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A-PDF MERGER DEMO

MANAGEMENT
ACCOUNTING

Prof. Satish Inamdar


M.Com., L.L.B., F.C.A., Gr.C.W.A., A.C.S.

(FOR PRIVATE CIRCULATION ONLY)

Published by
Symbiosis Center for Distance Learning,
Pune.

© Symbiosis Center for Distance Learning (SCDL)


No part of this book may be reproduced or copied or transmitted
in any form without prior permission of the publishers.

2005 Batch
PREFACE

Failure of majority of the industrial undertakings is mainly attributable to the lack of awareness
about the wrong financial decisions affecting the business, particularly accounting and costing
decisions. The crux of wrong financial decisions is that the implications of the wrong financial
decisions are not realized immediately, and by the time they are realized, it is too late. As
such, it is most important to take proper financial decisions at proper point of time. For this,
clear understanding of basic financial and costing principles is a must for everybody.

My objective of writing this book is to introduce the basic concept of financial and cost accounting
in the simplest possible language to the readers. I have attempted to explain the basic concepts
with the help of examples and illustrations. Good number of problems have been incorporated
for self-study.

I am thankful to Symbiosis Center for Distance Learning and particularly to Ms. Swati Chaudhary,
Director, SCDL, for providing me this opportunity to reach out to a very wide spectrum of
readership.

All the efforts have been done to make the text free of errors. Still, I don’t rule out the possibility
of some omissions. I will be obliged if such omissions can be pointed out and intimated so
that necessary modifications can be done in the subsequent editions.

Prof. Satish Inamdar

5, Brahma Residency, Bhusari Colony,


Kothrud, Pune 411 038
Tel : (020) 528 2058 / 528 5749
Email : sminamdar@yahoo.com
ABOUT THE AUTHOR

Prof. Satish Inamdar is holding a Master’s Degree in Commerce and Bachelor’s Degree in
Law. He is fellow Member of the Institute of Chartered Accountants of India, Graduate Member
of The Institute of Cost & Works Accountants of India and Associate Member of The Institute
of Company Secretaries of India. He is associated with the industry for the last two decades
in various senior capacities. For the past fifteen years, he is associated with Symbiosis
Institute of Business Management as a Faculty of Finance. He has conducted Management
Development Programmes and Executive Development Programmes for various private sector
and public sector organisations. He has authored three books on the subjects like Cost &
Management Accounting and Financial Management. He is Charter Member of Rotary Club
of Pune, Kothrud.
CONTENTS

Chapter Page
No. TITLE No.

1 Introduction 1
a) Streams of Accounting - Financial, Cost and
Management
b) Definition, Objects and Scope of Management
Accounting
c) Disadvantages/Limitations of Management Accounting
d) Comparison with Financial and Cost Accounting

2 Basics of Financial Accounting 15


a) Principals, Convention and Concepts of Accounting
b) Systems of Accounting
c) Types of Expenditure
d) Glossary of Terms Used in Financial Accounting
e) Double Entry System of Accounting
f) Depreciation Accounting

3 Process of Accounting 35
a) Journalising, Posting, Control Ledgers, Balancing of
Accounts, Preparation of Final Accounts
b) Illustration with Solutions
c) Problems for Students to Solve

4 Bank Reconciliation Statement 101


a) Preparation of Bank Reconciliation Statement
b) Illustration with Solution
c) Problems for Students to Solve

5 Rectification of Errors 129


a) Types of Errors
b) Effect of Errors on Trial Balance
c) Illustration with Solutions and Problems for
Students to Solve
Chapter Page
No. TITLE No.

6 Cost Accountancy (Basic Concepts and Principles) 147


a) Introduction
b) Concept of Cost Centre
c) Special Types of Cost
d) Illustration of Costing System

7 Elements of Costs 155


a) Cost Sheet / Cost Statement
b) Illustrative Problems with Solutions
c) Problems for Students to Solve

8 Material Cost 183


a) Direct / Indirect Material
b) Procurement / Issue of Material, P.O., GRN, MRN,
Bin Card
c) Methods of Valuation of Stores, Receipts / Issues
d) Techniques of Inventory Control
e) Illustrations with Solutions
f) ABC Analysis, Bill of Material, Perpetual Inventory
System
g) Illustrative Problems with Solution
h) Problems for Students to Solve

9 Labour Cost 247


a) Time Keeping Methods
b) Time Booking, Time Sheet, Job Card
c) Methods of Remuneration, Time Rate, Piece Rate,
Various Bonus/Incentive Systems
d) Important Terms in Case of Labour Cost
e) Illustrative Problems with Solutions
f) Problems for Students to Solve
Chapter Page
No. TITLE No.

10 Overhead Cost 289


a) Elementwise and Functionwise Classification
b) Procedure for Charging the Overheads
- Distribution Methods
c) Absorption of Overheads
d) Machine Hour Rate
e) Under/Over Absorption
f) Illustrative Problems with Solutions
g) Problems for Students to Solve

11 Marginal Costing 343


a) The Concept, Basic Assumption, Features
b) Form of Operating Statement
c) Basic Concepts of Marginal Costing, Contribution,
Profit Volume Ratio, Bank Even Point, Margin of Safety
d) Illustration with Solutions
e) Cost, Volume, Profit Relationship
f) Product Profitability
g) Limitations of Marginal Costing
h) Illustrations with Solutions
i) Problems for Students to Solve

12 Budgetary Control 437


a) Budgets and Budgetary Control, Advantages, pre-requisites
b) Types of Budgets
c) Fixed and Flexible Budget
d) Illustrative Problems with Solutions
e) Problems for Students to Solve
Chapter Page
No. TITLE No.

13 Standard Costing 493


a) Concept of Standard Cost and Standard Costing
b) Advantages, Limitations
c) Standard Costing Compared with Budgetary Control
d) Preliminaries for Establishing Standard Costing System
e) Basic Standards
f) Reporting and Analysis of Variances
g) Illustrations and Solutions
h) Problems for Students to Solve

14 Uniform Costing 547


a) Scope
b) Requisites, Advantage, Disadvantages

Suggested Reading 553

Assignment Question Bank 555


Chapter 1
INTRODUCTION

A business is an activity carried out with the intention of earning the profits. A person carrying
out the business is interested in knowing basically two facts about his business -

(a) What is the result of operations of the business activity? In other words, whether the
business has resulted into the profit or loss? Excess of revenue over the expenses will
be in the form of profits whereas excess of expenditure over the revenue will be in the
form of loss.

(b) Where the business stands in financial terms at any given point of time.

Providing the answers to the above questions is not possible unless the transactions relating
to the business are recorded in a systematic manner. Here the process of accounting comes
into the picture. According to American Institute of Certified Public Accountants, “Accounting
is the art of recording, classifying and summarizing in a significant manner and in terms of
money, transactions and events which are of a financial character and interpreting the results
thereof.” The process of recording the business transactions in a defined set of records, which
in technical words are called as Books of Accounts, is referred to as Book Keeping. Accounting
refers to the process of analyzing and interpreting the information already recorded in the
books of accounts with the ultimate intention of answering the above stated questions.

This intention is satisfied by preparing what are called as Financial Statements. The financial
statements prepared by the organization are basically in two forms-

(a) Profitability Statement, which is the answer to the first question i. e, what is the result of
operations of the business activity. Thus, profitability statement indicates the amount of
profit earned or the amount of loss incurred.

(b) Balance Sheet, which is the answer to the second question i.e. where the business
stands in financial terms at any given point of time. Thus, balance sheet indicates the
financial status of the business at any given point time in terms of its assets and liabilities.

Introduction 1
The nature of these financial statements is discussed in details in the following pages.

Thus, the process of book keeping is more procedural and clerical in nature while the process
of accounting is more managerial in nature. As such, the job of book keeping is entrusted to
junior level employees, whereas the job of accounting needs more professional expertise.

STREAMS OF ACCOUNTING

The process of Accounting gets split into three streams -


1. Financial Accounting
2. Cost Accounting
3. Management Accounting

Let us discuss the nature of these three streams of accounting in details.

Financial Accounting

Financial Accounting is the process .of systematic recording of the business transactions in
the various books of accounts maintained by the organization with the ultimate intention of
preparing the financial statements there from. These financial statements are basically in two
forms. One, Profitability Statement which indicates the result of operations carried out by the
organization during a given period of time and second Balance Sheet which indicates the
state of affairs of the organization at any given point of time in terms of its assets and liabilities.
This nature of Financial Accounting indicates following characteristic features of Financial
Accounting -

(a) Financial Accounting considers those transactions which can be expressed in terms of
money. All those transactions which can not be expressed in terms of money, howsoever
important they may be from business point of view, find no place in financial accounting
and hence in financial statements. E.g. Assuming that the business of an organization
is such that it is likely to be injurious to the health of local community. As such, there is
a strong opposition from the local community for the company’s carrying on the business
at that location. This opposition is something which can not be expressed in terms of
money and hence finds no place in financial accounting and hence in financial statements
though, it is affecting the business operations of the organization to a very great extent.

(b) Financial Accounting is referred to as Historical form of accounting. In other words,


financial accounting is concerned with recording of transactions which have already
taken place. No futuristic transactions and events, howsoever important and significant
they may be from business point of view. find any place in financial accounting and
hence in financial statements.

2 Management Accounting
(c) In practical circumstances Financial Accounting is more or less a legal requirement. In
case of certain organizations like Company form of organization, Banks, Insurance
Companies etc., not only it is necessary to maintain the financial accounting records
and prepare the financial statements there from, but it is obligatory to get these financial
statements audited also by an independent Chartered Accountant. In some cases, there
may not be direct legal requirement to prepare the financial statements, but indirectly it
is necessary to prepare the financial statements. E.g. If a partnership firm wants to file
its Income Tax Return as per the provisions of Income tax Act, 1961, preparation of
financial statements is a must to ascertain the profits.

(d) Financial Accounting is meant for those people who are external to the organization. In
other words, financial accounting is basically meant for those people who are not a part
of decision-making process regarding the organization. This class of people may consist
of the people like investors, customers, suppliers, banks, financial institutions etc.

(e) The information available from Financial Accounting, i.e. financial statement, is available
at a delayed point of time. E.g. Balance Sheets as on 31st March 2002 is available after
31st March 2002 is over. The various legal provisions also allow sufficient time lag for the
preparation of financial statements. For decision-making purposes, immediate availability
of financial data is a prerequisite which is not satisfied by financial accounting. In this
sense, financial accounting has the limitation. Further, as sufficient time is allowed for
the preparation of financial statements, they are expected to be accurate.

(f) Financial Accounting discloses the financial performance and financial status of the
business as a whole. It does not indicate the details about the individual department or
job or process inside the organization, the information which is more significant from
decision-making point of view. In this sense, financial accounting has the limitation.

(g) Financial statements are essentially interim reports and cannot be the final ones. E.g. In
order to understand the correct profitability and correct position of the assets and liabilities
of an organization, it will be necessary to stop the business operations, dispose off all
the assets of the organization and liquidate all the liabilities. Obviously it is not feasible
and practicable. In order to prepare the financial statements for a specific period, it may
be necessary to cut off various transactions involving costs and incomes at the date of
closing the accounts. This may involve personal judgements. Various policies and
principles are required to be formulated and followed consistently for such cutting off of
incomes and costs.

(h) As the “going concern principle” is followed while preparing the financial statements, the
various assets and liabilities are shown at the historical prices which may not necessarily
represent the current market prices or the liquidation prices. This may affect profitability

Introduction 3
also due to incorrect provision for depreciation on assets. This problem may be more
critical during the periods of extreme inflation or depression.

(i) The process of Financial Accounting gets largely affected due to the various accounting
policies followed by the accountants. Even though, attempts are being made to bring in
the uniformity in the various accounting policies followed by the accountants, still the
accounting policies may differ from organization to organization. These accounting policies
may differ basically in two fields :
l Valuation of Inventory
l Calculation of Depreciation

The effect of these different accounting polices is discussed in the following chapters.

Cost Accounting

Cost accounting is the process of classifying and recording of the expenditure in a systematic
manner with the intention of ascertaining the cost of a cost centre with the intention of controlling
the cost. The Institute of Cost and Management Accountants, London has defined Cost
Accounting as “the application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the ascertainment of profitability
as well as the presentation of information for the purpose of managerial decision making.” The
above description of Cost Accounting reveals the following characteristic features of Cost
Accounting -

(a) Cost Accounting views the organization from the angle of individual components of the
organization like department or job or process etc. Cost Accounting is interested in
ascertaining the profitability of these individual components of the organization.

(b) Cost Accounting is operated with basically three objectives -

l Ascertainment of cost and profitability with the help of various principles, methods
and techniques.

l Cost Control - This indicates the process of controlling the costs of operating the
business.

l Presentation of information to enable the managerial decision-making.

(c) Cost Accounting is meant for those people who are internal to the organization. In other
words, Cost Accounting is meant for those people who are a part of decision-making
process of the organization. The people who are external to the organization do not have
any access to the cost accounting records. In fact the basic objective of cost accounting
is to facilitate professional decision-making process on the part of managers.

4 Management Accounting
(d) Cost Accounting is not a legal requirement. Maintenance of cost accounting records is
not mandatory. However, maintenance of cost accounting records may be a legal
requirement in some exceptional cases. Section 209 (1) (d) if the Companies Act, 1956,
makes it mandatory for companies falling under certain class of industries to maintain
cost accounting records and also get them audited from an independent Cost Accountant
(which is technically referred to as “Cost Audit”).

(e) Cost Accounting does not necessarily restrict itself to the historical transactions or
historical events. Future transactions or events may find the place in cost accounting. In
fact, each and every transaction, whether past or future, which is likely to have an impact
on the business is of concern to the cost accounting.

(f) As Cost Accounting is supposed to facilitate professional decision making on the part of
manager, immediate availability of data is the prerequisite of cost accounting. As such,
accuracy is not insisted upon by cost accounting to the extent of hundred percent.

Management Accounting

Management Accounting is the process of analysis and interpretation of financial data collected
with the help of financial accounting and cost accounting with the ultimate intention to draw
certain conclusions therefrom in order to assist the management in the process of decision-
making.

Emergence of Management Accounting

In the olden days, when size of business operations was small and the complexities involved
in the same were limited, financial accounting was considered to be sufficient. Financial
Accounting ultimately aims at preparing financial statements which are basically in two forms.

(1) Profit and Loss statement which is a period statement and relates to a certain period,
usually one year. This tells about the result of operations, either profit or loss, arising out
of the conduct of business operations during that period.

(2) Balance Sheet which is a position statement and relates to a particular point of time.
This tells about the various properties held by the business (termed as ‘assets’) and
obligations accepted by the business (termed as liabilities’) as on a particular date.

The preparation of these financial statements was considered to be sufficient to serve the
requirements of all the interested parties, both outsiders as well as insiders.

However, due to the increasing size and complexities of the business operations and specifically
due to the segregation of ownership and management, only financial accounting was realised
to be insufficient. This was specifically due to certain limitations of financial accounting.

Introduction 5
(a) Financial accounting considers only those transactions which may be expressed in
financial terms, either fully or at least partially. However, it ignores the fact that there may
be other types of non-financial transactions which may have a bearing on business
operations, e.g.. Prestige of business, credit standing of business, efficiency and loyalty
of employees, efficiency and intensity of management etc.

(b) Financial accounting deals with recording of the past events and as such it is the post-
mortem record of business transactions. For taking correct decisions regarding the
business, the management may need, not only the past details but also the future
events, and future events are not the subject matter of financial accounting.

As such, financial accounting and preparation of financial statements therefrom is no longer


considered to be sufficient for successful and smooth running of business. The analysis and
interpretation of data available from financial accounting is also considered to be necessary
which may not be directly available from financial accounting itself. Here comes into the
picture Management Accounting. Management Accounting deals with, the analysis and
interpretation of financial data with the ultimate intention to draw certain conclusions therefrom,
in order to assist the management in the process of decision-making. To conclude, it may be
said that the role of management accounting has emerged due to the shortcomings of financial
accounting.

Definition of Management Accounting

The Institute of Chartered Accountants of England and Wales has defined management
accounting as “any from of accounting which enables a business to be conducted more
efficiently”.

Management Accounting Team of Anglo-American Council on Productivity has described the


term Management Accounting as “the presentation of accounting information in such a way
so as to assist management in the creation of policy and the day to day operation of an
undertaking.”

American Accounting Association has defined the term ‘Management Accounting as “the
application of appropriate techniques and concepts in processing historical and projected
economic data of an entity to assist management in establishing plans for reasonable economic
objectives and in the making of rational decisions with a view towards these objectives.”

The various definitions of the term ‘Management Accounting’ reveal the following features of
the same.

(1) Management Accounting is a service function which is concerned with providing various
information to the management to facilitate decision making and review of implementation
of those decisions.

6 Management Accounting
(2) Management Accounting uses not only the historical data but may also use the data
based on projections and forecasts for the purpose of evaluation of various possible
alternatives.

(3) Management Accounting assists the management in establishing the plans to attain the
economic objectives and in taking proper decisions required to be taken for the attainment
of these objectives.

(4) Management Accounting involves the application of various special techniques and
concepts for the attainment of its objects. The techniques used in the process of
management accounting are discussed in the following chapters.

Objects of Management Accounting

The above discussions reveal that the Management Accountant is an invaluable aid to the
management to discharge the basic functions of planning, execution and control. This is done
by -

(1) Making available accounting and other data to enable the management to plan effectively.

(2) Measuring the actual performance and reporting the same to the various levels of
management to indicate the effectiveness of the organisational methods used.

(3) Computation of deviation of actual performance from the plans and standards set.

(4) Presenting to the management the operating and financial statements at reasonable
intervals and interpreting the same to enable the management to take action/decisions
regarding future policy and operations.

Scope of Management Accounting

After considering the various objectives the Management Accounting aims at, it can be noted
that the scope of Management Accounting is much wider. It covers virtually every area and
every aspect of business operations. However, to be more precise, the various areas covered
by Management Accounting can be stated as below.

(1) Accounting : It deals with recording, summarising and analysing various business
transactions. The process of accounting may take basically two forms.

(a) Financial Accounting : It deals with recording the business transaction which are
financial in nature. It aims at the preparation of what is called financial statements
which may be basically in two forms. Firstly, the Balance Sheet which tells about
the state of affairs of the business in terms of the various assets and liabilities and
Secondly, the profitability statement which tells about the result of operations of

Introduction 7
the business i.e. profit earned or loss incurred. The financial statements are mainly
meant for the outsiders dealing with the business.

(b) Cost Accounting : It deals with recording of income and expenditure, ascertainment
of cost and profitability and the presentation of information derived therefrom for the
purpose of managerial decision making. Thus, the cost accounting is basically
meant for the management to enable it to take decisions.

(2) Cost Control Procedures : It deals with the various steps involved in the process of
controlling the cost. Thus, in turn it may deal with.
(a) Establishment of plans or budgets for the future.
(b) Comparison of actual performance with the planned or budgeted performance.
(c) Computation of variations between the planned and actual performance.

(3) Reporting : It deals with the presentation of cost data, statistical data or any other
information to the various levels of management. It may be required for the purpose of
decision making or for the purpose of fulfillment of various legal obligations.

(4) Taxation : It deals with the computation of income as per the law and filing the tax
returns and making the tax payments.

(5) Audit : It deals with devising the internal control systems and internal audit system to
cover the various operational areas of business. In many cases, it may also deal with the
management audit which is the evaluation of the managerial performance.

(6) Methods and Services : It deals with providing the management services and the
management information systems. It also deals with the various methods of reducing
the cost and improve efficiency of accounting and other office operations and preparing
and issuing the accounting and other operational manuals.

Disadvantages/Limitations of Management Accounting

In spite of the various advantages available from the management accounting in the era of ever
increasing complex business operations, it suffers from some limitations,

(1) A very wide scope of management accounting is the limitation by itself. It attempts to
operate in a wide range of areas and it is quite possible that it may not be able to make
proper justification to all of them.

(2) In spite of the fact that the management accounting provides the various details required
for qualitative decision making thus attempting to avoid the possibility of intuitive decision
making, in many cases in practice, the decisions are based upon the intuition of the
decision maker rather than the scientific data available therefor.

8 Management Accounting
(3) The installation and operation of management accounting requires a very elaborate
organisational structure and a large number of rules and regulations. It may make the
management accounting system a costly proposition which can be implemented only
by large scale organisations.

(4) Management Accounting system is still in the evolution stage and hence suffers from
the various limitations which any system may face in the initial stages like the requirement
of constant improvements of the techniques and uncertainty about the application of the
system etc.

(5) The installation and operation of management accounting system may call for the radical
changes in the entire organisational structure which may cause severe opposition and
resistance from the existing personnel.

FINANCIAL ACCOUNTING AND COST ACCOUNTING COMPARED

(a) Financial Accounting is concerned about the calculation of the profitability and state of
affairs of the organization as a whole with the help of preparation of the financial
statements. Financial Accounting takes into consideration only the historical data which
may not be of any use from the cost control point of view.

Cost Accounting may deal with the ascertainment of cost and calculation of profitability
of the individual products, departments, branches and so on. Cost Accounting involves a
much-detailed study of costs and profitability which takes into consideration not only
historical data but also the future events and possibilities. As such, cost accounting
proves to be better proposition from the cost control point of view.

(b) Due to the various statutory regulations, maintenance of financial accounting records
and preparation of financial statements therefrom is more or less a legal requirement.

Maintenance of cost accounting records is not a legal requirement except in case of


certain company form of organizations where maintenance of cost accounting records
has been made compulsory as per the provisions of Section 209 (1) (d) of the Companies
Act, 1956.

(c) Financial Accounting primarily protects the interests of the outsiders dealing with the
organization in various capacities like investors, suppliers, customers, banks, financial
institutions, government authority etc.

Cost Accounting is primarily meant for the management to enable the same to discharge
various functions in a proper manner i.e. planning, execution, co-ordination and decision-
making.

Introduction 9
This relationship between Cost Accounting and Financial Accounting can be better
explained with the help of the following illustration which states the presentation of the
profitability statement under both the sets accounting.

(a) Financial Accounting

Profit and Loss Account for the year ended on 31st march 1990.

To, Material Cost 1,50,000 By sales 5,00,000


To, Labour Cost 1,00,000
To, Factory Expenses 50,000
To, Gross Profit c/fd
(40% of sales) 2,00,000
5,00,000 5,00,000
To, Administration By Gross Profit
Expenses 90,000 C/f 2,00,000
To, Selling Expenses 50,000
To, Net Profit (12% of sales) 60,000
2,00,000 2,00,000

(b) Cost Accounting

Products

Total A B C

Material Cost 1,50,000 20,000 50,000 80,000


Labour Cost 1,00,000 15,000 30,000 55,000
PRIME Cost 2,50,000 35,000 80,000 1,35,000
Factory Expenses 50,000 20,000 10,000 20,000
FACTORY Cost 3,00,000 55,000 90,000 1,55,000
Administration Expenses 90,000 40,000 20,000 30,000
Selling Expenses 50,000 15,000 20,000 15,000
TOTAL COST 4,40,000 1,10,000 1,30,000 2,00,000
Profit 60,000 (-) 10,000 20,000 50,000
SALES 5,00,000 1,00,000 1,50,000 2,50,000
Profit % on sales 12% - 13.33% 20%

10 Management Accounting
Financial Accounting and Management Accounting compared

(a) For the purpose of extracting the data required for managerial decision-making,
Management Accounting may use the information appearing in the financial statements.
This information may be used as it is or it can be rearranged or regrouped if required. As
such, financial accounting becomes a source of information for management accounting.

(b) Financial Accounting considers only the historical financial transactions and does not
consider the non-financial transactions.

As Management Accounting aims at enabling the management to take the decisions


about the future, it may consider future data as well as non-financial factors.

(c) As stated earlier, due to the various statutory regulations, maintenance of financial
accounting records and preparation of financial statements therefrom is more or less a
legal requirement. Moreover, the format in which the financial statements are required to
be prepared is also standardized.

Management Accounting is not at all a legal requirement. Management is free to install


or not to install a management accounting system. Further, these systems have their
own reporting formats.

(d) As stated earlier, financial accounting primarily protects the interests of the outsiders
dealing with organization in various capacities like investors, suppliers, customers, banks,
financial institutions, government authorities etc.

The reports generated by management accounting are meant for the use by management
for effective decision-making.

(e) As stated earlier, the financial statements which are generated as a result of financial
accounting, report the financial performance of the organization as a whole.

Reports generated by the management accounting may deal with the various parts of
the organization. As such, management accounting reports may deal with the individual
department or the individual product also.

(f) The reports generated by financial accounting which are in the form of financial statements
are available only after the relevant accounting period is over. E.g. Balance Sheet as on
31st March 2002 is available after 31st March 2002. As such, financial accounting data
may not be available to the management for decision-making purposes. Moreover, as
the financial accounting data is available after a time lag, the financial statements are
required to be accurate.

Introduction 11
In case of management accounting, more emphasis is on making the data available to
the management as quickly as possible to facilitate the effective decision-making. If up-
to-date information is not made available to the management for decision-making,
management accounting will loose its utility. As such, accuracy is not the prerequisite
of management accounting.

Cost Accounting and Management Accounting compared

Cost Accounting and Management Accounting are similar to each other in many respects.
Both the streams of accounting primarily aim at the effective decision making on the part of
management. Both the streams of accounting are on and average not a legal requirement. The
various techniques which are used by management accounting viz. Marginal Costing, Budgetary
Control, Standard Costing, Uniform Costing etc. are basically regarded as the advanced
methods of Cost Accounting. As such Cost Accounting may be considered to be a part of
Management Accounting. Management Accounting is an extension of managerial aspects of
cost accounting with the ultimate intention to protect the interests of the business.

Techniques of Management Accounting

There may be various techniques with the help of which the basic functions of management
accounting can be discharged. We will discuss the following techniques in details in the
following chapters-

l Marginal Costing (Break Even Analysis)

l Budgetary Control

l Standard Costing

l Uniform Costing

12 Management Accounting
QUESTIONS

1. Explain the nature and characteristic features of Financial Accounting and Cost
Accounting. How are they related to each other?

2. What do you mean by Management Accounting?

State the advantages and limitations of Management Accounting. How Management


Accounting is related with other streams of accounting?

Introduction 13
NOTES

14 Management Accounting
Chapter 2
BASICS OF FINANCIAL ACCOUNTING

As stated earlier, financial accounting is the process of recording the past financial business
transactions and calculating the net result of these transactions, with the intention to
communicate the same to the various persons dealing with the business in the external
capacity. However, financial accounting is the technical process. Before we consider the
technicalities of financial accounting, let us consider some of the fundamental issues relating
to the financial accounting.

ACCOUNTING PRINCIPLES

In order to bring the uniformity in recording the business transactions, the accountants follow
certain basic procedures universally. These are referred to as the Accounting Principles. The
Accounting Principles can be classified in two categories –

a. Accounting Concepts
b. Accounting Conventions

Accounting Concepts

Accounting Concepts indicate those basic assumptions upon which the basic process of
accounting is based. Following are the important Accounting Concepts :

Business Entity Concept

This accounting concept proposes that the business is assumed to be a distinct entity than
the person who owns the business. The accounting process is carried out for the business
and not for the person who owns the business. E.g. If there is a partnership concern carrying
on the business in the name of M/s. XYZ & Co., where Mr. A and Mr. B are the equal partners,
M/s. XYZ & Co. is supposed to be a separate entity from Mr. A and Mr. B. The financial
statements prepared on the basis of accounting records are of M/s. XYZ & Co. and not of Mr.
A or Mr. B individually. It should be noted in this connection that the business entity concept
has nothing to do with the legal entity of the business. It applies to both corporate organization

Basics of Financial Accounting 15


(which by itself is a separate legal entity from the owners) as well as non-corporate organization
(which is not a legal entity separate from the owners).

Dual Aspect Concept

This concept proposes that every business transaction has two aspects. However, basic
relationship between assets and liabilities i.e. assets are equal to liabilities, remains the
same. E.g. If Mr. A starts the business by introducing the capital of Rs. 50,000, the assets
and liabilities structure will be as below -

Liabilities Assets
Capital 50,000 Cash 50,000

Now, if Mr. A uses the cash to purchase the material worth Rs. 40,000, the assets and
liabilities structure will change as below –

Liabilities Assets
Capital 50,000 Cash 10,000
Stock in Trade 40,000

50,000 50,000
If Mr. A sells the above material worth Rs. 40,000 for Rs. 45,000 on credit basis, the assets
and liabilities structure will change as below –

Liabilities Assets
Capital 55,000 Cash 10,000
Receivables 45,000

55,000 55,000

Going Concern Concept

This concept proposes that the business organization is going to be in existence for an
indefinitely longer period of time and is not likely to close down the business in the shorter
period of time. This affects the valuation of assets and liabilities. As such, the assets are
disclosed in the Balance Sheet at cost less depreciation and not at the current market price.
If the assets are to be disclosed in the Balance Sheet at correct value, the current market
price will be most suitable. However, as the business is likely to exist for an indefinitely longer
period of time and as the assets are not likely to be sold off in the market in the near future, the
market price becomes immaterial.

Accounting Period Concept

Even if the Going Concern Concept proposes that the business is going to be in existence for
an indefinitely longer period of time, in order to facilitate the preparation of financial statements
on periodical basis, the indefinitely longer life span on the business is divided into shorter time

16 Management Accounting
segments, each one being in the form of Accounting Period. Profitability is computed for this
accounting period (by preparing the profitability statement) and the finanial position is assesseed
at the end of this accounting period (by preparing the balance sheet). It should be noted that
the selection of accounting period may depend upon the various factors like characteristics of
the business organization, tax considerations, statutory requirements etc.

Cost Concept

This concept proposes that the assets acquired by the organization are recorded at their cost
of acquisition and this cost is considered for all the subsequent accounting purposes say
charging of depreciation. This concept does not take into consideration current market prices
of the various assets.

Money Measurement Concept

This concept proposes that only those transactions and facts find the place in accounting
which can be expressed in terms of money. As such, all those transactions and facts which
can not be expressed in terms of money (E.g. Morale and motivation of the workers, credibility
of the business organization in the market etc.) do not find any place in accounting and that is
why in financial statements, though they may be having direct or indirect bearing on the
business. This concept imposes severe restrictions on the kind of information available from
the financial statements. In fact, this is one of the major drawbacks of financial accounting
and financial statements.

Matching Concept

This concept proposes that while calculating profit for the accounting period in a correct
manner, the expenses and costs incurred during the period, whether paid or not, should be
matched with the revenues generated during the period. E.g. If the accounting period ends on
31st March, the salaries for the month of March should be considered as cost for the year
ending on 31st March, even if they are actually paid for in the month of April. Otherwise,
calculation of the profits for the year ending on 31st March will go wrong as the income will be
for 12 months while the expenses will be for 11 months only.

Accounting Conventions

Accounting Conventions indicate those customs and traditions that are followed by the
accountants while preparing the financial statements. Following are the important Accounting
Conventions.

Convention of Conservation

This convention is usually expressed as “anticipate all the future losses and expenses, however
do not consider the future incomes and profits unless they are actually realized.” This convention
generally applies to the valuation of current assets and as such, the current assets are valued

Basics of Financial Accounting 17


at cost or market price whichever is lower. The valuation of non-curret assets is done at cost
(as per the cost concept).

Convention of Materiality

This convention proposes that, while accounting for the various transactions, only those
transactions will be considered which have material impact on profitability or financial status
of the organization and other insignificant transactions will be ignored. E.g. If the organization
purchases some postal stamps, some of which remain unused at the end of the accounting
period. According to matching concept, the cost of such non-used postal stamps should not
be considered as the item of cost. However as its impact on the overall profitability is likely to
be negligible, the cost of non-used postal stamps may be ignored treating the cost of purchases
as the expenditure. Which transactions should be treated as material ones is a subjective
concept and depends upon the judgment and knowledge of the accountant.

Convention of Consistency

This convention proposes that the accounting polices and procedures should be followed
consistently on period-to-period basis so as to facilitiate the comparison of finanacial statements
on period-to-period basis. If there is any change in the accounting policies and procedures,
this fact coupled with its effect on profitabity should be disclosed explicitly while preparing the
financial statements.

SYSTEMS OF ACCOUNTING

a. Cash System of Accounting

In this system of accounting, expenses are considered to be the expenses only when
they are paid for and the incomes are considered to be incomes only when they are
actually received. This system of accounting is mainly used by the organizations
established not for earning the profits. This system of accounting is considered to be
defective in nature, as it may not represent the true picture of the profitability as well as
of the state of affairs.

b. Mercantile or Accrual System of Accounting

In this system of accounting, expenses are considered as expenses during the period to
which they pertain. Similarly, incomes are considered to be incomes during the period to
which they pertain. When the expenses are actually paid for or when the incomes are
actually received is not significant in case of Mercantile or Accrual system of accounting.
This system of accounting is considered to be more ideal, generally preferred by the
accountants. However, as the time of physical receipt of cash is immaterial in this system
of accounting, Accrual System of Accounting may result into the unrealized profits being

18 Management Accounting
reflected in the books of accounts on which the organization may be required to pay
the taxes also.

It will not be out of place to mention here that, as per the provisions of Section 209
of the Companies Act, 1956, all the company form of organizations are legally required
to follow Mercantile or Accrual system of accounting. Other organizations have a
choice to select either of the systems of accounting.

TYPES OF EXPENDITURE

For the purpose of accounting, the amount of money that is paid for is classified in three
ways –

a. Capital Expenditure

Capital Expenditure indicates the amount of funds paid for acquiring the infrastructural
properties required for doing the business that are technically referred to as Fixed
Assets. Fixed Assets do not give the returns during the same period during which
they are paid for. As such, benefits available from capital expenditure are long-term
benefits. Hence, it will be wrong to consider the capital expenditure as expenses
while calculating the profitability during a certain period. In technical words, capital
expenditure never affects the Profitability Statement, except in case of Depreciation,
which in simple words indicates that part of capital expenditure returns equivalent to
which are received during the corresponding period.

b. Revenue Expenditure

Revenue Expenditure indicates the amount of funds paid during a certain period with
the intention to receive the return during the same period. As such, the benefits
available from revenue expenditure are received during the same period during which
they are paid for. The entire amount of revenue expenditure affects the Profitability
Statement.

c. Deferred Revenue Expenditure

Deferred Revenue Expenditure indicates the amount of funds paid which does not
result into the acquisition of any fixed asset. However, at the same time benefits
from this expenditure are not received during the same period during which they are
paid for. The examples of Deferred Revenue Expenditure are –
a. Initial Advertisement Expenditure
b. Research and Development Expenditure
c. In case of company form of organization, Preliminary Expenses or Company
Formation Expenses.

Basics of Financial Accounting 19


Principally, Deferred Revenue Expenditure is not transferred to Profitability Statement
during the period during which they are paid for. As such, deferred revenue expenditure
does not affect the profitability of the period during which it is paid for. It is transferred to
Profitability Statement (in technical words “written off to Profitability Statement”) over the
period over which benefits are received, by passing the adjustment entry. As such,
deferred revenue expenditure affects the profitability only when they are written off to
Profitability Statement. Till they are written off to Profitability Statement, they are shown
on the Asset side of Balance Sheet.

GLOSSARY OF TERMS USED IN FINANCIAL ACCOUNTING

1. Account – Account is the record of all the transactions pertaining to a person, asset,
liability, income or expenditure which have taken place during a specified period and
shows the net effect of all these transactions finally.

2. Debit Side – Debit Side of the account is left hand side of the account.

3. Credit Side – Credit Side of the account is right hand side of the account.

4. Voucher – Voucher is any documentary evidence to justify that a particular transaction


has taken place. The voucher can be internal voucher or external voucher.

5. Entry – Entry means the record of a financial transaction in the books of accounts.

6. To debit – To debit an account means to make the entry on debit side of the account.

7. To credit – To credit an account means to make the entry on credit side of the account.

8. Journal – Journal is the Book of Original Entry or the Book of Prime Entry where the
financial transactions are recorded in the chronological order as and when they take
place.

9. Ledger – Ledger is the book where the transactions of the similar nature are pooled
together under one Ledger Account. Ledger or General Ledger as it is referred to in
practical circumstances, maintains all types of accounts i.e. Personal, Real and Nominal.
Whichever transactions are recorded in the Journal or Subsidiary Books in chronological
order, the same transactions are posted in the Ledger, account wise.

10. Narration – Narration is the summarized explanation or description of the financial


transaction recorded in the books of accounts.

11. Casting – Casting refers to totalling of the books of accounts.

12. Posting – Posting refers to the process of transferring the transaction entered into the
book or original entry or subsidiary book to the ledger account.

20 Management Accounting
13. Folio – Folio refers to the page number of the book of original entry or the ledger.

14. Brought Forward – When the balances in the ledger account or cash/bank book of the
previous year or previous period are entered in the current year’s books of accounts, the
balances are said to be Brought Forward.

15. Carried Forward – When the balances in the ledger account or cash/bank book of the
current year or current period are to be transferred to the next year’s books of accounts,
the balances are said to be Carried Forward.

16. Assets – All the properties owned by the business are collectively referred to as the
assets of the business.

17. Liabilities – All the amounts owed by the business to various providers of funds or services
are collectively referred to as liabilities.

18. Capital – Capital indicates the amount of funds invested by the owner of the business in
the business.

19. Drawings – Drawings indicates the amount of funds or goods withdrawn by the owner of
the business for the personal use.

20. Debtor – A Debtor is a customer who owes the money to the business for the goods or
services supplied to him on credit basis.

21. Creditor – A Creditor is a supplier to whom the business owes the money for the goods
or services bought from him on credit basis.

22. Debit Note – Debit Note is an intimation sent to a person dealing with the business that
his account is being debited for the purpose indicated therein.

23. Credit Note – Credit Note is an intimation sent to a person dealing with the business that
his account is being credited for the purpose indicated therein.

24. Trade Discount – Trade Discount is the discount received on purchases or discount
allowed on sales which is an adjustment with the basic purchase or sales price. Trade
discount is not accounted for in the books of accounts. Purchase value or sales value is
accounted for net of trade discount.

25. Cash Discount – Cash discount is the discount received from the suppliers or allowed to
customers for making the early payment of dues. Cash discount is accounted for in the
books of accounts. Cash discount received from the suppliers is revenue income and
cash discount allowed to the customers is revenue expenditure.

Basics of Financial Accounting 21


26. Balance Sheet – Balance Sheet is the summarized statement of what the business
owns i.e. assets and what the business owes i.e. liabilities at any given point of time.

27. Bills Payable – Bills Payable indicates the amount payable to the suppliers for which the
negotiable instrument in the form of Bill of Exchange is given to the suppliers.

28. Bills Receivable – Bills Receivable indicates the amount receivable from the customers
for which the negotiable instrument in the form of Bill of Exchange is received from the
customer.

29. Depreciation – The term Depreciation applies to fixed assets like Land, Buildings,
Machinery, Furniture, Vehicles etc. The term indicates reduction in the value of fixed
assets which can arise either due to time factor or use factor or both. A detailed note on
Depreciation Accounting is enclosed in the Annexure.

DOUBLE ENTRY SYSTEM OF ACCOUNTING

The basic presumption made by the Double Entry System of Accounting is that every business
transaction has two elements i.e. when the business receives something, it has to pay
something. Eg. If the business pays the telephone bill in cash, it gets the benefit of using the
telephone, but at the same time cash goes out. Similarly, if goods are sold to the customer for
cash, goods of the business go out, but it receives the corresponding amount of cash.
Accordingly, if Double Entry System of Accounting is followed, every business transaction
affects two accounts. One account is debited, while another account is credited by the similar
amount. Thus, Double Entry System of Accounting follows the principle of “every debit has a
corresponding credit” and hence, total of all debits has to be equal to the total of all credits.

Double Entry System of Accounting proves to be advantageous due to certain reasons –

a. It takes into consideration both the aspects of each business transaction.

b. Arithmetical accuracy of the accounting records can be verified by preparing

the Trial Balance.

c. The correct result of operations can be ascertained by preparing the final accounts
periodically.

d. Correct valuation of assets and liabilities is possible at any given point of time by preparing
the Balance Sheet.

TYPES OF ACCOUNTS

The various accounts for the purpose of Financial Accounting get classified under the following
categories –

22 Management Accounting
1. Personal Accounts - These are the accounts of persons with whom the organization
deals in various capacities. In practical circumstances, personal accounts may consist
of the following types of accounts –
Ø Accounts of the suppliers
Ø Accounts of the customers
Ø Bank / Financial Institutions
Ø Capital Account

2. Real Accounts – These are the accounts of assets and liabilities. In practical
circumstances, real accounts may consist of the following types of accounts –
Ø Land Account
Ø Building Account
Ø Machinery Account
Ø Furniture Account
Ø Vehicles Account

Real Accounts may also consist of the accounts of some intangible assets like –
Ø Goodwill Account
Ø Patents and Trade Marks Account

3. Nominal Accounts – These are the accounts of incomes or expenses. In practical


circumstances, nominal accounts may consist of following types of accounts –

Ø Salary Account
Ø Wages Account
Ø Printing & Stationary Account
Ø Insurance Account
Ø Telephone Expenses Account
Ø Interest paid or Received Account
Ø Commission paid or Received Account

RULES OF DOUBLE ENTRY BOOK KEEPING

While entering into various financial transactions in the records maintained by the organization,
following basic rules for accounting are followed –
a. In case of Personal Accounts – Debit the Receiver, Credit the Giver
b. In case of Real Accounts – Debit What Comes in, Credit What Goes out
c. In case of Nominal Accounts – Debit all the expenses, Credit all the incomes

Basics of Financial Accounting 23


ANNEXURE

Depreciation Accounting

Depreciation can be defined as a permanent, continuous and gradual reduction in the book
value of a fixed asset. Normally, all the fixed assets except land, depreciate in value rendering
the asset useless after the end of certain specific period. Following may be stated as the main
causes of depreciation.

(1) Use factor : The fixed assets depreciate because they are used for the purpose they are
meant for. It is applicable in case of tangible assets like machinery, furniture, office
equipments etc.

(2) Time factor : The fixed assets depreciate due to the passage of time.

(3) Obsolescence : It is the reduction in the value of fixed assets, say a machine, due to its
supersession at a date before it is completely worn out. It may take place due to new
inventions, modifications or improvements.

Need for Depreciation Accounting :

According to the nature of fixed assets, these are those assets which may be used for the
business purposes over a certain number of future accounting periods and the benefit received
from them is spread over the said number of future accounting periods. According to the
matching principle of accounting, the costs incurred during an accounting period are required
to be matched with the benefits or revenues earned daring that period. Hence, it is necessary
to distribute the cost of a fixed asset, less the scrap or salvage or realisable value, after the
useful life of the fixed asset is over, in such a way so as to allocate it as equitably as possible
to the periods during which the benefits are received from the use of fixed assets. This system
or procedure is called depreciation accounting. Thus the depreciation accounting is necessary
for two main purposes.

(a) To ascertain due profits by correctly matching the various costs and expenses incurred
with various incomes and revenues earned during various accounting periods.

(b) To represent the value of a fixed asset on the Balance Sheet at its unexpired cost i.e. at
book value less depreciation. If depreciation is not provided, the asset may appear in the
Balance Sheet at an overstated amount.

It may also be noted in this connection that the depreciation forms a part of cost for arriving at
the profits which can be distributed to the owners of the business in the form of dividend. By
providing the depreciation, the amount of distributable profits is reduced and retained in the
business, which can be utilized for the replacement of the asset at the end of its economic
life.

24 Management Accounting
Methods for Calculating Depreciation :

There may be various methods available for calculating the amount of depreciation to be
charged to Profit and Loss Account. Amount of depreciation is a function of various factors.

(1) Time, (2) Usage, (3) Time and Usage, (4) Time and Cost of maintaining the fixed asset,
(5) Provision of funds for replacing the assets.

As such the various methods available for charging the depreciation can be described as
below.

(1) Straight Line Method :

According to this method, the amount of yearly depreciation is calculated as below.

Cost of asset - Estimated scrap value


Estimated life in years

Eg. C = Cost of Asset. Rs. 1,10,000

Estimated scrap value


(At the end of life of the asset) Rs. 10,000

Estimated life 10 years


Rs. 1,10,000 - Rs. 10,000
∴ Yearly depreciation =
10 years

= Rs. 10,000

The benefit of this method is that equal amount of depreciation is charged every year throughout
the life of the asset, making the calculation of depreciation and cost comparison easy. The
main drawback of this method is that the amount of depreciation in later years is high when
the utility of the asset is reduced.

(2) Written Down Value (Reducing Balance) Method :

According to this method, the depreciation is provided at a predetermined percentage, on the


balance of cost of asset after deducting the depreciation previously charged (usually termed
as written down value).

Eg. Cost of asset Rs. 1,10,000


Estimated scrap value Rs. 10,000
Cost of asset subjected to depreciation Rs. 1,00,000
Rate of depreciation 10%

Basics of Financial Accounting 25


The amount of depreciation is calculated as shown below.

Year Balance Cost Depreciation Written Down


of Assets Value - WDV
Rs. Rs. Rs.

1 1,00,000 10,000 90,000


2 90,000 9,000 81,000
3 81,000 8,100 72,900
4 72,900 7,290 65,610
5 65,610 6,561 59,049

The rate of depreciation to be charged is calculated according to the following formula.

R
D = 1- n
C
where n = number of years
R = Residual / Scrap Value
C = Cost of the asset

The main benefit of this method is that it recognizes the fact that in the initial years of life of the
asset, the repairs and maintenance cost is less which goes on increasing gradually with the
progressing life of asset. According to this method, the higher amount of depreciation in the
initial years and a gradual decrease therein is counterbalanced by the lower amount of repairs
and maintenance cost in the initial years and a gradual increase therein. It should be noted
here that the written down value can never become zero.

(3) Production Unit Method :

According to this method, depreciation is provided at a predetermined rate per unit which in
turn is calculated on the basis of total number of units lo be produced during the life of the
asset.

Eg. Cost of the machine Rs. 1,10,000

Estimated scrap value Rs. 10,000

Estimated number of units to be produced 50,000

Rs. 1,10,000 - Rs. 10,000


∴ Rate of depreciation per unit =
50,000 units

= Rs. 2

26 Management Accounting
If in a particular year, 7,000 units are produced, the depreciation to be charged will be :
7,000 units x Rs. 2 per unit = Rs. 14,000.

This method gives more stress on usage factor rather than time factor. Higher the number of
units produced, higher is the amount of depreciation and vice versa.

(4) Production Hour Method :

This method is similar to the production unit method except that instead of number of units to
be produced during the life of asset, number of hours for which the asset is expected to work
are taken into consideration.

Eg. Cost of the machine Rs. 1,10,000

Estimated scrap value Rs.10,000

Estimated number of hours 25,000

∴ Rate of depreciation per hour = Rs. 1,10,000 - Rs. 10,000


25,000 hours

= Rs. 4

If in a particular year, the machine works for 2,500 hours, the depreciation to be charged will
be :
2,500 hours x Rs. 4 per hour = Rs. 10,000

(5) Joint Factor Rate Method :

According to this method, the depreciation is provided partly at a fixed rate on time basis and
partly at a variable rate on usage basis.

Eg. Cost of the machine Rs. 1,00,000

To be depreciated on time basis over life of the machine


i.e. 10 year Rs. 50,000

Estimated number of units to be produced 50,000

Depreciation :

(a) On time basis - Rs. 50,000


= Rs. 5,000 per year
10 years

(b) On usage basis - Rs. 50,000


= Re. 1 per unit
50,000 units

Basics of Financial Accounting 27


If in a particular year, the machine produces 6,000 units, the depreciation to be charged
will be :

Time basis Rs. 5,000


Usage basis 6,000 units x Re. 1 Rs. 6,000
Rs. 11,000

(6) Annuity Method :

This method assumes that the amount of capital invested in the fixed assets would have
earned interest had it been invested otherwise. The depreciation to be charged under this
method is a constant proportion of the aggregate of the cost of the asset depreciated and
interest at the specific rate on written down value of the asset at the beginning of each period.

Eg. Cost of the asset (c) Rs. 1,00,000

Life of the asset (n) 5 years

Rate of interest (r) 10%

Depreciation to be charged is calculated as below.

Cxr 1,00,000 x 0.10


D = = = Rs. 26,380
1 1
1- 1-
(1 + r)n -1 (1.10)5 -1
Year Cost/WDV Interest Total Depreciation WDV C/fd
Rs. Rs. Rs. Rs.
1 1,00,000 10,000 1,10,000 26,380 83,620
2 83,620 8,362 91,982 26,380 65,602
3 65,602 6,560 72,162 26,380 45,782
4 45,782 4,578 50,360 26,380 23,980

5 23,980 2,400 26,380 26,380 Nil

The amount of depreciation is very high under this method and covers the opportunity cost of
non-investment of the capital anywhere else.

(7) Sinking Fund Method :


Unlike any other method, this method attempts to make available funds equivalent to the
original cost of asset, at the end of useful life of the asset. According to this method, depreciation
to be charged is the fixed period charge which is invested at a compound rate and the amount
of investmen with the compounded interest earned over the life of the asset equals to the
original cost of the asset.

28 Management Accounting
Eg. Cost of the asset (c) Rs. 1,00,000
Life of the asset (n) 5 years
Rate of interest (r) 10%

Depreciation to be charged is calculated as below :

Cxr 1,00,000 x 0.10


D = = = Rs. 26,380
n
(1 + r) - 1 (1.10)5 - 1

Year Bal. B/fd Interest Annual Annual Bal.c/fd


Provision Investment
Rs. Rs. Rs. Rs. Rs.

1 – – 16,380 16,380 16,380


2 16,380 1,638 16,380 18,018 34,398
3 34,398 3,440 16,380 19,820 54,218
4 54,218 5,422 16,380 21,802 76,020

5 76,020 7,600 16,380 23,980 1,00,000

(8) Endowment Policy Method :

This method is similar to sinking fund method. Under this method, an insurance policy is
taken out for the amount required to replace the asset at the end of life of the asset. The
amount of depreciation to be charged is equal to the annual premium payable on the insurance
policy, which is decided by the insurance company.

(9) Revaluation Method :

According to this method, the asset is revalued periodically. The amount of depreciation for
that period is the difference between the cost of the asset at the beginning of the period and
the amount of revaluation at the end of the period.

This method of charging the depreciation is extensively used for the assets like livestock,
patterns etc.

(10) Renewal Method :

According to this method, the full cost of the asset is charged as depreciation during the
period in which asset is renewed. No depreciation is charged in between the period. This
method of charging can be used if the asset is of small value and is renewed frequently.

Basics of Financial Accounting 29


Practical considerations relating to depreciation

1. In spite of the fact that there are various methods available for calculating the depreciation,
the final choice of the method depends upon the individual organization. It should be
noted that Income Tax Act, 1961 which is a very important piece of legislation applicable
to all types of business organizations, recognizes only one method for calculating the
depreciation i.e. Written Down Value method. The rates at which the depreciation is to
be calculated are also specified in the Income Tax Act, 1961. If the organization wants to
calculate the depreciation on some different basis or at some different rates, it can do so
for financial accounting purposes. However, for calculating the tax liability, the depreciation
has to be calculated on Written Down Value basis and that too at the specified rates.

2. The company form of organizations to whom the provision of Companies Act, 1956 apply
are required to calculate the depreciation as per the provisions of Schedule XIV of the
Companies Act, 1956. The salient features of Schedule XIV of the Companies Act, 1956
can be stated as below -

a. Schedule XIV of the Companies Act, 1956 provides that the company can calculate
the depreciation by using either Written Down Value method or Straight Line method.
The companies are given the choice to select between these two methods. The
actual choice of the method may depend upon the effect on the profitability of the
company. If the company wants to change the method of calculating the depreciation,
it amounts to the change in accounting policy. Any change in the method of
calculating the depreciation has to be effected with retrospective effect from the
date of incorporation of the company. The company is required to disclose the fact
of change in the method of calculating the depreciation while preparing its financial
statements along with the effect of change in the method of calculating the
depreciation.

b. The rates at which the companies are required to calculate the depreciation are
also specified in Schedule XIV. For this purpose, the fixed assets are classified in
various categories. The broad categorization of the fixed assets is as below -

l Buildings - Factory Building as well as Administration Buildings


l Plant and Machinery
l Furniture
l Vehicles
l Computer Installations

30 Management Accounting
The rates for calculation of depreciation are as below -

Nature of the Fixed Assets WDV SLM


Buildings - Factory 10% 3.63%
Buildings - Administrative 5% 1.63%
Plant and Machinery 15% 4.75%
Furniture 10% 6.33%
Vehicles 20% 9.5%
Computer Installations 40% 16.21%

c. If during the financial year, any addition has been made to any asset or any asset
has been sold, the depreciation on such asset will be calculated on a pro rata basis
from the date of such addition or upto the date on which such asset has been sold.

There are some of the questions which are normally raised in respect of the nature
of depreciation.

(1) Is Depreciation a cost?

Yes, depreciation is a cost because of the obvious reasons that it reduces the
profitability and it is a charge against the profit. At the same time, it should
also be noted that it is a non-cash cost as it is never paid or incurred in cash.

(2) Does Depreciation generate funds for replacement of assets?

If the depreciation is provided under the Sinking Fund Method or Endowment


Policy Method, sufficient funds may be available, at the end of life of the
asset, equivalent to the original cost of the asset. As such, it can be said that
these two methods make available the funds equivalent to the original cost of
the asset at the end of life of the asset. However these funds may not be
sufficient to replace the asset due to the increased price of the same. Other
methods of charging the depreciation do not directly generate the funds required
for replacing the assets. The fact that the assets are depreciated to the extent
of almost entire of the original cost of the same, does not indicate that the
funds are available for the replacement purpose. However, depreciation may
be viewed from one more angle. It is a charge to profits which reduces the
profits which can be distributed among the shareholders by way of dividends,
thus conserving the business funds in the business itself. This may be
considered to be a very very indirect way of interpretation that the depreciation
involves a source of funds.

Basics of Financial Accounting 31


QUESTIONS

1. What do you mean by various accounting principles? Explain the various accounting
concepts and conventions used in the financial accounting.

2. Distinguish between the following pairs of terms.

– Cash Basis of Accounting and Accrual Basis of Accounting

– Revenue Expenditure and Capital Expenditure

– Written Down Value Method and Straight Line Method of Depreciation

– Depreciation as per Companies Act and Income Tax Act

3. What do you mean by depreciation? What are the objectives for calculating the
depreciation? Explain the various methods for calculating the depreciation.

4. Write an essay on “Depreciation”.

32 Management Accounting
NOTES

Basics of Financial Accounting 33


NOTES

34 Management Accounting
Chapter 3
PROCESS OF ACCOUNTING

JOURNALIZING

Journalizing refers to the process of recording the business transaction in the Journal that is
referred to as the Book of Original Entry or the Book of Prime Entry. The various transactions
are entered in the journal in the chronological order, as and when the transactions take place.

The Journal may look as stated below –

Journal

Date Particulars L.F. Debit – Rs. Credit – Rs.


a b c d e
Account (To be Debited) – Dr.
To, Account (To be Credited)
Narration

The Journal may be subdivided in the following five columns –

a. Date – It refers to the date on which a particular transaction has taken place.

b. Particulars – It refers to titles of the account to be debited or credited. Title of the


account to be debited starts from the extreme left and the abbreviation “Dr.” is written to
the extreme right of the same column on the same line. Title of the account to be
credited is entered on the next line preceded by the words “To” leaving some space from
the extreme left. In the same column on the next line, brief description of the transaction
is written which is referred to as “Narration”. The narration conventionally starts with the
wording “Being”.

c. L.F. – This is the abbreviation of Ledger Folio. This column refers to the page number of
the ledger. The nature of Ledger is discussed in the following paragraphs.

d. Amount Debited – The amount to be debited is stated in this column.

e. Amount Credited – The amount to be credited is stated in this column.

Process of Accounting 35
Illustration

Journalize the following transactions in the books of Mr. Amit Sen –

a. Mr. Sen commenced business with cash Rs. 10,000, Machinery Rs. 10,000, Buildings
Rs. 30,000 and Furniture Rs. 15,000.

b. Installed and paid for Neon Sign Board at a cost of Rs. 1,000

c. Mr. Sen borrowed Rs. 25,000 from his wife and the same were deposited by him in bank
to open an account.

d. Mr. Sen purchased goods for Rs. 7,000 for cash.

e. Mr. Sen purchased goods worth Rs. 10,000 from Mr. Rao on credit @2% Cash Discount.

f. Sold goods to Ramdas worth Rs. 15,000 against cash after allowing 5% Trade Discount.

g. Paid Rs. 1,995 to Mr. Rajesh for purchases of goods after allowing 5% Cash Discount on
the invoice.

h. Sent a cheque of Rs. 1,000 to Chief Minister’s Fund as Mr. Sen’s personal contribution.

i. Placed an order for goods worth Rs. 2,000 with M/s Archana Traders.

j. A personal table fan worth Rs. 450 brought in the office for office use.

Solution

In the Books of Mr. Amit Sen

Date Particulars L.F. Debit – Rs. Credit – Rs.

Cash A/c 10,000


Machinery A/c 10,000
Building A/c 30,000
Furniture A/c 15,000
To, Capital A/c 65,000

(Business started with cash,


machinery, building and furniture)

Advertisement A/c 1,000


To, Cash A/c 1,000
(Being paid for neon sign board
installed)

36 Management Accounting
Date Particulars L.F. Debit – Rs. Credit – Rs.

Bank A/c 25,000


To, Loan from Mrs. Sen A/c 25,000
(Being the amount borrowed from
Mrs. Sen to open account with the
bank)

Purchases A/c 7,000


To, Cash A/c 7,000

(Being paid for cash purchases)

Purchases A/c 10,000


To, Cash A/c 9,800
To, Discount Received 200

(Being purchases worth Rs. 10,000


after getting 2% cash discount)

Cash A/c 14,250


To, Sales 14,250
(Sold goods worth Rs. 15,000 after
allowing trade discount of 5%)

Purchases A/c 2,100


To, Cash A/c 1,995
To, Discount Received 105

(Paid Rs. 1,995 for goods purchased


after getting 5% cash discount)

Drawings A/c 1,000


To, Bank A/c 1,000

(Being donation paid to Chief Minister’s


Fund as Mr. Sen’s personal contribution)

No Journal Entry will be passed, as the


transaction is not a financial transaction.

Furniture A/c 450


To, Capital A/c 450

(Being the personal table fan brought


for office use)

Process of Accounting 37
Compound Journal Entry

If the similar transactions take place on the same day and the same account is either debited
or credited, instead of passing different journal entries, it can be accounted for by passing a
compound journal entry. It avoids duplication and makes the journal less bulky.

Illustration

Mr. A commenced the business with cash Rs. 10,000, Machinery worth Rs. 25,000 and the
Computer worth Rs. 50,000. The transaction will be journalized as below –

Date Particulars L.F. Debit – Rs. Credit – Rs.

1.4.2002 Cash A/c 10,000


Machinery A/c 25,000
Computer A/c 50,000
To, Capital A/c 85,000
(Commenced business with cash,
machinery and computer)

SUBSIDIARY BOOKS

If the volume of transactions is very large, recording all the transactions in the Journal may
prove to be a voluminous job. Hence, the transactions of the similar nature may be entered
into a separate Subsidiary Book and the net effect of the similar transactions may be transferred
into the main records.

In the practical circumstances, following subsidiary books are used very frequently –

a. Cash Book – This records all the cash transactions i.e., Cash Receipts and Cash
Payments. In some cases, Cash and Bank Book may be maintained which records
Cash as well Bank Receipts and Cash as well as Bank Payments.

The Cash and Bank Book may look as below –

Date Particulars L.F. Cash Bank Date Particulars L.F. Cash Bank

b. Purchases Register or Purchases Day Book – This records all the credit purchases
transactions.

Date Name of the Supplier L.F. Invoice No. Amount

Note : “L.F.” stands for Ledger Folio Number which indicates the Page Number in the
Creditors’ Ledger as the Control Ledger. The term Control Ledger is discussed in the
following paragraphs.

38 Management Accounting
c. Sales Register or Sales Day Book – This records all the credit sales transactions.

The Sales Register may look as stated below –

Date Name of the Customer L.F. Invoice No. Amount

Note : “L.F.” stands for Ledger Folio Number which indicates the Page Number in the
Debtors’ Ledger as the Control Ledger. The term Control Ledger is discussed in the
following paragraphs.

d. Purchases Returns Register – This records the transactions of return of goods to the
suppliers from whom purchases were made on credit basis.

The Purchases Return Register may look as stated below –

Date Name of the Supplier L.F. Debit Note No. Amount

Note : “L.F.” stands for Ledger Folio Number which indicates the Page Number in the
Creditors’ Ledger as the Control Ledger. The term Control Ledger is discussed in the
following paragraphs. The Debit Note stands for an intimation sent to the supplier at the
time of returning the goods which informs the supplier that his account is being debited
on account of goods returned to him.

e. Sales Returns Register – This records all the transactions of return of goods by the
customers to whom sales were made on credit basis.

The Sales Return Register may look as stated below –

Date Name of the Customer L.F. Credit Note No. Amount

Note : “L.F.” stands for Ledger Folio Number which indicates the Page Number in the
Debtors’ Ledger as the Control Ledger. The term Control Ledger is discussed in the
following paragraphs. The Credit Note stands for an intimation sent to the customer at
the time of accepting the returned goods which informs the customer that his account is
being credited on account of goods returned by him.

f. Journal Proper – This records all the residual transaction which cannot be entered into
any other subsidiary book.
The transactions which can be entered in the Journal proper are –
a. Opening Entries
b. Closing Entries
c. Rectification Entries
d. Adjustment Entries

Process of Accounting 39
LEDGER POSTING

If Journal or Subsidiary Books are the books which record of the transactions in the chronological
order, Ledger is the book where the transactions of the similar nature are pooled together
under one Ledger Account. Ledger or General Ledger as it is referred to in practical
circumstances, maintains all types of accounts i.e. Personal, Real and Nominal. Whichever
transactions are recorded in the Journal or Subsidiary Books in chronological order, the same
transactions are posted in the Ledger, account wise. Thus, a ledger account can be defined
as the record of all the transactions pertaining to a person, asset, liability, income or expenditure
which have taken place during a specified period and shows the net effect of all these
transactions finally. As such, the transactions are first entered into Journal or Subsidiary
Book when they take place and from there they are transferred to Ledger and this process is
called as Ledger Posting.

The Ledger Account may be maintained in two ways –

Type I

Dr. Cr.

Date Particulars Folio Rs. Date Particulars Folio Rs.

Type II

Date Particulars Folio Debit Credit Balance


Rs. Rs.

