipt, storage and issue of materials, the methods of wage payment, computation
and payment of wages and of arriving at overheads also deserve careful study.
(d) Technical Aspects: Although the cost accountant is not a technical expert, it is
necessary for him to get acquainted with the nature of product, the methods and
stages of production, the operations involved, varieties produced and such other technical
aspects of the business. Since production efficiency depends upon effective production
control, it is equally necessary to know the degree of control exercised over
production.
(e) Management's Expectations and Policies: The cost accounting system to be
designed also depends upon management policy and their expectations from the system.
If, for instance, the management's objective of installing a costing system is only to
ascertain the cost of each product, the cost accounting system should be simple enough
to achieve that objective.
(f) Simplicity: The system to be introduced should be simple and easy to operate. The
operating personnel should be capable of understanding the procedures laid down
for working the system efficiently.
(g) Co-operation and Support of Personnel: No system of cost accounting, however
carefully designed, can be worked successfully without enlisting the co-operation and
support of the personnel involved in the cost accounting process. As such, the

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 system should not be thrust upon them. They should be consulted, their views and
suggestions considered, and they should be made cost conscious and drawn into the
cost accounting process.
(h) Standardization of Forms: Accumulation of cost information necessarily involves
the maintenance of detailed cost records. Since this entails considerable clerical
work, the staff may resent it. It is, therefore, necessary to reduce clerical work to the
minimum. Printed forms should be used and they should be standardized as regards
size and contents with instructions printed.
(i) Accuracy of Data: It is also necessary to determine the degree of accuracy of data to be
supplied by the cost accounting system.
(J) Prompt Reporting: Since a cost accounting system is mainly intended for internal
reporting of cost information, cost data should be made available promptly and
regularly. It is also necessary that the information supplied should be clear, non-
technical and unambiguous. There should be no duplication in reporting the same
information.
(k) Flexibility: The costing system should be flexible and capable of adaptation to changing
circumstances. It requires periodical scrutiny and change to avoid the danger of
becoming obsolete owing to changes and developments in the business.
(l) Reconciliation: Where cost records are maintained independently of financial
records, arrangements should be made for regular reconciliation of the trading result
as revealed by both the set of books.
(m) Cost: It is equally necessary that the cost of installing a system of cost accounting
should be commensurate with the benefits of installation. In other words, the benefits
should not outweigh the cost of installation and operation of the costing system.
1.10 Practical Difficulties in Installation
Apart from technical problems, the practical difficulties which may arise in
connection with the introduction of a cost accounting system are the following:
(a) Lack of Support from Management: In many cases, the costing system is thrust on
the managerial personnel, without consulting them and without explaining the
benefits of the system. It may also happen that the system introduced may not be
supported by the top management, probably because of the expenditure involved. In
either case, the system introduced arouses fear and suspicion in the minds of line
managers. Consequently, they view the system as interference in their work, and are
likely to resist the same. The difficulty may be got over by explaining the benefits
accruing from the system to all those who would be involved in the cost accounting
process and instilling in their minds a sense of co-operation.They should be made
cost conscious by being drawn into the process of designing and installation.
(b) Resistance from the Accounting Staff: The accounting staff may offer resistance to the
introduction of cost accounting on the ground that their work would increase, or that
it is interference in their routine work of accounting. Their resistance may also be due
to their feeling of losing importance with the introduction of cost accounting. Even this
difficulty may easily be overcome by explaining to them the need for cost accounting

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 and assuring, at the same time that their position would not, in any way, be affected.
They should be made to feel that it is absolutely necessary to supplement their
accounting work with cost accounting and that the system would neither increase
their work nor bring about unemployment, but on the contrary, the system would
create more employment opportunities.
(c) Non-co-operation of Operating Personnel: The foremen, supervisory staff and operating
personnel may also offer resistance to the system due to ignorance and suspicion. As
a result, they may not supply the necessary data for the successful working of the cost
accounting system.
To overcome this difficulty, it is necessary to properly educate them. They should be made
aware of the benefits accruing from the system, and should be made cost conscious by
winning their confidence.
(d) Shortage of Trained Staff: At the time of introduction of a suitable system of cost
accounting, the concern may experience non-availability or shortage of trained staff to
handle the, work involved in operating it.
This difficulty need not be an excuse for non-introduction of the system designed. It is
necessary to train the existing staff and introduce the system rather slowly, instead of
thrusting a complete system upon them irrespective of whether or not they are ready to
accept and handle the system.
(e) Cost of Installation: The use of standardized forms necessary for recording and
reporting involves additional expenditure which the concern may not afford. The
design of a system and the details of the methods to be employed will vary widely
according to the nature of each concern. Accordingly, the system should be designed
to suit the concern, and the obtainable results should justify the cost of additional
staff and records involved. Cost-benefit analysis should be made to justify the costs
involved.
1.11 Essentials of a Good System
A suitably designed and an easily workable system of cost accounting should reflect the
following features:
1. The system designed should be appropriate to the organisation structure and
methods of production.
2. It should be capable of achieving the objectives and goals set by the management.
3. The system should be simple enough to be understood by the operating personnel.
4. It should be flexible so as to permit easy adaptability to changed conditions of
business.
5. The reports and statements produced by the system should contain the relevant
information for the intended purpose.
6. The reports and statements produced should be timely, accurate and effective.

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 QUESTIONS
1. Limitations of financial accounting have made the management realize the
importance of cost accounting Comment.
2. What is cost accounting? Discuss briefly its objectives and advantages?
3. State the main differences between cost accounting and financial accounting?
4. You have been asked to install a costing system in a manufacturing business. What
practical difficulties would you expect and how do you propose to overcome them?
5. Cost accounting system is neither unnecessary nor expensive rather it is a
profitable investment Comment.
6. What method of costing would you adopt for the following industries? Give reasons
1. Ship building
2. Toy making
3. Oil refinery
4. Sugar
5. Road transport company

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 LESSON 2

COST CONCEPTS AND CLASSIFICATION

Manisha Varma
Hans Raj College
University of Delhi

LEARNING OBJECTIVES

After studying this chapter, you should be able to understand

2.1 Costs vs. Expense and Loss
2.2 Cost Classifications
2.3 Elements of Cost
2.4 Items Excluded From Cost Accounts
2.5 Cost Sheet
2.6 Questions

2.1 Costs vs. Expense and Loss

The term `cost' does not have a definite meaning and its scope is extremely broad and
general. It is, therefore, not easy to define or explain this term without leaving any doubt
concerning its meaning. Cost accountants, economists and others develop the concept of cost
according to their needs because one complete description of `cost' to suit all situations is not
possible.
According to the Oxford Dictionary, cost means "the price paid for something." Some other
definitions of cost are given below:
According to CIMA, London Cost is the amount of expenditure (actual or notional)
incurred or attributable to a given thing.
According to WM Harper "A cost is the value of economic resources used as a result of
producing or doing the things coasted."
According to ICWA of India "Cost is a measurement, in monetary terms, of the amount
of resources used for the purpose of production of goods or rendering of services".
Often the terms `cost' and `expense' are used interchangeably. But cost 'should be
distinguished from expense and loss.
Expense is defined as "an expired cost resulting from a productive usage of an
asset." It is that cost which has been applied against revenue of a particular accounting period
in accordance with the principle of matching costs to revenue. In other words, an expense is
that portion of the revenue earning potential of an asset which has been consumed in the

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generation of revenue. Unexpired or unconsumed part of the cost is recorded as an asset in
the balance sheet. Such an unexpired cost is converted into an expense when it expires while
helping to earn revenue. For example: when a plant is purchased, depreciation on plant
(expired cost) is charged to profit and loss account as an expense and cost of plant
remaining after providing depreciation (unexpired cost) is shown as an asset in the balance
sheet. Every year, depreciation on plant representing expense is debited to profit and loss
account and depreciated value representing unexpired cost is shown in the balance
sheet. Pre-paid insurance is also an example of unexpired cost which is shown in the balance
sheet as an asset.
Loss is defined as "reduction in, a firm's equity other than from withdrawals of capital
for which no compensating value has been received." A loss is an expired cost resulting from the
decline in the service potential of an asset that generated no benefit to the firm. Obsolescence or
destruction of stock by fire are examples of loss.
2.2 Cost Classifications
Classification is the process of grouping costs according to their common
characteristics. It is a systematic placement of like items together according to their common
features.
The principal bases on which costs are classified are:
1. Variability (behavioral classification)
2 Functional areas (functional classification)
3. Responsibility (controllable and uncontrollable costs)
4: Traceability/identifiably (direct and indirect costs)
5. The accounting period charged to revenue (product costs and period costs)
6. Decision-making (relevant and irrelevant costs).
Behavioral Classification
The basis of classification, the behaviour pattern of costs considers how the costs
respond, i.e. change with a given change in the volume of production. While some costs
vary with the change in the quantity of output, others do not. Accordingly, there are
three categories of costs: fixed, variable and semi-variable.
Fixed costs: These are unaffected by variations in the volume of activity. The total
fixed costs remain constant over a relevant range of output, while the fixed cost per unit
varies with the output. Fixed costs have no particular relation to the volume of a ctivity.
These are incurred irrespective of production and sales. These are usually time based. Some
typical examples are rent, insurance, taxes and managerial salaries.
Variable cost: These are the costs which vary in direct proportion to changes in
volume. They increase or decrease in the same proportion in which the output increases or
decreases. The total amount of variable costs tends to change in respect to changes in
production volume, but the variable cost per unit stays at the same level for a considerable
period of time. The examples of such costs are direct material, direct labour, small tools,
commission of salesmen, power.

14
 Semi-variable costs: Also known as `mixed costs'. These costs include both a fixed
and a variable component, i.e. these are partly fixed and partly variable. A semi-variable
cost often has a fixed element below which it will not fall at any level of output. The
variable element in semi-variable costs changes either at a constant rate or in lumps. For
example, introduction of an additional shift in the factory will require additional
supervisors and certain costs will increase by steps. In the case of a telephone connection,
there is a minimum rent and beyond a specified number of calls, the charges very
according to the number of calls made. In fact, there is no definite pattern of behaviour of
semi variable costs. The examples of such costs are supervision, maintenance and repairs,
telephone expenses, light and power, depreciation.
Functional Classification
Costs classified according to managerial functions are accumulated according to the
activity performed. The costs of a typical organization may be divided into manufacturing,
marketing, administrative and financing groups.
Manufacturing cost: These are related to the production of an item. These are the sum of
direct materials, direct labour and factory overhead. In other words, these include all the costs
incurred in the factory up to that stage when the goods are ready for dispatch. Examples are:
salaries of factory manager, supervisors and foremen, rent, rates and insurance of the factory,
power and fuel used in the factory, depreciation, maintenance and repairs of building, plant,
machinery tools, etc.
Administrative costs: These include all expenditures incurred in formulating the plans,
directing the organization and controlling the operations. A major portion of these costs are policy
costs which are of fixed nature and, therefore, uncontrollable. These include salaries paid to
management and clerical staff, rent, rates and insurance of general offices, their lighting, heating
and air-conditioning, depreciation of office buildings, furniture, machinery, etc.
Selling and distribution costs: Selling Cost: These are incurred to create and stimulate
demand and to secure orders. These include salaries, commission and traveling expenses of
salesmen and technical representatives and sales managers, advertising, catalogues, price lists, bad
debts and collection charges, cost of market research, etc.
Distribution Cost: These are .the costs incurred in moving the goods from the point of
production to the point of consumption. These include: warehouse expenses, carriage outwards,
depreciation and upkeep of delivery vans, wages of packers, van drivers, etc.
Financing costs: These are costs incurred for raising and using capital, e.g. interest on
loans and debentures, commission or brokerage on issue of shares and debentures, discount on
the issue of shares and debentures, etc.
Controllability Classification
Costs are also classified in terms of responsibility over them. Responsibility carries the
authority of the manager to influence costs-increase or decrease their amount. As such, there
are two groups: Controllable and uncontrollable.
Controllable Costs. Costs are said to be controllable when the amount of the cost incurred
can be influenced by the action of a specified member (manager or supervisor) of an undertaking.

15
 Uncontrollable Costs. Costs which cannot be influenced by the action of a specified
member (manager or supervisor) of an undertaking are known as uncontrollable costs.
The distinction between controllable and uncontrollable costs depends upon a point of reference.
An item of cost may be uncontrollable at one level of management but the same item may be
controllable at another level of management. Almost all costs are controllable at some level of
management. Segregation of costs into controllable and uncontrollable categories will help the
management in fixing responsibilities of different executives for unfavourable cost variances. An
executive should be held responsible only for those costs which are under his control.
Manufacturing Classification
Costs are also classified as to when they are charged against revenue. The basis as the
period benefited by the particular cost. This is essential in matching expenses against revenues in
the relevant period. Such a grouping helps management in income measurement for the
preparation of financial statements. Here, two categories are product costs and period costs.
Product Costs. These are the costs directly identified with the product. These are the
cost of goods produced and kept ready for sale. They are direct materials, direct labour, variable
factory overheads. These costs provide no benefit till the product is sold, and are, therefore,
inventoried. When the products are sold, the total product costs are recorded as an expense, and is
called cost of goods sold. It is matched against revenue for the period in which
products are sold.
Period Costs. These are not directly related to the product and, therefore, not inventoried.
If the period costs benefit only one accounting period, it is called revenue expenditure. If they
benefit two or more accounting periods, they are treated as assets till they are charged as
expenditure for the relevant years. Normally, expense of fixed nature like depreciation of assets,
insurance premium, rent and rates are treated as fixed costs. These costs represent non-operating
items and are related to passage of time and not to the production and sales of the period.
In a manufacturing organisation all manufacturing costs are regarded as product costs
and non-manufacturing costs are regarded as period cost. In retailing and wholesaling
organisations goods are purchased for resale without changing their basic form. The cost of goods
purchased is regarded as product cost and all other costs such as administration and selling and
distribution are considered to be period costs.
Identification / Traceability Classification.
Costs are classified as direct and indirect costs on the basis of their identification with
particular jobs, products or processes.
Direct Cost: It is a cost which can be directly identified with a product, process or
department. Materials used and labour employed in manufacturing an article or in a particular
process of production, are common examples of direct costs.
Indirect Costs: These costs are not traceable to any particular product, process or
department, but are common to different products, processes or departments. Factory manager's
salary, factory rent, depreciation of machinery, etc., are typical examples of indirect costs.
The distinction between direct and indirect costs depends upon whether or not the cost can
be identified with the activity or other relevant unit. A cost such as the plant superintendent's
salary can be readily identified with the plant and hence is a direct cost of the plant. However, it is

16
an indirect cost of any department within the plant or of any line of product manufactured. Thus
the nature of business and cost unit chosen will determine which are direct and which
are indirect costs Direct costs are allocated whereas indirect costs are apportioned to
different jobs, products or services on a reasonable basis.
Decision-making Classification
For managerial decision-making, costs are -sub-divided under:
(i) Relevant costs and
(ii) Irrelevant costs.
Relevant costs: These are costs which are relevant for decision-making (for the
future) such as differential or incremental costs, opportunity costs, out-of-pocket costs, etc.
Differential Costs: Management is expected to make decisions and in doing so
compares alternatives. In making a decision, management compares the costs of the
alternatives. The costs that remain the same in any case can be disregarded but the
difference in cost between alternatives is relevant to decision-making. A difference in cost
between one course of action and another is differential cost. If a decision results in an
increased cost, the differential cost may be called incremental cost. If the cost is
decreased, the differential cost may be referred to as a decremental cost. A decision in
favour of an alternative is taken only when, the incremental revenue between two levels
of output is greater than differential cost of those levels of activity. This differential cost is
the difference in net costs and benefits between two or more alternative courses of action.
If the selection of an alternative involves changes in variable costs only, marginal cost
and differential costs are the same. However, a decision may involve changes in fixed costs
also.
Opportunity Costs: In choosing between alternative management has to select the
best alternative but in doing so, has to give up the returns that could have been derived
from the rejected alternatives. The sacrifice of a return or benefit from a rejected
alternative is known as the opportunity cost of the alternative accepted. Opportunity cost
are not entered in the accounting records, yet they are used in decision-making. Often
management is confronted with alternatives, each having its advantages.
Out-of-Pocket Costs: An out-of-pocket cost signifies the relevant cash expenditure
which is involved in a particular situation. Manangement decisions are directly affected by
such costs. Thus, an out-of-pocket cost is the present or future cash expenditure connected
with a certain decision which will change according to the nature of the decision made. For
example, if it is proposed to replace the company's delivery trucks by an arrangement to deliver
goods through public carriers, the depreciated value of the truck is irrelevant (being a sunk cost) to
decide upon the proposal. But, the cost of fuel, driver's salary and maintenance expenditure
involved in using the truck should be relevant costs in deciding whether the delivery system
should be change. These are out-of-pocket costs.
Irrelevant costs: These are those which are not pertinent to a decision. These are the
costs that will not be changed by a decision. Because irrelevant costs will not be affected,
they may be ignored in decision-making process. An example of irrelevant cost is that of sunk
cost.

