UNIT

01 Introduction to Cost and

Management Accounting

Names of Sub-Units

Sources of Data (Internal and External), Concept of Cost and Costing, Meaning of Cost Accounting and
Management Accounting, Objectives of Cost Accounting, Cost Accounting v/s Financial Accounting,
Cost Accounting v/s Management Accounting, Advantages of Cost Accounting.

Overview
This book titled Cost and Management Accounting deals with two different but related types of
accounting namely cost accounting and management accounting. This unit discusses about the
sources of data (internal & external), the concept of cost and costing, and the meanings of cost
accounting and management accounting. Further, the unit discusses the important objectives of cost
accounting and the major differences between cost accounting and financial accounting. Towards
the end, the unit discusses the advantages of cost accounting and how cost accounting differs from
management accounting.

Learning Objectives

In this unit, you will learn to:

 Explain the sources of data (internal & external)
 Discuss the concept of cost and costing
 Describe the meaning of cost accounting and management accounting
 List the objectives of cost accounting
 Differentiate between cost accounting and financial accounting
 Compare cost accounting and management accounting
 Examine the advantages of cost accounting
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Cost and Management Accounting

Learning Outcomes

At the end of this unit, you would:

 Evaluate the significance of cost accounting and management accounting
 Appraise the use of cost accounting and management accounting
 Outline the advantages of cost accounting

Pre-Unit Preparatory Material

 https://www.javatpoint.com/cost-accounting-vs-financial-accounting
 https://www.costmanagement.eu/blog-article/what-is-cost-and-management-accounting

1.1 INTRODUCTION
Organisations produce goods and provide services and these activities involve some expenditure
which may be direct or indirect with an ultimate goal to generate profits. Therefore, to earn profits, the
organisation needs to identify the basic elements of a transaction, which are cost, profit and price.

Suppose an organisation launches a new product. To produce the product, it incurs `4000 for material,
`5000 for labour, `5000 for other expenses on every unit. The selling price of the product is fixed at
`20,000 per piece. Thus, the cost of the machine is `14000 (4000 + 5000 + 5000). Therefore, the profit per
unit is `6000 (20,000 − 14000).

The management needs details such as cost, profit, sales, revenue, price for carrying out the core
managerial activities such as planning, cost control and decision making. All such information cannot
be provided by financial accounting process. This limitation of financial accounting has led to the
development of cost accounting which is a new system of accounting cost information of each product,
job department, process, etc.

Cost accounting is a branch of accounting that involves classification, recording and allocation of
expenditure for determining the cost of products or services. It applies accounting principles and costing
methods for ascertaining costs and comparing it with previous experiences and standards.

1.2 SOURCES OF DATA (INTERNAL & EXTERNAL)

Management data comes from multiple sources. The challenge for a business is to capture and use
relevant and reliable data. It is important to note that the value of such data should exceed the price
of getting this data. Modern IT systems have reduced the cost of such data. In general, data can be
obtained from internal and external sources.

Internal Sources
Accounting records are the most important source of internal data and include sales ledgers, purchase
ledgers, general ledgers and cost ledgers. All these records provide a historical summary of the

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organisation. At times, certain internal records are utilised by other functions of the organisation also.
For example, the marketing and the administration departments use the sales data and employee data
respectively.

The organisations also try to maintain the integrity of their systems and control over transactions.
For instance, the inventory management and control system is used by the management to record and
retrieve data related to monetary value of purchase, inventory in hand, purchase orders, goods received
notes, goods returned notes, etc.

Apart from accounting records, there are certain other internal sources from which information can be
derived. For instance, the data related to employees is linked to the payroll systems. The management
may use this data to determine the availability and rate of pay of different staff and the cost of recruiting
staff from outside.

The production department produces important data related to the machinery, materials, WIP, capacity,
fuel consumption, employee movement, set up times, etc.

In case of service-oriented businesses such as lawyers, advocates, etc.; the management and the key
employees usually maintain an account of time that they have spent on different activities and cases to
justify the fees they charge from clients and assess the efficiency of operations.

External Sources
Organisations also receive and send computer-based or paper-based communication and information
in form of letters, invoices, e-mails and advertisements. All these constitute external sources of data.
External sources of data are further divided into two main categories namely primary sources and
secondary sources. Primary data is the one that is derived for the first time by simply searching or
analysing available data. Secondary data is the one that is compiled or collected from the already
available sources such as books, articles, verbal or written reports. A few examples of external/secondary
sources of data are:
 Government publications on financial and monetary policies
 Press releases, newspapers, technical magazines, journals, etc. provide data concerning share value,
technological developments, updates about competitors and their products
 Banks offer data on potential customers and national markets
 Financial statements of different businesses
 Internet websites, social networking sites, forums etc.
 Databases controlled by public bodies and businesses
 Data warehouses that contain data from each internal & external sources

1.3 CONCEPT OF COST AND COSTING

For an organisation, cost refers to the monetary value that a company spends in order to produce a
good is called cost. The overall cost is comprised of various different costs such as factory cost, prime
cost, sunk cost, indirect and direct cost, labour cost, electricity cost, overhead costs, etc. This is the cost

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Cost and Management Accounting

incurred by an organisation to produce the goods. If the organisation sold its products at a price equal
to its overall cost, it will be able to breakeven or attain a no-profit and no-loss position.
Costing refers to the processes and techniques used in ascertaining the costs. In other words, costing
refers to a systematic process that is used to determine the unit cost of a product or service. Organisations
use costing systems to determine their cost of production. Frequently, costing methods make use of
historical costing and standard costing methods. Costing involves an analysis of both fixed as well as
variable costs.
The overall cost of a product or service is comprised of various elements. The different elements of costs
and their classification are shown in Figure 1:

Direct Materials
Material
Indirect Materials

Direct Materials
Classification
Labour
of Costs
Indirect Labour

Direct Expenses
Expenses
Indirect Expenses

Figure 1: Classification of Costs

Note:
1. Indirect Material + Indirect Labour + Indirect Expenses = Overheads
2. Overheads include factory/works overheads, office and administrative overheads, selling overheads and
distribution overheads.

Let us now study about these different elements of cost as:

 Direct material: The materials that form a part of the final product or are easily traceable in the
final product are direct materials. It must be noted that material should be traceable in the final
product in an economical way. Example: fabric used in garments.
 Indirect material: The materials that are not necessary for production but provide support to the
production processes indirectly are called indirect material. Example: printers, stationery material,
etc.
 Direct labour: Direct labour refers to labour costs that can be completely attributed to a cost centre
is called direct labour. Example: employees engaged in the actual production of goods or rendering
of services.
 Indirect labour: Indirect labour refers to labour costs that cannot be completely attributed to a cost
centre but can be absorbed by a cost centre. Example: labour costs related to foreman, supervisors,
etc.

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 Direct expenses: All expenses other than labour or material which can be directly attributed to a
cost centre are direct expenses. Example: cost of special layout, fees paid to consultants in connection
with a job.
 Indirect expenses: All expenses that cannot be allocated to cost centres completely conveniently
and cannot associated directly with any cost centre are indirect expenses. Example: rent, insurance,
power.

The costs can also be classified into the following categories:

 Manufacturing costs: All costs incurred in the production process, i.e., direct material, direct labour,
direct expenses and overheads that can be attributed to the production activity, are included in
manufacturing costs.
 Administration costs: All those costs that are required for the management and for supporting
organisational processes such as formulation of policies, direction setting within the organisation,
and control of operations but not related to the production, research, development or selling and
distribution are called administrative costs. Example: the cost of personnel in the accounting
department of the organisation, cost involved in setting budgets for the organisation and so on.
 Selling and distribution costs: All costs that are incurred by an organisation for gaining customers
for an organisation, are selling costs. Example: sales promotion, personal selling, market research,
etc. Costs related to making the product available for customers after production and packaging
are completed are called distribution costs. Example: warehousing costs, delivery costs, etc.
 Research and development cost: Costs incurred for gaining new knowledge or understanding
related to new products, processes or materials having commercial viability can be introduced.
 Fixed cost: The portion of cost that remains same irrespective of the volume of activity is called
fixed cost. Fixed cost does not change with change in output. For example, factory rent paid remains
unaffected by changes in the production quantity.
 Variable cost: Costs that vary with change in the production quantity are called variable costs.
Example: direct materials used in the manufacturing of products will vary directly with the changes
in output.
 Semi-variable cost: Costs which contain elements of fixed as well as variable costs are semi-variable
costs. These can be divided into fixed and variable components. Example: gas and electricity.
 Controllable cost: Costs that can be directly regulated by a particular authority within the
organisation are called controllable costs. Example: management decides the quantity direct
materials to be purchased.
 Uncontrollable cost: Costs that are not influenced by any authority within the organisation are
called uncontrollable costs.