Control Ledgers

In practical circumstances, if the transactions of purchases and sales are very large, it may
not be feasible to carry the accounts of all the suppliers and customers in the Main or General
Ledger. In such cases, apart from the Main Ledger or General Ledger, the Control Ledgers can
be maintained. Control Ledgers carry the individual accounts whereas the Main Ledger or
General Ledger records the consolidated effect of the individual transactions. As such, the
balance shown by the consolidated account in the Main Ledger or General Ledger has to tally
with the balances in the individual ledger accounts maintained in the control ledger. In practical
circumstances, control ledgers may be maintained for the following purposes –

a. Sundry Debtors
b. Sundry Creditors
c. Advances to Staff

40 Management Accounting
Balancing of Ledger Accounts

To ascertain the net effect of all the transactions recorded in the Ledger Account, the account
is required to be “balanced”. Balancing of Ledger Account involves the following steps –

a. Take the total of both sides of the Ledger Account.


b. Calculate the difference between totals of both the sides.
c. If the total of debit side is heavier, place the difference on the amount column of credit
side by writing “By Balance c/fd”. If the total of credit side is heavier, place the difference
on the amount column of debit side by writing the “To Balance c/fd”. If the balance
appears on the credit side, the account will be considered to have Debit Balance. If the
balance appears on the debit side, the account will be considered to have Credit Balance.
d. After balance is placed on the appropriate side, ensure that totals of both the sides
match with each other.

Illustration

Machinery Account

Date Particulars Folio Rs. Date Particulars Folio Rs.

01.04.01 Balance b/fd 25,000 31.03.02 Depreciation 10,000


10.04.01 Bank 70,000 31.03.02 Balance c/fd 85,000
(Balancing figure)
95,000 95,000

Steps explained –

a. Before considering the Balancing Figure, the total of debit side is Rs. 95,000 and the
total of credit side is Rs. 10,000. As such, debit side is heavy.

b. Difference between both the sides is Rs. 85,000.

c. As the debit side is heavy, the difference of Rs. 85,000 is put on the credit side.

Trial Balance

Trial Balance is the summary of all the balances in all the accounts listed in the General
Ledger and Cash / Bank Book of an organization at any given date. Tallying of the Trial
Balance is the evidence of the fact that all the transactions have properly been posted in the
General Ledger. As such, tallying of Trial Balance generally ensures the arithmetical accuracy
of the process of Ledger Posing.

Process of Accounting 41
Format of Trial Balance

Trial Balance as on 31st March 2002

Name of the Account Debit Credit

For the preparation of Trial Balance, all the accounts in the General Ledger need to be balanced
to ascertain the Closing Balance. Similarly, Cash Book / Bank Book is also required to be
balanced to ascertain the Closing Balance. Accounts having the Debit Balance are shown on
the Debit Side whereas the accounts having the Credit Balance are shown on the Credit Side.
Generally, accounts of the assets will have Debit Balance and hence will be shown on Debit
Side. Generally, accounts of all liabilities will have Credit Balance and hence will be shown on
Credit Side. Generally, accounts of all the Expenses will have Debit Balance and hence will be
shown on Debit Side. Generally, accounts of all the Incomes will have Credit Balance and
hence will be shown on Credit Side.

PREPARATION OF FINAL ACCOUNTS FROM TRIAL BALANCE

Preparation of the financial statements is the basic objective of financial accounting. These
financial statements are basically in two forms –

a. Profitability Statement – This financial statement is referred to as “Profit and Loss


Account” in more technical language. The purpose of this financial statement is to disclose
the result of operations of the business transactions during a given period of time. As
such, by nature Profit & Loss Account is a period statement which relates to a specific
duration of time. Hence, Profit and Loss Account is always referred to as “Profit and
Loss Account for the year ended on 31st March 2002.”

b. Balance Sheet – The purpose of this financial statement is to disclose the financial
status of the organization in terms of its assets and liabilities at any given point of time.
Thus, in simple language, Balance Sheet is a listing of the assets and liabilities of an
organization at any given point of time. Whichever sources are used by an organization
for raising the required amount of funds create an obligation or liability for the organization
and whichever ways the funds are used or applied by an organization create the properties
or assets for the organization. Hence, in practical circumstances, the liabilities are referred
to as “Sources of Funds” and the assets are referred to “Application of Funds”. As such,
by nature Balance Sheet is a position statement in the sense it relates to a specific
point of time or date. Hence, Balance Sheet is always referred to as “Balance Sheet as
on 31st March 2002.”

42 Management Accounting
PROFIT AND LOSS ACCOUNT

As stated earlier, Profit and Loss Account is prepared to disclose the result of operation of the
business transactions during a certain duration of time. In technical language, Profit and Loss
Account may have following four components –

a. Manufacturing Account – This part of Profit and Loss Account discloses the result of
manufacturing operations carried out by the organization. The final result disclosed by
the Manufacturing Account is the Cost of Production incurred by the organization.
Following is the specimen of Manufacturing Account.

Manufacturing Account for the year ended on 31st March 2002

Particulars Amount Particulars Amount


Opening Stock Closing Stock
Raw Material Raw Material
Work in Progress Work in Progress

Purchases of Raw Material Cost of Production


Carriage Inward (Transferred to Trading Account)
Wages Paid
Power and Fuel
Consumable Stores
Manufacturing Expenses
Depreciation on Production
Assets

Total Total

b. Trading Account – This part of Profit and Loss Account discloses the result of trading
operations carried out by the organization. The final result disclosed by the Trading
Account is the Gross Profit earned by the organization. Following is the specimen of
Trading Account.

Process of Accounting 43
Trading Account for the year ended on 31st March 2002
Particulars Amount Particulars Amount
Opening Stock Sales (Net of Sales Returns)
Finished Goods

Closing Stock
Cost of Production Finished Goods
(Brought from Manufacturing A/c)

Gross Profit

Total Total

c. Profit and Loss Account – This part of Profit and Loss Account discloses the final
result of business transactions of the organization. The final result disclosed by the
Profit and Loss Account is the Profit After Tax (PAT) earned by the organization. Following
is the specimen of Profit and Loss Account.

Profit & Loss Account for the year ended on 31st March 2002
Particulars Amount Particulars Amount
Administrative Expenses Gross Profit b/fd
Office Salaries
Postage & Telephone Other Income
Traveling & Conveyance Discount Received
Legal Charges Commission Received
Office Rent
Depreciation Non-Trading Income
Audit Fees Interest Received
Insurance Rent Received
Repairs & Renewals

Abnormal Income
Selling & Distribution Expenses Profit on the sale of assets
Advertisement
Carriage Outward
Free Samples
Bad Debts
Sales Commission

44 Management Accounting
Particulars Amount Particulars Amount
Financial Expenses
Interest & Bank Charges

Other Expenses
Loss on the sale of assets
Salary to Working Partners
Interest on Capital
Provision for Taxation

Net Profit after Taxes


(Transferred to Capital Account)

Total Total

d. Profit and Loss Appropriation Account – This part of Profit and Loss Account, which
is mainly applicable to company form of organization, discloses the manner in which the
PAT earned by the organization is appropriated. The amount of profit not appropriated or
retained is transferred to Reserves and Surplus in the Balance Sheet. Following is the
specimen of Profit and Loss Appropriation Account.

Profit & Loss Appropriation Account for the year ended on 31st March 2002
Particulars Amount Particulars Amount
Dividend Paid Profit After Tax b/fd

Transferred to Reserves Amount withdrawn from Reserves

Balance transferred to Balance Sheet

Total Total

BALANCE SHEET

As stated earlier, the purpose of preparing the Balance Sheet is to disclose the financial
status of the organization in terms of its assets and liabilities at any given point of time. As
such, the Balance Sheet has two sides –

a. Liabilities
b. Assets

Process of Accounting 45
Liabilities

Credit balances in all the Personal and Real Accounts appear on Liabilities side. Following
items may appear on the liabilities side –

a. Capital
Capital indicates the amount of funds contributed by the owners of the business to the
requirement of funds of the business. As owner of the business is considered to be a
separate entity than the business itself, any amount contributed by the owner is a liability
for the business. Similarly, any amount of profit earned in the past which is not distributed
to the owner also belongs to the owner and becomes a part of the capital.

b. Long Term Liabilities


This indicates the liabilities which are to be paid off over a longer span of time say 5 to 10
years. In practical circumstances, it may consist of long-term loan borrowed from banks
or financial institutions.

c. Current Liabilities
This indicates the liabilities which are supposed to be paid off within a very short span of
time say one year. In practical circumstances, it may consist of the flowing items –

1. Sundry Creditors – Amounts payable to the suppliers of goods and/or services.


2. Advances received from customers – This amount may not be paid back to the
customers. It gets adjusted with the final selling price. Till it is adjusted with the
selling price, it appears as a current liability.
3. Outstanding Expenses – This amount indicates the expenses already incurred
during the relevant period but not paid for.
4. Income Received in Advance
5. Liability for taxes

Assets

Debit balances in all the Personal and Real Accounts appear on Asset side. Following items
may appear on the assets side –

a. Fixed Assets
As stated earlier, fixed assets indicate the value of infrastructural properties acquired by
the business where the benefits are likely to be received over a longer duration of time.
Fixed assets are the assets which are not supposed to be sold, but they are supposed
to be used to do the business to earn the profits. Some of the fixed assets which can be
found in practical circumstances are Land, Building, Machinery, Furniture, Vehicles, and
Computers etc.

46 Management Accounting
b. Investments
This indicates the amount of funds invested by the organization outside the business.

c. Current Assets
Current Assets are the assets which are likely to be converted in the form of cash or
likely to be consumed during the normal operating cycle of the business within a very
short span of time say one year. The purpose of holding the current assets is to sell the
current assets or use them during the normal course of operations. Current assets
change their form very frequently while doing the business. Some of the current assets
which can be found in practical circumstances are Stock, Sundry Debtors, Cash & Bank
Balances, Prepaid Expenses etc.

Following is the specimen of Balance Sheet.

Balance Sheet as on 31st March 2002


Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets
Land
Long Term Liabilities Building
Loan from Bank Machinery
Furniture
Current Liabilities Vehicles
Sundry Creditors Computers
Advance from Customers
Outstanding Expenses Investments
Income Received in Advance
Current Assets
Stock
Sundry Debtors
Cash Balance
Bank Balance
Prepaid Expenses

Total Total
Adjustments

While preparing the final accounts from the Trial Balance, it should be remembered that the
Trial Balance might not reflect all the transactions which have the impact on profitability for the
relevant period or the state of affairs of the organization on a particular date. As such, before
preparing the final accounts, the effect of such transactions needs to be considered. The
same is done by passing the Adjustment Entries. Thus, the effect of Adjustment Entries is yet

Process of Accounting 47
to be reflected in the Trial Balance. As such, according to the Double Entry principles, the
Adjustment Entries always have two effects. Following are some of the main adjustment
entries made while preparing the final accounts from the Trial Balance.

a. Closing Stock

This indicates the amount of stock in hand on the date of Balance Sheet. The basic
principle on which the closing stock is valued is at cost or market price whichever is
less. Accordingly, the first effect of the closing stock is that it is shown on the credit side
of Manufacturing and/or Trading Account and the second effect is that it is shown on
Balance Sheet Asset side. The Journal Entry passed for this is –

Closing Stock A/c Dr.


To, Trading Account

b. Depreciation

This indicates the reduction in the value of fixed assets due to wear and tear. As the
basic cost of the fixed assets is not transferred to Profit and Loss Account, this adjustment
is necessary to reflect the cost for the use of fixed asset during the year. Accordingly,
the first effect of the adjustment for Depreciation is that the amount is debited to Profit &
Loss Account reducing the profit or increasing the loss and the second effect is that the
corresponding amount is reduced from the value of fixed asset in the Balance Sheet. In
other words, the value of fixed assets in the Balance Sheet is net of depreciation. The
Journal Entry passed for this is –

Depreciation A/c Dr.


To, Fixed Asset A/c

c. Outstanding Expenses

This indicates the amount of expenses pertaining to the relevant period which are not
paid during the said period. According to Matching Principle of Accounting, income for a
certain period needs to be compared with the expenses for the same period, whether it
is paid for or not. Accordingly, the first effect of this adjustment is that the corresponding
amount of expenses are increased reducing the profit or increasing the loss and the
second effect is that the corresponding amount is shown as Current Liability on the
Balance Sheet liabilities side. The Journal Entry passed for this is –

Expenses A/c Dr.


To, Outstanding Expenses A/c

48 Management Accounting
d. Prepaid Expenses

This indicates the amount of expenses pertaining to the next period which are paid in
advance during the relevant period. According to Matching Principle of Accounting, income
for a certain period needs to be compared with the expenses for the same period.
Accordingly, the first effect of this adjustment is that the corresponding amount of
expenses are reduced, thus increasing the profit or reducing the loss and the second
effect is that the corresponding amount is shown as Current Asset on the Balance Sheet
Asset side. The Journal Entry passed for this is –

Prepaid Expenses A/c Dr.


To, Expenses A/c

e. Accrued Income

This indicates the amount of income for the current period which is not received during
the current period. According to Matching Principle of Accounting, income for a certain
period needs to be compared with the expenses for the same period. Accordingly, the
first effect of this adjustment is that the corresponding amount of income is increased,
thus increasing the profit or reducing the loss and the second effect is that the
corresponding amount is shown as Current Asset on the Balance Sheet Asset side. The
Journal Entry passed for this is –

Accrued Income A/c Dr.


To, Income A/c

f. Income Received in Advance

This indicates the amount of income for the next period which is received during the
current period. According to Matching Principle of Accounting, income for a certain
period needs to be compared with the expenses for the same period. Accordingly, the
first effect of this adjustment is that the corresponding amount of income is reduced,
thus reducing the profit or increasing the loss and the second effect is that the
corresponding amount is shown as Current Liability on the Balance Sheet Liabilities
side. The Journal Entry passed for this is –

Income A/c Dr.


To, Income received in advance A/c

g. Bad Debts

This indicates the unrecoverable amount from the customers on account of credit sales
made to them. If the customer is not likely to pay the amount due from him, the same is
written off as Bad Debts. Accordingly, the first effect of this adjustment is that the amount

Process of Accounting 49
of Bad Debts is debited to Profit and Loss Account, thus reducing the profits or increasing
the losses and the second effect is that the amount of Sundry Debtors is reduced. The
Journal Entry passed for this is –

Bad Debts A/c Dr.


To, Sundry Debtors

h. Provision for Doubtful Debts

Provision for doubtful debts is necessary due to the possibility that all the customers to
whom the credit sales have been made may not pay the entire amount. Accordingly, the
first effect of this adjustment is that the amount equivalent to the provision for doubtful
debts is written off to Profit and Loss Account and the second effect is that the
corresponding amount is reduced from the Sundry Debtors in the Balance Sheet. It
should be noted that if the provision for bad and doubtful debts is to be maintained at a
certain percentage of Sundry Debtors and if the provision to some extent has already
been made in the books of account, the differential amount only needs to be debited to
Profit and Loss Account. The Journal Entry passed for this is –

Profit and Loss Account Dr.


To, Sundry Debtors A/c

i. Provision for Discount on Debtors

In some cases it is necessary to allow cash discount to the customers for making the
early payment. As the amount of debtors who are likely to avail the cash discount is not
known in advance, a provision is made in the books of account for the discount to be
allowed to debtors. Accordingly, the first effect of this adjustment is that the amount
equivalent to the provision for discount on debtors is written off to Profit and Loss Account
and the second effect is that the corresponding amount is reduced from the Sundry
Debtors in the Balance Sheet. The Journal Entry passed for this is –

Profit and Loss Account Dr.


To, Sundry Debtors A/c

j. Interest on Capital

In order to calculate the profit earned by the organization properly, in some cases interest
may be provided on the amount of capital introduced by the proprietor or partner in the
business. It may not be out of place to mention here that in case of partnership firms,
interest on capital is considered to be an allowable expenditure for calculating the tax
liability as per the provisions of Income tax Act, 1961 if it is payable to the Working
Partners at the rate which is not exceeding 12% p.a. Accordingly, the first effect of this

50 Management Accounting
adjustment is that the amount of Interest on Capital is debited to Profit and Loss Account,
thus reducing the profits or increasing the losses and the second effect is that the
corresponding amount is credited to the Capital Account of proprietor or partner. The
Journal Entry passed for this is –

Interest on Capital A/c Dr.


To, Capital A/c

k. Drawings

This represents the amount of cash or value of goods withdrawn by the proprietor or
partner for personal use. If the amount is withdrawn in cash, the same may be entered in
the books of account regularly and thus will be reflected in the Trial Balance. However,
the value of goods withdrawn by the proprietor or partner may be required to be considered
by way of adjustment. Accordingly, the first effect of this adjustment is that the amount
of Sales will be increased, thus increasing the profits or reducing the loss and the second
effect is that the corresponding amount will be debited to the Capital Account of the
proprietor or partner. The Journal Entry passed for this is –

Drawing / Capital A/c Dr.


To, Sales A/c

l. Deferred Revenue Expenditure Written Off

This represents that part of Deferred Revenue Expenditure, returns equivalent to which
are received during the current period. Accordingly, the first effect of this adjustment is
that the deferred revenue expenditure written off will be debited to Profit and Loss Account,
thus reducing the profit or increasing the loss and the second effect is that the
corresponding amount will be reduced from the Asset side of the Balance Sheet. The
Journal Entry passed for this is –

Deferred Revenue Expenditure Written Off A/c Dr.


To, Deferred Revenue Expenditure A/c

It should be noted that Deferred Revenue Expenditure Written Off Account is a Nominal
Account whereas Deferred Revenue Expenditure Account is a Real Account.

m. Abnormal Loss due to fire etc.

In some cases, the organization incurs the loss of stock due to some abnormal events
like fire, earthquake etc. Accordingly, the first effect of this adjustment is that the Trading
Account is credited with the cost of goods lost due to fire, earthquake etc. and the
corresponding amount is debited to Profit and Loss Account as Loss due to Fire Account.
The Journal Entry passed for this is –

Process of Accounting 51
Loss due to Fire Account Dr.
To, Stock Destroyed Account

In some cases, the stock held by the organization is insured with the Insurance Company.
After the abnormal event like fire or earthquake takes places, the insurance company
settles the claim, either in full or in part. The actual loss incurred by the organization is
to the extent of difference between the cost of goods destroyed and the amount of claim
settled by the insurance company. In such event, the amount of claim settled by the
insurance company is debited to the Insurance Company’s Account and only the net
amount of loss is debited to Profit and Loss Account. The Journal Entry passed for this
is –

Insurance Company A/c Dr.


Loss due to Fire A/c Dr.
To, Stock Destroyed A/c

n. Goods Distributed as Free Samples

This represents the value of goods distributed as free samples as a part of sales promotion
effort of the organization. This is in the form of advertisement. Accordingly, the first effect
of this adjustment is that the amount of goods distributed as free samples is debited to
Profit and Loss Account, thus reducing the profits or increasing the losses and the
second effect is that the amount of Sales is increased thus increasing the profit or
reducing the loss. The Journal Entry passed for this is –

Advertisement A/c Dr.


To, Sales A/c

o. Goods sent on approval basis

Goods sent to the customers on approval basis should not be treated as the sales till the
goods are finally approved by the customers or the period as agreed upon by both the
parties is over. This is due to the fact that the property in the goods is not transferred until
the said period is over. If the amount of such goods sent on approval basis is treated as
the sales, the effect of this entry needs to be reversed. At the same time, the closing
stock needs to be increased by the cost of such goods sent on approval basis.

p. Commission payable to the manager

In some cases, commission is payable to the manager as a percentage of profit earned


by the business. The calculation of this commission may be made in two ways –

l As a percentage of profit before charging such commission to Profit and Loss


Account.

52 Management Accounting
l As a percentage of profit after charging such commission to Profit and Loss Account.

In both the cases, the amount of profit needs to be calculated before the commission is
calculated and then the amount of commission is calculated based upon the methods to
be used for calculating the same. The journal Entry passed for this is –

Commission A/c Dr.


To, Commission Payable A/c

Illustration 1

From the following particulars in respect of M/s Pam Industries, Journalize the following
transactions, post them to the ledger, prepare the trial balance and prepare the final accounts.

Date Particulars
March
2002
1 Started business with the capital of Rs. 50,000
2 Opened a Bank Account by paying Rs. 35,000
3 Purchased goods from Ajay on credit Rs. 20,000
5 Sold the goods to Vijay on credit Rs. 14,000
7 Paid Ajay by cheque Rs. 19,500 in full settlement
9 Received Rs. 13,000 from Vijay in full settlement by cheque
15 Purchased furniture of Rs. 10,000 and paid the amount by cheque
18 Paid for traveling expenses in cash Rs. 3,000
21 Sold the goods to Vinod for cash Rs. 10,000
25 Goods purchased from Ashok against cash Rs. 8,000
27 Cash deposited in bank Rs. 5,000
28 Amount withdrawn by cheque for personal purpose Rs. 3,000
30 Paid salary in cash Rs. 2,000

Adjustments –

a. Value of goods unsold on 31st March 2002, valued at cost, Rs. 17,000
b. Depreciate furniture @2%
c. Telephone bill for the month of March 2002 not yet paid Rs. 1,500

Process of Accounting 53
Solution

In the books of M/s Pam Industries


Date Particulars L.F. Debit – Rs. Credit – Rs.
March 2002
1 Cash A/c Dr. 50,000
To, Capital A/c 50,000
(Capital introduced in the business)
2 Bank A/c Dr. 35,000
To, Cash A/c 35,000
(Opened Bank Account)
3 Purchases A/c Dr. 20,000
To, Ajay A/c 20,000
(Goods purchased on credit)
5 Vijay A/c Dr. 14,000
To, Sales A/c 14,000
(Sold goods on credit)
7 Ajay A/c Dr. 20,000
To, Bank A/c 19,500
To, Discount A/c 500
(Paid Ajay in full settlement)
9 Bank A/c Dr. 13,000
Discount A/c Dr. 1,000
To, Vijay A/c 14,000
(Received from Vijay in full settlement)
15 Furniture A/c Dr. 10,000
To, Bank A/c 10,000
(Furniture purchased against cheque)
18 Traveling Expenses A/c Dr. 3,000
To, Cash A/c 3,000
(Paid for traveling expenses)
21 Cash A/c Dr. 10,000
To, Sales A/c 10,000
(Sold goods for cash)
25 Purchases A/c Dr. 8,000
To, Cash A/c 8,000
(Goods purchased for cash)
27 Bank A/c Dr. 5,000
To, Cash A/c 5,000
(Cash deposited in bank)
28 Drawings A/c Dr. 3,000
To, Bank A/c 3,000
(Withdrawn for personal purpose)
30 Salary A/c Dr. 2,000
To, Cash A/c 2,000
(Paid salary in cash)

54 Management Accounting
General Ledger of M/s Pam Industries for March 2002

Cash Account

Date Particulars Folio Rs. Date Particulars Folio Rs.

1 To Capital A/c 50,000 2 By Bank 35,000


21 To Sales 10,000 18 By Traveling Exp. 3,000
25 By Purchases 8,000
27 By Bank 5,000
30 By Salary 2,000
31 By Balance c/fd 7,000
60,000 60,000

Bank Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
1 To Cash A/c 35,000 7 By Ajay 19,500
9 To Vijay 13,000 15 By Furniture 10,000
27 To Cash 5,000 27 By Drawings 3,000
31 By Balance c/fd 20,500
53,000 53,000

Purchases Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
3 To Ajay 20,000 31 By Trading A/c 28,000
25 To Cash 8,000

28,000 28,000

Sales Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
31 To Trading A/c 24,000 By Vijay 14,000
By Cash 10,000
24,000 24,000

Traveling Expenses Account


Date Particulars Folio Rs. Date Particulars Folio Rs.
18 To Cash 3,000 31 By Profit & Loss A/c 3,000

3,000 3,000

Process of Accounting 55
Salary Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
30 To Cash 2,000 31 By Profit & Loss A/c 2,000

2,000 2,000

Telephone Expenses Account


Date Particulars Folio Rs. Date Particulars Folio Rs.
31 To Outstanding Exp. 1,500 31 By Profit & Loss A/c 1,500

1,500 1,500

Discount Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
9 To Vijay 1,000 7 By Ajay 500
By Profit & Loss A/c 500
1,000 1,000

Depreciation Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
31 To Furniture 200 31 By Profit & Loss A/c 200

200 200

Ajay Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
7 To Bank 19,500 3 By Purchases 20,000
7 To Discount 500
20,000 20,000

Vijay Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
5 To Sales 14,000 9 By Bank 13,000
9 By Discount 1,000
14,000 14,000

56 Management Accounting
Capital Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
28 To Bank 3,000 1 By Cash 50,000
31 To Balance c/fd 47,000
50,000 50,000

Outstanding Expenses Account


Date Particulars Folio Rs. Date Particulars Folio Rs.
31 To Balance c/fd 1,500 31 By Telephone Exp. 1,500
1,500 1,500

Furniture Account
Date Particulars Folio Rs. Date Particulars Folio Rs.
15 To Bank 10,000 31 By Depreciation 200
31 By Balance c/fd 9,800
10,000 10,000

Trial Balance as on 31st March 2002

Name of the Account Debit Credit


Cash 7,000
Bank 20,500
Purchases 28,000
Sales 24,000
Traveling Expenses 3,000
Salary 2,000
Telephone Expenses 1,500
Depreciation 200
Discount 500
Capital 47,000
Furniture 9,800
Outstanding Expenses 1,500

Total 72,500 72,500

Process of Accounting 57
Trading Account for the year ended on 31st March 2002
Particulars Amount Particulars Amount

Opening Stock Nil Sales 24,000


Purchases 28,000 Closing Stock 17,000

Gross Profit c/fd 13,000

Total 41,000 Total 41,000

Profit & Loss Account for the year ended on 31st March 2002
Particulars Amount Particulars Amount

Traveling Expenses 3,000 Gross Profit b/fd 13,000


Salary 2,000
Telephone Expenses 1,500
Discount 500
Depreciation 200

Profit carried to Capital Account 5,800

Total 13,000 Total 13,000

Balance Sheet as on 31st March 2002


Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets
Balance 47,000 Furniture 10,000
Add : Profit for year 5,800 Less : Depreciation 200

52,800 9,800

Current Assets
Current Liabilities Stock 17,000
Outstanding Expenses 1,500 Cash 7,000
Bank 20,500

Total 54,300 Total 54,300

58 Management Accounting
Illustration 2
From the following balances and information, prepare Trading and Profit & Loss Account of Mr. X for
the year ended 31st March 1998 and a Balance Sheet as on that date.
Particulars Dr. Rs. Cr. Rs.
X’s Capital Account 10,000
Plant and Machinery 3,600
Depreciation on Plant and Machinery 400
Repairs to Plant 520
Wages 5,400
Salaries 2,100
Income Tax of Mr. X 100
Cash in Hand and at Bank 400
Land and Building 14,900
Depreciation on Building 500
Purchases 25,000
Purchase returns 300
Sales 49,800
Bank Overdraft 760
Accrued Income 300
Salaries Outstanding 400
Bills Receivable 3,000
Provision for Bad Debts 1,000
Bills Payable 1,600
Bad Debts 200
Discount on Purchases 708
Debtors 7,000
Creditors 6,252
Opening Stock 7,400

70,820 70,820

Information –
a. Stock as on 31st March 1998 was Rs. 6,000
b. Write off further Rs. 600 for bad Debt and maintain a provision for bad Debts at 5% on
Debtors.
c. Goods costing Rs. 1,000 were sent to customer for Rs. 1,200 on 30th March 1998 on
sale or return basis. This was recorded as actual sales.
d. Rs. 240 paid as rent of the office were debited to Landlord Account and were included in
the list of Debtors.

Process of Accounting 59
e. General Manager is to be given commission at 10% of net profits after charging the
commission of works manager and his own.
f. Works manager is to be given commission at 12% of net profits before charging the
commission of General Manager and his own.

Solution

Trading Account for the year ended on 31st March 1998

Particulars Amount Particulars Amount


Opening Stock 7,400 Sales 49,800
Purchases 25,000 Less : Goods on approval 1,200 48,600
Less : Returns 300 24,700
Closing Stock 6,000
Wages 5,400 Add : Goods on approval 1,000 7,000
Gross Profit c/fd 18,100

Total 55,600 Total 55,600

Profit & Loss Account for the year ended on 31st March 1998
Particulars Amount Particulars Amount
Salaries 2,100 Gross Profit b/fd 18,100
Depreciation on Plant 400 Discount 708
Depreciation on Building 500
Repairs to Plant 520
Rent 240
Bad Debts 200
Add : Additional Bad Debts 600
Add : Provision for Bad Debts 248
Less : Existing Provision 1000 48

Commission to Works Manager 1,800


Commission to General Manager 1,200

Profit transferred to Capital A/c 12,000

Total 18,808 Total 18,808

60 Management Accounting
Balance Sheet as on 31st March 1998
Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets
Balance 10,000 Plant & Machinery 3,600
Add : Profit for year 12,000 Building 14,900
Less : Income Tax 100
21,900 18,500
Current Liabilities Current Assets
Creditors 6,252 Closing Stock (Including stock on 7,000
Bills Payable 1,600 Approval)
Overdraft 760 Cash 400
Outstanding Salaries 400 Debtors 7,000
Commission Payable 3,000 Less : Bad Debts 600
Less : Goods on approval 1,200
Less : Due from Landlord 240
4,960
Less: Provision for Bad Debt 248 4,712
Bills Receivables 3,000
Accrued Income 300
Total 33,912 Total 33,912

Working Notes :

Rs.
Profit before calculating the commission 15,000
Commission payable to Works Manager @12% 1,800
Commission payable to General Manager on 13,200
Commission payable to General Manager @10% 1,200

(Calculated as 13200 / 110 x 100)

Illustration 3

The following Trial Balance is of Shri Om as on 31st March 1991. You are requested to prepare
the Trading and Profit & Loss Account for the year ended 31st March 1991 and a Balance
Sheet as on that date after making the necessary adjustments.

Process of Accounting 61
Particulars Dr. Rs. Cr. Rs.
Sundry Debtors 5,00,000
Sundry Creditors 2,00,000
Outstanding Liabilities for Expenses 55,000
Wages 1,00,000
Carriage Outwards 1,10,000
Carriage Inwards 50,000
General Expenses 70,000
Cash Discount 20,000
Bad Debts 10,000
Motor Car 2,40,000
Printing and Stationery 15,000
Furniture and Fittings 1,10,000
Advertisement 85,000
Insurance 45,000
Salesman’s Commission 87,500
Postage and Telephones 57,500
Salaries 1,60,000
Rates and Taxes 25,000
Drawings 20,000
Capital Account 14,43,000
Purchases 15,50,000
Sales 19,87,500
Stock as on 1st April 1990 2,50,000
Cash at Bank 60,000
Cash in Hand 10,500

36,30,500 36,30,500

The following adjustments are to be made –

a. Stock as on 31st March 1991 was valued at Rs. 7,25,000.

b. A provision for Bad and Doubtful Debts are to be made to the extent of 5% on Sundry
Debtors.

62 Management Accounting
c. Depreciate Furniture & Fixture by 10% and Motor Car by 20%.

d. Shri Om had withdrawn goods worth Rs. 25,000 during the year.

e. Sales include goods worth Rs. 75,000 sent out to Santi & Company on approval and
remaining unsold on 31st March 1991. The cost of the goods was Rs. 50,000.

f. The salesman was entitled to a commission of 5% on total sales.

g. Debtors include Rs. 25,000 bad debts.

h. Printing and Stationery expenses of Rs. 55,000 relating to 1989-90 had not been provided
in that year but were paid in this year by debiting outstanding liabilities.

i. Purchases include purchases of furniture worth Rs. 50,000.

Solution

Trading Account for the year ended on 31st March 1991

Particulars Amount Particulars Amount


Opening Stock 2,50,000 Sales 1987500
Purchases 1550000 Less : Goods on approval 75000 19,12,500
Less : Furniture purchased 50000 15,00,000
Closing Stock 725000
Wages 1,00,000 Add : Goods on approval 50000 7,75,000
Carriage Inwards 50,000
Goods withdrawn 25,000
Gross Profit c/fd 8,12,500
Total 27,12,500 Total 27,12,500

Process of Accounting 63
Profit & Loss Account for the year ended on 31st March 1991

Particulars Amount Particulars Amount


Salaries 1,60,000 Gross Profit b/fd 8,12,500
Carriage Outwards 1,10,000
Advertisement 85,000 Loss transferred to Capital A/c 44,625
Insurance 45,000
Salesman’s Commission 95,625
Postage & Telephones 57,500
Rates & Taxes 25,000
Bad Debts 10000
Add : Additional Bad Debts 25000
Add : Provision for Bad Debts 20000 55,000

General Expenses 70,000


Cash Discount 20,000
Printing & Stationery 15,000
Depreciation 64,000
Previous Year Expenses 55,000
Total 8,57,125 Total 8,57,125

Balance Sheet as on 31st March 1991


Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets
Balance 14,43,000 Motor Car 240000
Less : Loss for year 44,625 Less : Depreciation 48000 1,92,000
Less : Drawings 20,000
Less : Goods withdrawn 25,000 Furniture 110000
Add : Purchases 50000
13,53,375 Less : Depreciation 16000 1,44,000

Current Liabilities Current Assets


Creditors 2,00,000 Closing Stock (Including stock on 7,75,000
Outstanding Commission 8,125 Approval)
Cash at Bank 60,000
Cash in Hand 10,500
Debtors 500000
Less : Bad Debts 25000
Less : Goods on approval 75000
400000
Less: Bad Debt Provision 20000 3,80,000

Total 15,61,500 Total 15,61,500

64 Management Accounting
Illustration 4

The following is the Trial Balance of Hari as at 31st December 1994

Particulars Dr. Rs. Cr. Rs.


Hari’s Capital Account 76,690
Stock as on 1st January 1994 46,800
Sales 3,89,600
Returns Inwards 8,600
Purchases 3,21,700
Returns Outwards 5,800
Carriage Inward 19,600
Rent and taxes 4,700
Salaries and Wages 9,300
Sundry Debtors 24,000
Sundry Creditors 14,800
Bank Loan @14% 20,000
Bank Interest 1,100
Printing and Stationery 14,400
Bank Balance 8,000
Discount Earned 4,440
Furniture and Fitting 5,000
Discount Allowed 1,800
General Expenses 11,450
Insurance 1,300
Postage and Telegram 2,330
Cash Balance 380
Travelling Expenses 870
Drawings 30,000

5,11,330 5,11,330

The following adjustments are to be made –

a. Included among the Debtors is Rs. 3,000 due from Ram and included among the Creditors
Rs. 1,000 due to him.

Process of Accounting 65
b. Provision for Bad and Doubtful Debts to be created at 5% and for Discount @2% on
Sundry Debtors.

c. Depreciation on Furniture and Fitting @10% should be written off.

d. Personal purchases of Hari amounting to Rs. 600 had been recorded in the Purchases
Day Book.

e. Interest on Bank Loan shall be provided for the whole year.

f. A quarter of the amount of Printing and Stationary expenses is to be carried forward to


the next year.

g. Credit Purchase Invoice amounting to Rs. 400 had been omitted from the book.

h. Stock as on 31st December 1994 was Rs. 78,600.

Prepare Trading and Profit & Loss Account for the year ended on 31st December, 1994 and
the Balance Sheet as on that date.

Solution

Trading Account for the year ended on 31st December, 1994

Particulars Amount Particulars Amount


Opening Stock 46,800 Sales 389600
Purchases 321700 Less : Returns Inwards 8600 3,81,000

Less : Personal purchases 600


Add : Unrecorded purchases 400 Closing Stock 78,600
Less : Returns Outwards 5800 3,15,700

Carriage Inwards 19,600

Gross Profit c/fd 77,500

Total 4,59,600 Total 4,59,600

66 Management Accounting
Profit & Loss Account for the year ended on 31st December 1994

Particulars Amount Particulars Amount


Salaries and Wages 9,300 Gross Profit b/fd 77,500
Rent and Taxes 4,700 Discount Earned 4,440
Bank Interest 1100
Add : Outstanding 1700 2,800
Printing and Stationery 14400
Less : Prepaid 3600 10,800
Discount Allowed 1,800
General Expenses 11,450
Insurance 1,300
Postage and Telegram 2,330
Travelling Expenses 870
Provision for Bad Debts 1,150
Discount on Debtors 437
Depreciation 500

Profit transferred to Capital A/c 34,503

Total 81,940 Total 81,940

Balance Sheet as on 31st December, 1994


Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets
Balance 76,690 Furniture & Fitting 5000
Add : Profit for year 34,503 Less : Depreciation 500 4,500
Less : Personal Purchases 600
Less : Drawings 30,000 Current Assets
Closing Stock 78,600
80,593 Prepaid Printing & Stationary 3,600
Bank Balance 8,000
Current Liabilities Cash in Hand 380
Creditors 14800 Debtors 24000
Add : Unrecorded Purchases 400 Less: Due to Ram 1000

Less : Due to Ram 1000 14,200 23000


Less: Bad Debt Provision 1150
Outstanding Interest 1,700 21850

Less: Discount 437 21,413


Bank Loan 20,000

Total 1,16,493 Total 1,16,493

Process of Accounting 67
Illustration 5

From the following trial balance and information, prepare Trading and Profit & Loss Account of
Mr. Rishabh for the year ended 31st march 1999 and a Balance Sheet as on that date.

Particulars Dr. Rs. Cr. Rs.


Capital 1,00,000
Drawings 12,000
Land and Building 90,000
Plant and Machinery 20,000
Furniture 5,000
Sales 1,40,000
Returns outwards 4,000
Debtors 18,400
Loan from Gajanand on 1.7.98 @6% p.a. 30,000
Purchases 80,000
Returns Inward 5,000
Carriage 10,000
Sundry Expenses 600
Printing and Stationery 500
Insurance Expenses 1,000
Provision for bad and doubtful Debts 1,000
Provision for Discount on Debtors 380
Bad Debts 400
Profit of textile Department 10,000
Stock of General Goods on 1st April, 1998 21,300
Salaries and wages 18,500
Creditors 12,000
Trade Expenses 800
Stock of Textile Goods on 31st March, 1999 8,000
Cash at Bank 4,600
Cash in Hand 1,280

2,97,380 2,97,380

68 Management Accounting
Information –

a. Stock of General Goods on 31st March, 1999 valued at Rs. 27,300.

b. Fire occurred on 23rd March, 1999 and Rs. 10,000 worth of general goods were destroyed.
The insurance company accepted claim for Rs. 6,000 only and paid the claim money on
10th April, 1999.

c. Bad Debts amounting to Rs. 400 are to be written off. Provision for bad and Doubtful
Debts is to be made at 5% and for discount at 2%.

d. Received Rs. 6,000 worth of goods on 27th March ,1999, but the invoice of purchase was
not recorded in Purchase Book.

e. Rishabh took away goods worth Rs. 2,000 for personal use but no record was made
thereof.

f. Charge depreciation at 2% on Land and Building, 20% on Plant and Machinery and 5%
on Furniture.

g. Insurance prepaid amounted to Rs. 200.

Solution

Trading Account for the year ended on 31st March, 1999

Particulars Amount Particulars Amount


Opening stock of General Goods 21,300 Sales 140000
Purchases 80000 Less : Return Inwards 5000 1,35,000

Less : Return Outwards 4000


Add : Unrecorded Purchases 6000 82,000 Goods withdrawn 2,000
Goods destroyed by fire 10,000
Carriage 10,000

Closing Stock of General Goods 27,300


Gross Profit c/fd 61,000

Total 1,74,300 Total 1,74,300

Process of Accounting 69
Profit & Loss Account for the year ended on 31st March 1999

Particulars Amount Particulars Amount


Salaries & Wages 18,500 Gross Profit b/fd 61,000
Sundry Expenses 600 Profit of Textile Department 10,000
Printing & Stationery 500
Insurance 1000 Provision for Bad Debts 900
Less : Prepaid 200 800 Less : Existing 1000 100
Bad Debts 400
Add : Additional Bad Debts 400 800 Discount on Debtors 342
Trade Expenses 800 Less : Existing 380 38
Depreciation 6,050
Loss by Fire 4,000
Interest on Loan 1,350

Profit carried to Capital A/c 37,738

Total 71,138 Total 71,138

Balance Sheet as on 31st March, 1999


Capital & Liabilities Amount Assets & Properties Amount
Capital Fixed Assets
Balance 100000 Land & Building 90000
Less : Drawings 12000 Less: Depreciation 1800 88,200
Less : Goods withdrawn 2000 Plant & Machinery 20000
Add: Profit for year 37738 1,23,738 Less : Depreciation 4000 16,000
Furniture 5000
Loan from Gajanand 30,000 Less : Depreciation 250 4,750
Current Liabilities
Creditors 12000 Current Assets
Add : Unrecorded Purchases 6000 18,000 Stock of General Goods 27,300
Stock of Textile Goods 8,000
Outstanding Interest on Loan 1,350 Sundry Debtors 18400
Less : Bad Debts 400
18000
Less : Bad Debts Provision 900
17100
Less : Discount 342 16,758
Cash at Bank 4,600
Cash in Hand 1,280
Prepaid Insurance 200
Receivable from Insurance Company 6,000
Total 1,73,088 Total 1,73,088

70 Management Accounting
Illustration 6

Hira and Manik are partners in a firm sharing profits and losses in equal proportion. Following
is the Trial Balance as at 31st March, 1989.

Debit Balances Rs. Credit Balance Rs.


Plant & Machinery 50,000 Sales 2,40,000
Opening Stock 30,000 Discount 2,000
Purchases 80,000 Sundry Creditors 20,000
Land & Building 85,000 Bills Payable 10,750
Carriage Inwards 1,700 Hira’s Loan Account 50,000
Carriage Outwards 2,500 Capital Accounts –
Wages 16,000 Hira 50,000
Sundry Debtors 50,000 Manik 25,000
Salaries 12,000
Furniture 18,000
Trade Expenses 6,000
Return Inwards 950
Advertisement Suspense 12,500
Discount 900
Partners’ Drawings -
Hira 3,000
Manik 2,000
Bills Receivable 20,000
Insurance 1,200
Bad Debts 1,000
Cash at Bank 5,000

Total 3,97,750 Total 3,97,750

You are required to prepare Trading and Profit & Loss Account of the firm for the year ended on
31st March 1989 and the Balance Sheet on that date after taking into consideration following
adjustments –
a. Closing Stock Rs. 45,000.
b. Depreciate Plant @10% and Furniture @20%. Appreciate Land and Building to
Rs. 90,000.

c. Bad Debts Reserve to be raised to 2.5% on Sundry Debtors.

Process of Accounting 71
d. Advertisement Suspense Account to be written off against revenue over five years.

e. Partners’ Drawings are to bear interest @10% p.a. Amounts were withdrawn on
31st December, 1988.

f. Annual charges for insurance Rs. 1,000. Balance represents amount paid in advance.

g. Hira gave loan to the firm on 30th September, 1988 which carries the interest @6% p.a.

h. Manik was to be allowed a salary of Rs. 250 per month.

i. The partners agree to contribute 50% of the distributable profit to the National Defence
Fund.

Solution

Trading Account for the year ended on 31st March, 1989

Particulars Amount Particulars Amount


Opening Stock 30,000 Sales 240000
Purchases 80,000 Less : Returns Inwards 950 2,39,050

Carriage Inwards 1,700 Closing Stock 45,000


Wages 16,000

Gross Profit c/fd 1,56,350

Total 2,84,050 Total 2,84,050

Profit & Loss Account for the year ended on 31st March, 1989

Particulars Amount Particulars Amount


Salaries 12,000 Gross Profit b/fd 1,56,350
Trade Expenses 6,000 Discount Received 2,000
Carriage Outwards 2,500 Interest on Drawings –
Insurance 1200 Hira 75
Less : prepaid 200 1,000 Manik 50
Discount 900
Bad Debts 1,000 Appreciation of Land & Building 5,000
Bad Debts Reserve 1,250
Advertisement 2,500
Salary Payable to Manik 3,000
Interest on Loan from Hira 1,500
Depreciation 8,600
Sub-Total 40,250

72 Management Accounting
Particulars Amount Particulars Amount
Contribution to National Defence Fund 61,613

Transferred to Capital Account


Hira 30,806
Manik 30,806
Total 1,63,475 Total 1,63,475

Balance Sheet as on 31st March, 1989

Capital & Liabilities Amount Assets & Properties Amount


Capital Fixed Assets
Hira’s Capital 50000 Land & Building 85000
Add : Profit for year 30806 Add : Appreciation 5000 90,000
Less : Drawings 3000 Plant & Machinery 50000
Less : Interest on Drawings 75 77,731 Less : Depreciation 5000 45,000
Furniture 18000
Less : Depreciation 3600 14,400
Manik’s Capital 25000
Add : Profit for year 30806 Current Assets
Add : Salary 3000 Closing Stock 45,000
Less : Drawings 2000 Sundry Debtors 50000
Less : Interest on Drawings 50 56,756 Less : Bad Debt Reserve 1250 48,750
Bills receivables 20,000

Hira’s Loan Account 50,000 Cash at Bank 5,000


Prepaid Insurance 200
Current Liabilities
Sundry Creditors 20,000 Advertisement Suspense 12500
Bills Payable 10,750 Less : Transferred to revenue 2500 10,000
Interest on Hira’s Loan Account 1,500

Contribution to National Defence Fund 61,613

Total 2,78,350 Total 2,78,350

Illustration 7

Following is the Trial Balance of M/s. Pandit Brothers, a partnership firm, as on


31st March, 1992.

Process of Accounting 73
Particulars Dr. Rs. Cr. Rs.
Capital Account H. Pandit 1,00,000
Capital Account K. Pandit 1,00,000
Drawings H. Pandit 16,000
Drawings K. Pandit 16,000
Buildings 80,000
Furniture 20,000
Purchases 2,00,000
Sales 3,00,000
Stock (1st April, 1991) 50,000
Wages 44,000
Rates and Taxes 1,600
Office Expenses 10,000
Salaries 50,000
Sundry Debtors 25,000
Sundry Creditors 12,000
Cash in Hand 400
Bank Overdraft 29,000
Carriage Inwards 28,000

Total 5,41,000 5,41,000

Following further information relating to the firm is made available –


a. Stock at the end of the year on 31st march, 1992 was Rs. 1,14,500
b. There was a fire in the premises on 26th November, 1991 which damaged a portion of
stock and the loss was estimated at Rs. 17,500.
c. H. Pandit is in charge of purchases and is to be paid 2.5% commission on such
purchases.
d. A steel table purchased on 1st February, 1992 for Rs. 3,000 was debited to purchases
account.
e. K. Pandit who looks after all other business aspects except purchases is entitled to a
commission of 5% on net profits after charging commission on purchases due to H.
Pandit and commission payable to himself.
f. Depreciation on Buildings @2.5% and on Furniture @10%
g. Profits or losses are shared equally.

74 Management Accounting
You are required to prepare Trading and Profit & Loss Account for the year ended on 31st
March, 1992 and the Balance Sheet on that date.

Solution

Trading Account for the year ended on 31st March 1992

Particulars Amount Particulars Amount


Opening Stock 50,000 Sales 3,00,000
Purchases 200000
Less : Table Purchased 3000 1,97,000 Closing Stock 1,14,500
Wages 44,000
Carriage Inwards 28,000 Stock destroyed by fire 17,500
Commission on purchases 4,925

Gross Profit c/fd 1,08,075

Total 4,32,000 Total 4,32,000

Profit & Loss Account for the year ended on 31st March 1992

Particulars Amount Particulars Amount


Salaries 50,000 Gross Profit b/fd 1,08,075
Rates and Taxes 1,600
Office Expenses 10,000
Stock destroyed by fire 17,500
Depreciation 4,050

83,150

Commission to K. Pandit 1,187

Profit transferred to Capital Account

H. Pandit 11,869
K. Pandit 11,869

Total 1,08,075 Total 1,08,075

Process of Accounting 75
Balance Sheet as on 31st March, 1992

Capital & Liabilities Amount Assets & Properties Amount


Capital Fixed Assets
H. Pandit Capital 100000 Building 80000
Add : Profit for year 11869 Less : Depreciation 2000 78,000
Add: Commission 4925 Furniture 20000
Less : Drawings 16000 1,00,794 Add : Purchases 3000
Less : Depreciation 2050 20,950

K. Pandit Capital 100000


Add : Profit for year 11869 Current Assets
Add: Commission 1187 Closing Stock 1,14,500
Less : Drawings 16000 97,056 Sundry Debtors 25,000
Cash in Hand 400

Current Liabilities
Sundry Creditors 12,000
Bank Overdraft 29,000

Total 2,38,850 Total 2,38,850

Note – Commission payable to K. Pandit is calculated as below –

(108075 – 83150)
—————————— x 5
105

Illustration 8

The following is the Trial Balance of Shri Arihant as on 31st December 1999.

Particulars Dr. Rs. Cr. Rs.


Capital 14,00,000
Drawings 75,000
Opening Stock 80,000
Purchases 16,20,000
Freight on purchases 15,000
Wages 1,10,000
Sales 25,00,000
Salaries 1,00,000

76 Management Accounting
Particulars Dr. Rs. Cr. Rs.
Travelling Expenses 23,000
Miscellaneous Expenses 35,000
Printing and Stationery 27,000
Advertisement Expenses 25,000
Postage and Telegram 13,000
Discounts 7,600 14,500
Bad Debts written off (after adjusting recovery of bad
debts of Rs. 6,000 written off in 1997) 14,000
Building 10,00,000
Machinery 75,000
Furniture 40,000
Debtors 1,50,000
Provision for Doubtful Debts 19,000
Creditors 1,60,000
Investments (12% Purchased on 1st October, 1999) 6,00,000
Bank Balance 83,900

40,93,500 40,93,500

Adjustments –

a. Closing Stock Rs. 2,25,000.

b. Goods worth Rs. 5,000 were taken for personal use but no entry was made in the books.

c. Machinery worth Rs. 35,000 purchased on 1st January, 1997 was wrongly written off
against Profit & Loss Account. This asset is to be brought into account on
1st January, 1999 taking depreciation at 10% per annum on straight line basis upto
31st December, 1998.

d. Depreciation Building at 2.5%, Machinery at 10% and Furniture at 10%.

e. Provision for Doubtful Debts should be 6% on Debtors.

f. The manager is entitled to a commission of 5% of net profits after charging his commission.

Prepare Trading and Profit & Loss Account for the year ending 31st December, 1999 and a
Balance Sheet as on that date.

Process of Accounting 77
Solution

Trading Account for the year ended on 31st December, 1999

Particulars Amount Particulars Amount


Opening Stock 80,000 Sales 25,00,000
Purchases 16,20,000
Freight on purchases 15,000 Goods withdrawn 5,000
Wages 1,10,000
Closing Stock 2,25,000
Gross Profit c/fd 9,05,000

Total 27,30,000 Total 27,30,000

Profit & Loss Account for the year ended on 31st December 1999

Particulars Amount Particulars Amount


Salaries 1,00,000 Gross Profit b/fd 9,05,000
Travelling Expenses 23,000 Bad Debts recovered 6,000
Miscellaneous Expenses 35,000 Provision for bad Debts 9000
Printing & Stationery 27,000 Less : Existing 19000 10,000
Advertisement Expenses 25,000 Income from investments 18,000
Postage and Telegram 13,000 Discount Received 14,500
Discount 7,600
Bad Debts 20,000
Depreciation 40,000

Sub-Total 2,90,600

Commission to Manager 31,567

Profit transferred to Capital A/c 6,31,333

Total 9,53,500 Total 9,53,500

78 Management Accounting
Balance Sheet as on 31st December, 1999

Capital & Liabilities Amount Assets & Properties Amount


Capital Fixed Assets

Balance b/fd 1400000 Building 1000000

Less : Drawings 75000 Less : Depreciation 25000 9,75,000

Less : Goods withdrawn 5000 Machinery 75000

Add : Profit for year 631333 Add : Capitalized 28000

Add : Machine capitalized 28000 19,79,333 Less : Depreciation 11000 92,000

Furniture 40000

Less : Depreciation 4000 36,000

Current Liabilities

Sundry Creditors 1,60,000 Investments 6,00,000

Commission to Manager 31,567

Current Assets

Closing Stock 2,25,000

Debtors 150000

Less : Bad Debt Provision 9000 1,41,000

Bank Balance 83,900

Investment Income outstanding 18,000

Total 21,70,900 Total 21,70,900

Note

Value of machine purchased – Rs. 35,000.

Depreciation for 1997 and 1998 – Rs. 7,000.

Value of machine to be capitalized – Rs. 28,000.

Depreciation for 1999 on this machine – Rs. 3,500.

Process of Accounting 79
Illustration 9

Following is the Trial Balance of K as on 31st March, 2000.

Particulars Dr. Rs. Cr. Rs.

Capital 8,00,000
Drawings 60,000
Opening Stock 75,000
Purchases 15,95,000
Freight on Purchases 25,000
Wages (11 months up to 29th February, 2000) 66,000
Sales 23,10,000
Salaries 1,40,000
Postage, Telegrams, Telephones 12,000
Printing and Stationery 18,000
Miscellaneous Expenses 30,000
Creditors 3,00,000
Investments 1,00,000
Discount Received 15,000
Debtors 2,50,000
Bad Debts 15,000
Provision for Bad Debts 8,000
Building 3,00,000
Machinery 5,00,000
Furniture 40,000
Commission on sales 45,000
Interest on Investments 12,000
Insurance (Year up to 31st July 2000) 24,000
Bank Balance 1,50,000
34,45,000 34,45,000

80 Management Accounting
Adjustments –

a. Closing Stock Rs. 2,25,000.

b. Machinery worth Rs. 45,000 purchased on 1st October, 1999 was shown as purchases.
Freight paid on the machinery was Rs. 5,000 which is included in the freight on purchases.

c. Commission is payable on sales @2.5% on sales.

d. Investments were sold at 10% profit, but the entire sale proceeds have been taken as
sales.

e. Write off Bad Debts Rs. 10,000 and create a provision for Doubtful Debts at 5% of
Debtors.

f. Depreciate building by 2.5% p.a. and Machinery and Furniture at 10% p.a.

Prepare Trading and Profit & Loss Account for the year ended on 31st March, 2000 and the
Balance Sheet on that date.

Solution

Trading Account for the year ended on 31st March 2000

Particulars Amount Particulars Amount


Opening Stock 75,000 Sales 2310000
Purchases 1595000 Less : Sale of Investments 110000 22,00,000
Less: Machine Purchased 45000 15,50,000

Freight on Purchases 25000 Closing Stock 2,25,000


Less : Freight on Machinery 5000 20,000
Wages 66000

Add : Outstanding 6000 72,000

Gross Profit c/fd‘ 7,08,000

Total 24,25,000 Total 24,25,000

Process of Accounting 81
Profit & Loss Account for the year ended on 31st March 2000

Particulars Amount Particulars Amount


Salaries 1,40,000 Gross Profit b/fd 7,08,000
Postage, Telegrams, Telephones 12,000 Discount Received 15,000
Printing and Stationery 18,000 Interest on Investments 12,000
Miscellaneous Expenses 30,000 Profit on sale of Investments 10,000
Bad Debts 15000
Add : Additional 10000 25,000
Provision for Bad Debts 12000
Less : Existing Provision 8000 4,000
Commission on Sales 45000
Add : Outstanding 10000 55,000
Insurance 24000
Less : prepaid 8000 16,000
Depreciation 64,000

Profit transferred to Capital A/c 3,81,000


Total 7,45,000 Total 7,45,000

Balance Sheet as on 31st March, 2000

Capital & Liabilities Amount Assets & Properties Amount


Capital Fixed Assets
Balance b/fd 800000 Building 300000
Add : Profit for year 381000 Less: Depreciation 7500 2,92,500
Less : Drawings 60000 11,21,000 Machinery 500000
Add : Purchased 50000
Less: Depreciation 52500 4,97,500
Furniture 40000
Current Liabilities Less : Depreciation 4000 36,000
Creditors 3,00,000
Sales Commission outstanding 10,000 Current Assets
Wages Outstanding 6,000 Closing Stock 2,25,000
Debtors 250000
Less : Bad Debts 10000
240000
Less : Bad Debts Provision 12000 2,28,000
Bank Balance 1,50,000
Prepaid Insurance 8,000

Total 14,37,000 Total 14,37,000

82 Management Accounting
Illustration 10

From the following particulars extracted from the books of Ganguli, prepare Trading and Profit
& Loss Account for the year ended on 31st March 1994 and Balance Sheet on that date after
making the necessary adjustments.

Debit Balances Rs. Credit Balance Rs.


Opening Stock 23,400 Capital 54,050
Sales Returns 4,300 Sales 1,44,800
Purchases 1,21,550 Purchases Returns 2,900
Carriage Inwards 9,300 Sundry Creditors 7,400
Rent 2,850 Loan from Bank @12% 10,000
Salaries 4,650 Interest Received 725
Sundry Debtors 12,000 Discount Received 1,495
Printing & Stationery 1,700
Interest Paid 450
Advertisement 5,600
Cash at Bank 4,000
Investments at 5% on 1.4.93 2,500
Furniture on 1.4.93 900
Discount Allowed 3,770
General Expenses 1,960
Audit Fees 350
Fire Insurance Premium 300
Travelling Expenses 1,165
Postage & Telegrams 435
Cash on Hand 190
Deposits @10% on 1.4.93 15,000
Drawings 5,000

Total 2,21,370 Total 2,21,370

Adjustments –

a. Value of stock as on 31st March, 1994 is Rs. 39,300. This includes goods returned by
customers on 31st March, 1994 of the value of Rs. 1,500 for which on entry has been
passed in the books.

Process of Accounting 83
b. Purchases include furniture purchased on 1st January 1994 for Rs. 1,000.

c. Depreciation should be provided on furniture @10% p.a.

d. Bank Loan as on 1st April, 1993 was Rs. 5,000. An amount of Rs. 5,000 was borrowed
on 31st March, 1994.

e. Sundry Debtors include Rs. 2,000 due from Robert and Sundry Creditors include
Rs. 1,000 due to him.

f. Interest paid includes Rs. 300 paid on the Bank Loan.

g. Interest received represents Rs. 100 from the Sundry Debtors and the balance on
investments and deposits.

h. Provide for interest payable on Bank Loan and for interest receivable on investments and
deposits.

i. Make a provision for doubtful debts @5% on the balance under Sundry Debtors. No such
provision is necessary for the deposits.

Solution

Trading Account for the year ended on 31st March 1994

Particulars Amount Particulars Amount


Opening Stock 23,400 Sales 144800

Purchases 121550 Less : Goods returned 1500


Less : Purchase Returns 2900 Less : Sales Returns 4300 1,39,000
Less : Furniture Purchased 1000 1,17,650
Carriage Inwards 9,300

Gross Profit c/fd 27,950 Closing Stock 39,300

Total 1,78,300 Total 1,78,300

84 Management Accounting
Profit & Loss Account for the year ended on 31st March 1994

Particulars Amount Particulars Amount


Salaries 4,650 Gross Profit b/fd 27,950
Rent 2,850 Interest Received 725
Printing & Stationery 1,700 Add : Receivable 1000 1,725
Interest paid 450 Discount received 1,495
Add : Interest on Bank Loan 300 750
Advertisement 5,600
Discount Allowed 3,770
General Expenses 1,960
Audit Fees 350
Fire Insurance Premium 300
Travelling Expenses 1,165
Postage & Telegrams 435
Depreciation 115
Reserve for Bad Debts 475

Profit transferred to Capital A/c 7,050

Total 31,170 Total 31,170

Balance Sheet as on 31st March, 1994

Capital & Liabilities Amount Assets & Properties Amount


Capital Fixed Assets
Balance 54050 Furniture 900
Less: Drawings 5000 Add : Purchases 1000
Add : Profit for year 7050 56,100 Less : Depreciation 115 1,785
Investments 2,500
Loan from Bank 10,000
Current Assets
Closing Stock 39,300
Current Liabilities Sundry Debtors 12000
Sundry Creditors 7400 Less : Due to Roberts 1000
Less : Due to Roberts 1000 6,400 Less : Goods returned 1500
Outstanding Interest 300 Less : Bad Debts reserve 475 9,025
Cash on Hand 190
Cash at Bank 4,000
Deposits 15,000
Interest Receivable 1,000

Total 72,800 Total 72,800

Process of Accounting 85
QUESTIONS

1. If the Trial Balance does not agree, what steps will you take to ensure that it tallies?

2. What do you mean by Final Accounts? Explain in brief the structure of Profitability
Statement and Balance Sheet.

3. What are the various components of Profit and Loss Account ? Explain the purpose of
each component.

4. How would you deal with the following while preparing the final accounts –

a. Goods lost by fire

b. Goods distributed as free samples

c. Goods sent on approval basis

d. Bad Debts and Provision for Bad Debts

e. Interest on Capital

f. Prepaid Expenses and Outstanding Expenses

86 Management Accounting
PROBLEMS

Q.1. The following is the Trial Balance of Shri Paras as on 31st March 1991. You are requested
to prepare the Final Accounts after giving effect to the adjustments.

Particulars Dr. Rs. Cr. Rs.


Sundry Creditors 63,000
Sundry Debtors 1,45,000
Capital Account 7,10,000
Drawings 52,450
Insurance 6,000
General Expenses 30,000
Salaries 1,50,000
Patents 75,000
Machinery 2,00,000
Freehold Land 1,00,000
Building 3,00,000
Stock on 1st April 1990 57,600
Carriage on Purchases 20,400
Carriage on Sales 32,000
Fuel and Power 47,300
Wages 1,04,800
Returns Outwards 5,000
Returns Inwards 6,800
Sales 9,87,800
Purchases 4,06,750
Cash at Bank 26,300
Cash in Hand 5,400

17,65,800 17,65,800

The following adjustments are to be made –

a. Stock as on 31st March, 1991 was valued at Rs. 68,000.

b. A provision for Bad and Doubtful Debts is to be made to the extent of 5% on Sundry
Debtors.

c. Depreciate Machinery @10% and Patents @20%.

Process of Accounting 87
d. Wages include a sum of Rs. 20,000 spent on erection of a cycle shed for employees and
customers.
e. Salaries for the month of March 1991 amounting to Rs. 15,000 were unpaid.
f. Insurance includes a premium of Rs. 1,700 on a policy, expiring on 30th September,
1991.

Q.2. Mr. A, a Shopkeeper had prepared the following trial balance from his ledger as on
31st March 1989.

Particulars Dr. Rs. Cr. Rs.