17
 Sunk Cost: It is a cost incurred as a result of decision made in the past which
cannot be reversed or altered by any decision in the future. Sunk costs are irrelevant for
decision-making. The written down values of assets previously purchased are sunk costs.
Let us suppose the management of a company is considering the desirability of replacing
an existing machine by a new one. Suppose, an old machine originally costs Rs. 20,000 and
it has been depreciated to the extent of Rs. 15000 so far. If it is scrapped (no value being
realisable on sale) there will be an accounting loss of Rs. 5000. It would be wrong to
recognise this loss as a cost for deciding upon the proposed replacement. The book value of
the existing machine is really a sunk cost and the decision to replace or not to replace the
machine will not make any difference to its undepreciated value. It is irrelevant to the
question of replacing the existing machine. The difference in income which will result from
the installation of new machine and expected return on capital investment should be the
deciding factor.
Other Cost Concepts
Shut down cost: These are the costs which will still be incurred although a plant is
shut down temporarily, e.g. rent, rates, depreciation, maintenance of plant, etc.
Research cost: It is the cost of searching for new or improved products, new
application of materials or new or improved methods of production.
Development cost: It is the cost of the process which begins with the implementation
of the decisions to produce a new/improved product. It ends with the commencement of
production of that product or method. Thus, it is the cost of commercial exploitation of
successful research. Development cost of new products is treated as an item of deferred
expenditure to be spread over a number of years. It is charged to product costs when
production is fully established.
Joint cost: These are the costs incurred up to the point in a given process where
individual products can be identified. Whenever two or more products are produced out of
the same basic raw material or process, the cost of material purchased and processing are
called joint costs. Such costs have to be apportioned to various products on some basis.
2.3 Elements of Cost
A cost is composed of three elements, i.e., material, labour and expense. Each of these
elements may be direct or indirect.
Material Cost: According to CIMA, London, material cost is "the cost of
commodities supplied to an undertaking. Material cost includes cost of procurement,
freight inwards, taxes, insurance, etc., directly attributable to the acquisition. Trade
discounts, rebates, duty drawbacks, refund on account of modvat, sales tax, etc., are
deducted in determining the cost of material. Materials may be direct or indirect.
Direct materials: Direct material cost is that which can be conveniently identified
with and allocated to cost units. Direct materials generally become a part of the finished
product. For example, cotton used in a textile, clay in bricks, leather in shoes, steel in
machines, cloth in garments, timber in furniture.
Indirect materials: These are those materials which cannot be conveniently
identified with individual cost units. These are minor in importance, such as (i) small

18
and relatively inexpensive items which may become a part of the finished product, e.g.,
pins, screws, nuts and bolts, thread, etc., (ii) those items which do not physically
become a part of the finished products, e.g., coal, lubricating oil and grease, sand paper
used in polishing, soap, etc.

Labour Cost: According to CIMA, London, labour cost is the cost of remuneration
(wages, salaries, commission ,bonuses etc) of the employees of an undertaking. It includes
all fringe benefits like P.F.contribution, gratuity, ESI, overtime, incentive bonus, wages for
holidays, idle time etc. Labour may be direct or indirect.
Direct labour cost consists of wages paid to workers directly engaged in converting raw materials
into finished products. These wages can be conveniently identified with a particular product, job
or process. Wages paid to a machine operator, shoe-maker carpenter, weaver, tailor is a
case of direct wages.
Indirect labour: It is of general character and cannot be conveniently identified with a
particular cost unit. In other words, indirect labour is not directly engaged in the production
operations but only to assist or help in production operations. Supervisor, Inspector,
Cleaner, Clerk, Peon, Watchmen are examples of indirect labour.

Expenses: All costs other than material and labour are termed as expenses. According
to CIMA, London. It is defined as the cost of services provided, to an undertaking and the
notional cost of the use of owned assets. Expenses may be direct or indirect.
Direct expenses: are those expenses which can be identified with and allocated to
cost centres or units. These are those expenses which are specifically incurred in
connection with a particular job or cost unit. Direct expenses are also known as chargeable
expenses. Hire of special plant for a particular job, Travelling expenses in securing a particular
contract, Cost of patent rights, Experimental costs, Cost of special drawings, designs and
layouts, Job processing charges, Royalty paid in mining, Depreciation or hire of a plant used on a
contract at site are examples of direct costs.
Indirect expenses: All indirect costs, other than indirect materials and indirect labour
costs, are termed as indirect expenses. These cannot be directly identified with a particular job,
process or work order and are common to cost units or cost centres. Rent and rates,
Depreciation, Lighting and power, Advertising, Insurance, and Repairs are examples of indirect
expenses.

Direct material + Direct labour + Direct expenses = Prime Cost

Indirect material + Indirect labour + Indirect expenses = Overhead

Overheads are divided into three groups as follows:

(a) Manufacturing (works, factory or production) overheads: Such indirect expenses
which are incurred in the factory and concerned with the running of the factory or plant are
known as manufacturing overheads. Following are a few items of such expenses: Rent, rates and
insurance of factory premises, power used in factory building, plant and machinery, etc.
(b) Office and Administrative Overheads. These indirect expenses are not related to factory
but they pertain to the management and administration of business. Such expenses are incurred
on the direction and control of an undertaking. Examples are: Office rent, lighting and heating,
postage and telegrams, telephones and other charges, depreciation of office building, furniture

19
and equipment, bank charges, legal charges, audit fee etc.
(c) Selling and Distribution Overheads. Indirect Expenses incurred for marketing of a
commodity, for securing orders for the articles, despatching goods sold, and for making efforts to
find and retain customers, are called selling and distribution overheads. Examples are
advertisement expenses, cost of preparing tenders, travelling expenses, bad debts, collection charges,
warehouse charges, packing and loading charges, carriage outwards, etc.
2.4 Items excluded from Cost Accounts
There are certain items which are included in financial accounts but not in cost accounts.
These items fall into three categories:
Appropriation of profits
(i) Appropriation to sinking funds.
(ii) Dividends paid.
(iii) Taxes on income and profits.
(iv) Transfers to general reserves.
(v) Amount written off-goodwill, preliminary expenses, underwriting commission,
discount on debentures issued, expenses on capital issue.
(vi) Capital expenditure specifically charged to revenue.
(vii) Charitable donations.
Matters of pure finance
(a) Purely financial charges:
(i) Losses on sale of investments, buildings, etc.
(ii) Expenses on transfer of company's office.
(iii) Interest on bank loan, debentures, mortgages, etc.
(iv) Penalties and fines.
(v) Losses due to scrapping of machinery.
(vi) Remuneration paid to the proprietor in excess of a fair reward for services rendered.
(b) Purely financial incomes :
(i) Interest received on bank deposits.
(ii) Profits made on the sale of investments, fixed assets, etc.
(iii) Transfer fees received.
(iv) Rent receivable.
(v) Interest, dividends, etc., received on investments.
(vi) Brokerage received.
(vii) Discount, commission received.
Abnormal gains and losses
(i) Losses or gains on sale of fixed assets.
(ii) Loss to business property on account of theft, fire or other natural calamities .
2.5 Cost Sheet
The statement of cost according to element-wise is known as cost sheet. The preparation of
cost-sheet is one of the most important and primary function of cost accounting. The statement discloses
the following:
1. Prime cost
2. Work cost

20
 3. Cost of production
4. Total cost

When the total cost is divided by the number of units produced, quotient is the average cost
per unit of the work performed. Separate columns could be provided for the total and unit cost of
each element of cost. Columns could also be drawn for the current and the past periods.
Cost sheet is prepared at weekly, monthly or other intervals.
ABC Ltd.
COST SHEET FOR THE PERIOD.
Production-Units
Total cost (Rs.) Cost per unit(Rs.)
Direct Materials:
Opening stock
Purchases
Carriage inwards
Less: Closing stock
Direct materials consumed
Direct wages
Direct expenses
Prime Cost:
Add: Works or Factory Overheads:
Indirect materials
Indirect wages
Rent and rates (factory)
Lighting and heating
Power and Fuel
Repairs and maintenance
Cleaning
Drawing office expenses
Cost of research & experiments
Depreciation of factory plant
Works stationery
State insurance
Welfare service expenses Insurance-Fixed assets etc.
-Stock and finished goods
Loose tools-Very small
Works manager's salaries etc.

Works or Factory Cost:

Add: Office and Administrative Overheads:
Rent and rates
Salaries
Lighting and heating
Insurance Cleaning
Telephone and postage

21
 Printing and stationery
Depreciation of furniture and office Equipments and buildings
Legal expenses
Audit fees
Bank charges
Cost of Production:
Add: Selling and Distribution Overheads:
Showroom rent and rates
Lighting and heating
Salemens salaries
Commission
Travelling expenses
Sales printing and stationery
Advertising
Bad debts
Postage
Depreciation and expenses of delivery vans
Debt collection expenses
Carriage freight outwards
Samples and other free gifts

Cost of Sales:
Add: Profit
Sales
While preparing cost sheet, special attention must be paid to the stock. Stocks may be of
raw materials, work-in-progress, and finished goods.
Stock of raw materials. In a manufacturing enterprise, besides normal purchases, there is
always a certain- amount of opening and closing stock of raw materials. For the purpose
of cost sheet, the value of raw materials used can be ascertained with the help of the
following formula :

Value of materials consumed = Opening stock of raw materials + Net purchases +

Expenses on Purchase -Closing stock of raw materials
Stock of work-in-progres: It rarely happens that every unit initiated during a period
is finished in that very period. These incomplete units are called 'work-in-progress'. It may be
valued either on the basis of prime cost or works cost. However, its valuation on works cost
basis i.e. prime cost plus proportionate factory overheads, is more scientific. Treatment of
work-in-progress in the cost sheet or production account is made as follows:
Prime cost + Factory overheads + Opening balance (stock) of work-in-Progress -
Closing balance (stock) of work-in-progress
Stock of finished goods: If the opening and closing stocks of finished goods are also
given, these must be adjusted before calculating cost of goods sold as follows:
Cost of production + Opening stock of finished goods - closing stock of finished
goods = Cost of goods sold

22
 Treatment of scrap: Scrap is the incidental residue from certain types of
manufacture. It is generally, of small amount and low value, recoverable without further
processing. Such realizable value of scrap is deducted from the factory overheads or the
factory cost.

QUESTIONS
Q1. Prepare a cost sheet for the period ended 31 March 2007
Cost of raw material Rs. 200000
Productive wages Rs. 150000
Indirect labour Rs.10000
Carriage inwards Rs.20000
Other factory expenses Rs.25000
Office expenses Rs.40000
Legal expenses Rs.10000
Expenses for testing the quality of goods Rs.5000
General managers salary Rs.30000
Selling expenses Rs.20000
Profit 20% on total cost
Answer : Rs
Direct Material: Cost of raw material 200000
Direct Wages: Productive wages 150000
Direct expenses: Carriage inwards 20000
PRIME COST 370000
Add Factory Overheads
Indirect labour 10000
Other factory expenses 25000
FACTORY COST 405000
Add Office Overheads
Office expenses 40000
Legal expenses 10000
General managers salary 30000
COST OF PRODUCTION 485000
Add Selling & Distribution Overheads
Expenses for testing the quality of goods 5000
Selling expenses 20000
COST OF SALES/ TOTAL COST 510000
PROFIT 20% on cost 102000
SALES 612000

23
Q2. Find cost of sales and profit.
Opening Stock Closing Stock
Raw material 25000 26000
Finished goods 17000 16000
Work in progress 8000 9000

Purchases of raw material 30000

Direct wages 17000
Work expenses 8800
Office expenses 3000
Selling expenses 4000
Sale of finished goods 77000
Depreciation of plant and machinery 8000
Sale of scrap 3000

Answer:
Direct Material: Opening Stock Raw material 25000
Add Purchases of raw material 30000
Less Closing Stock of raw material 26000
Direct wages 17000
PRIME COST 46000

Add Factory Overheads

Work expenses 8800
Depreciation of plant and machinery 8000
62800
Less Sale of scrap 3000
GROSS FACTORY COST 59800
Add Opening Stock WIP 8000
Less Closing stock WIP 9000
NET FACTORY COST 58800
Add Office Overheads
Office expenses 3000
COST OF PRODUCTION 61800

24
Add Opening Stock of finished goods 17000
Less Closing stock of finished goods 16000
COST OF GOODS SOLD 62800
Add Selling & Distribution Overheads
Selling expenses 4000
COST OF SALES 66800
Profit 10200
SALES 77000

25
 UNIT 2

LESSON 3
ACCOUNTING FOR MATERIAL COST
Manisha Verma
Hans Raj College
University of Delhi

LEARNING OBJECTIVES

After studying this chapter, you should be able to understand

3.1 Meaning of Materials
3.2 Material Control
3.3 Inventory Control
3.4 Techniques of Inventory Control
1. ABC Analysis
2. Economic Order Quantity (EOQ)
3. Stock Levels, Minimum Level, Maximum Level, Recorder Level, Reorder Quantity.
4. Inventory Turnover Ratio and review of Slow and Non-moving items.
5. Proper Purchase Procedure
6. Proper Storage Procedure
7. Proper Issue Procedure
8. Two Bin system
9. Use of Perpetual Inventory Records and Continous Stock Verification.

A very important component of total cost of production which may be as high as 40% to
60% is the material cost element. Materials are commodities that are used up while rendering a
service or if it is a manufacturing organization then materials gets converted into finished
product. Whatever is the case materials are purchased, stored and issued according to the
requirements of a company. Inorder to prevent the chances of theft, deterioration ,wastage
,shrinkage, spoilage of materials, physical controls will have to be excerised at each stage right
from purchase till the final consumption.
3.1 Meaning of Materials
The term `materials' refer to all commodities supplied to an undertaking. Materials may be
direct or indirect.
Direct materials are those materials which can be conveniently identified with and can be
directly allocated to a particular product, job or process. Examples : timber in furniture, cloth in
garments, milk & cream in ice cream, paper in books, gold/silver in jewellery, bricks & cement in building
construction, steel in machines, leather in shoes.
Indirect materials are those materials which cannot be conveniently identified with and cannot
directly allocated to a particular product, job or process. Examples :
1. Stores used for maintaining machines such as lubricant oil & grease, cotton waste,
consumable stores etc.
2. Stores used by service departments (like power house, boiler house).