1.4 MEANING OF COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Cost accounting is a branch of accounting that is concerned with the ascertainment of past, present
and future costs of products or services. Cost accounting helps in determining the costs of products and
services. Financial accounting provides financial statements that are used by management. However,

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Cost and Management Accounting

management also requires detailed information provided by cost accounting for multiple reasons such
as optimising use of scarce resources and controlling expenditure incurred under various heads with
an aim to increase the overall profitability of the organisation.

The term management accounting refers to accounting for management. Management accounting is a
tool used by the management and provides techniques for interpreting accounting data. Management
accounting facilitates decision-making process through the management. Managers require
information about business activities to make decisions so that organisational goals can be realised
effectively. Business decisions entail uncertainty which cannot be eliminated but may be reduced.

Management accounting is a management-oriented accounting that provides relevant accounting

information to the management for pursuing activities such as planning, organising, decision making
and controlling. Management accounting is meant for internal use. It helps managers build prudent
business choices for short-term as well as long-term. Management accounting helps the managers
make forecasts, make-or-buy decisions, forecast financial gains and cash-flows.

The importance of management accounting data can be explained using following points:
 Provides accounting cost and other statistical data to the management for use in planning and
decision making
 Helps in assessing sustainability and feasibility of different business plans formulated by the
management.
 Helps in measuring the actual performance against standards
 Helps in reporting the results of operations
 Helps in finding out the best alternative

1.5 OBJECTIVES OF COST ACCOUNTING

Determining costs, controlling costs and providing costing information is the most important objective
of cost accounting. Apart from these, some other objectives of cost accounting include:
 Determining the selling price
 Controlling and reducing costs
 Comparing actual costs with standard costs and taking corrective actions in case of discrepancies
 Providing guidance to management for decision making (such as make or buy decisions, capacity
optimisation, etc.)

Cost accounting makes use of cost accounting principles, methods and techniques for controlling cost
and ascertaining profits. The scope of cost accounting includes the following:
 Cost ascertainment
 Cost control
 Cost reporting
 Cost audit by a qualified cost accountant

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The objective of the cost accounting is to work out the strategies to lower the expenditure on materials,
wages and overheads. Organisations are concerned with ascertaining the per unit costs for different
products. Some other objectives of cost accounting include:
 Presenting and interpreting information for management designing, decision-making, and
management.
 Helping in the preparation of budgets
 Implementing monetary fund management
 Aiding management in the formulation and implementation of incentive bonus plans for increasing
productivity and cost savings
 Organising cost reduction programmes with the assistance of various division managers
 Providing specialised services for value audit so as to eliminate errors and frauds.
 Providing reliable data to management on on-demand basis
 Determining cost accounting profit or loss by linking the revenues to prices of these products or
services

1.6 COST ACCOUNTING VS. FINANCIAL ACCOUNTING

Both Cost accounting and Financial accounting help the management in formulating organisational
policies and decision making. Financial management offers a broad overview of profit or loss situation
whereas cost accounting helps in carrying out elaborate product-wise analysis.

For example, if a corporation is dealing in ten sorts of merchandise, financial accounting provides data
of all the merchandise in for different classes of expense heads such as cost of fabric, cost of labour,
freight charges, direct expenses, and indirect expenses. On the other hand, cost accounting offers details
of every overhead product-wise, like materials, labour, direct and indirect expenses. Cost accounting
helps in deriving product-wise cost and profit.

Cost accounting relates to cost accumulation, cost classification, and cost control, etc. whereas
financial accounting focuses on recording, classifying, summarising and presenting all transactions
of the organisation (historical data) keeping in view the general needs of different stakeholders such as
creditors, lenders, employees, shareholders, etc. Cost accountants classify different costs according to
work activities and processes.

Table 1 lists the major differences between cost accounting and financial accounting.

Financial Accounting Cost Accounting

Financial accounting provides information about the Cost accounting helps in ascertaining costs for
financial position and profitability of an organisation. cost control and decision making. It also helps in
determining the cost of the merchandise along with
variable prices, fastened prices, semi-fixed prices,
overheads and opportunity cost.
It is essential to prepare and publish financial Cost reports can be prepared on an on-demand basis.
statements periodically (annually).

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Cost and Management Accounting

Financial Accounting Cost Accounting

Involves recording transactions and analysing them. Involves use of costing techniques such as budgetary
control and standard costing for controlling costs.
Financial accounting makes use of historical data. Cost accounting makes use of historical data as well
as pre-determined cost data.
Provides information for all units as well as for the Provides cost data for different cost objects and cost
entire entity. centres.
Financial statements are presented in a specified No specified format in general, but format for cost
format. audit reports is usually specified.

1.7 COST ACCOUNTING VS. MANAGEMENT ACCOUNTING

Management accounting collects information from cost accounting and financial accounting which it
analyses and interprets to generate reports and other information for the management.

Table 2 lists the major differences between cost accounting and financial accounting.

Management Accounting Cost Accounting

Management accounting provides management with The primary objective of cost accounting is to assess
the knowledge for effective execution of planning, the cost of goods or services and to monitor them.
directing and managing activities.
On the basis of past and current expense data, Both past and current statistics are based on
management accounting deals with future cost accounting.
projections.
No prescribed procedures, practices or processes. Follows defined processes and practices.
Uses both qualitative and quantitative information. Cost accounting makes no prescriptions in respect of
what information is used.
Its scope includes: financial accounting, expense Its scope includes: cost assessment and cost control.
accounting, budgeting, tax preparation and
management reporting.

1.8 ADVANTAGES OF COST ACCOUNTING

Cost accounting method helps in organising and analysing data to determine if an organisation earns
and uses funds. The advantages of accounting are:
 Cost object analysis: Revenues and expenses may be grouped by cost objects such as by product, by
channel, to determine which of them are profitable or need additional support.
 Investigation of causes: An effective cost controller locates issues in an organisation, discovers the
reasons behind the problem, and recommends solutions to management. Trend analysis of costs may
be tracked to determine trends and any changes that fall outside the usual trends are investigated.
 Budget compliance: Actual costs incurred may be compared to the budgeted or standard prices to
determine deviations.

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Some other advantages of cost accounting include: inventory valuation, measuring efficiency,
facilitating decision making, making effective budgets, and higher bonus plan.

Conclusion 1.9 CONCLUSION

 Management data comes from multiple sources.

 In general, data can be obtained from internal and external sources.
 Accounting records are the most important source of internal data and include sales ledgers,
purchase ledgers, general ledgers and cost ledgers.
 The organisations also try to maintain the integrity of their systems and control over transactions.
For instance, the inventory management and control system is used by the management to record
and retrieve data related to monetary value of purchase, inventory in hand, purchase orders, goods
received notes, goods returned notes, etc.
 Organisations also receive and send computer-based or paper-based communication and
information in form of letters, invoices, e-mails and advertisements.
 For an organisation, cost refers to the monetary value that a company spends in order to produce
a good is called cost. The overall cost is comprised of various different costs such as factory cost,
prime cost, sunk cost, indirect and direct cost, labour cost, electricity cost, overhead costs, etc. This
is the cost incurred by an organisation to produce the goods. If the organisation sold its products at
a price equal to its overall cost, it will be able to breakeven or attain a no-profit and no-loss position.
 Costing refers to the processes and techniques used in ascertaining the costs.
 The overall cost of a product or service is comprised of various elements such as: direct materials,
indirect materials, direct labour, indirect labour, direct expenses, indirect expenses, etc.
 Cost accounting is a branch of accounting that is concerned with the ascertainment of past, present
and future costs of products or services. Cost accounting helps in determining the costs of products
and services. Financial accounting provides financial statements that are used by management.
 Management accounting is a management-oriented accounting that provides relevant accounting
information to the management for pursuing activities such as planning, organising, decision
making and controlling.
 Objectives of cost accounting include: determining the selling price, controlling and reducing costs,
etc.
 Cost accounting relates to cost accumulation, cost classification, and cost control, etc. whereas
financial accounting focuses on recording, classifying, summarising and presenting all transactions
of the organisation (historical data) keeping in view the general needs of different stakeholders such
as creditors, lenders, employees, shareholders, etc.
 The advantages of accounting are: cost object analysis, investigation of causes and budget
compliance.