Purchases 6,20,000
Sales 8,30,000
Cash in Hand 4,200
Cash in Bank 24,000
Stock of Goods on 1st April, 1988 1,00,000
Mr. A’s Capital 5,77,200
Drawings 8,000
Salaries 64,000
Postage and Telephone 23,000
Salesmen Commission 70,000
Insurance 18,000
Advertising 34,000
Furniture 44,000
Printing and Stationery 6,000
Motor Car 96,000
Bad Debts 4,000
Cash Discount 8,000
General Expenses 60,000
Carriage Inwards 20,000
Carriage Outwards 44,000
Wages 40,000
Creditors 80,000
Debtors 2,00,000

14,87,200 14,87,200

You are requested to prepare Trading and Profit & Loss Account for the year ended 31st
March, 1989 and Balance Sheet as on that date. You are also given the following further
information –

88 Management Accounting
a. Cost of goods in stock as on 31st March, 1989 Rs. 1,45,000
b. Mr. A had withdrawn goods worth Rs. 5,000 during the year.
c. Purchases include purchase of furniture worth Rs. 10,000.
d. Debtors include Rs. 5,000 Bad Debts.
e. Creditors include a balance of Rs. 4,000 to the credit of Mr. B in respect of which it has
been decided and settled with the party to pay only Rs. 1,000.
f. Sales include goods worth Rs. 15,000 sent to Ram & Co. on approval and remaining
unsold as on 31st March 1989 and the cost of goods was Rs. 10,000.
g. Provision for bad debts is to be created at 5% on Sundry Debtors.
h. Depreciate furniture by 15% and Motor Car by 20%
i. The salesmen are entitled to a commission of 10% on total sales.
Q.3. From the following balances extracted from the books of Mr. Yellow, prepare Trading and
Profit & Loss Account for the year ended 31st December, 1990 and a Balance Sheet as
on that date.

Particulars Dr. Rs. Cr. Rs.


Purchases 71,280
Mr. Yellow’s Capital Account 60,000
Computer at cost 18,380
Cash at Bank 4,000
Cash on Hand 2,836
Sundry Creditors 13,000
Bills Payable Account 10,220
Furniture & Fittings Account at cost 1,540
Rent 12,540
Discount Received 22,000
Bills Receivables Account 6,720
Trade Charges 920
Sundry Debtors 34,156
Sales 60,720
Returns Outwards 11,432
Drawings Account 5,200
Rent Due 320
Discount 540
Wages 1,800
Salaries 16,780
Returns Inwards 1,000

1,77,692 1,77,692

Process of Accounting 89
Adjustments –
a. Closing Stock on 31st December, 1990 was valued at cost Rs. 25,000 (Market Value
Rs. 16,200)
b. Rs. 6,000 paid to Mr. Red against Bill Payable were debited by mistake to Mr. Green’s
Account and included in the list of Sundry Debtors.
c. Travelling expenses paid to sales representative Rs. 5,000 for the month of December
1990 were debited to his personal account and included in the list of Sundry Debtors.
d. Depreciation on furniture & fittings shall be provided at 10% per annum.
e. Provide for doubtful debts at 5% on Sundry Debtors.
f. Goods costing Rs. 1,500 used by the proprietor.
g. Salaries include Rs. 12,000 paid to sales representative who is further entitled to a
commission of 5% on net sales.
h. Stationary charges Rs. 1,200 due on 31st December, 1990.
i. Purchases include opening stock valued at Rs. 7,000 (cost price)
j. Sales representative further entitled to an extra commission of 5% on net profit after
charging his extra commission.
k. No depreciation need to be provided for computer as it had been purchased on
31st December, 1990 and not put to use.

Q.4. From the following trial balance of Hari and additional information, prepare Trading and
Profit & Loss Account for the year ended 31st March, 1995 and a Balance Sheet as on
that date.

Particulars Dr. Rs. Cr. Rs.


Capital 1,00,000
Furniture 20,000
Purchases 1,50,000
Debtors 2,00,000
Interest Earned 4,000
Salaries 30,000
Sales 3,21,000
Purchase returns 5,000
Wages 20,000
Rent 15,000
Sales Returns 10,000
Bad Debts written off 7,000

90 Management Accounting
Particulars Dr. Rs. Cr. Rs.
Creditors 1,20,000
Drawings 24,000
Provision for Bad Debts 6,000
Printing and Stationery 8,000
Insurance 12,000
Opening Stock 50,000
Office Expenses 12,000
Provision for Depreciation 2,000

5,58,000 5,58,000

Additional Information –

a. Depreciation furniture by 10% on original cost.

b. A provision for Doubtful Debts is to be created to the extent of 5% on Sundry Debtors.

c. Salaries for the month of March 1995 amounting to Rs. 3,000 were unpaid which must
be provided for. However, salaries include Rs. 2,000 paid in advance.

d. Insurance amounting to Rs. 2,000 is prepaid.

e. Provide for outstanding office expenses Rs. 8,000.

f. Stock used for private purpose Rs. 6,000.

g. Closing Stock in Trade Rs. 60,000

Q.5. The following is the Trial Balance of Shri Arihant as on 31st December, 1999.

Particulars Dr. Rs. Cr. Rs.


Capital 14,00,000
Drawings 75,000
Opening Stock 80,000
Purchases 16,20,000
Freight on purchases 15,000
Wages 1,10,000
Sales 25,00,000
Salaries 1,00,000

Process of Accounting 91
Particulars Dr. Rs. Cr. Rs.
Travelling Expenses 23,000
Miscellaneous Expenses 35,000
Printing and Stationery 27,000
Advertisement Expenses 25,000
Postage and Telegram 13,000
Discounts 7,600 14,500
Bad Debts written off (after adjusting recovery of bad
debts of Rs. 6,000 written off in 1997) 14,000
Building 10,00,000
Machinery 75,000
Furniture 40,000
Debtors 1,50,000
Provision for Doubtful Debts 19,000
Creditors 1,60,000
st
Investments (12% Purchased on 1 October 1999) 6,00,000
Bank Balance 83,900

40,93,500 40,93,500

Adjustments –
a. Closing Stock Rs. 2,25,000.
b. Goods worth Rs. 5,000 were taken for personal use but no entry was made in the books.
c. Machinery worth Rs. 35,000 purchased on 1st January, 1997 was wrongly written off
against Profit & Loss Account. This asset is to be brought into account on 1st January
1999 taking depreciation at 10% per annum on straight line basis upto 31st December,
1998.
d. Depreciation on Building at 2.5%, Machinery at 10% and Furniture at 10%.
e. Provision for Doubtful Debts should be 6% on Debtors.
f. The Manager is entitled to a commission of 5% of net profits after charging his commission.
Prepare Trading and Profit & Loss Account for the year ending 31st December, 1999 and a
Balance Sheet as on that date.

Q.6. From the following information, you are required to prepare Trading Account, Profit &
Loss Account and Balance Sheet as on 31st December, 1999 for “SANPAT” Co.

92 Management Accounting
Particulars Dr. Rs. Cr. Rs.
Sundry Debtors 40,000
Bills Receivables 18,500
Goodwill 40,500
Land & Building 1,10,000
Plant & Machinery 40,000
Furniture 40,200
Motors 50,800
Telephone Bills 11,200
Opening Stock 18,700
Wages 2,000
Advertisement 11,700
Royalty 12,000
Power & Fuel 12,800
Legal Charges 1,200
Audit Fees 4,090
Lighting 2,000
Salaries 3,500
Repairs 110
Purchases 22,000
Rent 1,700
Cash in Hand 78,000
Depreciation Fund 8,000
Outstanding Taxes 1,800
Bills Payable 2,200
Sundry Creditors 4,700
Bank Overdraft 3,200
Capital 1,50,000
General Reserves 38,000
Bank Loan 1,00,000
Provident Fund 40,000
Purchases Returned 1,000
Sales 1,20,500
Bank Loan 50,400
Outstanding Interest 1,200

5,21,000 5,21,000

Process of Accounting 93
Adjustments –
a. Interest on Capital 10%.
b. Closing Stock Rs. 75,000.
c. Goods costing Rs. 8,000 lost by fire and insurance company admitted a claim of
Rs. 6,500.
d. Depreciation on Motors 10%, Furniture 20%, Plant & Machinery 5%.
e. Provide RDD 10% on Debtors.
f. Outstanding Wages Rs. 1,000.
g. Prepaid Telephone Bill Rs. 1,200.

Q.7. Following Trial Balance was taken out on 31st March, 1996 from the books of Mr. Raman.
You are required to prepare Trading and Profit & Loss Account for the year ended 31st
March, 1996 and Balance Sheet as at that date, after making the necessary adjustments.

Debit Balances Rs. Credit Balances Rs.


Wages & Salaries 6,000 Sales-Cash 8,000
Drawings 2,000 Sales-Credit 18,000
Purchases 18,000 Capital 34,000
Sales Returns 300 Discount earned 340
Office Furniture 4,000 Purchases Returns 460
Buildings 12,000 Provision for Bad Debts 1,500
Office Expenses 800 Sundry Creditors 2,800
Advertisement 500 Bank Overdraft 1,300
Opening Stock 5,000 Income from Investments 250
Rent and Taxes 400
Commission 200
Bills receivables 800
Travelling Expenses 250
Trade Expenses 350
Bad Debts 190
Sundry Debtors 11,000
Cash in Hand 1,800
Investments 2,000
Fuel & Power (Factory) 1,060

Total 66,650 Total 66,650

94 Management Accounting
Adjustments –

a. Depreciation to be provided on Building and Furniture @10%.

b. Rent outstanding was Rs. 120.

c. Provision for Doubtful Debts to be maintained at 5%.

d. Interest accrued but not received was Rs. 50.

e. Goods of the value of Rs. 100 were given away as free samples.

f. Closing Stock was valued at Rs. 8,200.

Q.8. From the following Trial Balance and adjustments, prepare Trading and Profit & Loss
Account for the year ending 31st December 1997 and Balance Sheet as on that date.

Debit Balances Rs. Credit Balances Rs.


Salaries 16,500 Commission Received 1,250
Bad Debts 1,500 Sales 1,70,000
Opening Stock 12,500 Interest Received 2,250
Purchases 87,500 Provision for Bad Debts 1,750
Wages 5,000 Capital 1,00,000
Commission Paid 250 Loan taken on 1.10.97 @12% p.a. 12,500
Carriage Outwards 2,500
Octroi 7,000
Machinery 25000
Additions on 1.7.97 12500 37,500
Bank 22,500
Goodwill 25,000
Cash 15,000
Sundry Debtors 52,500
Legal & Professional Fees 2,500

Total 2,87,750 Total 2,87,750

Adjustments –
1. Closing stock was valued at cost Rs. 37,500.
2. Outstanding salaries amounted to Rs. 1,500.
3. Commission received but not earned Rs. 250.

Process of Accounting 95
Q.9. From the following Trial Balance and adjustments, prepare Trading and Profit & Loss
Account for the year ending 31st December, 1997 and Balance Sheet as on that date.

Debit Balances Rs. Credit Balances Rs.


Opening Stock 25,000 Rent Received 1,500
Wages 5,000 Commission Received 750
Carriage 1,000 Miscellaneous Income 250
Salaries 3,800 Bad Debts recovered 1,000
Bad Debts 700 RDD 700
Purchases 1,10,000 Sales 2,00,000
Return Inwards 2,000 Return Outwards 1,000
Plant & Machinery 35,000 Bills Payable 7,500
Furniture as on 1st January, 1997 20,000 Capital 70,000
Furniture purchased 1.7.1997 5,000 Creditors 20,000
Investments 27,500
Patent Rights 3,500
Cash in Hand 750
Cash at Bank 13,250
Sundry Debtors 40,000
Bills Receivables 10,000
Postage and Telegrams 200

Total 3,02,700 Total 3,02,700

Adjustments –

1. Write off Bad Debts Rs. 500 and create 5% RDD on Debtors.

2. Salaries Outstanding Rs. 200.

3. Unearned commission Rs. 50.

4. Plant & Machinery and Furniture to be depreciated @10% p.a.

5. Closing Stock Rs. 10,000.

Q.10. Melon and Lemon are partners sharing profits equally. From the following Trial Balance
and the additional information, prepare Trading and Profit & Loss Account for the year
ending 30th June, 1982 and Balance Sheet on that date.

96 Management Accounting
Debit Balances Rs. Credit Balances Rs.
Drawings - Melon 2,000 Capital - Melon 35,000
- Lemon 3,500 - Lemon 25,000
Land & Building 36,000 Sales 95,500
Machinery 18,000 Returns 1,300
Salaries 3,700 Bad Debts Reserve 800
Motor Car 10,500 Creditors 3,000
Trade Expenses 1,900 Commission 1,500
Carriage Inward 400 Bank Loan taken 0n 1.1.82 20,000
Royalties 1,800
Purchases 45,300
Return Inwards 2,500
Debtors 24,600
Discounts 1,000
Insurance 1,200
Stock on 1.7.81 23,800
Advertisement 3,000
Cash at Bank 2,900

Total 1,82,100 Total 1,82,100

Additional Information

a. Stock on 30th June, 1982 was worth Rs. 36,000 at cost while its market value was
Rs. 39,000

b. Goods worth Rs. 4,000 taken by Lemon for personal use were not entered in the books
of accounts.

c. Of the debtors, Rs. 600 were bad and should be written off and reserve for doubtful debts
should be maintained at 5%.

d. 5% interest is to be allowed on capital.

e. Provide for interest on bank loan @10% per annum.

f. Insurance is paid for the year ending 31st December, 1982.

Process of Accounting 97
Q.11. From the Trial Balance of M/s. Hocus and Pocus, you are required to prepare Trading
and Profit & Loss Account for the year ending 31st December 1982 and the Balance
Sheet as on that date after taking into account the additional information. Partners
share the profits and losses equally.

Debit Balances Rs. Credit Balances Rs.


Drawings – Hocus 14,450 Capital – Hocus 1,80,000
Drawings – Pocus 15,000 Capital – Pocus 1,50,000
Stock as on 1.1.82 2,00,000 Sales 4,00,000
Bills Receivables 25,000 Bills Payable 61,000
Purchases 2,75,000 Return Outwards 4,500
Returns Inwards 5,000 Sundry Creditors 1,40,000
Plant and Machinery 1,00,000
Furniture 45,000
Sundry Debtors 1,20,000
Cash in Hand and at Bank 77,550
Salaries 12,000
Wages 19,000
Rent and Taxes 11,500
Insurance 3,000
Printing and Stationary 2,000
General Expenses 6,500
Power and Fuel 4,500

Total 9,35,500 Total 9,35,500

Additional Information.
a. Stock as on 31st December, 1982 was Rs. 1,60,000.
b. It is discovered that sales effected on 31st December, 1982 of the value of Rs. 2,000 has
not been recorded in the books.
c. Stock worth Rs. 3,000 uninsured has been destroyed by fire.
d. Depreciate Plant & Machinery by 20% and Furniture by 5%
e. Provide for bad and doubtful debts Rs. 6,000.
f. Outstanding Expenses – Salaries Rs. 2,500, Wages Rs. 1,000.
g. Prepaid insurance Rs. 500.

98 Management Accounting
Q.12. The Accountant of M/s. Kasturi Agencies extracted the following Trial Balance as on
31st March, 1987.

Particulars Dr. Rs. Cr. Rs.


Capital 1,00,000
Drawings 18,000
Buildings 15,000
Furniture 7,500
Motor Van 25,000
Bank Loan at 12% Interest 15,000
Interest paid on above 400
Sales 1,00,000
Purchases 75,000
Stock as on 1.4.86 25,000
Stock as on 31.3.87 32,000
Establishment Expenses 15,000
Freight Inwards 2,000
Freight Outwards 1,000
Commission Received 7,500
Sundry Debtors 28,100
Bank Balance 20,500
Sundry Creditors 10,000

2,28,500 2.68,500
The Accountant located the following errors but is unable to proceed further any more.
a. A totalling error in bank column of payment side of cash book whereby the column was
undercast by Rs. 500.
b. Interest on Bank loan paid for the quarter ending 31st December, 1986, Rs. 450, was
omitted to be posted in the ledger. There was no further payment of interest.
c. You are required to set right the Trial Balance and prepare the Trading and Profit and
Loss Account for the year ended on 31st March, 1987 and the Balance Sheet on that
date, after carrying out the following –
1. Depreciation is to be provided on the assets as follows :
l Buildings 2.5% p.a.
l Furniture 10% p.a.
l Motor Van 10% p.a.
2. Balance of interest due on the loan is also to be provided for.

Process of Accounting 99
NOTES

100 Management Accounting


Chapter 4
BANK RECONCILIATION STATEMENT

If the account is opened in a bank in the name of business, the bank periodically gives the
bank passbook or the bank statement. The bank passbook or the bank statement is the
extract of the account in the name of business as it appears in the books of the bank.
Similarly, in the books of business also, it maintains the bank book which is the extract of
bank transactions as it appears in the book of business. As both the bank book in the books
of business and bank passbook as per the books of bank record the same transactions, the
balance as per bank book should match with the balance as per passbook. However, in
reality, the said balances may not match with each other. These balances may not match with
each due to the following reasons –

1. Cheques issued but not debited - The business might have issued some cheques
which are not yet presented in the bank for clearing. As such, the balance as per bank
pass book may be higher.

2. Cheques deposited but not cleared - The business might have deposited some
cheques in the bank account, but the bank might not have received the payment for the
same and hence the amount is not yet credited to the bank account. As such, balance
as per bank book may be higher.

3. Other Reasons – There may be a possibility that certain items may appear only in the
passbook without any corresponding effect of the same in the bank book. This may be
possible due to following reasons –

a. The bank debits periodical bank charges and bank interest to the account. These
amounts appear only in the bank passbook. The business organization makes the
entry of the same on the receipt of intimation from the bank. Till the entry is passed
in the bank book, the bank book may show higher balance than the passbook.

b. If the cheques deposited by the business organization get dishonoured, bank


immediately debits the same amount to the account. The business organization
makes the entry of the same on the receipt of intimation from the bank. Till the
entry is passed in the bank book, the bank book may show higher balance than the
passbook.

Bank Reconciliation Statement 101


c. In some cases, some of the customers of the business organization may make the
payment directly in the bank account of the business organization. The business
organization makes the entry of the same on the receipt of intimation from the
bank. Till the entry is passed in the bank book, the bank book may show lower
balance than the passbook.

d. In some cases, the business organization may give the standing instructions to the
bank to make the recurring payments like rent, electricity bills, telephone bills etc.
as and when they become due for payment. Accordingly, the bank might have paid
these amounts and on payment, they are debited to the account. The business
organization makes the entry of the same on the receipt of intimation from the
bank. Till the entry is passed in the bank book, the bank book may show higher
balance than the passbook.

e. In some cases, the bank is given the responsibility of collecting the investment
income or the principal amount of investment or the bills of exchanges on the date
of maturity. Accordingly, the bank collects the same and credits the same to the
account. The business organization makes the entry of the same on the receipt of
intimation from the bank. Till the entry is passed in the bank book, the bank book
may show lower balance than the passbook.

f. There may be some clerical error on the part of bank when certain amounts may be
wrongly debited or credited by the bank to the account. The business organization
makes the entry of the same on the receipt of intimation from the bank. Till the
entry is passed in the bank book, the bank book may show lower or higher balance
than the passbook depending upon the nature of error on the part of bank.

Bank Reconciliation Statement is the statement prepared to explain the reasons as to why
the bank balance as per passbook and bank balance as per bankbook does not match.

Preparation of Bank Reconciliation Statement

The bank reconciliation starts with the Closing Bank Balance as per Bank Book and by
making the additions and subtractions therefrom, the Bank Balance as per the Bank Statement
or Pass Book is arrived at. Alternatively, the bank reconciliation statement may start with
Balance as per the Bank Statement or Pass Book and by making the additions and subtractions
therefrom, the Bank Balance as per the Bank Book may be arrived at. For preparing the bank
reconciliation statement, entries on the payment side of Bank Book are compared with the
withdrawal column of the Pass Book or Bank Statement and the entries on the receipts side
of Bank Book are compared with the deposits column of Bank Statement or Pass Book. If
entries on the payment side or receipt side of the Bank Book appear on the withdrawal or
deposit column of Bank Statement or Pass Book respectively, bank reconciliation statement

102 Management Accounting


does not get affected. Bank reconciliation statement is affected due to those amounts which
appear on the payment side of Bank Book but are not there in the withdrawals column of Bank
Statement or Pass Book or amounts which appear on the receipts side of Bank Book but are
not there in the deposits column of Bank Statement or Pass Book.

Following is the specimen of bank reconciliation statement –

Bank Reconciliation Statement as on ——

Bank Balance as per Bank Book


Add : a. Cheques issued but not presented
b. Amount credited in Pass Book but not in
Bank Book
c. Deposits made in the account directly
d. Wrong credits given by bank
Sub-Total
Less : a. Cheques deposited but not cleared
b. Interest/Bank Charges debited by bank
c. Direct payments made by bank not entered in
Bank Book
d. Cheques dishonoured not recorded in
Bank Book
e. Wrong debits given by bank
Sub-Total

Bank Balance as per Bank Statement or Pass Book

Following points should be remembered –


a. If the bank reconciliation statement is prepared by starting with Bank Balance as per
Bank Statement or Pass Book, amounts added in the above specimen need to be
subtracted and the amounts subtracted in the above specimen need to be added.

b. If the bank has given the overdraft facility, generally the Bank Book will show closing
balance as credit balance. If the bank reconciliation statement is prepared starting with
bank balance as per Bank Book, amounts added in the above specimen need to be
subtracted and the amounts subtracted in the above specimen need to be added.

c. If the bank reconciliation statement prepared discloses the amounts for which the entries
have not been made in the Bank book, those entries should be made in the books of
accounts and the balance as per the Bank book should be modified accordingly.

Bank Reconciliation Statement 103


d. After all the entries as disclosed by the bank reconciliation statement are passed in the
books of account, there will be mainly two amounts appearing in the final bank reconciliation
statement viz. cheques issued but not presented for payment and cheques deposited
but not cleared. In some abnormal circumstances, the final bank reconciliation statement
may have the amounts which are wrongly debited or credited by the bank erroneously for
which the bank needs to pass rectification entries subsequently.

e. For the purpose of preparation of Trial Balance, bank balance as per Bank Book will be
considered and not the balance as per Bank Statement or Pass Book.

Illustration

Following are the entries recorded in the Bank Column of the Cash Book of Mr. X for the month
ending 31st March 1997.

Cash Book (Bank Column only)

Date Particulars Rs. Date Particulars Rs.

15.3.97 To Cash 36000 01.3.97 By Balance b/fd 40000


20.3.97 To Roy 24000 04.03.97 By John 2000
22.3.97 To Kapoor 10000 06.3.97 By Krishnan 400
31.3.97 To Balance c/fd 7640 15.3.97 By Kailash 240
20.3.97 By Joshi 35000

Total 77640 Total 77640

On 31st March, 1997, Mr. X received the Bank Statement. On perusal of the statement, Mr. X
ascertained the following information –

a. Cheques deposited but not cleared by bank Rs. 10,000

b. Interest on securities collected by the bank but not recorded in cash book Rs. 1,080

c. Credit transfers not recorded in the cash book Rs. 200

d. Dividend collected by the bank directly but not recorded in the cash book Rs. 1,000

e. Cheques issued but not presented for payment Rs. 37,400

f. Interest debited by the bank but not recorded in the cash book Rs. 1,000

g. Bank Charges not recorded in the cash book Rs. 340

From the above information you are asked to prepare a Bank reconciliation statement to
ascertain the balance as per Bank Statement.

104 Management Accounting


Solution

Bank Reconciliation Statement as on 31st March, 1997

Bank Balance as per Cash Book (Overdraft) 7,640


Add : a. Cheques deposited but not cleared 10,000
b. Interest debited by bank not recorded in Cash Book 1,000
c. Bank Charges debited by bank not recorded in
Cash Book 340 11,340
Sub-Total 18,980
Less : a. Cheques issued but not presented 37,400
b. Interest on securities collected by bank not
Recorded on cash book 1,080
c. Credit transfer not recorded in cash book 200
d. Dividend collected by bank not recorded in
Cash Book 1,000 39,680
Bank Balance as per Bank Statement (Overdraft) 20,700

Illustration

From the following extracts of the cash book (bank column) and bank pass book of Mr.X,
prepare the bank reconciliation statement for the month ending on 31st March, 1997.

Cash Book (Bank Column only)

Date Particulars Rs. Date Particulars Rs.

01.3.97 To Balance b/fd 8,680 02.3.97 By Salaries & Wages 3,250


03.3.97 To A 1,200 03.3.97 By Interest on Loan 80
05.3.97 To B 1,620 08.3.97 By Bank Charges 5
16.3.97 To C 600 12.3.97 By X 1,500
21.3.97 To Interest 700 21.3.97 By Y 200
24.3.97 To D 1,200 24.3.97 By Z 1,350
28.3.97 To E 3,500 28.3.97 By Drawings 800
29.3.97 To F 2,200 31.3.97 By Balance c/fd 15,315
31.3.97 To G 2.800

Total 22,500 Total 22,500

Bank Reconciliation Statement 105


Extracts of Pass Book of Mr. X
In the books of Bank of India, Karve Road Branch, Pune

Date Particulars Withdrawals Deposits Dr/Cr Balance


01.4.97 Balance b/fd Cr 7,165
02.4.97 To Z 1,350 Cr 5,815
02.4.97 By E 3,500 Cr 9,315
03.4.97 By D 1,200 Cr 10,515
04.4.97 To Insurance Premium 700 Cr 9,815
05.4.97 To M 1,200 Cr 8,615
05.4.97 By Cash 1,000 Cr 9,615
06.4.97 By F 2,200 Cr 11,815
06.4.97 To Y 200 Cr 11,615
07.4.97 By G 2,800 Cr 14,415
07.4.97 To Interest 500 Cr 13,915

Solution

Bank Reconciliation Statement as on 31st March 1997

Bank Balance as per Bank Book 15,315


Add : Cheques issued but not presented
Mr. Z 1,350
Mr. Y 200 1,550
Sub-Total 16,865
Less : Cheques deposited but not cleared
Mr. E 3,500
Mr. D 1,200
Mr. F 2,200
Mr. G 2,800 9,700
Sub-Total
Bank Balance as per Bank Statement or Pass Book 7,165

106 Management Accounting


Illustration

Following particulars are extracted from the books of accounts of Mr. Bose for the month
ending 31st March, 1989.

a. Bank balance as per cash book Rs. 7,000.

b. Cheques issued but presented after 31st March, 1989 Rs. 1,000.

c. Three cheques were issued for Rs. 500, Rs. 1,000 and Rs. 1,500 respectively, but the
cheque for Rs. 1,000 was presented on 3rd April, 1989.

d. Cheques issued but not recorded in the cash book Rs. 750.

e. Cheques deposited but credited after 31st March, 1989 Rs. 250.

f. Three cheques were deposited for Rs. 1,000, Rs. 1,200 and Rs. 1,600 respectively, but
the cheque for Rs. 1,600 was credited on 2nd April.

g. Cheques deposited into the bank but not recorded in the cash book Rs. 1,000.

h. Debit side of the cash book was overcast by Rs. 500.

i. Credit side of the cash book was undercast by Rs. 800.

j. Bank interest credited for Rs. 150 and debited for interest Rs. 50 not recorded in the
cash book.

k. Dividend collected by the bank not recorded in the cash book Rs. 1,000.

l. A debtor directly deposited into bank but not recorded in the cash book Rs. 500.

m. Rs. 1,000 in respect of dishonoured cheques appeared in the pass book but not in the
cash book.

n. Bank met a Bill Payable of the firm Rs. 1,500 on 30th March, 1989 under an advice to the
firm on 2nd April, 1989.

o. Bank’s charges for a cheque book Rs. 5 were entered in the cash book twice.

p. A cheque for Rs. 50 drawn by Mr. Mukherjee had been charged to Mr. Bose’s account in
error in March, 1989.

Prepare the bank reconciliation statement as on 31st March, 1989 before and after making
the necessary adjustments in the cash book.

Bank Reconciliation Statement 107


Solution
Bank Reconciliation Statement as on 31st March, 1989
(Before making adjustments in the cash book)

Bank Balance as per Bank Book 7,000


Add : a. Cheques issued but not presented 1,000
b. Cheques issued but not presented 1,000
c. Cheques deposited but not recorded in cash book 1,000
d. Bank Interest credited not credited in cash book 150
e. Dividend collected not entered in cash book 1,000
f. Deposits made in bank not entered in cash book 500
g. Bank charges recorded twice in cash book 5 4,655
Sub-Total 11,655
Less : a. Cheques deposited but not cleared 250
b. Cheques issued but nor recorded in cash book 750
c. Cheques deposited but not cleared 1,600
d. Debit side of cash book overcast 500
e. Credit side of cash book undercast 800
f. Bank Interest debited not debited in cash book 50
g. Bill paid by bank not entered in cash book 1,500
h. Cheques dishonoured not recorded in cash book 1,000
i. Cheque wrongly debited by bank 50
Sub-Total 6,500
Bank Balance as per Bank Statement or Pass Book 5,155

Cash Book (Bank Column only)

Particulars Rs. Particulars Rs.


To Balance b/fd 7,000 By Cheques issued 750
To Cheques deposited 1,000 By Debit side overcast 500
To Interest Received Account 150 By Credit side undercast 800
To Dividend Received Account 1,000 By Bank Charges 50
To Debtors 500 By Debtors (Dishonoured cheques) 1,000
To Bank Charges (debited twice) 5 By Creditors 1,500
By Balance c/fd 5,055
Total 9,655 Total 9,655

108 Management Accounting


Bank Reconciliation Statement as on 31st March, 1989
(After making adjustments in the cash book)

Bank Balance as per Bank Book 5,055

Add : a. Cheques issued but not presented 2,000

Sub-Total 7,055

Less : a. Cheques deposited but not cleared 1,850

b. Wrong debits given by bank for cheque 50 1,900

Sub-Total

Bank Balance as per Bank Statement or Pass Book 5,155

Illustration

From the following particulars, prepare the bank reconciliation statement for Mr. S.Sarkar as
on 31st December, 1985 before and after making necessary adjustments in the cash book.

a. Bank Balance as per cash book Rs. 610 (Credit).


b. Cheques issued but not presented Rs. 3,000.

c. Cheques deposited but not cleared Rs. 2,500.

d. A cheque drawn for Rs. 100 has been incorrectly entered as Rs. 10 in the cash book.
e. A debtor directly deposited into Sarkar’s bank account but not recorded in the cash
book Rs. 1,000.

f. Payment side of the cash book was undercast by Rs. 500.


g. A cheque for Rs. 5,000 drawn by Mr. Banerjee has been charged to Sarkar’s account in error.

h. Bank paid a Bill Payable for Rs. 1,450 but it was recorded in the cash book as Rs. 1,540.
i. The receipt column of cash book was overcast by Rs. 1,000.

j. Discount allowed Rs. 410 has been entered through mistake with the cheque in the bank
column of the cash book.
k. Pursuant to instructions dated 30th December, 1985, asking the banker to transfer
Rs. 10,000 to fixed deposit account and entry for this was made in the cash book but the
bank acted in January 1986.

l. The bank debited the account with Rs. 500 being the amount of cheque received from a
customer and returned unpaid but not entered in the cash book.
m. Cheques amounting to Rs. 300 though actually banked were not entered in the cash book.

Bank Reconciliation Statement 109


Solution

Bank Reconciliation Statement as on 31st December, 1985


(Before making adjustments in the cash book)

Bank Balance as per Cash Book (Overdraft) 610


Add : a. Cheques deposited but not cleared 2,500

b. Cheque for Rs. 100, entered as Rs. 10 90


c. Payment side of cash book undercast 500

d. Wrong debit in pass book for Mr. Banerjee’s Cheque 5,000


e. Receipt column of cash book overcast 1,000

f. Discount allowed treated as receipt of cheque


in the cash book 410

g. Cheque dishonoured 500 10,000


Sub-Total 10,610

Less : a. Cheques issued but not presented 3,000


b. Amount deposited by debtor in bank account 1,000
c. Bill Paid for Rs. 1,450 entered as Rs. 1,540 90

d. Cheques deposited but not entered in cash book 300


c. Transfer to fixed deposit 10,000 14,390

Bank Balance as per Bank Statement 3,780

Cash Book (Bank Column only)

Particulars Rs. Particulars Rs.


To Debtor 1,000 By Balance b/fd 610

To Creditor 90 By Creditor 90

To Fixed Deposit Account 10,000 By Payment side undercast 500

To Debtors 300 By Receipt side overcast 1,000

By Discount 410

By Debtors 500

By Balance c/fd 8,280

Total 11,390 Total 11,390

110 Management Accounting


Bank Reconciliation Statement as on 31st December, 1985
(After making adjustments in the cash book)

Bank Balance as per Bank Book 8,280

Add : a. Cheques issued but not presented 3,000

Sub-Total 11,280

Less : a. Cheques deposited but not cleared 2,500

b. Wrong debits given by bank for cheque 5,000

Sub-Total 7,500

Bank Balance as per Bank Statement or Pass Book 3780

Illustration

Following are the cash book and pass book of Mr. X for the month of April, 2002.
Cash Book (Bank Column only)

Date Particulars Rs. Date Particulars Rs.

01.4.02 To balance b/fd 12,500 01.4.02 By Salaries (C.No. 183) 4,000

04.4.02 To Sales A/c 8,000 06.4.02 By Purchases (C.No. 184) 3,200

08.4.02 To P A/c 1,500 11.4.02 By Machinery (C.No. 185) 6,000

13.4.02 To M A/c 3,400 15.4.02 By Omprakash (C.No. 186) 1,000

18.4.02 To Kamal A/c 4,600 19.4.02 By Drawings (C.No. 187) 800

21.4.02 To Furniture A/c 1,200 23.4.02 By K A/c (C.No. 188) 2,000

25.4.02 To Sales A/c 3,800 27.4.02 By S A/c (C.No. 189) 1,000

30.4.02 To F A/c 3,000 30.4.02 By Printing (C.No. 190) 500

30.4.02 By Balance c/fd 19,500

38,000 38,000

Bank Reconciliation Statement 111


Pass Book

Date Particulars C.No. Withdrawals Deposits Dr/Cr. Balance


01.4.02 By Balance b/fd Cr. 12,500
02.4.02 To Cheque 183 4,000 Cr. 8,500
06.4.02 By Cheque 8,000 Cr. 16,500
06.4.02 To Cheque 184 3,200 Cr. 13,300
10.4.02 By Cheque 1,500 Cr. 14,800
16.4.02 By Cheque 3,400 Cr. 18,200
17.4.02 To Cheque 187 800 Cr. 17,400
20.4.02 By Cheque 4,600 Cr. 22,000
24.4.02 By Cheque 3,800 Cr. 25,800
28.4.02 To Cheque 185 6,000 Cr. 19,800
28.4.02 To Cheque 189 1,000 Cr. 18,800
30.4.02 By Interest 100 Cr. 18,900
30.4.02 By Deposit (K.Sen) 3,000 Cr. 21,900
30.4.02 To Charges 10 Cr. 21,890
You are required to prepare a Bank Reconciliation Statement as on 30th April 2002.

Solution
Bank Reconciliation Statement as on 30th April, 2002

Bank Balance as per Cash Book 19,500


Add : a. Cheques issued but not presented
(Rs. 1,000 + Rs. 2,000 + Rs. 500) 3,500
b. Deposited by K.Sen 3,000
c. Interest credited by bank, not in cash book 100
6,600
Sub-Total 26,100
Less : a. Cheques deposited but not cleared
(Rs. 1,200 + Rs. 3,000) 4,200
b. Bank Charges debited by bank 10
Sub-Total 4,210

Bank Balance as per Bank Statement or Pass Book 21,890

112 Management Accounting


Illustration

Fun Fare Limited have a current account with National Bank Limited. The following is the
extract from the Bank’s books of account for the last week of June, 1988.

Particulars C.No. Withdrawals Deposits Dr/Cr. Balance


Balance b/fd Cr. 21,000
Gopal Brothers 212 4,000 Cr. 17,000
Madhu Industries 5,000 Cr. 22,000
N Traders 213 7,200 Cr. 14,800
Ram Gopal Sons 7,500 Cr. 22,300
Gopal Brothers 215 4,100 Cr. 18,200
Ourselves 216 2,400 Cr. 15,800
Dividend Warrants 500 Cr. 16,300
Incidental Charges 10 Cr. 16,290
Interest on Loan 900 Cr. 15,390
Lal Chand 217 1,000 14,390

It is understood that –
a. Cheque no. 214 drawn in favour of T.W.Traders for Rs. 2,100 was not yet presented to the bank.
b. Advice regarding the incidental charges, interest on loan and dividend warrants reached
Fun Fare Limited only in July.
c. Cheque favouring Lal Chand was towards rent for the month of June.
From the above data you are required to prepare a cash book (bank column only) of Fun Fare
Limited and a bank reconciliation statement in their books at the end of the month.

Solution :
Cash Book (Bank Column only)
Date Particulars Rs. Date Particulars Rs.
30.6.88 To Balance b/fd 21,000 30.6.88 By Gopal Brothers 4,000
To Madhu Industries 5,000 By N Traders 7,200
To Ram Gopal 7,500 By T W Traders 2,100
By Gopal Brothers 4,100
By Cash 2,400
By Rent 1,000
By Balance c/fd 12,700
33,500 33,500

Bank Reconciliation Statement 113


Bank Reconciliation Statement as on 30th April, 2002

Bank Balance as per Cash Book 12,700


Add : a. Cheques issued but not presented 2,100
b. Dividend collected by bank, not in cash book 500
2,600
Sub-Total 15,300
Less : a. Incidental charges debited by bank 10
b. Interest on Loan debited by bank 900
Sub-Total 910
Bank Balance as per Bank Statement or Pass Book 14,390

QUESTIONS

1. What do you mean by Bank Reconciliation Statement ? What are the reasons for
difference between the balance shown by cash book and the one shown by the pass
book?

2. What are the different causes of discrepancy between bank balance as per cash book
and pass book ?

3. What is Bank Reconciliation Statement ? Why is it prepared ?

114 Management Accounting


PROBLEMS

Q. 1

The Bank account of Mukesh was balanced on 31st March, 1992. It showed an overdraft of
Rs. 5,000. The Bank Statement of Mukesh showed a credit balance of Rs. 76,750. Prepare a
Bank reconciliation statement taking the following information into account –

a. Cheques issued but not presented for payment till 31st March, 1992 Rs. 12,000.

b. Cheques deposited but not collected by bank till 31st March, 1992 Rs. 20,000.

c. Interest on term loan Rs. 10,000 debited by bank on 31st March, 1992 but not accounted
in Mukesh’s books.

d. Bank charges Rs. 250 was debited by bank but accounted in the books of Mukesh on
4th April, 1992.

e. An amount of Rs. 1,00,000 representing collection of Mukesh’s cheques was wrongly


credited to the personal account of Mukesh by the bank in their bank statement.

Q. 2

From the following particulars, prepare a Bank Reconciliation Statement as on 31st December,
1993.

a. On 31st December, 1993, the cash book of a firm showed a bank balance of Rs. 6,000
(Debit Balance).

b. Cheques had been issued for Rs. 5,000, out of which cheque worth Rs. 4,000 only were
presented for payment.

c. Cheques worth Rs. 1,400 were deposited in the bank on 28th December, 1993 but had
not been credited by the bank. In addition to this, one cheques for Rs. 500 was entered
in the cash book on 30th December, 1993 but was banked on 3rd January, 1994.

d. A cheque from Susan for Rs. 400 was deposited in the bank on 26th December, 1993
but was dishonoured and the advice was received on 3rd January, 1994.

e. Passbook showed bank charges of Rs. 20 debited by the bank.

f. One of the debtors deposited a sum of Rs. 500 in the bank account of the firm on 20th
December, 1993 but the intimation in this respect was received from the bank on 2nd
January, 1994.

g. Bank Passbook showed a credit balance of Rs. 5,180 on 31st December, 1993.

Bank Reconciliation Statement 115


Q. 3

On 31st May, 1994, the cash book of ABC Ltd. showed a bank overdraft of Rs. 1,234. On an
examination of the cash book and bank pass book, the following information was gathered –

a. Two cheques received from P and Q for Rs. 234 and Rs. 456 respectively were deposited
with the bank on 30th May, 1994, but they were cleared only on 1st June 1994.

b. A cheque for Rs. 345 issued on 26th May, 1994 was presented to the bank for payment
on 3rd June, 1994.

c. A cheque for Rs. 567 deposited by a customer in the company’s account with bank
directly on 25th May, 1994.

d. Rs. 5,678 being proceeds of a bill collected on 30th May, 1994 did not appear in the cash book.

e. A bill payable for Rs. 5,789 was duly paid off on 31st May, 1994 according to the instructions
of the company, entry of which was made in the cash book on 1st June, 1994.

f. Interest on overdraft Rs. 111 appears in the pass book.

Q. 4

On 31st January, 1988, my cash book showed a bank overdraft of Rs. 12,500. On comparing
it with the pass book, following differences were located –
a. Cash and cheques amounting Rs. 1,340 were sent to bank on 27th January, but cheques
worth Rs. 230 were credited on 2nd February and one cheque for Rs. 45 was returned by
them as dishonoured on 4th February.
b. During the month of January, I issued cheques worth Rs. 1,760 to my creditors. Out of
these, cheques worth Rs. 1,370 were presented for payment on 5th February.
c. According to my standing orders, the bankers have paid during the month of January the
following –
• Life insurance premium Rs. 170
• Driving license fee Rs.40
d. My bankers have collected Rs. 150 as dividend on the shares.
e. My bankers have given me wrong credit for Rs. 150.
f. A bill receivable for Rs. 100 discounted with the bank in December, 1987 has been
dishonoured on 31st January, 1988.
g. Interest charged by the bank Rs. 125.
Prepare a bank reconciliation statement on 31st January, 1988.

116 Management Accounting


Q. 5

From the following particulars, find out adjusted bank balance as per cash book and prepare
thereafter bank reconciliation statement as on 31st December, 1995 of Raja Brothers –

Particulars Rs.
Bank Overdraft as per Cash Book 80,000
Cheques deposited as per bank statement but not entered in cash book 3,000
Cheques recorded for collection but not sent to the bank 10,000
Credit side of bank column cast short 1,000
Bank charges recorded twice in the cash book 100
Customers’ cheques returned as per bank statement only 4,000
Cheques issued but dishonoured on technical grounds 3,000
Bills collected by bank directly 20,000
Cheques received entered twice in cash book 5,000

Q. 6

The cash book of a firm showed an overdraft of Rs. 30,000 on 31st March, 1999. A comparison
of the entries in cash book and pass book revealed that –

a. On 22nd March, 1999, cheques totaling Rs. 6,000 were sent to bankers for collection. Out
of these, a cheques for Rs. 1,000 was wrongly recorded on the credit side of the cash book
and cheques amounting to Rs. 300 could not be collected by bank before 1st April, 1999.

b. A cheque for Rs. 4,000 was issued to a supplier on 28th March, 1999. The cheque was
presented to bank on 4th April, 1999.

c. There were debits of Rs. 2,600 in the pass book for interest on overdraft and bank
charges, but the same had not been recorded in the cash book.

d. A cheque for Rs. 1,000 was issued to a creditor on 27th March 1999, but by mistake the
same was not recorded in the cash book. The cheque was however duly encashed on
31st March, 1999.

e. As per standing instructions, the banker collected dividend of Rs. 500 on behalf of the
firm and credited the same to its account by 31st March, 1999. The fact was however
intimated to the firm on 3rd April, 1999.

You are required to prepare a bank reconciliation statement as on 31st March, 1999.

Bank Reconciliation Statement 117


Q. 7

On 31st March, 1998, Mehta’s Pass Book showed a debit balance of Rs. 6,350. From the
following information, prepare a Bank Reconciliation Statement as on that date –

1. Out of total cheques of Rs. 6,000 deposited into the bank in March. 1998, one cheque of
Rs. 500 was collected on 28th March, 1998 and another cheque of Rs. 1,000 was
collected on 3rd April, 1998.

2. The bank had paid a premium of Rs. 300 on 17th March for which there was no entry
made in the cash book.

3. The total of debit side bank column of cash book was undercast by Rs. 100.

4. Amount withdrawn from the bank on 26th March Rs. 200 was not recorded in the cash
book at all.

5. During March, cheques issued amounted to Rs. 2,000 of which cheques for Rs. 1,500
were presented to the bank on 2nd April 1998.

Q. 8

D. Diwakar’s Pass Book shows a balance of Rs. 5000 (Credit) on 30th June, 1998. His cash
book shows a different balance. On an examination, it is found that –

a. No record has been made in the cash book for dishonour of a cheque for Rs. 100.

b. Cash and cheques amounting to Rs. 700 were paid into the bank on 29th June, 1998 and
the same had not been entered in the pass book.

c. Bank charges of Rs. 15 have not been entered in the cash book.

d. Cheques amounting to Rs. 1,800 issued by P. Prabhakar and paid into the bank on 28th
June, 1998 had not been credited.

Prepare a bank reconciliation statement as on 30th June, 1998.

Q. 9

On 30th September 1998, cash book of a firm showed a bank balance of Rs. 7,500. From the
following information, prepare a bank reconciliation statement showing the balance as per
pass book –

a. Cheques amounting to Rs. 1,200 were paid on 28th September, 1998 had not been
credited by the bank. One cheque for Rs. 375 was entered in the cash book on 28th
September, 1998 but was banked on 3rd October, 1998.

b. Cheques issued for Rs. 900 had not yet been presented for payment at the bank.

118 Management Accounting


c. A cheque for Rs. 200 paid on 26th September, 1998 was dishonoured but the advice was
received only on 3rd October, 1998.

d. Bank charges of Rs. 15 were debited in the pass book by the bank.

e. There was an entry in the pass book for the receipt of Rs. 600 collected by the bank as
interest.

Q. 10

From the following particulars, ascertain the balance by means of a statement that would
appear in the pass book of Mr. S.Gavaskar as on 31st December 1998.

a. Overdraft as per Cash Book Rs. 4,558.

b. Interest on overdraft for six months ending 31st December, 1998 Rs. 120.

c. Bank charges debited in the pass book Rs. 24.

d. Cheques drawn but not cashed by the customers prior to 31st December, 1998 Rs. 1,326.

e. Cheques paid into the bank but not cleared before 31st December, 1998 Rs. 2,412.

f. A Bill Receivable originally discounted with the bank in November 1998 is dishonoured
Rs. 800.

Q. 11

From the following particulars, ascertain the balance that would appear in the cash book of
Mr. M. Ranganathan as on 31st December, 1998 –

a. Overdraft balance as per Pass Book Rs. 24,240.

b. Cheques amounting to Rs. 8,200 were paid into the bank on 28th December, 1998 out of
which only Rs. 600 was credited by the bank in the pass book till 31st December, 1998.

c. Cheques for Rs. 5,400 were issued on 28th December, 1998 out of which only one
cheque for Rs. 800 was presented for payment.

d. There is a debit of Rs. 200 for interest and Rs. 50 for bank charges in the pass book
which have not been entered in the cash book.

e. Rs. 400 debited to bank account in the cash book has been omitted to be banked.

f. There was a wrong debit of Rs. 600 in the pass book.

Bank Reconciliation Statement 119


Q. 12

On 30th June, 1990, the pass book of Sunil & Co. showed a balance of Rs. 9,800 as cash at
bank –

a. Prior to that date, they had issued cheques amounting to Rs. 3,500, of which, cheques
amounting to Rs. 1,900 have so far been presented for payment.

b. Out of the cheques for Rs. 2,000 paid by him into the bank before that date, only cheques
for Rs. 1,200 were credited in the pass book.

c. He had also received a cheque for Rs. 680 which although entered in the cash book had
been omitted to be paid into bank.

d. The bank had collected dividend directly and credited them.

Q. 13

From the following particulars, prepare a Bank Reconciliation Statement as on 28th February,
1989. Thiru Pandiyan had an overdraft balance of Rs. 80,500 as shown by the bank columns
of the cash book. Cheques amounting to Rs. 10,000 had been paid into the bank on 24th
February, 1989 but of these only Rs. 7,500 were credited in the pass book. He had issued
cheques amounting to Rs. 25,000, of which Rs. 20,000 worth only seem to have been presented.
The bank has debited in the pass book Rs. 750 for interest. A cheque for Rs. 600 which was
debited in the bank column in the cash book has been omitted to have been presented. An
entry appears in the pass book for Rs. 3,000 for a direct deposit by a customer of Thiru
Pandiyan.

Q. 14

On 31st March 1991 the cash book of Mr. X showed a bank balance of Rs. 14,850. While
verifying with the pass book, the following facts were noted –

a. Cheques sent in for collection before 31st March, 1991 and not credited by bank amounted
to Rs. 845.

b. Cheques issued before 31st March, 1991 but not presented for payment amounted to Rs. 885.

c. The banker has debited a sum of Rs. 100 towards the bank charges and credited Rs. 250
for interest received and Rs. 1,000 for dividend collected.

d. The banker has given a wrong credit for Rs. 250.

e. Mr. Y has paid into the bank a sum of Rs. 300 on 28th March, 1991 which has not been
entered in the cash book.

f. A cheque for Rs. 200 sent for collection returned dishonoured has not been entered in
the cash book.

120 Management Accounting


Q. 15

Find out the balance as per pass book from the following particulars –

a. Bank overdraft as per cash book on 30th April, 1992 was Rs. 2,000.

b. Cheque issued but not presented for payment Rs. 1,350.

c. Cheques deposited but not yet collected by the banker Rs. 500.

d. Bank charges Rs. 80 debited by the bank not yet entered in the cash book.

e. Interest on investments collected by the bankers and credited in the pass book amounted
to Rs. 905.

Q. 16

From the following particulars, ascertain the balance that would appear in the cash book of B
as on 31st December, 1998, before and after making necessary adjustments –
a. Overdraft as per pass book as on 31st December 1998 Rs. 13,880.
b. Interest on overdraft for six months ending 31st December 1998 not yet entered in the
cash book Rs. 240.
c. Bank charges for the above period not yet entered in the cash book Rs. 60.
d. Cheques drawn but not encashed by customers before 31st December, 1998 Rs. 3,300.
e. Cheques paid into the bank but not cleared before 31st December, 1998 Rs. 4,340.
f. A Bill Receivable, discounted with the bank in November, dishonoured on 31st December,
1998 Rs. 1,000.

Q. 17

From the following particulars taken on 31st December, 1989, you are required to prepare a
bank reconciliation statement to reconcile the bank balance shown in the cash book with that
shown in the pass book –

a. Balance as per pass book on 31st December, 1989 Rs. 1,027 (Credit).
b. Four cheques drawn on 31st December but not cleared till January Rs. 1,144.

c. Interest on overdraft not entered in the cash book Rs. 51.


d. Three cheques received on 30th December, 1989 and entered in the bank column of
cash book but not lodged in bank for collection till 3rd January, Rs. 5,280.

e. Cost of cheque book Rs. 5 entered twice erroneously in cash book in November.
f. A Bill Receivable for Rs. 250 on 29th December, 1989 was passed to the bank for
collection on 28th December, 1989 and was entered in the cash book forthwith, whereas
the proceeds were credited in the pass book only in January following.

Bank Reconciliation Statement 121


g. Chamber of Commerce subscription Rs. 10 paid by bank on 1st December, 1989 had
not been entered in the cash book.

h. Bank Charges of Rs. 5 had been debited in the pass book twice erroneously.

Q. 18

On 30th June, 1981, the pass book of M/s Thin and Short showed a balance of Rs. 2,000 at
the bank. They had sent cheques amounting to Rs. 10,000 to the bank before 30th June, 1981
but it appears from the pass book that cheques worth Rs. 9,000 had been credited before that
date. Similarly, out of the cheques for Rs. 5,000 issued during the month of June, cheques for
Rs. 4,000 were presented and paid in July. The pass book showed the following payments –

a. Rs. 320 as premium according to standing instructions.

b. Rs. 2,000 against a promissory note as per the instructions.

The pass book showed that the bank had collected Rs. 1,800 as interest on Government
Securities. The bank had charged as interest Rs. 50 and incidental expenses Rs. 20. There
was no entry in the cash book for the payment of interest etc. A bill sent for collection was
returned dishonoured on 29th June amounting to Rs. 600.

Prepare the Bank Reconciliation Statement as on 30th June, 1981.

Q. 19

From the following particulars, prepare a bank reconciliation statement showing the balance
as per pass book on 31st March, 1989.

a. Cheques for Rs. 7,900 was paid into bank in March, 1989 but were credited only in April,
1989.

b. Cheques for Rs. 11,000 were issued in March, 1989 but were cashed in April, 1989 only.

c. A cheque for Rs. 1,000 which was received from a customer was entered in the bank
column of the cash book in March, 1989 but the same was paid into the bank in April,
1989 only.

d. The pass book shows a credit of Rs. 2,500 for interest and a debit of Rs. 500 for bank
charges.

e. The bank balance as per cash book was Rs. 1,80,000 on 31st March, 1989.

122 Management Accounting


Q. 20

From the following particulars, prepare a bank reconciliation statement as at 31st December, 1991.

a. As on 31st December, 1991, bank overdraft as per cash book Rs. 2,49,900.

b. Interest debited in the bank pass book only Rs. 27,870.

c. Cheques issued but not presented for payment Rs. 66,000.

d. Draft deposited in the bank but not yet credited in the pass book Rs. 13,500.

e. Dividend collected by the bank Rs. 42,500 has not yet been entered in the cash book.

f. A direct payment into the bank by a customer Rs. 16,000 has not been recorded in the
cash book.

g. Bank column on the debit side of the cash book has been undercast by Rs. 3,500.

Q. 21

From the following particulars, prepare a bank reconciliation statement showing the balance
as per cash book as on 31st December, 1997.

The following cheques were paid into the bank in December 1997 but were credited by the
bank in January, 1998.

• Premnath Rs. 350


• Shaym Lal Rs. 250
• Ram Lal Rs. 200

The following cheques were issued by the firm in December, 1997 but were presented for
payment in January, 1998.
• Suresh Rs. 400
• Ramesh Rs. 450

A cheque for Rs. 100 which was received from a customer was entered in the bank column of
cash book in December, 1997 but was omitted to be banked in the month of December, 1997.
The pass book shows a credit of Rs. 100 for interest and a debit of Rs. 20 for bank charges.

The bank balance as per pass book was Rs. 6,200 as on 31st December, 1997.

Q. 22

According to the cash book of Gopi, there was a balance of Rs. 44,500 standing to his credit
on 30th June, 1996. On investigation you find that –

1. Cheques amounting to Rs. 60,000 issued to creditors have not been presented for payment
till that date.

Bank Reconciliation Statement 123


2. Cheques paid into bank amounting to Rs. 1,05,000 out of which cheques amounting to
Rs. 55,000 only collected by the bank up to 30th June, 1996.

3. A dividend of Rs. 4,000 and rent amounting to Rs. 6,000 received by the bank and
entered in the pass book but not recorded in the cash book.

4. Insurance premium (up to 31st December, 1996) paid by the bank Rs. 2,700 not entered
in the cash book.

5. The payment side of the cash book had been undercast by Rs. 50.

6. Bank charges Rs. 50 shown in the pass book had not been entered in the cash book.

7. A bill payable for Rs. 2,000 has been paid by the bank but is not entered in the cash
book and bill receivable for Rs. 6,000 has been discounted with the bank at a cost of
Rs. 100 which has also not been recorded in the cash book.

You are required –

a. to make appropriate adjustments in the cash book.

b. To prepare a statement reconciling it with the bank pass book.

Q. 23

From the following extracts of the cash book (bank column) and bank pass book of Mr.X,
prepare the bank reconciliation statement for the month ending on 31st March, 1997.

Cash Book (Bank Column only)

Date Particulars Rs. Date Particulars Rs.

01.3.97 To Balance b/fd 1,000 02.3.97 By Drawings 500

03.3.97 To D 750 03.03.97 By K 700

05.3.97 To A 250 08.3.97 By Rent 450

16.3.97 To M 800 12.3.97 By P 650

21.3.97 To N 2,500 21.3.97 By S 330

24.3.97 To R 1,700 24.3.97 By H 900

28.3.97 By Wages & Salaries 770

31.3.97 By Balance c/fd 2,700

Total 7,000 Total 7,000

124 Management Accounting


Extracts of Pass Book of Mr. X
In the books of Bank of Baroda, Pune

Date Particulars Withdrawals Deposits Dr/Cr Balance

01.4.97 Balance b/fd Cr 1,280

02.4.97 P 650 Cr 630

02.4.97 N 2,500 Cr. 3,130

04.4.97 C 350 Cr. 2,780

04.4.97 Pal 500 Cr. 3,280

05.4.97 M 800 Cr. 4,080

07.4.97 S 330 Cr. 3,750

09.4.97 H 900 Cr. 2,850

11.4.97 Sen 300 Cr. 3,150

11.4.97 Bose 470 Cr. 3,620

Prepare a Bank Reconciliation Statement as on 31st March, 1997.

Q. 24

On 31st December, 1982, the bank column of the cash book of P shows a debit balance of
Rs. 922. On examination of cash book and statement, you find that –

a. Cheques amounting to Rs. 1,260 issued before 31st December and entered in the cash
book were not presented for payment till that date.

b. Cheques amounting to Rs. 500 entered in the cash book as sent to the bank on
31st December were entered in the bank statement after that date.

c. A cheque from a debtor for Rs. 146 had been dishonoured prior to 31st December but no
record appeared in the cash book.

d. A dividend warrant for Rs. 76 was paid direct to the bank and nothing appeared in the
cash book.

e. Bank interest and charges amounting to Rs. 84 were not entered in the cash book but
appeared in the bank statement.

f. There was no entry in the cash book for a club membership subscrption Rs. 20 paid by
banker’s order in November, 1982.

g. Bank charges for a cheque book received by P Rs. 2 were entered in the cash book
twice.

Bank Reconciliation Statement 125


h. A cheque for Rs. 54 drawn by Q had been charged to P’s account in error.

Make appropriate adjustment in the cash book to bring down the correct balance and prepare
a bank reconciliation statement reconciling the corrected cash book balance with the balance
as per bank statement.

Q. 25

When Sweetex Limited received its bank statement for the period ended 30th June, 1984, this
did not agree with the balance shown in the cash book of Rs. 2,972 in the company’s favour.
An examination of the cash book and bank statement disclosed the following –

a. A deposit of Rs. 492 paid on 29th June 1984 had not been collected by the bank until
1st July, 1984.

b. Bank charges amounting to Rs. 17 had not been entered in the cash book.

c. A debit of Rs. 42 appeared in the bank statement for an unpaid cheque which had been
returned marked “out of date”. The cheque had been re-dated by the customer of Sweetex
Limited and paid into the bank again on 3rd July, 1984.

d. A standing order for payment of an annual subscription amounting to Rs. 10 had not
been entered in the cash book.

e. On 25th June, 1984, managing director had given the cashier a cheque for Rs. 100 to
pay into his personal account at the bank. The cashier had paid the same into company’s
account by mistake.

f. On 27th June, two customers of Sweetex Limited had paid direct to the company’s bank
account Rs. 499 and Rs. 157 respectively for the payment of goods supplied. The advices
were not received by the company until 1st July and were not entered in the cash book
until that date.

g. On 30th March, 1984, the company had entered into a hire purchase agreement to pay
by banker’s order a sum of Rs. 26 on the 10th day of each month, commencing April. No
entries had been made in the cash book.

h. A cheque for Rs. 364 received from Mr. B and paid into the bank had been entered twice
in the cash book.

i. Cheques issued amounting to Rs. 4,672 had not been presented to the bank for payment
until 30th June, 1984.

126 Management Accounting


j. A customer of the company who received a cash discount 2.5% on his account of
Rs. 200 paid the company a cheque on 10th June. The cashier in error entered the gross
amount in the bank column of the cash book.

After making the adjustments required by the foregoing, the bank statement reconciled with
the balance in the cash book.

You are required –

1. to show the necessary adjustments in the cash book of Sweetex Limited bringing down
the correct balance on 30th June, 1984.

2. to prepare a Bank Reconciliation Statement

Bank Reconciliation Statement 127


NOTES

128 Management Accounting


Chapter 5
RECTIFICATION OF ERRORS

The errors in accounting can be classified into the following main groups –

a. Errors of Omission – These errors refer to a situation where a transaction is totally


omitted to be recorded in the subsidiary book or partially omitted while posting from
subsidiary books to the ledger.

b. Errors of Commission – These errors refer to wrong posting or totalling errors,


calculation errors or errors in carrying forward etc. Following are the examples of errors
of commission –

l Posting of wrong amounts

l Posting to wrong side of account

l Posting to wrong account

l Wrong totalling of subsidiary books or ledger accounts

l Errors while carrying forward figures from one page to another page

c. Errors of Principle – These errors refer to wrong classification of income or expenditure.


Following are the examples of errors of principle –

l Purchases of fixed assets recorded in the Purchases Register

l Revenue expenditure treated as capital expenditure

l Capital receipt treated as revenue income

l Revenue receipt treated as capital receipt

d. Compensating Error – These errors refer to a situation where excess or less debits in
one or more accounts are compensated by equal amount of excess or less credits in
one or more accounts. Due to these errors arithmetical accuracy of the Trial Balance
does not get affected.

Rectification of Errors 129


EFFECT OF ERRORS ON TRIAL BALANCE

Tallying of Trial Balance is the primary indication about the arithmetical accuracy of the books
of account. However, it cannot be the conclusive evidence of the total accuracy of the books of
accounts maintained. This is due to the fact that certain errors as stated above do not affect
the trial balance. As such, locating the errors requires a lot of skills, particularly when they do
not affect the agreement of trial balance.

Errors affecting Trial Balance

Following errors may affect the agreement of Trial Balance –

a. Wrong totalling of subsidiary books – If the total of any subsidiary books is taken
wrongly but the posting to the individual accounts is made correctly, it will affect the
agreement of trial balance. Eg. Total of Purchase Register for the month of March is
taken as Rs. 1,50,000 instead of Rs. 1,55,000. Posting to the individual accounts of
suppliers total to the correct amount of Rs. 1,55,000, but the Purchases Account is
debited by Rs. 1,50,000, the trial balance will not agree.

b. Posting on the wrong side of an account – If a transaction is posted on the wrong


side of the account, the trial balance will not agree. Eg. A payment of Rs. 10,000 made
to M/s. Pam Industries is posted on the credit side of M/s. Pam Industries Account, the
trial balance will not agree.

c. Omission of posting an amount in the ledger – If an amount is entered in the journal


or subsidiary book but not posted in the ledger, the trial balance will not agree. Eg. A
cash payment of Rs. 1,500 for the conveyance expenses has been entered in the cash
book but is not debited to Conveyance Account, the trial balance will not agree.

d. Posting of wrong amount – If an amount is wrongly posted to an account, the trial


balance will not agree. Eg. A cash payment of Rs. 1,500 for the conveyance expenses
has been correctly entered in the cash book, but while posting the same to the Conveyance
Account, it is posted as Rs. 150, the trial balance will not agree.

e. Error in balancing – If an error has been committed while calculating the closing balance
of cash book or a ledger account, the trial balance will not agree.