26
 3. Materials of small value which can not be conveniently identified with a particular
product, job or process. For example, nails used in furniture, thread used in stitching
garments.
3.2 Material Control
Material Control involves the planning, organising and controlling the procurement, storage
and usage of materials so to as achieve the objectives of efficiency and economy.
Objectives of Material Control
The main objectives of material control are as follows:
1. To avoid the situation of under stocking i.e. to provide continous supply of required materials
so that the activities of production and service departments may not be held up.
2. To avoid the situation of over-stocking i.e. to maintain optimum investment in inventory
considering the operating requirements and financial resources ,so as , to reduce carrying
costs.
3. To ensure the procurement of materials and stores of the required quality at minimum cost
from a reliable source.
4. To minimise the total cost (i.e. ordering costs & carrying costs)
5. To avoid wastages and losses during storage and usage.
6. To maintain proper and upto date records of inventory
7. To provide the required information to the management so as to help the management in
taking inventory decisions.
Essential Requirements of Material Control
The essential requirements of material control are as follows:
1. Proper Co-ordination - There should be proper co-ordination of all departments involved viz.
Purchasing, Receiving, Inspection, Storage, Production, Cost and Finance.
2. Proper Purchase System - There should be proper purchase system to ensure the procurement of
materials and stores of the required quality at minimum cost from a reliable source.
3. Proper Storage System - There should be proper storage system to ensure a place for
everything and everything in its place and avoidance of losses during storage and minimum
storage cost.
4. Proper Issue System - There should be proper system for the issue of materials to ensure that
delivery of materials of the required quality in the required quantity at the required time
upon requisition to the department making requisition.
5. Perpetual Inventory System - There should be perpetual inventory system so as to determine
the quantity and value of each item of materials in stock at any point of time.
6. Continuous Stock Taking System - There should be continuous stock taking system so as to
ensure accuracy of perpetual inventory records.
7. Internal Check System - These should be internal check system so that all transactions
concerning materials are automatically checked.
8. Proper Budgetary Control System - There should be proper budgetary control system to
ensure economy in purchasing and usage of materials and stores.

27
9. Proper Forms - There should be use of proper forms with regard to Purchase Requisition,
Purchase Order, Material Received Note, Material Requisition, Bill of Materials, Material
Returned Note, Material Transfer Note, Bin Card, Stores Card etc.
10. Proper Accounting System - There should be proper accounting system so as to determine the
cost of materials at time of receipt and consumption.
11. Proper Reporting System - These should be proper reporting system to ensure regular
reporting to the management regarding :
(a) Materials purchased (b) Materials issued (c) Materials in hand (d) Slow-moving and
obsolete stock etc.
3.3 Inventory Control
Inventory comprises -
(a) Stock of Raw-materials; (b) Stock of Work-in-progress;
(c) Stock of Finished Goods; and (d) Stock of Stores and Spares
Inventory control involves the planning, organising and controlling the purchase and
storage of inventory so as to ensure the availability of inventory (a) of the required
quality(b) in the required quantity(c) at the required time(d) at the minimum cost.
3.4 Techniques of Inventory Control
The various techniques of inventory control are as follows:
1. ABC Analysis
2. Economic Order Quantity (EOQ)
3. Stock Levels, Minimum Level, Maximum Level, Recorder Level, Re -order
Quantity.
4. Inventory Turnover Ratio and review of Slow and Non-moving items.
5. Proper Purchase Procedure
6. Proper Storage Procedure
7. Proper Issue Procedure
8. Two Bin system
9. Use of Perpetual Inventory Records and Continous Stock Verification.
ABC analysis
ABC analysis is a system of inventory control. It exercises discriminating control
over different items of stores classified on the basis of the investment involved. It is based
on the principle of management by exception i.e. concentrate more on critical areas than
others.
Usually all items of stores are classified into 3 categories according to their
importance (i.e. their value and frequency of replenishment during a period) as follows:

28
 Category Composition Control
A It consist of those items which High degree of control is
require large investments(say excerised by use of various
about 70%of total value of stores) techniques such as fixing stock
but consistute a small levels like max level, min level,
percentage(say about 10%) of total reoder level, determining EOQ.
items of stores.
B It consist of those items which Moderate degree of control is
require relatively moderate excerised. Orders are placed on
investments(say about 20%of total periodic review basis.
value of stores) but consistute
relativelymoderate percentage(say
about 20%) of total items of stores.
C It consist of those items which Lower degree of control is
require small investments(say excerised. Orders of large size are
about 10%of total value of stores) placed either after 6 months or
but consistute a large once in a year to minimize
percentage(say about 70%) of total ordering cost and to take
items of stores. advantage of bulk purchase.

Advantages of ABC Analysis

The advantages of ABC analysis are the following:
(i) It ensures effective control on costly items (i.e. A category items) which require large
investment.
(ii) It saves time and cost by exercising economic systems of control over low value items (i.e. C
category items).
(iii) It ensures optimum investment in inventory considering the operational requirements and
financial resources with the use of economic order quantities.
(iv) It ensures minimum total cost (i.e. ordering costs and carrying costs) of inventory.
(v) It helps in the maintenance of high inventory turnover rate.
Re-Order Quantity or Economic Order Quantity (E0Q)
Re-order quantity is the quantity for which order is placed when the stock reaches reorder
level. It is known as economic order quantity when it is the quantity which is most economical to
order. The EOQ refers to the quantity of inventory, at which total of ordering costs and the
carrying costs is minimum. At EOQ the ordering costs are equal to carrying costs.EOQ is
determined after considering the following factors:
(a) Ordering Costs- The term `Ordering Costs' refer to the costs incurred for acquiring inputs.
These costs include -
(i) Cost of placing an order,
(ii) Cost of transportation,
(iii) Cost of receiving goods,
(iv) Cost of inspecting goods.

29
There is an inverse relationship between order size and ordering cost.
Larger the order size, Lower the ordering costs because of fewer orders
Smaller the order size , Higher the ordering costs because of more orders
(b) Carrying Costs- The term 'Carrying Costs' refer to the costs incurred in maintaining a given
level of inventory. These costs include
(i) cost of storage space,
(ii) cost of handling materials,
(iii) cost of insurance,
(iv) cost of deterioration or obsolescence,
(v) cost of store staff
There is positive relationship between order size and carrying cost.
Larger the order size, higher the carrying costs because of high average inventory.
Smaller the order size, lower the carrying costs because of low average inventory.
(c) Annual consumption (usage) of inventory: Importance of EOQ
The EOQ technique solves one of the major problems of the inventory management
i.e. the order quantity problem by answering to the question: How much inventory should
be ordered at a particular point of time?
Following are the assumptions of EOQ:
1. Prior knowledge of Annual Usage (consumption) of inventory
2. Constant rate of usage
3. Constant ordering costs
4. Constant carrying costs, and
5. Zero lead-time/delivery period
EOQ may be determined by any of the following three methods:
(a) Graphical Method
(b) Tabular Method
(c) Formula Method
(a) Graphical Method: The optimum quantity of inventory which should be ordered at a
point of time is determined after achieving a trade off between ordering cost and carrying
cost.

30
 Y

Total Cost

Cost (Rs)
Minimum Total Cost

Carrying Cost

Ordering Cost

O
EOQ Order Size Q X

(b) Tabular or Trial and Error Method: The ordering and carrying costs for different order
sizes are computed and the order size with lowest total cost (ordering and carrying) of inventory
is the EOQ as follows:
Particulars Order size 1 Order size 2 Order size 3
A.Annual consumption
(units)
B. Order size (units)
C.No.of orders(A/B)
D.Cost per order(Rs)
E. Total Ordering Cost(CXD)
F. Average
Inventory(Units)(Ordersize/2)
G. Carrying cost per unit
H. Total carrying cost(FXG)
I. Total cost(E+H)

Alternatively, total ordering and carrying cost at different order sizes may be computed
as follows:
Total annual ordering and carrying cost at any order size
= (no.of orders x ordering cost per order)+(Average inventory x carrying
cost per unit p.a.)

(c) Formula Method: EOQ may be calculated with the help of following formula:
EOQ = 2AO
C

where , A = Annual consumption of material in units

31
 O = ordering cost per order
C = carrying cost per unit pa.
No.of orders per year = total annual consumption in units / EOQ

Economic order frequency= 365 Days /no.of orders per year

Total annual ordering and carrying cost at EOQ= 2AOC

Limitations of EOQ Technique

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

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

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

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

Stock Levels
Setting of various stock levels is one of the techniques of inventory control. The main
purpose of setting various stock levels is to avoid the situation of under stocking and over
stocking. These levels are not permanent but need revision according to the changes in
the factors which determine these levels.
Maximum Stock Level: Maximum Stock Level is that level of stock above which the stock
in hand should not normally be allowed to exceed. It is the largest quantity of a particular material which
may be held in the store at any time. The objective of fixing the maximum stock level is to avoid the costs
of overstocking such as Cost of storage, cost of investment in stock Cost of insurance, risk of
obsolescence etc.

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

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

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

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

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

32
 Re-order level is that level of stock at which fresh order should be placed for
replenishment of stock. It is fixed somewhere between maximum and minimum levels in such a
way that fresh supplies are received in such a way that fresh supplies are received just before the
minimum level is reached. It is the level at which purchase requisition should be made out for fresh
supplies.

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

Reorder Level is computed with the help of following formula:

Reorder Level= Maximum Consumption x Maximum Reorder Period

Or
= Minimum Level + ( Normal Consumption x Normal Reorder Period )

Average Stock Level: Average Stock Level indicates the average stock held by the
organisation.

This level of stock may be computed by using an y one of the following formula:
Average Stock Level = Minimum Level + Reorder Quantity
Or
Maximum Level + Minimum Level
2
Danger level: Danger level is the level at which normal issues of the raw material
inventory are stopped and emergency issues are only made on special requisition approved by the
competent authority .When stock reaches this level an urgent action is required for the fresh supplies of
materials. It is generally below the minimum level. However some enterprises treat minimum
level as danger level whereas some others fix the danger level above the minimum level but below
the reorder level .Fixing danger level below the minimum level is meant for taking urgent
corrective action whereas fixing it above the minimum level is for preventive action. The object of
fixing danger level (below minimum level) is to determine when an urgent action is required
for fresh supplies of materials.
Danger Level = Average Consumption x Maximum Reorder Period For Emergency
Purchases.
Inventory Turnover Ratio
Inventory Turnover Ratio is one of the techniques of inventory control. It expresses the
relationship between the cost of material consumed and the average stock held. The objective of
computing the Inventory Turnover Ratio is to determine the efficiency with which inventories are
maintained. In other words, the objective is to find out

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

(b) Slow Moving Stock i.e. stock in low demand
(c) Dormant Stock i.e. stock having no demand at present
(d) Obsolete Stock i.e. stock no longer in demand

33
Inventory Turnover Ratio is computed with the help of following formula:

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

Cost of average stock held during the period

where, Cost of Materials Consumed= Opening Stock +Purchases-Closing Stock

Average stock= (opening stock + closing stock)
Average no of days for which an average inventory is held = 365 days
Inventory Turnover
It indicates the speed with which the inventory is consumed. In general, a high ratio
indicates fast moving stock and a low ratio indicates slow moving stock. However, too high ratio
and too low ratio call for further investigation. A too high ratio may be the result of a very low
inventory levels which may result in frequent stock-outs and thus the firm may incur high stock-
outs. On the other hand, a too low ratio may be the result of excessive inventory levels, slow-
moving or dormant or obsolete inventory and thus, the firm may incur high carrying costs. Thus, a
firm should have neither a very high nor a very low stock turnover ratio, it should have a
satisfactory level. To judge whether the ratio is satisfactory or not, it should be compared with
its own past ratios or with the ratio of similar firms in the same industry or with industry average.
On the basis of Inventory Turnover Ratio, the management may take the necessary
corrective action such as -(a) Decision as to how to prevent the under-stocking of fast
moving stock items. (b) Decision as to how to prevent the over-stocking of slow moving
stock items. (c) Decision as to whether to retain or scrap the dormant stock items. (d)
Decision as to scrapping or discard of obsolete stock items.

Purchase of Materials
Purchasing means the procurement of materials, components, supplies etc. required for
use in production and other departments of an enterprise. Objective of purchasing is to procure
the materials -(a) of the right quality, (b) in the right quantity, (c) at the right time, (d) at the right
price,(e) from the right source
Purchase Department works under the supervision and control of Purchase manger. The
main functions of Purchase Department are as follows:
1. To receive the purchase requisition from the department which needs the material.
2. To select the supplier from whom materials are to be purchased.
3. To place the purchase order with the selected supplier.
4. To follow-up the purchase order.

Just in Time (JIT) Purchasing

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

34
Purchase Procedure
Depending upon the size and nature of the operations the purchase procedure may differ
from organization to organization. However, the main steps involved in purchasing procedure
are as follows:

Receipt of Purchase requisition

Purchase requisition is a form used to make a formal request to the purchase department to
purchase the materials specified therein. Purchase Requisition is received from:
(i) The storekeeper for all items in regular use.
(ii) The production department for specific items, not regularly used and stored.
(iii) The production planning department for new production development.

A purchase requisition serves the following purposes:

1. It authorizes the purchasing department to purchase the materials specified therein
2. It provides written record of details of materials required.

Generally three copies of purchase requisition are prepared which are used asunder:
The original and duplicate are sent to the purchase department where one copy is
retained and the other copy is sent back to the indenting department after noting as office
record. The third copy is retained as permanent office record in the department which initiates the
purchase requisition.
A general format of purchase requisition is given below:

PQR LTD.
Purchase Requisition

P.R.No.. Date ..
Department. Date by which materials are required.
Place where materials are required..

Serial no. Description Code no. Quantity Remarks

Requested by Checked by. Approved by .

35
Selection of Supplier
After receiving the purchase requisition, the next step is to select the supplier from whom
purchases are to be made. Tenders are the offers from prospective suppliers to supply the required
material. After the sealed tenders are received, they are opened on a specified date and time. The
details given in tenders received are summarized and tabulated in a alive statement. After the
comparative statement containing the details of tenders is received, it is scrutinized for the
important details such as quantity offered , quality offered, price quoted, term of delivery, term of
payment, past performance, reputation of the supplier in the Market. Finally, the purchase
department selects a supplier or suppliers from whom purchases are to he made.
Preparation, Placement and Follow up of Purchase Order
After selecting the supplier, the next step is to prepare the purchase order and place it with
the selected supplier. Purchase Order is a written document prepared by the purchase department
which authorizes the supplier to supply the specified quantity of materials of specified quality at
specified price on terms specified therein. A large sized enterprise usually prepares five copies, the
original being sent to the supplier, one copy sent to receiving department, accounts department,
department initiating the purchase requisition, and one copy is retained for office records by the
purchase department.
A general format of purchase order is given below:

PQR LTD.
Purchase Order
To, Date..
.. Requisition no..
.. Purchase order no
(Name & address of supplier)
Please supply the following items in accordance with the terms and conditions mentioned
therein.

Serial No. Description Code No. Quantity Price Total Remarks

Packing and dispatching instructions..

Discount
Terms of payment
Excise duty and VAT tax.
For PQR LTD.
(Signature)
Chief Purchasing Officer
Place of Delivery
Date of Delivery.

36
Receipt of Materials
All incoming materials are received by the Receiving Department.

Functions of Receiving Department

1. It takes the delivery of packages sent by supplier along with advice of dispatch.
2. It gets the packages opened.
3. It checks the quantity received with quantity dispatched as per supplier's advice.
4. It checks the quantity received with quantity ordered as per purchase order.
5. It brings the discrepancy (if any) to the notice of supplier,
6. It prepares four copies of Goods Received Note and sends one copy to the purchase
department, second to the stores department and third to accounts department and
retains the last copy for office records.

A general format of Goods Received Note is given below:

PQR LTD.
Goods Received Note

To, G.R.N No...

Suppliers Date..
Purchase order no.

Item no. Description Code No. Quantity Price Total Remarks

Received by..
Storekeeper Inspected by
Store ledger posted by

Inspection of Materials
After physical verification by the Goods Received department, the materials are sent to the
inspection department to the check the quality of materials received. The Inspection Department
checks the quality of material received to ensure that the quality of raw materials is as per
specifications stated in the purchase order. After checking the quality, it prepares the
Inspection Report to show its results of the inspection. If the goods are rejected, reasons for
rejection are specified in this report. The report is either prepared separately or incorporated
in the Goods Received Note. In either case, the report is forwarded to the Purchasing
Department.