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Cost and Management Accounting

1.10 GLOSSARY

 Cost classification: The separation of different types of costs into different groups
 Cost control: The practice of reducing or eliminating costs to increase profits
 Cost object: Any item for which costs are calculated separately
 Factory cost: The total cost required for manufacturing a product

1.11 CASE STUDY: SIGNIFICANCE OF COST ACCOUNTING IN ABC CO.

Case Objective
This Case Study discusses the significance of cost accounting.

ABC Co. produces delicious varieties of ice cream in multiple flavours. Consumers appreciate the quality
and natural fruit taste of its ice cream. The company has passed all the food quality tests and also
has all the required food quality certificates and licenses for the coming 10 years. All age groups and
specifically children of age group 3 to 15 years like this ice cream. Children like the free gifts that they
get free with the ice cream.

The company organises quiz competitions for children and gives awards, certificates and free ice creams
for a certain period of time to the winners.

The Company had generated funds in the past and decided to go for expansion. Due to its popularity,
ABC wants to enter the market of probiotic drinks and frozen yogurts without compromising on the
taste, quiz activities and customer

retention with freebies. Before actually expanding its operations and products, the management wants
to determine the per unit cost of the probiotic drinks and frozen yogurts. For this purpose, the production
and the marketing & sales teams calculated the per unit cost of manufacturing frozen yogurt and
probiotic drinks. They determined that the per unit cost of ice cream was `3. The cost of frozen yogurt
was estimated to be in the range of `4-6 and whereas probiotic drinks cost range between `3.50 to 7.

The teams also told the management that the purchase of new machinery is required to start the
manufacturing process of frozen yogurt and probiotic drinks. The teams were able to find out the actual
direct per unit cost of probiotic drinks and yoghurt but they couldn’t determine the exact indirect costs
for these products.

They estimated that the indirect cost would include two shifts of watchmen at the factory premises
as the production plan necessitates the production of ice creams during the day whereas yogurt and
probiotic drinks would be produced at night. Also, it is required that new workers should be hired for
the second shift.

The teams were also able to reduce the cost of manufacturing yogurt and probiotic drinks by 15%. The
Company launched its new products and it distributed samples of frozen yogurt and probiotic drinks in
place of freebies which helped in reducing marketing costs for launching the products. The consumers
liked the taste of new products and the company started production of new products.

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During its launch month, the company made a profit of 25% on the sale of new products. Due to the
success of probiotics and yoghurt, the company has decided to open up five more production units in
five different cities of India in the year.

Questions
1. Why is it important to calculate the cost per unit of the product before launching new products?
(Hint: It helps in determining the efficiency and success of a company and the steps to improve.)
2. What were the direct and indirect costs involved in manufacturing new products by ABC Co.?
(Hint: Direct costs include raw materials. Indirect costs include cost of two shifts of watchmen and
cost of new workers.)

1.12 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. What are the sources of data for accounting?
2. Differentiate between cost accounting and financial accounting.
3. Explain the concept of cost and costing.
4. Differentiate between cost accounting and management accounting.

1.13 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. In general, data can be obtained from internal and external sources. Accounting records are the
most important source of internal data and include sales ledgers, purchase ledgers, general ledgers
and cost ledgers. All these records provide a historical summary of the organisation. Apart from
accounting records, there are certain other internal sources from which information can be derived.
For instance, the data related to employees is linked to the payroll systems. Refer to Section Sources
of Data (Internal & External)
2. Cost refers to the monetary value that a company spends in order to produce a good is called cost. The
overall cost is comprised of various different costs such as factory cost, prime cost, sunk cost, indirect
and direct cost, labour cost, electricity cost, overhead costs, etc. Costing refers to the processes and
techniques used in ascertaining the costs. In other words, costing refers to a systematic process
that is used to determine the unit cost of a product or service. Refer to Section Concept of Cost and
Costing
3. Financial accounting provides information about the financial position and profitability of an
organisation whereas cost accounting helps in ascertaining costs for cost control and decision
making. It also helps in determining the cost of the merchandise along with variable prices, fastened
prices, semi-fixed prices, overheads and opportunity cost. Refer to Section Cost accounting vs.
Financial Accounting

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Cost and Management Accounting

4. Management accounting provides management with the knowledge for effective execution of
planning, directing and managing activities whereas the primary objective of cost accounting is
to assess the cost of goods or services and to monitor them. Refer to Section Cost Accounting vs.
Management Accounting

@ 1.14 POST-UNIT READING MATERIAL

 https://byjus.com/commerce/difference-between-cost-accounting-and-management-accounting/
 https://maaw.info/Chapter2.htm

1.15 TOPICS FOR DISCUSSION FORUMS

 Discuss and elaborate about the use of accounting information systems.

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 UNIT

02 Cost Concepts and Classification

Names of Sub-Units

Classification of cost based on nature of expense, function and variability, cost behaviour with the
help of graph, meaning of cost object, cost unit, cost center, preparation of cost statement and cost
sheets, tender and quotation.

Overview
The unit starts by explaining the concept of cost classification based on nature of expense and function
and variability of cost. Further it explains the cost behaviour using graph and meaning of cost objects,
cost units and cost center. It also explains preparation of cost statement or cost sheet and concept of
tender and quotation.

Learning Objectives

In this unit, you will learn to:

 Discuss the classification of cost based on nature of expense
 Describe function and variability
 Explain cost behaviour using graph
 Highlight the meaning of cost object, cost units and cost centers
 Discuss tender and quotation
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Cost and Management Accounting

Learning Outcomes

At the end of this unit, you would:

 Assess the cost classification based on the nature
 Evaluate the function and variability of cost
 Analyse the cost behaviour
 Appraise the meaning of cost object, cost units and cost centers
 Analyse the preparation of cost sheet
 Examine tender and quotation

Pre-Unit Preparatory Material

 https://www.academia.edu/20408965/Chapter_12_Cost_Sheet_or_Statement_of_Cost
 https://www.accountingtools.com/articles/cost-classification.html

2.1 INTRODUCTION

Concept of Cost
According to the Chartered Institute of Management Accountants, price is “the quantity of expenditure
(actual or notional) incurred on or due to a mere issue or activity.” equally, in keeping with Anthony
and Walsh “cost could be a measuring in financial terms of the number of resources used for a few
functions.”
Cost has been outlined by the Committee on price word of the yank Accounting Association as “the
preceding, in financial terms, incurred or doubtless to be incurred within the realisation of the target of
management which can be producing of a product or rendering of a service.”
From the top, it should be declared that price means the entire of all expenses incurred for a product or
a service. Thus, price of an editorial means the particular outgoings or observed changes incurred in
its production and sale activities. In short, it’s the number of resources burnt up in exchange for a few
products or services.
Cost is “a proceeding, measured in financial terms, incurred or probably to be incurred to realize a
particular objective”.
Cost refers to the financial live of the quantity of resources given up or used for a few nominal purpose.
It’s the worth the products or services gone to get current or future advantages.

Costs will be classified in numerous ways. There are producing prices and non-manufacturing prices,
direct and indirect prices, product and amount prices, governable and uncontrollable prices, fastened
and variable, etc.

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Management accountants have to be compelled to perceive price ideas as a result they’re very important
in several areas of coming up with, control and decision-making. This chapter presents the various
styles of prices and merchandise cost accounting systems.

It is the worth the products or services gone to get current or future advantages. Costs are often classified
in several ways. There are producing prices and non-manufacturing prices, direct and indirect prices,
product and amount prices, governable and uncontrollable prices, fastened and variable, etc.
The supposed resources area unit is expressed in terms of cash or financial units. What we have a
tendency to declare on top of won’t be an important one till constant is employed with an adjective
solely, i.e. once it communicates which means that it’s meant.

Thus, once we say Prime price or Works price or fixed costs etc., we would like to elucidate a specific
which means that is crucial whereas computing, mensuration or analysing the varied aspects of price.

Classification of Cost
Classification of prices implies the method of grouping prices in keeping with their common
characteristics. Correct classification of prices is totally necessary to say the prices with cost centres
the same price figure is also classified in numerous ways that in keeping with the requirements of the
companies.