Errors not affecting the Trial Balance

Following types of errors may not affect the agreement of Trial Balance.

a. Errors of Principle – If the revenue expenditure is treated as capital expenditure or if


revenue receipt is treated as capital receipt or if capital expenditure is treated as revenue
expenditure or if capital receipt is treated as revenue receipt, it will not affect the agreement

130 Management Accounting


of trial balance. Eg. An amount of Rs. 10,000 paid for maintenance of machinery. Instead
of posting this amount to Machinery Maintenance Account, it is debited to Machinery
Account, the trial balance will still agree but it will not show a true and fair view.

b. Errors of Omission – If a transaction is totally omitted while making the entries in the
books of accounts, it will not affect the agreement of trial balance. Eg. A bill for the
purchase of material worth Rs. 15,000 has been received, but it is not entered in the
Purchase Register at all, the trial balance will still agree but it will not show a true and fair
view.

c. Errors of Commission – If an amount is posted to the correct side of a wrong account,


it will not affect the agreement of trial balance. Eg. A payment is Rs. 25,000 made to
Mr. Salim is debited to the account of Mr. Sham, the trial balance will still agree but it will
not show a true and fair view.

d. Recording of wrong amount in the books of prime entry or subsidiary books – If


a transaction is wrongly entered in the book of prime entry or the subsidiary book and
then correctly posted to the correct account, it will not affect the agreement of trial
balance. Eg. Stationary worth Rs. 4,500 has been purchased but it is entered as Rs.
4,700 in the cash book, the trial balance will still agree but it will not show a true and fair
view.

e. Compensating Errors – If one type of error is compensated by the error of the opposite
nature, it will not affect the agreement of trial balance. Eg. While balancing the traveling
expenses account, the closing debit balance is taken as Rs. 1,40,000 instead of
Rs. 1,50,000. Similarly, while balancing the sales account, the closing credit balance is
taken as Rs. 28,90,000 instead of Rs. 29,00,000. The trial balance will still agree but it
will not show a true and fair view.

Steps in locating the errors

If the errors result into the disagreement of trial balance, following steps should be taken to
locate the errors.

a. Total of all the subsidiary books and cash book should be checked carefully. Similarly,
the total of trial balance should be checked carefully.

b. It should be ensured that all the opening balances have been correctly brought forward in
the current year’s books of account.

c. It should be ensured that all the ledger accounts have been properly balanced and the
balances of all the ledger accounts have been reflected in the Trial Balance.

d. If an amount of Rs. 24,000 is debited to a certain account instead of crediting the same
to the same account, the difference between the debit side and credit side of trial balance

Rectification of Errors 131


will be Rs. 48,000. As such, the difference in trial balance should be halved to locate
such errors.

e. If the difference in the trial balance is divisible by 9 without any reminder, it may indicate
the transposition or transplacement of the amounts. Eg. If the cash payment of Rs. 176
is posted as Rs. 167, the difference in the trial balance will be divisible by 9.

f. The trial balance of the current year can be compared with the trial balance of the previous
year to locate certain highlighting error.

How to rectify the errors

The errors should be rectified by any one of the following methods –

I. In some cases, if the trial balance does not agree but the books have to be closed, the
difference is placed to a Suspense Account and the trial balance is tallied. If the credit
side of the trial balance is heavy by Rs. 50,000 and same amount is placed on the debit
side of Suspense Account. Subsequently, attempts are made to locate the errors and
the rectification entries are routed through the Suspense Account. After all the errors
have been located, the balance in Suspense Account will become zero. It should be
remembered that the Suspense Account is operated till the errors are located and finally
the balance in Suspense Account has to become zero. Further, only the errors affecting
the agreement of trial balance are routed through the Suspense Account.

Illustration

A merchant while balancing his books of account finds that, the trial balance shows excess
credit of Rs. 1,700. Being required to prepare the final accounts, he places the difference to a
newly opened Suspense Account which he carries forward. In the next accounting year, the
following errors are discovered –

a. Goods bought from Narayan amounting to Rs. 5,000 had been posted to the credit of
Narayan as Rs. 5,500.

b. An item of Rs. 1,000 entered in the sales returns book was posted to the debit of Pandey
who had returned the goods.

c. Sundry items of furniture sold for Rs. 26,000 had been entered in the sales book. Ignore
depreciation and profit or loss on the sale.

d. Discount amounting to Rs. 200 from a creditor had been duly entered in the creditor’s
account, but not posted to discount account.

Draft journal entries necessary for rectifying the abovementioned errors. Prepare the Suspense
Account and show the ultimate effect of the errors on the last year’s profit by preparing the
Profit and Loss Adjustment Account.

132 Management Accounting


Solution

a. Goods bought from Narayan had been posted to the credit of Narayan Account by
Rs. 5,500 instead of Rs. 5,000. As such, Narayan Account has been credited more by
Rs. 500. As such, this excess credit needs to be reversed by passing following entry –

Narayan A/c. Dr. 500


To, Suspense A/c. 500

b. Goods supplied to Pandey worth Rs. 1,000 should have appeared on the debit side of
Pandey’s account. Instead of that the entry has been made on the credit side of Pandey’s
account. This excess credit needs to be reversed by passing the following entry –

To Suspense A/c. Dr. 2,000


Pandey A/c. 2,000

c. As the amount of furniture sold has been entered in the sales book, sales account has
been wrongly credited. This wrong credit needs to be reversed by debiting sales account.
The journal entry to be passed is –

Sales A/c. Dr. 26,000


To Furniture A/c. 26,000

d. Discount received from the creditor has been entered in the creditor’s account but discount
account has not been credited. As such, the error will be rectified by passing the following
entry –

Suspense A/c. Dr. 200


To Discount Received A/c. 200

Suspense Account

Date Particulars Folio Rs. Date Particulars Folio Rs.


1 To Balance b/fd 1,700 1 By Narayan A/c. 500
1 To Discount Recd. A/c. 200 1 By Pandey A/c. 2,000
To Balance c/fd 600
2,500 2,500

II. The errors which affect two accounts and which do not affect the agreement of trial
balance may be rectified by passing the rectification entries. The basic principle for
rectifying the errors by this means suggests the following steps to be taken –

a. What is the wrong entry passed ?

Rectification of Errors 133


b. What should be the correct entry to be passed ?

c. Nullify the wrong effect by reversing the same and reinstate the correct by passing
the rectification entry.

Illustration

Pass necessary journal entries to rectify the following errors –

a. An amount of Rs. 200 withdrawn by the proprietor for his personal use has been debited
to trade expenses account.

b. A purchase of goods from Nathan amounting to Rs. 300 has been wrongly entered
through the sales book.

c. A credit sale of Rs. 100 to Santhanam has been wrongly passed through the purchase
book.

d. Rs. 150 received from Malhotra have been credited to Mehrotra.

e. Rs. 375 paid on account of salary to the cashier Dhawan stands debited to his personal
account.

f. A contractor’s bill for the extension of premises amounting to Rs. 2,750 has been debited
to building repairs account.

g. On 25th June, goods of the value of Rs. 500 were returned by Akashdeep and were taken
into stock but the returns were entered in the books under date 3rd July i.e. after the
expiration of the financial year on 30th June.

h. A bill of Rs. 200 for old office furniture sold to Sethi was entered in the sales daybook.

i. The periodical total of the sales book was cast short by Rs. 100.

j. An amount of Rs. 80 received on account of interest was credited to commission account.

134 Management Accounting


Solution

a Wrong Entry Trade Expenses A/c 200


To Cash A/c 200
Correct Entry Drawings A/c 200
To Cash A/c 200
Rectification Entry Drawings A/c 200
To Trade Expenses A/c 200
b Wrong Entry Nathan A/c 300
To Sales A/c 300
Correct Entry Purchases A/c 300
To Nathan A/c 300
Rectification Entry Sales A/c 300
Purchases A/c 300
To Nathan A/c 600
c Wrong Entry Purchases A/c 100
To Santhanam A/c 100
Correct Entry Santhanam A/c 100
To Sales A/c 100
Rectification Entry Santhanam A/c 200
To, Purchases A/c 100
To Sales A/c 100
d Wrong Entry Cash A/c 150
To Mehrotra A/c 150
Correct Entry Cash A/c 150
To Malhotra A/c 150
Rectification Entry Mehrotra A/c 150
To Malhotra A/c 150
e Wrong Entry Dhawan A/c 375
To Cash A/c 375
Correct Entry Salary A/c 375
To Cash A/c 375
Rectification Entry Salary A/c 375
To Dhawan A/c 375
f Wrong Entry Building Repairs A/c 2,750
To Cash A/c 2,750
Correct Entry Building A/c 2,750
To Cash A/c 2,750
Rectification Entry Building A/c 2,750
To Building Repairs A/c 2,750
g Wrong Entry No entry passed

Rectification of Errors 135


Correct Entry Sales returns A/c 500
To Akashdeep A/c 500
Rectification Entry Sales returns A/c 500
To Akashdeep A/c 500
h Wrong Entry XYZ A/c 200
To Sales A/c 200
Correct Entry XYZ A/c 200
To Furniture A/c 200
Rectification Entry Sales A/c 200
To Furniture A/c 200
i Wrong Entry No entry passed
Correct Entry Suspense A/c 100
To Sales A/c 100
Rectification Entry Suspense A/c 100
To Sales A/c 100
j Wrong Entry Cash A/c 80
To Commission A/c 80
Correct Entry Cash A/c 80
To Interest A/c 80
Rectification Entry Commission A/c 80
To Interest A/c 80

QUESTIONS

1. It is said that tallying of Trial Balance is not the conclusive proof of accuracy of the books
of account. Why ?

2. What are errors in financial accounting ? What are the different types of errors ?

3. What do you mean by Suspense Account? How is it operated in financial accounting?


Can the balance of Suspense Account appear in the Trial Balance in ideal situations?

4. What are errors in financial accounting? Do all the errors affect the Trial Balance? State
the errors that affect the Trial Balance and the errors that do not affect the Trial Balance.

PROBLEMS

Q.1

Ganesh drew a Trial Balance of his operations for the year ended 31st March 1992. There was
a difference in the Trial Balance which he closed with a Suspense Account. On a scrutiny by
the Auditors, the following errors were found –

a. Purchases day book for the month of April 1991, was undercast by Rs. 1,000.

136 Management Accounting


b. Sales day book of October 1991 was overcast by Rs. 10,000.

c. A furniture purchased for Rs. 8,100 was entered in the Furniture Account as Rs. 810.

d. A bill for Rs. 10,000 drawn by Ganesh was not entered in the Bills Receivable Book.

e. A machinery purchased for Rs. 10,000 was entered in the purchase day book.

Pass necessary journal entries to rectify the same and ascertain the difference in the Trial
Balance that was shown under the Suspense Account in respect of the above items.

Q.2

A bookkeeper while preparing his Trial Balance finds that the debit exceeds by Rs. 7,250.
Being required to prepare the final accounts, he places the difference to a Suspense Account.
In the next year, the following mistakes were discovered –

a. A sale of Rs. 4,000 has been passed through the Purchase daybook. The entry in
customer’s account has been correctly recorded.

b. Goods worth Rs. 2,500 taken away by the proprietor for his use has been debited to
Repairs Account.

c. A bill receivable for Rs. 1,300 received from Krishna has been dishonoured on maturity
but no entry passed.

d. Salary Rs. 650 paid to a clerk has been debited in his Personal Account.

e. A purchase of Rs. 750 from Raghubir has been debited to his account. Purchase Account
has been correctly debited.

f. A sum of Rs. 2,250 written off as depreciation on furniture has not been debited to
Depreciation Account.

Draft the Journal Entries for rectifying the above mistakes and prepare Suspense Account.

Q.3

The accountant of X prepared the Trial Balance for the year ended 31st March 1996. But there
was a difference and the accountant put the difference in Suspense Account. Rectify the
following errors found and prepare the Suspense Account.

a. The total of the Returns Outward book, Rs. 420 has not been posted in the ledger.

b. A purchase of Rs. 350 from Y has been entered in the sale book. However, Y’s account
has been correctly entered.

Rectification of Errors 137


c. A sale of Rs. 390 to Z has been credited to his account as Rs. 290.

d. Old furniture sold for Rs. 5,400 has been entered as Rs. 4,500 in sales account.

e. Goods taken by proprietor, Rs. 500 have not been entered in the books at all.

Q.4

A bookkeeper finds the difference in the Trial Balance amounting to Rs. 1,000 and puts it in
the Suspense Account. Later on he detects the following errors –

a. Purchased goods from Ravi but entered into Sales Book.

b. Received one bill for Rs. 25,000 from Arun but recorded in Bills Payable Book.

c. An item of Rs. 3,500 relating to prepaid rent account was omitted to be brought forward.

d. An item of Rs. 2,000 in respect of purchase returns, had been wrongly entered in the
purchase book.

e. Rs. 25,000 paid to Hari against our acceptance were debited to Harish Account.

f. Bills received from Janaki for repairs done to radio Rs. 2,500 and radio supplied for
Rs. 45,000 were entered in the Purchase Book as Rs. 46,000.

Give rectifying journal entries with full narration and prepare Suspense Account.

Q.5

There is a difference in the Trial Balance of Shri Om. Subsequently, the following errors were
found to have been committed. Pass journal entries to rectify them and ascertain the difference
in the Trial Balance.

a. A sale of Rs. 2,000 to Shanti & Co. was credited to their account.

b. The Returns Inward Book had been cast Rs. 1,000 short.

c. A sale of Rs. 10,000 had been passed through the Purchase Day Book. The customer’s
account, had, however been correctly debited.

d. Rs. 3,750 paid for wages to workmen for making showcases had been charged to Wages
Account.

e. A purchase of Rs. 6,710 had been posted to the debit of the creditor’s account as
Rs. 6,170. The creditor was Paras & Co.

138 Management Accounting


Q. 6

There was difference in the Trial Balance of Shri Arihant which was put to newly opened
Suspense Account. Subsequently, the following mistakes were discovered. Pass journal entries
to rectify them and ascertain the difference in the Trial Balance.

a. Materials costing Rs. 700 in the erection of machinery and the wages paid for amounting
to Rs. 400 were included in the Purchase Account and Wages Account respectively.

b. Goods sold under credit terms Rs. 16,900 to Mohan were recorded properly in the Sales
Book but were debited to his account as Rs. 19,600 and carriage outward freight paid
Rs. 700 chargeable from him were posted to Sales Expenses Account.

c. Sales Returns by Yogesh Rs. 2,300 were correctly recorded in the Sales Returns Book
from where they were debited to Yogesh Account by Rs. 3,200.

d. Old furniture originally purchased for Rs. 1,800 written down to Rs. 1,100 was sold for
cash Rs. 1,700 and was credited to Furniture Account.

e. Machinery purchased on credit Rs. 17,000 was recorded in Purchase Book and transport
charges for the machine Rs. 1,200 were debited to Trade Expenses Account.

Q.7

Give journal entries to rectify the following errors –

a. Rs. 2,500 paid for the purchase of a radio set for the personal use of the proprietor
debited to general expenses account.

b. Rs. 1,300, the amount of sale of old machinery, has been posted to sales account.

c. A sum of Rs. 160 paid by way of rent has been debited to landlord’s personal account.

d. Rs. 245 cost of repairing the floor of room has been charged to buildings account.

e. A payment of Rs. 250 made to Harish Brothers for cash purchase of goods from him
stands debited to his account.

Q.8

Rectify the following errors by passing necessary journal entries –

a. Goods taken by the proprietor Rs. 1,500 for gift to his daughter were not recorded at all.

b. Rs. 1,500 received from Praveen against debts previously written off as bad debts have
been credited to his personal account.

Rectification of Errors 139


c. Received interest Rs. 150 posted to loan account.

d. A cheque received from Amar, a debtor, for Rs. 2,000 was directly received by the proprietor
who deposited it into his personal bank account.

Q.9

While preparing the final accounts for the year ended 31st March 1995, Mr. Smart could not
get his Trial Balance agreed. He transferred the difference to Suspense Account and prepared
the final accounts. In April 1995, following errors were discovered in the books of accounts for
the year 1994-95 –

a. The sales book for January 1995 was undercast by Rs. 1,000.

b. Entertainment expenses Rs.150 incurred on 5th January 1995 were omitted to be posted
from cash book to the ledger.

c. Discount column on the receipt side of the cash book for February 1995 was added as
Rs. 2,230 instead of Rs. 2,130.

d. A purchase from Mr. Sumer for Rs. 8,200 on 3rd March 1995 was correctly recorded in
the purchase book. But the supplier was wrongly debited for the purchase.

Pass the necessary journal entries to rectify the above-mentioned errors without affecting the
profit for the year 1995-96. Also prepare Suspense Account and Profit & Loss Adjustment
Account. Assume that all the errors have been located.

Q.10

An accountant could not tally the Trial Balance. The difference was temporarily placed to
Suspense Account for preparing the final accounts. The following errors were discovered later
on –

a. The sales book was undercast by Rs. 350.

b. Entertainment expenses Rs. 95 though correctly entered in the cash book were omitted
to be posted in the ledger.

c. Commission of Rs. 25 paid was posted twice, once to discount account and again to
commission account.

d. A sales of Rs. 139 to Ramnath, though correctly entered in the sales book was posted
wrongly to his account as Rs. 193.

140 Management Accounting


You are required to pass the necessary journal entries in the books of the next accounting
year so as not to affect the profit of that year.

Q.11

The Trial Balance of N Ltd. does not tally. In order to give it a semblance of agreement, the
accountant of the company transfers the difference to a newly opened Suspense Account.
Later on, he discovers the following errors –

a. An item of Rs. 5,850 paid for purchase of a new typewriter for the accounts department
has been wrongly passed through the purchases book.

b. An item of Rs. 780 in the sales book has been posted as Rs. 960 in the customer’s
account.

c. An addition in the returns inward book has been cast Rs. 240 short.

d. An item of Rs. 450 appearing in the discount column on the credit side of the cash book
has been posted to the credit side of the concerned personal account as Rs. 540.

e. A bill of exchange for Rs. 2,650 accepted by R & Co. and later discounted with the bank
has been returned by the bank as dishonoured. On dishonour, the amount of the bill has
been debited to sales account.

Give journal entries to rectify the above mentioned errors and also show the Suspense Account.

Q.12

Pass journal entries to rectify the following errors –

a. A purchase amounting to Rs. 1,000 made for a staff member was recorded in the purchases
book.

b. Wages paid to workers for installing machinery, Rs. 750 were debited to wages account.

c. A dishonoured bill receivable for Rs. 5,000 returned by the bank with whom it was
discounted was credited to bank and debited to bills receivable account.

d. A sum of Rs. 1,000 drawn by the proprietor for his personal use was debited to traveling
expenses account.

Rectification of Errors 141


Q.13

Pass journal entries to rectify the following errors –

a. A sum of Rs. 100 paid to Suresh was debited to Subhash.

b. A credit sale of Rs. 587 was recorded in the sales book as Rs. 857.

c. Goods sold to Prem for Rs. 170 were returned by him, but no entry was passed in the
books.

d. A bill receivable for Rs. 2,000 accepted by Vimal was recorded in bills payable book.

e. Repairs of furniture amounting to Rs. 500 were debited to furniture account.

Q.14

Pass journal entries to rectify the following errors and prepare Suspense Account.

a. Rs. 1,080 received from Mohan was posted to the debit of his account.

b. Rs. 200 being purchase returns were posted to the debit of purchases account.

c. Rs. 400 received as discount was posted to the debit of discount account.

d. Rs. 1,148 paid for repairs of motor car was debited to motor car account as Rs. 148.

e. Rs. 400 paid to Suresh was debited to Satish.

Assume that there are no other errors.

Q.15

On 28th February 1999, the Trial Balance of X did not agree. X put the difference in a newly
opened Suspense Account. Subsequently, following errors were located –

a. The returns inward book for January 1999 had been cast Rs. 1,000 short.

b. A purchase of Rs. 1,671 had been posted to the debit of the creditor’s account as
Rs. 1,617. The creditor is Panna & Co.

c. A sale of Rs. 2,000 to Singhi & Co. was credited to the account of the customer.

d. A sale of Rs. 4,000 has been passed through the purchase book. The customer’s account
has however been correctly debited.

e. While carrying forward the total of sales book from one page to the next, the amount was
written as Rs. 1,76,658 instead of Rs. 1,67,568.

142 Management Accounting


Pass journal entries to rectify the above-mentioned errors. Also prepare the Suspense Account
assuming that all the errors have been located.

Q.16

An accountant prepared a Trial Balance on 31st January 2000, which revealed a difference in
the books of account. He put the difference in a newly opened Suspense Account. During
February 2000, he detected the following errors –

a. The total of the returns outward book, Rs. 4,200 had not been posted in the ledger.

b. A purchase of Rs. 3,500 from Y had not been entered in the purchase book. However,
Y’s account had been correctly credited with the amount.

c. A sale of Rs. 3,900 to Z had been credited to his account as Rs. 2,900.

d. Furniture sold for Rs. 5,400 had been entered as Rs. 4,500 in the sales book.

e. Goods worth Rs. 500 taken by the proprietor for personal use had not been recorded at
all.

f. Wages paid for an installation of machinery Rs. 1,000 had been debited to wages account.

Pass journal entries to rectify the abovementioned errors and prepare Suspense Account
assuming that all the errors have been located.

Q.17

Give journal entries to rectify or adjust the following in the books of both the head office and the
branch.

a. Goods costing Rs. 16,000 purchased by branch, but payment made by head office. The
head office has debited the amount to its own purchase account.

b. Branch paid Rs. 30,000 as salary to a visiting head office official. The branch has debited
the amount to salaries account.

c. Depreciation, Rs. 50,000 in respect of branch assets whose accounts are kept in the
head office books is to be recorded by both the parties.

d. Expenses Rs. 70,000 to be charged to the branch for work done on its behalf by the
head office.

Rectification of Errors 143


Q.18

On finding a difference between two sides of the Trial Balance, the accountant transferred the
excess debit of Rs. 770 to a suspense account. Subsequently, the following errors were
detected. Give journal entries to rectify the errors and show the suspense account.

1. Repairs to machinery Rs. 2,000 were debited to Machinery Account.

2. A sale of Rs. 900 to Patel was recorded in the Purchases Book.

3. The total of the Returns Inwards Book Rs. 400 was not posted.

4. A purchase of Rs. 590 from Sathe was posted to his account as Rs. 950.

5. The bank column of the receipt side of the cash book was undercast by Rs. 110.

6. A cash sale of Rs. 200 to Ramesh was entered both in the cashbook and sales book.

7. A credit purchase of Rs. 300 from Satish was omitted to be recorded.

8. Cash Rs. 150 paid to Brijmohan was posted twice to his account.

9. A credit balance of Rs. 450 to Malasingh’s account was carried forward as Rs. 540 on
the debit side.

10. The name of Vinod, a creditor, to whom we owed Rs. 500 was omitted from the list of
sundry creditors.

Q.19

Rectify the following errors –

1. Carriage on machinery is debited to Carriage Account Rs. 100.

2. Goods purchased from Sahani Rs. 531 was debited to his account as Rs. 351.

3. A television purchased for the workers’ canteen in the factory for Rs. 25,000 was debited
to Factory Expenses.

4. An amount of Rs. 15,000 paid for the construction of a new hall in the building was
debited to Repairs Account.

5. The total of the Sales Book for the month of February was cast short by Rs. 10.

6. A credit sale of Rs. 575 to Mahendra was debited to Mohinder’s Account.

7. A sum of Rs. 500 paid to Poonawalla for salary was debited to his personal account.

8. A credit sale of Rs. 1,000 to Rashid was correctly entered in the Sales Book but was
posted to the credit of his account in the ledger as Rs. 100.

9. Goods sold to Devidas Rs. 590 was recorded in the Sales Book as Rs. 950.

144 Management Accounting


NOTES

Rectification of Errors 145


NOTES

146 Management Accounting


Chapter 6
COST ACCOUNTANCY
[BASIC CONCEPTS AND PRINCIPLES]

INTRODUCTION :

The Institute of Cost and Management Accountants, London has defined the Cost Accountancy
as “The Application of Costing and Cost Accounting principles, methods and techniques to
the science, art and practice of cost control and the ascertainment of profitability as well as
presentation of information for the purpose of managerial decision making.”. The analysis of
the above definition reveals the following facts.

(1) Cost Accountancy is a science, art and practice of a Cost Accountant. Science indicates
the possession and the application of relevant systematic knowledge. Art indicates the
skill and ability of the Cost Accountant. Practice indicates a continuous effort on the part
of the Cost Accountant.

(2) The terms costing and cost accounting should not be confused. Costing indicates the
process of ascertaining the costs which can be done arithmetically also. Cost accounting
indicates the process of recording the costs in a formal and systematic manner with the
intention of preparing statistical data therefrom to ascertain the cost.

(3) The objects of Cost Accountancy can be threefold.

(a) Ascertainment of cost and profitability with the help of various principles, methods
and techniques.

(b) Cost control – This indicates the process of controlling the costs of operating the
business. This process, in turn, involves the following stages. To plan the operations
(which can be done by the establishment of budgets and standards), execute the
plans, measuring the actual performance, comparison of planned and actual
performance, computing the variations between planned and actual performance
and taking the decisions to maintain favourable variations or to remove unfavourable
variations.

Cost Accountancy [Basic Concepts and Principles] 147


(c) Presentation of information to enable managerial decision making. Unless and until
the results of any study or action are presented correctly to the person who takes
the decision in respect of the same, the study has no meaning.

CONCEPT OF COST CENTRE :

Cost Centre is defined as a location, person, or item of equipment (or a group of these) in or
connected with an undertaking, in relation to which costs may be ascertained and used for the
purpose of cost control. Correct identification of a cost centre is pre-requisite for the successful
implementation of cost accounting process as the costs are ascertained and controlled with
respect to the cost centres. Similarly, correct identification of cost centre facilitates the fixation
of responsibility in a correct manner. Eg. A person in-charge of a cost centre may be held
responsible for the proper functioning and cost control in relation to that cost centre. As cost
centres facilitate this control function, in many cases, they are termed as ‘Responsibility
Centres’. There may not be any fixed principle for deciding the number and size of cost
centres. It depends upon the nature and size of organisation, expenditure involved, requirements
of management from cost control point of view and so on. However, following pattern of
classification may be followed to decide the cost centres.

(1) Impersonal and Personal Cost Centres :

An impersonal cost centre consists of location or item of equipment (or group of these).
Eg. A region of sales, a branch, a department, a grinding machine and so on. A personal
cost centre consists of a person or a group of persons. Eg. Finance Manager, Sales
Manager, Works Manager and so on.

(2) Production and Service Cost Centres :

Production cost centre is the one where the production activity is carried on. Eg. Machine
shop, Paint shop, Assembly shop and so on.

Service cost centre is the one which assists the production activity. Eg. Store Dept.,
Internal Transport Dept., Labour Office, Maintenance Dept., Accounts/Costing Dept.,
and so on.

CONCEPT OF COST :

The term cost indicates the amount of expenditure (actual or notional) incurred on or attributable
to, a given thing.

The term cost can be viewed from various angles.

148 Management Accounting


(1) Direct Cost and Indirect Cost :

Direct Cost indicates that cost which can be identified with the individual cost centre. It
consists of direct material cost, direct labour cost and direct expenses. It is also termed
as Prime Cost.

Indirect Cost indicates that cost which cannot be identified with the individual cost centre.
It consists of indirect material cost, indirect labour cost and indirect expenses. It is also
termed as overheads. As it is not possible to identify these costs with individual cost
centres, such identification is done in the indirect way by following the process of allocation,
apportionment and absorption. (It is discussed in details in the following chapters).

(2) Fixed, Variable and Semi-variable/Semi-fixed Cost :

Fixed cost indicates that portion of total cost which remains constant at all the levels of
production, irrespective of any change in the later. As the volume of production increases,
per unit fixed cost may reduce, but not the total fixed cost.

Variable cost indicates that portion of the total cost which varies directly with the level of
production. Higher the volume of production, higher the variable cost and vice versa,
though per unit variable cost remains constant at all the levels of production.

Semi-variable or semi-fixed cost indicates that portion of the total cost which are partly
fixed and partly variable in relation to the volume of production.

(3) Controllable Cost and Uncontrollable Cost :

Controllable cost indicates that cost which can be controlled by a specific number of
person(s) in the organisation. Eg. A person in charge of a responsibility centre may be in
the position to control the costs in relation to that responsibility centre.

Uncontrollable cost indicates that cost which cannot be controlled by a specific number
of person(s) in the organisation. Eg. The costs relating to one responsibility centre cannot
be controlled by a person who is in-charge of another responsibility centre.

It should be noted here that a clear-cut distinction between controllable and uncontrollable
costs may not be possible. The cost which is controllable for one person may not be
controllable by another one. In fact, no cost is completely uncontrollable. The degree of
controllability varies in relation to a particular individual and a level of management. In a
very broad sense, it can be said that the variable costs are controllable at the lower level
of management while fixed costs are controllable at the top level of management.

Cost Accountancy [Basic Concepts and Principles] 149


(4) Normal Cost and Abnormal Cost :

Normal Cost indicates that cost which is normally incurred at a certain level of output
under normal circumstances.

Abnormal cost indicates that cost which is normally not incurred at a certain level of
output under normal circumstances.

SPECIAL TYPES OF COST :

(a) Opportunity Cost :

In very simple language, opportunity cost is the cost of opportunity foregone. The resource
like men, material, machine, money etc. may be having various alternative uses each
one having some specific yield or return. However, if they are used in one particular way,
they cannot be used in any other way. Opportunity cost refers to the return or yield
which is not available if the resources are used in any specific manner. Eg. Mr. A has Rs.
1,00,000 to invest. He is having two options open.

(i) Keep the same with some Bank in Fixed Deposit and get the interest of 10% p.a.

(ii) Invest the money in the business and get the return on investment of 12%.

If Mr. A decides to invest the money in business, he cannot get the interest on
Fixed Deposit from Bank. As such, opportunity cost of investing the money in the
business is in the form of lost interest on Fixed Deposits with the Bank. It should
be noted that the opportunity cost itself finds no place in the accounting process.
However, it is required to be considered in the decision making process, for the
comparison purpose. The returns available from a proposal should be more than
the cost of opportunity lost, then and then only the proposal can be accepted.

(b) Differential Cost :

Differential cost indicates increased or decreased cost due to the increased or decreased
volume of operations. While assessing the acceptability of a proposed change, the
differential costs are compared with differential revenues, and so long as differential
revenues are more than the differential costs, the proposed change may be accepted.

(c) Sunk Cost :

Sunk cost indicates historical cost which is incurred in past. This type of cost is normally
not relevant in the decision-making process. Eg. While deciding about the replacement
of a machine, the depreciated book value of the machine may not be relevant being in the
form of sunk cost.

150 Management Accounting


INSTALLATION OF COSTING SYSTEM :

At the outset, it should be noted that if it is decided to install a costing system in an organisation
there may not be any standard type of costing system applicable. The details of costing
system may be required to be worked out in such a way that they satisfy the individual
requirements of the organisation. Following factors will have to be considered before installing
a costing system.

(a) Nature of the Product :

Before installing the costing system, the nature of product in respect of which the system
is to be installed will have to be studied. If the product is material intensive, more stress
may be necessary on inventory control procedures, if the product is labour intensive,
more stress may be necessary on control procedures and so on.

(b) Nature of the Organisation :

The nature of the organisation may be required to be studied from the various angles.

(1) Size and layout of the factory.

(2) Organisational structure of the organisation.

(3) The procedures presently followed in the respect of accounting of material cost,
labour cost and overheads.

(4) Management requirements from the cost control point of view.

(c) Manufacturing Process :

Before installing the costing system, the technical process involved in the manufacturing
of the product will have to be studied. This may involve the study from the stage of
designing of the product, the quantity, quality and mix of the materials used, the degree
of automation involved, the production control techniques implemented, the degree of
complexities involved in the production process and so on.

(d) Simplicity and Cost :

The costing system to be installed should be simple to understand and easy to operate.

The costing system should be economic in terms of cost of installing and operating the
system, and the results obtained therefrom should justify the cost.

Cost Accountancy [Basic Concepts and Principles] 151


(e) Reporting systems :

The costing system should be designed in such a way that it generates proper reports in
a proper way to facilitate cost control decisions from the management’s side. The reporting
system should be based upon the principle of Management by Exception. Forms and
records required to be maintained to facilitate correct reporting should be designed in
such a way that it involves minimum clerical work and minimum cost.

Some problems may arise while installing a costing system in an organisation. However, they
are faced mainly where the system is not properly planned, executed and communicated.
These problems are definitely not of the costing principles as such and can easily be overcome
by having systematic planning and communication procedures. The problems which are usually
faced while installing a costing system can be stated as below.

(1) The costing system may not be suitable considering the nature of product and nature of
business.

(2) The employees and the executives may resist the installation of the costing system
feeling that it is meant for pointing out their drawbacks. This arises only out of ignorance
and suspicion.

(3) Lack of cost consciousness among the various levels of management.

(4) The cost involved in installing a costing system may be too high.

(5) Laxity on the part of various employees to complete the forms of cost office and to
forward them to the cost office.

152 Management Accounting


QUESTIONS

1. Explain the nature of Cost Accounting.

Explain the factors which need to be considered for installing a costing system for a
medium sized engineering organisation.

2. Write short notes on –


a) Cost Centre
b) Opportunity Cost

Cost Accountancy [Basic Concepts and Principles] 153


NOTES

154 Management Accounting


Chapter 7
ELEMENTS OF COSTS

In case of a typical manufacturing type of operation, the activity may consist of conversion of
raw material in the form of finished goods with the help of labour and other services and selling
the finished goods in the market to earn the profits. In order to interpret the term cost correctly
and to ascertain the cost with respect to the centres, the cost attached with the manufacturing
process may be subdivided into what is known as Elements of Cost. Broadly there can be
three elements of costs.

(A) Material :

This is the cost of commodities and materials used by the organization. It can be direct or
indirect.

Direct Material indicates that material which can be identified with the individual cost centre
and which becomes an integral part of the finished goods. It basically consists of all raw
materials, either purchased from ourside or manufactured in house.

Indirect Material indicates that material which cannot be identified with the individual cost
centre. This material assists the manufacturing process and does not become an integral part
of finished goods. The examples of this type of material may be consumable stores, cotton
waste, oils and lubricants, stationery material etc.

(B) Labour :

This is the cost of remuneration paid to the employees of the organisation. It can be direct or
indirect.

Direct Labour Cost indicates that labour cost which can be identified with the individual cost
centre and is incurred for those employees who are engaged in the manufacturing process.

Indirect Labour Cost indicates that labour cost which cannot be identified with the individual
cost centre and is incurred for those employees who are not engaged in the manufacturing
process but only assist in the same. The examples of this type of cost are wages paid to
foreman/storekeeper, salary of works manager, Accounts/Personnel department salaries etc.

Elements of Costs 155


(C) Expenses :

This is the cost of services provided to the organisation (and the notional cost of assets
owned). It can be direct or indirect.

Direct Expenses are those expenses, which can be identified with the individual cost centres.
The examples of these expenses are hire charges of machinery/ equipments required for a
particular job, cost of defective work for a particular job etc.

Indirect Expenses are those expenses, which cannot be identified with the individual cost
centres. The examples of these expenses are rent, telephone expenses, insurance, lighting
etc.

The above elements of cost can be shown as below.

Cost

Material Labour Expenses

Direct Indirect Direct Indirect Direct Indirect

The aggregate of Direct Material Cost, Direct Labour Cost and Direct Expenses is termed as
‘Prime Cost’.

The aggregate of Indirect Material Cost, Indirect Labour Cost and Indirect Expenses is termed
as ‘Overheads’.

Overheads :

As discussed above, the aggregate of Indirect Material cost, Indirect Labour cost and Indirect
Expenses is termed as ‘Overheads’. For the proper interpretation and presentation of cost,
the term overheads may be further classified as below.

(a) Factory Overheads (Also termed as production/works/manufacturing overheads.)

(b) Office and Administration Overheads.

(c) Selling and Distribution Overheads.

(a) Factory Overheads :

These overheads consist of all overhead costs incurred from the stage of procurement of
material till the stage of production of finished goods. They include :

l Indirect Material such as consumable stores, cotton waste, oil and lubricants etc.

156 Management Accounting


l Indirect Labour Cost such as wages paid to foreman/storekeeper, works manager’s
salary etc.

l Indirect Expenses such as carriage inward cost, cost of factory lighting/power


expenses, rent/insurance/repairs for factory building/machinery, depreciation on
factory building or machinery etc.

(b) Office and Administration Overheads :

These overheads consist of all overhead costs incurred for the overall administration of
the organization. They include :

l Indirect Material such as stationery items, office supplies etc.

l Indirect Labour cost such as salaries paid to Accounts and Administration staff,
Directors’ remuneration etc.

l Indirect Expenses such as postage/telephone, rent/insurance/repairs/depreciation


on office building, general lighting, legal/audit charges, bank charges etc.

(c) Selling and distribution Overheads :

These overheads consist of all overhead costs insured from the stage of final manufacturing
of finished goods till the stage of sale of goods in the market and collection of dues from
the customers. They include :

l Indirect Material such as packing material, samples etc.

l Indirect Labour like salaries paid to sales personnel, commission paid to sales
manager etc.

l Indirect Expenses like carriage outwards, warehouse charges, advertisement, bad


debts, repairs and running of distribution van, discount offered to customers etc.

Elements of Costs 157


The above classification of overheads can be shown as below :

Indirect Material

Factory Indirect Labour

Indirect Expense

Indirect Material

Overheads Office/Administration Indirect Labour

Indirect Expense

Indirect Material

Selling & Distribution Indirect Labour

Indirect Expense

Cost Sheet/Cost Statement :

The various elements/components of the cost as discussed above can be presented in the
form of a statement, popularly known as ‘Cost Sheet’ or ‘Cost Statement’. The cost sheet
may be prepared separately for each cost centre and may have the columns like cost per unit
or cost of previous period etc.

A Proforma cost sheet is shown below :

Direct Material Cost

Direct Labour cost

Direct Expenses

PRIME COST

Add : Factory Overheads


FACTORY/WORKS COST

Add : Office and Administration Overheads


TOTAL COST

Add : Selling and Distribution Overheads


COST OF SALES

Add : Profit
SALES

158 Management Accounting


The above relationship among the various elements of costs can be explained in a better way
with the help of following diagram.

PROFIT

SELLING & DISTRIBUTION


OVERHEADS

ADMINISTRATION
OVEREHEADS

FACTORY
OVERHEADS

DIRECT
EXPENSES

COST OF SALES
FACTORY COST
PRIME COST

TOTAL COST
DIRECT
LABOUR

SALES
DIRECT
MATERIAL

Note :

The difference between sales and factory/works cost is termed as ‘Gross Profit’ and the
difference between sales and cost of sales is termed as ‘Net Profit’ or ‘Operating Profit’. As
such, the difference between Gross Profit and Office and Administration Overheads and Selling
and Distribution may be different from the ‘Net Profit’ or ‘Operating Profit’. This Net Profit may
be different from the net Profit as disclosed by the financial statement in the form of Profit and
Loss Account. This is due to the fact that the Profit and Loss Account considers the various
non-operating incomes/expenses or incomes/expenses of purely financial nature (as discussed
below) while they may be ignored by the cost statement.

(a) Non-operating/Financial Incomes :

These represent incomes which arise not as a part of regular operations of the organisation.
Eg. Profit on the sale of assets/investment, dividend received, windfall income etc. Due
to these, the operating profit as per cost statement may be less than profit as per Profit
and Loss Account.

(b) Non-operating/Financial Expenses :

These represent expenses which arise not as a part of regular operations of the
organisation. Such expenses may be in the form of those incurred as a result of policy.

Elements of Costs 159


Eg. loss on the sale of assets/investment, good-will/ preliminary expenses written off,
provision for Income Tax, Interest paid, Dividend paid etc. Due to these, the operating
profit as per cost statement may be more than profit as per Profit and Loss Account.

As such cost structure may also be presented as below.

Sales

Less : Factory/Works Cost


Gross Profit

Less : Office and Administration Overheads


Selling and Distribution Overheads
Operating Profit

Less : Non-Operating/Financial Expenses


Add : Non-Operating/Financial Income
Net Profit (As per Profit and Loss Account)

It goes without saying that if an organisation maintains cost records and financial records
separately, there may be a need to reconcile the profits as disclosed by the cost records and
the profit as disclosed by the financial records.

ILLUSTRATIVE PROBLEMS

(1) From the following list of balances, prepare a statement showing Cost of Sales, Gross
Profit, Operating Expenses, Operating Profit and Net Profit.

Rs.
Sales 7,80,000
Purchases 4,83,375
Sales Returns 30,000
Salaries : Office 40,350
Selling 22,950 63,300
Rent and Taxes : Office 2,700
Selling 1,350 4,050
Stationery and Postage 3,850
Depreciation 13,950
Advertising 4,700
Selling expenses 2,350
Travelling expenses 3,000

160 Management Accounting


Opening Stock 1,14,375
Sundry Expenses : Office 16,500
Selling 8,250 24,750
Closing Stock 1,47,750
Dividend on shares 13,500
Profit and sale of shares 4,500
Loss on sale of shares 6,000

Solution :

COST STATEMENT

(A) Sales Rs. Rs.


Gross Sales 7,80,000
Less : Sales Returns 30,000
Net Sales 7,50,000

(B) Prime Cost (Material consumed)


Opening Stock 1,14,375
Add : Purchases 4,83,375
5,97,750
Less : Closing stock 1,47,750
4,50,000

(C) Gross Profit (i.e. A-B) 3,00,000

(D) (a) Office and Administration Overheads


- Salaries 40,350
- Rent and Taxes 2,700
- Stationery and Postage 3,850
- Depreciation 13,950
- Travelling Expenses 3,000
- Sundry Expenses 16,500

80,350

Elements of Costs 161


(b) Selling and Distribution Overheads

- Salaries 22,950
- Rent and Taxes 1,350
- Advertising 4,700
- Selling Expenses 2,350
- Sundry Expenses 8,250

39,600 1,19,950

(E) Operating Profit (i.e. C-D) 1,80,050

(F) (a) Less : Non-operating Expenses


Dividend on shares 13,500
Loss on sale of shares 6,000 19,500

1,60,550

(b) Add : Non-operating Income

Profit on sale of shares 4,500

(G) Net Profit 1,65,050

Notes :

(a) From the available details, it appears that the above activity is a trading activity. As such
there will be no factory overheads and prime cost will consist of only material cost.

(b) In want of sufficient information, depreciation and travelling expenses are treated as
office and administration overheads.

(c) Dividend on shares may indicate the non-operating income also. However, in want of
sufficient information, it is treated as dividend paid by the company i.e. a part of non-
operating expenses.

(2) From the books of accounts of M/s. Aryan Enterprises, the following details have been
extracted for the year ending March, 1994.
Rs.
Stock of Materials – Opening 1,88,000
– Closing 2,00,000
Materials purchased during the year 8,32,000
Direct Wages paid 2,38,400
Indirect Wages 16,000

162 Management Accounting


Salaries to administrative staff 40,000
Freights – Inward 32,000
– Outward 20,000
Cash Discounts allowed 14,000
Bad Debts written off 18,800
Repairs to Plant & Machinery 42,400
Rent, Rates and Taxes – Factory 12,000
– Office 6,400
Travelling Expenses 12,400
Salesmens’ Salaries and Commission 33,600
Depreciation – Plant & Machinery 28,400
– Furniture 2,400
Directors’ Fees 24,000
Electricity Charges (Factory) 48,000
Fuel (for boiler) 64,000
General Charges 24,800
Manager’s Salary 48,000

The manager’s time is shared between the factory and the office in the ratio of 20:80.
From the above details, you are required to prepare :-
a. Prime Cost
b. Factory Overheads
c. Factory Cost
d. Administration Overheads
e. Selling Overheads
f. Total Cost
Solution :

COST SHEET
Direct Materials Cost Rs. Rs.
Opening Stock 1,88,000
Add : Purchases 8,32,000
Less : Closing Stock 2,00,000
8,20,000
Add : Freight Inward 32,000

Elements of Costs 163


Rs. Rs.
8,52,000
Direct Wages 2,38,400
PRIME COST 10,90,400
Factory Overheads

Indirect wages 16,000


Repairs to Plant & Machinery 42,400
Rent, Rates and Taxes 12,000
Depreciation – Plant & Machinery 28,400
Electricity Charges 48,000
Fuel for boiler 64,000
Manager’s Salary 9,600
2,20,400

FACTORY COST 13,10,800

Administration Overheads

Salaries 40,000
Rent, Rates and Taxes 6,400
Travelling Expenses 12,400
Depreciation – Furniture 2,400
Directors’ Fees 24,000
General Charges 24,800
Manager’s Salary 38,400
1,48,400
OFFICE COST 14,59,200

Selling Overheads

Freight Outward 20,000


Cash Discount allowed 14,000
Bad Debts written off 18,800
Salesmens’ Salary & Commission 33,600
86,400

TOTAL COST 15,45,600

164 Management Accounting


(3) An advertising agency has received an enquiry for which you are supposed to submit the
quotation. Bill of Materials prepared by the Production Department for the job states the
following requirement of material :

Paper – 10 reams @ Rs. 1800 per ream


Ink & Other printing material – Rs. 5,000
Other consumables – Rs. 3,000
Some photography is required for the job. The agency does not have a photographer as an
employee. It decides to hire a professional photographer who is to be paid professional fees of
Rs. 10,000.
Estimated job card prepared by the Production Department specifies that services of the
following employees will be required for the execution of the job. Monthly remuneration payable
to these employees as indicated by the Personnel Department is also given.
Artist – 80 hours. Paid Rs. 12,000 p.m.
Copywriter – 75 hours. Paid Rs. 10,000 p.m.
Client Servicing – 30 hours. Paid Rs. 9,000 p.m.
You can assume that a month consists of 25 working days and one working day consists of
6 working hours.
An amount of Rs. 4,000 will be required for the cost of primary packing material.
Production overheads are likely to be 40% of direct cost while selling and administration
overheads are likely to be 25% of production cost. The agency expects the profit of 10% on
basic quotation price.
COST SHEET
Rs. Rs.
Direct Materials Cost –
Paper 18,000
Ink & Other printing material 5,000
Other Consumables 3,000
Primary Packing Material 4,000
30,000
Direct Labour Cost
Artist 6,400
Copywriter 5,000
Client Servicing 1,800
13,200

Elements of Costs 165


Direct Expenses

Photography Charges 10,000


DIRECT COST 53,200
Production Overheads 21,280
PRODUCTION COST 74,480
Selling & Administration Overheads 18,620
TOTAL COST 93,100
Profit 10,344
QUOTATION PRICE 1,03,444

(4) Pune Equipments Ltd. manufactured and sold 1,000 refrigerators in year ending
31 December, 1984. The Trading and Profit & Loss Account is as below:

Trading and P&L Account for the year ending 31.12.84.

To, Cost of material 80,000 By, Sales 4,00,000


To, Direct wages 1,20,000
To, Manufacturing Cost 50,000
To, Gross Profit 1,50,000
4,00,000 4,00,000

To, Mgn. & Staff Salary 60,000 By, Gross Profit 1,50,000
To, Rent, Rates etc. 10,000
To, Selling Expenses 30,000
To, General Expenses 20,000
To, Income Tax 5,000
To, Net Profit 25,000
1,50,000 1,50,000

For the year ending 31.12.85, it is estimated that :

1. Output and sales will be 1,200 refrigerators.


2. Prices of the materials will rise by 20% on the previous year’s level.
3. Wages will rise by 5%.
4. Manufacturing cost will rise in proportion to combined costs of materials and wages.
5. Selling cost per unit will remain unchanged.
6. Other expenses will remain unaffected by the rise in output.

166 Management Accounting


You are required to prepare a cost statement showing the price at which each refrigerator
should be marked so as to show profit of 10% on the selling price.

Solution :

Cost Statement for the Year Ending 31.12.85


(Base - 1,200 Refrigerators)

Per Unit Total


Rs. Rs.
Material Cost 96.00 1,15,200
Direct Wages 126.00 1,51,200

Prime Cost 222.00 2,66,400


Manufacturing Cost (25% of Prime Cost) 55.50 66.600

Factory Cost 277.50 3,33,000


Management & Staff Salary 50.00 60,000
Rent/Taxes and General Expenses 25.00 30,000
Selling Expenses 30.00 36,000

Cost of Sales 382.50 4,59,000


Profit (1/9th of Total Cost) 42.50 51,000

Sales 425,00 5,10,000

Note :

(1) Material Cost and Direct Cost increases both due to increase in volume and increase in
prices.

(2) Calculation of manufacturing cost percentage -

Present Materials Cost Rs. 80,000

Present Direct Wages Rs. 1,20,000

Present Prime Cost Rs. 2,00,000

Present Manufacturing Cost Rs. 50,000

∴ Manufacturing Cost is 25% of Prime Cost.

(3) Expenditure in the form of income tax will be ignored being non-operating expenditure.

Elements of Costs 167


(5) The standard production for a particular work order is 20 units per day and piece rate
wages is 60 paise per unit if daily production is 20 units or more. The rate is 50 paise per
unit if production is less than 20 units. Cost of material is 30 paise per unit. It is proposed
to charge factory overhead under one of the following methods.

(i) 100% on labour cost.

(ii) 80% on prime cost.

Tabulate the above data in the form of a suitable statement and indicate in the factory
cost per unit, under each of the above methods if the daily production is (a) 15 units
(b) 20 units (c) 25 units.

Solution :

COST SHEET

(a) No. of units produced per day 15 20 25

(b) Material cost (Rs) 4.50 6.00 7.50

(c) Labour cost (Rs) 7.50 12.00 15.00

(d) Prime cost i.e. b+c 12.00 18.00 22.50

Alternative I Alternative II

(a) No. of units produced per day 15 20 25 15 20 25

(b) Prime Cost (Rs) 12.00 18.00 22.50 12.00 18.00 22.50

(c) Factory overheads (Rs) 7.50 12.00 15.00 9.60 14.40 18.00

(d) Total factory cost i.e. b+c 19.50 30.00 37.50 21.60 32.40 40.50

(e) Factory cost per unit i.e. d/a (Rs) 1.30 1.50 1.50 1.44 1.62 1.62

Note :

According to Alternative I, Factory Overheads are charged

@ 100% on Labour Cost.

According to Alternative II, Factory Overheads are charged.

@ 80% on Prime Cost.

168 Management Accounting


(6) X Ltd. manufactures four brands of toys A, B, C and D. If the Company limits the
manufacture to just one brand, the monthly production will be-

A - 50000 Units B - 100000 Units


C - 150000 Units D - 300000 Units

You are given the following set of information, from which you are requested to find out the
profit or loss made on each brand showing clearly, the following elements.

(a) Direct cost (b) Works cost (c) Total cost

Brands

A B C D

Monthly Production (units) 6,750 18,000 40,500 94,500

Direct Wages (Rs.) 15,000 27,500 37,500 1,05,000

Direct Material Cost (Rs.) 50,000 92,500 1,27,500 3,80,000

Selling Price Per Unit (Rs.) 20 15 10 8

Factory overhead expenditure for the month was Rs. 1,62,000. Selling and distribution cost
should be assumed @ 20% of works cost. Factory overhead expenses should be allocated to
each brand on the basis of the units which could have been produced in a month when a single
brand production was in operation.

Solution :

From the information given, it is observed that

One unit of B is equivalent to 2 units of A.

One unit of C is equivalent to 3 units of A

One unit of D is equivalent to 6 units of A

Expressing the actual production in terms of unit equivalents of product A

Product A 6,750 units.


Product B 9,000 units equivalent of A
Product C 13,500 units equivalent of A
Product D 15,750 units equivalent of A
45,000

Elements of Costs 169


The factory overheads of Rs. 1,62,000 are to be distributed over 45,000 equivalent units of
product A. As such rate of factory overheads for one unit of Product A will be

Rs. 1,62,000
= Rs. 3.60/per unit
45,000 units

As such, per unit factory overheads for other products will be -

Product B - Rs. 3.60/2 = Rs. 1.80/ per unit.

Product C - Rs. 3.60/3 = Rs. 1.20/ per unit.

Product D - Rs. 3.60/6 = Rs. 0.60/ per unit.

On this basis, the cost sheet for each product can be worked out as below.

A B C D

(a) Direct Material Cost 50,000 92,500 1,27,500 3,80,000


(b) Direct Wages 15,000 27,500 37,500 1,05,000
(c) Total Direct Cost i.e. a+b 65,000 1,20,000 1,65,000 4,85,000
(d) Factory Overheads 24,300 32,400 48,600 56,700
(e) Works cost i.e. c+d 89,300 1,52,400 2,13,600 5,41,700
(f) Selling/Distribution overheads 17,860 30,480 42,720 1,08,340

(g) Cost of Sales e+f 1,07,160 1,82,880 2,56,320 6,50,040


(h) Units Sold/Produced 6,750 18,000 40,500 94,500
(i) Units Selling Price - Rs. 20 15 10 8
(j) Total Sales Rs. 1,35,000 2,70,000 4,05,000 7,56,000
(k) Profit i.e. j-g 27,840 87,120 1,48,680 1,05,960

(7) A manufacturing company has an installed capacity of 1,20,000 units per annum. The
cost structure of the product manufactured is as under –

1. Variable Cost (Per unit)


Materials Rs. 8
Labour (subject to a minimum
of Rs. 56,000 per month) Rs. 8
Overheads Rs. 3
2. Fixed overheads Rs. 1,04,000 per annum

170 Management Accounting


3. Semi variable overheads Rs. 48,000 per annum at 60% capacity which increase by Rs.
6,000 per annum for increase of every 10% of the capacity utilization or any part thereof.

The capacity utilisation for the next year is estimated at 60% for 2 months, 75% for 6 months
and 80% for the balance part of the year. If the company is planning to have a profit of 25% on
the selling price, calculate the estimated selling price for each unit of production. Assume that
there is no opening or closing stock.

Solution :

Capacity Utilisation 60% 75% 80%


Months 2 6 4
No. of units 6000 7500 8000

Hence, total number of units will be –

6000 x 2 months + 7500 units x 6 months + 8000 units x 4 months = 89,000 units

Total
Materials (Rs.) 96,000 360,000 256,000 7,12,000
Labour 112,000 360,000 256,000 7,28,000
Overheads 36,000 135,000 96,000 2,67,000
Semi-variable Overheads 8,000 30,000 20,000 58,000
Fixed Overheads 1,04,000
Cost of Production 18,69,000
Per Unit Cost of Production i.e. 18,69,000/89,000 = Rs. 21

As profit is 25% on the selling price, selling price will be Rs. 28 per unit.

(8) AB & Co. manufactures two types of pens P and Q. The cost data for the year ended
30th September, 1990 is as follows –

Direct Materials Rs. 4,00,000


Direct Wages Rs. 2,24,000
Production Overheads Rs. 96,000

Rs. 7,20,000

It is further ascertained that :

a. Direct Materials in type P cost twice as much direct materials in type Q.


b. Direct wages for type Q were 60% of those for type P.
c. Production overheads were of same rate for both types.

Elements of Costs 171


d. Administration overhead for each was 200% of direct labour.
e. Selling costs were 50 paise per pen for both types.
f. Production during the year –
Type P 40,000 units
Type Q 1,20,000 units
g. Sales during the year –
Type P 36,000 units
Type Q 1,00,000 units
h. Selling prices were Rs. 14 per pen for type P and Rs. 10 per pen for type Q.

Prepare a statement showing per unit cost of production, profit and total sales value and profit
separately for two types of pens P and Q.

Solution :

Cost Statement for the year ended on 30th September, 1990

Particulars P Q
Direct Material 1,60,000 2,40,000
Direct Wages 80,000 1,44,000
Production Overheads 24,000 72,000
Administration Overheads 1,60,000 2,88,000
a. Cost of Production 4,24,000 7,44,000

b. Production (Units) 40,000 1,20,000


c. Per Unit Cost of Production (Rs.) 10.60 6.20
(Being a/b)
d. Sales (Units) 36,000 1,00,000
e. Cost of Sales 3,81,600 6,20,000
(Being d x c)
f. Selling Cost 18,000 50,000
g. Total Cost 3,99,600 6,70,000
(Being e + f)
h. Per Unit Selling Price (Rs.) 14.00 10.00
i. Sales 5,04,000 10,00,000
(Being d x f)
j. Profit 1,04,400 3,30,000

172 Management Accounting


Working Notes :

a. Direct Materials
Let per unit direct materials cost of Q be Rs. X. Hence, per unit direct materials cost of
P will be 2X Total Direct Materials Cost will be – 40,000 units x 2X + 1,20,000 units x X
= 4,00,000.
Solving for X, we get X = Rs. 2
Hence, Direct Materials Cost for P will be Rs. 1,60,000 and Direct Materials Cost for Q
will be Rs. 2,40,000.

b. Direct Wages
Let rate of labour be Rs. X for P Hence, rate of labour for Q will be 0.6X for Q
Total Direct Wages will be – 40,000 units x X + 1,20,000 units x 0.6X = 2,24,000
Solving for X, we get X = 2
Hence, Direct Wages Cost for P will be Rs. 80,000 and Direct Wages Cost for Q will be
Rs. 1,44,000.

(9) A company presently sells an equipment for Rs. 35,000. Increase in prices of labour and
material are anticipated to the extent of 15% and 10% respectively in the forthcoming
year. Material cost represents 40% of cost of sales and labour cost 30% of cost of sales.
The remaining relate to overheads. If the existing selling price is retained, despite the
increase in labour and material prices, the company would face a 20% decrease in the
existing amount of profit on the equipment.

You are required to arrive at a selling price so as to give the same percentage of profit on
increased cost of sales, as before. Prepare a statement of profit/loss per unit showing the new
selling price and cost per unit in support of your answer.

Solution :

Let cost of sales per unit be Rs. X. Then per unit profit will be 35000 – X.
Per unit cost structure will be as below –
Material Cost 0.4X
Labour Cost 0.3X
Overheads 0.3X

After the price increase, per unit cost structures will change as below –
Material Cost 0.44X
Labour Cost 0.345X
Overheads 0.3X

Elements of Costs 173


However, after the price increase and existing selling price remaining the same, the profit per
unit will come down by 20%.

Hence, the following equation will emerge –

35,000 – (0.44X + 0.345X + 0.3X) = 0.8 (35,000 – X)

Solving for X, we get X = 24,561. Hence, the existing per unit cost of sales is Rs. 24,561.

As such, following is the per unit cost structure with the existing prices and after the price
increase,

Existing Future
Materials Cost 9,825 10,808
Labour Cost 7,368 8,473
Overheads 7,368 7,368

Cost of Sales 24,561 26,649


Profit 10,439 8,351

Selling Price 35,000 35,000

Existing profit on cost of sales works out as –

10,439
X 100 = 42.5%
24,561

If the same profit percentage is to be maintained after the cost increase, the new selling price
will be –

26,649 + 42.5% of 26,649 = Rs. 37,975.

(10) A firm has purchased a plant for manufacturing a new product, the cost data for which is
given below.

Estimated Annual Sales 24,000 units.


Estimated Costs
Material Rs. 4.00 per unit
Direct Labour Rs. 0.60 per unit.
Overheads Rs. 24,000 per year.
Administrative Expenses Rs. 28,800 per year.
Selling Expenses 15% of sales.

Calculate the selling price if profit per unit is Rs. 1.02.

174 Management Accounting


Solution :

Let the selling price be Rs. X


Hence, total sales will be Rs. 24000X
The cost sheet will be as below –
Material Cost 24000 x Rs. 4.00 96,000
Direct Labour 24000 x Rs. 0.60 14,400
Overheads 24,000
Administrative Expenses 28,800
Selling Expenses 15% of sales 3,600X
Profit Re. 1.02 per unit 24,480

Hence,
24000X = 96000 + 14400 + 24000 + 28800 + 3600X + 24480
24000X = 187680 + 3600X
20400X = 187680
X = 9.20

Hence, selling price will be Rs. 9.20

QUESTIONS

1. What do you mean by Elements of Cost? Explain in details. Draw a standard format of
cost sheet for a machine tool manufacturing company. Assume suitable data.

2. How the cost is classified into various elements for presenting the same in the form of a
cost sheet. Prepare a standard format of cost sheet for a furniture making unit. Assume
suitable data.

Elements of Costs 175


PROBLEMS

(1) The following figures relates to the trading activities of Hind Traders for the year ended
30.6.79. Prepare a statement showing net operating income.
Rs. Rs.
Sales 5,20,000 Office Salaries 27,000
Purchases 3,22,250 Rent 2,700
Opening Stock 76,250 Stationery & Postage 2,500
Closing Stock 98,500 Depreciation 9,300
Sales Returns 20,000 Other charges 16,500
Interest on Debentures 15,300 Provision for Tax 40,000
Advertising 4,700
Travelling 2,000

(2) From the following list of balances, prepare a statement showing net operating income.
Rs.
Sales 5,40,000
Purchases 1,60,000
Sales Returns 40,000
Purchases Returns 10,000
Opening Stock 50,000
Closing Stock 60,000
Rent Received 1,50,000
Profit on sale of asset 1,00,000
Office Expenses 25,000
Manufacturing Expenses 30,000
Selling Expenses 10,000
Depreciation 13,000
Interest on Loan 2,000
Income Tax 150

176 Management Accounting


(3) A Ltd. is a company which is engaged in the business of executing the various jobs as
per the customer requirements. It has received one job from one of the customers for
which it is required to submit the quotation. The Production Manager of the company
has worked out the following details of the cost in respect of the said job –

Raw Materials Rs. 40,000


Bought Out Components Rs. 50,000
Primary Packing Material Rs. 5,000
Consumable Stores Rs. 4,000
Direct Workers 400 Labour Hours @ Rs. 30 per hour
Royalty Payable 20% of Direct Material
Other Factory Overheads 15% of Prime Cost
Support from administrative staff 100 Man-hours @ Rs. 50 per hour
Other administration overheads 15% of Factory Cost
Selling Overheads 10% of Total Cost

What selling price should be quoted by the Company if it intends to earn a profit of 20% on
selling price?