37
Storage of Materials
Storage refers to the act of storing materials for their safe custody till these are issued to the
production and other departments. It is a service function and involves receiving, storing and issuing
of materials. The place where materials are kept is known as store. The person who is incharge
of store department is known as stores keeper. He is responsible for the receipt, storage and issue
of materials. The Stores Department works under the supervision and control of stores-
manager The main functions of stores department are as follows:
1. To issue purchase requisition to the purchase department when the stock of materials reaches
the Re-order Level (i.e. the level at which the next order should placed immediately).
2. To receive the materials from the Goods Receiving Department or Inspection Department and
ensure that materials received are as per Goods Received Note/Goods Inspection Report.
3. To maintain proper records of receipt, issue, and balance of all items of materials.
4. To provide adequate and proper storage for every item.
5. To place and arrange materials received at proper place so that everything is in its place.
6. To keep the materials in good condition to avoid pilferage, wastage and deterioration.
7. To issue materials against proper stores requisitions.
8. To ensure that the stocks neither exceed the maximum level nor go below the minimum level
at any time.
9. To carry out periodic physical stock taking and compare the physical balances with the
balances as per records and find out the discrepancies, if any and take the appropriate action
in this behalf.
10. To locate the slow-moving and obsolete items and inform the management about them.
11. To check from time to time measuring equipment like balances, scales etc. for their
accuracy.
12. To minimize the storage handling and maintenance cost.
Material issue procedure
The following two documents are used for issue of materials to production department:
(a) material requisition (or stores requisition) (b) bill of materials
Material requisition: Material requisition is a document which is used to authorize and record
the issue of materials from the store. It is usually prepared by a foreman but in case of costly
materials or large quantity of materials, an approval by some higher authority may be
required. Usually three copies of material requisition are prepared. One copy for the
storekeeper, one copy for the cost accounting department and one copy for the department
initiating it.
Bill of Materials: Bill of Materials is a list of standard quantities of all materials required for a
particular job or work order or a process. Bill of Materials is prepared by engineering or
planning department in a standard form on receipt of an order. Usually four copies of the Bill
of Materials are prepared-one copy for Production Department, one copy for Stores

38
 Department, one copy for Cost Accounting Department and one copy is retained by
engineering or planning department.
Two Bin System or Double Bin System
Under Two Bin System each bin is divided into two parts-one smaller part , to store the
quantity equal to the minimum stock or even the re-ordering level and the other to store the
remaining quantity.
Issues are made out of the larger part; but as soon as it becomes necessary to use quantity
out of the smaller part of the bin, fresh order is placed. On receipt of supply of fresh order,
quantity already issued out of smaller part of the bin is replaced out of fresh supply.
Inventory Systems
There are two inventory systems, viz. Periodic Inventory System and Perpetual Inventory system
Periodic Inventory System is a system of ascertaining the quantity and value of inventory
on the basis of an actual physical count or measure or weight of all the inventory items on hand at
the end of accounting period. It usually requires closing down of normal functioning for
stock-taking. The cost of materials issued is calculated as a residual figure (which may include
cost of materials lost also) as under:

Cost of materials issued = opening inventory + purchases closing inventory

Perpetual Inventory System is a system of recording stores balances after every receipt and
issues to facilitate regular checking and to obviate closing down for stock-taking. It requires
(a) Use of Perpetual Inventory Records - Bin Card and Stores Ledger
(i) Bin Card provides a continous quantitative record of receipts, issues and balances of each item
of stores. Separate bin cards are maintained each item. It is filled up with the physical
movement of goods .
(ii) Stores Ledger provides a continous quantitative-cum value record of receipts, issues and
balances of each item of stores. It is filled up with the physical movement of goods (i.e. on its
receipt and issue) with the help of Goods Received Note, Material Issue Requisitions, Material
return note.

(b) Continuous Stock taking involves selecting and counting a number of items daily or at
frequent intervals in such a way that each item of stores gets checked up at least a certain number of
times in a year by rotation by an independent staff, and comparing the actual physical balance with
the quantity balance shown by the bin card and store ledger.

The basic objective of Perpetual Inventory System is to provide a continuous quantitative

cum value record of receipts, issues and balances of each item of stores followed by continous
stock taking.

39
 QUESTIONS
1. The annual demand for a product is 6,400 units. Inventory carrying cost is Rs. 1.50 per unit per
annum. If the cost of one procurement is Rs. 75, determine:
(a) Economic order quantity;
(b) No. of orders per year;
(c) Time between two consecutive orders.
2. The purchase department of your organisation has received an offer of quantity discounts on
its orders of materials as under :

Price per tonne Tonnes Rs.

1,400 Less than 500
1,380 500 and less than 1,000
1,360 1,000 and less than 2,000
1,340 2,000 and less than 3,000
1,320 3,000 and above.

The annual requirement of the material is 5,000 tonnes. The delivery cost per order is Rs.
1,200 and the annual stock holding cost is estimated at 20 per cent of the average
inventory.
The Purchase Department wants you to consider the following purchase options and
advise which among them will be the most economical ordering quantity, presenting the
relevant information in a tabular form.
The purchase quantity options to be considered are 400 tonnes, 500 tonnes, 1,000 tonnes,
2,000 tonnes and 3,000 tonnes.

3. Two components, A and B are used as follows:

Usage : Maximum. 75 per week each, Minimum 25 per week each, Normal. 50 per week
each Re-order quantity: A: 300; B : 500 Re-order period: A: 4 to 6 weeks, B: 2 to 4 weeks
Required: Calculate for each component
(a) Re-ordering level,
(b) Minimum level
(c) Maximum level;
(d) Average Stock level.

40
 LESSON 4

PRICING OF MATERIALS
Manisha Verma
Hans Raj College
University of Delhi

LEARNING OBJECTIVES

After studying this chapter, you should be able to understand

4.1 Methods of Pricing Material Issues
1. Actual Cost Method
2. First in First out Method (FIFO)
3. Last In First out Method (LIFO)
4. Simple Average Cost Method
5. Weighted Average Cost Method
6. Periodic Simple Average Price Method
7. Periodic Weighted Average Price Method
8. Moving Simple Average Price Method
9. Moving Weighted Average Price Method
10. Standard Cost Method
11. Base Stock M ethod
12. Replacement Cost Method (Market Price Method)
4.2 Discrepancies in Stock Items
4.3 Considerations in Selection of Material Pricing Method
4.4 Material Losses

4.1 Methods of Pricing Material Issues

In charging out material issued from stores, the key question to be answered is that
of material pricing. In principle, the pricing of issue should be at cost. However, while
the materials are purchased at varying prices, difficulty arises in deciding the price to be
charged to any particular issue. If the material is purchased for a specific job, pricing of
such issue does not pose any problem. The price paid for the procurement of such material
will be charged to that job. Frequent changes in the material prices, inflationary trends,
nature of material and its storage and the frequency with which materials are issued to
production departments are some of the matters which further complicate the decision. The
pricing of material issues is intended to meet the two objectives of (a) allocating material
costs to various jobs; and (b) Determining relevant cost of material for decision-making and
product costing. Different methods of pricing material issues can be summarised as follows:

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

41
 First in First out Method (FIFO) - Under this method materials are issued out of stock in
the order in which they were first received into stock. It is assumed that the first material to come
into stores will be the first material to be used. CIMA defines FIFO as "a method of pricing the
issue of material using, the purchase price of the oldest unit in the stock.

Advantages
(i) It is easy to understand and simple to price the issues.
(ii) It is a good store keeping practice which ensures that raw material leave the stores in a
chronological order based on their age.
(iii) It is a straight forward method which involves less clerical cost than other methods of
pricing.
(iv) This method of inventory valuation is acceptable under standard accounting practice.
(v) It is a consistent and realistic practice in valuation of inventory and finished stock.
(vi) The inventory is valued at the most recent market prices and it is near to the valuation
based on replacement cost.

Disadvantages
(i) There is no certainty that materials which have been in stock longest will be used, if
they are mixed up with other materials purchased at a later date at different prices.
(ii) If the price of the materials purchased fluctuates considerably it involves more clerical
work and there is possibility of errors.
(iii) In a situation of rising prices, production cost is understated.
(iv) In the inflationary market there is a tendency to under pricing of material issues and in
deflationary market there is a tendency to overprice such issues.
(v) Usually more than one price has to be adopted for a single issue of materials.
(vi) It makes cost comparison difficult of different jobs when they are charged with
varying prices for the same materials.
This method is more suitable where the size of the raw materials is large and bulky and its price
is high and can be easily identified in the stores separately. This method is useful when the
frequency of material receipts is less and the market price of the material are stable and steady.

Illustration 1: At the beginning of August 2004 Brush Company had in stock 10,000
brushes valued at Rs.10 each. Further purchases were made during the month as follows :
7 August 4000 Brushes @Rs. 12.50
14 August 6000 Brushes@ Rs.15.00
24 August 8000 Brushes@ Rs.16.50
Issues to shop floor were as follows:
16 august 16000 Brushes
28 August 10000 Brushes
You are required to prepare a Stores Ledger Card for the month of august on the assumption
that materials were Issued on the First-in-First-out Principle.

42
 Stores Ledger Account (FIFO method)
Date Receipts Issues Balance
Qty. Rate Value Qty. Rate Value Qty. Rate Value
Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.

Aug 8 - - - - - - 10,000 10.00 1,00,000

7 4,000 12.50 50,000 - - - 10,000 10.00 1,00,000
4,000 12.50 50,000
14 6,000 15.00 90,000 - - - 10,000 10.00 1,00,000
4,000 12.50 50,000
6,000 15.00 90,000
16 - - - 10,000 10.00 1,00,000 4,000 15.00 60,000
4,000 12.50 50,000
2,000 15.00 30,000
24 8,000 16.50 1,32,000 - - - 4,000 15.00 60,0001
8,000 16.50 1,32,0 00
28 - - - 4,000 15.00 60,000 2,000 16.50 33,000
6,000 16.50 99,000
31 - - - - - - 2,000 16.50 33,000

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

Advantages
(i) Stocks issued at more recent price represent the current market value based on the
replacement cost
(ii) It is simple to understand easy to apply.
(iii)Product cost will tend to be more realistic since material cost is charged at more recent
price.
(iv) In times of rising prices, the pricing of issues will beat a more recent current market price.
(v) It minimies unrealized inventory gains and tends to show the conservative profit
figure by valuation of inventory at value before price rise and provides a hedge against
inflation.
Disadvantages
(i) Valuation of inventory is not acceptable in preparation of financial accounts.
(ii) It is an assumption of a cost flow pattern and is not intended to represent the true physical
flow of materials from the stores.
(iii)More than one rates may have to be adopted for an issue.
(iv) It renders cost comparison between jobs difficult.
(v) It involves more clerical work and some times valuation may go wrong.
(vi)In times of inflation, valuation of inventory under this method will not represent the
current market prices.

43
Illustration 2: Show the Stores Ledger entries as they would appear when using the LIFO Method, of
pricing issues, in connection with the following transactions

April Units Value (Rs.)

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 -

Stores Ledger (LIFO Method)

Date Receipts Issues Balance
Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
units Rs. Rs. units Rs. Rs. units Rs. Rs.
Apr. l - - - - - - 300 2.00 600
2 200 2.20 440 - - - 300 2.00 600
200 2.20 440
4 - - - 150 2.20 330 300 2.00 600
50 2.20 110
6 200 2.30 460 - - - 300 2.00 600
50 2.20 110
200 2.30 460
11 - - - 150 2.30 345 300 2.00 600
50 2.20 110
50 2.30 115
50 2.30 115
19 - - - 50 2.20 110 200 2.00 400
100 2.00 200
22 200 2.40 480 - - - 200 2.00 400
200 2.40 480
27 - - - 200 2.40 150 2.00 300
50 2.00 480]
100

Simple Average Cost Method -Under this method all the materials received are merged
into exist existing stock of materials,their identity being lost. The simple average price is
calculated without any regard to the quantities involved. The simple average cost is arrived at
by adding the different prices paid during the period for the batches purchased by dividing the
number of batches. For example, three batches of materials received at Rs. 10, Rs. 12 and Rs. 14
per unit respectively. The simple average price is calculated as follows:
= Rs.10 + Rs.12 + Rs.14
3
= Rs.36 = Rs.12 per unit
3

44
 This method is not popular because it takes into consideration the prices of different
batches but not the quantities purchased in different batches. This method is used when prices
do not fluctuate very much and the stock values are small in value.

Weighted Average Cost Method - It is a perpetual weighted average system where the
issue price is recalculated every time after each receipt taking into consideration both the total
quantities and total cost while calculating weighted average price. For example, three batches of
material received in quantities of 1,000 units @ Rs. 15, 1,300 units @ Rs. 16 and 800 units @
Rs. 14.
The weighted average price is calculated as follows :

= (1000 X 15) + (1300 X 16 ) + (800 x 14)

1000 + 1300 + 800

= 15000 + 20800 + 11200

3100
= Rs. 15.16 per unit
This method tends to smooth out the fluctuations in price and reduces the number of calculations
to be made, as each issue is charged at the same price until a fresh batch of material is received.
This method is easier as compared to FIFO and LIFO, as there is no necessity to identify each batch
separately. But this method increases the clerical work in calculation of new average price every
time a new batch is received. The issue price calculated rarely represents the actual purchase
price.

Illustration 3 : The following particulars have been extracted in respect of a material. Prepare the
Stores Ledger account showing the receipts and issues, pricing the materials issued on the basis of (a)
simple average (b) weighted average.

Year 2001 Quantity(kg) Rate per kg.(Rs.)

Jan 2 Received 2000 10
6 Received 300 12
9 Issued 1200 -
10 Received 200 14
11 Issued 1000 -
22 Received 300 11
31 Issued 200 -

45
 Stores Ledger (Simple Average)
Receipts Issues Balance
Date P.R. Qnty. Rate Amount M.R. Qnty Rate. Amount Qnty. Rate Amount
No. Kgs Rs. Rs. No. Kgs Rs. Rs. Kgs Rs. Rs.
2001
Jan. 2 - 2,000 10 20,000 - - - - 2,000 10 20,000
6 - 300 12 3,600 - - - - 2,300 - 23,600
9 - - - - - 1,200 11 13,200 1,100 - 10,400
10 - 200 14 2,800 - - - - 1,300 - 13,200
11 - - - - - 1,000 12 12,000 300 - 1,200
22 - 300 11 3,300 - - - - 600 - 4,500
31 - - - - - 200 1233 2,466 400 - 2,037

Closing Stock (Simple average) = 400 Units Rs. 2037

Note: Issue price on 9th Jan = 10 + 12 = Rs. 11

2
Issue price on 11th Jan = 10 + 12+ 4 = Rs. 12
3

Issue price on 31st Jan = 12 + 14+ 11 = Rs. 12.33

3

Receipts Issues Balance

Date P.R. Qnty. Rate Amount M. R. Qnty. Rate. Amount Qnty. Rat e Amount
No. Kgs Rs. Rs. No. Kgs Rs Rs. Kgs Rs. Rs.
2001
Jan. 2 - 2,000 10 20,000 - - - - 2,000 10 20,000
6 - 300 12 3,600 - - - - 2,300 - 23,600
9 - - - - - 1,200 10.26 12,312 1,100 - 11,288
10 - 200 14 2,800 - - - - 1,300 - 14,088
11 - - - - - 1,000 10.84 10,840 300 - 3,248
22 - 300 11 3,300 - - - - 600 - 6,548
31 - - - - - 200 10.91 2,182 400 - 4,366

Closing Stock (Weighted average) = 400 Units Rs. 4366

Note: Issue price on 9th Jan. = 23600 = Rs. 10.26

2300

Issue price on 11th Jan. = 14088 = Rs. 10.84

1300

Issue price on 31st Jan. = 6548 = Rs. 10.91

600

46
Periodic Simple Average Price Method

This method is similar to Simple Average Price Method except that the, average price is
calculated periodically (say weekly or monthly and not at the time of each issue of materials).In
other words, the price paid during the period for different lots of material purchased are added up
and the total is divided by the number of purchases made during the period. The rate so computed is
then used to price all the issues made during the period, and also for valuing the closing
inventory of the period.