2.2 CLASSIFICATION BASED ON NATURE OF EXPENSES

Classification by nature
Based on nature, cost can be classified as:
1. Direct cost
2. Indirect cost
1. Direct cost: Direct cost is the cost experienced by an organisation while doing its core business
activity and may be directly attributable to production costs such as raw material costs, wages paid
to factory employees and so on.
2. Indirect cost: Any expense that is not directly associated with a single, ultimate cost objective but
is associated with two or more final cost objectives or an intermediate cost objective is considered
an indirect cost. It is not subject to direct cost treatment. Direct costs are those that remain to be
assigned to the various cost objectives after direct costs have been identified and charged directly
to the contract or other job. If additional expenditures expended for the same purpose in similar
circumstances have been included as a direct cost of that or any other final cost target, an indirect
cost shall not be allocated to that or any other final cost objective.
This is the analytical classification of prices. Thus, primarily there square measure 3 broad classes as
per this classification, specifically Labour price, Materials price and Expenses. They assist ascertain
the full price and confirm the price of the work-in-progress.
3. Material Costs: Material costs square measure the prices of any materials we have a tendency to use
within the production of products. We have a tendency to divide these prices more. As an example,
let’s divide material prices into stuff prices, spare elements, prices of packaging material etc.

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4. Labour Costs: Labour costs consist of the remuneration and wages paid to permanent and temporary
staff within the pursuit of the producing of the products
5. Expenses: All alternative expenses related to creating and marketing the products or services.

2.3 FUNCTION AND VARIABILITY

Function
The total costs are divided into totally different segments in keeping with the aim of the firm. That’s
why prices are sorted as per the necessities of the firm so as to gauge its functions properly. In short,
the entire prices embrace all prices ranging from the price of materials to the value of packing the
merchandise.

It takes the value of direct material, direct labour and indictable expenses and every one indirect expense
underneath the pinnacle Manufacturing/Production price.

At constant time administration price (i.e., with reference to workplace and administration) and
marketing and Distribution expenses (i.e., with reference to sales) are to be classified singly and to be
value-added so as to seek out the entire price of the merchandise. If these useful classifications aren’t
created properly, true price of the merchandise cannot accurately be observed.

Variability
Practically, prices are classified in keeping with their behaviour with reference to the modification
(increase or decrease) in their volume of activity.

These prices as per volume are also divided into:

i. Fastened Cost;
ii. Variable Cost;
ii. Semi-variable value.

Fixed costs square measure those that don’t vary with the amendment in output, i.e., no matter the
number of output created, it remains fastened (i.e., Salaries, Rent etc.) up to an explicit limit. It’s
attention-grabbing to notice that if additional unit square measure product, fixed costs per unit are
going to be reduced and, if less unit square measure created, obviously, fixed costs per unit are going to
be increased.

Variable costs, on the opposite hand, square measure those that vary proportionately with the quantity
of output. Therefore the value per unit can stay fastened no matter the number created. That is, there’s
no direct impact on the price per unit if there’s an amendment within the volume of output (i.e., worth
of staple, labour etc.).

On the contrary, semi-variable prices square measure those that square measure part fastened and
part variable (i.e., Repairs of building).

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2.4 COST BEHAVIOUR WITH THE HELP OF GRAPHS

The approach a selected price reacts to changes in activity levels is named cost behaviour. Cost might
keep a similar or might modification proportionately in response to a modification in activity. Knowing
however a price reacts to a modification within the level of activity makes it easier to make a budget,
prepare a forecast, confirm what proportion of profit a replacement product can generate and confirm
that 2 alternatives ought to be elite.

Fixed prices
Fixed prices area unit people who keep similar in total in spite of the amount of units made or sold.
Though total fastened prices area unit a similar, fastened prices per unit changes as fewer or additional
units are made. Straight line depreciation is an associate degree example of a set price. It doesn’t matter
whether or not the machine is employed to provide 1,000 units or 10,000,000 units in a very month, the
depreciation expense is that the same as a result of it’s supported the amount of years the machine is
in commission.

Variable prices
Variable prices area units the prices that modify in total when a further unit is made or sold. With a
variable price, per cost stays similar, however the additional units made or sold, the upper the full price.
Direct materials could be a variable price. The direct material cost changes with the level of production.

Graphically, the full fixed price feels like a straight horizontal line whereas the full variable cost line
slopes upward.

The graphical representation is shown below:

Price Total Cost

Variable Cost

Fixed Cost

Units

Figure 1: Total fixed and variable cost

Source: https://www.preplounge.com/en/bootcamp.php/business-concept-library/common-terms-of-business/fixed-variable-costs

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The fixed cost and variable cost per unit graph look precisely the opposite, as the variable cost per unit
remains constant, while fixed cost per unit decreases with every additional unit of production. Though
total fastened prices area unit constant, the charge per unit changes with the amount of units. The
variable price per unit is actually constant.

Fixed cost per Unit

Number of Unit Produced

Figure 2: fixed cost per unit

Source: https://xplaind.com/552306/cost-behavior
Variable cost per Unit

Number of Unit Produced

Figure 3: Variable cost per unit

Source: https://xplaind.com/552306/cost-behavior

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When cost behaviour is mentioned, associate degree assumptions should be created regarding
operational levels. At sure levels of activity, new machines can be required, which ends in additional
depreciation, or overtime is also needed of existing staff, leading to higher per hour direct labour prices.

Mixed costs
Some costs, referred to as mixed costs, have characteristics of each fastened and variable costs. As an
example, an organisation pays a fee of $1,000 for the primary 800 native phone calls in a very month
and $0.10 per call created higher than 800. Throughout March, an organisation created a pair of, 2000
native calls. Its invoice are $1,120 ($1,000 + (1,200 × $0.10)).

Total $

Included with variable costs

Included with fixed costs

Unit

Figure 4: Mixed cost

Source; https://courses.lumenlearning.com/tcc-managacct/chapter/mixed-costs/

To analyse price behaviour once prices are mixed, the value should be split into its fastened and variable
parts. many strategies, as well as scatter diagrams, the highlow methodology and least-square
regression, area unit accustomed to determine the variable and stuck parts of a mixed price, that area
unit supported the past expertise of the corporate.

Scatter diagram
In a very scatter diagram, all elements would be planned on a graph with activity. A line is drawn through
purpose associate degree an estimate created for total fastened prices at the point wherever the road
intersects the vertical axis at zero units of activity. To cypher the variable price per unit, the slope of the
road is set by selecting 2 points and dividing the modification within their price by the modification in
the units of activity for the 2 points elite.

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Figure 5: Scatter diagram

Source: https://businessjargons.com/scatter-diagram-method.html

Methods for separation of cost can be classified as:

High-low method
The high-low method divides the modification in prices for the best and lowest levels of activity by the
modification in units for the best and lowest levels of activity to estimate variable prices.

Least-squares analysis
The least-squares multivariate analysis could be a statistical procedure accustomed calculates variable
prices. It needs a pc program (for example, Excel) or calculator and uses all points of knowledge rather
than simply 2 points just like the just like the.

2.5 MEANING OF COST OBJECTS, COST UNITS & COST CENTERS

Cost Centres
The Institute of Cost and Management Accountants (ICMA) that is predicated in London outlined a price
centre a location, person or item of apparatus (or a gaggle of these) that prices are also observed and
used for the needs of value management.

That’s to mention, a price centre refers to any place, person, machine, section, part, activity or perform
among a company or enterprise by that prices area unit collected or accumulated and to that prices
area unit allotted.

Given the higher than, a price centre is, therefore, a natural division of associate degree enterprise that
helps to live and perceive operational prices and apply prices to merchandise.

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A value centre in a very company is created by considering the convenience of cost accumulation,
equivalence and value management. If prices area unit accumulated for someone, machine or
department, then this entity is treated as a price centre.

In associate degree enterprise, cost centres are also divided into 2 parts:
 Production cost centres
 Service cost centres

A cost centre refers to a price centre that’s engaged in regular production (i.e., changing raw materials
into finished products).

A service value centre may be a centre that’s not engaged in regular production, however that assists the
assembly value centres in implementing their activities (i.e., store department, section, or maintenance
department).

Cost Unit
After prices are observed, accumulated, classified and recorded, they need to be associated with a
convenient number of the merchandise or service. This live of the number of a product or service is
thought because the price unit.

A cost unit is outlined as “a unit of amount of product, service, or time (or a mixture of these) in relevancy
that prices could also be observed or expressed.” In alternative words, a value unit may be a normal or
unit of mensuration of the products factory-made or services rendered.

A cost unit could also be expressed in terms of variety, length, area, weight, volume, time or value.

Characteristics of a Cost Unit

The following are the characteristics of the cost unit:

1. It should be one that expenditure is handily related to.
2. It should be acceptable or natural to business operations and therefore the product.
3. It should make sure or definite and not amendment over time.
4. It should be easy to grasp and to quote.
5. It should be universally accepted.
6. Types of price Units

Cost units are classified as follows:

 Simple Unit: These use one normal or unit of mensuration of the products factory-made (i.e., per
piece, per metric weight unit, per quintal, per ton, per gallon, or per meter).
 Composite Unit or advanced Unit: These mix 2 easy units (i.e., per passenger-kilometre, per ton-
kilometre, or per kilowatt-hour).