(4) Honesty Engineering Works has a machining shop in which it manufactures two Auto
Parts P1 and P2 out of forgings F1 and F2. For the quarter ending December 1993,
following cost data are available –

Consumption of Raw Materials - F1 1,50,000


- F2 2,00,000
Wages and Salaries 1,53,000
Stores and Spares 12,000
Repairs and Maintenance 15,000
Power 16,000
Insurance 8,000
Depreciation 50,000
Factory Overheads 68,000
Administration Overheads 64,400
Distribution Overheads 75,000

Total Cost 8,11,400

Elements of Costs 177


You are given further information –

a. Production and Sales of P1 and P2 were as under -


P1 P2
Production (Pieces) 6,000 4,000
Sale of above pieces (Rs.) 4,80,000 5,20,000

b. Direct wages paid were Rs. 36,000 incase of P1 and Rs. 32,000 for P2. This is used for
apportioning Wages and Salaries and Factory Overheads.

c. Following machine hours were utilized in production of these products –

P1 – 550 P2 – 450

d. Stores & Spares, Repairs & Maintenance, Power, Insurance and Depreciation are charged
to cost of both the products on the basis of machine hours used.

e. Administration Ovcrheads are apportioned on the basis of respective conversion costs


while Distribution Overheads on the basis of their sales realizations.

f. All the production was sold out.

Required – Prepare cost sheets of both the products and work out profit earned of each of
them.

(5) The cost of manufacturing 5,000 units of a commodity comprises Material Rs. 20,000,
Wages Rs. 25,000, Chargeable Expenses Rs. 400. Fixed Overheads Rs. 16,000, Variable
Overheads Rs. 4,000.
For manufacturing every 1,000 extra units of the commodity, the cost of production
increases as follows.
1. Materials : Proportionately.
2. Wages : 10% less than proportionately.
3. Chargeable Expenses : No extra cost.
4. Fixed Overheads : Rs. 200 extra.
5. Variable Overheads : 25% less than proportionately.
Calculate the estimated cost of producing 8,000 units of the commodity and show by
how much it would differ if a flat rate of factory overhead were charged.

(6) The following is the profit and loss account of a manufacturing company for the year
1987-88 (figures in lakhs).

178 Management Accounting


Rs. Rs.
Materials 48 Sales 96
Wages 36 Closing Stock of
Factory overheads 24 finished goods 18
Gross Profit c/d 12 Work in Progress (at cost)
Materials 3.00
Labour 1.80
Works Expenses 1.20 6
120 120
Administration Expenses 6 Gross Profit b/d 12
Goodwill and Preliminary Interest Received 1
Expenses written at 2
Net Profit 5
13 13

During the year 6000 units were manufactured and 4800 units were sold. The costing records
show that works expenses have been charged @ Rs. 300 per article,and administration
expenses @ Rs. 150 per article. The costing books show a profit of Rs. 12 lakhs.

Prepare cost sheet and show the reconciliation

(7) A firm manufactured and sold 500 units during the year ended on 31st March, 2001. The
summarised Trading and Profit & Loss Account is as below :

Particulars Rs. Particulars Rs.

Material Consumed 40,000 Sales 2,00,000


Direct Labour 60,000
Manufacturing Cost 25,000
Gross Profit 75,000
2,00,000 2,00,000

Management Expenses 30,000 Gross Profit 75,000


Rent 5,000
General Expenses 10,000
Selling Expenses 15,000
Net Profit 15,000
75,000 75,000

Elements of Costs 179


For the year 2001-2002, the estimates are :

a. Output and sales will be 600 units.

b. Material prices will increase by 20% over the previous year.

c. Direct Labour rate will rise by 5%.

d. Manufacturing expenses will increase in proportion to prime cost.

e. There will be no change in selling expenses per unit.

f. Rise in output will not affect other expenses.

Prepare a statement showing the price in such a way that profit will be 20% on selling price.

(8) Following costs were incurred in producing 800 MT of M.S. Rods –

Materials 2,80,000
Labour 1,00,000
Processing Charges 1,00,000

Total Cost 4,80,000

Of the total output, 10% was defective and had to be sold after a discount of 10% off the
normal price. The scrap arising out of the production realized a sum of Rs. 8,760. The sale
price is calculated to yield 15% profit on sales. You are required to find out the normal price as
well as the discounted price of per MT of M.S. Rods.

(9) In a factory, the methods mentioned below are adopted for the allocation of office and
selling overheads.

(a) Advertisement and Sales Promotion - On Factory Cost figures.

(b) Credit and Collection Expenses - On Sales figures.

(c) Direct Selling Costs - On Sales figures.

(d) Other items - On Factory Cost figures.

The factory deals with five different types of products viz. B, C, D, E and F. The following
information has been collected from its books.

180 Management Accounting


Particulars B C D E F
Rs. Rs. Rs. Rs. Rs.
Direct Materials 24,000 48,000 66,000 33,000 40,500
Direct Wages 27,000 36,000 57,000 24,000 34,500
Sales 1,12,500 1,65,000 2,62,500 1,09,500 1,60,500

Factory overhead charges are 80% of direct wages. Office and sales expenses are :

Rs.
Direct Selling Costs 81,000
Other Items 53,280
Credit and Collection Expenses 8,100
Advertisement and Sales Promotion 79,920

Prepare a statement showing the costs incurred and the profit earned in respect of each
product. (Calculations may be made to the nearest rupee).

Elements of Costs 181


NOTES

182 Management Accounting


Chapter 8
MATERIAL COST

Material cost is the first and probably the most important element of cost. In case of some
specific types of industries, say cement, sugar, chemicals, iron and steel etc., the materials
cost forms a very significant portion of the overall cost of production.

The term material refers to all commodities which are consumed in the production process.
The materials which can be consumed in the production process can be basically classified
as:

(i) Direct Materials

(ii) Indirect Materials

The meaning of both these terms has already been discussed. The basic objective of cost
accounting i.e. ascertainment of cost and control of cost is equally applicable to material cost
as well. The ascertainment of material cost is made from basically two documents i.e. the
invoice of the supplier of material and material requisition slip specifying material issued from
stores department to production department. However, a whole lot of organisational procedures
are also involved in the process, which affect the material cost, either directly or indirectly.
E.g. Purchases from improper source of supply may be expensive, non-availability of material
in time may result into hold ups and so on. As such, a proper study of the various procedures
involved in case of the movement of materials and a proper control thereon enables an
organisation to exercise the control on a sizeable manufacturing cost.

The movement of material may involve the following stages.

(a) Procurement of materials.

(b) Storing the material till it is required for consumption.

(c) Issue of the material for consumption.

(A) Procurement of Materials : Though the practices may differ from organisation to
organisation, normally, the process of purchasing the materials involves the following
stages.

Material Cost 183


(1) Purchase Requisition : It is an indication given to the purchases department to
purchase certain material. It is issued either by storekeeper (in respect of material
required for regular production purposes) or by production department (in respect of
special materials required). Following particulars must appear in purchase requisition.

(i) Material to be purchased : It should be clearly specified. To make it more


specific, in addition to the description of the material required, code number
should also be specified.

(ii) When it is required : Unless the material is required for regular production
purposes (when the storekeeper himself will place the purchase requisition as
soon as it reaches the ordering level), purchase requisition should mention
the last date by which the material is required. Ideally, the material should be
purchased whenever the market for the same is favourable.

(iii) How much to be purchased : Purchase requisition should state the quantity
of the material required. Before deciding the quantity of material to be
purchased, the principle which should be kept in mind is that there should not
be any overstocking or understocking of materials as both these situations
involve costs.

Overstocking may have following consequences :

- Blocking of working capital.

- Risk of deterioration of quality and obsolescence.

- More storage facilities.

- Additional Insurance Cost.

- More material handling and upkeeping.

- Risk of breakage/pilferage etc.

Understocking may have following consequences :

- Production hold ups, resulting into disturbed delivery schedules.

- Frantic eleventh hour purchases which may result into unfavourable prices
and quality.

- Payment for idle time to workers.

Before deciding the quantity to be purchased, consideration will have to be


given to the following factors also :

(i) Quantity already ordered.

184 Management Accounting


(ii) Quantity reserved. There may be the case that a particular quantity, though
in hand, might have been reserved for a particular job which is not available
for other purposes. In such cases, this quantity is such, as if it is not in
stock.

(iii) Funds availability - Amounts which are kept aside for drawing up purchase
budget should be considered.

The purchase requisition should be signed by Head of the Department drawing the same.
A standard form of Purchase Requisition is as shown below :

PURCHASE REQUISITION

To : Purchase Department From : Department


No. :
Date :
Please purchase the material stated below.
Sr. No. Description Code No. Quantity Required Quantity on hand Remarks

Signed by : Storekeeper Approved by

For the use of Purchase Department only

Date P.O. No. Name of Supplier Delivery Date Remarks

Signed : Purchase Manager

(2) Selection of Source of Supply :

For this purpose, the purchase department may call for the quotations from the prospective
suppliers of a certain type of material. In practice, following types of quotations may be
called for :

(a) Single Tender : It is addressed to only one selected source when there is only
one source of supply available.

Material Cost 185


(b) Limited Tender : It is addressed to a limited number of suppliers known to be
reliable sources on the basis of data maintained by the purchase department.

(c) Open Tender : It is open to all who can supply specified quality and quantity of the
required material. Tenders are called by giving advertisements in the newspapers,
journals etc.

(d) Global Tender : Anybody from any part of the world can respond to these tenders.

To discourage unreliable and unwanted sources from quoting, some tender deposit may be
insisted upon.

Comparative Statements :

After receiving the tenders as stated above, a comparison has to be made among the various
available sources so that the best possible source can be selected. All the offers are tabulated
in a comparative statement. The authority which is authorised to accept the tender should be
specified. The criteria for selecting the final source of supply may depend upon the terms of
offer which can be compared in respect of price offered, quality, other terms (like Sales Tax,
Octroi, Freight etc.), terms of delivery, terms of payment, guarantee offered by the supplier,
goodwill of the supplier etc. Lowest quotation may not necessarily be the best quotation.

(3) Purchase Order :

The contractual obligation between the supplier and purchaser starts from purchase
order. It is drawn in favour of the supplier by the purchase department. It may specify a
number of facts.
- Material to be supplied (Description as well as code numbers and quality).
- Quantity to be supplied.
- Price and other terms (e.g. excise duty, sales tax, octroi, insurance, packing and
transportation etc.).
- Cash and trade discount.
- Instructions in respect of delivery.
- Guarantee clause.
- Liquidated damages clause.
- Escalation clause.
- Inspection clause.
- Method of settlement of disputes.
- Details in respect of letters of credit, import licence etc.
- Details in respect of interest payable in the event of late payment of dues.

186 Management Accounting


Ideally, purchase orders should be serially numbered. Normally, four or five copies of
Purchase Orders are drawn, to be distributed as below :
- One to Supplier.
- One to User Department.
- One to Stores Department.
- One to Accounts/Costing Department.
- One with Purchase Department.

A standard form of Purchase Order is as shown below :

PURCHASE ORDER

No. –
Date –
Requisition No.–
Date –

Please supply the following material on such terms and conditions as stated therein.

Description Code No. Quantity Rate Rs. Value Rs. Delivery Date Remarks

Delivery : Goods to be delivered at –


Extra as applicable –
Excise Duty
Sales Tax
Packing Charges
Insurance
Terms of payment
For ——————(Purchasing Company)

Purchase Manager

Material Cost 187


(4) Receipt and Inspection : After material is received from the supplier, the quantity
received actually, is compared with quantity ordered. Variations, if any, are taken up with
the supplier again. Excess material received may be dealt with in any of the following
ways :

– Accept all the material received.

– Accept the material ordered and return the excess to the supplier.Before accepting,
material may be subjected to inspection. The extent of inspection may vary from
material to material.

(5) Checking invoice and accounting for purchases : The supplier’s invoice received for
the supply of material is subjected to scrutiny before a voucher is passed for the same
for making the entry in the books of accounts. For this purpose, the supplier’s invoice
may be compared alongwith the following documents.

(a) Purchase Order.

(b) Goods Received Note.

(c) Inspection Report.

If the quantity and/or rate as per purchase order and invoice match with each other, the
invoice of the supplier is passed for making the entry in the books of accounts. If the
quantity and/or rate as per purchase order and invoice differ from each other, the difference
is adjusted by raising a debit or credit note in favour of the supplier.

(B) Storing and Issue of Material : After the material is received, inspected and approved,
the process of storing comes into operation which deals with storing the material in good
condition till it is required for use by production departments and issuing the same
whenever required.

As far as the movement of the material from the stores point of view is concerned, there
can be basically four types of movements.

(1) Receipt of material.

(2) Issue of material

(3) Return of material from Production Department to Stores Department.

(4) Transfer of material.

(1) Receipt of Material :Usually the receipt of material is accompanied by delivery


challan given by the supplier. On receipt of the material, quantity received is checked
with the quantity ordered by the Stores Department. The received material may be
inspected, before acceptance either by separate inspection department or by Stores

188 Management Accounting


Department itself. A document known as Goods Received Note or Goods Received
Report (GRN or GRR) is prepared to record the details of the material received. The
usual form in which GRN or GRR is prepared is as below :

GOODS RECEIVED NOTE

No.
Date

S. No. Description Code Qty. Recd. Qty. Accepted Qty. Rejected Remarks

Prepared by Received by Inspected by Store Keeper

It may be prepared in quadruplicate to be distributed as follows.

– One copy to Purchases Department for comparing with purchases order and approving
the invoice of the supplier.

– One copy to Accounts Department for making the payment of supplier’s invoice.

– One copy to Costing Department for pricing and entering in stores record.

– One copy to be retained by Stores Department.

Ideally, GRN/GRR should be serially numbered in order to locate the material which is physically
received but for which invoice is not received.

Discrepancies in material receipts :

The material physically received when compared with material ordered as per the purchase
order may reveal certain discrepancies which may take any of the following forms.

(1) Quantity received in excess.

(2) Quantity received in short.

(3) Quantity received of different quality.

Excess quantity received may be retained and accepted, if required, with the approval of the
purchase department. Alternatively, if it is not accepted, it may be returned to the supplier with
Goods Returned Note. The usual form in which Goods Returned Note is prepared is as below:

Material Cost 189


GOODS RETURNED NOTE

To : No.
Date :

Following material supplied by you vide your D.C. No.____________ and Invoice
No.____________against our Purchase Order No. ______________is being returned to
you for the reasons stated below:

Description Quantity Reasons

Signature

Usually, three copies of Goods Returned Note are prepared to be distributed as below :

- One copy to the Supplier.

- One copy to the Purchase Department.

- One copy to be retained by the Stores Department.

Excess Quantity Accepted : If excess quantity is already billed in the invoice, it will be
approved and paid. If not, either the supplier may be asked to give a supplementary invoice or
credit note may be issued to the supplier for amending the amount.

Excess Quantity Returned : If excess quantity is already billed in the invoice, debit note may
be issued to the supplier for amending the amount.

In case the quantity received is short, purchase department may take up the case with the
supplier or carrier or insurer as per the terms of purchases. If quantity short supplied is billed
in the invoice, invoice is suitably amended and debit note is issued to the supplier.

If quantity received is of different quality and is rejected in inspection, it can either be retained
or returned. It may be retained by accepting some mutually decided concessional price. The
variation in prices may be adjusted by issuing either the credit note or debit note in favour of
the supplier.

(2) Issue of Material : Here, the issue of material refers to issue of material from stores
department to production department. The material should not be issued from the stores
unless a proper authority in writing is produced before the stores department. Usually,
this authority is in the form of Material Requisition Note or Material Requisition Slip.

190 Management Accounting


The normal contents of this note/slip are :
– Number and date (Ideally, they should be serially numbered).
– Department demanding the material.
– Description and code of material demanded.
– Quantity of material demanded.
– Signature of authority approving the demand.
– Signature of the person receiving the material.
Normally one note/slip is prepared for requisitioning a single item of material.
The usual form in which it is prepared is as below :

MATERIAL REQUISITION NOTE

Production/Job Order No. No.


Bill of Materials No. Date :
Department :

Description Code Qty. Unit Cost (for costing Dept. only)


Rate per unit Amount Rs.

Authorised Issued Received Entered and Valued


by by by by

Normally, it is prepared in three copies.Two copies to Stores Department which in its turn
passes one copy to Costing Department for pricing while second copy is retained by the
Stores Department. One copy is for demanding department.

(3) Return of material :

There can be some situations, when material once issued to production departments is
returned back to the stores. It can happen in the following circumstances.

(a) Material issued in excess of requirement.

(b) Scrap or defective work arising out of the production processes.

Under these circumstances, a document in the form of Materials Returned Note is prepared,
which is to record return of unused materials. The usual form in which this document is
prepared is as below :

Material Cost 191


MATERIALS RETURNED NOTE

Production/Job Order No. No.


Bill of Materials No. Date :
Department :

Description Code Qty. Unit Cost (for costing Dept. only)


Rate per unit Amount Rs.

Authorised Received Posted


by by by

As far as the valuation of the returned material is concerned, it may be treated as the fresh
receipt of the material or alternatively, it may be treated as the negative(minus) issues.

(4) Transfer of Materials :In some situations, considering the urgency for the requirement
of the material, it may be necessary to transfer the material from one production/job
order to another. Such transfer of material is usually accompanied by preparing a document
in the form of Material Transfer Note. The usual form in which this document is prepared
is as below :

MATERIAL TRANSFER NOTE

No.
Date :
From…………Dept. To…………..Dept.
Production/Job Production/Job
Order No. Order No.
Description Code No. Qty. Cost (for costing Dept. only)
Rate per unit Amount Rs.

Authorised Received Entered


by by by

192 Management Accounting


Transfer of materials does not result into any fresh issue of material. However, material transfer
notes will have to be valued and considered in order to compute the material cost as per the
job orders and production orders.

PROPER CONDUCT OF STORAGE FUNCTION

As discussed earlier, proper conduct of storage function requires that material should be
properly stored in good condition till it is required for use by production departments and
should be issued whenever required. This proper conduct is ensured by what is known as
“Perpetual Inventory System”. The aims of the perpetual inventory system are two fold.

(1) Recording receipts and issues in such a way so as to know at any time, the stock in
hand, in quantity and/or value, without the need of physical counting. This aim is achieved
by maintaining what is called as Bin Card and Stores Ledger.

(2) Continuous verification of physical stock at regular intervals.

Bin Card

It is only a quantitative record of receipts, issues and closing balance of an item of material.
Separate bin card is maintained for each item of material. The usual form in which a bin card
is maintained is as below.

BIN CARD

Description Maximum level


Code No. Minimum level
Location/Unit Recorder level

Date Document No. Receipt Issue Balance Remarks

Entries in receipts column are made on the basis of Goods Received Note or Material Returned
Note. Entries in issues column are made on the basis of Material Requisition Note. After every
entry of either receipts or issues, the balance quantity is calculated and recorded so that the
balance can be known at any point of time. The levels indicated on bin card enable the stores
department to keep a watch on balance and replace the material as soon as it reaches the
reorder level.

Material Cost 193


Ideally, bin card should be placed alongwith the material. But it may not be possible in all the
cases, then bin cards are placed at a centrally located place but within stores department
only.

Stores Ledger

Like Bin Card, it is maintained to record all receipts and issue transactions of material but with
the exception that it records not only the quantities received or issued or in stock but also the
financial expressions of the same. The usual form in which the stores ledger is maintained is
as following :

STORES LEDGER

Description Maximum level


Code No. Minimum level
Location/Unit Recorder level

Date Document No. Receipts Issues Balance Remark


Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.

By summing up the amounts appearing in the ‘issues’ column of stores ledger, one can get
the cost of material issued to Production Department which forms the ‘Material Cost’.

As in case of bin card, separate store ledger sheets are maintained in case of each item of
material. The stores ledger sheets are maintained either in loose form or in bound book form.

Bin Card Vs. Stores Ledger :

If the stores ledger is having all the information mentioned in a bin card plus some additional
information is also available, the next question which arises is why is it necessary to maintain
both bin card and stores ledger simultaneously as it will be only duplication of work. In the
situations of computerized inventory accounting system, maintenance of bin card and sotres
ledger simultaneously can be avoided. However, in the situations of manual inventory accounting
system, it will be ideal to maintain bin card and stores ledger simultaneously due to the
following reasons.

(1) Bin card is maintained by stores department while stores ledger is maintained by costing
department.

194 Management Accounting


(2) Bin card is not an accounting record but only a quantity record and as such is not
concerned with the financial implications of stores transactions.
(3) Maintenance of stores ledger provides a second check on maintenance of bin cards.

Reconciliation of Bin Card and Stores Ledger :

As the source documents for the entries in Bin Card and Stores Ledger are the same, the
closing balances disclosed by both of them should match with each other. But in practice,
they may not match due to the following reasons.
(1) Arithmetical error in calculating balance.
(2) Non-posting of certain document in either of these documents.
(3) Posting on wrong bin card or stores ledger sheet.
(4) Treating receipts transaction as issue transaction or vice versa.

If the closing balance as per bin card and stores ledger is not matching, the very purpose of
maintaining these two documents simultaneously will be defeated. As such, it is necessary
to reconcile both balances at regular intervals by keeping all the postings upto date. If the
balances as on a particular day are not matching, all the previous transactions should be
checked to locate differences.

Valuation of Material Movements :

As discussed above, the stores ledger considers not only the movement of material in terms
of quantity but also in terms of its financial implications. As such, it is necessary that all the
possible movements of material are valued properly and are expressed in terms of money. We
will consider this problem under the following heads.
(a) Valuation of receipts.
(b) Valuation of issues.
(c) Valuation of returns from production department to stores department.

(a) Valuation of receipts :

Valuation of receipts is relatively an easy task, as the invoice or bill received from the
supplier of the material is available as a starting point. Following propositions should be
considered for this purpose.
(1) The price as billed by the supplier will be the valuation of the receipts. The trade
discount is deducted from the basic price and all other amounts as billed by the
supplier are added viz. Excise Duty, Sales Tax, Octroi Duty, Transport/Insurance
charges etc. There are different opinions in respect of the treatment of cash discount.
One opinion says that cash discount should be ignored being purely of financial
nature while valuing the receipts, while another opinion says that it should be
considered while valuing the receipt of the material.

Material Cost 195


(2) In some cases, more than one item of material are included in one single bill and
some costs are jointly incurred for all the items of material. Such joint costs may
be distributed on the basis of basic price of the material.

(3) In case of the imported material, the cost of the material consists of basic price
(which may be stated in foreign currency and should be converted in Indian Rupees),
Customs Duty, Clearing Charges, Transport Charges, Octroi Duty etc. In some
cases, the point of receipt of imported material and the point of making the payment
of invoice amount may be different. As such, rate of foreign currency may be different
at the time of payment of customs duty and at the time of payment of invoice
amount. In such cases, the rate of exchange existing at the time of making the
payment of invoice amount should be considered for valuing basic cost of material
imported.

Illustration :

The particulars relating to 1,200 kgs. of a certain raw material purchased by a company during
June, were as below.

(a) Lot prices quoted by suppliers and accepted by the company for placing the purchase
order.

(b)
Lot upto 1000 kgs.
Between 1000 - 1500 kgs.
Between 1500 - 2000 kgs

Trade Discount 20%.


@ Rs. 22 per kg.
@ Rs. 20 per kg.
@ Rs. 18 per kg. } For
Supplies
to Factory

(c) Additional charge for containers @ Rs. 10 per drum of 25 kgs.

(d) Credit allowed on return of containers @ Rs. 8 per drum.

(e) Sales Tax at 10% on raw material and 5% on drums.

(f) Total freight paid by the purchaser Rs. 240,

(g) Insurance at 2.5% (on net invoice value) paid by the purchaser.

(h) Stores Overheads applied at 5% on total purchase cost of material.

The entire quantity was received and issued to production :

The containers are returned .in due course. Draw up a suitable statement to show :

(a) Total cost of material purchased.

(b) Unit cost of material issued to production.

196 Management Accounting


Solution :

(a) Statement showing cost of purchases

Basic Cost Rs. Rs.


1,200 kgs x Rs. 20/kg. 24,000
Less : Trade Discount @ 20% 4,800
19,200.00
Container Cost :
48 Drums x Rs. 10 /Drum 480.00
19,680.00
Sales Tax :
10% on Rs. 19,200 1,920.00
5% on Rs. 480 24.00
1,944.00
21,624.00
Other charges
Insurance 2.5% on Rs. 21,624.00 540.60
Freight 240.00
22,404.60
Less : Credit for drums returned
Rs. 8 per Drum x 48 Drums 384.00
TOTAL COST 22,020.60
Add : Stores Overheads 5% 1,101.03
23,121,63

(b) Unit cost for valuation of issues

Rs. 23,121.63.
= Rs. 19.268/kg.
1,200 kgs.

Illustration :

The particulars related to the import of Sealing Ring made by AB & Co. during December 85
are given below.
(a) Sealing Ring 1,000 pieces invoiced @ £ 2 CIF, Bombay Port.
(b) Customs Duty was paid @ 100% on invoice value (which was converted to Indian Currency
by adopting an Exchange Rate of Rs. 17.20 per £)

Material Cost 197


(c) Clearing charges : Rs. 1,800 for the entire consignment

(d) Freight charges : Rs. 1,400 for transporting the consignments from Bombay Port to
Factory premises.

It was found on inspection that 100 pieces of the above material were broken and therefore
rejected. There is no scrap value for the rejected part. No refund of the broken material would
be admissible as per the terms of contract. The management decided to treat 60 pieces as
normal loss and the rest 40 pieces as abnormal loss. The entire quantity of 900 pieces was
issued to production.

Calculate :

(a) Total cost of material.

(b) Unit cost of material issued to production.

Also state briefly how the value of 100 pieces rejected in inspection will be treated in costs.

Solution :

Total Cost of Material

(1) Invoice Price Rs.


UK £ - 1,000 pieces x £2 = £ 2,000
- £ 2,000 x Rs. 17.2 per UK £ 34,400
(2) Customs Duty @ 100% 34,400
(3) Clearing Charges 1,800
(4) Freight charges 1,400

Total Cost 72,000

As loss of 40 pieces is considered as abnormal loss, it will be transferred to Costing Profit and
Loss Account.

Rs. 72,000
∴ Abnormal Loss = X 40 pieces
1,000 pieces

= Rs. 2,880

Balance of the cost (i.e. Rs. 72,000 - Rs. 2,880 = Rs. 69,120)Includes cost of units treated as
normal loss i.e. 60 pieces.

This cost will be borne by good pieces.

198 Management Accounting


Rs. 69,120
∴ Unit cost of good pieces =
900 pieces

= Rs. 76.80
(b) Valuation of Issues :

This is a more complex process than the valuation of the receipts. It is because of the
reason that the material may be issued out of the various lots which might have been
purchased at various prices. As such, a problem may arise as to which of the receipt
prices should be used to value the material requisition notes. Various methods may be
used for this purpose, main methods of which may be discussed as below.

(a) First In First Out (FIFO)Under this method, the price of the earliest available lot is
considered first and if that lot is exhausted, the price of the next available lot is
considered. It should be remembered that the physical issue of the material may
not be made out of the said lots, though it is presumed that it is made out of these
lots as stated above.

Illustration :

Following transactions have taken place in respect of a material during March 1990.
Date :
1 Opening Balance 500 units @ Rs. 6 per unit.
5 Purchased 100 units @ Rs. 7 per unit.
7 Issued 400 units.
9 Purchased 300 units @ Rs. 8 per unit.
19 Issued 250 units.
22 Issued 50 units.
25 Purchased 300 units @ Rs. 7.50 per unit.
30 Issued 250 units.

Prepare the Stores Ledger assuming that the issues are valued on FIFO basis.

Material Cost 199


Stores Ledger

Description/Code No. Maximum level


Unit Minimum level
Location Re-order level

Date Particulars RECEIPTS ISSUES BALANCE


Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.
Rs. Rs. Rs.

1 Op. Bal. 500 6 3,000


5 GRN No. 100 7 700 500 6
100 } 7 3,700
7 MRN No. 400 6 2,400 100 6 1300
100 } 7
9 GRN No. 300 8 2,400 100 6
100
300
} 7
8
3700

100 6
19 MRN No. 100
50
} 7
8
1700 250 8 2,000

22 MRN No. 50 8 400 200 8 1,600


25 GRN No. 300 7.5 2,250 200 8
300 } 7.5 3850
30 MRN No. 200
50
} 8
7.5 1975 250 7.5 1,875

Value of closing stock is Rs. 1,875 which considers latest available market price of the material.

The advantages of this method are as below :

(a) It is simple to operate.

(b) It considers the valuation of closing stock at the current market prices.

(c) It can be conveniently applied if transactions are not too many and the prices of the
material are fairly steady.

200 Management Accounting


The objections raised against this method are as below :

(a) Calculations become complicated if the lots are received frequently and at varying prices.

(b) Costs may be wrongly presented if the price of different lots of material are used for
pricing issues to various batches of production.

(c) In case of varying prices, the pricing of issues does not consider current market prices.

(b) Last In First Out (LIFO) :

Under this method, the price of the latest available lot is considered first and if that lot is
exhausted, the price of the lot prior to that is considered. Here also, it should be
remembered, that the physical issue of the material may not be made out of the said
lots, though it is presumed that it is made out of the lots as stated above.

Illustration :

Following transactions have taken place in respect of a material during March 1990.

Date:

1 Opening Balance 500 units @ Rs. 6 per unit.

5 Purchased 100 units @ Rs. 7 per unit.

7 Issued 400 units.

9 Purchased 300 units @ Rs. 8 per unit.

19 Issued 250 units.

22 Issued 50 units.

25 Purchased 300 units @ Rs. 7.50 per unit.

30 Issued 250 units.

Prepare the stores ledger assuming that the issues are valued on LIFO basis.

Material Cost 201


Stores Ledger

Description/Code No. Maximum level


Unit Minimum level
Location Re-order level

Date Particulars RECEIPTS ISSUES BALANCE


Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.
Rs. Rs. Rs.

1 Op. Bal. 500 6 3,000


5 GRN No. 100 7 700 500
100 } } 6
7
3,700

7 MRN No. 100


300 } 7
6
2,500 200 6 1,200

9 GRN No. 300 8 2,400 200


300 } } 6
8
3,600

} }
19 MRN No. 250 8 2,000 200 6 1,600
50 8
22 MRN No. 50 8 400 200 6 1,200
25 GRN No. 300 7.5 2,250 200
300 } } 6
7.5
3,450

30 MRN No. 250 7.5 1,875 200 6 1,575


50 } } 7.5

Value of closing stock is Rs. 1,575 which consists of 200 units valued at Rs. 6 per unit which
happens to be the earliest available price of the material i.e. price of the opening balance
available.

The advantages of this method are as below :

(a) It is simple to operate.

(b) The cost of materials issued considers fairly recent and current prices. The prices quoted
on this cost fairly represent its real cost.

(c) It can be conveniently applied if transactions are not too many and prices of the material
are fairly steady.

202 Management Accounting


The objections raised against this method are as below :

(a) Calculations become complicated if the lots are received frequently and at varying prices.

(b) Costs may be wrongly presented if the price of different lots of material are used for
pricing issues to various batches of production.

(c) In case of falling prices in the market, this method may give wrong results.

(C) Average Price Method :

Both the above methods i.e. FIFO and LIFO, consider the exact or actual cost for valuing
the issue of material. However these methods may prove to be disadvantageous if the
transactions are too many and are at varying prices. In such cases, instead of considering
the exact or actual cost, average cost may be considered to lessen the effect of variation
in prices, either upward or downward.

E.g. Assume a situation as below :


Mar. 1 - Received - 1500 units @ Rs. 10 - Rs. 15,000
Mar. 15 - Received - 1600 units @ Rs. 30 - Rs. 48,000

On March 20, 1800 units were issued to production.


If FIFO method is followed to price the issues, the issues will be valued as below.

1500 units @ Rs. 10 per unit Rs. 15,000

300 units @ Rs. 30 per unit Rs. 9,000

Rs. 24,000

The issues will be considerably under-valued and closing stock will be considerably over
valued, as compared to the current market prices.

If LIFO method is followed to price the issues, the issues will be valued as below.

1600 unite @ Rs. 30 per unit Rs. 48,000

200 units @ Rs. 10 per unit Rs. 2,000

Rs. 50,000

The closing stock will be considerably under valued as compared to the current prices.

To lessen the effect of such drastic price variation, both on the valuation of issues as well
as of closing stock, instead of considering the actual/exact price of Rs. 10 per unit or
Rs. 30 per unit, average price may be taken into consideration.

There are mainly two ways in which average prices may be considered.

Material Cost 203


(1) Simple Average Method :Under this method, the simple average of the prices of the
lots available for making the issues is considered for pricing the issues. After the receipt
of new lot, a new average price is worked out. It should be remembered in this connection
that, for deciding the possible lots out of which the issues could have been made, the
method of First In First Out is followed.

Illustration :

Following transactions have taken place in respect of a material during March 1990.

Date :
1 Opening Balance 500 units @ Rs. 6 per unit
5 Purchased 100 units @ Rs. 7 per unit.
7 Issued 400 units.
9 Purchased 300 units @ Rs. 8 per unit.
19 Issued 250 units.
22 Issued 50 units.
25 Purchased 300 units @ Rs. 7.50 per unit.
30 Issued 250 units.

Prepare the stores ledger assuming that the issues are valued on Simple Average basis.

Stores Ledger

Description/Code No. Maximum level


Unit Minimum level
Location Re-order level

Date Particulars RECEIPTS ISSUES BALANCE


Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.
Rs. Rs. Rs.
1 Op. Bal. 500 6 3,000
5 GRN No. 100 7 700 600 3,700
7 MRN No. 400 6.5 2,600 200 1,100
9 GRN No. 300 8 2,400 500 3,500
19 MRN No. 250 7 1,750 250 1,750
22 MRN No. 50 7 350 200 1,400
25 GRN No. 300 7.5 2,250 500 3,650
30 MRN No. 250 7.30 1,825 250 1,825

204 Management Accounting


This method is suitable if the material is received in uniform quantity.If the material quantity of
each lot varies widely, this method may lead to wrong results.

(2) Weighted Average Method :As stated above, the simple average method of valuation
of issues may lead to wrong results, if the quantity of each lot of material received varies
widely. Eg. Assume the following situation.

Mar. 1 Received 100 units @ Rs. 10 Rs. 1,000

Mar. 10 Received 5,000 units @ Rs. 30 Rs. 1,50,000

Rs. 1,51.000

On March 20, 4800 units were issued to production. As both the lots are possible lots for
making the issue, the average of prices of both the lots will be taken into account if
simple average method is considered. Hence, per unit issue price will be -

Rs. 10 + Rs. 30
i.e. Rs. 20
2

As such, the issue quantity will be priced at : 4,800 units x Rs.20 i.e. Rs. 96,000, which
will be incorrect, as considering the quantity of issue, the price of the material received
on March 10 should get more weightage.

To overcome this drawback of simple average method, weighted average method may be
used which considers not only the price of each lot but also the quantity of the same.

Though this method involves considerable amount of clerical work, in practice, this method
proves to be very useful in the event of varying prices and quantities. In practice, the
calculation of weighted average rate proves to be very simple. The products of quantity
and price divided by the total quantity of all lots, just before the issue, gives the unit price
in respect of the subsequent issues.

Illustration :

Following transactions have taken place in respect of a material during March 1990.
Date :
1 Opening Balance 500 units @ Rs. 6 per unit
5 Purchased 100 units @ Rs. 7 per unit.
7 Issued 400 units.
9 Purchased 300 units @ Rs. 8 per unit.
19 Issued 250 units.
22 Issued 50 units.

Material Cost 205


25 Purchased 300 units @ Rs. 7.50 per unit.
30 Issued 250 units.

Prepare the Store Ledger assuming that the issues are valued on Weighted Average Basis.

Stores Ledger

Description/Code No. Maximum level


Unit Minimum level
Location Re-order level

Date Particulars RECEIPTS ISSUES BALANCE


Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.
Rs. Rs. Rs.
1 Op. Bal. 500 6.00 3,000

5 GRN No. 100 7 700 600 6.16 3,700

7 MRN No. 400 6.16 2,467 200 6.16 1,233

9 GRN No. 300 8 2,400 500 7.27 3,633

19 MRN No. 250 7.27 1,817 250 7.27 1,816

22 MRN No. 50 7.27 363 200 7.27 1,453

25 GRN No. 300 7.5 2,250 500 7.41 3,703

30 MRN No. 250 7.41 1,851 250 7.41 1,852

(d) Highest In First Out :This method assumes that the stock should always be shown at
the minimum value and hence the issues should always be valued at the highest value of
receipts. E.g. Assume a situation as follows.

Mar. 1 Purchased 100 units @ Rs. 12


Mar. 5 Purchased 125 units @ Rs. 18
Mar. 10 Purchased 75 units @ Rs. 15

On March 20, 120 units are issued to production and they will be valued at Rs. 18 per
unit being the highest price. This method is not very popular. It always overvalues the
issues and undervalues the closing stock. This method may be useful in case of the
organisations dealing with monopoly products which is a rare possibility.

206 Management Accounting


(e) Market Price : Under this method, market price is considered to be the base for pricing
the issues. In this case, market price may be treated as latest purchase price, realisable
price or replacement price. This method is used mainly in respect of obsolete stock
items or non-moving stock items.

The defect in respect of this method is that the price concessions obtained in respect of
bulk purchases are not reflected in cost of material.

(f) Specific Price :

If the material is purchased against a specific job or production order, the issue of material
is priced at actual purchase price.

This method can be adopted if purchase prices are fairly stable.

(g) Standard Price :

This is the normal or ideal price which will be paid in the normal circumstances, based
on the basis of estimated market conditions, transportation costs and normal quantity of
purchases. Any issue of material will be priced at standard prices irrespective of actual
prices. This enables the simplification of accounting system with reduced clerical work
and also enables to decide the efficiency of purchase department,

(c) Valuation of Returns :

This indicates the material returned by production departments to stores department

The way in which returned material may be valued can be as below :

(a) At the same price at which issued :

The original price of issue will be a base for valuing the returns for which original
material requisition note will be the base.

(b) At the current price of issues :

The method which is followed for valuing the issue on the same date is considered
for valuing the returns.

This will avoid the clerical efforts, but at the same time the track of original issue of
material can’t be maintained.

Treatment of shortages :

In some cases, the physical verification of stock may reveal that the physical stock is less
than the stock as per stores ledger. For proper accounting, the shortage has to be treated as
an issue so that the book stock can be brought down to the level of physical stock. The

Material Cost 207


valuation of this shortage is done as if it is an issue of material. The treatment given to the
valuation of shortages in Cost Accounts depends upon the nature of the shortage i.e. Normal
Shortage or Abnormal Shortage.

Inventory Control :

The object of inventory control is to reduce the investment in inventory without affecting the
efficiency in the area of production and sales. It should be remembered that the object is not
only to reduce the investment in inventory. If that would have been the object, no organisation
would have maintained inventory of any kind, thereby making the investment in inventory as
Nil. However, that is not the ultimate object as it is likely to affect the production and sales
function adversely. E.g. If sufficient stock of raw material is not available, the production
activity is likely to be interrupted. If sufficient stock of finished goods is not available, it may
not be possible for the organisation to serve the customers properly and they may shift to the
competitors. The object of inventory control is to avoid the situation of over investment as well
as under investment. The level of inventories should be maintained at the optimum level.

Techniques of Inventory control

(1) Economic Order Quantity :

It indicates that quantity which is fixed in such a way that the total variable cost of
managing the inventory can be minimised. Such cost basically consists of two parts.
First, Ordering Cost (which in turn consists the costs associated with the administrative
efforts connected with preparation of purchase requisitions, purchase enquiries,
comparative statements and handling of more number of bills and receipts) Second,
Carrying Cost i.e. the cost of carrying or holding the inventory (which in turn consists of
the cost like godown rent, handling and upkeep expenses, insurance, opportunity cost
of capital blocked i.e. interest etc.) There is a reverse relationship between these two
types of costs i.e. If the purchase quantity increases, ordering cost may get reduced but
the carrying cost increases and vice versa. A balance is to be struck between these two
factors and it is possible at Economic Order Quantity where the total variable cost of
managing the inventory is minimum.

It is possible to fix the Economic Order Quantity with the help of mathematical formula.
The following assumptions may be made for this purpose.

Let Q be Economic Order Quantity.


A be Annual Requirement of material in units.
O be cost of placing an order (which is assumed to remain constant irrespective of
size of order.)
C be cost of carrying one unit per year.

208 Management Accounting


Now, if A is the annual requirement and Q is the size of one order, the total number of
orders will be A/Q and the total ordering cost will be - A/Q x O
Similarly, if the size of one order is Q and if it is assumed that the inventory is reduced at
a constant rate from order quantity to zero when it is repurchased, the average inventory
will be Q/2 and the cost of carrying one unit per year being C, the total carrying cost will
be Q/2 X C.
Thus, Total Cost = Ordering Cost + Carrying Cost

A Q
= X O + XC
Q 2

The intention is that the value of Q should be such that the total cost should be minimum.
Hence, taking the first derivative of the equation with respect to Q and setting the result
to zero,

do 1 C
= AO ( – ) + = O OR
dq Q2 2


Q = 2xAXO Where
C

Q = Economic Order Quantity

A = Annual Requirement in Units

O = Cost of Placing an Order

C = Cost of Carrying One Unit Per Year

Illustration :

A manufacturer uses 200 units of a component every month and he buys them entirely from
outside supplier. The order placing and receiving cost is Rs. 100 and annual carrying cost is
Rs. 12. From this set of data, calculate Economic Order Quantity.

Solution :


EOQ = 2xAxO
C

=
√ 2 x 2400 x 100
12
= 200 units

Material Cost 209


In some cases, the carrying cost may be expressed as an annual percentage of the unit cost
of purchases, in which case, the calculation of Economic Order Quantity takes the following
form.


EOQ = 2xAxO
where
Cxi

A = Annual Requirement in units


O = Cost of placing an order
C = Unit purchase price
i = Carrying cost expressed as a percentage of unit purchase price.

Illustration :

From the Following data, work out the EOQ of a particular component.

Annual Demand : 5000 Units

Ordering Cost : Rs. 60 per Order

Price per Unit : Rs. 100

Inventory carrying Cost : 15% on average inventory,

Solution :


EOQ = 2 x 5000 x 60
15% of 100

= 200 units

The total cost of managing inventory will be

Ordering Cost - 5000 X 60 i.e. 25 X 60 Rs. 1,500


200

200
Carrying Cost - X 15% of 100 Rs. 1,500
2
(Based on average inventory) Rs. 3,000

Now, the next question is whether the purchases in Economic Order Quantity really reduce
the total cost of managing inventory to the minimum, We can verify this, by trial and error
method, by considering the above results.

210 Management Accounting


Order No. of Ordering Carrying Total
Quantity Orders Cost Cost Cost
A/Q A/Q x O Q/2 x Ci
Rs. Rs. Rs.

50 100 6,000 375 6,375


100 50 3,000 750 3,750
200 25 1,500 1,500 3,000
250 20 1,200 1,875 3,075
1,000 5 300 7,500 7,800
1,250 4 240 9,375 9,615
2,500 2 120 18,750 18,870

It can be observed from the above, that the order size of 200 units proves to be the most
economic one in terms of minimum total cost. If the purchases are made in any other way, the
same may not necessarily result into minimum total cost.

Illustration :

Kapil Motors purchase 9,000 motor spare parts for its annual requirements, ordering one-
month usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15
and the carrying charges are 15% of the average inventory per year. You have been asked to
suggest a more economical purchasing policy for the company. What advice would you offer
and how much would it save the company per year.

Solution :

Present Policy :

Annual Requirement
Number of Orders =
Order size
= 9000
= 12
750
Ordering Cost = 12 X 15 = 180 ...(1)
Order Size
Carrying Cost = X Cost Price X Carrying cost in %
2
= 750
X 15% of Rs. 20
2
= 375 X 3 = 1,125 ...(2)

Total Cost i.e. 1 + 2 = 180 + 1125 = 1305 ...(3)

Material Cost 211


Proposed Policy :

To purchase in Economic Order Quantity


2xAxO
EOQ =
Cxi

= √ 2 x 9000 x 15
15% of 20
= 300 units

Now, the revised total cost will be

9000
Number of Orders = = 30
300

Ordering Cost = 30 x 15 = 450 ...(4)

300 X 15% of 20
Carrying Cost = ...(5)
2

= 150 X 3 = 450

Total Cost i.e. 4 + 5 = 450 + 450 = 900 ...(6)

Thus, purchases in Economic Order Quantity will result into the yearly saving of Rs. 405 (i.e.
Rs. 1305 - Rs. 900)

(2) Fixation of Inventory Levels :

Fixation of various inventory levels facilitates initiating of proper action in respect of the
movement of various materials in time so that the various materials may be controlled in
a proper way. However, the following propositions should be remembered.

(i) Only the fixation of inventory levels does not facilitate the inventory control. There
has to be a constant watch on the actual stock level of various kinds of materials so
that proper action can be taken in time.

(ii) The various levels fixed are not fixed on a permanent basis and are subject to
revision regularly.

The various levels which can be fixed are as below.

(1) Maximum Level :

It indicates the level above which the actual stock should not exceed. If it exceeds, it
may involve unnecessary blocking of funds in inventory. While fixing this level, following
factors are considered.

212 Management Accounting


(i) Maximum usage.

(ii) Lead time.

(iii) Storage facilities available, cost of storage and insurance etc.

(iv) Prices for the material.

(v) Availability of funds.

(vi) Nature of material e.g. If a certain type of material is subject to Government regulations
in respect of import of goods etc., maximum level may be fixed at a higher level.

(vii) Economic Order Quantity.

(2) Minimum Level :

It indicates the level below which the actual stock should not reduce. If it reduces, it may
involve the risk of non-availability of material whenever it is required. While fixing this
level, following factors are considered.

(i) Lead time.

(ii) Rate of consumption.

(3) Re-order Level:

It indicates that level of material stock at which it is necessarily to take the steps for
procurement of further lots of material. This is the level falling in between the two extremes
of maximum level and minimum level and is fixed in such a way that the requirements of
production are met properly till the new lot of material is received.

(4) Danger Level :

This is the level fixed below minimum level. If the stock reaches this level, it indicates the
need to take urgent action in respect of getting the supply. At this stage, the company
may not be able to make the purchases in a systematic manner but may have to make
rush purchases which may involve higher purchases cost.

Calculation of various Levels :

The various levels can be decided by using the following mathematical expressions.

(1) Re-order Level : Maximum Lead Time x Maximum Usage.

(2) Maximum Level : Reorder Level + Reorder Quantity - (Minimum Usage X Minimum
Lead Time).

Material Cost 213


(3) Minimum Level : Reorder Level - (Normal Usage x Normal Lead Time.)

(4) Average Level : Maximum Level + Minimum Level.

(5) Danger Level : Normal Usage x Leadtime for emergency purchases.

Note : It should be noted that the expression of the Reorder Quantity in the calculation of
Maximum Level indicates Economic Order Quantity.

Illustration :

Two components X and Y are used as follows.


Normal usage – 50 units per week each.
Minimum usage – 20 units per week each.
Maximum usage – 75 units per week each.
Reorder quantity – X - 400 units
Y - 600 units
Recorder period – X - 4 to 6 weeks
Y-2 to 4 weeks
Calculate for each component :
a. Reorder level
b. Minimum level
c. Maximum level
d. Average stock level.

Solution :

(1) Reorder Level :


Maximum Lead time x Maximum Usage
X = 6 weeks x 75 units = 450 units
Y = 4 weeks x 75 units = 300 units.

(2) Minimum Level :


Reorder Level – (Normal Usage x Normal Leadtime)
X = 450 units – (50 units X 5 weeks) = 200 units.
Y = 300 units – (50 units x 3 weeks) = 150 units

214 Management Accounting


(3) Maximum Level :
Reorder Level + Reorder Quantity - (Minimum Usage x Minimum Leadtime)
X = 450 units + 400 units - (25 units x 4 weeks) = 750 units.
Y = 300 units + 600 units - (25 units x 2 weeks) = 850 units.
(4) Average Stock Level :

Minimum Level + Maximum Level


2
200 units + 750 units
X = = 475 units
2

150 units + 850 units


Y = = 500 units
2

As stated above, the expression of the Reorder Quantity in the calculation of Maximum level
indicates Economic Order Quantity. Hence, in some cases, it may be necessary to decide
the Economic Order Quantity before fixing the inventory levels.

Illustration :

Shriram Enterprises manufactures a special product ‘ZED’

The following particulars are collected for the year 1986.

(a) Monthly demand of ZED - 1000 units.

(b) Cost of placing an Order - Rs. 100.

(c) Annual carrying cost per unit - Rs. 15.

(d) Normal Usage 50 units per week.

(e) Minimum Usage 25 units per week.

(f) Maximum Usage 75 units per week.

(g) Re-order period 4 to 6 weeks.

Compute from the above:

(1) Re-order Quantity.

(2) Re-order Level.

(3) Minimum Level.

(4) Maximum Level.

(5) Average Stock Level.

Material Cost 215


Solution :

(1) Reorder Quantity :

√ 2xAxO
C
where

A = Annual Requirement

O = Ordering cost per cost

C = Carrying cost per unit per year

∴ EOQ =
√ 2 x 12000 x 100
15

= 400 units

(2) Reorder Level :

Maximum Lead Time x Maximum Usage.

∴ 6 weeks X 75 units = 450 units

(3) Minimum Level :

Reorder Level - (Normal Usage x Normal Lead Time)

∴ 450 units - (50 units X 5 weeks) = 200 units

(4) Maximum Level :

Reorder Level + Reorder Quantity – (Minimum Usage X Minimum Leadtime)

∴ 450 units + 400 units - ( 25 units X 4 Weeks) = 750 units.

(5) Average Stock Level :

Minimum Level + Minimum Level


2
∴ 200 units + 750 units
= 475 units
2
There may be one more way in which the various inventory levels may be fixed and for this
determination of the safety stock (also called as minimum stock or buffer stock) is essential.
Safety stock is that level of stock below which the actual should not be allowed to fall. The
safety stock may be calculated as -

216 Management Accounting


(Maximum Usage X Maximum Leadtime) less
(Normal Usage X Normal Leadtime)

According to this method, the various inventory levels as discussed above may be fixed as
below.

(1) Minimum Level :


It is equal to safety stock.

(2) Maximum Level :


It can be calculated as - Safety Stock + EOQ.

(3) Reorder Level :


It can be calculated as :

Safety Stock + (Normal Usage x Normal Leadtime)

(4) Average Stock Level :


It can be calculated as -

Minimum Level + Maximum Level


2

= Safety Stock + Safety stock + EOQ


2

= Safety Stock + EOQ


2

Illustration :

You have been asked to calculate the following levels for Part No. 007 from the information
given thereunder:

(a) Re-ordering level, (b) Maximum level

(c) Minimum level, (d) Danger level,

(e) Average level.

The ordering quantity is to be calculated from the following data :

(i) Total cost of purchasing relating to the order Rs. 20.

(ii) Number of units to be purchased during the year 5,000

(iii) Purchase price per unit including transportation costs Rs. 50.

Material Cost 217


(iv) Annual cost of storage of one unit Rs. 5.
Lead Times : Average ... 10 days
Maximum .. 15 days
Minimum .. 6 days
Maximum for emergency purchases ... 4 days
Rate of consumption:-
Average .. 15 units per day
Maximum .. 20 units per day

Solution :

Working Notes :

(a) Calculation of Safety Stock :

(Maximum Usage x Maximum Leadtime) - (Normal Usage x Normal Leadtime)


= (20 units x 15 days) - (15 days x 10 days)
= 300 units - 150 units
= 150 units.

(b) Calculation of EOQ :

√ 2xAxO
where
C

A = Annual requirement
O = Ordering cost per order
C = Carrying cost per unit per year.
Hence,

EOQ =
√ 2 X 500 X 20
5

= 200 units.

(1) Reordering Level :

It can be calculated as -
Safety Stock + (Normal Usage x Normal Leadtime)
= 150 units + (15 units X 10 days)
= 150 units + 150 units = 300 units.

218 Management Accounting


(2) Maximum Level :
It can be calculated as -

Safety Stock + EOQ

= 150 units + 200 units = 350 units.

(3) Minimum Level :


It is equal to Safety Stock

= 150 units.

(4) Danger Level :


Normal Usage X Leadtime for emergency purchases

= 15 units X 4 days = 60 units.

(5) Average Stock Level :


It can be calculated as

EOQ
Safety Stock +
2

200
= 150 units + units = 250 units
2

(3) Inventory Turnover :

Inventory turnover indicates the ratio of materials consumed to the average inventory
held. It is calculated as below :

Value of material consumed


where
Average inventory held

Value of material consumed can be calculated as :

Opening Stock + Purchases - Closing Stock.

Average inventory held can be calculated as :

Opening Stock + Closing Stock


2

Inventory turnover can be indicated in terms of number of days in which average inventory
is consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio.

Material Cost 219


Illustration :

From the following data for the year ended 31st December, 1986, calculate the inventory
turnover ratio of the two items and put forward your comments on them.

Material A Material B
Rs. Rs.
Opening Stock 1.1.86 10,000 9,000
Purchases during the year 52,000 27,000
Closing Stock 31.12.86 6,000 11,000

Solution :

Inventory turnover ratio = Value of material consumed


Average Inventory held

Material A Material B
Inventory Turnover = 56,000 25,000
8,000 10,000
= 7 2.5

Material A Material B
Inventory Turnover Period = 365 365
7 2.5
= 52 days 146 days

A high inventory turnover ratio or low inventory turnover period indicates that maximum material
can be consumed by holding minimum amount of inventory of the same, thus indicating fast
moving items. Thus high inventory turnover ratio or lower inventory turnover period will always
be preferred.

Thus, knowledge of inventory turnover ratio or inventory turn over period in case of various
types of material will enable to reduce the blocked up capital in undesirable types of stocks
and will enable the organisation to exercise proper inventory control.

(4) ABC Analysis :

This technique assumes the basic principle of “Vital Few Trivial Many” while considering the
inventory structure of any organisation and is popularly known as “Always Better Control”. It is
an analytical method of inventory control which aims at concentrating efforts in those areas
where attention is required most. It is usually observed that, in practice, only a few number of
items of inventory prove to be more important in terms of amount of investment in inventory or

220 Management Accounting


value of consumption, while a very large number of items of inventory account for a very
meager amount of investment in inventory or value of consumption. This technique classifies
the various inventory items according to their importance. E.g. A Class consists of only a
small percentage of total number of items handled but are most important in nature. B Class
items include relatively less important items. C Class items consist of a very large number of
items which are less important. The importance of the various items may be decided on the
basis of following factors.
(i) Amount of investment in inventory.
(ii) Value of material consumption.
(iii) Critical nature of inventory items.

An example of ABC Analysis can be given as below.

Class No. of items % of total Value/ % of Total Value/


No. of Consumption Consumption
items Rs.

A 300 6 5,60,000 70
B 1500 30 1,60,000 20
C 3200 64 80,000 10

5000 100 8,00,000 100

In order to exercise proper inventory control, A Class items are watched very closely and
control is exercised right from initial stages of estimating the requirements, fixing minimum
level/leadtimes, following proper purchase/ storage procedures etc. Whereas in case of C
Class of items, only those inventory control measures may be implemented which are
comparatively simple, elaborate and inexpensive in nature.

Advantage of ABC Analysis :

(a) A close and strict control is facilitated on the most important items which constitute a
major portion of overall inventory valuation or overall material consumption and due to
this the costs associated with inventions may be reduced.

(b) The investment in inventory can be regulated in a proper manner and optimum utilisation
of the available funds can be assured.

(c) A strict control on inventory items in this manner helps in maintaining a high inventory
turnover ratio.However it should be noted that the success of ABC analysis depends
mainly upon correct categorisation of inventory items and hence should be handled by
only experienced and trained personnel.

Material Cost 221


(5) Bill of Materials :

In order to ensure proper inventory control, the ‘basic principle to be kept in mind is that proper
material is available for production purposes whenever it is required. This aim can be achieved
by preparing what is normally called as “Bill of Materials”.

A bill of material is the list of all the materials required for a job, process or production order.
It gives the details of the necessary materials as well as the quantity of each item. As soon as
the order for the job is received, bill of materials is prepared by Production Department or
Production Planning Department.

The form in which the bill of material is usually prepared is as below :

BILL OF MATERIALS

No. Date of Issue Production/Job Order No.

Department authorised

S. No. Description Code Qty. For Department Use only Remarks


of Material No. Material Date Quantity
Requisition No. demanded

The functions of bill of materials are as below :

(1) Bill of material gives an indication about the orders to be executed to all the persons
concerned.

(2) Bill of material gives an indication about the materials to be purchased by the Purchases
Department if the same is not available with the stores.

(3) Bill of material may serve as a base for the Production Department for placing the material
requisitions ships.

(4) Costing/Accounts Department maybe able to compute the material cost in respect of a
job or a production order. A bill of material prepared and valued in advance may serve as
a base for quoting the price for the job or production order.

222 Management Accounting


(6) Perpetual Inventory System :

As discussed earlier, in order to exercise proper inventory control, perpetual inventory


system may be implemented. It aims basically at two facts.

(1) Maintenance of Bin Cards and Stores Ledger in order to know about the stock in
quantity and value at any point of time.

(2) Continuous verification of physical stock to ensure that the physical balance and
the book balance tallies.

The continuous stock taking may be advantageous from the following angles :

(1) Physical balances and book balances can be compared and adjusted without waiting
for the entire stocktaking to be done at the year-end Further, it is not necessary to
close down the factory for Annual stocktaking.

(2) The figures of stock can be readily available for the purpose of periodic Profit and
Loss Account.

(3) Discrepancies can be located and adjusted in time.

(4) Fixation of various levels and bin cards enables the action to be taken for the
placing the order for acquisition of material.

(5) A systematic maintenance of perpetual inventory system enables to locate and


slow and non-moving items and to take remedial action for the same.

(6) Stock details are available correctly for getting the insurance of stock.

ILLUSTRATIVE PROBLEMS

(1) The following informative is extracted from the Stores ledger in respect of Material X

Opening Stock Nil


Purchases
Jan. 1 100 @ Re. 1 per unit
Jan. 20 100 @ Rs. 2 per unit
Issues
Jan. 22 60 for Job W 16
Jan. 23 60 for Job W 17

Complete the receipts and issues valuation by adopting the First In First Out, Last In First Out
and Weighted Average method. Tabulate the values allocated to Job W 16 and 17 and the
closing stock under the methods aforesaid.

Material Cost 223


Solution :

(a) Valuation of receipts : (For all methods)

Jan. 1 100 x 1.00 = Rs. 100


Jan. 20 100 x 2.00 = Rs. 200

200 units Rs. 300

Rs. 300
Weighted Average Rate = = Rs. 1.50/Unit
200 units

(b) Valuation of Issues/Closing Stock

(1) Issues
FIFO LIFO Weighted Average
Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
Date Unit Rs. Rs. Unit Rs. Rs. Unit Rs. Rs.

Jan. 22-W16 60 1.00 60.00 60 2.00 120.00 60 1.50 90.00


Jan.23-W17 40 1.00 40.00 40 2.0 80.00 60 1.50 90.00
20 2.00 40.00 20 1.00 20.00
140.00 220.00 180.00
(2) Closing
Stock 80 2.00 160.00 80 1.00 80.00 80 1.50 120.00

(c) Values allocated to individual jobs

W 16 W 17
Rs. Rs.
FIFO 60 80
LIFO 120 100
Weighted Average 90 90

(2) From the records of an oil distributing company, the following summarised information is
available for the month of March 1986.

Sales for the month - Rs. 19,25,000

Opening Stock as on 1-3-86 - 1,25,000 Litres @ Rs. 6.50 litre

Purchases (including freight and insurance)

March 5 -1,50,000 litres @ Rs. 7.10 litre

224 Management Accounting


March 27 - 1,00,000 litres @ Rs. 7.00 litre.

Closing stock as on 31-3-86 - 1,30,000 litres

General Administrative expenses for the month Rs. 45,000

On the basis of the above information, work out the following using FIFO and LIFO
methods of inventory valuation assuming pricing of issues is being done at the end of the
month (after all receipts during the month).

(a) Value of Closing Stock as on 31-3-86

(b) Cost of goods sold during March 86

(c) Profit or Loss for March 86.

Solution :

(a) Value of Closing Stock

(1) FIFO :

Under this method, the value of closing stock will constitute the value of latest available lot for
consumption, earlier lots assumed to have been consumed. As such, value of closing stock
will be:

Purchased on 27-3-86 1,00,000 Its. x Rs. 7.00 = Rs. 7,00,000


Purchased on 5-3-86 30,000 Its. x Rs. 7.10 = Rs. 2,13,000
Rs. 9,13.000

(2) LIFO :

Under this method, the value of closing stock will constitute the value of earliest available lot
for consumption, latest lots assumed to have been consumed. As such, value of closing stock
will be :

Opening Stock on 1-3-86 1,25,000 Its. x Rs. 6.50 = Rs. 8,12,500


Purchased on 5-3-86 5,000 Its. x Rs. 7.10 = Rs. 35,500
Rs. 8,48,000

Material Cost 225


(b) Cost of goods sold during March 1986
FIFO LIFO
Rs. Rs.
Opening Stock 1,25,000 Its. x Rs. 6.50 8,12,500 8,12,500
Purchases 17,65,000 17,65,000

25,77.500 25,77,500
Less : Closing Stock (as per ‘a’ above) 9,13,000 8,48,000

16,64,500 17,29,500

The value of purchases is calculated as below :

Purchased on 5-3-86 – 1,50,000 X Rs. 7.10 = Rs. 10,65,000

Purchased on 27-3-86 – 1,00,000 X Rs. 7.00 = Rs. 7.00,000

Rs. 17,65,000

(c) Profit or Loss for March 1986


FIFO LIFO
Rs. Rs.
(1) Sales 19,25,000 19,25,000
Total Cost
Cost of goods sold 16,64,500 17,29,500
Administrative Expenses 45,000 45,000
17,09,500 17,74,500
(2) Profit (1 - 2) 2,15,500 1,50,500

(3) A company uses annually 50,000 units of an item each costing Rs.1.20. Each
older costs Rs. 45 and inventory carrying costs 15% of the annual average inventory
value.

(a) Find EOQ

(b) If the company operates 250 days a year, the procurement time is 10 days, and
safety stock is 500 units, find reorder level, maximum, minimum and average
inventory.