Advantages
(i) It is simple to operate, as it avoids calculation of issue price after every receipt.
(ii) It 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
(i) It cannot be applied in job industry where each individual job order is to be priced at each
stage of its completion.
(ii) It is unscientific because it ignores the quantities purchased at different prices.
(iii) It also suffers from all those disadvantages of simple average cost method.

Periodic Weighted Average Price Method

This method is like weighted average price method, except that the calculation of issue
prices are made periodically (say, a month) and not at the time of each new receipt of materials.
The rate so arrived is used for the issues made during that period and also for valuing the
inventory at the end of the period.

Advantages
(i) It is superior to the periodic simple average price method as it takes into account the
quantities also.
(ii) It overcomes or evens out the effect of fluctuations.
(iii) In addition to above, it also possesses all the advantages of the simple
weighted average price method.

Disadvantages
(i) It is not suitable for job costing because each job is to be priced at each stage of
completion.
Moving Simple Average Price Method
Under this method, the rate for material issues is calculated by dividing the total of the
periodic simple average prices of a given number of periods by the number 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 3 monthly period is decided upon and moving average rate for
the month of March is to be calculated. Under such a situation, we have to make a list of the
simple average prices from January to March and add them up, and divide the total by 3. To

47
calculate the moving average rate for April, we have to omit simple average rate pertaining to
January and add the rate relating to April and divide the total by 3.
Advantages
It evens out price fluctuations over a longer period, thus stabilising the charges to work-in-
progress. Thus, the cost of production will be stable to a significant extent.
Disadvantages
An unrealised profit or loss may arise because it uses moving simple average cost and not
actual cost.
Moving Weighted Average Price Method
Under this method, the issue rate is calculated by dividing the total of the periodic
weighted average prices of a given number of periods by the number of periods.
Standard Cost Method -Under this method, material issues are priced at a predetermined
standard issue price. Any variance between the actual purchase price and standard issue price is
written off to the Profit and loss account. Standard cost is a predetermined cost set by the
management prior to the actual material costs being known and the standard issue price is used for
all issues to production and for valuation of closing stock. If initially the standard price is set
carefully then it reduces all the clerical work and errors and the stock recording procedure is
simplified. The realistic production cost comparisons can be made easier by eliminating
fluctuations in cost due to material price variance. In a situation of fluctuating prices, this method
is not suitable.
Illustration 4: The purchases and issues of material X in the month of January, 2001 is as
follows
Jan. 3 Purchase 800 units @ Rs. 20 per unit.
Jan. 17 Purchase 800 units @ Rs. 20 per unit.
Jan. 8 Purchase 700 units @ Rs. 18 per unit.
Jan. 25 Purchase 500 units @ Rs. 25 per unit.
Jan. 9 Issue 600 units.
Jan. 11 Issue 800 units.
Jan. 31 Issue 1,000 units.
The standard price per unit of material is Rs. 20 fixed for the year 2001. Show the Stores Ledger
entries and determine the price variance for the month of January.
Stores Ledger Account (Standard Rate Method

Date Receipts Issues Balance

Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
units Rs. Rs. units Rs. Rs. units Rs. Rs.
Jan. 3 800 20 16,000 - - - 800 - 16,000
8 700 18 12,600 - - - 1,500 - 28,600
9 - - - 600 20 12,000 900 - 16,600
11 - - - 800 20 16,000 100 - 600
17 800 20 16,000 - - - 900 - 16,600
25 500 25 12,500 - - - 1,400 - 29,100
31 - - 1,000 20 20,000 400 - 9,100

48
Closing Stock = 400 units of Rs. 9,100.
The stock valuation of 400 units at the standard price of Rs. 20 per unit comes to Rs. 8,000.
Material Price Variance = Standard Cost - Actual Cost
= Rs. 8,000 - Rs. 9,100 = Rs. 1,100 (Adverse)

Base Stock Method -Under this method, a specified quantity of material is always
held in stock and is priced at its original cost as buffer or base stock and any issue of materials above
the base stock quantity is priced under any one of the methods discussed above. This method
indicates how prices are moving over a longer period of time. But this method is not popular and
accepted under standard accounting practice since it would result in stock valuation totally
unrealistic.

Illustration 5: The stock of materials as on 1st January 2001 was 750 units at the rate of
Rs. 1.50 per unit. Following purchases and issues of this item were made subsequently.

Date Receipt Quantity Rate Per Unit Issue Quantity

(units) Rs. (units)
Jan. 6th - - 300
9th 600 1.65 -
16th 450 1.80 -
19th - - 750
22nd - - 300
25th 750 1.95 -
28th - - 450
31st - - 300

Prepare stores ledger account assuming that issues are made under Base Stock method in
conjunction with FIFO method. Base stock units 400.

Stores Ledger A/c - Base Stock Method with FIFO (Base Stock-400 units)

Date Receipts Issues Balance of stock

Units Rate Amt. Units Rate Amt. Units Rate Amt.
Rs. Rs. Rs.
1 - - - - - - 750 1.50 1125
6 - - - 300 1.50 450 450 1.50 675
9 600 1.65 990 - - - 1,050 - 1,665
16 450 1.80 810 - - - 1,500 - 2,475
19 - - - 50 1.50 75 750 - 1,230
600 1.65 990
100 1.80 180
22 - - - 300 1.80 540 450 - 690
25 750 1.95 1463 - - - 1,200 - 2153
28 - - - 50 1.80 90 750 1283
400 1.95 780
31 - - - 300 1.95 585 450 - 698

49
 Replacement Cost Method (Market Price Method) - The replacement cost is a cost
at which material identical to that is to be replaced could be purchased at the date of pricing
material issues as distinct from the actual cost price at the date of purchase. The replacement
price is the price of replacing the material at the time of issue of materials or on the date of
valuation of closing stock. This method is not acceptable for standard accounting practice since it
reflects a cost which has not really been paid. If stock is held at replacement cost for balance sheet
purposes when they have been bought at a lower price, an element of profit which has not yet been
realized will be built into the Profit and Loss Account.
This method is advocated by charging the market price of material to the Job or Process,
make it easier to determine the profitability of the Job or Process. This method is suitable
particularly in the inflationary tendency of market prices of materials. Where there is no precise
market for particular materials, it would be difficult in ascertainment of replacement prices for the
material issues.
Illustration 6: Prepare Stores Ledger A/c showing pricing of material issues on replacement
price basis , from the following particulars:
Opening Balance 800 units @ Rs. 6 each
10-3-2001 Received 200 units @ Rs. 6.20 each.
15-3-2001 Issued 600 units to Job A vide M.R. No 101
17-3-2001 Received 400 units @ Rs. 6.30 each.
20-3-2001 Issued 500 units to Job B vide M.R. No. 102
25-3-2001 Received 800 units @ Rs. 6.50 each.
26.3-2001 Issued 400 units to Job C vide M.R. No 103
27-3-2001 Received 200 units @ Rs. 6.60 each.
30-3-2001 Issued 600 units to Job D vide M.R. No 104

Replacement prices on various dates:

15-3-2001 Rs. 6.20
20-3-2001 Rs. 6.40
26-3-2001 Rs. 6.60
30-3-2001 Rs. 6.80

Date Receipts Issues Balance

March RO. No. Qty Rate Amnt M.R. Qty Rate Amnt Qty Amount
2000 units Rs. Rs. No. units Rs. Rs. units Rs.
1 - - - - - - - - 800 4,800
10 - 200 6.20 1240 - - - - 1000 6,040
15 - - 101 600 6.20 3720 400 2,320
17 - 400 6.30 2520 - - - - 800 4,840
20 - - - - 102 500 6.40 3200 300 1,640
25 - 800 6.50 5200 - - - - 1100 6,840
26 - - - - 103 400 6.60 2640 700 4,200
27 - 200 6.60 1320 - - - - 900 5,520
30 - - - - 104 600 6.80 4080 300 1,440

50
4.2 Discrepancies in Stock Items
The possible reasons for discrepancy between physical stock and stock shown in records
may be due to the following:
Shortage of material due to spoilage, evaporation, wastage in material handling, break-
down in handling and storing. Increase in weight due to absorption of water etc.
Items of material placed in wrong location.
Pilferage and theft from stores by insiders and outsiders.
Issue and receipt of stock without proper recording and maintenance of stores recording
and accounting.
Stock returns not recorded properly.
Stock issues to production departments without proper recording in bin card and stores
ledger.
Arithmetical errors in calculating the balances in bin card.
Clerical errors in stores ledger.
Supplier supplies a different quantity of material than is mentioned in the delivery challan.
Discrepancy due to improper weighing of material.

Steps to avoid Discrepancies -Steps to be taken to avoid discrepancies in physical stock and stock
shown in records are as follows:
Entry into the stores should be restricted only to authorised persons.
Material requisition should be signed only by the authorised persons.
Proper maintenance of stores records like Bin Card/Stock Card, Stores Ledger
Regular check by independent staff to detect and correct mistakes.
Issue of material only against proper requisition slip.
Recording of all movements of stock.
Physical verification and counting at the time of receipt and issue of material.
Use of FIFO method for stock issues for avoidance of deterioration and obsolescence.
4.3 Considerations in Selection of Material Pricing Method
The following factors should be given due consideration in selection of method in pricing issues of
materials and valuation of stocks :
Method of production or process
Nature of materials used
Quantum of materials used in the organisation
Frequency of purchases and issues

51
 Bulkness and the price of the materials
Economic batch quantity
Tendency of inflation or deflation
Violent fluctuation in prices
Rate of stock turnover
Routinisation and mechanisation of stores procedures
Accounting practice acceptable in valuation of inventory
Sensitivity of profit calculations to the pricing method adopted
Normal losses due to evaporation etc.
The objective of charging material cost to production on consistent and realistic basis
Trade and industry practice in materials purchase, pricing of issues and valuation of stocks
System of costing prevailing in the organisation
Level of usage of standard costing in the organisation
Possibility of adoption of different pricing methods for different classes of materials
The system prevailing for adjustment of difference between actual cost and cost under
pricing method adopted.
.~_ _

4.4 Material Losses

Waste: Waste is the portion of basic raw material lost in processing, having no recoverable
value. Waste may occur due to evaporation, breaking the bulk, loading and unloading, leakage,
inefficient handling, fire, etc. It may be visible or invisible, for example, gases, dust, smoke and
unsaleable residues. The effect of waste is to increase the unit cost of production, since total cost is
spread over a smaller number of good units.
Accounting treatment. The accounting treatment of waste depends upon whether the waste is
normal or abnormal.
For normal waste arising from breakage, evaporation, deterioration, shrinkage in
production , the total cost incurred is distributed over the good output. The treatment is based on
the principle that normal losses should be borne by good output.
Abnormal wastage of material arising due to abnormal reasons, i.e. theft, fire, careless
handling, etc., is not added to the cost of production but is transferred to costing profit and loss
account. This is necessary to avoid any fluctuation in cost of production.
Control of Waste. In order to control waste in manufacturing industries, a waste report is
prepared at regular intervals. The actual percentage of waste is compared with the standard
percentage and remedial measures are taken to remove any abnormal waste.
Scrap. Scrap is defined as the incidental residue from certain types of manufacture usually
of small amount and low value recoverable without further processing. Example of scrap are
available in operations like turning, boring, punching, shaving, moulding, etc. There are three type
scraps, namely (a) legitimate scrap, i.e. scrap which is predetermined and arises due to the nature

52
of operations like turning, boring, punching, etc. (b) Administrative scrap, i.e. scrap which arises
due to administrative action such as change in the method of production. (c) Defective scrap, i.e.
which arises because of the use of inferior quality of material or bad workmanship or defective
machine. There is difference between waste and scrap. Waste cannot be realised whereas scrap can
be realised. Scrap is always visible whereas waste may or may not be visible.

Accounting of Scrap: The usual methods for accounting of scrap are as follows:
1. The sale value of scrap is credited to profit and loss account as other income. The unit cost of
production is, therefore, inclusive of cost of scrap. This method fails to secure effective control
over scrap as detailed records are not kept and scraps are not identified to jobs or processes.
2. From the sale proceeds of scrap selling and distribution costs are deducted and the net value is
deducted from material cost or factory overhead. The effect of this method is to reduce material
cost or overhead recovery rate. This method fails to secure effective control of scraps arising in
processes or jobs. It is suitable in cases where several production orders are taken in hand and it
is not possible to segregate the value of scrap for each order.
3. The value realised from sale of scrap is credited to particular job, process or operation. This
method has an advantage of identifying scrap with each operation, process or job.

Control over Scrap: Control over scrap is possible by:

1. Setting standards for scrap,
2. Determining the responsibility for scrap,
3. Keeping up proper records of scrap in the form of scrap reports.
Spoilage Spoilage consists of goods that do not meet production standards and are either sold for
their salvage value or discarded without further processing. Spoilage cost is the difference between
costs incurred up to the point of rejection less the disposal or salvage value. When spoiled goods
are discovered, they are taken out of production and no further work is performed on them.
Accounting of Spoilage
1. If spoilage is caused by an order's exacting specifications, the spoilage cost as reduced by the
recovery or sales value of the spoiled units should be charged directly to that order.
2. If some spoilage is normal in the manufacturing process, the cost of such spoilage will be borne
by good units.
3. Incase of abnormal spoilage, cost of spoilage is transferred to costing profit and loss account.
Control of spoilage : For effective cost control, normal spoilage rates should be established
for each department and for each type or class of material. Weekly or monthly spoilage reports
should be reviewed by the inspector. The actual spoilage is compared with the standard or normal
spoilage and steps are taken to remove any abnormal spoilage.
Defectives
Goods that do not meet production standards and must be processed further in
order to be saleable as good units are known as defectives. Defective work can be corrected to
meet specificied standards with additional materials, labour and overhead. Defectives may arise
due to substandard materials, poor workmanship, bad supervision and careless inspection. The
additional cost of rectifying the defectives is added to the total cost and the quantity of defectives
rectified is quantity of good output because defective units rectified can be sold as `first' or
seconds. The main difference between spoilage and defectives is that spoilages are sold without

53
further processing , whereas defectives are rectified by additional expenditure and sold as `first' or
seconds.
Accounting of Defectives
1. If the defective units are clearly identified with a numbered job order and defects are peculiar to
the job, the cost to complete the defective units can be charged to the job.
2. If the defective units occur irregularly, the cost of rectification is properly charged to factory
overhead.
3. If the defective production is due to abnormal reasons, the rectification cost is transferred to
costing profit and loss account.

Control of defectives
On the receipt of defective work report, a decision is taken whether to rectify or not to
rectify work. All costs of rectification are collected against the rectification work order. Adequate
steps should be taken to see that defective work remains within standard limits.