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The terms of mensuration utilized in price units are:

 Number
 Area
 Volume
 Length
 Weight
 Time
 Value

Cost units are perpetually selected rigorously supported the character of business operations.

For instance, the value unit of steel is of course observed in terms of per ton. Similarly, the value unit
of carrying a traveller by transporter is of course observed in terms of the gap travelled in kilometres.

The following area unit samples of price units are applied in numerous industries:
1. Brick Industries Cost unit per a thousand bricks
2. Coal Mines Cost unit per quintal
3. Cotton Mills Cost unit per meter
4. Electric Company Cost unit per unit
5. Transport Companies Cost unit per metric linear unit
6. Steel Companies Cost unit per ton
7. Water Supply Cost unit per 1,000 litters
8. Furniture Industries Cost unit per variety
9. Oil Companies Cost unit per cubic decimetre
10. Soap Factory Cost unit per dozen, per metric weight unit or per pill

Cost Object
A cost object is any item that prices an area unit being individually measured. It’s a key idea employed
in managing the prices of a business. Many forms of price object area units are noted below.

The cost object can be classified as:

 Output-Related Cost Objects: The most common price objects area unit a company’s product and
services, since it desires to grasp the value} of its output for gain analysis and price setting.
 Operational Cost Objects: A cost object may be among a corporation, like a department, machining
operation, assembly line or process. For instance, you may track the price of planning a brand new
product, a client trip or of transforming a cameo product.

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 Business Relationship Cost Objects: A cost object may be outside of a corporation - there could also
be a requirement to accumulate prices for a provider or a client, to see the price of managing that
entity. Another variation on the idea is that the price of revitalizing a license with an office.

Accounting for Cost Objects

A cost object could also be the topic of right smart current scrutiny, however additional usually
a corporation can solely accumulate prices for it often, to examine if there has been any important
amendment since the last analysis. This can be a result of most accounting systems don’t seem to be
designed to accumulate prices for specific price objects, thus should be reconfigured to try and do so
on a project basis. An annual review is common for several price objects. If AN analysis is particularly
advanced, the review could also be at an excellent longer interval.

It may be necessary to possess a price object so as to derive evaluation from a baseline cost, or to
examine if prices area units are cheap, or to derive the total price of a relationship with another entity.

2.6 PREPARATION OF COST STATEMENT OR COST SHEET

A cost statement or cost sheet could be a breakdown of all prices incurred that is comprised of direct
and indirect expenses. Whereas the statement is ready to calculate the value of any item from attending
a university to a development project, it’s most ordinarily used for merchandise. The value statement
is the largest expense on the earnings report and shows the value of the merchandise. The value for
retailers and wholesalers is the quantity paid throughout the amount. The method for calculating
the value for makers is a lot of advanced and has several components: direct material, direct labour,
industrial plant and administration overheads and merchandising and distribution overheads.

Add gap balance of the stock of direct materials, purchases throughout the accounting amount and the
other purchase expenses. From that quantity cypher the closing balance of the stock of direct materials.
The result’s the value of direct materials used.

Add salaries paid to labour and the other direct charges to the value of direct materials used. This is
often the prime price.

Compile industrial plant overheads together with rent, utilities, indirect labour, indirect material,
insurance, realty taxes and depreciation.

Sum up the prime price, industrial plant overheads and gap balance of work-in-progress at the start
of the accounting amount. Cypher the closing balance of the work-in-progress and also the result’s the
value of fine factory-made.

Add the gap stock of the finished inventory to the value of products factory-made to allow the value of
products out there available.

Subtract the closing balance of the finished inventory at the top of the accounting amount from the
value of products out there available. This is often the value of products sold.

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List merchandising and distribution overheads, like the pay of sales personnel, travel expenses,
advertisement and excise tax. Total the overheads with the value of products sold, leading to the cost of
sales or the whole cost at the top of the value statement.

2.7 TENDER AND QUOTATION

Tender
Tender is the response to asking for supply. This invite provides services/products at the quoted value
at specific quality (with specific conditions). Usually tenders are floated by government undertakings,
company players and money establishments.

They want merchandise at massive scales so as to satisfy the assembly necessities. In most cases, so as
to satisfy the necessity they cannot deliver on their own and they need to visit a 3rd party provider to
satisfy the necessities.

Quotation is the fastened value offered to customers in response to render notice. It’s legal binding and
once a client accepts, it can’t be modified. Whereas, tender is the response to asking for tender that is
submitted by a prospective provider.

Invitation of tender is the open request type that is printed in written media (local news newspapers).
It may be issued for a construction contractor, a machinery providers, info technology, etc. the entire
method ranging from tantalising tender, submitting tender and filling quotation is a component of the
tendering method.

Quotation
Quotation is the formal document or document of the promise given by the provider to provide
merchandise & services to purchaser at an explicit value below some specific conditions.

Quotation consists of terms of sales, payment, warranty, value to charge for product/services, time,
date, delivery location, validity amount. It additionally helps patrons in knowing the price of goods/
services before purchase. Usually, government enterprises float the tenders.

Conclusion 2.8 CONCLUSION

 Cost is “a proceeding, measured in financial terms, incurred or probably to be incurred to realize a

particular objective”.
 Classification of prices implies the method of grouping prices in keeping with their common
characteristics.
 Material costs square measure the prices of any materials we have a tendency to use within the
production of products.
 Labour costs consists of the remuneration and wages paid to permanent and temporary staff within
the pursuit of the production of the products.
 The entire prices embrace all prices ranging from the price of materials to the value of packing the
merchandise.

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 Semi variable costs are those cost that are fixed to some extent but changes after it, for example,
post-paid phone bill.
 A cost object is any item that prices an area unit being individually measured. It’s a key idea employed
in managing the prices of a business.
 A value centre in a very company is created by considering the convenience of cost accumulation,
equivalence and value management.

2.9 GLOSSARY

 Merchandise: goods that are for sale

 Tendency: something that a person or thing usually does; a way of behaving
 Cost: amount incurred to earn revenue
 Direct cost: cost that can be directly identifiable in the final product
 Tender: tender is that the response to asking of supply

2.10 CASE STUDY: COST CLASSIFICATION CONCEPT

Case Objective
This case study discusses the cost classification and its uses.

PQR limited is running a manufacturing unit for men’s wear. They incurred different costs to produce
clothes. The main cost includes, direct labour, direct material and overhead costs. These all costs are
classified as variable costs. The company also established a plant in which they run their operations.
The cost of setting up the plant and machinery is considered the fixed cost of production because this
cost does not change with the level of production.

While preparing the cost sheet, PQR limited classify these costs as a fixed and variable cost. The
classification of cost is based on the nature of expense, the plant cost is classified as the fixed cost
because it remains same at a particular level of production, in the long run fixed cost may change after
a company reaches a specific production level, while variable cost change in total but per unit cost
remains same.

Cost classification is considered a useful concept because it uses different cost pools to classify a large
number of costs. By classifying similar nature costs in a single cost pool, the managers may find it
easy to use cost information for making appropriate decisions for different financial and non-financial
purposes and it enhances the accuracy of decision-making.

Questions
1. Why overhead cost is classified as variable cost?
(Hint: Overhead cost is the indirect expense but it increases when the production level increases,
hence it should be classified as variable cost increases)

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2. Where are direct material and direct labour are located on the cost sheet?
(Hint: It is shown under prime cost)

2.11 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. What is the cost concept?
2. Explain classification based on nature of expenses?
3. Explain meaning of cost objects?
4. Explain the preparation of the cost sheet?
5. Define Tender and quotation?

2.12 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. The cost is defined as the expense that a business organisation incurs to earn the revenue for the
organisation. Refer to Section Introduction.
2. Based on nature of expense, cost can be classified as direct and indirect cost. Refer to Section
Classification Based on Nature of Expenses.
3. Any item for which costs are being separately measured is known as cost object. It is an important
cost concept for cost management of the organisation. Refer to Section Cost Objects
4. A cost sheet is a document that records the total cost of production by classifying it in different type
of costs, the first item of this sheet is prime cost. Refer to Section Preparation of Cost statement or
cost sheet.
5. A tender is a request to participate in a project or accept a formal offer, such as a takeover bid. A
quote is a document issued by a seller to a buyer in order to provide products or services at a set
price and under specified terms. Refer to Section tender and quotation.