226 Management Accounting


Solution :

(a) Economic Order Quantity

√ 2 X A X O
Ci

=
√ 2 X 50,000 X 45
15% of 1.20

= 5,000 units

(b) (1) Reorder Level :

Safety Stock + (Normal Usage x Normal Leadtime)

= 500 units + (200 units x 10 days) = 2,500 units

(2) Maximum Level :

Safety stock + EOQ

= 500 units + 5,000 units

= 5,500 units

(3) Minimum Level

It is equal to safety stock i.e. 500 units

(4) Average Level

EOQ
Safety Stock +
2

5000 units
= 500 units +
2

= 3000 units

(4) M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is fairly constant
at 6,250 per month. The valve costs Rs. 1.50 per unit when purchased in quantities and
inventory carrying cost is 20%. The average inventory investment on annual basis. The
cost to place an order and to process the delivery is Rs. 18. It takes 45 days to receive
from the date of an order and minimum stock of 3,250 valves is desired. You are required
to determine -

Material Cost 227


a. The most economical order quantity and the number of orders in year.

b. The reorder level

c. The most economic order quantity if valve costs Rs. 4.50 each instead of Rs. 1.50
each.

Solution :

(a) Economic Order Quantity :


2xAxO
EOQ = Ci

√ 2 x 75,000 x 18
= = 3,000 units
20% of 1.50

Number of Orders :

Annual Consumption
EOQ

75,000 units
= = 25
3,000 units

(b) Reorder Level :

Safety stock + (Normal Usage x Normal Leadtime)

= 3,250 units + (6,250 units x 1.5 months)

= 12,625 units

(c) Revised EOQ

(If unit cost is Rs. 4.50 instead of Rs. 1.50)


2xAxO
EOQ =
Ci


= 2 x 75,000 x 18
20% of 4.50
= 1,732 units

228 Management Accounting


(5) The Purchase Department of your Organisation has received an offer of quantity discounts
on its orders of materials as under :

Price Per Tonne Tonnes


1,200 Less than 500
1,180 500 and less than 1000
1,160 1000 and less than 2000
1,140 2000 and less than 3000
1,120 3000 and above.

The annual requirement for the material is 5000 tonnes. The delivery cost per order is Rs.
1,200 and the stock holding cost is estimated at 20% of material cost per annum. You are
required to advice the Purchase Department the most economic purchase level.

Solution :

As the price discount varies with lot size, EOQ will have to be decided by Trial and Error
Method.

Lot Size Price per Purchase Ordering Carrying Total


(Units) Tonne-Rs. Cost for Cost Cost Cost
Q P 5,000 5000 Q Rs.
Tonnes X 1200 X P X 20%
Rs. Q 2

1 2 3 4 5 6(3+4+5)

100 1200 60,00,000 60,000 12,000 60,72,000

250 1200 60,00,000 24,000 30,000 60,54,000

500 1180 59,00,000 12,000 59,000 59,71,000

625 1180 59,00,000 9,600 73,750 59,83,350

1,000 1160 58,00,000 6,000 1,16,000 59,22,000

1,250 1160 58,00,000 4,800 1,45,000 59,49,800

2,000 1140 57,00,000 3,000 2,28,000 59,31,000

2,500 1140 57,00,000 2,400 2,85,000 59,87,400

3,000 1120 56,00,000 2,000 3,36,000 59,38,000

4,000 1120 56,00,000 1,500 4,48,000 60,49,500

Material Cost 229


It will be observed, that if the purchases are made in the lot size of 1,000 units it proves to be
most economical.

(6) (a) A company needs 24,000 units of raw materials which costs Rs. 20 per unit and
ordering cost is expected to be Rs. 100 per order. The company maintains safety
stock of 1 month’s requirements to meet emergency. The holding cost of carrying
inventory is supposed to be 10% per unit of average inventory. Find out :
1. Economic lot size.
2. Ordering cost
3. Holding cost
4. Total cost

(b) The supplier of raw material has agreed to supply the goods at a discount of 5% in
price on a lot size of 4,000 units. Find whether the concession price should be
availed.

Solution :

(a) (1) Economic Lot Size


2xAxO
Ci


= 2 x 24,000 x 100
10% of 20

= 1,550 units (Approx.)

(2) Ordering Cost

Annual Requirement
X Ordering cost per order
EOQ

= 24,000
X 100 = Rs. 1,548 (Approx.)
1550

(3) Holding Cost :

As the company maintains safety stock of one month’s requirement, the average inventory
held at any point of time will not only be EOQ/2 but safety stock + EOQ/2. Assuming
that the usage of raw material is steady throughout the year i.e. 2,000 units per month,
holding cost will be :

230 Management Accounting


(Safety Stock + EOQ/2) / Carrying cost per unit per year

1,550 units
= (2,000 units + ) X 10% of Rs. 20
2

= 2,775 units X Rs. 2

= Rs. 5,550

(4) Total cost :

Cost of material 24,000 x 20 = Rs. 4,80,000


Ordering Cost = Rs. 1,548
Holding Cost = Rs. 5,550
Total Cost = Rs. 4,87,098

(b) Revised Total Cost : (with 5% discount)

(1) Ordering Cost :

As order size is going to be 4,000 units, total 6 orders will be placed. Hence total ordering cost
will be -

6 orders x Rs. 100 per order i.e. Rs. 600

(2) Holding Cost :

The holding cost will be as below :

Order Size
(Safety Stock + ) x Carrying cost per unit per year
2

4000 units
= (2,000 units + ) x 10% of Rs. 19
2

= Rs. 7,600

(3) Total Cost :

Total Cost of material - 24,000 x 19 = Rs. 4,56,000


Ordering Cost = Rs. 600
Holding Cost = Rs. 7,600

Total Cost = Rs. 4,64,200

Material Cost 231


Conclusion :

If purchased in Economic Lot Size, total cost (including material cost) is Rs. 4,87,098.

If purchased in Lot Size of 4,000 units with 5% discount, total cost (including material cost) is
Rs. 4,64,200.

As purchases in Lot Size of 4,000 units result in the saving of Rs. 22,898 (i.e. Rs. 4,87,098 -
Rs. 4,64,200) that alternative will be preferred.

QUESTIONS

1. Explain the various steps in which a raw material moves in a manufacturing organization
till it gets consumed in the production. Give the format of various documents which are
prepared in the process.

2. Write a detailed essay on -

a) Valuation of Receipts

b) Valuation of Issues

c) Valuation of Returns

232 Management Accounting


PROBLEMS

(1) The following is the record of receipts and issues of certain material in a factory during
the week ending May 1979.
Opening balances 100 tons at Rs. 10 per ton.
Issued 60 tons.
Received 120 tons at Rs. 10 per ton
Issues - 50 tons (Stock verifier reported shortage of 2 tons)
Received back from order 20 tons (originally issued at Rs. 9.90)
Issued 80 tons.
Received 44 tons at Rs. 10.20 per ton.
Issued 66 tons.

Received 44 tons at Rs. 10.20 per ton.

Issued 66 tons.

From the above particulars prepare stores ledger separately under e method charging
issues at weighted and simple average method.

(2) Following transactions appeared in a specified material during month of August 1980.

Date Particular Quantity (Tons) Rate per ton


1 Opening balance 100 24
4 Purchased 50 26
5 Issued 30
12 Issued 40
13 Purchased 30 25
19 Issued 40
25 Issued 30
30 Purchased 40 28
31 Issued 30

The stock verifier noticed shortage in stock on 26th August of 5 tons and on 29th August
of 4 tons. Write up stores ledger by charging issues by FIFO and by weighted average
methods.

(3) The following is the history of the receipt and issue of materials in a factory during
February 1980,

Material Cost 233


Feb. 1 Opening balance -500 tons at Rs. 25
2 Issued 70 tons
4 Issued 100 tons
8 Issued 80 tons
13 Received from vendor 200 tons at Rs. 24.50
14 Refund of surplus from a work order 15 tons at Rs. 24
16 Issued 180 long
20 Received from vendor 240 tons at Rs. 24.40
24 Issued 304 tons
25 Received from vendor 320 tons at Rs. 24.30
26 Issued 112 tons
27 Refund of surplus from a work order 12 tons at Rs. 24.50
28 Received from vendor 100 tons at Rs. 25

Issues are to be priced on the principle of LIFO and simple average method. The stock
verifier of the factory noted that on the 15th he had found a shortage of 5 tons and on 27th
another shortage of 8 tons. Write out complete stores ledger account in respect of the
material.

(4) A cloth manufacturer commenced the business on 1.1.82. Textile materials used include
two types - M & N. During 6 months ending on 30.6.82, transactions were as
follows :

Date Purchased (Mtrs.) Issued (Mtrs.)


M N Rates per Mt. M N
4.1.82 1000 10
6.1.82 1600 15
7.1.82 700
12.1.82 1200
18.3.82 2300 12
28.3.82 1420
16.4.82 3000 16
22.4.82 2860
26.5.82 800 9.50
1.6.82 1580
2.6.82 1000 17.50
8.6.82 1300

234 Management Accounting


You are required to prepare stores ledger account for M type of material by charging
issues by LIFO method and N type of material by charging the issues on weighted
average method.

(5) The stores ledger account of material C in the books of Saurabh and Sweta Ltd. revealed
following transactions for September 1984,

Sept. 1 Opening stock 200 kgs at Rs. 7.50 per kg.

5 Received from supplier 400 kgs at Rs. 7.75 per kg GRN 448

8 Issued to Production Dept. 240 kgs SR No. 883

10 Received from supplier 500 kgs at Rs. 7.90 per kg. GRN 45

12 Issued to Production Dept. 160 kgs SR No. 897

15 Issued to Production Dept. 400 kgs SR No. 912

16 Received from supplier 250 kgs at Rs. 8.00 per kg GRN 469

19 Received from supplier 600 kgs at Rs. 8.25 per kg GRN 561

21 Issued to Production Dept. 350 kgs SR No. 946

24 Issued to Production Dept. 260 kgs SR No. 959

27 Issued to Production Dept. 340 kgs SR No. 974

You are required to price the issues and draw out the closing balance in the stores
ledger account under the pricing method in which the material costs charged to production
would be closely related to current prices.

(6) Record the following transactions in a store ledger and show the cost of consumption
and closing stock by using FIFO method of pricing issues.

For the month of January 1985 :

Jan. 1 Opening Stock 300 units at Jan. 11 Issues 400 units


Rs. 9.70 per unit 20 Issues 210 units
3 Purchases 250 units at 29 Issues 100 units
Rs. 9.80 per unit
15 Purchases 300 units at
Rs. 10.50 per unit
25 Purchases 150 units at
Rs. 10.30 per unit

Material Cost 235


(7) Prepare a stores ledger account on the basis of FIFO method.

Jan. 1 Opening stock 250 units @ Re. 1 each


3 Purchased 100 units @ Rs. 1.05 each
4 Purchased 200 units @ Rs. 1.05 each
6 Issued 400 units
10 Purchased 400 units @ Rs. 1.20 each
12 Issued 150 units
13 Issued 100 units
16 Purchased 100 units @ Re. 1 each
22 Purchased 200 units @ Rs. 1.25 each
31 Issued 300 units

(8) The following is a summary of the receipts and issues of a material in a factory during a
month.

1st Opening Balance 500 units at Rs. 25 per unit.

3rd Issued 70 units.

4th Issued 100 units.

8th Issued 80 units.

13th Receipts 200 units at Rs. 24.50 per unit (Supplier)

14th Returned to stores 15 units at Rs. 24 per unit.

16th Issued 180 units.

20th Receipts 240 units at Rs. 24.75 per unit (Supplier)

24th Issued 304 units.

25th Receipts 320 units at Rs. 24.50 per unit (Supplier)

26th Issued 112 units.

27th Returned to stores 12 units at Rs. 24.50 per unit

28th Received from supplier 100 units at Rs. 25 per unit.

Stock verification revealed that on 15th there was a shortage of 5 units and another on
27th of 8 units. Prepare Stores Ledger Account on the basis of FIFO basis.

236 Management Accounting


(9) Following is an extract of receipts and issues for the month of January 1989 of a
manufacturing company.

Date 2 Purchased 8,000 units @ Rs. 2


4 Purchased 1,000 units @ Rs. 2.50
6 Issued 4,000 units
10 Purchased 12,000 units @ Rs. 3
15 Issued 8,000 units
19 Issued 2,000 units
22 Issued 4,000 units
25 Purchased 9,000 units @ Rs. 2.75
30 Issued 6,000 units

Draw up store Ledger Account by LIFO method showing balance as on 31.1.89

(10) The transactions in connection with the materials are as follows :

Days Receipts Issues (Units)


Unit Rate per unit Rs.

1st 40 15.00 -
2nd 20 16.50 -
3rd - - 30
4th 50 14.30 -
5th - - 20
6th - - 40

Calculate the cost of material issued under FIFO method and Weighted Average method
of issue of materials.

(11) From the following details of stores receipts and issues of Material EXE in a manufacturing
unit, prepare the stock ledger using “Weighted Average” method of valuing the issues.

Nov. 1 Opening Stock 2,000 units (S) Rs. 5.00 each

Nov. 3 Issued 1,500 units to production

Nov. 4 Received 4,500 units @ Rs. 6.00 each

Nov. 8 Issued 1,600 units to production.

Nov. 9 Returned to stores 100 units by production department (from the issues of Nov. 3)

Nov. 16 Received 2,400 units @ Rs. 6.50 each

Material Cost 237


Nov. 19 Returned to supplier 200 units out of the quantity received on Nov. 4Nov. 20
Received 1,000 units @ Rs. 7 each.
Nov. 24 Issued to production 2,100 units
Nov. 27 Received 1,200 units @ Rs. 7.50 each
Nov. 29 Issued to Production 2,800 units (Use rates upto two decimal places)

(12) The following are the transactions in respect of purchases and issues of components
forming part of an assembly of a product manufactured by a firm which requires, to
update its cost of production very often for bidding tenders and finalising cost plus
contracts.

Date Quantity Particulars


1986 (in Nos.)

January 5 1,000 Purchased @ Rs. 1.20 each


11 2,000 Issued
February 1 1,500 Purchased @ Rs. 1.30 each
18 2,400 Issued
26 1,000 Issued
March 8 1,000 Purchased @ Rs. 1.40 each
17 1,500 Purchased @ Rs. 1.30 each
28 2,000 Issued.

The stock on 1st January 1986 was 5,000 Nos. valued at Rs. 1.10 each. State the
method you would adopt in pricing the issues of components giving reasons. What value
would you place on stocks as on 31st March which happens to be the financial year end
and how would you treat the difference in value, if any, on the stock account.

(13) The following are the extract from the transactions on the bin card of Job No. 12-3-89 for
March 1987
Date On order Receipt Rate Issue Balance

2 - 40 25.00 - 40
6 - - - 20 20
8 - 50 28.00 - 70
12 - - - 30 40
15 - 30 24.00 - 70
18 50 - 26.00 - 70
28 - - - 50 20

238 Management Accounting


Find out the pricing of material issue under LIFO, FIFO and simple average method.

(14) XYZ Ltd. requires 20,000 units of product A per annum. The purchase price is Rs. 4 per
unit. The inventory carrying cost is 20% per annum and the cost of ordering is Rs. 100
per order. Advise the company, on how many times they should order in a year, so as to
minimise the cost of product A?

(15) A Manufacturer buys certain essential spares from outside suppliers at Rs. 40 per set.
Total annual requirements are 45000 sets. The annual cost of investment in inventory is
10% and costs like rent, stationery, insurance, taxes etc. per unit per year work to Re.
1, cost of placing an order is Rs. 5. Calculate the Economic Order Quantity.

(16) Following information relating to a type of raw material is available.


Annual Demand 2,400 units
Unit Price Rs. 2.40
Ordering cost per order Rs. 4.00
Storage cost 27% p.a.
Interest Rate 10% p.a.
Lead Time Half month

Calculate Economic Order Quantity and total annual inventory cost in respect of the
particular raw material.

(17) From the particulars given below, you are required to compute.
(a) Economic Order Quantity
(b) Maximum Level
(c) Minimum Level
(d) Re-ordering Level
(e) Average stock Level
(i) Quantity required annually 3,000 units @ Rs. 5 per unit.
(ii) Interest and cost of storing 10%.
(iii) Cost of placing an order Rs. 30 per order.
(iv) Consumption per week Normal 60 units
Maximum 70 units
Minimum 50 units.
(v) Lead time (in weeks) Normal 5
Maximum 6
Minimum 4

Material Cost 239


(18) The Stock-Ledger Account for material X in a manufacturing concern reveals the following
data for the quarter ended September 30, 1989.

Receipts Issues

Quantity Price Quantity Amount


Units Rs. Units Rs.
July 1 Balance b/d
1.600 2.00 – –
July 9 3,000 2.20 – –
July 13 – – 1,200 2,556
August 5 – – 900 1,917
August 17 3,600 2.40 – –
August 24 – – 1,800 4,122
September 11 2,500 2.50 – –
September 27 – – 2,100 4,971
September 29 – – 700 1,656

Physical verification on September 30, 1989 revealed an actual stock of 3,800 units. You are
required to :

(a) Indicate the method of princing employed in the above.

(b) Complete the above account by making entries you would consider necessary including
adjustments, if any, and giving explanations for such sdjustments.

(19) Following information is available in respect of two components A and B.

Particulars A B
Normal Usage Units 50 50
Minimum Usage Units 25 25
Maximum Usage Units 75 75
Lead Time Week 4-6 2-4
Annual Consumption Units 9,000 6,250
Ordering cost per order Rs. 45 100
Carrying cost per unit per year Rs. 9 5

Calculate for each component.

240 Management Accounting


(i) Re-order level
(ii) Minimum level
(iii) Maximum level
(iv) Average level

(20) P. Ltd. uses three types of materials, A, B and C for production of X, the final product.
The relevant monthly data for the components are as given below :

A B C

Normal Usage (Units) 200 150 180


Minimum Usage (Units) 100 100 90
Maximum Usage (Units) 300 250 270
Re-older Quantity (Units) 750 900 720
Re-order period (Months) 2 to 3 3 to 4 2 to 3

Calculate for each component.


(1) Re-order Level
(2) Minimum Level
(3) Maximum Level
(4) Average stock Level

(21) The following data are available from the records of M/s. Naveen Industries Ltd. using two
types of materials A and B for the manufacture of their product.

A B

Normal Usage (Units per month) 250 200


Minimum Usage (Units per month) 100 200
Maximum Usage (Units per month) 350 400
Reorder Quantity (Units) 900 1000
Reorder Period (Months) 2 to 3 3 to 4

Compute for each type of material, the following levels.


(1) Reorder Level
(2) Minimum Level
(3) Maximum Level
(4) Average Stock Level

Material Cost 241


(22) Following details are available in respect of a material.

(i) Ordering cost per order Rs. 45


(ii) Annual consumption 9,000 units
(iii) Carrying cost per unit per year Rs. 9
(iv) Lead Times - Average - 10 days
Minimum 6 days
Maximum 15 days
Maximum for emergency purchases 4 days
(v) Rate of consumption - Average 15 units per day
Maximum 20 units per day

Calculate :
(i) Reordering Level
(ii) Maximum Level
(iii) Minimum Level
(iv) Average Level

(23) Certain purchased part of which annual requirements are 8000 units, involves ordering
cost equal to Rs. 12.50 per order, cost per piece Re. 1 and the annual carrying cost
20%. In addition, average daily usage is 32 units (based on 250 operating days per
year), lead time is 10 days and safety stock has been calculated to be 100 units.

Calculate :
(a) Economic Order Quantity
(b) Reorder point

(24) (i) XYZ Company buys in the lot of 500 boxes which is a 3 months supply. The cost
per box is Rs. 125 and the ordering cost is Rs. 150. The inventory carrying cost is
estimated at 20% of unit value. What is the total annual cost of the existing inventory
policy?

(ii) How much money could be saved by employing the economic order quantity?

(25) To decided to buy an item, the following data is given.


Annual Demand 600 units
Ordering Cost - Rs. 400
Holding Cost - 40%

242 Management Accounting


Cost per unit - Rs. 15
Discount 10% if the order quantity is 500
What should be the decision? Justify your answer.

(26) A manufacturer requires 10 lakhs components for use during the next year which is
assumed to consist of 250 working days. The cost of storing one component for one
year is Rs. 4 and the cost of placing order is Rs. 32. There must always be a safety
stock equal to two working days usage and the lead time from the supplier, which has
been guaranteed, will be 5 working days throughout the year.

Assuming usage takes place steadily throughout the working days, delivery takes place
at the end of the day and orders are placed at the end of working day, you are required to
calculate.

(i) Economic Order Quantity.


(ii) Reorder point.

(27) Anil Company buys its annual requirement of 36,000 units in six instalments. Each unit
costs Re. 1 and the ordering cost is Rs. 25. The inventory carrying cost is estimated at
20% of the unit value. Find the total cost of the existing inventory policy. How much
money can be saved by using Economic Order Quantity?

(28) A Company, for one of the A class items, placed 6 orders each of size 200 in a year.
Given ordering cost Rs. 600, holding cost 40%, cost per unit Rs. 40, find out the loss to
the Company by not operating scientific inventory policy. What are your recommendations
for the future?

(29) A manufacturer has to supply his customers 600 units of his product per year. Shortages
are not allowed and the inventory carrying cost amounts to Rs. 0.60 per unit per year.
The set up cost per run is Rs.80. Find

(a) The Economic Order Quantity


(b) The minimum average yearly cost.
(c) The optimum number of orders per year.

(30) A purchase manager has decided to place order for minimum quantity of 500 numbers of
a particular item in order to get a discount of 10%. From the records, it was found that in
the last year, 8 orders each of size 200 number have been placed. Given Ordering cost
Rs. 500 per order, Inventory carrying cost 40% of the inventory value and cost per unit
Rs. 400, is the purchase manager justified in his decision. What is the effect of his
decision on the company?

Material Cost 243


(31) A publishing house purchases 2000 units of a particular item per year at a unit cost of
Rs. 20, the ordering cost per order is Rs. 50 and the inventory carrying cost is 25%. Find
the optimal order quantity and minimum total cost including purchase cost.

If a 3% discount is offered by the supplier for purchase in lots of 1000 or more, should the
publishing house accept the proposal?

(32) Calculate for each Component A and B the following -


(a) Reorder Level
(b) Maximum Level
(c) Minimum Level
(d) Average stock Level
Normal Usage - 300 units per week each.
Maximum Usage - 450 units per week each
Minimum Usage - 150 units per week each
Reorder Quantity - A - 2,400 units
B - 3,600 units
Reorder Period - A - 4 to 6 weeks
B - 2 to 4 weeks

244 Management Accounting


NOTES

Material Cost 245


NOTES

246 Management Accounting


Chapter 9
LABOUR COST

Labour Cost is another important element of cost in the manufacturing cost. It is important
element of cost eventhough the production is material intensive. The basic factor which gives
rise to the labour cost is the remuneration paid to workers. However, the objective of cost
accounting (i.e. cost ascertainment with respect to the individual cost centre and cost control)
can not be fulfilled properly unless and until the functions performed by the related departments
are properly considered. These functions can be stated as below :

(1) Personnel Department : This ensures the availability of correct workers to perform the
jobs which are best suited for them. This is done by selecting them properly and training
them properly. This department may also be involved with maintenance of records of job
classification/ wage rates payable to workers, preparation of wages sheet and procedural
aspects of wage payment.

(2) Time Keeping Department : This is concerned with recording of workers time. This is
not only for the purpose of wage calculations but also for the purpose of cost analysis
and apportionment of cost over various jobs. The main functions performed by this
department are time keeping and time booking.

(3) Cost Accounting Department : This department accumulates and classifies cost data
with respect to labour cost from the analysis of wages sheet and presents the reports to
management to facilitate the control over labour cost.

The starting point for ascertaining the labour cost is in the form of Time Keeping and Time Booking.

Time Keeping :

This is the process of recording attendance time of the workers. It is the responsibility of Time
Keeping Department which may function as separate department in some cases or else may
function as the part of Personnel Department. Attendance time recording may be necessary
as the payment of wages may depend on the attendance. Even when the payment of wages
does not depend on time attended, say in case piece rate payment, the recording of time
attended may be necessary from the following angles.

Labour Cost 247


(1) To Maintain discipline.

(2) Though the regular wages may not depend upon the time attended, in some cases, the
other payments like overtime wages, dearness allowance etc. may be linked with the
attendance.

(3) The fringe benefits like Pension, Gratuity on retirement. Provident Fund etc. may depend
on the continuity of service which will be available only if time attended is recorded
properly.

(4) Attendance records may be required for research and other purposes.

Methods of Time Keeping :

For the purpose of time keeping, various methods may be followed, though the selection of the
method may depend upon nature of organization and policy of management. Main such methods
may be stated as below:

(1) Hand-Written Method :

Under this method, names of the workers are recorded in the attendance register with
provision of various columns for various days. The attendance of the worker may be
recorded either by calling out his name or by physical check. Alternatively, the workers
themselves may sign in the attendance register.

This method, though simple, has become outdated. This method can also result in
malpractices with the collusion between workers and time keeping/ personnel department.
Also recording of late coming, overtime, short leave etc. may involve more clerical work
and may be subject to errors.

(2) Token or Disc Method :

Under this method, each worker is allotted an identification number and a disc or token
bearing that number. Immediately before the scheduled opening time, all the tokens/
discs will be placed at the factory gate. Every incoming worker will take out his token
and drop it in a separate box or hang it on a separate board. The tokens/discs not
removed will indicate that the said worker is absent. Similar procedure is followed while
the workers leave the factory. In addition to the physical handling of tokens/ discs, it will
be required to record the attendance time separately.

Though it is an improved method, as compared to manual/handwritten method, it is also


subject to errors.mistakes and frauds. Further care should be taken to see that a worker
does not remove the disc/token of his absent fellow in addition to his own.

248 Management Accounting


(3) Time Recording Clock Method :

Under this method, every worker is alloted individual ticket number and a clock card
which bears that ticket number. The cards are placed on two racks on either side of the
time recording clock denoting separately ‘In’ rack and ‘Out’ rack. At the opening time, all
the cards are placed in ‘Out’ rack. On arrival, worker takes out his own card, puts it in the
slot available on the time clock recorder which punches the time on that card, and
places the card in ‘In’ rack. All the cards, left in the ‘Out’ rack indicate absent workers.
At the time of departure, he removes the card from In’ rack, gets it punched and places
it in ‘Out’ rack.

Though, this method involves heavy capital outlay initially, it has certain advantages
also.

(1) It is economical in the sense it avoids clerical work: involved in manual/handwritten


method.

(2) It is clean, safe and quick and has printed records to avoid disputes.

(3) Chances of fraudulent entries being made can be avoided.

Time Booking :

The ultimate aim of costing is to decide the cost of each cost centre. As such, recording of
time attended is not sufficient. Equally important is to record the time spent for individual cost
centres. This process is in the form of time booking. The methods followed for this purpose,
may be considered as below :

(a) Daily time sheets :

Under this method, each worker is provided with a daily time sheet on which time spent by
him on various jobs/work orders is expected to be mentioned. If the worker works on various
jobs in a particular day, the daily time sheets move along with the worker. The entries on the
same may be made by the worker himself or by the foreman.

This method may be conveniently used if the worker works on various jobs of short duration.
Say in case of maintenance jobs.

This method is disadvantageous in the sense that it involves considerable paper work. The
form in which the daily time sheets may be prepared is as below :

Labour Cost 249


DAILY TIME SHEET

Name of Employee

Employee No. Date :

Job No. Dept. Time Record Time taken

ON OFF

Checked by Cost office reference

(b) Weekly Time Sheets :

Under this method also; one sheet is alloted to each worker but instead of recording the work
done for a day only, record of time for all the jobs during the week is made. These types of time
sheets are useful for intermittent types of jobs like building or construction work. It involves
comparatively less paper work. The form in which weekly time sheets may be prepared is as
below.

WEEKLY TIME SHEET

Name of Employee Week ending on...

Employee No.

Day Job No. Time Time Standard Rate Amount


On Off taken

TOTAL

Checked by Cost office reference

250 Management Accounting


(c) Job Card :

Under this method, the details of time are recorded with reference to the jobs or production/
work orders undertaken by the workers rather than with reference to individual workers, and
this facilitates the computation of labour cost with reference to jobs or production/work orders.
There may be two ways in which job card may be maintained.

(1) According to first method, each job or production/work order is alloted a number. When
a worker takes up a job, the time of starting and finishing the job is entered on the card
meant for that worker. The summary of this card states the total time taken by that
worker for that job. In order to compute the total time booked for the job as a whole, all
cards of all the workers with respect to that job are required to be analysed. The form in
which this card may be prepared is as below.

JOB CARD

Name of Employee Job No.

Employee No.

Day Time Time Standard Rate Amount


ON OFF Taken Rs. Rs.

FRI

SAT

SUN

MON

TUE

WED

Checked by Cost office reference

(2) According to this method, a job card is prepared for each job production/work order
accepted by the organization for execution. It describes the various operations/stages
involved in the execution of the job. Time taken by the various workers to complete the
job is entered on the card. This provides the information about the time taken by various
workers to complete a particular job.

Labour Cost 251


The form in which this card may be prepared is as below.

JOB CARD WITH OPERATIONS

Job No. Drawing No.

Job Description

Operation Employee ON OFF Time Rate Amount


No. taken

Cutting
1
2
Drilling
1
2
Grinding
1
2
Painting
1
2
Assembly
1
2
3

TOTAL

Checked by Cost office reference

Reconciliation of time attended and time booked

If a combined time and job card is maintained, the problem of reconciliation will be relatively
simple as both the details will be available on the same card. In other cases, at the end of the
wage period or at a shorter interval also, the total time attended has to be compared with the
time booked on job cards on the various jobs. If the time booked as per the job cards, is less
than the attendance time, this indicates the idle time during which the worker has not done
any work, though he was present in the factory.

252 Management Accounting


Methods of remunerating the workers :

Remuneration to workers indicate the reward for labour and services. The remuneration may
be paid in monetary terms (which in turn may be in direct form or indirect form) or non-
monetary terms. The remuneration paid in the monetary form may be by way of basic wages
or salaries and other allowances and may be paid either on time basis or on work basis.
However, payment of only basic wages or salaries may not be sufficient enough to induce the
workers to work efficiently, hence they may be remunerated in the form of some incentives. In
case of remuneration in non-monetary form, the workers may not receive anything in the from
money but they may get facilities which induce them to stay with the organization. It may be
in the form of the provision of health or welfare or recreational facilities, provision of working
conditions and so on. We will discuss these methods of remuneration under the following
heads.

(1) Remuneration on Time Basis i.e. Time Rate System.

(2) Remuneration on Work Basis i.e. Payment by Results.

(3) Incentive/Bonus Systems.

(a) Individual Incentive Systems

(b) Group Incentive Systems.

(4) Indirect monetary remuneration

(a) Profit sharing

(b) Co-partnership

(5) Non-monetary incentives

Principles of a good wage payment system :

(1) As a general rule, if the efficiency of the workers can be measured in the objective terms,
the wages receivable by a worker should be in conformity with his efficiency. Otherwise
an efficient worker is likely to be demotivated from working efficiently. At the same time,
the standards fixed to measure the efficiency of a worker should be normal which can be
attained by a normal worker under normal conditions.

(2) The wage payment system should be clearly defined and communicated to the workers
leaving no scope for any ambiguity. At the same time, a good wage payment system
should be simple to understand and easy to operate.

(3) No upper limit should be imposed on the wages which can be earned by an efficient
worker.

Labour Cost 253


(4) A good wage payment system will not punish the workers for the matters beyond the
control of the workers. E.g. Workers should not be punished in terms of reduced wages
due to the circumstances like machinery break down or power failures etc.

(5) A good wage payment system should be reasonably permanent in nature. Frequent
changes in the same should be avoided. If any changes are proposed to be made in
system of wages payment, they should not be thrust upon the workers by force, but
should be implemented by having mutual discussions with and due approval from the
workers.

(6) Wage payment system should be properly tied up with quality control procedures to
ensure that the workers are paid only for good and quality production.

(7) The basic objective of the wage payment system should be to get maximum cooperation
from the workers, improve the morale and productivity of the workers and to minimize the
cost of supervision and labour turnover.

(8) The wage payment system should take into consideration the external obligations to
which the organization may be subjected to. These obligations may be in the form of
various statutes like Minimum Wage Act and the agreement entered into with the workers
and so on.

(A) Time Rate System :

Under this, a worker is paid on the basis of time attended by him. He is paid at a specific rate
irrespective of the production achieved by him. The pay rate may be fixed on daily basis,
weekly basis or monthly basis.

This type of remuneration system is helpful in the following circumstances.

(a) If the output of the worker is beyond his control e.g. His speed depends upon speed of a
machine or speed of other workers.

(b) If the output can’t be measured or standard time can’t be fixed e.g. Maintenance work.

(c) If close supervision is possible.

(d) If quality, accuracy and precision in work is of prime importance e.g. Artist, Ad-agency
person.

The time rate system of remunerating the workers is useful due to the following features :

(a) Useful for highly efficient and highly inefficient workers.

(b) Easy for calculations.

(c) Easy to understand for the worker.

(d) Assurance of minimum wages.

254 Management Accounting


The time rate system has one most important disadvantage attached to it that the efficiency
of the worker is disregarded while paying remuneration to him. To avoid this difficulty, some
variations as discussed below can be applied in practice.

(i) High Wage Plan :

Under this system, timely wage rate of the workers may be fixed at such a level which is
higher as compared to wages paid to workers in the same industry or locality. Suitable working
conditions are provided. Correspondingly, a high standard of efficiency is expected from the
workers.

Those who are not able to come up to the standard, are taken off the scheme.

(ii) Differential Time Rate :

Under this method, different hourly rates are fixed for different levels of efficiency. Up to a
certain level of efficiency, normal day rate is applicable which gradually increases as efficiency
increases. This can be illustrated as below :

Up to 80% efficiency : Re. 1.00 per hour (Normal Rate)

80% to 90% efficiency : Rs. 1.25 per hour

90% to 100% efficiency : Rs. 1.40 per hour

101% to 125% efficiency : Rs. 1.50 per hour

(B) Payments by results :

Under this system, workers are paid according to the production achieved by them. In many
cases, time attended is not material. These methods can be reclassified as below.

(a) Straight Piece Rate System :

Under this method, each job, production or unit of production is termed as a piece and the rate
of payment is fixed per piece. The worker is paid on the basis of production achieved irrespective
of the time taken for its performance. Thus, the earnings of the worker can be computed as :
Wages = No. of units produced x Piece Rate per unit This method can be suitably applied if
the production is of standard or repetitive nature. It can’t be applied if the production can’t be
measured in suitable units.

It can be seen that the crux of this method is to decide the time required to complete a piece.
The fixation of this time should be done in such a way that within that much time, a normal
worker can complete the piece. This can be done either on the basis of previous experience or
on the basis of time and motion study.

Labour Cost 255


(b) Piece Rate With Guaranteed Time Rate :

Under the straight piece rate system, the remuneration of a worker depends upon the production
achieved. If the production is less due to some factors beyond his control, he is likely to be
penalised. To remove this difficulty, it may be decided that he will be paid on time rate if his
piece rate earnings fall below time rate earnings, so that the worker is assured of minimum
earnings on time basis. However, if this guaranteed time rate payment is too high, the incentive
to increase output to get piece rate payment is less.

(c) Differential Piece Rate System :

Under this system, higher rewards are guaranteed to more efficient workers. The piece rates
are fixed in such a way that normal piece rate is paid for work performed within and upto the
standard level of efficiency. If efficiency exceeds the standard, payment at higher piece rate is
made.

This can be illustrated as below :

Up to 83% efficiency - Normal Piece Rate.

Up to 100% efficiency - 10% above normal piece rate.

Above 100% efficiency - 30% above normal piece rate.

This method offers more inducement to the workers to work more efficiently and earn higher
wages. But it is complicated to understand and expensive to operate.

Following systems use this principle of differential piece rates.

(1) Taylor Differential Piece Rate System :

This was introduced by F.W. Taylor. It provides two piece rates, a low piece rate for output
below standard and a high piece rate for output above standard and does not provide for any
guaranteed time rate payment. Eg. If standard output is 10 units and piece rate is Re.l per
unit, the total wages are :

(i) If actual hourly output is 8 units i.e. below standard, the piece rate is say 80% of normal
piece rate i.e. Re. 0.80. Hence total wages are 8 units x Re. 0.80 = Rs.6.40.

(ii) If actual hourly output is 12 units i.e. above standard, the piece rate is say 120% of
normal piece rate i.e. Rs. l.20.

Hence, total wages are 12 units x Rs.l.20 = Rs. 14.40.

The basic defect with this system is that eventhough the efficiency of the worker is below
standard even marginally, he is punished heavily and even though the efficiency of the worker
is above standard even marginally, he is benefited to a very great extent.

256 Management Accounting


(2) Merrick Differential Piece-rate System :

To remove the defect existing in case of Taylor’s System which heavily punishes the worker
who produces below standard, the Merrick System provides for three piece rates Eg.

Efficiency Piece rate

Up to 83% Normal

Up to 100% 110% of normal piece rate

Above 100% 130% of normal piece rate

It should be noted that under this method also, no guaranteed time rate payment is provided.

Illustration :

The following particulars relate to a company.

Piece Rate - 6 paise per unit. Production of the workers


M - 125 units per day
N - 80 units per day
O - 150 units per day

Standard production per day 120 units.

Calculate the wages of the workers on the basis of Merrick’s Differential piece rate system,
when basic piece rate is guaranteed below the standard and workers get 108% of the basic
piece rate between 100% and 120% of the basic piece rate above 120% efficiency.

Solution :

Calculation of total wages :

(a) Worker M :

Actual production 125 units i.e. 104% efficiency.

∴ Applicable piece rate - 108% of normal i:e. 6.48 paise per unit.

∴ Total wages : 125 units x 6.48 paise = 810 paise i.e. Rs. 8.10

(b) Worker N :

Actual production 80 units i.e. below the standard.

∴ Applicable piece rate : basic piece rate i.e. 6 paise per unit

∴ Total wages : 80 units x 6 paise = 480 paise i.e. Rs. 4.80

Labour Cost 257


(c) Worker O :

Actual production 150 units i.e. 125% efficiency.

∴ Applicable piece rate - 120% of normal i.e. 7.20 paise per unit.

∴ Total wages 150 units x 7.20 paise = 1080 paise i.e. Rs. 10.80

(3) Gantt Task Bonus System :

This system is a combination of time rate and piece rate and provides for minimum time rate
payment. A high task or standard is set. The wage structure may be fixed as below.

Output below standard - Minimum time rate payment.

Output at standard - Time wages plus some increase in wage rates.

Output above standard - High piece rate for entire output.

(C) Individual Incentive Systems :

In case of time rate systems, the losses due to inefficiency of workers or benefits due to
efficiency of workers are suffered or enjoyed by the employer alone. Similarly in case of piece-
rate systems, the losses due to inefficiency of workers or benefits due to efficiency of workers
are suffered or enjoyed by the worker alone. (The employer may be indirectly affected in the
form of increased or decreased per unit overheads.) The incentive systems differ from both
these systems in such a way that the financial advantages arising out of the efficiency of
workers are enjoyed by both employer as well as workers. There are various systems by
which the incentive may be paid to workers. We will consider following main systems.

(a) Halsey Premium System :

Under this system, if the actual time taken is equal to or more than standard time, worker is
paid at the time rate. If actual time is less than standard time, the worker, in addition to time
wages for hours actually worked, gets a bonus payment. The bonus is equivalent to the wages
for the time saved in the decided percentage to be shared with the employer The percentage
allowed to worker may vary from 30% to 70% (usually 50%). The total wages payable to the
worker under this system, can be computed as below.

(SH - AH) X HR
AH X HR + Assuming 50% - 50% sharing
2

Where - AH - Actual hours

SH - Standard hours

HR - Hourly rate

258 Management Accounting


(b) Halsey - Weir Premium System :

This system is a deviation of Halsey Premium System only with the exception that the ratio of
sharing between the worker and the employer is fixed as 1/3 : 2/3. The computation of total
wages is the same as in case of Halsey Premium System, except the change in this ratio.

(c) Rowan Premium System :

Under this system also, guaranteed time rate payment is made. The amount of bonus paid is
a percentage of hourly rate which is in proportion to the time saved. The total wages payable
to the workers under this system can be computed as below :

SH - AH
AH X HR + X AH X HR
SH

Where AH - Actual Hours

SH - Standard Hours

HR - Hourly Rate

Comparative study of Halsey and Rowan System :

Comparative study of total wages under both these systems reveals that if time saved is less
than 50% of the standard time. Rowan system assures more wages than those under Halsey
system. But if time saved exceeds 50% of the standard time, Halsey system proves to be
more beneficial. In Rowan System a less efficient worker gets the same bonus as a more
efficient worker. As such Rowan System may be implemented in case of loose fixation of
standards. The fall in bonus as time saved increases, offsets the damage done by loose
standards.

Illustration :

The following are the particulars given to yon.

Standard time .. 10 hours.

Time rate .. Re. 1 per hour.

Prepare a comparative table under Halsey Premium System and Rowan Premium System, if
time taken is 9 hours, 8 hours, 6 hours, 5 hours 4 hours and 3 hours. Also calculate the
amount of total wages and labour cost per hour under two methods. What conclusions do you
draw from the table.

Labour Cost 259


Solution :

Hours Halsey Premium system Rowan Premium system.


taken Wages = Actual Hours x Hourly rate Wages = Actual Hours x Hourly rate
+ 1/2 (Time Saved x Hourly rate) + Time Saved/Time Allowed Actual Hours
x Hourly rate

(a) 9 Wages = 9x1+1/2 (I x 1) Wages = 9 x 1 + 1/10 x 9 x 1


= Rs. 9.50 = Rs. 9.90
(b) 8 Wages = 8x1+1/2 (2 x 1) Wages = 8 x 1+ 2/10 x 8 x 1
= Rs. 9 = Rs. 9.60
(c) 6 Wages = 6x1+1/2 (4 x 1) Wages = 6 x 1 + 4/10 (6 x 1)
= Rs. 8 = Rs. 8.40
(d) 4 Wages = 4 x 1 1/2 (6 x 1) Wages = 4 x 1 + 6/10 (4 x 1)
= Rs. 7.00 = 6.40
(e) 3 Wages = 3 X l+ 1/2 (7 x 1) Wages = 3 x 1 + 7/10 (3 x 1)
= Rs. 6.50 = Rs. 5.10

Conclusion :

It can be concluded from the above table that so long as time saved is less than 50% of
standard time, the total wages are more under Rowan Premium system than under Halsey
Premium System. If the time saved is more than 50% of standard time, Halsey system proves
to be more beneficial in terms of the total wages.

The other systems for making the payment of premium can be briefly described as below.

(a) Barth Premium System :

Under this system, the wages payable to the workers are computed as below.

Wages = Hourly Rate x √ Standard Hours x Actual Hours


Eg. Standard Hours are 10

Actual hours are 8

Hourly rate is Rs. 2 per hour.

Total wages will be

2x √10x8
= Rs. 17.89

260 Management Accounting


It should be noted that this system does not provide for any guaranteed time wages. This
system is suitable for beginners or apprentices.

(b) Emersons’s Efficiency Bonus System :

Under this system the wages payable to the workers are computed as below.

Wages = Actual Hours x Hourly Rate


+ Bonus Percentage x Actual -Hours x Hourly rate.

For calculating bonus percentage, following directions are provided.

Efficiency Bonus

(1) Below 66.2/3 % No bonus is payable. Only the guaranteed time


wages are payable.

(2) 66.2/3% to 100% In Addition to time wages, bonus is paid at different percentages
increasing rapidly to 20% at 100% efficiency.

(3) Above 100 % In addition to time wages and bonus @ 20%, 1% bonus for
each 1% increase in efficiency beyond 100% is paid.

Eg. 101 % efficiency - 21 % Bonus

110 % efficiency - 30 % Bonus

120 % efficiency - 40 % Bonus & so on.

The efficiency percentage can be calculated as below.

(1) On time basis :

Standard Hours
x 100
Actual Hours

(2) On output basis :

Actual output
x 100
Standard output

Eg. Standard Hours are 10

Actual Hours are 8

Hourly Rate is Rs. 2 per hour.

Labour Cost 261


Efficiency percentage will be as below.

Standard Hours 10
X 100 = X 100 = 125%
Actual Hours 8
∴ Bonus percentage will be 45%

Total Wages = 8 x 2+ 45% of 8 x 2

= 16 + 45% of 16

= 16 + 7.20

= Rs. 23.20

It can be seen that the abovestated system is similar to that of piece rate with guaranteed
time rate. This system may be suitable for non efficient workers for improving their efficiency.

(c) Bedaux Point System :

Under this system, the standard time is divided into standard minutes, each standard minute
identified as Bedaux Point or B. The wages payable to the worker are computed as below.

75 % of BS x Hourly Rate
Wages = Actual Hours x Hourly Rate +
60

Where BS indicates the number of B’s saved i.e. the difference between B’s earned and
standard B’s allowed for the job.

Eg. Standard points for a job - 400 points in 8 hours.

Hourly Rate - Rs. 3 per hour.

75% of (450 - 400) x 3


Wages = 8x3+
60

= 24 + 75% of 2.50

= 24 + 1.875

= Rs. 25.875.

It should be noted that a very accurate system of work study is required for this system. It is
difficult to understand and involves a lot of clerical efforts.

262 Management Accounting


(d) Accelerating Premium System :

Under this system, incentive increases at a fast rate with the increase in output. Total wages
payable to the worker are computed as below.

Y = 0.8 X2 where

Y = Earnings X = Efficiency.

i.e. If efficiency is 140%, the earnings will be :

0.8 x 140 x 140 x 1.568 of basic wages i.e.


100 100

100% wages, 56.8% bonus.

Eg. Standard hours are 10

Actual Hours are 8

Hourly rate is Rs. 2 per hour.

∴ Efficiency percentage will be

10/8 x 100 = 125%

125 125
Earnings = 0.8 x x
100 100

= 1.25

∴ Earnings will be 125% of basic wages i.e 100% basic wages, 25% bonus.

Basic, wages - 8x2 = 16


Bonus - 25% of Rs. 16 =4
Total Wages = 20

This system is very difficult to understand.

(e) Baum Differential Plan :

This is a combination of Taylor’s differential piece rate system and Halsey system and is also
known as Milwaukee Plan.

Labour Cost 263


(f) Diemer System :

This is a combination of Halsey System and Gantt system.

(D) Group Incentive System :

In many cases, the output of the individual workers cannot be measured though the output of
a group of workers can be measured. In such cases, the individual time rates or in some
specified proportion depending upon the skill of the workers or equally, can be applied.

(E) Indirect Monetary Remuneration :

This may take the following two forms.

(a) Profit Sharing :

According to this method, the workers, are entitled to share in profits earned by an
organisation, in addition to the regular wages, at a specified percentage. The legal
provisions in this regard are enacted by way of Payment of Bonus Act, 1965. According
to the provisions of this Act, all the employees drawing a monthly remuneration of
Rs. 2,500 or less are entitled to a bonus at the minimum rate of 8.33% of wages of the
subject to the maximum ceiling of 20 % of the wages. It should be noted that the statutory
requirement of the payment of bonus does not depend on the profit earned necessarily,
as the bonus is payable eventhough there are no profits. It is also worth noting that the
statutory requirement of payment of bonus is the specific percentage of the wages or
salaries paid to the workers and hence remains unaffected by any changes, either upwards
or downward, in the profits earned by the organisation.

(b) Co-partnership :

According to this method, the workers are granted ownership rights in the operations of
the organisation by which the workers are in the position to control the affairs of the
organisation. In corporate organisations, it may be in the form of offering the shares of
the company to the workers or granting of loans to the workers to buy company’s shares,
according to which the workers get the voting rights to control the affairs of the company.
The workers get dividend on the shares as bonus. With the help of this method, the
morale of the workers is increased. However, certain objections are raised against this
method. First, the increase in earnings is too small. Second, the shareholding of the
workers is too small to control the affairs of the company. Third, the workers are not
rewarded according to the individual efficiency.

264 Management Accounting


(F) Non-monetary Incentives :

The intention of these incentives is to attract better workers, retain the existing workers,
encourage loyalty, reduce labour turnover, provide better working conditions to workers and so
on. Various benefits as stated below may be granted to the workers, either free or at reduced
rates, remaining amount being contributed by the workers.

(1) Health and safety services.

(2) Education and training to workers and their children.

(3) Canteen facility.

(4) Pension, superannuation fund etc.

(5) Loans at reduced rate of interest.

IMPORTANT TERMS IN CASE OF LABOUR COST :

(A) Labour Turnover :

In every business organisation, the process of employees leaving the organisation and new
workers being recruited is a normal feature. Labour Turnover indicates this change in labour
force showing a highly increasing trend or highly decreasing trend. Labour turnover showing
sharp increasing trend may involve the reduction in labour productivity and increasing costs.
Too low a labour turnover trend may be due to inefficient workers who would not like to leave
the organisation.

Causes of labour turnover :

The causes of labour turnover can be broadly classified as below :

(a) Avoidable causes :

(1) Dissatisfaction with job.

(2) Dissatisfaction with remuneration.

(3) Dissatisfaction with working conditions.

(4) Dissatisfaction with hours of work.

(5) Relationship with supervisors and workers.

(b) Unavoidable causes :

(1) Betterment/Personal.

(2) Illness or accident.

(3) Move from locality.

Labour Cost 265


(4) Discharge.

(5) Marriage.

(6) Retirement.

(7) Death.

(8) National service.

Costs of labour turnover

The cost of labour turnover may be classified under two headings.

(a) Preventive Costs :

These refer to all the costs which may be incurred by the organisation to keep
workers happy and discourage them from leaving the job. This, in turn, may include the
costs like :

(1) Cost of Personnel Administration - To maintain good relations with the workers.

(2) Cost of medical services- To keep the workers and their families in healthy condition,
as healthy workers are assets for the organisation who contribute towards higher
efficiency and productivity.

(3) Costs of welfare activities - To give facilities like transport, canteen etc.

(4) Other incentive schemes like pension, provident fund, superannuation fund, Bonus
etc.

(b) Replacement Costs :

These refer to the costs incurred for recruitment and training of new workers and the
resulting losses, wastages and reduced productivity due to the inefficiency and
inexperience of new workers.

This in its turn may include the costs like-

(1) Inefficiency of new workers.

(2) Cost of selection and placement.

(3) Training costs.

(4) Loss of output due to delay in getting new workers

(5) Increased spoilage and defectives.

(6) Cost of tools and machine breakages.

266 Management Accounting


Measurement of labour turnover :

There are three methods for measuring the labour turnover.

(1) Separation Method

Under this method, it is computed as :

No. of Separations in a period


X 100
Average no. of workers

(2) Replacement Method

Under this method, it is computed as

No. of Replacements in a period


X 100
Average no. of workers.

(3) Flux Method

Under this method, it is computed as -

No. of separations + No. of replacement


X 100
Average no. of workers

Illustration :

From the following data given by Personnel Department, calculate the labour turnover rate by
applying :

(a) Separation Method

(b) Replacement Method

(c) Flux Method

No. of workers on pay-roll

- At the beginning of the month 900

- At the end of the month 1,100

During the month, 10 workers left, 40 persons were discharged and 150 workers were recruited.
Of these 25 workers are recruited in the vacancies of those leaving while the rest were for an
expansion scheme.

Labour Cost 267


Solution :

Calculation of Labour Turnover

(1) Separation Method

No. of separations in a period


X 100
Average No. of workers

50
= X 100 = 5
1000

∴ Monthly Turnover Rate : 5%

365
Annual Turnover Rate : 5 X = 60.83%
30

(2) Replacement Method :

No. of replacements in a period


X 100
Average No. of workers

25
= X 100 = 2.5%
1000

Monthly turnover Rate : 2.5%

365
Annual Turnover Rate : 2.5 X = 30.42%
30

(3) Flux Method :

No. of separations + No. of replacements


X 100
Average No. of workers

50 +25
= = 100 = 7.5%
1,000

Monthly Turnover Rate : 7.5%

365
Annual Turnover Rate : 7.5 X = 91.25%
30

268 Management Accounting


Working Notes :

Average number of workers is calculated as -

No. of workers at beginning + No. of worker at end


2
900 + 1,100
=
2

= 1,000

(B) Idle Time :

It indicates the time for which wages are paid to the workers but during which no production is
obtained. To exercise proper control on idle time, causes of the same should be analysed
properly and studied from its controllability point of view.

The causes of idle time can be analysed as below :

(a) Productive causes :

These can be further classified as :

(i) Due to machine breakdown.

(ii) Power failures.

(iii) Waiting for tools, work or raw materials.

(iv) Waiting for instructions.

These causes are supposed to be controllable causes and can be controlled if planned
properly.

(b) Administrative causes :

Some idle time may be caused due to administrative decisions. E.g. the organisation is
having excess machine capacity or during the depression period, it is not having sufficient
work to be performed, but it has decided not to get rid of trained workers temporarily. As
such cost of idle time is accepted.

(c) Economic causes :

Economic causes may be of seasonal nature, cyclical nature or industrial nature. E.g. if
the product manufactured is of a seasonal nature, for other periods of the year, the
capacity may remain unused, unless some other product to take care of slack season is
introduced. In case it is not possible to make alternate use of such idle capacity, some

Labour Cost 269


idle time is unavoidable. In case of cyclical causes, the causes are similar to seasonal
fluctuations but these causes are beyond the control of management.

Treatment of idle time cost :

If Idle time payment is normal and controllable, it should be classified as overheads. If it is


possible to allocate the same to some department, it should be allocated and absorbed in the
production department cost.

If idle time is normal and uncontrollable, the labour rates should be suitably modified. E.g. if
time attended is 8 hours but time booked is only 7.5 hours and labour cost is Rs. 1.5 per hour,
the hourly labour rate should be computed as -

8 hours X Rs. 1.5


i.e. Rs. 1.60
7.5 hours

If idle time payment is uncontrollable and abnormal, it should not be considered as a part of
manufacturing cost but should be written off to Costing Profit and Loss Account.

(C) Internal Control Problems in Labour Cost :

In today’s world, labour is one of the most important factors of production, and contributing to
a very great extent to the cost of production. As such, it will be the intention of every organisation
to have proper control on the labour cost. The implementation of various Internal Control
Procedures indicate the following of all those methods and procedures which ensures fluent
and smooth running of the operations of the organisation and also of achieving protection of
assets, prevention of errors and frauds, proper recording of information whenever necessary.

The cost of labour may be high due to the various reasons stated below :

(1) Excess staffing - Having more staff than the requirement.


(2) Lack of experienced and efficient personnel.
(3) Excessive remuneration pattern - Settlement of the wage rates or piece rates on higher
side which may not be justified on the basis of efficiency of workers.
(4) Clerical errors or fraudulent practices taking place in the area of time keeping, computation
of wages payable, procedure for payment of wages to the workers etc.
(5) Idle time or unusual overtime wages.
(6) Increase of spoilage due to lack of proper supervision and inspection.
(7) High labour turnover.

After locating the reasons for increasing labour costs, attempts can be made to keep the
same in control after following various internal control measures as discussed below.

270 Management Accounting


(1) To avoide the problem of excess staffing, the employment of the workers should be
made only after the receipt of labour placement requisition from the concerned department.
After the receipt of this requisition, it should be seen, whether it is possible to meet the
requirement of said department with the help of existing staff only or at least by transferring
the existing excess staff in other departments. Before proceeding with the actual process
of selection of the staff, care should be taken to decide in advance about the nature of
work which may be assigned to the individual employee.

(2) To ensure that correct personnel is employed to work in the correct places, care should
be taken to analyse the requirements of the job and then to select the personnel which
suits these requirements. This process may be in the form of ‘job evaluation.’

Selection of the proper personnel may not be enough. To train the selected personnel to
extract maximum of their efficiency is equally necessary.

(3) The problem of setting the excessive rate structure in the form of higher time rate or
piece rates or bonus rates may be avoided by setting the standards in the most scientific
manner. For this purpose, the techniques like time and motion study, work study etc.
may be implemented.

(4) To avoid the clerical errors or fraudulent practices in the areas of wage sheet preparation
or wage payments, proper internal check procedures may be implemented, so that the
work of one person is properly checked by another person. For this, following steps may
be taken :

(a) Time recording clock should be installed, wherever possible. Proper supervision is
required to ensure that one person punches his own card only.

(b) The terms of remuneration should be set and made known to the workers in very
very clear terms.

(c) Proper internal checks should be executed while preparing the wages sheets.
Cashier should not be allowed to handle the wages sheets and the person preparing
the sheets should not be allowed to prepare wage packets. Personnel officer/manager
should check and authorize the wages sheets.

(d) The wages should be paid to workers after they are properly identified. The wages
should not be paid to any other person, unless proper authorization letter is produced
in exceptional circumstances.

(e) Distribution of wages should be made in all the departments at a time so as to


avoid the possibility of one person being present at two places.

Labour Cost 271


(5) Existence of idle time should be properly analyzed according to controllability. The causes
of controllable idle time should be attempted to be avoided.

If it is necessary to work overtime, it should be properly authorized and should be paid


and accounted for properly. Care should be taken to see that proper returns are obtained
for making overtime wages payment.

(6) If the labour cost is higher due to spoilage of work which in turn may be due to lack of
proper supervision or inspection, it is a cost which can very will be controlled by having
proper supervision or inspection.

(7) The causes of labour turnover should be analysed according to normality. All the avoidable
causes of labour turnover should be paid proper attention. Higher trend of labour turnover
adds to the costs in two ways mainly. It reduces the labour productivity and at the same
time, increases the costs. If the workers have the grievances which are of avoidable
nature, say dissatisfaction with remuneration or other benefits or working hours or working
conditions or job itself or relations with the fellow workers or the supervisors, attempts
can be made to avoid those causes of labour turnover.

ILLUSTRATIVE PROBLEMS

(1) The standard hours for job X is 100 hours. The job can be completed by A in 60 hours, by
B in 70 hours and by C in 95 hours.

The bonus system applicable to the job is as follows :

% of time saved to time allowed Bonus

Saving upto 10% 10% of time saved

Saving from 11% to 20% 15% of time saved

Saving from 21% to 40% 20% of time saved

Saving from 41% to 100% 25% of time saved.

Rate of pay per hour is Rs.1 Calculate the total earnings of each worker and also the
rate of earnings per hour.

272 Management Accounting


Solution :

A B C
(1) Standard Hours 100 100 100
(2) Actual Hours 60 70 95
(3) Hours Saved 40 30 5
(4) % Hours saved 40% 30% 5%
(5) Applicable bonus rate
(% of wages for time saved) 20% 20% 10%
(6) Hourly Rate (Rs.) 1 1 1
(7) Basic wages (Rs.) - 2 x 6
i.e. Actual Hours x Hourly rate 60 70 95
(8) Wages for time saved (Rs.) - 3 x 6
i.e. Hours Saved x Hourly Rate 40 30 5
(9) Bonus (Rs.) - 8 x 5
i.e. Wages for time saved x Bonus Rate 8 6 0.5
(10) Total - (Rs.) 7+ 9 68 76 95.5

Note :

It is assumed that the amount of bonus is not decided on rates of bonus on cumulative basis.

(2) During one week X makes 200 units. He receives wages for a guaranteed 44 hours per
week at a rate of Rs. 1.50 per hour. Estimated time to produce one unit is 15 minutes.
Time allowed is increased by 20% allowance on estimated time, under incentive scheme.
Calculate earnings as per :

(i) Time rate

(ii) Piece rate

(iii) Rowan scheme

(iv) Halsey scheme

Solution :

(i) Time Rate :

No. of Hours X Hourly Rate

= 44 Hours x Rs. 1.50 = Rs. 66

Labour Cost 273


(ii) Piece Rate :

Hourly Rate
Units produced X
Units per hour

Rs. 1.50
= 200 units X = Rs. 75
4 units

(iii) Rowan Scheme :

Time Saved
Actual Hours X Hourly Rate + X Actual Hours X Hourly rate
Time Allowed

16 Hours
= 44 Hours x Rs. 1.50 + X 44 Hours X Rs. 1.50
60 Hrs

= Rs. 66 + Rs. 17.60

= Rs. 83.60

(iv) Halsey Scheme :

Actual Hours X Hourly Rate + 1/2 (Time Saved X Hourly Rate)

= 44 Hours X Rs. 1.50 + 1/2 (16 Hours X Rs. 1.50)

= Rs. 66 + Rs. 12

= Rs. 78

Working Notes :

For incentive scheme, time allowed is increased by 20% of estimated time

Estimated time is 15 minutes per unit

∴ For incentive scheme, time allowed will be -

15 minutes + 20% = 18 minutes

Time allowed for 200 units will be -

18 minutes
X 200 units = 60 Hours
60 minutes

Actual time taken is 44 Hours.

Hence, time saved will be 16 hours ( i.e. 60 hours - 44 hours)

274 Management Accounting


It is assumed that the allowance of 20% is available only in case of incentive systems
and not in case of time rate or piece rate systems.

(3) In a factory under bonus system, bonus hours are credited to the employee in the
proportion of time taken which time saved bears to time allowed. Jobs are carried forward
from one week to another. No overtime is worked and payment is made in full for all units
worked on, including those subsequently rejected. From the following information, you
are required to calculate for each employee.

(1) Bonus hours and amount of bonus earned.

(2) Total wages cost.

(3) Wage cost of each unit (good) produced.

Employee A B C
Basic wage rate per hour Rs. 5 Rs. 8 Rs. 7.5
Units issued for production 2,500 2,200 3,600
Time allowed for 100 units 2H 36M 3H 1H 30M
Time taken 52H 75H 48H
Rejections 100 units 40 units 400 units

Solution :

The description of the bonus system indicates that it is Rowan system of incentive payment.

A B C
(1) Time allowed for 100 units 156 min. 180 min. 90 min.
(2) Units issued for production 2,500 2,200 3,600
(3) Time allowed for actual production 65 hours 66 hours 54 hours
(4) Time taken 52 hours 75 hours 48 hours
(5) Time saved i.e. 3-4 13 hours - 6 hours
(6) Hourly basic wage rate (Rs.) 5 8 7.5
(7) Basic wages i.e. 4 x 6 (Rs.)
Time taken x Hourly rate 260 600 360
(8) Bonus earned : (Rs.)
Time Hourly Time saved
X X
taken rate Time allowed 52 - 40

(9) Total wages i.e. 7 + 8 (Rs.) 312 600 400

Labour Cost 275


A B C
(10) Rejections (units) 100 40 400

(11) Good units i.e. 2-10 2,400 2,160 3,200

(12) Wages per good unit i.e. 9/11 Re. 0.13 Re. 0.28 Re. 0.125

(4) From the following particular, you are required to work out the earnings of a worker under.

(a) Straight Piece Rate


(b) Differential Piece Rate
(c) Halsey Premium Scheme (50% Sharing)
(d) Rowan Premium Scheme

Weekly working hours - 48


Hourly wage rate - Rs. 7.50
Piece Rate per unit - Rs. 3.00
Normal time taken per piece - 20 minutes
Normal output per week - 120 pieces
Actual output for the week - 150 pieces
Differential piece rate - 80% of piece rate when output below normal and
120% of piece rate when output above normal.