QUESTIONS
1. Mention any six methods of pricing the issue of materials?
2. Compare the FIFO and LIFO methods of stock valuation with special reference to their effect
on pricing of issues of goods ,valuation of closing stock and profits during a period of rising
prices ?
3. What do you understand by Weighted Average Method of stock valuation?
4. What factors have to be considered for adopting a method for the pricing of materials?
5. What do you mean by Waste, Scrap, Spoilage and Defectives? How are these treated in cost
accounts?
6. AMAN India is a bulk distributor of high octane petrol. A periodic inventory of petrol on hand
is taken when the books are closed at the end of each month. The following summary of
information is available for the month of April 2005:
Sales Rs. 94,50,000
General administrative cost Rs. 25,000
Opening stock :100000 litres @Rs. 3 per litre Rs. 3,00,000
Purchases
1 April 200000 litres @Rs 2.85 per litre
30 April 100000 litres @Rs3.03 per litre
Closing stock 30 April 13,00,000 litres

Compute the following data by the first in first out, weighted average and last in first out methods
of inventory costing.
(a) Value of inventory on April 30.
(b) Amount of the cost of goods sold for April
(c) Profit or loss for April

54
 UNIT 3

LESSON 5

LABOUR COST
Manisha Verma
HansRaj College
University of Delhi

LEARNING OBJECTIVES

After studying this chapter, you should be able to understand

5.1 Meaning of Labour
5.2 Control Over Labour Costs
5.3 Personnel Department
5.4 Engineering Department
5.5 Labour Remuneration

5.1 Meaning of Labour

Labour is the physical or mental effort expended, in manufacturing a product. Labour
cost is the price paid for using human resources. The compensation to employees who work
in production represents labour cost. Total labour, cost like material costs can broadly be
classified into: (a) direct and (b) indirect. Direct labour is defined, as labour that is
directly involved in the production of a finished product. It can be associated directly with
the product. Examples are: assembly line workers in an automobile factory or knitting machine
operators in a sweater factory. Indirect labour includes wages paid for all labour which is not
directly engaged in changing the shape or composition of raw material. It cannot be traced
directly to the product Examples of indirect labour cost are wages paid to foremen,
supervisors, storekeeper, timekeepers, salaries of office executives and the commission
payable to sales representatives.
5.2 Control Over Labour Costs
Labour cost control is based upon predetermined standards of efficiency and
comparisons of actual costs with the standards as production progresses. Effective control
is achieved through (a) production planning; (b) use of labour budgets and labour standards;
(c) labour performance reports; and (d) appropriate payment for labour performance
including wage incentive schemes. Production schedules, performance standards and
labour budgets represent plans and expectations. But efficient control of labour efficiency
and costs depends on meaningful and timely performance reports sent to foremen and
supervisors, who are directly responsible for departmental production. Performance
reports are designed to compare budgets and standards with actual results attained thereby
pointing to variances from planned and expected performance. Control of labour cost is
effected in a large industrial concern by the concerted efforts of the following departments:

55
 1. Personnel
2. Engineering
3. Time-keeping
4. Pay-roll
5. Cost accounting.
5.3 Personnel Department
The chief function of the personnel department is to provide an efficient labour force.
Personnel functions most directly related to labour cost control involve employment
procedures, job descriptions, job evaluation and time and motion study. Hiring of
employees may be for replacement or for expansion. Recruitment, interviewing, testing,
physical examination, induction procedures and assignment to jobs are carried out by this
department.
Employee's History Card
The personnel department maintains a complete record of each worker of the
organisation. As soon as an employee joins the organisation a personal file is maintained for
him. This file is known as worker's history card or personal record card. The service history
card gives full details of the employee and essential information about him during his
employment in the concern. A specimen of the service history card with necessary columns
is given.
Besides permanent recruitment of workers, an organisation needs workers for short
period known as casual or temporary workers. In the interest of the organization and
effective cost control, it is advisable that (a) all recruitments are made through the
personnel department, (b) frequent reviews of all placements for promotion/transfer be made;
(c) labour utilisation report should be introduced in each department and (d) absenteeism and
labour turnover should be kept at a minimal.

EMPLOYEES HISTORY CARD

EMPLOYEES HISTORY (OR PERSONAL RECORD) CARD
Clock Number
Name
Address Marital Status.
Date of Birth Children.
Education. Previous Experience..
Date of Employment Grade.
Department.. Starting Pay
Category.. Engaged as.
Date left... Previous Employer.
Reason for leaving... Re-engaged

PARTICULARS OF CHANGES IN PAY AND SERVICE

Date Occupation Grade Pay Reason for change (increment,
transfer, promotion or demotion etc.)

56
Labour Turnover
Labour turnover is the rate of displacement of personnel employed in an
organisation. A high labour turnover is a sign of instability of labour. It results in low morale
with the attendant costs associated with demoralised staff. It is important that labour
turnover is kept-as low as possible. The low labour turnover rate is an indication of.
1. Well managed organization.
2. Higher preventive costs being incurred by the management for the satisfaction of
employees.
3. Strong and well organised trade union exerting considerable influence over the
management.
4. Considerable state regulatory control over the policy of the management in respect
of employment and retrenchment.
5. Absence of alternative avenues for better employment and
6. Widespread unemployment as in India.
Labour turnover arises because of various factors including dissatisfaction with job,
low rate of wages, unsatisfactory working conditions, and non-availability of adequate basic
amenities. The causes of labour turnover may be sub-divided into:

1. Personal causes;
2. Avoidable causes, and
3. Unavoidable causes.
(i) Personal causes. These causes induce or compel workers to leave their jobs purely on
personal grounds, including the following:

1. Change of job for betterment.

2. Premature retirement due to ill health and old age.
3. Domestic responsibilities to look after old parents.
4. Discontentment over the job and working environment.
5. Marriage, especially female workers or later on childbirth.
6. During seasons of festivals, marriage or harvesting, the workers in the cities leave
for home in large batches.

(ii) Avoidable causes. These include:

1. Low wages in the present organisation and the worker may look for higher wages
elsewhere,
2. Dissatisfaction with job,
3. Bad working conditions,
4. Long and odd working hours,
5. Unsatisfactory relationship with the supervisors,
6. Bad relationship with the fellow workers,
7. Lack of adequate recreational facilities,
8. Inadequate housing, medical facilities,

57
 9. Unfair methods of promotion and lack of promotional avenues,
10. Lack of planning and foresight on the part of management, seasonal nature of
industry, non availability of raw materials, power, etc.
(iii) Unavoidable causes. These include:
1. Seasonal nature of business,
2. Change in the plant location,
3. Shortage of raw material; power; slack market for the product,
4. Accident or illness rendering workers permanently incapable to work,
5. Dismissal or discharge due to insubordination, negligence, inefficiency, etc.,
6. Marriage, specially in case of women workers.

Effect of Labour Turnover : The higher rate of labour turnover results in increased
cost of production. This is due to:
1. Increased cost of new recruitment and training,
2. Interruption of production,
3. Decrease in production due to inefficiency and inexperience of newly recruited workers,
4. The new workers are more accident prone and are liable to cause more damage to
machinery, tools than old employees,
5. Losses due to wastage, spoilage and defectives,
6. Increased number of accidents causing loss of output and increase in medical expenses
and cost of repairs.
7. Lack of cooperation and coordination between old and new employees resulting in
fall in output and increased cost of production.
Labour turnover is measured by any of the following methods:
1. Separation Method: This method takes into account only those workers who have left
during a particular period. It is calculated as follows:

Labour turnover Rate = No. of workers left during a period_____ x 100,

Average number of workers in the period
2. Replacement Method : This method takes into consideration only the actual
replacement of labour irrespective of the number of persons leaving. If new workers are
employed on account of expansion of business, they are not included in replacements. It is
calculated as follows:

Labour turnover Rate = No. of workers replaced during a period x 100,

Average number of workers in the period

3. Flux Method : It denotes total change in the composition of labour force due to addition
and separations of workers. It is calculated as follows:

Labour Turnover Rate = No.of separation + No. of additions x 100

Average number of workers in the period

58
From the management point of view, the cost of labour turnover can be divided into two
groups:
Preventive costs,
Replacement costs.

Preventive costs: These include costs incurred to keep the labour turnover rate as low as
possible. The object of incurring preventive costs is to keep the workers satisfied and induce
them to stay in the organisation. The preventive costs include:
1. Cost of providing medical, housing and other recreational facilities,
2 Cost of providing benefits like pension, gratuity,
3. Cost of providing educational facilities to the children of the employees,
4. Cost of providing good working conditions, and.
5. Cost of providing other welfare facilities.

If a company incurs high preventive costs, the rate of labour turnover is likely to be
low.

Replacement costs: These costs arise on account of labour turnover and

consequential replacement of employees. These costs include:
1. Cost of recruitment and training of new workers,
2. Loss of output due to (a) interruption of production (b) inefficiency of new workers,
(c) delay in obtaining new workers, (d) abnormal breakage of tools, accidents and scrap,
etc.
Treatment of Labour Turnover Costs: Labour turnover costs usually be treated as factory
overhead costs. The preventive costs should be distributed among different departments on the
basis of workers in each department. The replacement costs are to be shared by the departments
affected by the labour turnover on the basis of number of workers replaced.
Reduction and Control of Labour Turnover: It is important that labour turnover is kept
as low as possible. The following steps may be taken to reduce the labour turnover:
1. A suitable personnel policy should be framed for employing the right man for the right job.
2. Providing working conditions conductive to health and efficiency.
3. Fair rates of pay and allowances and other monetary benefits should be introduced.
4. Maximum non-monetary benefits (i.e. fringe benefits) should be introduced
5. Distinction should be made between efficient and inefficient workers by introducing
incentive plans.
6. Encouraging labour participation in management.
7. An employee suggestion box scheme should be introduced whereby workers who suggest
improvements in the methodof production should be suitably rewarded.
8. An effective employee-grievance redressal procedure should be introduced.
In addition to the above steps, the personnel department may be asked to prepare a report
monthly or quarterly giving the turnover rate and the normal reasons given for leaving.

59
 Illustration 1: From the following information calculate labour turnover rates:
No.of workers as on 01-01-2006 = 7600
No.of workers as on 31-12-2006= 8400
During the year ,80 workers left while 320 workers were discharged ,1500 workers were
recruited during the year of whom 300 workers were recruited because of exists and the rest were
recruited in accordance with expansion plans.
Answer :
Labour turnover rates
(i) Separation method = workers left +discharged x 100,
Average number of workers

= 80 + 320 = 400 x 100

(7600 +8400) / 2 8000

= 5%

(ii)_ Replacement method = workers replaced X 100

Average number of workers

= 300 x 100
8000
= 3.75%

(iii) Flux rate = separations + replacements x 100

Average number of workers

= 400 + 300 x 100

8000
= 8.75 %
Alternatively,
(iv) Flux rate = separations + accessions x 100
Average number of workers

= 400 + 1500 x 100

8000
= 23.75 %

5.4 Engineering Department

This department is required to maintain control over working conditions and

production methods for each job and department by performing the following functions:
1. Preparation of plans and specifications for each job scheduled for production.

60
 2. Making job analysis.
3. Inspection of jobs at successive stages production to make sure that jobs are being done
according to the plans and specifications laid down.
4. Inspection of jobs after they are completed to ensure that they are satisfactorily
completed.
5. Making provision for safe working conditions.
6. Conducting research and developmental work before undertaking new jobs.
7. Conducting time and motion studies.
8. Conducting job evaluation and merit rating.
Some of these functions are being discussed below:
Job Evaluation
Job evaluation is a technique for determining the worth of each job relative to other
jobs. The procedure has certain steps. First, the job factors involved in the evaluation are
determined. These include training, experience, intelligence, responsibility, working
conditions. Secondly, a range of points for each factor are determined. The hourly rate is
then adjusted to take into account the total number of points awarded: The advantages of
job evaluation are:

1. Job evaluation process helps in the development of rational wage and salary structure
because rates are fixed according to the characteristics of the jobs held by the job -
holders.
2 It is helpful in developing harmonious relationship between the employer and the
employees because no scope is left for personal bias of the employer for fixing the wage
rates.
3. It brings into focus the particular needs of a job and a worker who possesses the
particular needs is asked to do the job.
4. As job evaluation is followed by job analysis so advantages of job analysis are available
with job evaluation. These advantages may be proper recruitment, selection,
placement, training, promotion, transfer etc.
5. It helps in job classification and work simplification.
6. It helps in bringing uniformity in wage structure.

Merit Rating
Promotion and placement of workers must be made on their personal performance.
The personal performance of an employee is judged by his merit rating. It is a technique for
determing any addition that should be made to an individual's normal rate, to reward him
for above average service. It should be carefully distinguished from job evaluation which
evaluates the employee doing the job. To conduct a merit rating, each employee is rated
in respect of a number of personal attributes. These could bee initiative, responsibility,
attendance, punctuality, accuracy, safety, co-operativeness, etc. He is often - given points for
each attribute . The total of his points is then related to some predetermined scale which sets
out the merit addition to be made to his rate of pay. The assignment of merit rating should
be done periodically, say at quarterly or six-monthly intervals, by the manager or foreman.

61
The following are some important advantages of merit rating:
1. Merit rating helps in determining fair rates of pay for different workers on the basis of their
performance.
2. Merit rating is helpful in transfer, promotion, placement and discharge of employees.
3. It helps in judging the effectiveness of the employment office of the company as it
reveals the defects, in selection and placement procedures of workers.
4. On the basis of merit rating the right types of employees are recruited by eliminating
unfit and misfit workers.
5. On the basis or merit rating permanent disciplinary and performance records of employees are
maintained. Such records protect management from the charges of discrimination,
favouritism and unfair labour practices.
6. The merit rating distinguishes between the good workers and inefficient workers.
Workers with high rating are suitably rewarded while those in the very low rating group
are exposed. Such exposure provides them an opportunity to improve their performance.
7. It also helps in developing a sense of competition among the workers, and hence the ultimate
result is an increase in production.

Work Study
Almost all incentive schemes operate from an allowed time. Ideally, this should be
calculated by the work-study engineers after the job, methods and equipment have been
studied to ensure that the best way to do the job has been found. Work-study involves an
objective and effective study of work activity in order to effect improvement. It is divided
into two sections: method study and work measurement.
Method Study
Method study examines the way a particular task is carried out. Careful, meticulous study
of the existing method followed by a critical analysis generally reveals an improved way of
carrying out the work. Method study is undertaken to improve methods of production and
to achieve the most effective use of materials, manpower and plant.
Work Measurement
Work measurement involves ascertaining the time it should take to carry out a
specified task. The best known technique here is stop-watch timing. Work measurement is
undertaken to establish the time required to perform the work. The time may be used for
incentive schemes, production planning and estimating selling prices.

5.5 Labour Remuneration

The term remuneration is used to cover the total monetary earnings of employees. It
includes wages according to time or piece basis and other financial incentives. The efficiency in
production can be increased by using improved equipment, by more effective utilisation of plant
and by adoption of better methods of production, but the most important contribution must
come from labour. Accordingly, the methods of remuneration of labour should be so
designed as to encourage workers to do their best. Methods of remuneration which allow
high wages to be paid have the effect of increasing labour cost but may also result in

62
increased production and productivity thereby reducing the labour cost per unit. On the
other hand, low wages generally result in high labour cost per unit due to lower
productivity, high rate of labour turnover, etc.
Requisites of a Satisfactory System of Labour Remuneration
Before deciding on a particular system of labour remuneration, the following factors
should be taken into account:
1. The system should be such as will produce the best quality and quantity of work.
2. It should be satisfactory from the point of view of both employer and employee and
reward should be related to effort.
3. The scheme should be clearly defined and intelligible to workers. The work ers should
be able to calculate wages on their own. If the workers do not understand the system,
they may view it with suspicion.
4. It should guarantee a minimum living wage to each worker irrespective of his efficiency.
5. No maximum limit should be placed on the amount of individual earnings.
6. The earnings of the workers should not be affected by matters beyond their control.
They should not, for example, be penalised for production losses due to power
failure, machine breakdown, etc., for which they are not responsible.
7. It should reduce labour turnover and labour absenteeism.
8. The system should be flexible so that changes may be introduced as and w hen
necessary.
9. The system should be capable of operation without excessive clerical wor k. Those
methods should be avoided which demand much detailed recording of time, quantity of
output, etc.
10.If possible, the system adopted should be one which is in vogue in that particular
industry or in that particular locality.
Methods of Remuneration (Systems of Wage Payment)
There are two basic methods of labour remuneration: (a) Time Rate System; and (b)
Piece Rate System.
In addition, there are a number of incentive plans to induce workers to work hard so as to
produce more and earn more.
Time Rate System
Under time rate system, workers are paid according to the time for which they work
Payment may be on hourly basis; daily basis or monthly basis. In this system consideration is
given to the quantity and quality of work done. When payment is made on hourly basis,
total wages payable are calculated as follows:
Wages = No. of hours worked x Rate per hour
For example, if a worker is paid at the rate of Rs. 25 per hour, his wages for a day of 8
hours will be: 8 hours x Rs. 25 = Rs. 200. Though this is the oldest system of wage
payment, it is still commonly used these days.
Time wage system is suitable for the following type of situations:
(i) Where quality of work is more important than quantity, e.g., high class
tailoring.
(ii) Where output cannot be measured in quantitative terms, e.g., in the case of
indirect workers like watchman, cleaners and sweepers, etc.