@ 2.13 POST-UNIT READING MATERIAL

 https://www.accountingnotes.net/cost-accounting/top-7-advantages-of-classifying-cost/7506

2.14 TOPICS FOR DISCUSSION FORUMS

 Discuss the benefits of classifying cost based on variability of the cost and its use in make or buy
decision.

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 UNIT

03 Accounting for Material

Names of Sub-Units

Accounting for Material Costs, Ordering, Receiving & Issuing Material, Methods of Valuing Purchases
and Issues, Economic Order Quantity (EOQ), Inventory Levels

Overview

The unit begins by explaining the meaning of material costs. Further, it discusses the ordering,
receiving & issuing material. The unit explains the methods of valuing purchases and issues. It also
discusses Economic order quantity (EOQ) and Inventory levels.

Learning Objectives

In this unit, you will learn to:

 Explain accounting for material costs
 Describe ordering, receiving & issuing material
 Explain methods of valuing purchases and issues
 State economic order quantity (EOQ)
 Describe inventory levels
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Learning Outcomes

At the end of this unit, you would:

 Assess accounting for material costs
 Appraise ordering, receiving & issuing material
 Evaluate methods of valuing purchases and issues
 Examine economic order quantity (EOQ)
 Analyse inventory levels

Pre-Unit Preparatory Material

 https://www.accountingtools.com/articles/what-is-material-costing.html
 https://www.zoho.com/inventory/guides/inventory-valuation-methods-fifo-lifo-wac.html

3.1 INTRODUCTION
Material cost accounting is the method of determining the prices at that inventory things area unit
recorded into stock, in addition to their ulterior valuation within the accounting records. We tend to
subsume these ideas singly.

Material Cost Accounting for Initial Inventory Acquisition

A company should decide whether or not it’ll record no inheritable materials at their purchased costs, or
if extra prices are going to be additional, like freight in, sales taxes and customs duties. The addition of
those alternative prices is allowable, however, could need a precise quantity of extra work. It’s easier to
charge these extra prices to expenses as incurred so that they seem directly within the value of products
oversubscribed.

Overhead isn’t allotted to raw materials, since these things haven’t undergone any production activities
(with that overhead is associated). Overhead is merely allotted to work-in-process and finished
product inventory.

3.2 ACCOUNTING FOR MATERIAL COSTS

In accountancy, material is outlined because of the part of inventory. Basically, material and material
are used for the same purpose. This can be main a part of the total value of production. It will cut back
or increase per the fluctuation in production. So, this can be terribly versatile and governable supply of
production. For creating articles of furniture, wood is that the material. 60% to 70% proportion of the
total value of production is material value. So, it’s necessary for manufacturing any new product. Its
value can replicate the profit of the company directly. This input may be store and transported from one
place to a different.

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To record and management over the fabric value is critical as a result of:
 Conciliation for correct Quality with worth of fabric: If company buys top quality material its
worth is high. If company buys quality material it’s worth can less. Company has got to compromise
quality with the worth of fabric. Quality won’t but minimum customary. At that level, company has
got to pay worth of fabric.
 Purchase at Competitive worth: If the company is commercialism the product in the competitive
market its worth should be same with alternative competitors. It’ll be solely potential, if company
can purchase products at competitive worth. For purchasing competitive worth, company has got
to check past records of purchased material and compare costs with alternative competitors.
 Continue provide of fabric: It is the main objective and have of fabric that for continue operational
of machinery, it’s necessary that we should always need to continue to provide of material for
production. Without, this our fixed charges are raised. That’s not sensible. So, it’s required that store
keeper should record once he problems the products to the production department. He conjointly
alerts to buy department for brand spanking new shopping for fabric.
 Equilibrium within the Stock of fabric: Over-stocking and under-stocking each are harmful to
concern. Equilibrium availability of fabric suggests that optimum stocking of materials. It may be
solely potential, if company records and manage the stock and use completely different techniques
for mensuration level of stock.
 To scale back the Wastage and Losses: To reduce traditional and abnormal wastage and losses of
fabric in production ought to be conjointly the aim of fabric record and management.

3.3 ORDERING, RECEIVING & ISSUING MATERIAL

Although the main points of an acquisition procedure could take issue from concern to concern, the vital
procedures in getting and receiving of materials square measure as follows; assumptive that purchases
square measure centralised:
 Purchase Requisition: Purchases of materials square measure initiated through purchase
requisitions. It’s a proper request by the pinnacle of the department or alternative authorities to the
acquisition manager to buy the required materials.
 Selection of Suppliers: When the business department receives a punctually authorised purchase
requisition, a supply of offers must be designated. The acquisition department typically maintains
a listing of providers for every variety of material and selects a specific supplier when tantalizing
tenders. The vital rule is to shop for the most effective quality materials at rock bottom doable value
when giving due thought to delivery dates and alternative terms of purchases. Purchase ought to
be made up of dependable sources of offer and moral standards in addressing suppliers ought to
be maintained. In several industries,long run contracts square measure entered into with suppliers.
As an example – an auto manufacturer could contract ahead for the availability of tyres and tubes
for a year’s necessities at a time. Such a briefing has the advantage of avoiding staying giant stocks
if the continuity of offer will be relied upon. Moreover, the provider gets an everyday client and will
provide favourable terms. Periodic withdrawals against the contract square measure created by
raising an acquisition order.

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 Purchase order and Follow-Up: When the provider has been designated, the foremost common
procedure is that the preparation of an acquisition order. The acquisition order is that the kind
utilised by business department authorising the suppliers to provide the required materials at a
value and terms expressed in this. A purchase order ought to be fastidiously ready because it forms
a basis of legal contract between the parties involved. For this reason, authority to sign purchase
orders ought to even be restricted to choose an accountable officers. Large corporations typically
prepare 5 copies of the acquisition order. The initial is distributed to the provider. Second copy is
maintained by the acquisition department for its own file and reference. Third copy is distributed to
the receiving department as advance intimation to expect the materials. Fourth copy is distributed
to the price accounting department for entry within the ordered column of the stores ledger account.
Last copy is distributed to the department requisitioning the fabric as an intimation of the order
and expected date of receipt of materials.
 Receipt of Materials: All incoming material ought to be received by the receiving department.
This department performs the functions of unpacking the products received and verifying their
quantities and conditions. the amount is checked against the acquisition order copy and therefore
the supplier’s recommendation note that is generally received alongside the products.
Goods received note serves the subsequent purposes:
 It informs the shop keeper of alternative requisitions of the receipt of materials.
 It notifies the accounting department that the materials are received and that a voucher will
be ready.
 Once it includes columns of price, it will function as a supply of entry within the store’s ledger.
Original copy of this merchandise received note is distributed to the acquisition department to
be marked completed.
Second copy is distributed to the shop keeper. Third copy is distributed to the accounting department
for entry within the store’s ledger and the last copy is maintained by the receiving department for
its own file.
 Inspection and Testing of Materials: Goods received ought to be inspected for the amount to make
sure that they accommodate specifications expressed on the acquisition order. Wherever technical
or the laboratory inspection is important, the products square measure passed to laboratory which
is able to offer a report on the standard of products.
An inspection report is ready to indicate the results of the scrutiny. This report is either ready one by
one or incorporated within the merchandise received the note. In either case, the report is forwarded
to the business department.
 Return of Rejected Material: Materials received square measure broken or don’t seem to be in
accordance with the specifications, these square measures sometimes came back to the provider
along side a debit note, informing him that his account has been debited with the worth of materials
involved. once such a claim is accepted by the provider, he signifies his acceptance by the difficulty
of a credit note. The rejected materials could also come back to the provider forthwith or they will
be controlled unfinished his directions. The debit note could also be prepared by the acquisition
department on the premise of the scrutiny report. Original copy is distributed to accounts department
for adjustment entry and one copy is maintained for the purchase department file.

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 Passing Invoices for Payment: When the invoices square measure received by the business
department, the method of grouping the business paper involved with every purchase and
preparation of vouchers begins. Invoices square measure numbered serially and entered within the
invoice register.
The following documents square measure assembled in support of the invoice:
a. Commercial instrument.
b. Merchandise Received Note.
c. Scrutiny Report.
d. Debit/Credit Note.

After scrutiny of these documents with the invoice, if it’s found that the invoice is so as, the acquisition
manager can sign it and pass it to the accounts department for payment. All calculations are square
measure checked before a voucher authorising payment is ready. All connected documents like
commercial instruments, merchandise received notes, etc., square measure marked with the invoice
range to preclude the passing of a doable duplicate invoice.