Solution :

(a) Straight Piece Rate :

Actual output x piece rate per unit

= 150 pieces x Rs. 3

= Rs. 450

(b) Differential Piece Rate :

Actual output is more than normal output. Hence, piece rate will be 120% of normal
piece rate.

∴ Applicable piece rate 120% of Rs. 3 i.e. Rs. 3.60

∴ Wages = Actual output x Applicable piece rate per unit

= 150 piece x Rs.3.60

= Rs. 540

276 Management Accounting


(c) Halsey Premium Scheme :

(Time Saved x Hourly Rate)


Actual Hours X Hourly Rate +
2

2 hours X Rs. 7.50


= 48 hours X Rs. 7.50 +
2

= Rs. 360 + Rs. 15/2

= Rs. 367.50

(d) Rowan Premium Scheme :

Time Saved
Actual Hours x Hourly Rate + X Actual Hours X Hourly Rate
Time Allowed

2 hours
= 48 hours X Rs.7.5 + X 48 hours x Rs. 7.50
50 hours

= Rs. 360 + Rs. 14.40

= Rs. 374.40

Note :

Time saved is calculated as below :


Normal time per piece - 20 minutes
Pieces per hour - 3
Pieces produced - 150
Hours allowed for pieces produced - 50
i.e. 150/3
Actual hours taken - 48
Hours saved - 2

(5) In an engineering workshop, 15 persons work in a group. If the weekly production of the
group exceeds 120 units per hour (which is standard), each man gets a bonus in addition
to his hourly earnings.

Bonus regulation - Each worker’s share should be 1/2 of the percentage in excess of
standard production. The bonus shall be payable at this percentage of wage rate Rs.1.50
per hour. There is no relationship between individual workers’ hourly rate and bonus rate.

Labour Cost 277


The following is a weekly output :

Day Hours worked Output in units

Monday 150 24,700

Tuesday 160 25,500

Wednesday 145 17,060

Thursday 155 18,050

Friday 170 28,900

Saturday 160 21,150

940 1,35,360

Compute

a. The rate and amount of bonus for the week.

b. Total earnings of David who worked 40 hours during the week and his basic wage was
Rs. 1.20 per hour and that of Abdulla who worked for 48 hours and his basic wage was
Rs. 1.25 per hour.

Solution :

(a) Actual Production for the week 1,35,360 units

Standard production i.e. 940 x 120 1,12,800 units

Excess Production 22,560 units

22,560
Excess production percentage = X 100 = 20%
1,12,800

Bonus percentage for the group = 1/2 of 20%

= 10%

Bonus Rate : 10% of Rs. 1.50

= Re. 0.15 per hour

278 Management Accounting


(b) (1) Total Earnings of David :

Basic wages - 40 hours x Rs. 1.20 hours Rs. 48.00

Bonus - 40 hours x Re. 0.15/hour Rs. 6.00

Rs. 54.00

(2) Total Earnings of Abdulla :

Basic wages - 48 hours x Rs. 1.25/hour Rs. 60.00

Bonus - 48 hours x Rs. 0.15/hour Rs. 7.20

Rs. 67.20

(6) Two fitters, a labourer and a boy, undertake a job on piece rate basis for Rs. 1,290. The
time spent by each of them is 220 ordinary working hours. The rates of pay on time rate
basis are Rs. 1.50 per hour for each of the two fitters. Re. 1 per hour for the labourer and
Re. 0.50 per hour for the boy. Calculate :

(a) The amount of piece-work premium and the share of each worker, when the piece
work premium is divided proportionately to the wages paid.

(b) The selling price of the above job on the basis of following data - Cost of Direct
Materials is Rs. 2,010, works overhead at 20% of Prime Cost, selling overhead at
10% of works cost and Profit at 25% of cost of sales.

Solution :

(A) (1) wages payable on time basis

Fitter 220 hrs. x 2 x Rs. 1.50 = Rs. 660

Labourer 220 hrs. x Re. 1 = Rs. 220

Boy 220 hrs. x Re. 0.50 = Rs. 110

Basic Wages = Rs. 990

(2) Price of the job Rs. 1,290

(3) Premium received i.e. b - a Rs. 300

(4) Share of each worker -

Rs. 300
Fitters X Rs. 660 Rs. 200.00
Rs. 990

Labour Cost 279


Rs. 300
Labourer X Rs. 220 - Rs. 66.67
Rs. 990

Rs. 300
Boy X Rs. 110 - Rs. 33.33
Rs. 990

Rs. 300.00

(b) Fixation of selling price :

Cost of Direct Material Rs. 2,010.00


Cost of Labour Rs. 1,290.00

Prime Cost Rs. 3,300.00


Works Overheads
(20% of Prime Cost) Rs. 660.00

Works Cost Rs. 3,960.00


Selling Overheads
(10% of works cost) Rs. 396.00

Cost of Sales Rs. 4,356.00


Profit (25% on cost of sale) Rs. 1,089.00
Selling Price Rs. 5,445.00

(7) A worker, whose daily work wages is Rs. 2.50 an hour, received production bonus under
the Rowan scheme. He carried out the following works in a 48 hours week.

Job 1 - 1,500 items at 4 hours per 1000

Job 2 - 1,800 items at 3 hours per 1000

Job 3 - 9,000 items at 6 hours per 1000

Job 4 - 1,500 items for which no “Standard time” was fixed and it was arranged that
the worker would be paid a bonus of 25%. Actual time taken on the job was
4 hours.

Job 5 - 2,000 items at 8 hours per 1000, each item was estimated to be half finished.

Job No. 2 was carried out on a machine running at 90% efficiency and an extra allowance
of 1/9th of actual time was given to compensate the worker.

280 Management Accounting


4 hours were lost due to power cut. Calculate the earnings of the worker, clearly stating your
assumptions for the treatment given by you for the hours last due to power cut.

Solution :

(a) Calculation of time allowed

Job 1 - 6 hours
Job 2 - 6 hours
Job 3 - 54 hours
Job 4 - 5 hours
Job 5 - 8 hours

79 hours

(b) Time taken 44 hours


(Except idle time)

(c) Time saved 35 hours

(d) Total wages (As per Rowan system)

Time saved
Time taken X Hourly rate + X Time taken X Hourly Rate
Time allowed

35 hours
= 44 hours X Rs. 2.50 + X 44 hours X Rs. 2.50
79 hours

= Rs. 110 + Rs. 48.73

= Rs. 158.73

(e) Idle time wages (At hourly rate)

4 hours X Rs. 2.50

= Rs. 10

(f) Total earnings - i.e. d + e

Rs.158.73 + Rs. 10.00

= Rs.168.73

Labour Cost 281


Note :

(1) The idle time is not treated for computing time taken. For idle hours, the worker will get
the wages at normal hourly rate.

(2) Time allowed for Job 2, Job 4 and Job 5 is calculated as below :

(a) Job 2 :
Time taken for 1,800 units 5.40 hour
Add :Extra allowance 1/9 0.60 hour
Time allowed 0.60 hour

(b) Job 4 :
Time taken for 1500 units 4 hours
Add : Allowance @ 25 1 hour
Time allowed 5 hours

(c) Job 5 :
Time taken for 2000 16 hours
Each item half finished
∴ Equivalent finished units 1,000
∴ Time for equivalent finished units 8 hours

QUESTIONS

1. Explain the various steps in the process of identifying the direct labour cost with the
individual cost center.

2. What do you mean by idle time. Explain in details the cost accounting treatment of idle
time.

3. Explain the term “Labour Turnover”. What are the causes responsible for labour turnover?
Explain the costs of labour turnover. How the Labour turnover is measured?

282 Management Accounting


PROBLEMS

(1) During the first week of March, 1984 the workman Mr. Saurabh manufactured 300 articles.
He receives wage for a guaranteed 48 hours week at the rate of Rs. 4/- per hour. The
estimated time to produce one article is 10 minutes and under incentive scheme the
time allowed is increased by 20%. Calculate his gross wages according to :

(a) Piece work with guaranteed weekly wage.

(b) Rowan premium bonus and

(c) Halsey premium bonus 50% to workman.

(2) Calculate total monthly remuneration of three workers A, B and C from the following
data.

(a) Standard production per month per worker 1,000 units.

(b) Actual production during the month


A - 850 units, B - 750 units, C - 950 units.

(c) Piece rate is Re. 0.10 per unit.

(d) Additional production bonus is Rs. 10 for each percentage of actual production
exceeding 80% over standard.
(Example 79% Nil, 80% - Rs. 10, 81% - Rs. 20 and so on)

(e) Dearness allowance fixed Rs. 60 per month.

(3) Following are the particulars as regards a worker who worked on jobs No. 122 and 133.

Job No. Time allowed Time taken


122 26 hours 20 hours
133 26 hours 30 hours

His normal and basic rate of wages was Rs. 28 per day of 8 hours and the dearness
allowance was Rs. 42 per week of 48 hours.

Calculate the amount payable to him by showing your workings on the following basis.

(a) Time basis.

(b) Halsey Incentive Plan basis (Bonus at 50% of time saved)

(c) Rowan Incentive Plan basis.

Labour Cost 283


(4) Standard time fixed for a job is 40 hours and time rate is Rs. 4 per hour. You are required
to prepare a comparative table under Halsey Plan 50 - 50 and Rowan Plan, if actual time
taken is 36 hours, 32 hours, 24 hours, 16 hours and 12 hours.

The table should clearly show (a) Bonus payable, (b) Total earnings, (c) Effective rate of
earnings per hour.

(5) Calculate the earnings of a workman under Halsey Premium Plan and Rowan Premium
Plan for executing a piece of work in 60 hours as against 75 hours allowed. His hourly
rate is 25 paise and under Halsey system, he is to be paid bonus at 50% of time saved.
In addition, he gets a dearness allowance for Re. 1 per day of 8 hours worked.

(6) From the following information, calculate the earnings of A, B and C under Halsey and
Rowan premium bonus plans.

A B C
Standard time in hours per 100 units 35 40 42
Wages per unit of output Rs. 2 Rs. 3 Rs. 4
Wage rate per hour Rs. 7 Rs. 8 Rs. 10
Actual hours taken 50 48 46
Actual no. of units produced 200 150 125

(7) The firm employs 5 workers at an hourly rate of Rs. 2.00. During the week they worked
for 4 days for a total period of 40 hours each and completed a job for which standard time
was 48 hours for each worker.

Calculate the labour cost under the Halsey Method and Rowan Method of incentive Plan
Payments.

(8) Compute the total time wages and total earnings of a worker, the rate earned per hour
and the bonus per hour in respect of three workers X,Y, and Z under the Halsey-Weir
bonus plans. The following are the particulars supplied.

Standard Time : 20 hours.


Hourly Rate of Wages : Re. 1.00 per hour.
Time Taken X = 16 hours, Y = 12 hours and Z = 10 hours.

284 Management Accounting


(9) The three workers Govind, Ram and Shyam produced 80, 100 and 120 pieces of a
product X on a particular day in May 1987 in a factory. The time allowed for 10 units of
Product X is 1 hour and their hourly rate is Rs. 4. Calculate for each of these three
workers the following :

(a) Earnings for the day

(b) Effective rate of earnings per hour under

(i) Straight piece Rate

(ii) Halsey Premium Bonus (50% sharing)

(iii) Rowan Premium Bonus methods of Labour Remuneration

(10) A worker takes 6 hours to complete a job under a scheme of payment by results. The
standard time allowed for the job is 9 hours. His wage rate is Rs. 1.50 per hour. Material
cost of the job is Rs. 16 and the overheads are recovered at 150% of the total direct
wages. Calculate the factory cost of the job under - (a) Rowan and (b) Halsey scheme of
incentive payments.

(11) In an engineering concern, the employees are paid incentive bonus in addition to their
normal wages at hourly rates. Incentive bonus is calculated in proportion of time taken to
time allowed, of the time saved. The following details are made available in respect of
employees X, Y and Z for a particular week.

X Y Z

Normal Wages (Rs. per hour) 4.00 5.00 6.00

Completed units of production 6000 3000 4800

Time Allowed (per 100 units) 0.8 hr. 1.5 hrs. 1 hr.

Actual time taken (hours) 42 40 48

You are required to work out for each employee

(a) The amount of bonus earned.

(b) The total amount of wages received.

(c) The total wages cost per 100 units of output.

Labour Cost 285


(12) A workman whose basic rate of pay under Rowan plan of premium bonus is Rs. 2 per
hour. In addition, he receives a cost of living bonus of Rs. 33 per week of 66 hours on
actual hours worked. During a week, he does the following jobs.

(i) Job A for which 30 hours are allowed in 20 hours.

(ii) Job B for which 36 hours are allowed in 20 hours.

During this week, his waiting time was 4 hours.

Calculate his earnings and amount to be charged to each job.

(13) An operator engaged on a machine, receives an ordinary day rate of Rs. 1.60 per day of
8 hours. The standard output has been fixed at 80 pieces per hour (time as fixed for
premium bonus.) On a certain day, the output of a worker on this machine is 800 pieces.
Find the labour cost per 100 pieces and the wages that should have been actually
earned by the workman under the following -

(a) If a bonus of Re. 0.23 is paid per 100 of extra output.

(b) If paid on straight piece work basis at the standard rate.

(c) If Halsey Premium System is adopted.

(14) In a manufacturing concern, 20 workmen work in a group. The concern follows a group
incentive bonus system whereby each workman belonging to the group is paid a bonus
on the excess output over the hourly production standard of 250 pieces, in addition to his
normal wages at hourly rate. The excess of production over the standard is expressed
as a percentage and two thirds of this percentage is considered to be the share of the
workman and is applied to the normal hourly rate of Rs. 6.00 (Considered only for purpose
of computation of bonus.) The output data for a week are stated below.

Days Manhours worked Output (in pieces)


Monday 160 48,000
Tuesday 172 53,000
Wednesday 164 40,000
Thursday 168 52,000
Friday 160 46,000
Saturday 160 42,000

984 2,81,000

286 Management Accounting


You are required to -

(a) Work out the amount of bonus for the week and the average rate of which each workman
is to be paid the same.

(b) Compute the total wages including bonus payable to Ram Jadhav who worked for 48
hours at an hourly rate of Rs. 2.50 and to Francis Williams who worked for 52 hours at an
hourly rate of Rs. 3.00.

(15) Following data for the month of October 1990 is available for a company.

No. of workers on payroll on 1st October, 90 - 1450

No. of workers on payroll on 31st October 90 - 1550

During the month 10 workers left the company, 70 persons were discharged and 200
workers were recruited. Of these workers, 40 workers were recruited in the vacancies of
those who had left and the remaining were recruited for an expansion programme.

Calculate the labour turnover rate by using -


(i) Separation Method
(ii) Replacement Method
(iii) Flux Melhod

Labour Cost 287


NOTES

288 Management Accounting


Chapter 10
OVERHEAD COST

It has already been discussed that the term cost can be basically classified as Direct Cost
and Indirect Cost. Direct Cost indicates all those costs which can be identified with the
individual cost centre and indirect cost indicates all those costs which cannot be identified
with the individual cost centre. The total of indirect costs are termed as overheads.

There may be various ways in which the overheads may be classified.

(1) Elementwise Classification :

As the cost can be basically classified as per the Elements of Cost i.e. Material Cost,
Labour Cost and Expenses, the indirect cost i.e. overheads may be classified as per the
elements of cost. This classification of overheads takes the form of :
(a) Indirect Material
(b) Indirect Labour
(c) Indirect Expenses.

The meaning and the type of expenses included in this classification have already been
discussed in the chapter on Cost Sheet.

(2) Functionwise Classification :


Under this classification, the overheads are classified according to the functions they
perform. This classification of overheads takes the form of :
(a) Factory Overheads (also termed as production or works or manufacturing overheads)
(b) Administration Overheads.
(c) Selling and Distribution Overheads.The meaning and the type of expenses included
in this classification have already been discussed in the chapter on Cost Sheet.

(3) Variabilitywise Classification :

(i) Fixed overheads : These overheads indicate the costs which remain unaffected
by variations in volume of output. E.g. Rent, Insurance on building, salary to

Overhead Cost 289


administrative staff etc. Per unit cost of overheads may reduce as the volume of
output increases but the total overheads remain constant.

(ii) Variable overheads : These overheads indicate the costs which vary directly in
proportion to volume of output. E.g. Consumable stores, nuts/bolts, loose tools
etc. Per unit cost of overheads remains the same but total overheads may increase
or decrease as per volume of output.

(iii) Semi-variable overheads : These overheads indicate those which are neither
fixed nor variable in nature. These may remain fixed at certain levels of activity while
may vary proportionately at other levels of activity. E.g. maintenance cost, power,
electricity, supervision cost etc.

(4) Controllabilitywise Classification :

Under this classification, the overheads are classified according to their controllable
nature. This classification takes the form of :

(a) Controllable overheads.


(b) Uncontrollable overheads.This classification has already been discussed.

(5) Normalitywise Classification :

Under this classification, the overheads are classified according to the fact as to whether
the overheads are normally incurred at a certain level of output under normal circumstances.
This classification takes the form of :

(a) Normal overheads.


(b) Abnormal overheads.
This classification has already been discussed.

It should be noted in this connection, that the above classification refers to the classification
of same amount of overheads in different forms to suit the individual requirements. E.g. For the
purpose of preparing the cost statement, overheads may be classified according to functions
while for the purpose of marginal costing applications, overheads may be classified according
to variability.

Procedure for Charging the Overheads :

The basic aim of costing is to find out the cost of each cost centre. The cost of each cost
centre can be either the direct cost or the indirect cost. The direct cost can be identified with
the individual cost centre and hence poses no difficulties. To charge the indirect costs i.e.
overheads to the individual cost centres is the major problem. For this, the following procedure
may be followed.

290 Management Accounting


(A) Allocation/Primary Apportionment :

There can be some overheads which are incurred for the company as a whole, i.e. for all the
departments. i.e. Production as well as Service departments. To identify the common costs
with the individual departments is the first stage problem. This can be solved in two ways.

(1) If at all it is possible to identify some overheads with the individual departments they
should be identified by following the procedure of allocation of overheads.

E.g. Wages paid to the maintenance department workers can be obtained from wages
sheet and can be allocated to maintenance department. Similarly, cost of indirect material
can be allocated to individual departments by pricing material requisition slips.

(2) It may not be possible in all the cases to allocate the overheads, i.e. in case of common
expenses for the entire factory. In this case, they can be apportioned among the various
departments on some suitable basis, i.e. to all production as well as service departments.
This process is in the form of Primary apportionment or distribution of overheads.
The selection of the base on which overheads are or should be apportioned depends on
the following principles :

(a) Service or use basis : If the benefit obtained by various departments from the
overheads can be measured, overheads can be apportioned on that basis.

(b) Survey basis : If amount of services rendered can’t be measured, survey basis
may be applied. E.g. If it can be noted that a supervisor is giving 60% of his services
to department ‘A’ and 40 % to department ‘B’, his wages can be apportioned on
that basis.

(c) Ability to pay basis : In this case, the apportionment may depend upon the factors
like total sales/profitability. It may not be fair in some cases as most efficient
departments may have to bear higher amounts of overheads, though actual overheads
of that department may be lower than those of other departments.

The usual bases which can be selected for Primary Apportionment may be as below :

Item of expenditure Base


(1) Canteen expenses/Staff Supervision Number of workers.
(2) Rent/Taxes Area
(3) Power HP/KWh
(4) General Lighting Number of light points/area
(5) Depreciation Value of assets
(6) Supervision Number of Employees/wages paid

Overhead Cost 291


(7) Telephone expenses Number of telephone calls made
(8) Fire Insurance. Value of stocks held/value of Assets.

Illustration :

The Omega Co, is having four departments. A, B, and C are production departments and D is
a servicing department. The actual costs for a period are as follows.
Rs.
Rent 2,000
Repairs 1,200
Depreciation 900
Light 200
Supervision 3,000
Insurance 1,000
Employees Insurance (Employer’s liability) 300
Power 1,800

The following data are also available in respect of departments.

Dept. A Dept. B Dept. C Dept. D

Area sq. ft. 150 110 90 50


Number of workers 24 16 12 8
Total wages (Rs.) 8,000 6,000 4,000 2,000
Value of plant (Rs.) 24,000 18,000 12,000 6,000
Value of stock (Rs.) 15,000 9,000 6,000 –

Apportion the cost to the various departments on the most equitable method.

292 Management Accounting


Solution :

Apportionment of Overheads

Particulars Base Total Dept. Dept. Dept. Dept.


Rs. A B C D
Rs. Rs. Rs. Rs.

Rent Area sq. ft. 2,000 750 550 450 250


Repairs Total wages 1,200 480 360 240 120
Depreciation Value of Plant 900 360 270 180 90
Light Area – sq. ft. 200 75 55 45 25
Supervision No. of workers 3,000 1,200 800 600 400
Insurance Value of stock 1,000 500 300 200 -
Employees’ Insurance
(Employer’s Liabilities) No. of workers 300 120 80 60 40
Power Value of Plant 1,800 720 540 360 180

10,400 4,205 2,955 2,135 1,105

Notes :

It is assumed that the insurance is payable only on stock. Had it been assumed that it is
payable on stock as well as plant, the base would have been the combined value of stock and
plant.

For the apportionment of power cost, Kwh/HP rating would have been an ideal base. As
relevant data is not available, it is apportioned on the basis of value of plant.

Repairs are apportioned on the basis of total wages assuming that repair charges consist of
mainly labour charges.

(3) Secondary Apportionment :

With the process of primary apportionment or distribution, the loading of overheads for all
the departments i.e. production as well as service departments can be obtained. Next
step is to transfer the overheads of non-production departments to production departments,
as the various cost centres move through the production departments only. This is in the
form of ‘Secondary apportionment or distribution of overheads’.

Overhead Cost 293


The usual bases which can be selected for the secondary apportionment may be as
below :
(1) Maintenance Dept. - Number of hours worked.
(2) Stores Dept. - Number of requisitions.
(3) Purchase Dept. - Number of Purchase orders
(4) Building Service Dept. - Area
(5) Welfare/ Canteen and other facilities - Number of employees.
(6) Personnel or Time keeping Dept. - Number of employees.
(7) Internal Transport - Weight/value of goods moved.

While apportioning the overheads of non-production departments to production


departments, the problem will be there if non-production departments are rendering the
services inter-se.

There can be two ways to handle the situation like this -

(A) Ignore the services given by one service department to another. The defects involved with
this method are very obvious.

Illustration :

Following figures are extracted from the accounts of M/s. Vasant Works for the month of
July 1983.

Production Depts. Service Depts.


P1 P2 S1 S2 S3

Indirect Material 280 140 170 350 160


Indirect Wages 324 312 296 190 218
Power and Light Rs. 3,000
Supervision Charges Rs. 2,200
Rent and Taxes Rs. 500
Insurance on assets Rs. 60

Depreciation at 12% p.a. on capital value of assets to be considered. From the above information
and the following departmental data, prepare overhead recovery rates for the production
departments PI and P2 on the basis of direct labour hours. The expenses of service departments
should be apportioned straight to the production depts. with the information that SI is tool
room, S2 is maintenance dept. and S3 is stores dept.

294 Management Accounting


Departmental Data : P1 P2 S1 S2 S3

Area (sq. ft.) 400 200 100 200 100


Capital Value of Assets (Ps.) 8000 4000 7000 5000 6000
Kilowatt Hours 4000 3000 1000 1000 1000
Number of employees 150 100 75 100 125
Direct Labour Hours 5000 5000
Number of requisitions 1000 300

Solution :

Statement showing apportionment of overheads

Items Base P1 P2 S1 S2 S3
Rs. Rs. Rs. Rs. Rs.

Indirect Material Allocation 280 140 170 350 160


Indirect wages Allocation 324 312 296 190 218
Power & Light Kilowatt Hrs 1200 900 300 300 300
Supervision No. of employees 600 400 300 400 500
Rent & Taxes Area 200 100 50 100 50
Insurance on Assets Value of assets 16 8 14 10 12
Depreciation Value of assets 80 40 70 50 60

2700 1900 1200 1400 1300

Dept. S1 Labour Hours 600 600 (-)1200


Dept. S2 Labour Hours 700 700 (-)1400
Dept. S3 No. of requisitions 1000 300 (-)1300

5,000 3,500

(B) If it is decided to consider the services rendered by one service department to another,
the first problem will be to decide the percentage in which services are given by service
departments inter-se. After such percentage is decided, the secondary apportionment
can be made by either of the following methods.

(i) Simultaneous Equation Method : Under this method the amount of overheads of
each production department can be obtained by solving simultaneous equations.

Overhead Cost 295


(ii) Repeated Distribution Method : Under this method service dept. overheads are
distributed to other departments, production as well as service, on agreed percentage
and this process is repeated till the figures of service departments are exhausted or
are too small to consider further apportionment.

Illustration :

A company has 3 production depts. and 2 service depts. and for a period departmental
distribution summary has the following totals.
Production Depts. A ..Rs. 800 B Rs. 700 C. Rs. 500
Service Depts. 1 ....Rs. 234 2.. Rs. 300

The expenses of service depts. are charged out on a percentage basis as :


A B C 1 2
Service Dept. 1 20% 40% 30% - 10%
Service Dept. 2 40% 20% 20% 20%

You are required to show the apportionment of overheads.

Solution :

(a) Simultaneous Equation Method :

Let x = total overheads of Dept. 1


y = total overheads of Dept. 2
∴ x = 234+ 2/10 y
and y = 300 1/10 x
∴ 10 x = 2340 + 2y ...(1)
and 10 y = 3000 + x ...(2)
Rearranging equation 2 and multiplying equation I by 5
– 10y = 11700 - 50x
10y = 3000 + x
Adding 0 = 14700 – 49x
∴ 49 x = 14700
∴ x = 300 ...(3)
However, Y = 300 + 1/10 x
Y = 300 + 1/10 x 300
Y = 330 ...(4)

296 Management Accounting


Total overheads can be apportioned on the basis of agreed percentages to production
departments as below.

Total Dept. A Dept. B Dept. C


Rs. Rs. Rs. Rs.

As per Primary appointment 2,000 800 700 500


Dept. 1 (90% of Rs. 300) 270 60 120 90
Dept. 2 (80% of Rs. 330) 264 132 66 66
2534 992 886 656

(b) Repeated Distribution Method :

Dept. A Dept. B Dept. C Dept. 1 Dept. 2


Rs. Rs. Rs. Rs. Rs.

As per Primary appointment 800 700 500 234 300


Dept. 1 47 94 70 (-) 234 23
Dept. 2 129 65 64 65 (-) 323
Dept. 1 13 26 20 (-) 65 6
Dept. 2 3 1 2 - (-) 6

992 886 656 - -

(3) Absorption :

The process of secondary apportionment of overheads, ensures the loading of overheads


to production departments. Now the next stage is that each job or product should get the
loading of the overheads while it is moving through the production department and this
process is in the form of Absorption or Recovery of overheads. There can be a number of
methods for absorbing the overheads but the ultimate selection of method has to be
made after considering various factors like type of industry, nature of products,
manufacturing process, requirements and policy of management, cost of operating the
system etc.

The various methods which can be considered for deciding the rates of overhead absorption
are as below :

(1) Direct Materials Cost Percentage Rate :

This is calculated as :

Amount of overheads to be absorbed


X 100
Direct Materials cost

Overhead Cost 297


E.g. If production overheads to be absorbed are Rs. 25,000/-

and Direct materials cost is Rs. 50,000, the absorption rate will be :

25,000
X 100 i.e. 50%
50,000

Now if the direct materials cost of a job is Rs. 500, it will be getting the loading of
overheads to the extent of 50% of direct materials cost, i.e. Rs. 250. This method is
useful if materials cost forms a major part of production cost and is normally used if
materials costs are stable and equipments used remain unchanged.

This method leads to unsatisfactory results due to following reasons.

(i) There can be some situations where material prices vary without any change in the
amount of over heads, in which case, this method may show wrong results.

(ii) If this method is used, a job using expensive material may get high loading of
overheads as compared to a job using cheap material, which may not be fair.

(2) Direct Wages Percentage Rate :

This is calculated as :

Amount of overheads to be absorbed


X 100
Direct wages cost

E.g. If the production overheads to be absorbed are Rs. 10,000 and direct wages cost is
Rs. 40,000, the absorption rate will be :

10,000
X 100 i.e. 25%
40,000

Now if the direct wages cost of a job is Rs. 400, it will be getting the loading of overheads
to the extent of 25% of direct wages cost, i.e. Rs. 100. This method is useful if labour
cost forms a major part of production cost and also if the work performed by all the
workers is uniform, ratio of skilled and unskilled workers is constant and labour rates do
not fluctuate widely.

The problem with this method is that there is very little relationship between direct wages
and overhead expenses. It may give wrong results if the workers vary in ability.

298 Management Accounting


(3) Prime Cost Percentage Rate :

This is calculated as :

Amount of overheads to be absorbed


X 100
Prime Cost

E.g. if the production overheads to be absorbed are Rs. 16,000 and prime cost is
Rs. 80,000, the absorption rate will be :

16,000
X 100 i.e. 20%
80,000

Now if the prime cost of a job is Rs. 250, it will be getting the loading of overheads to the
extent of 20% of prime cost, i.e. Rs. 50.

This method is useful in this sense that it considers both the materials cost as well as
labour cost.

(4) Labour Hour Rate :

This is calculated as :

Amount of overheads to be absorbed


Labour hours required for production.

E.g. if production overheads to be absorbed are Rs. 50,000 and labour hours worked are
100,000, the absorption rate will be :

Rs. 50,000
i.e. Re. 0.50 per labour hour.
100,000

Now, if a job requires 20 labour hours to complete it, the loading of overheads to the
same will be Re. 0.50 per labour hour i.e. Rs. 10/-.

This method is useful if labour is the most important element of cost.

However, additional records are required to be kept for time booking per job. Further, if
machinery forms a dominant portion in production cost, this method may lead to wrong
results.

Overhead Cost 299


(5) Machine Hour Rate :

This is calculated as :

Amount of overheads to be absorbed


Number of Machine Hours

E.g. if production overheads to be absorbed are Rs. 20,000 and machine hours worked
as 5000, the absorption rate will be

Rs, 20,000
i. e. Rs. 4 per machine hour.
5,000

Now if a job requires 25 machine hours to complete, the loading of overheads to the same will
be Rs. 4 per machine hour, i.e. Rs. 100.

If the machine use accounts for a large element of cost in the overall production cost, then this
method can be used conveniently. This rate can be considered to be useful and ideal especially
in the days of high mechanisation and automation.

While computing the machine hour rate, it is necessary to consider the various overheads
required to be incurred for running a machine or group of machines treating the same as
distinct cost centres.

Illustration :

Following information relates to activities of a production dept. of a factory for a certain period.

Direct Materials used Rs. 4,000


Direct wages Rs. 6,000
Direct Labour hours worked
(Including 20,000 hrs. of Machine operations) 24,000
Overheads chargeable to the dept. Rs. 5,000
For order No. 156 carried out in dept. relevant figures were.
Direct Materials used Rs. 200
Direct wages Rs. 165
Direct labour hours
(Including 800 machine hours) 820

Calculate the overheads chargeable to Order No. 156 by 5 cost rates.

300 Management Accounting


Solution :

Calculation of overhead absorption rate

(a) Direct Material Cost percentage :


Amount of overheads
X 100
Direct Material Cost
Rs. 5,000
= X 100 = 125%
Rs. 4,000
(b) Direct Labour Cost percentage :
Amount of overheads
X 100
Direct Labour Cost
Rs. 5,000
= X 100 = 83 1/3%
Rs. 6,000
(c) Prime Cost percentage :
Amount of overheads
X 100
Prime Cost
Rs. 5,000
= X 100 = 50%
Rs. 10,000
(d) Labour Hour Rate :
Amount of overheads
Direct Labour Hours
Rs. 5,000
= = Re. 0. 2083 / Labour Hour.
24,000
(e) Machine Hour Rate
Amount of overheads
Machine Hours
Rs. 5,000
= = Rs 0.25 / Machine Hour.
20,000

Overhead Cost 301


The overheads chargeable to Order No. 156 and the total cost of the same can be calculated
as below :

Material Labour Overheads Total


Rs. Rs. Rs. Rs.

(a) Direct Material


Cost percentage 200.00 165.00 250.00 615.00
(b) Direct Labour
Cost percentage 200.00 165.00 137.50 502.50
(c) Prime Cost percentage 200.00 165.00 182.50 547.50
(d) Labour Hour Rate 200.00 165.00 170.83 535.83
(e) Machine Hour Rate 200.00 165.00 200.00 565.00

Illustration :

Compute the machine hour rate from the following data.

Cost of the machine Rs. 1,00,000


Installation charges Rs. 10,000
Estimated scrap value after the expiry of life (15 years) Rs. 5,000
Rent and Rates for the shop per month Rs. 200
General lighting for the shop per month Rs. 300
Insurance charges for the machine per annum Rs. 960
Repairs and Maintenance expenses per month Rs. 1,000
Power consumption 10 Units per hour.
Estimated working hours per annum 2,200
(This includes setting up time of 200 hours)
Rate of power per 100 Units Rs. 20
Shop supervisor’s salary per month Rs. 600

The machine occupies 1/4 of the total area of the shop. The supervisor is expected to devote
1/5 of the total time for the supervision of the machine.

302 Management Accounting


Calculation of Machine Hour Rate :

(a) Standing Charges Rs.

Depreciation 7,000.00
Rent and Rates 600.00
General lighting 900.00
Insurance Charges 960.00
Repairs and Maintenance 12,000.00
Shop Supervisor’s salary 1,440.00
Annual standing charges 22,900.00
Annual Machine Hours (Excluding setting up time) 2000
Hourly standing charges Rs. 11.45

(b) Running charges :


Power Expenses
Rate of power 20 paise per unit.
Power consumption - 10 units per hour.
Hourly power expenses Rs. 2.00

(c) Machine Hour Rate i.e. a + b Rs. 13.45

Working Notes :

(1) It is assumed that during the setting up time, the machine will not be used for the
intended purpose and hence the said time is ignored for the calculation of machine hour
rate.

(2) It is assumed that the depreciation is charged on straight-line basis.

Hence, it is calculated as :

Cost of Machine + Installation charges – Estimated scrap value


Estimated life of machine

Rs. 100,000 + Rs. 10,000 – Rs 5000


= = Rs. 7,000 p.a.
15 years

(3) It is assumed that the Repairs and Maintenance expenses are incurred only for the
machine.

Overhead Cost 303


Actual V/s. Predetermined Overhead Absorption Rates

The overhead absorption rates can be considered on actual basis or predetermined basis. For
computing the absorption rates on actual basis, the actual data for the previous period is
considered, i. e. Actual overheads, actual direct materials/wages cost, actual prime cost,
actual labour hours worked, actual machine hours worked etc. However, the actual overhead
absorption rates have certain limitations.

(1) The actual details are available only after the end of actual accounting period and required
details may not be available either for proper control of overheads or for price fixation.

(2) If the production is of seasonal nature, overhead absorption rates will not be constant
monthwise and comparison of production costs monthwise will be difficult.

As such, it is customary to consider predetermined overheads absorption rates instead of


actual overhead absorption rates. By predetermined rates it is meant that instead of considering
actual data in respect of Direct Materials/Wages/Prime Cost or Labour/Machine Hours,
estimations are made in respect of the same and predetermined overhead absorption rate is
applied whenever computations are to be made in respect of product cost of a job.

Under Absorption or Over Absorption of Overheads

If the organization follows the policy of considering predetermined overhead absorption rates,
it may face the problem of under or over absorption of overheads if the actual overheads to be
absorbed or the bases for the absorption, i.e. Materials/ Wages/ Prime cost or Labour/Machine
Hours etc. vary from the assumption. E.g. A Company considers the overhead absorption rate
as a direct materials cost percentage rate. It is decided that predetermined overhead absorption
rate should be considered for the forthcoming year 1989. As such, the predetermined overhead
rate was estimated on the basis of following details.

Estimated amount of overheads


i.e. X 100
Estimated Direct Materials cost

i.e. Rs. 10,000


X 100 i.e. 20%
Rs. 50,000

Now, on this basis all the jobs moving through that department during 1989 will be getting the
loading of overheads @ 20% of Direct Materials Costs.

After the year 1989 ended, the actual details are computed and it is found out that whereas
Direct Materials cost was as estimated, i.e. Rs. 50,000, the actual amount of overheads was
reduced to Rs. 9,000. As such, the rate at which the overheads should have been absorbed,
should have been

304 Management Accounting


Rs. 9,000
X 100, i.e. 18% and not 20% as originally considered
Rs. 50,000

Such situation gives rise to the under absorption or over absorption of overheads.

The situation of under absorption arises if the overheads absorbed are less than the actual
overheads. The situation of over absorption arises if the overheads absorbed are more than the
actual overheads.

E.g. Overheads Actual Remarks


Period Absorbed Overheads
Rs. Rs.

I 7,500 9,000 Underabsorption

II 10,000 8,000 Overabsorption.

Causes :

Under absorption of overheads may take place due to the reasons like.
– Actual overheads being more than the estimated overheads or
– Actual output or hours worked being less than those as estimated.
Over absorption of overheads may take place due to the reasons like
– Actual overheads being less than the estimated overheads OR
– Actual output or hours worked being more than those as estimated.

Treatment of Under or Over Absorbed Overheads :

The overheads which are under or over absorbed may be treated in either of the following
ways –

(1) Use of supplementary rate : If the amount of under or over absorbed overheads is
considerably significant, the cost of the cost centres may be adjusted by means of the
use of supplementary overhead absorption rate. This method of treating the over or under
absorption of overheads is most important where the cost is considered as a base for
quoting selling prices, E.g. Cost plus contracts.

E.g. The predetermined overhead absorption rate, for the forthcoming period of months,
was decided as below.

Amount of overheads Rs. 50,000


= = Rs. 2 / Labour Hour.
Total labour Hours 25,000

Overhead Cost 305


A mid term review of 6 monthly operations revealed that whereas the total labour hours
during the period were 12,500, the amount of overheads incurred was Rs. 30,000. The
overheads actually absorbed will be 12,500 hours x Rs. 2 i.e. Rs. 25,000. Considering
the same trend of amount of overheads, the total annual overheads are likely to be
Rs. 60,000, out of which Rs. 25,000 are already absorbed. As such, for the remaining 6
months, the overhead absorption rate may be calculated as :

Revised amount of overheads


Number of Labour Hours
Rs. 60,000 – Rs. 25,000
=
12,500
Rs. 35,000
= = Rs. 2.80 / Labour Hour.
12,500

(2) Carrying over to remaining period : In case of seasonal types of organization, the
overheads under or over absorbed during a certain period may be carried over to the
remaining part of the accounting period with the hope that they may be compensated
during the remaining period of time.

(3) Writing off to Costing Profit and Loss Account : In case of the under or over absorption
of the overheads arising out of the abnormal circumstances, they are written off to Costing
Profit and Loss Account.

Illustration :

The budgeted working conditions of a cost centre are as follows :

Normal working per week - 42 hours


No. of machines - 14
Normal weekly loss of hours on maintenance etc. - 5 hours per machine
No. of weeks worked per year - 48
Estimated annual overheads - Rs. 1,24,320
Estimated direct wage rate - Rs. 4 per hour.
Actual result in respect of a 4 week period are :
Wages incurred - Rs. 9,000
Overheads incurred - Rs. 10,200
Machine hours produced - 2,000

306 Management Accounting


You are required to calculate :
(a) The overhead rate per machine hour
(b) The amount of under or overabsorption of wages and overheads.

Solution :

(a) Normal working hours per year – 42 weekly hours per machine
(For all 14 machines) x 14 machines x 48 weeks
= 28,224 machine hours.
(b) Hours lost on maintenance – 5 hours per week x 14 machines
x 48 weeks = 3,360 machine
hours.
(c) Effective machine hours i.e., a - b – 24,864 machine hours.
(d) Estimated annual overheads – Rs. 1,24,320
(e) Machine hour rate i.e., d / c – Rs. 5
(f) Overheads absorbed – 2000 machine hours x Rs. 5
– = Rs. 10,000
(g) Overheads actually incurred – Rs. 10,200
(h) Overheads underabsorbed
i.e., g - f – Rs. 200

WAGES

(a) Labour hours for 4 weeks – 42 hours x 4 week = 168 hours


(b) For 14 machines – 168 hours x 14 machines
= 2,352 hours
(c) Estimated direct wage rate – Rs. 4 per hour
(d) Estimated direct wages for4 weeks i.e., b x c – Rs. 9,408
(e) Wages actually incurred – Rs. 9,000
(f) Wages overabsorbed
i.e., d-e – Rs. 408

Control Over Overheads :

As the basic intention of cost accounting is to exercise the control over the costs and as the
overheads is a part of cost, cost accounting procedures attempt to control the overheads also.
For this purpose, the following propositions should be remembered :

(1) The success of procedures to control the overheads largely depends upon the correct
classification of the overheads. This classification can be done from the various angles.

Overhead Cost 307


(a) Functionwise : This takes the form of classification in the form of factory overheads,
administration overheads and selling and distribution overheads.

(b) Variabilitywise : This takes the form of classification in the form of fixed overheads,
variable overheads and semi-fixed or semi – variable overheads.

(c) Normalitywise : This takes the form of classification in the form of normal overheads
and abnormal overheads.

Fixed overheads normally arise as a result of policy and are largely uncontrollable at the lower
level of management. They can be controlled at the top level of management. However, the
variable overheads can be controlled at the lower or middle level of management as well.

Most of the administration overheads are fixed in nature and can be controlled mainly at top
management level. However, the factory overheads can be controlled at lower or middle
management level also.

(2) After the correct classification of overheads, use may be made of following two techniques
with the intention to exercise proper control over overheads.
(a) Budgetary control
(b) Standard costing

Both these techniques are discussed in details in the following chapters.

However, both these techniques necessarily involve the following stages in the process
of implementation.

(i) Planning : This lays down the course of action to be taken in future.

In case of budgetary control, it is in the form of the budgets and in case of standard
costing, it is in the form of the standard cost.

(ii) Implementation of plan : This indicates actual steps to execute the plan. For this,
downward communication may be necessary from top management level to lower
management level.

(iii) Measuring actual performance, comparison with plans and computing


variances : Measurement of actual performance may be in terms of actual costs or
actual output. Actual costs and actual output is compared with the planned performance
and variations, if any are calculated.

(iv) Analysis of variances and decision making : Variations between actual performance
and planned performance is required to be analysed as to the causes and proper corrective
actions are required to be taken to remove unfavourable variations or maintain favourable
variations.

308 Management Accounting


(3) Classification of overheads as fixed and variable, facilitates the preparation of flexible
budgets which provides proper base for comparison in the form of budgeted overheads
for any level of activity actually attained. Flexible budgets may be treated as an improved
method to control the overheads.

ILLUSTRATIVE PROBLEMS

(1) Meera Industries Limited is a single product organization having a manufacturing capacity
of 6,000 units per week of 48 hours. The output data vis-a-vis different elements of cost
for three consecutive weeks are given below :

Units Direct Direct Total factory overheads


Produced Material Labour (Variable and Fixed)
Rs. Rs. Rs.

2,400 4,800 6,000 37,200


2,800 5,600 7,000 38,400
3,600 7,200 9,000 40,800

As a cost Accountant, you are asked by the company to work out the selling price assuming
level of 4,000 units per week and a profit of 20% on selling price.

Solution :

It can be observed that an increase in production by 400 units increases the total factory
overheads by Rs. 1,200 indicating that per unit variable overheads are Rs. 3. Hence, at the
activity level of 2,400 units, the total variable overheads are Rs. 7,200 i.e. 2400 units x Rs.3
per unit, out of total overheads of Rs. 37,200. Hence, the balance amount represents fixed
overheads. It should be noted that the direct material cost and direct labour cost represents
the variable cost of production. At 2,400 units, per unit cost is as below :

Direct material - Rs. 4800 / 2400 units = Rs. 2 / per unit.

Direct Labour - Rs. 6000 / 2400 units = Rs. 2.5 per unit

The cost sheet for the production of 4000 units can be worked out as below :

Overhead Cost 309


Cost Sheet - 4000 units

Per Unit Total


Rs. Rs.

Direct Material Cost 2.00 8,000


Direct Labour Cost 2.50 10,000
Variable Overheads 3.00 12,000
Fixed Overheads 7.50 30,000
Total Cost 15.00 60,000
Add : Profit i.e. 20% of selling price of
Or 25% of total cost 3.75 15,000
Sales 18.75 75,000

(2) XYZ Ltd., a manufacturing company, having an extensive marketing net work throughout
the country, sells its products through four zonal sales offices viz. A,B,C and D. The
budgeted expenditure for the year are given below :

Rs.

Sales Manager’s salary 1,20,000


Expenses relating to Sales Manager’s office 80,000
Travelling salesmen’s salaries 3,20,000
Travelling Expenses 36,000
Advertisement 30,000
Godown Rent-Zone A 15,000
B 25,200
C 9,800
D 18,000
68,000
Insurance on inventories 20,000
Commission on sales @ 5% on sales 6,00,000

310 Management Accounting


The following further particulars are also available :

A B C D

Sales (Rs. in lakhs) 36 48 16 20


No. of salesmen 5 6 2 3
Total mileage covered 6000 14000 4500 5500
Allocation of Advertisement 30% 30% 20% 20%
Average stock (Rs. in lakhs) 6 8 4 2

Based on the above details, compute zonewise selling overheads, as a percentage to sales.

Solution :

Calculation of Sales Overheads - Zone wise

Items Base Total A B C D


Rs. Rs. Rs. Rs. Rs.
1. Sales Sales 1,20,000 36,000 48,000 16,000 20,000
Manager’s Salary
2. Expenses of Sales Sales 80,000 24,000 32,000 10,667 13,333
Manager’s office
3. Travelling salesmen’s No. of Salesman 3,20,000 1,00,000 1,20,000 40,000 60,000
Salaries
4. Travelling Expenses Mileage covered 36,000 7,200 16,800 5,400 6,600
5. Advertisement Allocation 30,000 9,000 9,000 6,000 6,000
6. Godown Rent Allocation 68,000 15,000 25,200 9,800 18,000
7. Insurance on Average stock 20,000 6,000 8,000 4,000 2,000
inventories
8. Sales Commission Sales 6,00,000 1,80,000 2,40,000 80,000 1,00,000
Total
Overheads 12,74,000 3,77,200 4,99,000 1,71,867 2,25,933
Sales in Lakhs Rs. 120 36 48 16 20
Overheads as % of sales 10.62% 10.48% 10.40% 10.74% 11.30%

(3) The following yearly charges are incurred in respect of a machine where work is done by
means of 5 machines of exactly same type.

(1) Rent and Rates Rs. 4,800


(2) Depreciation on each machine Rs. 500
(3) Repairs & maintenance of 5 machines Rs. 1,000
(4) Power consumed (as per meter at 5 paise per unit) Rs. 3,000
(5) Electric charges for the shop Rs. 450

Overhead Cost 311


(6) Two attendants looking after 5 machines and are
paid Rs. 700 per year each Rs. 1,400
(7) Supervision – One supervisor looking after 5 machines and paid Rs. 3,000
(8) Sundry supplies for the shop Rs. 450

The machine uses 10 units of power per hour. Calculate the machine hour rate.

Solution :

Calculation of Machine Hour Rate

Rs.
(a) Standing charges :
Rent and Rates 960
Depreciation 500
Repairs and Maintenance 200
Electricity charges 90
Attendants salary 280
Supervisor’s Salary 600
Sundry Supplies 90
Annual standing charges 2,720
Annual Machine Working Hours 1,200
Hourly Standing Charges Rs. 2.27

(b) Running charges :


Power charges - Rate of power - 5 paise per unit
Power consumption - 10 units per hour
Hourly power expenses Rs. 0.50

(c) Machine Hour Rate i.e. a + b Rs. 2.77

Working Notes :

Number of machine working hours are calculated as below :

(a) Total power cost for the shop - Rs. 3.000

(b) Power cost relating to the machine - Rs. 600

(c) Rate of power - 5 paise per unit

312 Management Accounting


(d) Total power consumption in units -
Rs. 600
= 12.000 units
Paise 5

(e) Rate of power consumption - 10 units per hour

(f) If total units consumed are 12.000 and if rate of power consumption is 10 units per
hour, it means that the machine must have worked for 1,200 hours.

(4) From the following data, work out the predetermined machine hour rates for departments
A and B of a factory.

Preliminary Estimates of Expenses


Total Dept. A Dept. B
Rs. Rs. Rs.

Power 15,000 – –
Spare Parts 8,000 3,000 5,000
Consumable Stores 5,000 2,000 3,000
Depreciation on Machinery 30,000 10,000 20,000
Insurance on Machinery 3,000 – –
Indirect Labour 40,000 – –
Building Maintenance 7,000 – –

The final estimates are to be prepared on the basis of above figures after taking into consideration
the following factors :

(1) An increase of 10% in the price of spare parts.

(2) An increase of 20% in the consumption of spare parts for Department B only.

(3) Increase in the straight–line method of depreciation from 10% on the original value of
machinery to 12%.

(4) 15% general increase in wage rates.

The following information is available

Dept. A Dept. B

Estimated Direct Labour Hours 80,000 1,20,000


Ratio of K W Rating 3 2
Estimated Machine Hours 25,000 30,000
Floor Space (sq. ft.) 15,000 20,000

Overhead Cost 313


Solution :

Calculation of machine hour rate

Expenses Base Total Dept. A Dept. B


Rs. Rs. Rs.

Power KW Rating 15,000 9,000 6,000


Spare Parts Allocation and adjustment for
Final Estimates 9,900 3,300 6,600
Consumable stores Allocation 5,000 2,000 3,000
Depreciation on Machinery Allocation and adjustments for
Final Estimates 36,000 12,000 24,000
Insurance on Machinery Ratio of depreciation 3,000 1,000 2,000
Indirect Labour Direct Labour Hours and
adjustment for Final Estimates 46,000 18,400 27,600
Building Maintenance Floor space 7,000 3,000 4,000
1,21,900 48,700 73,200
Estimated Machine Hours – 25,000 30,000
Machine Hour Rate Rs. – 1.948 2.44

Working Notes :

(1) Spare Part Cost Total Dept A Dept B

Original Estimate 8,000 3,000 5,000


+ Extra consumption 1,000 - 1,000
9,000 3,000 6,000
+ 10% Price Increase 900 300 600
9,900 3,300 6,600

(5) The factory overhead costs of four production departments of a company engaged in
executing job orders, for an accounting year, are as follows :

Depts. Rs.
A 19,300
B 4,200
C 4,000
D 2,000

314 Management Accounting


Overhead has been applied as under
Dept A - Rs. 1.50 per machine hour for 14,000 hours
Dept B - Rs. 1.30 per Direct Labour Hour for 3,000 hours
Dept C - 80% of Direct Labour cost of Rs. 6,000
Dept D - Rs. 2 per piece for 950 pieces.

Find out the amount of departmentwise under or over absorbed factory overheads.

Solution :

(a) Factory Overheads absorbed

Dept. Rs. Base


A 21,000 Rs. 1.50 per Machine Hour for 14,000 hours
B 3,900 Rs. 1.30 per Direct Labour Hour for 3,000 hours
C 4,800 80% of Direct Labour cost of Rs. 6,000
D 1,900 Rs. 2 per piece for 950 pieces

(b) Calculation of under or over absorption

Dept. Overheads Overheads Over Under


Incurred Absorbed Absorption Absorption
Rs. Rs. Rs. Rs.

A 19,300 21,000 1,700 -


B 4,200 3,900 - 300
C 4,000 4,800 800 -
D 2,000 1,900 - 100
29,500 31,600 2,500 400

Net Over absorption Rs. 2,100

(6) In a factory, annual average charges for direct wages amount to Rs. 4,80,000. Following
are some of the expenses incurred in factory.

a. Works Manager’s salary Rs. 50,000

b. Factory Rent Rs. 36,000. The total area is 45,000 Sq. Ft. out of which shop is in
40,000 Sq. Ft.

c. Wages of Peons and Sweepers Rs. 7,000

d. Other factory overheads Rs. 53,000

Overhead Cost 315


A work order is executed in a shop’s part occupying an area of 6,000 Sq. Ft. and costs
Rs. 10,000 in wages. If the total wages for all work orders executed in the shop amount to
Rs. 1,60,000, calculate the total amount of factory overheads charges to be allocated to this
work order.

Solution :

Factory Rent Rs. 36,000

40,000 Sq. ft.


Rent of shop Rs. 32,000 i.e., Rs. 36,000 X
45,000 Sq. ft.

Rent for that area of shop where work order is executed. i.e.

6,000 Sq. ft.


Rs. 32,000 X = Rs. 4,800
40,000 Sq. ft.

Apportionment of rent to work order on the basis of wages -

Rs. 10,000
X Rs. 4,800 = Rs. 300
Rs. 160,000

Other factory overheads

Rs.
Works Manager’s Salary 50,000
Factory Rent (Balance) 4,000
Wages of Peons /Sweepers 7,000
Others 53,000
1,14,000

Apportionment of overheads to works order on the basis of wages

Rs. 10,000
X Rs. 1,14,000 = Rs. 2,375
Rs. 4,80,000

Factory overheads chargeable to the work order

Rent Rs. 300


Factory overheads Rs. 2,375
Rs. 2.675

316 Management Accounting


(7) Superclass Co. Ltd. has three production departments X, Y and Z and two service
Departments A and B.

The following estimated figures for a certain period have been made available.

Rs.
Rent and Rates 10,000
Lighting and Electricity 1,200
Indirect wages 3,000
Power 3,000
Depreciation of machinery 20,000
Other expenses and sundries 20,000

The following further details are also available.

Total X Y Z A B

Floor space (Sq. Mts.) 10,000 2,000 2,500 3,000 2,000 500
Light Points (Nos.) 120 20 30 40 20 10
Direct wages (Rs.) 20,000 6,000 4,000 6,000 3,000 1,000
Horsepower of machines 300 120 60 100 20 –
Cost of Machinery (Rs.) 1,00,000 24,000 32,000 40,000 2,000 2,000
Working Hours – 4,670 3,020 3,050 – –

The expenses of the service departments are to be allocated as follows.

X Y Z A B

A 20% 30% 40% - 10%


B 40% 20% 30% 10% -

You are required to calculate the overhead absorption rate per hour in respect of the three
production departments.

What will the total cost of an article with material cost of Rs. 50 and direct labour cost of
Rs. 40 which passes through X, Y and Z for 2, 3 and 4 hours respectively.

Overhead Cost 317


Solution :

Primary Apportionment of Overheads

Expenses Base X Y Z A B
Rs. Rs. Rs. Rs. Rs.

Rent & Rates Floor space 2000 2500 3000 2000 500
Lighting & Electricity Light points 200 300 400 200 100
Indirect wages Direct wages 900 600 900 450 150
Power HP of machines 1200 600 1000 200 -
Depreciation Cost of machines 4800 6400 8000 400 400
Other expenses Direct wages 6000 4000 6000 3000 1000
Direct wages
(Only Service Depts.) Allocation – – – 3000 1000

15100 14400 19300 9250 3150

Secondary Apportionment of Overheads

Result of Primary Apportionment

X - Rs. 15,100 Y - Rs. 14,400 Z - Rs. 19,300


A - Rs. 9,250 B - Rs. 3,150

Let X = Total overheads of Dept. A


Y = Total overheads of Dept. B
∴ X = 9,250 + Y/10
Y = 3,150 + X/10
∴10 X = 92,500 + Y ...(1)
10 Y = 31,500 + X ...(2)

Multiplying equation 1 by 10 and rearranging :

-10 Y = 9,25,000 - 100 X


10 Y = 31,500 + X
Adding, 0 = 9,56,500 - 99X
∴ 99X = 9,56,500
∴ X = 9,662 ...(3)
∴ Y = 4,116 ...(4)

318 Management Accounting


Total overheads can be apportioned to production departments at agreed percentages to
calculate the overhead absorption rate as below :

Total X Y Z
Rs. Rs. Rs. Rs.

As per Primary apportionment 48,800 15,100 14,400 19,300


Dept A – 90% of Rs. 9662 8,696 1,933 2,898 3,865
Dept B – 90% of Rs. 4116 3,704 1,647 822 1,235
61,200 18,680 18,120 24,400
Working Hours - 4,670 3,020 3,050
Labour Hour Rate Rs. 4.00 6.00 8.00

Calculation of Total Cost

Rs.
Direct Material Cost 80
Direct Labour Cost 40

Overheads

Dept X - 2 Hrs x Rs. 4/ Hour = Rs. 8


Dept Y - 3 Hrs x Rs. 6/ Hour = Rs. 18
Dept 2 - 4 Hrs x Rs. 8/ Hour = Rs. 32
58
178

(8) The expenses of a machine cost centre for a particular month are as under.

(i) Power - Rs. 50,000


(ii) Maintenance and Repairs - Rs. 10,000
(iii) Machine operator’s wages - Rs. 2,000
(iv) Supervision - Rs. 6,000
(v) Depreciation - Rs. 40,000

Overhead Cost 319


Other particulars are given below :

Products Rate of Production Production Units


A 30 Units per hour 1,800
B 10 Units per hour 500
C 6 Units per hour 300
D 4 Units per hour 260

The entire production was to be offered to Government on ‘Cost Plus 20%’ basis. Material
Costs per unit are -

A - Rs. 40, B - Rs. 60, C - Rs. 100 and D - Rs. 300

Prepare a statement showing product wise ‘cost’ and ‘offer price’.

Solution :

Total Cost of Machine Centre

Rs.
Power 50,000
Maintenance and Repairs 10,000
Machine operator’s wages 2,000
Supervision 6,000
Depreciation 40,000
1,08,000

On the basis of rate of production and number of units produced of each product, number of
machine hours used can be calculated as below :

Product Rate of Production Production Machine Hours


(Units) used

A 30 Units per hour 1,800 60


B 10 Units per hour 500 50
C 6 Units per hour 300 50
D 4 Units per hour 260 65
225

Rs. 1,08,000
∴ Machines Hour Rate = = Rs. 480 Machine Hour
225 Machine Hour

320 Management Accounting


Calculation of per unit total cost and offer price

Product Material Machine Cost Total Profit Offer


Cost Machine Machine Total Cost 20% of Price
Hours Hour Machine Total
Rate Cost Cost
1 2 3 4 5 6(2+5) 7 8
Rs. Rs. Rs. Rs. Rs. Rs. Rs.

A 40.00 1/30 480 16.00 56.00 11.20 67.20

B 60.00 1/10 480 48.00 108.00 21.60 129.60

C 100.00 1/6 480 80.00 180.00 36.00 216.00

D 300.00 ¼ 480 120.00 420.00 84.00 504.00

Overhead Cost 321


QUESTIONS

1. Discuss the factors which would create unabsorbed factory overheads and overabsorbed
factory overheads.

2. Mention the broad principles on which overhead expenses are generally apportioned.
Upon what basis would you apportion the following expenses to individual cost centres
in an engineering unit?
(a) Rent
(b) Power
(c) Fire Insurance Premium
(d) Lighting

3. Explain the term underabsorption and overabsorption of overheads. Explain any three
methods of absorbing production overheads into the cost of production.

4. Distinguish between actual and predetermined rates for absorption of factory overheads.
Cite the major problems involved in using actual rates and discuss how predetermined
rates eliminate this problem.

5. How do you deal with under or over absorption of overheads? Mention the various items
that go into –
(a) Manufacturing overheads.
(b) Administration overheads.
(c) Selling overheads.
(d) Distribution overheads.

6. What basis would you recommend for the apportionment of the following items of expenses
to production departments, giving justification for the suggested one.
(a) Internal Transport.
(b) Air-Conditioning.
(c) General Factory Maintenance.
(d) Stores.
(e) Rent.
(f) Labour office.

7. What is meant by apportionment of overheads? What can be considered as a good base


for apportioning the following overheads with reference to a Diesel Engine Manufacturing
Company?

322 Management Accounting


(i) Internal Transport
(ii) Time Keeping expenses
(iii) Shop supervision
(iv) Power, lighting and other utilities

Short Notes :

(a) Machine Hour Rate –

(b) Control of overheads –

(c) Underabsorption and overabsorption of overheads –

(d) Treatment of over- absorption of overheads –

(e) Primary and Secondary apportionment of overheads –

PROBLEMS

(1) A certain type of factory produces a uniform type of article and has a capacity to produce
1,500 units per week of 48 hours. Following data shows different elements of costs for 3
weeks of 48 hours each when output has changed from one week to another.

Units Produced Direct Material Direct Labour Factory Overheads


(Fixed & Variable)
Rs. Rs. Rs.
400 800 1,600 3,800
500 1,000 2,000 4,000
800 1,600 3,200 4,600

You are asked to find out selling price per unit when weekly output is 1,000 units and a profit
of 8.33% on selling price will be made.

(2) A factory is having three production departments A, B and C and two service departments-
Boiler House and Pump Room. The Boiler House has to depend upon the Pump Room
for the supply of water and the Pump room in its turn is dependent on the boiler house for
supply of steam power for driving the pump. The expenses incurred by the production
departments during a period are A – Rs. 8,00,000, B – Rs. 7,00,000 and C - Rs. 5,00,000.

The expenses for boiler house is Rs. 2,34,000 and the pump room is Rs. 3,00,000.

The expenses of the boiler house and pump room are apportioned to the production
departments on the following basis.

Overhead Cost 323


A B C BH PR
Expenses of BH 20% 40% 30% - 10%
Expenses of PR 40% 20% 20% 20% -

Show clearly as to how the expenses of boiler house and pump room would be apportioned to
A, B and C departments. Use an Algebrical equation.

(3) The overheads distribution summary for the month of September 1980 disclosed following
overheads expenses for departments mentioned below :

Production Depts. Service Depts.

A B C D E

Overheads Rs. 7,810 Rs. 12,543 Rs. 4,547 Rs. 4,000 Rs. 2,600

Expenses of service departments D and E are apportioned as follows.

A B C D E
D 30% 40% 20% - 10%
E 10% 20% 50% 20% -

You are required to find out the total cost of each production dept. by charging the respective
costs of service depts. by simultaneous equations method.

(4) The primary distribution of expenses disclosed the following details in respect of production
departments PI, P2 and P3 and Service Departments S1 and S2

Dept. P1 P2 P3 S1 S2

Overheads (Rs.) 6.300 7,400 2,800 4,500 2,000

The services given by S1 and S2 are as follows.

Dept. P1 P2 P3 S1 S2

S1 40% 30% 20% - 10%

S2 30% 30% 20% 20% -

Find out the overheads to production Departments by using simultaneous equations method.