63
 (iii) Where output is beyond the control of the worker, e.g., in process industries
the flow of work is regulated by the speed of conveyor belt or where the
work of a worker is dependent on the work of other workers.
(iv) Where work is being done on a small scale so that close supervision is
possible.
(v) Where the worker is a learner or an apprentice.
Advantages:The main advantages of time rate system are:
(i) Simplicity. The system is simple and calculation of wages is easily understood
by workers.
(ii) Security to workers. Workers are assured of a certain amount of wages payable
if there is stoppage of work due to power failure, machine breakdown, etc.
This gives a sense of security to workers.
(iii) Quality of work. As this method does not give weight to the quantity of work
done, workers can concentrate on the quality of goods produced thus the quality
of work under this method is better.
(iv) Accepted by trade unions. Trade unions mostly favour this method because it treats all
workers alike and no distinction is made between efficient and inefficient workers.
(v) Economical. Under this method, no detailed records are required to be maintained
regarding the work done by workers. This results in saving of clerical costs. Moreover
workers avoid over-speeding and cause less damage to plant and machinery and
materials. This also results in economy.
Disadvantages: The main disadvantages are:
(i) No incentive. It offers no positive inducement to workers to improve performance as it
does not distinguish between efficient and inefficient workers.
(ii) Low quantity. When workers are-paid on time basis, they tend to be slow in work. This
results in lower production quantity.
(iii) Extra supervision costs. Under this method, extra supervision is needed so that
workers do not waste time. Appointment of additional supervisors increases cost
(iv) Costing difficulties. From costing point of view, it creates difficulties in the
calculation of labour cost per unit because the output is constantly, fluctuating
(v) Idle time. Workers waste a lot of time resulting in increase in idle time.
Illustration2: Compute earnings of X and Y for the month of August 2005 on the basis of
the following information.
Hours worked of X -----150 hrs Y------------200 hrs
Rate per hour X ------Rs.10 perhour Y----------Rs.15per hour

Answer
Earnings = Hours worked X Rate per hour
Earnings of X = 150 hours X Rs.10 per hour =Rs.1500
Earnings of Y =200 hours X Rs.15 per hour =Rs3000
Piece Rate System
Wages under this system are paid according to the quantity of work done. A rate is fixed per unit of
production and wages are calculated by the following formula

64
 Wages = Rate per unit x No. of units produced
For instance, if rate per unit is Rs. 17 and during a day a worker has completed 10 units, then his
wages will be Rs. 17 x 10 units = Rs. 170.
This method does not give any consideration to the time taken by the worker completing the
work. Only quantity of work is taken into account for calculating wages. ,
Suitability of piece rate system Conditions under which piece rates may be useful employed are:
(a) Where production. is standardised and repetitive in nature.
(b) When the aim is continuous maximum production.
(c) Where the output of workers can be measured.
(d) Where workers continue at the same job for long periods.
(e) Where the standard time required to complete a job can be measured accurately.
Advantages: Piece rate system has the following advantages:
1. Incentive to efficient workers: As remuneration is in proportion to the worker effort, the
method provides a strong incentive to work more.
2. Increase in production: Each worker tries his best to produce more to earn higher wages.
This results in increase in production.
3. Lower Cost: On account of increase in production, fixed cost per unit is reduced resulting
in higher profit.
4. Equitable: This system is more equitable than time rate system because wages are paid
according to the efficiency of each worker.
5. Decrease in supervision : Strict supervision is not necessary because the workers interested
in maximising their earnings through the maximization of output.
6. Simplifies costing: As wages are paid at a rate per unit, this method simplifies cost
ascertainment because labour cost per unit is known in advance.
7. Simple and easy: This method is simple and is easily understood by the workers.
Disadvantages : Piece rate system suffers from the following limitations:
1. Poor quality of work: This method lays too much emphasis on quantity of production
and ignores quality of work. In order to maximise their wages, workers try to produce
more and more without caring for the quality of production.
2. No security of wages: This system does not guarantee a minimum wage to a worker If
a worker is not able to complete his day's work, for any reason, he is paid less, thus
earnings of workers are uncertain.
3. Misuse of materials and equipment: In the greed to produce more, workers may of
materials and damage to plant and machinery.
4. Injurious to health of workers: In an effort to earn more wages, workers try to work
excessively and with speed. This proves injurious to the health of workers.
5. Opposed by trade unions: Piece rate system is generally opposed by trade unions because
it creates inequality in the wages of workers. Slow and inefficient workers feel jealous of
the higher wages of their fellow workers. .

65
 6. Difficulties in fixing piece rate: Fixing equitable piece rate is quite a difficult task and may
require considerable amount of work in the form of time studies.
7. Unsuitable in certain cases: This method does not suit where work is of artistic and
refined nature.
Illustration 3: Compute earnings of X and Y for the month of August 2005 on the basis of
the following information.
No.of units produced X--------3000units
Y ---------2500 units
Rate per unit Rs. 1.50
Answer
Earnings = no. of units produced X rate per unit
Earnings of X= 3000 Units X Rs.1.50 per unit = Rs.4500
Earnings of Y= 2500 Units X Rs.1.50 per unit = Rs.3750

QUESTIONS
1. Discuss the different methods of wage payment to workers?
2. What do you understand by labour turnover? Enumerate the causes of such labour turnover and
indicate some steps which may reduce labour turnover?
3. The cost accountant of K limited has computed labour turnover rates for the quarter ended 31st
march 2005 as 10%, 5%, and 3% under flux method, replacement method and separation
method respectively. If the number of workers replaced during that quarter is 30, find out the
number of
(1) workers recruited and joined
(2) workers left and discharged
4. In a factory Ram and Shyam produce the same product using the same input of same material
and at the same normal wage rate.Bonus is paid to both of them in the form of normal time
wage rate adjusted by the proportion which time saved bears to the standard time for the
completion of time. The time allotted to the product is 50 hours. Ram takes 30 hrs and
Shyam takes 40 hrs to produce the product. The factory cost of the product for Ram is Rs
3100 and for Shyam Rs 3280. The factory overhead rate is Rs. 12 per man hour. Calculate
(1) Normal wage rate,
(2) Cost of material used for the product,
(3) Input of material, if unit material cost is Rs. 16.

66
 LESSON 6

TIME-KEEPING AND TIME BOOKING

Manisha Verma
Hans Raj College
University of Delhi

LEARNING OBJECTIVES

After studying this chapter, you should be able to understand

6.1 Time-Keeping
6.2 Time Booking
6.3 Idle Time
6.4 Overtime
6.5 Payroll department
6.6 Cost Accounting Department

6.1 Time-Keeping Department

Time-keeping forms a most valuable link in a harmonious labour-management
relationship. Most companies have a separate time-keeping department accumulating the
total numbers of hours worked for each employee. It embraces two functions:
l. Time-keeping, i.e. recording of time of workers for purpose of attendance and wage
calculations.
2. Time-booking, i.e. reporting of each worker's time for each department, operation and
job for the purpose of cost analysis and apportionment of labour costs between
various jobs and departments.
Purposes of Time-Keeping
Recording of time is essential for the following purposes:
1. Preparation of pay rolls, where the workers are paid on time basis.
2. Meeting the statutory requirements.
3. For internal administration, like increments, pension, provident fund, gratuity and leave
benefits.
4. For proper distinction between direct and indirect costs, normal time and overtime, and
regular and late comers.
5. For overhead rates, if based on labour hours.
6. For enforcing regularity, discipline and ensuring daily requirement of labour force in the
factory.
Methods of Time-Keeping or Recording
The following are the usual methods of recording attendance of workers at the gate of a factory:

67
1. Manual Methods:
(a) Attendance Register, and (b) Disc or Token system.
2. Mechanical Methods:
(a) Time Recording Clock, and (b) Dial Time Recorders.
Manual methods.
(i)Attendance Register Method (Hand-Written Record): Under this method, a register, with
necessary column like name, identity no. of the employee and arrival and departure time is
maintained.
In a large factory separate registers may be maintained for each department but in a small
factory one register may serve the needs of the entire factory. The practice of recording attendance
or roll calls may conveniently be adopted depending upon the nature of employees and their
number. As soon as a worker enters into the premises of the factory, the necessary entries in the
attendance register are completed either by calling name of each worker or by some other physical
method.
If the workers are literate, they may be required to sign the attendance register. This method
is very popular in government departments and administrative wings of other organizations. This
method is very simple and inexpensive. But in a larger factory this method may become
inconvenient. Moreover, this method is liable for many undesirable practices on the part of the
persons who record the attendance in collusion with some workers. This method is most suitable for
small factories and outdoor workers.
(ii)Disc or token or check method: Under this method, each worker is allotted a metal disc
or token bearing his identification. On each disc the name and number of the worker is engraved
or painted. all the tokens or discs are hung on a board serially before the arrival time of the workers
as soon as a worker reports for duty on the appointed time , he removes his/her disc from the board
and puts into a box. Immediately after the scheduled time for entering into the premises of
the factory the board is removed and a list is prepared of all such discs or tok ens not
collected and dropped into the box by the workers. The late-comers collect their discs
and hand over personally to the time-keeper. The list of late-comers is prepared
separately. The tokens not removed from the board represent the absentee workers. This
method may be adopted with some variations such as: (a) the discs or tokens instead of
dropping into the box by the workers at the gate of the factory are deposited in the
respective departments. Factories may adopt either of these methods, convenient to them
keeping in view the number of workers and the distance between gate and the work point.
With the help of these- lists the time-keeper records the attendance in the register known
as Muster Roll for the purpose of pay rolls.
Although these methods are simple and economical, yet they are open to many
abuses. The disadvantages are:
1. A worker may remove the disc of his fellow-worker to ensure his presence who is either
late or absent.
2. There is no certainty that the exact arrival time of the w orkers has been recorded.
The timekeeper marking the attendance may commit errors deliberately or through
carelessness and this may result in many disputes.

68
3. The time-keeper may include the dummy or ghost workers in the muster roll that cannot be
easily detected except by a surprise check by some responsible officials.
The manual methods of recording attendance of the workers, therefore, cannot be taken as
being foolproof.
Mechanical methods:
Different mechanical devices have been designed for recording the exact time of the
workers. These include:
Time Record or Recording Clocks.
Dial Time Records.
Time Record Clocks: The attendance under this system is marked by a time recording
clock on a card. Each worker is given a time card usually for one week duration. These time or
clock cards are serially arranged and kept in a tray at the gate of the factory and as the
worker enters into the gate, he picks up his/her time card from the tray, puts it in the time
recording clock that records the exact arrival time at the space provided on the card against
the particular day.
This process is repeated when the worker leaves the, factory after his/her day's work.
Other particulars of time in respect of lunch, late arrivals, early leaving and overtime are
printed in red so as to distinguish these from normal period spent in the factory. This is a
very popular method of recording the attendance of workers.
Dial Time Recorders: This is a machine which records correct attendance time of
worker automatically. There are a number of holes (about 1600) around a dial. Each hole
represents a number which corresponds the identification or token number of the worker
concerned. There is a radial arm in the centre of the dial. While entering into the gate of
the factory, a worker has to press the dial arm into a hole and the time is automatically
recorded on the roll of the paper placed inside the dial time recorder against his number.
The rolled paper placed inside the machine provides a running account of workers' timing
and may be used as a part of the pay roll obviating further copying of the attendance records.
Advantages of mechanical methods of time keeping
1. They record correct attendance time at the gate of the factory
2. They reduce chances of incorrect recording of attendance time and this avoids the
disputes regarding time.
3. Possibility of inclusion of dummy or ghost workers in the muster roll is minimised.
4. The mechanical system is clean, safe and quick. The printed record is more reliable
and avoids unnecessary disputes.
5. The system is economical, reduces workload in connection with the preparation of pay
rolls.
6. The overtime, idle time and late time are recorded separately and correctly.
However, the most difficult problem of this system is initial capital outlay and
secondly any mechanical defects may adversely affect the working of the entire time
recording to system of the factory.

69
 6.2 Job Time Booking
For proper labour cost analysis, it is essential that the worker records, in details, his
activities of production and time he spends on each job correctly. Time spent by a worker
on the job, process or activity may be recorded manually or mechanically depending upon
the nature and size of an enterprise. Recording of time spent by the worker on the job is
better known as time booking. The objects of time booking are:
1. To ensure that the time paid for is properly utilized.
2. To ascertain the labour cost for each individual job and the cost of work done.
3. To determine the rate of absorption of overhead expenses based on direct labour and
machine hour methods against each job.
4. To ascertain and minimise idle time.
5. To evaluate each employee's performance by comparing the actual time taken with the
budgeted time.
For achieving these objectives, it is very important that clear instructions should be issued
and proper forms designed for recording work-time.
The following are some important forms generally used for time booking:
1. Daily Time Sheet 2. Weekly Time Sheet 3. Job Card or Ticket 4. Labour Cost Card.
Daily Time Sheet
This is the record of each day's work done by a worker. Every worker is given a Daily
Time Sheet on which he records the time spent by him on each job or work. At the end of
the day, all then sheets, duly countersigned by the foreman, are collected.
This method of time booking is very simple and practicable but it suffers from many
drawbacks. This method is suitable only for small concerns; secondly, if a daily time
sheet is lost or misplaced then it becomes difficult to ascertain the daily wages of worker
and finally, it is very expensive since a large number of sheets have to be used for
calculation of wages. It is time consuming also.

Daily Time Sheet

Name of the worker..
Ticket no.. date..

Job Department Time Total hours Wage rate Total

no. wages
Start finish Ordinary Overtime Ordinary Overtime
Rs. Rs.

Worker Foreman.
Cost clerk..

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Weekly Time Sheet
Instead of recording time on daily time sheets, a worker is given a sheet on which
he records his time for a week. This method of recording is an improvement over the
daily time sheet since the number of documents to be prepared is considerably reduced.
The weekly time sheet provides a consolidated time spent by a worker on a job and can
conveniently be reconciled with the attendance record. Weekly time sheets are suitable where
the worker has to handle a few jobs and the foreman can ascertain the work done by a
worker during the week.
These sheets are liable to be mutilated or lost. The workers may fill wrong time and
hence strict supervision is required. It is always advisable that these sheets are filled by the
departmental clerk so that these disadvantages are avoided and the foreman exercises
effective supervision on the jobs.

Weekly Time Sheet

Name of the worker..

Ticket no..Week ended

Day Job no. Job no. Job no. Total hours Wage rate Total
Rs.
On off on off on off Ordinar Overtime Ordinary Overtim
y Rs. e
Rs.
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
Sunday
Worker Foreman.
Cost clerk..

Job Card / Ticket

A job or time card is a document made out for each job. Its basic function is to
show the time spent by an employee on each job or -process on which he works during
the day. It shows the time an employee starts work on a particular job, the time he finishes,
the department, for which the worker is done, and the job number. If he spends some of his
time on work other than individual jobs or processes, for example, on maintenance and
repairs, the time is shown as indirect labour on the time card. It is unlike time-sheets which
are made out for each employee. Generally five different types of job cards are used and
these are:

71
 1. Job card for each job
2. Job card for each operation
3. Job card for each worker .
4. Combined time and job card.
5. Piece work card.