3.4 METHODS OF VALUING PURCHASES AND ISSUES

In the reference to the estimation of the cost of the merchandise for evaluation selections, material
problems assure a key role. Material worth sometimes refers to the cost quoted and accepted within the
purchase orders.

Materials square measure issued from the stores to figure orders supported the fabric requisition.
However, stock of materials consists at totally different consignments received at different dates and
costs. Their square measure totally different ways used for evaluating the materials problems could
also be summarised within the following classes:
 FIFO (First In First Out)
 LIFO (Last In First Out)
 Weighted Average methods

3.4.1 FIFO (First In First Out)

This way of fabric valuation is far and away from additional systematic than the ways mentioned
higher than. The receipts and also the problems follow a consecutive pattern, i.e., the materials that
square measure received 1st also are issued 1st and once the entire ton is completed with them any
receipt is taken into account for issue. In easy words, the closing inventory merely represents the stock
that was procured at the last and so represents the most recent value.

This method is appropriate throughout deflation, once the most recent costs square measure low. The
apparent reason is that the fabric procured at higher rates has already been absorbed and shutting
inventory so showing at a minimum level following the principles of political theory.

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Implications of first in first out methodology within the Periods of Rising or Failing costs:

Period

Advantages of first in first out method:

 Materials square measure issued on the premise of purchases.
 it’s terribly easy and simply comprehensible.
 The closing inventory is valued at this level of cost.
 Principally employed in case of putrescible product.
 higher to follow just in case of deflation than inflation to scale back the liabilities.

Disadvantages of first in first out methodology:

 it’s tough to record the returns and rejected things.
 Regular purchases and problems will build this cumbersome.
 As within the warehouse, all the materials square measure unbroken along, there’s no positive that
the one that was purchased earlier is issued 1st.
 Thanks to frequent value changes comparison between similar job become tough.
 If followed throughout inflationary scenario, the worth of the closing stock are going to be higher,
there by liabilities can increase.

3.4.2 LIFO (Last in First Out)

Under this method, the last purchased merchandise square measure discharged initially. However, this
assumption is formed just for the aim of valuing the problems of a listing. This methodology operates
in an associate inverse manner to inventory accounting methodology. The particular flow of inventory
could dissent. This methodology employs the worth of the most recent ton till all the units from the ton
square measure are exhausted. Later it continues with previous tones. If a brand new batch is received
then such batch is taken into account to be the last ton.

Advantages of inventory accounting method:

 This methodology is appropriate for the period once the value is rising.
 Since the material is charged at the most recent indicant the value of production is realistic.
 It’s straightforward to know.
 This results in bottom unsuccessful gain.

Disadvantages of inventory accounting methodology:

 It doesn’t change the physical flow of the products.
 Inventory isn’t priced at the current market value.
 Cost comparison is totally different if similar jobs square measure allotted exploitation material
from totally different tons.

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 This methodology isn’t supported by the tax Act or Accounting Conventions.

 This methodology results in inflated profit and liabilities within the time of downward costs and
contrariwise.
 It is often troublesome to calculate if their square measure frequent cost changes.

3.4.3 Weighted Average Methods

One of three methods for valuing your company’s inventory stock is the weighted average cost method,
which establishes the average cost of all inventory items based on individual expenses and the quantity
of each item held in stock. Businesses calculate the amount that goes into inventory and the cost of
products sold using the weighted average (COGS). Due to the variety of inventory stock kinds or the
same stock items purchased at various times, a firm may pay varying prices when purchasing items
of inventory. The weighted average cost approach, which is frequently employed when inventory items
are so similar to one another or blend into one another that it is difficult to assign precise costs to single
units, divides the cost of goods available for sale by the number of units available for sale.

3.5 ECONOMIC ORDER QUANTITY (EOQ)

The Economic Order Quantity (EOQ) is the range of units that a corporation ought to raise inventory
with every order to attenuate the whole prices of inventory—such as holding prices, order prices and
absence prices. The EOQ is employed as a part of an eternal review inventory system within which the
amount of inventory is monitored in the least times and a hard and fast amount is ordered every time
the inventory level reaches a selected reorder purpose.

The EOQ provides a model for hard the suitable reorder purpose and therefore the optimum reorder
amount to confirm the fast replacement of inventory with no shortages. It will be a valuable tool for
little business homeowners an agency got to build choices regarding what quantity inventory to stay to
be had, what percentage of things to order every time and the way usually to reorder to incur all-time
low doable prices.
The EOQ model assumes that demand is constant, and inventory is depleted at a hard and fast rate till
it reaches zero. At that time, a selected range of things arrives to come to the inventory to its starting
level. Since the model assumes fast replacement, there are not any inventory shortages or associated
prices. Therefore, price of inventory underneath the EOQ model involves a trade-off between inventory
holding prices (the cost of storage, likewise because of the value of arrival capital in inventory instead
of investment it or victimisation it for alternative purposes) and order prices (any fees related to putting
orders, like delivery charges). Ordering an outsized quantity at only once can increase a little business’s
holding prices, whereas creating a lot of frequent orders of fewer things can scale back holding prices
however increase order prices. The EOQ model finds the number that minimizes the ad of those prices.

The basic EOQ relationship is shown below. Allow us to scrutinize it assumptive we’ve a painter
victimisation 3,500 gallons of paint each year, paying $5 a gallon, a $15 charge anytime he/she orders
and a listing value per gallon control averaging $3 per gallon each year.

The relationship is TC = Pd + HQ/2 + SD/Q ‘¦ wherever

How four high Performers Maintain Their Mental and Physical eudemonia

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Cost and Management Accounting

TC is that the total annual inventory cost—to be calculated.

P is that the value per unit paid—assumes $5 per unit.

D is that the total range of units purchased during a year—assume three,500 units.

H is that the holding value per unit per year—assumes $3 per unit every year.

Q is that the amount ordered every time AN order is placed—initially assume 350 gallons per order.

S is that the charge of every order—assumes $15 per order.

Calculating TC with these values, we have a tendency to get a complete inventory value of $18,175 for
the year. Notice that the most variable during this equation is the amount ordered, Q. The painter may
commit to purchase a smaller amount. If he or she will thus, a lot of orders can mean a lot of fastened
order expenses (represented by S) as a result of a lot of orders being handled—but lower holding charges
(represented by H): less space is going to be needed to carry the paint and fewer cash involved within the
paint. Assumptive the painter buys two hundred gallons at a time rather than 350 the TC can drop to
$18,063 a year for a savings of $112 a year. Inspired by this, the painter lowers his/her purchases to 150
at a time. However, currently, the result is unfavourable. Total prices are currently $18,075. Wherever is
the optimum purchase amount to be found?

The EOQ formula produces the solution. The best order amount comes regarding once the 2 elements of
the most relationship (shown above)— “HQ/2” and therefore the “SD/Q”—are equal. We will calculate
the order amount as follows: Multiply total units by the fastened ordering prices (3,500 × $15) and
acquire 52,500; multiply that range by two and acquire 105,000. Divide that range by the holding value
($3) and acquire 35,000. Take the root of that and acquire 187. That range is then alphabetic character.

In the next step, HQ/2 interprets to 281 and SD/Q additionally involves 281. Victimisation 187 for an
alphabetic character within the main relationship, we have a tendency to get a complete annual
inventory value of $18,061, an all-time low value doable with the unit and valuation factors shown
within the example on top.

Thus, EOQ is outlined by the formula: EOQ = root of 2DS/H. the amount we have a tendency to get, 187
during this case, divided into three,500 units, suggests that the painter can buy paint nineteen times
within the year, shopping for 187 gallons at a time.

The EOQ can generally modify as a result of the amount of discounts offered by some suppliers as AN
incentive to customers for UN agency place larger orders. For instance, a precise provider could charge
$20 per unit on orders of but one hundred units and solely $18 per unit on orders over one hundred
units. to see whether or not it is smart to require advantage of an amount discount once rearrangement
inventory, a little business owner should reason the EOQ victimisation by the formula (Q = the root of
2DS/H), reason the whole value of inventory for the EOQ and all value break points on top of it, then
choose the order amount that has the minimum total value.

For example, say that the painter will order two hundred gallons or a lot for $4.75 per gallon, with
all alternative factors within the computation remaining an equivalent. He should compare the whole

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prices of taking this approach to the whole prices underneath the EOQ. Victimisation the whole value
formula made public on top of, the painter would notice TC = Pd + HQ/2 + SD/Q = (5 × three,500) + (3
× 187)/2 + (15 × three,500)/187 = $18,061 for the EOQ. Ordering the upper amount and receiving the
worth discount would yield a complete value of (4.75 × 3,500) + (3 × 200)/2 + (15 ×3,500)/200 =
$17,187. In alternative words, the painter will save $875 each year by taking advantage of the worth break
and creating seventeen.5 orders each year of two hundred units.