(5) A company has three production cost centres A, B and C and two service cost centres
X and Y. Costs allocated to service cost centres are required to be apportioned to the

324 Management Accounting


production centres to find out cost of production of different products. It is found that
benefit of service cost centres is also received by each other along with the production
cost centres. Overhead costs as allocated to the five cost centres and estimates of
benefits of service cost centres received by each of them are as under -

Cost Centres Overhead Costs Estimates of benefits


as allocated received from service
Rs. centres %

X Y

A 80,000 20 20
B 40,000 30 25
C 20,000 40 50
X 20,000 - 5
Y 10,000 10 -

Required -

Work out final overhead costs of each of the production departments including apportioned
cost of service centres using -
a. Continuous Distribution Method
b. Simultaneous Equations Method

(6) The following particulars related to the production department of a factory for the month
of June 1985.

Rs.
Material Used 80,000
Direct Wages 72,000
Direct Labour Hours Worked 20,000
Hours of Machine operation 25,000
Overhead charges allocated to the department 90,000

Cost data of a particular work order carried out in the above department during June 1985 are
given below.

Rs.
Material Used 8,000
Direct wages 6,250
Labour hours booked 3,300
Machine hours booked 2,400

Overhead Cost 325


What would be the factory cost of the work order under the following methods of charging
overheads?
(i) Direct Labour Cost Rate
(ii) Machine Hour Rate
(iii) Direct Labour Hour Rate

(7) The following information is extracted from the budget of A Ltd. for 1985.

Factory Overheads .. Rs. 62,000


Direct Labour cost .. Rs. 1,00,000
Direct Labour hours .. 1,55,000
Machine hours .. 50,000

The following details are available for job 195

Direct Material Cost Rs. 45


Direct Labour Cost Rs. 50
Direct Labour hours 40
Machine hours 30

You are required to work out the overhead application rates and ascertain the cost of job 195
by using the following methods of overheads absorption.

(1) Direct Labour Hours Rate, (2) Direct Labour Cost, (3) Machine Hour Rate

(8) Atlas Engineering Ltd. accepts a variety of jobs which require both manual and machine
operations. The budgeted Profit and Loss Account for the period 1996-97 is as follows :

(Rs. in Lakhs)
Sales 75
Cost :
Direct Materials 10
Direct Labour 5
Prime Cost 15
Production Overhead 30
Production Cost 45
Other Overheads 15
60
Profit 15

326 Management Accounting


Other budgeted data -

Labour Hours for the period 2,500


Machine Hours for the period 1,500
No. of jobs for the period 300

An enquiry has been received recently from a customer and the production department has
prepared the following estimate of the prime cost required for the job -

Direct Material 2,500


Direct Labour 2,000
Prime Cost 4,500

Labour Hours required = 80


Machine Hours required = 50

You are required to -

a. Calculate by different methods, six overhead absorption rates for absorption of production
overhead and comment on the suitability of each.

b. Calculate the production overhead cost of the order based on each of the above rates.

c. Give your recommendation to the company.

(9) A company has two production departments and two service departments. The data
relating to a period are as under :

Production Depts. Service Depts.


PD1 PD2 SD1 SD2

Direct Materials (Rs.) 80000 40000 10000 20000


Direct Wages (Rs.) 95000 50000 20000 10000
Overheads (Rs.) 80000 50000 30000 20000
Power requirement
at normal capacity
operation (kwh) 20000 35000 12500 17500
Actual power consumption
during the period (Kwh) 13000 23000 10250 10000

The power requirement of these departments are met by a power generation plant. The said
plant incurred an expenditure, which is not included above, of Rs. 1,21,875 out of which a sum
of Rs. 84,375 is variable and the rest fixed.

Overhead Cost 327


After apportionment of power generation plant costs to four departments, the service department
overheads are to be redistributed on the following bases :

PD1 PD2 SD1 SD2

SD1 50% 40% – 10%


SD2 60% 20% 20% –

You are required to :

a. Apportion the power generation plant costs to the four departments.

b. Re-apportion service department cost to the production departments.

c. Calculate the overhead rates per direct labour hour of production departments, given that
the direct wages rate’s of PD1 and PD2 are Rs.- 5 and Rs. 4 respectively.

(10) Following information is extracted from the cost records of Hilton Ltd. which specialises
in the manufacture of automobile spares. The parts are manufactured in Department A
and assembled in Department B.

Total Dept. A Dept. B


Direct Labour hours worked 80,000 30,000 50,000
Machine Hours worked 30,000 25,000 5,000
Machine Horse Power 400 353 47
Book Value of Machines (Rs.) 50,000 40,000 10,000
Floor Space (Sq.Ft.) 20,000 10,000 10,000
Direct Material 65,000 50,000 15,000
Direct Labour 90,000 40,000 50,000
Factory Rent 15,000 - -
Supervision 6,000 2,500 3,500
Depreciation on Machines 5,000 - -
Power 4,000 - -
Repairs to Machines 2,000 1,600 400
Indirect Labour 4,000 2,000 2,000

The prime cost of batch B-401 has been booked as under

Total Dept. A Dept. B


Materials 3,200 2,700 500
Labour 7,500 3,000 4,500

328 Management Accounting


Direct Labour hours worked on Batch B-401 were 2,500 in Department A and 5,000 in
Department B. Machine hours worked on this batch were 1,250 in Department A and 600 in
Department B. Allocate overhead expenditure and calculate the cost of each unit in Batch B-
401 which consists of 1,000 units.

(11) Strongman Ltd. has three production departments A,B and C and two service departments
X and Y. The data available for the month of March 1991 concerning the organization

Rs.
Rent 15,000
Municipal Taxes 5,000
Electricity 2,400
Indirect wages 6,000
Power 6,000
Depreciation on Machinery 40,000
Canteen Expenses 30,000
Other Labour related costs 10,000

Following particulars are also available -

Total A B C X Y

Floor Space (Sq. Mts.) 5,000 1,000 1,250 1500 1,000 250
Light Points (Nos.) 240 40 60 80 40 20
Direct Wages (Rs.) 40,000 12,000 8,000 12,000 6,000 2,000
HP of Machines 150 60 30 50 10 –
Cost of Machines (Rs.) 20,0000 48,000 64,000 80,000 4,000 4,000
Working Hours – 2,335 1,510 1,525 – –

The expenses of Service Departments are to be allocated in following manner -

A B C X Y

X 20% 30% 40% – 10%

Y 40% 20% 30% 10% –

You are requested to calculate the overhead absorption rate per hour in respect of the three
production departments.

Overhead Cost 329


(12) A company has 3 production departments A, B and C and two service departments X
and Y. The following data are extracted from the records of the company for a particular
given period.

Rs.
Rent and Taxes 25,000
General Lighting 3,000
Indirect Wages 7,500
Power 7,500
Depreciation on Machinery 50,000
Sundries 50,000

Additional data departmentwise

Total A B C X Y

Direct Wages (Rs.) 50000 15000 10000 15000 7500 2500


HP of Machines 150 60 30 50 10 –
Cost of Machines (Rs. in Lakhs) 12.50 3.00 4.00 5.00 0.25 0.25
Floor Space (Sq.Mts.) 10000 2000 2500 3000 2000 500
Lighting Points (Nos.) 60 10 15 20 10 5
Production Hours – 6226 4028 4066 – –

Sundries can be apportioned on the basis of Direct Wages.

Service Departments’ expenses allocation -

A B C X Y

X 20% 30% 40% – 10%


Y 40% 20% 30% 10%

You are required to -

a. Compute the overhead rate of production departments using repeated distribution method.

b. Determine the total cost of a product whose direct material cost and direct labour cost
are Rs. 150 and Rs. 150 respectively and which would consume 4 hours, 5 hours and 3
hours in departments A, B and C respectively.
(13) Universal Ltd. has four production departments A, B, C and D and two service departments
viz. Transport and Power Supply.

330 Management Accounting


Particulars of expenses of the respective departments are as follows :

A Rs. 2,000
B Rs. 1,800
C Rs. 1,600
D Rs. 1,400
Transport Rs. 1,100
Power Supply Rs. 760

The service department’s expenses are charged out on a percentage basis as given below :

A B C D Transport Power

Transport 10% 30% 20% 20% - 20%

Power 30% 20% 30% 10% 10% -

Using the above information, apportion the service department overheads to various production
departments using

a. Simultaneous Equations Method

b. Repeated Distribution Method

(14) A shop has 2 newly purchased machines, each occupying equal area of space. One is
4 - spindle drilling machine and the other is 6-spindle drilling machine costing Rs. 80,000
and Rs. 1,00,000 respectively. Following are the expenses for one year :

a. Rent Rs. 40,000


b. Rates and Taxes Rs. 17,000
c. Lighting and heating Rs. 12,600
d. power expenses
- 4 spindle machine Rs. 10,000
- 6 spindle machine Rs. 15,000
e. Administration expenses Rs. 38,000
f. Running and Maintenance Rs. 80,000

The life of each machine is 10 years without any salvage value. Each machine works for 45
hours a week for 50 weeks in a year. 250 hours per machine are used for repairs. Running and
repairs expenses are shared between two machines on the basis of power expenses.

You are required to prepare statement showing computation of Machine Hour Rate.

Overhead Cost 331


(15) Calculate the machine hour rate in respect of machine No. 179 from the following
particulars :

Cost of machine Rs. 20,000


Estimated Life 15,000 hours
Estimated scrap value Rs. 500/-
Estimated working hours per annum 2200
Estimated hours required for maintenance 100 (included in above)
Setting up time (Hours) 100 (included in above)
Power 20 units @ Rs.0.17 per unit
Repairs and maintenance per annum Rs. 1500/-
No. of operators (looking after also 3 other machines) 2
Wages per operator per month Rs. 150/-
Chemical required for operating the machine Rs. 100/- p.m.
Overheads chargeable to the machine Rs. 200/- p.m.
Insurance premium -1% p.a. on the cost of machine.

(16) You are required to calculate the composite machine hour rate from the following particulars
in respect of a jig boring machine whose scrap value is Rs. 50,000 after its working life of
10 years.
1. Cost of the machine - Rs. 2,00,000
2. Importation charges & Customs duty etc.- Rs. 50,000
3. Working hours per year - 2,000
4. Repairs & Maintenance charges - 50% of depreciation charge.
5. Lubricating oil - Rs. 20 per working day of 8 hours
6. Consumable stores - Rs. 500 per month of 25 working days.
7. Power 10 units per working hour at Re. 0.30 per unit
8. Wages of the operator - Rs. 1,000 per month of 25 working days.

332 Management Accounting


(17) From the particulars furnished below, compute a machine hour rate :

Name of the Equipment - Single spindle Automat


Date of purchase - 1.4.1983
Cost - Rs. 75,000
Estimated Life - 10 years
Depreciation - 15% on original cost
Insurance - Rs. 4,000 p.a.
Repairs - Rs.1,800 p.a.
Consumable stores - Rs. 1,500 p.a.
Rent - Rs. 2,400 p.a.
Superintendence - Rs. 2,500 p.a.
(l/5th for the machine)

The machine can work for 200 hours in a month and had actually worked for 80% of the normal
working hours. Cost of oils and greases consumed per hour is Rs.4.50,

(18) A dept. is having 3 machines. The figures indicate the departmental expense of these
machines. Calculate the machine hour rate from the data below :

Depreciation of machines Rs. 12,000


Rent Rs. 2,880
Repairs to machines Rs. 4,000
Insurance of machines Rs. 800
Indirect wages Rs. 6,000
Power Rs. 6,000
Lighting Rs. 800
Misc. Expenses Rs. 4,200
Rs 36,680

Overhead Cost 333


Other information :
M/c1 M/c2 M/c3

Direct wages– Rs. 1,200 2,400 2,400


Power units 30,000 10,000 20,000
No. of workers 4 8 8
Light points 8 24 48
Space occupied (Sq. Ft.) 400 800 800
Cost of machine Rs. 3,00,000 1,20,000 1,80,000
Hours worked 200 300 300

(19) Following particulars relate to a machine :

Rs.
Purchase Price of machine 80,000
Installation Expenses 20,000
Rent per Quarter 3,000
General Lighting for the total area 200 per month
Supervisor’s salary 6,000 per quarter
Insurance premium 600 per annum
Estimated repairs 1,000 per annum
Estimated consumable stores 800 per annum

Power 2 units per hour @ Rs. 50 per 100 units

The estimated life of the machine is 10 years and the estimated scrap value is
Rs. 20,000. The machine is expected to run 20,000 hours in its life time. The machine
occupies 25% of the total area. The supervisor devotes l/6th of his time for the machine.
You are required to work out machine hour rate.

(20) From the following particulars, calculate the machine hour rate of machine installed in a
Department.

Cost of Machine Rs. 16,000

Estimated scrap value after the expiry


of its life (15 years) Rs. 1,000

334 Management Accounting


Estimated working hours of the machine per year 2,000

Monthly salary of a foreman engaged in supervision


of this machine and other two identical machines. Rs. 1,500

Repails and Maintenance of the machine Rs. 2,400 per year

Insurance premium for the machine Rs. 120 per year

Departmental rent and rates are Rs. 1,200 per year. The space occupied by the machine
is l/6th of the floor space of the department. Power consumption of the machine is 2
units per hour @ 10 paise per unit.

(21) A machine costing Rs. 20,000 is expected to work for 10 years and at the end of which
the scrap value is estimated Rs. 2,000, installation charges amount to Rs. 200. repairs
over 10 years life is expected Rs. l,800 and the machine is expected to run for 2.190
hours in a year.

Its power consumption would be 15 units per hour at Rs. 5 per 100 units. The machine
occupies l/4th of the area of the department and has two points out of ten for lighting. The
foreman has to devote l/3rd of his time for this machine. The rent for the department is
Rs. 300 p.m. and charges for lighting Rs. 80 p.m. The foreman is paid salary
Rs. 960 p.m. Find out the hourly rate assuming insurance is 1% per annum and expenses
on oil etc. Rs. 9 per month.

(22) Following data is available relating to a company for a certain month.

Territory
I II III

Selling Expenses (Rs.) 7,600 4,200 6,240


Distribution Costs (Rs.) 4,000 1,800 2,000
No. of units sold 16,000 6,000 10,000
Sales (Rs.) 76,000 28,000 52,000

The company adopts sales basis and quantity basis for application of selling and distribution
costs respectively.
Compute -
(a) The territorywise overhead recovery rates separately for Selling and Distribution costs.

(b) The amounts of selling and distribution cost chargeable to a consignment of 2,000 units
of a product, sold in each territory at Rs. 4.50 per unit.

Overhead Cost 335


(23) A machine is purchased for cash at Rs. 9,200. Its working life is estimated to be 18,000
hours after which its scrap value is estimated at Rs. 200. It is assumed from the past
experience that

a. The machine will work for 1,800 hours annually.

b. The repair charges will be Rs. 1,080 during the whole period for life of the machine.

c. The power consumption will be 5 units per hour at 6 paise per unit.

d. Other annual standing charges are estimated to be -

1. Rent of department (machine l/5th) 780

2. Light (12 points in the department, 2 points engaged in the machine) 288

3. Foreman’s salary (l/4th of his time is occupied in the machine) 6000

4. Insurance premium for machine 36

5 Cotton Waste 60

Find out the machine hour rate on the basis of above data for allocation of the works expenses
to all jobs for which the machine is used.

(24) The following particulars relate to a new machine purchased.

Purchase Price of the machine Rs. 4,00,000


Installation Expenses Rs. 1,00,000
Rent per Quarter Rs. 15,000
General Lighting for the total area Rs. 1,000 p.m.
Foreman’s Salary Rs. 30,000 p.a.
Insurance Premium for the machine Rs. 3,000 p.a.
Estimated repair for the machine Rs. 5,000 p.a.
Estimated Consumable Stores Rs. 4,000 p.a.

The estimated life of the machine is 10 years and the estimated value at the end of 10 years
is Rs. 1,00,000. The machine is expected to run 20,000 hours in its life time. The machine
occupies 25% of the total area. The foreman devotes l/6th of his time for the machine.

Calculate the machine hour rate for the machine.

336 Management Accounting


(25) A manufacturing unit has added a new machine to its fleet of five existing machines. The
total cost of purchase and installation of the machine is Rs. 7,50,000. The machine has
an estimated life of 15 years and is expected to realise Rs. 30,000 as scrap at the end
of its working life.

Other relevant data are as follows :

a. Budgeted working hours are 2,400 based on 8 hours per day for 300 days. This includes
400 hours for plant maintenance.

b. Electricity used by the machine is units per hour at a cost of Rs. 2 per unit. No current
is drawn during maintenance.

c. The machine requires special oil for heating which is replaced once in every month at a
cost of Rs. 2,500 on each occasion.

d. Estimated cost of maintenance of the machine is 500 per week of 6 working days.

e. 3 operators control the operations of the entire battery of six machines and the average
wages per person amounts to Rs. 450 per week plus 40% fringe benefits.

f. Departmental and general overheads allocated to the operation during the last year were
Rs. 60,000. During the current year it is estimated that there will be an increase of
12.5% of this amount. No incremental overhead is envisaged for the installation of the
new machine.

You are required to compute the machine hour rate for the recovery of the running cost of the
machine.

(26) The following annual charges are incurred in respect of a machine in a shop where
manual labour is almost nil and where work is done by means of five machines of exactly
similar type and specification.

(a) Rent and Taxes (Proportionate to the floor space occupied) for the shop - Rs. 4,803.

(b) Depreciation on each machine - Rs. 500.

(c) Repairs and maintenance for five machines - Rs. 1,000

(d) Power consumed @ 6.25 paise per unit for the shop Rs. 3,750.

(e) Electric charges for light in the shop - Rs. 540.

(f) Attendants - There are two attendants for the five machines and they are each paid
Rs. 60 per month.

(g) Supervision - There is one supervisor in the shop for the five machines and he is paid
Rs. 250 per month.

Overhead Cost 337


(h) Sundry supplies such as lubricants, jute and cotton waste etc. for the shop - Rs. 494.

(i) Hire Purchase - Instalment payable for the machine (including Rs. 300/- as interest) -
Rs. 1,200.

(j) The machine uses 10 units of power per hour. Calculate the machine hour rate for the
year.

(27) In a manufactring concern ABC Ltd., die machine shop has 8 identical machines manned
by 6 operators. The machines cannot be worked without an operator wholly engaged on
them. The total cost of the machines are Rs. 8,00,000.

Following information relates to a six monthly period ended 30th June, 1990.
Normal available hours per month 208
Absenteeism (without pay) hours
per month. 18
Leave (with pay) hours per month 20
Normal idle time (unavoidable)
hours per month 10
Average rate of wages per day of 8 hours Rs. 20
Production hours 15% on wages
Power and Fuel consumption Rs. 9,000
Supervision and Indirect Labour Rs. 3,300
Electricity Rs. 1,200

The following particulars are on a yearly basis.

Repairs and Maintenance 3% of value of machines


Insurance Rs. 42,000
Depreciation 10% of original cost.
Other factory expenses Rs. 12,000
Allocated General Management
Expenses Rs. 63,670
You are required to work out a comprehensive machine hour rate for the machine shop.

338 Management Accounting


(28) In a factory, the following particulars have been extracted for the quarter ending 30th
June, 2001 in respect of Production Department P1, P2 and P3 and service Departments
S1 and S2. Compute the departmental overhead rate for each of the production
departments, assuming that overheads are absorbed as a percentage of direct wages.

Particulars P1 P2 P3 S1 S2

Direct Wages (Rs.) 30000 45000 60000 15000 30000


Direct Material (Rs.) 15000 30000 30000 22000 22000
No. of Workers 150 225 225 75 75
Power (KWHrs.) 6000 4500 3000 1500 1500
Asset Value 60000 40000 30000 10000 10000
Light Points 10 16 4 6 4
Area in Sq. Fts. 150 250 50 50 50

Expenses for the period were –

Power Rs. 1,100


Lighting Rs. 200
Stores overheads Rs. 800
Staff Welfare Rs. 3,000
Depreciation Rs. 36,000
Rent Rs. 550
General Overheads Rs. 12,000

Apportion general overheads in the proportion of direct wages. Apportion the expenses of S1
according to direct wages and those of S2 in the ratio of 5 : 3: 2 to the production departments.

(29) A Ltd. has 3 production departments A, B and C and 2 service departments D and E.
The following are the figures of the company.

Rs.
Rent and Rates 5,000/-
General lighting 600/-
Indirect wages 1,500/-
Power 1,500/-
Depreciation of Machinery 10,000/-
Sundry Expenses 10,000/-

Overhead Cost 339


The following further details are available :

A B C D E

Floor Space (Sq.Ft) 2000 2500 3000 2000 500


Light points 10 15 20 10 5
Direct wages (Rs.) 3000 2000 3000 1500 500
Value of Machinery (Rs.) 60,000 80,000 1,00,000 5,000 5,000
H.P. of Machines 60 30 50 10 –

Sundry expenses are apportioted on the basis of direct wages

The expenses of D and E are allocated as under :

A B C D E

D 20% 30% 40% - 10%

E 40% 20% 30% 10% -

Find the rate per hour if the working hours are as under :

A Department 6226

B Department 4028

C Department 4066

(30) In a light engineering factory, the following particulars have been collected for the three
monthly period ended 31.12.80. Compute the departmental overhead rates for each of
the production departments assuming that the overheads are recovered as a percentage
of direct wages.

Production Dept. Service Dept.


A B C D E

Direct wages Rs. 2,000 3,000 4,000 1,000 2,000


Direct materials Rs. 1,000 2,000 2,000 1,500 1,500
Staff Nos. 100 150 150 50 50
Electricity Kwh. 4,000 3,000 2,000 1,000 1,000
Light points Nos. 10 16 4 6 4
Asset value Rs. 60,000 40,000 30,000 10,000 10,000
Area occupied Sq.Ft. 150 250 50 50 50

340 Management Accounting


The expenses for the period were :
Motive power Rs. 550
Lighting power Rs. 100
Stores overhead Rs. 400
Amenities to staff Rs. 1,500
Depreciation Rs. 15,000
Repairs and Maintenance Rs. 3,000
General overheads Rs. 6,000
Rent and Taxes Rs. 275

Apportion the expenses of service dept. E proportionate to direct wages and that of service
dept. D in the ratio of 5 : 3 : 2 to depts A, B and C respectively.

Overhead Cost 341


NOTES

342 Management Accounting


Chapter 11
MARGINAL COSTING

In the conventional system of cost ascertainment, the direct cost may be identified with the
individual cost center. However, the indirect costs i.e. the overheads are identified with the
individual cost center on the most equitable basis. This results into some problems in the
process of managerial decision-making.

a. The above process does not take into consideration the behaviour of cost. All the costs
in the practical circumstances do not behave in the same manner. Some of the costs
tend to remain constant despite the changes in the level of activity or volume of operations.
These types of costs are comparatively irrelevant in the managerial decision-making.

b. The above process results into the under absorption or over absorption of overheads.

The said limitations have given rise to a managerial decision making technique that basically
tries to classify the costs based upon the behaviour of cost. The technique is referred to as
Marginal Costing. The basic proposition made by this technique is that the costs should be
classified on the basis of behaviour of the costs. From this angle, the costs can be viewed as
fixed costs and variable costs,

Fixed Cost is the cost that tends to remain constant irrespective of the level of activity or
volume of operations. Fixed Cost tends to vary with time rather than with level of activity. Basic
characteristic feature of fixed cost is that this cost in terms of amount may remain constant at
all the levels of activities, however per unit fixed cost goes on decreasing with the increasing
level of activity and vice-a-versa.

Variable Cost is the cost that varies in direct proportion with the level of activity or volume of
operations. Basic characteristic feature of variable cost is that variable cost in terms of amount
may increase or decrease with the changing level of activity or volume of operations. However,
per unit variable cost remains constant.

In practical circumstances, some costs may not be entirely fixed or entirely variable. They are
technically in the form of semi-fixed costs or semi-variable costs. For the purpose of marginal
costing, the semi-fixed costs or semi-variable costs are required to be classified in the individual

Marginal Costing 343


components of fixed cost and variable cost. For segregating the semi-fixed or semi-variable
cost into the individual components of fixed cost and variable cost, various techniques or
methods may be available viz.

l Comparison by period or level of activity

l Range or High and Low method

l Analytical method

l Scattergraph method

l Lease Square method

Based upon the above discussions, let us make some calculations for a manufacturing
organization manufacturing and selling a single product, operating at various levels of activities.

Level of Activity – Units 1000 1500 2000


Per Unit Selling Price – Rs. 100 100 100
Total Sales – Rs. 1,00,000 1,50,000 2,00,000
Variable Cost – Rs. 60,000 90,000 1,20,000
Fixed Cost – Rs. 30,000 30,000 30,000
Total Cost – Rs. 90,000 1,20,000 1,50,000
Per Unit Variable Cost – Rs. 6 6 6
Per Unit Fixed Cost – Rs. 3 2 1.5
Per Unit Total Cost – Rs. 9 8 7.5

It can be observed from the above calculations that if the fixed cost is included in the calculation
of total cost, per unit total cost becomes non-comparable with the changes in the level of
activity in one cost-period to another cost-period. To avoid this non-comparability, it is necessary
to eliminate the fixed costs while determining the total cost.

As such, the technique of Marginal Costing proposes that fixed cost tends to remain stagnant
at least over a shorter period of time and hence should be ignored in the entire decision
making process. As such, marginal costing considers only the variable cost as the relevant
cost in the decision making process.

The Concept

Marginal Cost is defined as the amount at any given volume of output by which the aggregate
costs are changed if the volume of output is increased or decreased by one unit. The aggregate
cost consists of both fixed cost and variable cost. As in the short run, fixed costs remain
constant irrespective of changes in the volume, aggregate costs may increase or decrease

344 Management Accounting


with the changes in volume, specifically due to variable cost. As such, in simple words,
marginal cost indicates Per Unit Variable Cost.

Marginal Costing is defined as the ascertainment, by differentiating between fixed and variable
costs, of the marginal costs and of the effect on profit of changes in volume and type of output.

Basic assumptions made by Marginal Costing

The entire technique of Marginal Costing is based upon the following assumptions.

a. Variable Cost varies in direct proportion with the level of activity. However, per unit variable
cost remains constant at all the levels of activities.

b. Per unit selling price remains constant at all the levels of activities.

c. Whatever is produced by the organization is sold off. In other words, there are no variations
due to the stock.

Features of Marginal Costing

1. The product costs are classified as fixed costs and variable costs. Semi-variable costs
are also classified in their individual components of fixed cost and variable cost.

2. Only variable costs are considered while computing the product costs. The closing stock
of finished goods and semi-finished goods is valued after considering variable costs only.

3. Fixed costs are written off during the period of incurrence and hence do not find the place
in product cost determination or inventory valuation.

4. Prices of the product are based on variable costs only.

5. Profitability of the products or departments is decided in terms of marginal contribution.

Marginal Costing and Cost-Volume-Profit Relationship

The definition of the term “Marginal Costing” requires the computation of-

a. Marginal Cost

b. Cost-Volume Profit Relationship

a. Determination of Marginal Cost

As stated earlier, the marginal cost is the additional cost for manufacturing one additional
unit, which is nothing else but the variable cost per unit. Thus the marginal cost or
variable cost includes the direct cost plus the variable overheads. Fixed overheads get
clubbed with the fixed cost.

Marginal Costing 345


b. Cost Volume-Profit Relationship :

The intention of every business activity is to earn the profit and to maximize the profit.
Determination of the profits depends upon the interplay between the following factors
and there exists a close relationship among these factors :

(1) Selling price per unit and total sales amount.

(2) Total cost which in its turn may be in the form of variable cost or fixed cost.

(3) Volume of sales

Cost-Volume-Profit Analysis aims at studying the relationships existing among these


factors and its impact on the amount of profits.

The relationships existing among these factors may be basically presented in two forms.

(a) In statement or report form

(b) In graphical form, the graphs or charts taking the form of break even chart, contribution
break even chart or profit chart.

Form of operating statement :

Under the marginal costing technique, the operating statement takes the form as specified
below.

(a) In case of a single product company

Rs.
Sales x
Less : Marginal cost
Direct Material Cost x
Direct Labour Cost x
Direct Expenses x
Variable Overheads x
x
Contribution x
Less : Fixed costs x
Profit x

346 Management Accounting


(b) In case of a multi product company

Product Product Product Total


A B C
Rs. Rs. Rs. Rs.

Sales x x x x
Less : Marginal cost
Direct Material cost x x x x
Direct Labour cost x x x x
Direct Expenses x x x x
Variable Overheads x x x x
Contribution x x x x
Less : Fixed costs x
Profit x

Basic concepts in Marginal Costing :

(1) Basic equation of Marginal Costing :

The basic intention of the business is to earn the profit which is the excess of sales over
the total costs.
∴ Profit = Sales - Total Cost

However, total cost can be either fixed cost or variable cost. As such the basic equation
takes the following forms.
∴ Profit = Sales - (Variable Cost + Fixed Cost)
∴ Profit = Sales - Variable cost - Fixed cost
∴ Profit + Fixed cost = Sales - Variable cost.

This is the basic equation of marginal costing.

Both the expressions of Sales - Variable Cost and

Profit + Fixed cost are technically termed as contribution.

∴ Sales - Variable Cost = Contribution = Fixed Cost + Profit

∴ Contribution - Fixed cost = Profit

Marginal Costing 347


(2) Contribution :

As discussed earlier, the term contribution can be expressed in two ways basically :
(a) Sales - Variable Cost
(b) Fixed cost + Profit

As in the short period, fixed costs are ineffective due to their stagnant nature, variable
cost becomes the most important cost in deciding the profitability. As such, the situation
which generates higher contribution is treated as profitable situation.

Further, the term contribution, plays an important role in a situation where there are more
than one products and the profits on individual products cannot be ascertained due to
the problems of apportionment of fixed costs to different products. This is due to the fact
that the fixed costs are ignored by marginal costing.

(3) Profit Volume (P/V) Ratio :

This ratio indicates the contribution earned with respect to one rupee of sales. As such,
it is expressed as

Contribution
X 100
Sales

As in the short run, fixed cost remains the same, if there is any change in profits, that is
only due to change in contribution. Hence P/V ratio may also be expressed as :

Change in Profits
X 100
Change in Sales

E.g. Sales price is Rs. 10 per unit, variable cost is Rs.6 per unit, and fixed costs are
Rs.300, we observe that for 100 and 150 units, P/V Ratio works out as :

100 Units 150 Units


Rs. Rs.
Sales 1,000 1,500
Variable cost 600 900
Contribution 400 600
Fixed cost 300 300
Profit 100 300

348 Management Accounting


Hence, P/V Ratio is

Contribution 400 600


X 100 = X 100 = X 100
Sales 1,000 1,500

OR i.e. 40% = 40%

Increase in Profits 200


X 100 i.e. X 100 = 40%
Increase in Sales 500

The fundamental property of P/V Ratio is that it remains constant at all the levels of
activities, provided per unit sales price and variable cost remains constant. It should be
noted that P/V Ratio remains unaffected by any variation in fixed costs though overall
profits may change due to this variation.

A high P/V Ratio indicates that a slight increase in sales without corresponding increase
in fixed costs will result in higher profits and vice-versa. This is a pointer to increased
sales promotion efforts to increase sales volume.

A low P/V Ratio indicates low profitability so that efforts can be made to increase the
profits by increasing selling price or by reducing variable cost. Overall profitability may
also be increased by concentrating more on products having high P/V Ratio.

Note : The basic expression of P/V Ratio i.e.Contribution/Sales may lead to other useful
conclusion as -

(a) Sales x P/V Ratio = Contribution

(b) Contribution
= Sales
P/V Ratio

(4) Break Even Point (BEP) :

This is a situation of no profit no loss. It means that at this stage, contribution is just
enough to cover the fixed costs i.e. Contribution = Fixed Cost. It also means that
contribution generated by all sales beyond Break Even Point will directly result into
profits. As such, it will be intention of every business to reach the Break Even Point, as
early as possible.

The Break Even Point may be expressed in two ways.

Fixed Costs
(a) In terms of quantity –
Contribution per unit

Marginal Costing 349


Fixed Costs
(b) In term of amount –
P/V Ratio

(5) Margin of Safety :

These are the sales beyond Break even point. A business will like to have a high margin
of safety because this is the amount of sales which generates profits. As such, the
soundness of the business is indicated by the margin of safety. A high margin of safety
indicates that the Break Even Point is much below the actual sales and even if there is
reduction in sales, business will be still in profits. A low margin of safety accompanied
by high fixed cost and high P/V Ratio indicates that efforts are required to be made for
reducing the fixed cost or increasing sales volume. A low margin of safety accompanied
by a law P/V Ratio indicates that efforts are required to be made for reducing the variable
cost or increasing the selling price.

Margin of safety may be expressed as below :

Margin of Safety = Sales - Break Even Sales

Fixed cost
= Sales -
P/V Ratio

Sales x P/V Ratio - Fixed Cost


Margin of Safety =
P/V Ratio

Contribution - Fixed Cost


=
P/V Ratio

Profit
=
P/V Ratio

Margin of safety may be expressed as a ratio or as a percentage. E.g. If actual sales are
Rs.l,00,000 and Break Even Sales are Rs.60,000, Margin of Safety will be

Sales - Break Even Sales


X 100
Sales

1,00,000 - 60,000 40,000


i.e. X 100 = = X 100
1,00,000 1,00,000

i.e. 40% of Sales

350 Management Accounting


Illustrations :

(1) Following details are available :

Sales Total Cost


Rs. Rs.
Period I 39,000 34,800
Period II 43,000 37,600

Calculate variable cost, fixed cost and contribution for each period.

Solution :

As Sales - Total Cost = Profit, we know as below :

Sales Total Cost Profit


Rs. Rs. Rs.
Period I 39,000 34,800 4,200
Period II 43,000 37,600 5,400

Increase in Profits
As P/V Ratio = X 100
Increase in Sales

= 5,400 - 4,200 1,200


X 100 = X 100 = 30%
43,000 - 39,000 4,000

As Sales x P/V Ratio = Contribution,For period I, Contribution = 39,000 x 30% = 11,700


For period II, Contribution = 43,000 x 30% = 12,900
As Sales - Contribution = Variable Cost,
For period I, Variable Cost = 39,000 - 11,700 = 27,300
For period II, Variable Cost = 43,000 - 12,900 = 30,100
As Contribution - Profit = Fixed Cost,
For period I, Fixed Cost = 11,700- 4,200 = 7,500
For period II. Fixed Cost = 12,900 - 5,400 = 7,500

To summarise,
Period I Period II
Rs. Rs.
Contribution 11,700 12,900
Variable cost 27,300 30,100
Fixed cost 7,500 7,500

Marginal Costing 351


(2) Following details arc available :

Sales Profit
Rs. Rs.
Period I 2,00,000 20,000
Period II 3,00,000 40,000

Find out Break even Sales

Solution :

Increase in Profits
We know that P/V Ratio = X 100
Increase in Sales

20,000
P/v Ratio = X 100 = 20%
100,000

Profit
Margin of safety =
P/V Ratio

20,000
For period I, Margin of Safety is = = 1,00,000
20%

As Break Even Sales = Sales - Margin of Safety.

Considering Period I,

Break Even Sales = 2,00,000 - 1,00,000

= 1,00,000

(3) Following details are available:

Actual Sales Rs. 20,000


Break Even Sales Rs. 10,000
Fixed Cost Rs. 5,000

Find out the profit at actual sales,

Solution :

At break Even Point, Contribution = Fixed Cost

At Break Even Point, sales are Rs. 10,000 and contribution Rs. 5,000

352 Management Accounting


However we know that,

Contribution 5,000
P/V Ratio = X 100 = X 100= 50%
Sales 10,000

We also know that. Sales x P/V Ratio = Contribution,

∴ At actual sales of Rs. 20,000

Contribution = 20,000 x 50%

= 5,000

We know that Contribution - Fixed cost = Profit

∴ Profit = 10,000 - 5,000

= 5,000

(4) Following details are available:


Break Even Sales Rs. 20,000
Fixed cost Rs. 10,000
Profit Rs. 5,000

Find out the margin of safety.

Solution :

At Break Even Point, Fixed Cost = Contribution

∴ When sales are Rs. 20,000, Contribution is Rs. 10,000

However, we know that -

Contribution
X 100 = P/V ratio
Sales

10,000
P/V Ratio = X 100 = 50%
20,000

We also know that,

Profit
Margin of safety =
P/V Ratio

5,000
= = 10,000
50%

Marginal Costing 353


(5) Find, out the Break Even Point and Profit if sales are Rs. 50,00,000 and P/V Ratio is
50% and Margin of safety is 40%.

Solution :

Sales are Rs. 50,00,000 and Margin of safety is 40% of sales, hence margin of safety is Rs.
20,00,000. As Break Even Sales = Sales – Margin of Safety.

BEP = Rs. 50,00,000 - Rs. 20,00,000 = Rs. 30,00,000

We know that,

Profit
Margin of Safety =
P/V Ratio

∴ Margin of Safety x P/V Ratio = Profit

As Margin of Safety is Rs. 20,00,000 and P/V Ratio is 50%,

Profit = 20,00,000 x 50% = 10,00,000

GRAPHICAL PRESENTATION OF COST-VOLUME-PROFIT RELATIONSHIPS

As discussed earlier, the Cost-Volume-Profit relationships may be expressed in the form of


visual aids like graphs and charts. There may be various ways in which these charts and
graphs can be prepared depending upon the purpose for which they are prepared. We will
discuss three of these ways.

(1) Simple Break Even Chart

It can be prepared as below.

Y TS

TC
a
COST/REVENUE

BEP

LOSS
FC
MOS
}

O X
VOLUME SL

354 Management Accounting


TS = Total Sales Line
TC = Total Cost Line
BEP = Break Even Point
SL = Selected Level of Activity
FS = Fixed Cost
MOS = Margin of Safety
Angle a = Angle of Incidence.

Note : It will be observed from the above chart, that the angle formed by total sales line and
total cost line is termed as Angle of Incidence. As the difference between total sales and total
cost is in the form of profits, higher the angle of incidence better will be the situation.

The limitation of Simple Break Even Chart is that contribution cannot be shown separately. As
such, the following type of Break Even Chart may be prepared i.e. Contribution Break Even
Chart.

(2) Contribution Break Even Chart :

This is a chart where the contribution is shown more clearly and specifically than in a
simple break even chart. It can be prepared as below.

Y TS

TC

a
COST/REVENUE

BEP FC VC

VC
MOS
}

X
O VOLUME SL

TS = Total Sales Line PC = Fixed Cost


TC = Total Cost Line VC = Variable Cost
BEP = Break Even Point MOS = Margin Of Safety
SL = Selected Level of Activity Angle a = Angle of Incidence.
C = Contribution

Marginal Costing 355


(3) Profit Graph :

In case of this type of break even chart, horizontal axis represents sales volume and
vertical axis represents profit or loss. The diagonal line represents contribution. The
point where the contribution line cuts horizontal axis indicates sales at the Break Even
Point indicating that at this point, there is no profit or no loss.

PL

BEP P
L SALES
} FC

PL = Profit Line L = Loss Area


FC = Fixed Cost BEP = Break Even Point
P = Profit Area

PRACTICAL APPLICATIONS OF MARGINAL COSTING :

The technique of marginal costing can be profitably employed in the following situations.

(1) Evaluation of Performance :

The performance of various segments of a business, say a department or a product or a


branch and so on, can be evaluated with the help of marginal costing and the evaluation
of the performance will be based upon the contribution generating capacity of these
segments. If the fixed costs are apportioned over these segments on any basis
whatsoever, it will be ignored while evaluating the performance.

356 Management Accounting


Illustration :

Following details are available in respect of 3 products.

Products
A B C
Rs. Rs. Rs.
Sales 1,00,000 1,50,000 2,50,000
Total Cost
Variable Cost 90,000 1,00,000 1,50,000
Fixed cost (Apportioned
on the basis of sales) 20,000 30,000 50,000
Total Cost 1,10,000 1,30,000 2,00,000
∴ Profit (Loss) (10,000) 20,000 50,000

As product A is incurring the losses, it is decided to close down its production. Advise the
management,

Solution :

It will not be advisable to close down the production of product A, because it is generating the
positive contribution

(i.e. Rs. 1,00,000 - Rs. 90,000 = Rs. 10,000)

Closing down of product A will mean loss of contribution generated by it, fixed cost still
remaining the same. Assuming that the production of product A is closed down, what will be
the effect on profitability? Let us verify by applying marginal costing principles.

Product B Product C Total


Rs. Rs. Rs.

Sales 1,50,000 2,50,000 4,00,000


Variable Cost 1,00,000 1,50,000 2,50,000
∴ Contribution 50,000 1,00,000 1,50,000
Fixed costs 1,00,000
∴ Profits 50,000

It means that existing total profits of Rs. 60,000 will reduce to Rs. 50,000 which will affect
profitability adversely.

Marginal Costing 357


(2) Profit Planning :

Marginal costing, through the calculations of P/V Ratio, enables the management to
plan the activities in such a way that the profits can be maximised or to maintain a
specific level of profits. As such, this technique helps the planning of profits.

Illustration :

(1) M/s. C and P Ltd. Produces and sells industrial containers and packing cases. Due to
competition, the company proposes to reduce the selling price. If the present level of
profit is to be maintained, indicate the number of units to be sold if the proposed reduction
in price is (a) 10% and (b) 15%. The following information is available:

Rs. Rs.

(1) Present Sales (30,000 Units) 6,00,000


(2) Variable Cost (30,000 Units) 3,60,000
(3) Fixed Cost 1,40,000
5,00,000
(4) Net Profit 1,00,000

Solution :

The present cost structure can be stated as below:

Per Unit Total


Rs. Rs.

Sales 20 6,00,000
Variable Cost 12 3,60,000
Contribution 8 2,40,000
Fixed Cost 1,40,000
Net Profit 1,00,000

If the price is reduced by 10% or 15%, the per unit cost structure is going to change
as below :

Present 10% Price Reduction 15% Price Reduction


Rs. Rs. Rs.
Sales 20 18 17
Variable Cost 12 12 12
Contribution 8 6 5

358 Management Accounting


If the present level of profits is to be maintained i.e. Rs. 1,00,000, the revised total contribution
which the sales will have to generate with reduced per unit contribution will be Expected Profit
+ Fixed Cost, and the number of units which will have to be sold will be :

Expected Profit + Fixed Cost


Revised per unit contribution

As such, the number of units which will have to be sold in the above cases of price reduction
will be -

10% Price Reduction 15% Price Reduction


Rs. 1,00,000 + Rs. 1,40,000 Rs. 1,00,000 + Rs. 1,40,000
Rs. 6 Rs. 5

Rs. 2,40,000 Rs. 2,40,000


= =
Rs. 6 Rs. 5

= 40,000 Units = 48,000 Units

(2) Per Unit cost structure of a single product manufacturing company is as below :

Selling Price Rs. 100


Direct Material Rs. 60
Direct Labour Rs. 10
Variable overheads Rs. 10

Number of Units sold in the year are 5,035. As per the agreement with the employee’s
union, there will be an increase of 10% in Direct wages.

Work out -

(a) How many more units have to be sold next year to maintain same quantum of
profits.

(b) By what percentage the selling price has to be raised to maintain same P/V Ratio?

Marginal Costing 359


Solution :

The present profitability structure is as below :

(i) Total number of units sold 5,035


(ii) Per unit cost structure
Selling price Rs. 100
Variable cost
Direct Material Rs. 60
Direct Labour Rs. 10
Variable Overheads Rs. 10
Rs. 80
Contribution per unit Rs. 20
(iii) Total Contribution Rs. 1,00,700

In the next year, the per unit Direct Labour Cost will be more by 10% i.e. Rs. 11 per unit which
will reduce the per unit contribution to Rs. 19.

Alternative (a) :

If the same quantum of profits is to be maintained, same amount of contribution will have to be
generated with reduced per unit contribution.

As such, number of units required to be sold will be :

Amount of contribution
=
Revised per unit contribution

Rs. 1,00,700
=
Rs. 19

= 5.300 Units

Hence, the company will have to sell 265 units more (i.e. 5,300 Units - 5,035 Units) to maintain
same quantum of profits.

Alternative (b) :

At present, when selling price is Rs. 100, contribution is Rs. 20 meaning that per unit variable
cost is Rs. 80.

In future, the variable cost is likely to be Rs. 81 per unit instead of Rs. 80. Accordingly, the
selling price will also be required to be increased if it is intended that the same P/V Ratio
should be maintained.

360 Management Accounting


The new selling price will be :

Rs. 81
X 100 = Rs. 101.25
Rs. 80

As such, the selling price has to be raised by 1.25% to maintain the same P/V Ratio.

The profitability structure will be -

Selling Price Rs. 101.25


Variable Cost Rs. 81.00
Contribution Rs. 20.25

Contribution per unit


P/V Ratio = X 100
Selling Price per unit

20.25
X 100 = 20%
101.25

(3) Fixation of Selling Price :

The technique of marginal costing may be applied in the area of price fixation in such a
way that prices fixed should cover atleast the variable cost. As in the short run, the fixed
cost is a stagnant cost, it can be ignored, though it can not be ignored in the long run
because of the simple fact, that it is a cost. In the short run, the prices fixed above the
variable cost may generate some positive contribution which may help in the recovery of
fixed cost. However, if the fixed cost is ignored in the long run, it may put the business
into serious troubles as the business will never be able to earn the profits.

In this connection, following propositions should be kept in mind.

(a) In some exceptional circumstances viz. during the phase of depression, serious
competition in the market, to introduce the new product in the market by keeping
the price as low as possible in the initial stages, to dispose off the product which
may deteriorate in quality etc., it may be necessary to fix the selling price even
below the variable cost, however it is a deliberate decision taken by the management.

(b) The above principle is equally applicable while fixing the export price as well. The
export price over and above the variable cost will result into increased amounts of
profits if the fixed costs can be taken care of by the inland sales and if the home
market is not likely to get affected by the export price fixed. However, if certain
specific costs, either fixed or variable, are required to be incurred specifically for the
execution of the export order, they will have to be recovered while fixing the export
price as if it is a part of the variable cost.

Marginal Costing 361


Illustration :

(1) The operating statement of a company is as follows :

Rs.
Sales (80,000 Units @ Rs. 15) 12,00,000
Costs – Variable
Materials 2,40,000
Labour 3,20,000
Overheads 1,60,000
7,20,000
Fixed 3,20,000
Total Costs 10,40,000
Profit 1,60,000

The plant capacity is 1,00,000 units. A customer from U.S.A. is desirous of baying 20,000
units at a net price of Rs. 10 each unit. Advice the company whether or not offer should be
accepted? Will your advice be different if the customer is a local one?

Solution :

At present, variable cost per unit is Rs. 9 i.e.

Rs. 7,20,000
80,000 units

So long as the export price is more than Rs. 9, it is going to generate additional contribution
which is going to increase the profits, as the fixed costs are already covered by the local
sales. As the export price offered is Rs. 10 i.e., Re. 1 more than the variable cost per unit, the
company should accept the offer. The advice will be the same even it the customer is a local
one, provided the price discrimination, i.e. Rs. 15 per unit for 80,000 units and Rs. 10/- per unit
for 20,000 units is not going to adversely affect the current market for 80,000 units at the
current price of Rs. 15. If the company accepts the export offer of Rs. 10 per unit, the revised
profitability structure will be as below:

Rs.
Sales : 80,000 units @ Rs. 15 12,00,000
20,000 units @ Rs. 10 2,00,000
14,00,000

362 Management Accounting


Costs : Variable
1,00,000 units @ Rs. 9 9,00,000
Fixed 3,20,000
Total costs 12,20,000
Profit 1,80,000

The revised amount of profit will be more by Rs. 20,000 as compared to the existing amount of
profits. Hence, the export order should be accepted by the company.

(4) Make or buy decision :

If the management is facing problem to decide whether a component or a product should


be manufactured in house which can be purchased from an outside source as well, the
technique of marginal costing may render useful assistance. E.g. The following cost
data is made available in respect of two components A and B.

Component A Component B
Rs. per unit Rs. per unit
If manufactured
Variable Cost 30 30
Fixed Cost 25 20
55 50
If purchased 40 25

If the above data is viewed from total cost point of view, without considering the
classification of cost like fixed or variable, it may be concluded that the purchase
proposition may be profitable for both the components A and B. However, the conclusion
may be misleading as the total cost in case of component A, if purchased, is not going
to be only Rs. 40 per unit, but it is going to be Rs. 65 (i.e. Rs. 40 purchase price per unit
plus Rs. 25 fixed cost per unit) which being more than present total cost, manufacturing
proposition will be beneficial. On the other hand, in case of component B, total cost, if
purchased, is going to be Rs. 45/- per unit (i.e. Rs. 25 purchase price per unit plus Rs.
20 fixed cost per unit) which being less than present total cost, buying proposition will be
beneficial.

The above conclusions may be simplified in the following way :

If Purchases Price < Variable Cost, go in for purchase proposition.

If Purchase Price > Variable Cost, go in for manufacturing proposition.

Marginal Costing 363


Before taking any make or buy decision only on the basis of marginal cost analysis,
following points should also be taken into consideration.

(1) If buying proposition is beneficial in case of a component or product, the final decision
to buy may depend on other factors also viz. whether the supplier is reliable one,
whether the supplier can assure required quality, whether the supplier can assure
uninterrupted supply etc.

(2) If it is decided to buy a component or a product which was being manufactured till
now, the manufacturing capacity released should be profitably used for some other
purposes. If it is decided to manufacture a companent which was being purchased
till now, there may be two possibilities. One, production capacity used for same
component or product may be diverted to manufacture another component or
product. In this case, the loss of contribution of that another component or product
should be considered as a part of cost. Second, if additional production facilities
are required to be acquired for the manufacturing proposition, the additional fixed
costs attached with the manufacturing proposition should be considered.

(5) Optimising product mix :

Product mix refers to the proportion in which various products of a company can be sold.
If a concern is dealing in a number of products, a problem which usually arises is to
decide a mix or proportion in which the sales of the various products should be made so
that the profits can be maximized. Such a problem can be solved by studying the
contributions generated by the various products individually and by selecting that mix
which generates the maximum total contribution.

Illustration :

Following information has been made available from the cost records of Universal Automobiles
Ltd. manufacturing spare parts
Direct Materials per unit
X Rs. 8
Y Rs. 6
Direct wages
X 24 hours @ 25 paise per hour.
Y 16 hours @ 25 paise per hour.
Variable overheads - 150% of wages
Fixed overheads - Rs. 750
Selling price
X Rs. 25
Y Rs. 20

364 Management Accounting


The Directors want to be acquainted with the desirability of adopting any one of the following
alternative sales mixes in the budget for the next period.

(a) 250 units of X and 250 units of Y

(b) 400 units of Y only

(c) 400 units of X and 100 units of Y

(d) 150 units of X and 350 units of Y

State which of the alternatives you would recommend to management.

Solution :

Productwise Profitability Structure

Product X Product Y
Rs. Rs.

(1) Selling Price per unit 25 20


(2) Variable cost per unit
Direct Material 8 6
Direct Wages 6 4
Variable Overheads 9 6
23 16
(3) Contribution per unit 2 4

Evaluation of various alternative sales mixes as per Total Contribution

Alternative Product X Product Y Total


Rs. Rs. Rs.

a. 250 x 2 = 500 250 x 4 = 1,000 1,500


b. — 400 x 4 = 1,600 1,600
c. 400 x 2 = 800 100 x 4 = 400 1,200
d. 150 x 2 = 300 350 x 4 = 1,400 1,700

Fixed overheads are going to be the same in all these alternatives. As such, the alternative
which generates maximum contribution is the maximum profitable one.As alternative d i.e.
150 units of X and 350 mills of Y generates maximum of contribution, it will be recommended
to the management.

Marginal Costing 365


(6) Cost control :

Marginal costing is necessarily a technique of cost classification and cost presentation.


The segregation of total costs as fixed costs and variable costs itself facilitates the cost
control. Variable costs are the controllable costs at the lower level of management whereas
fixed costs can be controlled only on the top level of management and that too, to a
limited extent only. Classification of costs as fixed costs and variable costs enables the
management to concentrate on the controllable costs. At the same time, the fixed costs
are not completely ignored. The only thing is that they are collected and reported separately
as an amount deducted from total contribution. As such, the fixed costs can also be
controlled as they can be programmed and estimated in advance.

(7) Flexible Budget Preparation :

Marginal costing technique and more particularly the classification of costs as fixed and
variable, facilitates the preparation of flexible budgets which is discussed in details in the
chapter ‘Budgetary Control’.

PROBLEM OF KEY FACTOR :

Under the marginal costing technique, profitability is measured in terms of the contribution
and the products generating maximum contribution or having maximum P/V Ratio are treated
as the maximum profitable products. As the intention of every business is to maximize the
profits, the company will concentrate maximum on the products having highest P/V Ratio and
will thus maximize the profits. However, in practice, there may be some factors which may
come into play which may restrict the company’s intention or capability to maximize the
profits E.g. In case of the products having highest P/V Ratio, market may be limited, or in
case of a maximum profitable product, raw material may not be available. These factors are in
the form of ‘Key Factor’ or ‘Limiting Factor’ or ‘Scarce Factor’. A key factor is defined as the
factor which, at a particular point of time or over a period, will limit the volume of output. The
key factor may be in various forms viz. sales/market, material, labour, machine availability and
so on. In order to evaluate the profitability of a product under key factor situations, the contribution
per unit of key factor is the basic criteria. A product generating maximum contribution per unit
of key factor is the maximum profitable product.

366 Management Accounting


Illustration :

From the following details, which product would be recommended if time is the key factor.

Product A Product B

Direct Material per unit Rs. 24 Rs. 14


Direct Labour @ Rs. 2 per hour Rs. 20 Rs. 30
Variable Overheads (% of labour cost) 200% 300%
Selling Price per unit Rs. 150 Rs. 200

Solution :

Product A Product B

(1) Selling Price Unit Rs. 150 200


(2) Variable Cost per unit Rs.
Direct Material 24 14
Direct Labour 20 30
Variable Overheads 40 90
84 134
(3) Contribution per unit Rs. 66 66
(4) Number of labour hours 10 15
(5) Contribution per labour hour Rs. 6.6 4.4

As labour hours is the key factor and contribution per labour hour is more in case of product A,
it will be recommended for production.

Multiplicity of Key Factors

In practice, more than one key factors may come into play and any decision regarding product
mix ascertainment or profitability ascertainment will have to be decided on the basis of
consideration of multiplicity of key factors. The situation of multiplicity of key factors is a more
complex situation, the solutions to which may be found in the more advanced techniques like
linear programming.

Marginal Costing 367


Illustration :

Following data is available to decide the product mix.

A B C
Raw material per unit 10 kgs 6 kgs 15 kgs.
Labour Hours required 15 25 20
(Rate Rs. 1 per hour)
Selling price per unit Rs. 125 100 200
Maximum production
Possible Units 6,000 4,000 3,000

1,00,000 kgs of raw material is available at Rs. 10 per kg. Maximum production hours are
1,84,000 with a facility for a further 15,000 hours on overtime basis at twice the normal wage
rate.

Solution :

Product A Product B Product C


(1) Selling Price per units Rs. 125 100 200
(2) Variable cost
Material 100 60 150
Labour 15 25 20
115 85 170
(3) Contribution per unit Rs. 10 15 30
(4) Contribution per Kg of Raw material - Rs. 1.00 2.50 2.00
(5) Contribution per labour hrs Rs. 0.66 0.60 1.50

Considering the contribution per kg of raw material as well as per labour hour, the rankings
among the various products will be as below.
I - Product C
II - Product B
III - Product A

Hence, the available raw material and labour hours will be used for the manufacture of Product
C and Product B respectively.

368 Management Accounting


Product Units Raw Material Kgs. Labour Hours No.

C 3,000 45,000 60,000


B 4,000 24,000 1,00,000
69,000 1,60,000

Hence, the balance of raw material and labour hours available for manufacturing of Product A
will be as below.

Raw Material - Kgs. - 31,000 kgs. (i.e. 1,00,000 kgs - 69,000 kgs)
Labour Hours - 24,000 (i.e. 1,84,000 - 1,60,000)
Plus 15,000 extra hours by paying double the normal wage rate.

If extra labour hours are used for the manufacture of product A by paying double the normal
wage rate, the cost structure of product A will be as below :

(1) Selling Price per unit Rs. 125


(2) Variable cost per unit
Material Rs. 100
Labour Rs. 30
Rs. 130
(3) Contribution per unit (-) Rs. 5

As there cannot be the positive contribution generated, it will not be advisable to use the
labour hours which require the payment of wages at double the normal wage rate. As such,
product A will be manufactured by utilising the labour hours which require the payment of
wages at the normal wage rate only i.e. 24,000 hours with the help of which 1,600 units of A
(24,000 Hours/ 15 Hours per unit) can be manufactured. As such, the final product mix will be
as below.

Product A 1,600 Units


Product B 4,000 Units
Product C 3,000 Units

Note : One alternate solution is possible to solve the problem of key factors. If the labour
hours which require the payment of wages at double the normal wage rate can be utilised for
the manufacture of Product C, its cost structure will be as below.

Marginal Costing 369


(1) Selling Price Per Unit Rs. 200
(2) Variable cost per unit
Material Rs. 150
Labour Rs. 40
Rs. 190
(3) Contribution per unit Rs. 10

As such, apparently it may be possible to utilise the labour hours carrying double the normal
wage rate for manufacturing product C and utilise the released labour hours carrying the
normal wage rate for manufacturing Product A (i.e. 15,000 hours) In this case, the final product
mix will be as below.
Product A – 2,600 Units
Product B – 4,000 Units
Product C – 3,000 Units
The calculation of total contribution generated under both those alternatives is as below.

Alternative I

Product No. of Units Contribution Total Contribution


Per Unit Rs. Rs.

A 1,600 10 16,000
B 4,000 15 60,000
C 3,000 30 90,000
1,66,000

Alternative II

Product No. of Units Contribution Total Contribution


Per Unit Rs. Rs.

A 2,600 10 26,000
B 4,000 15 60,000
C 2,250 30 67,500
C 750 10 7,500
1,61,000

As in the second alternative, the total contribution generated is less than the one generated in
the first alternative, the second alternative can not be accepted. As such, it will be advisable
for the company not to utilise the labour hours requiring the payment of wages at double the
normal wage rate.

370 Management Accounting


LIMITATIONS OF MARGINAL COSTING

(1) The classification of total cost as variable cost and fixed cost is difficult. No cost can be
completely variable or completely fixed. In some cases, the cost which is considered to
be variable, may not be variable in practical terms E.g. Direct Labour Cost. Under normal
situations this cost is treated as variable cost. However, in India, considering the
tremendous legal backing the workers are having, the direct labour cost may not be
variable in nature. As such, it may be necessary to consider the direct labour cost as a
part of fixed cost.

(2) Under the marginal costing, the fixed costs are eliminated for the valuation of inventory of
finished goods and semi-finished goods, inspite of the fact that they might have been
actually incurred. As such, it is not correct to eliminate the fixed costs. Further, such an
elimination affects the profitability adversely.

(3) In the age of increased automation and technological development, the component of
fixed costs in the overall cost structure may be sizeable. Any technique like marginal
costing which ignores the fixed costs altogether, may not be proper under these
circumstances as a major portion of cost is not taken care of.

(4) Marginal costing technique does not provide any standard for the evaluation of performance.
In that sense, the techniques of budgetory control and standard costing may be considered
to be better techniques from cost control point of view.

(5) Fixation of selling price on marginal cost basis may be useful for short term only. Here
also, an undue importance given to only variable cost may result into taking on heavy
business with low margin which in turn may increase the fixed costs. As such, over the
long run, the prices should be decided on total cost basis only. Fixation of selling price
on the marginal cost basis in the long run may be dangerous. Moreover, consideration of
fixed costs may be necessary in price fixation under certain circumstances like cost
plus contracts unless a very high percentage over the marginal cost is considered to
take care of both fixed costs as well as profit margin.

(6) Marginal costing does not take into consideration the fixed overheads, as such the
problem of under or over absorption of fixed overheads can be avoided. But the problem
of under or over absorption of variable overheads cannot be avoided.

(7) Marginal costing can be used for assessment of profitability only in the short run. However,
in the long run, one has to consider the fixed costs also in order to assess the profitability.
Moreover, interpretation of the term ‘short run’ is a subjective concept. For how long the
decision can be taken on the basis of marginal costing principles cannot be decided in
the objective manner.

Marginal Costing 371


ILLUSTRATIVE PROBLEMS

(1) Profit and sales for the year 1984 are as follows. Profit Rs. 18,000, Sales Rs. 2,40,000.
In 1985, the sales increased by Rs. 40,000 and the profit naturally increased by Rs.
8,000.

You are required to calculate.

(1) P/V Ratio

(2) Sales required to achieve a profit of Rs. 1,00,000.

(3) Sales at Break even Point.

Solution :

We know that

Increase in Profits
P/V Ratio = X 100
Increase in Sales

P/V Ratio = 8,000


X 100 = 20% ...(a)
40,000

We also know that Sales x P/V Ratio = Contribution


and Contribution - Profit = Fixed Cost.
Applying this to the information available for the year 1984
2,40,000 x 20% = Rs. 48,000 is the contribution and
48,000 - 18,000 = Rs .30,000 is the fixed cost

If the company wants to achieve the profit of Rs. 1,00,000 the total contribution which will have
to be generated will be Expected Profit + Fixed cost
i.e. Rs. 1,00,000 + Rs. 30,000
i.e. Rs. 1,30,000

Contribution
We know that Sales =
P/V Ratio

As such sales required to achieve a profit of Rs. 1,00,000 will be

Expected Profit + Fixed Cost


P/V Ratio

372 Management Accounting


1,00,000 + 30,000
=
20%
1,30,000
= = Rs. 6,50,000 ...(b)
20%

We know that
Fixed Cost
Break Even Point =
P/V Ratio
30,000
∴ Sales at Break Even Point =
20%
= Rs. 1,50,000 …(c)

(2) The Directors of Sports Material Manufacturing Co. gives the following information.

Sales - (1,00,000 Units) - Rs. 1,00,000


Variable Costs - Rs. 40,000
Fixed Costs - Rs. 50,000

(a) Find out P/V Ratio, Break Even Point and Margin of Safety.
(b) Evaluate the effects on P/V Ratio, Break Even Point and Margin of safety of the
following -
(i) 20% increase in physical sales volume.
(ii) 10% increase in fixed costs.
(iii) 5% decrease in variable costs.
(iv) 10% increase in selling price.

Solution :

(A) Present profitability structure is as below.

Sales - 1,00,000 Units

Per Unit (Rs.) Total (Rs.)


Sales 1.00 1,00,000
Variable Costs 0.40 40,000
Contribution 0.60 60,000
Fixed Costs