1. Job card for each Job : With this kind of job card, the card travels round with the
job and labour times are recorded upon each after each operation. This has the advantage
that when the card reaches the cost office, all labour times are listed, and the cost clerks
have only to insert the labour rates, multiply and add to obtain the full labour cost. It has,
however, a serious disadvantage that unless the job is fully complete, none of the times are
known in the cost office.
As some jobs may take many weeks to get completed, it is virtually impossible to reconcile
labour time with gate times each week.

Job card for each job

Job No. Time started..
Job description.. Time finished..
Drawing No. Hours or job..
Operation No.. Time allowance

Date Operation Dept. Worker Hourly Time Hours Cost

No. rate
Start Finish

Total for the job

Checked and verified Cost office
Foreman Reference

72
 2. Job card for each operation: This method of recording means that a single
job will have a number of job cards, one for each operation. This involves considerable
paper work, but it does enable time bookings to reach the cost office quickly.

Job card for each operation

Work order No.
Work drawing NoQuantity
Description of job..
Operation Particulars Clock Date time Hours Rate Cost
no. No.
Start Finish
1. Turning
2. Thread roll
3. Drilling
4. Removing
5. Inspecting
6. Packing
7. ----------
total
Material required Date started Date finished Passed inspection
Signed foreman Cost office reference

3. Job card for each worker: This is a card issued to each worker for job at the
beginning of each day or week depending upon the number of jobs he has to work on. The
necessary job numbers are mentioned either by the foreman or the departmental clerk.
Job card for each worker
Name.. Clock no. ..
Department Hourly rate Week ending
Job no. Mon Tue Wed Thurs Fri Sat Total Cost
hours
Start
finish
Start
Finish
Start
Finish
Total hours Normal Idle time
overtime
Checked and verified Worker/ department Cost office
reference
Foreman Clerk

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 4. Combined Time and Job Card : Time cum job card is used by small organizations
where there is no need of recording time at the gate of the factory and then on the job. The
special of the card is that it records both the attendance, time and the job time of a worker
on one card.
Combined Time and Job Card.
Workers name.
Workers No. Week Ending
Department
Day Job No. Time Time For cost office
On Off Normal Overtime Rate Amount
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
Sunday

Worker. Foreman Costed by .

Entered in wage sheet by..

5. Piece Work Card: This card is most suitable for an organisation where the workers are
paid wages on piece rate basis. A record of units manufactured by a worker with reference to
their quality and time is to be kept on this card. Besides wages, bonus is to be paid to
worker for time saved and his efficiency is to be judged on the basis of units produced
during the specified period.

Piece Work Card

Form No.
Name Card no.
Department Week ending
Days No.of units No.Rejected Good units Rate Amount

Worker: Foreman : Inspector: Cost office:

Dept clerk:

Reconciliation of Gate Time with Time Booked

While preparing the wage sheets it becomes necessary to reconcile the time recorded
at the gate of the factory with the time booked to different jobs of each worker. . Time recorded at
two different places must agree. But sometimes there is some discrepancy between the,gate
time and time booked to different jobs. This discrepancy is known as idle time.

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6.3 Idle Time
Idle time is that time for which the worker has been paid, without giving any
production to the employer. Idle time normally results from poor production scheduling and
lack of sales order. It is necessary to identify the reasons for the idle time, otherwise it
would be difficult for the management to exercise effective control over the labour costs.
The idle time normally arises due to normal and abnormal causes:
(i) Normal causes: Whatever precautions may be taken, some idle time is inherent in every
situation. Normal causes for which idle time arises are:
1. Time lost between factory gate and place of work.
2.Time taken in picking up the work for the day.
3 The interval between one job and another.
4. The setting-up time for the machine.
5. Time taken for personal needs, and
6. Time lost due to normal fatigue
If the time lost is. due to the above-mentioned reasons, it is known as normal idle time.
(ii) Abnormal causes : Idle time may also arise, due to abnormal factors.
1. Temporary lack of work.
2. Breakdown of machinery.
3. Power failure.
4. Non-availability of raw materials, and
5. Strikes, lockouts, floods, fires etc.
Treatment of normal idle time cost. Normal idle time cost can be treated in the
following two ways in the cost accounting.
1. The labour cost of normal idle time be treated as a part of the cost of production.
Normal idle time cost of direct workers be treated as direct wages. Assuming a worker
is paid Re. 1 per hour for 8 hours a day, he actually spends 7 hours on the job and
one hour is lost due to routine work. Since it is a case of normal idle time, the
worker will be paid Rs. 8 for the day. Thus, in case of direct workers an allowance for
normal idle time is built into the labour costing rates.
In case of indirect workers, the normal idle time is spread over all the products or jobs.
In this case, it is treated as factory indirect wages and, is distributed through the
process of absorption of factory overheads.
2. The entire normal idle time cost be treated as an item of factory expenses and be
recovered as indirect charge.
Treatment of abnormal idle time cost : A basic principle of cost accounting is that
abnormal expenses and losses should not be included in costs while ascertaining the cost of a
unit or activity. It is on the principle that the abnormal idle time costs are excluded from, the cost

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of production. Abnormal idle time cost is directly transferred to Costing Profit and Loss
Account without disturbing the normal costs. Such treatment at once attracts the attention
of the management towards the losses due to abnormal idle time.
Control of idle time. The abnormal idle time, costs should be further categorised
into controllable and uncontrollable. This would help the management in fixing
responsibility of controllable idle time. Idle time cards should be prepared to know the
reasons which are responsible for such a time. Timely provisioning of materials and regular
maintenance of plant and machinery will also go a long way in reducing the idle time. The
management should aim at eliminating abnormal idle time and reducing the normal idle time
to the minimum.

Idle Time Card

Workers name
Workers No..
Department
Reasons of idle time Time Time lost For cost office Remarks
On Off Rate Amount
1.waiting for materials
2.waiting for tools
3.waiting
for instructions
4.Machine breakdown
5.power failure
6.inspections
7.other reasons

Worker. Foreman.. costed by

Idle Time and Idle Capacity

Idle capacity means that plant and machinery is available for utilisation but is not
fully used due to normal or abnormal reasons. This generally arises from market
constraints or defective management policy. The normal reasons for idle facilities are,
generally, preventive maintenance and intermittent use of machine during processes. The
abnormal reasons may be trade depression, flood, recession etc. The cost of normal idle
facilities should be charged as overhead expenses and the abnormal idle facilities should be
charged to Costing Profit and Loss Account. It should be noted that idle time of labour is
different from idle capacity of the plant. Care, should be taken to calculate the capacity usage
ratio of each machine and adopt measures to raise the ratio to unity wherever possible.
6.4 Overtime
Over and above the normal working hours, if a worker spends more time on the job, it
is generally known as overtime. .In India, the Factories Act provides for payment of
overtime wages. If a worker works for more than 8 hours on any day or for more than 48
hours in a week, he is treated to be engaged in overtime and is given wages at double the
basic hourly rate for the overtime put in by him. The main causes of overtime are:

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1. It is usually necessitated high doe to temporary increase in demand.
2. It maybe, necessary to complete-urgent work or execute rush orders.
3. If there is unavoidable interruption in work during normal hours due to power failure,
voltage fluctuation, or bottleneck in work flow, the scheduled work may have to be
completed with overtime work.
4. Slackness during the regular working hours, due to inadequate supervision, may cause
overtime work.
5. Often overtime work is also necessary to make up production deficiency or arrears of
work which could not be done due to official holidays, strike or lockout.
Treatment in cost accounts :. Overtime wages and overtime premium should be treated
in the cost Accounts as follows:
1. When overtime is regular feature undertaken for increasing production; the normal wage rate
should be proportionately increased so as to include the overtime premium. Overtime
wages should be treated in this case as cost of labour-direct or indirect as the case may
be.
2. If overtime is a direct result of a customer's urgent request for the completion of the
order and not due to general pressure of factory work, then the overtime should be charged
directly to the job.
3. If overtime work is of an intermittent nature i.e. caused by int erruptions during
normal work time which are beyond the control of management; e.g. power failure,
breakdown of machinery etc. then it should be treated as a part of factory overheads.
4. When overtime work is caused by loss of time (abnormal idle time) which was avoidable,
overtime wages should be, treated as a loss and charged to Costing Profit and Loss
Account.
However, it maybe noted that overtimes should be avoided as far as possible because it
adversely affects the cost of production due to the following reasons.
1. Overtime wages are paid at higher rate;
2. Overtime work is done when the efficiency of the worker is generally falling after day's work
or is at its lowest ebb;
3. Workers develop a tendency of postponing the normal work to be done in overtime; and,
4. Other, overhead expenses increase proportionately during the overtime.
Control over overtime: For cost control purposes, overtime should be analyzed by
responsibility centres. It is also necessary to prepare overtime reports them regularly to the
works managers. These reports will indicate the justification or otherwise of the
overtime.

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6.5 Payroll department
A payroll or wage sheet is a list of all employees showing major details relating to
their pay particularly their gross pay, deductions and net pay. Most manufacturing
companies have a separate payroll department whose function is to compute the total payroll
indicating the gross amount earned and the net amount payable to employees after deductions.
The pay roll department also pays the employees and maintains records of their earnings,
their wage rate and job classification. Payroll accounting . requires the provision of certain
information relating to employees attendance, time, details of absenteeism, hourly rates of pay
and details of various deductions such as tax, provident fund, employees state -insurance ,etc.
The wage sheets are generally prepared department wise. Departmental wages sheets
are summarized in a master wages sheet which forms the basis for the preparation of the payroll
voucher entry in the general ledger in cost control account.
The gross wages of each employee is computed by reference to the following
documents:
1. Clock or Time cards.
2. Piecework cards.
3. Job cards.
4. Employee's record card.
The payment of Wages Act, 1936 , authorizes the following deductions as per rules given in the act.
1. Fines and deductions for absence from duty
2. Deductions for damage or loss of goods or money, expressly entrusted to, employed
persons.
3. House rent and supply of other amenities and services.
4. Deduction for recovery of advance.
5. Income-tax.
6. Deductions in respect of an order of a court or other competent authority.
7. Provident Fund
8. Deduction of cooperative society dues.
9. Deduction for life insurance premium.
10. Employee's state insurance contribution.
The total deductions in respect of an employee are deducted from his gross wages, and net
amount due to him is paid. In many organizations; the payroll accounting function is now
likely to be carried out by a computer.

Frauds in the Payment of Wages

Calculations and disbursement of wages to the employees must be made with utmost
care. Cases of fraud in the calculation and payment of wages are not unknown. The following
kinds of fraud are generally perpetuated in the payroll and wage payment:
1. Inclusion of dummy workers in the payroll.
2 Inclusion of wrong hours in the time and job cards.
3. Payment of leave wages, holiday wages, allowances or other perquisites to
workers not entitled thereto.

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 4. Use of high rate of pay in the payroll.
5. Wrong inclusion of`bonus or inclusion of bonus amount more than the entitlement.
6. Recording overtime not actually worked by workers
7 Payment of work not done(if payment is on the basis of piece rate).
8. Omission to make deductions, partial or total.
9. Payment of wages to wrong persons.
10. Paying excess wages to workers.
Precautions and internal check: Rigid control over, the calculation and payment of
wages should be exercised to minimise the risk of fraud.The following steps are
1. All the workers should be asked to record correct time of their arrival in the factory,
and departure from the factory.
2. Job and time cards should be properly designed and the workers should be asked to book
the time started on and off correctly.
3. Workers who are paid on piece rate basis should be asked to book time for th e work
done and their cards duly initialled by the foreman.
4. All the cards should be kept in the custody of time office.
5. In the payroll, details of workers time/ hours worked, piece produced, rate of pay, overtime
and bonus etc. should be carefully recorded. Calculations should be made with care and
precision.
6. Payments for idle time, rejected and spoiled production, special allowance etc. should
only be made if sanctioned by the proper authority.
7. A number of persons should be engaged in the compliation of the records of the wages
payable.
8. The payroll should bear the initials of each person concerned in its preparation with
details of the work carried out.
9. Deductions should be recorded properly.
10. A cheque of the net amount payable to the workers should be drawn for each payroll and,
the amount entrusted to some responsible person and he should be different from those
who prepared and checked the payrolls.
11. Pay envelopes should be prepared for each worker for the exact amount by one person
and checked by another person.
12. Actual payment to the workers should be made, as far as possible, in the department
after proper identification. Each worker should be asked to present himself/herself
personally. `
13. The foreman should be present to ensure that the envelope is given to the right person
and employees may be asked too sign a receipt.
14. From time to time a senior officer of the company should personally be present when
wages are being paid.

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15. Unpaid wages should be tallied with the payrolls and be returned to the pay office. Workers,
absenting themselves on the pay day should be paid on some other fixed date.
16. The reason for all unclaimed payment should be established.
17. Payment of wages to out workers or casual workers who work on the locations away
from the factory or head office should be made on the site by the persons deputed from
the head office for the purpose.
18. The wages rolls should occasionally be scrutinised .by the Personnel Officer or
Works Manager to guard against inclusion of dummy workers on the payroll.

6.6 Cost Accounting Department

Using time cards, job cards and payrolls as a guide, the cost accounting d epartment
must allocate the total payroll costs to individual jobs, departments or products. The total
payroll cost for one period must equal the sum of the labour costs allocated to individual
jobs, departments or products.
Wages Analysis Sheet or Wages Abstract
The cost accounting department prepares the wages abstract in order to determine
the direct labour costs, indirect labour costs, departmental labour costs and difference between
the budgeted labour costs and the actual labour costs and to inform the management of the
effectiveness of labour policies. The wages abstract is like materials abstract and it is
prepared with the help of the time cards, job cards and wages sheet. A specimen of wage
abstract is given below:

Wages Analysis Sheet or Wages Abstract

Total No. Week ending
Job No 101 Job No 102 Job No 103 Job No 104 Overheads Cost
ledger
folio
Clock Hrs Amt Clock Hrs Amt Clock Hrs Amt Clock Hrs Amt Clock Hrs Amt
No. No. No. No. No.

Prepared by Cost ledger posted by. Checked by.

QUESTIONS

1. What is idle time? Give reasons for idle time? How do you treat idle time in cost
accounts?
2. What are the various methods of time booking? State the advantages and disadvantages
of each method?
3. A worker is paid 50 paise per hour and the 5 days working week contains 42 hours. The
daily allowance for approved absence from his place of work, maintenance of machine
etc is 12 minutes and his job card shows that his time chargeable during the week to
various job is as follows:
Job no. 305 20 hours
Job no. 310 10 hours
Job no. 320 8 hours

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 The unaccounted time is caused by a power failure. Show how his wages for the week
would be dealt with in cost accounts.

4. Calculate the normal and overtime wages payable to a workman from the following data :
Days Hours Worked
Monday 8
Tuesday 10
Wednesday 9
Thursday 11
Friday 9
Saturday 4
Normal working hours 8 hours a day
Normal rate Rs.10 per hour Overtime rate upto 9 hours in a
day at single rate and over 9 hours in a day at
double rate
Or
upto 48 hours per week at single rate and over 48
hours at double rate,whichever is more beneficial
to the workman.

5. An employee of XYZ Co. gets the following emoluments and benefits:

(a)Salary Rs.250 pm
(b) Dearness allowance
On 1st Rs.100 of salary Rs.400
On next Rs.100 of salary Rs.100
On balance of every Rs. 100 Rs.50 or part thereof
(c) Employers contribution
-to provident fund 8% of salary and D.A.
-to ESI 4% of salary and D.A.

(d)Bonus 20% of salary and D.A.

(e) Other allowances Rs.2725 per annum
A works for 2400 hours per annum out of which 400 hours are non productive but treated
as normal idle time. A worked for 18 effective hours on job no. 13 where the cost of direct
materials equals As earnings and the overhead applied is 100%of prime cost. The sale
value of the job is quoted to earn a profit of 10%on such value. You are required to find out
(1) Effective hourly cost of A
(2) Effective sale value of job No.13

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