EOQ calculations are seldom as straightforward as this instance shows. Here the intent is to elucidate
the most principle of the formula. The little business with an outsized and regularly turning inventory
could also be well served by trying around for inventory code that applies the EOQ construct a lot of
complexly to real-world things to assist in getting choices a lot dynamically.

3.6 INVENTORY LEVELS

Stock level refers to the quantity of products or raw materials that ought to be maintained by businesses
to continue their activities and avoid any things like under stocking or overstocking. Each organisation
must always keep an associate optimum quantity of inventory to confirm the regular operation of its
production activities.

Inventory acts as a bridge between production and sales of business and ensures a daily provision
of finished products to customers. Raw materials, work-in-progress, finished product and varied
consumables like fuel and writing paper square measure 3 necessary varieties of inventories that each
firm has to maintain. Inventory managers ought to properly manage the inventory and verify the
optimum size to be continuously unbroken among the organisation. Managers ought to contemplate
varied factors like cupboard space of the firm, the frequency with that inventory is sold or used, risk
of inventory obtaining out-of-date before it’s used, insurance price on inventory, etc. for deciding the
correct quantity of stock. Major varieties of stock levels of inventory square measure as follows:
 Reorder Stock Levels: When the number of materials reaches a precise level then recent order
is distributed to obtain materials once more. The order is distributed before the materials reach
the minimum stock level. The rearrangement level is mounted between the minimum level and
most levels. The speed of consumption, range of days needed to fill again the stocks and also the
most amount of materials needed on any day square measure taken into thought when fixing the
rearrangement level.
Reordering Stock Level Formula:
Reordering Level = most Consumption Rate x most Reorder amount.
 Minimum Stock Levels: This represents the number that has got to be maintained in hand in the
slightest degree times. If stocks square measure but the minimum level, then the work can stop
thanks to a shortage of materials.
Minimum Stock Level Formula:
Minimum stock Level = Re-ordering Level – (Normal Consumption x traditional Reorder
Period

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 Most Stock Levels: It is the number of materials on the far side that a firm shouldn’t exceed its
stocks. If the number exceeds the most level limit, then it’ll be termed overstocking. A firm avoids
overstocking as a result of it’ll end at high material prices. Overstocking can result in the necessity of
a lot of capital, extra space for storing the materials and a lot of charges of losses from devolution.
Maximum Stock Level Formula:
Maximum Stock Level = rearrangement Level + rearrangement amount – (Minimum Consumption
x Minimum rearrangement period)
 Average Stock Levels: It is the amount of a median minimum level and most level. It suggests that
the common level is maintained in states.
Average level Formula:
Average stock level = (Maximum level + Minimum level)/2
 Danger Stock Levels: This is the amount below the minimum stock level. Once a stock reaches this
level, immediate action is required to require for the replacement of stock. If the stock is reached
at this level, the traditional interval isn’t out there and thus regular purchase procedure can’t
be adopted. This might end in high-cost remedial action solely. If this is often mounted below the re-
order level and higher than the minimum level, it’ll be the potential to require preventive action.
Danger level Formula:
Danger level = (Average rate of consumption) ×Urgent provide time

Solved Example

Calculate minimum stock level, most stock level and re-ordering level:
i. Maximum Consumption = three hundred units per day
ii Minimum Consumption = a hundred and eighty units per day
iii. Traditional Consumption =190 units per day
iv. Reorder Period = 10-15 days
v. Reorder Quantity = a pair of 2,000 units
vi. Normal reorder amount = thirteen days.

Solution:
1. Reordering Level = most Consumption x most Reorder amount
= three hundred units X fifteen = four,500 units
2. Minimum Stock price = rearrangement Level – (Normal Consumption x traditional rearrangement
Period)
= 4,500 – (190 multiply 10) = 4,500 – 1,900 = 2,600 units

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3. Most Stock Level = rearrangement Level + Reorder amount – (Minimum Consumption x Reorder
period) =4,500+ 2,000 – (180 X 10) =4,500 + 2,000 – 1,800 = 4700 units.

Conclusion 3.7 CONCLUSION

 In accountancy, material is outlined because of the part of inventory. Basically, material and material
are used for same purpose. This can be main a part of the total value of production
 FIFO method is appropriate throughout deflation, once the most recent costs square measure low.
The apparent reason is that the fabric procured at higher rates have already been absorbed and
shutting inventory so showing at a minimum level following the principles of political theory.
 One of three methods for valuing your company’s inventory stock is the weighted average cost
method, which establishes the average cost of all inventory items based on individual expenses and
the quantity of each item held in stock.
 The Economic Order Quantity (EOQ) is the range of units that a corporation ought to raise inventory
with every order to attenuate the whole prices of inventory—such as holding prices, order prices
and absence prices.
 The EOQ provides a model for hard the suitable reorder purpose and therefore the optimum reorder
amount to confirm the fast replacement of inventory with no shortages.
 When the number of materials reaches a precise level then recent order is distributed to obtain
materials once more. The order is distributed before the materials reach the minimum stock level.
 The acquisition order is the kind utilised by the business department authorising the suppliers to
provide the required materials at a value and terms expressed in this.
 Average stock order is the amount of a median of minimum level and most level. It suggests that the
common level is maintained in states.
 Inventory acts as a bridge between production and sales of business and ensures a daily provision
of finished products to customers.
 EOQ is outlined by the formula: EOQ = root of 2DS/H.

3.8 GLOSSARY

 Inventory: Refers to the ready-to-sell goods and products of a corporation

 Economic order quantity: Is a company’s ideal order quantity for reducing the sum of its ordering,
receiving and holding inventory-related expenditures
 Invoice: An official document that details the products or services you’ve gotten and how much you
owe for them
 Scrutiny Report: When you scrutinise anything, you examine it carefully, such as when you check a
test for errors

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Cost and Management Accounting

3.9 CASE STUDY: IMPORTANCE OF MFCA IN A XYZ LTD

Case Objective
This case study in showing the importance of MFCA

In XYZ. Ltd management is having a problem in accosting material costs after some time one of its
managers get to know about Material Flow Cost Accounting and starts using with the consent
of all other managers. Material Flow Cost Accounting also known as MFCA is actually a new cost
accounting method which can enable the identification of improvement opportunities in terms of all
other material consumption and accrual of costs. Until now, no meta-analysis were concerning MFCA
which has been undertaken. 73 odd case studies about MFCA can use in companies that have been
analysed and synthesized to actually determine the whole effects and drawbacks experienced by
these companies when implementing and then applying MFCA. The main focus of the case studies was
MFCA, although, the reported effects cover a broad spectrum. By comparing and then synthesizing
over 700 statements in each of the case studies, a very clear picture of the experiences reported by other
companies after having applied to MFCA is presented. Whilst the majority of the case studies describe
all the positive effects of MFCA, the reader must then consider the described effects with caution, as
the insights provided are one of the best that can be then achieved given all the limited availability of
data. This research may be helpful in practice when one considers whether to use MFCA, and in theory
as a basis for all further research due to its rich description. After using MFCA company was able to
resolve its problem.

Questions
1. What is MFCA?
(Hint: Material Flow Cost Accounting also known as MFCA is actually a new cost accounting method
which can enable all the identification of improvement opportunities in terms of all other material
consumption and accrual of costs)
2. What is the main focus of MFCA?
(Hint: The main focus of the case studies was MFCA, although, the reported effects cover a broad
spectrum)

3.10 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. What is accounting for material costs?

2. Describe the FIFO.
3. What is Economic order quantity (EOQ)?

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3.11 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. In accountancy, material is outlined because the part of inventory. Basically, material and material
are used for the same purpose. This can be main a part of total value of production. It will cut back
or increase per the fluctuation in production. So, this can be terribly versatile and governable supply
of production. For creating an article of furniture, wood is that the material. 60% to 70% proportion
within the total value of production is material value. So, it’s terribly necessary for manufacturing
any new product. Its value can replicate the profit of company directly. This input may be store and
transported from one place to a different. Refer to Section Accounting for Material Costs
2. This ways of fabric valuation is far and away additional systematic than the ways mentioned
higher than. The receipts and also the problems follow a consecutive pattern., i.e., the materials that
square measure received 1st also are issued 1st and once the entire ton is completed with them the
any receipt is taken into account for issue. In easy words, the closing inventory merely represents
the stock that was procured at the last and so represents the most recent value. Refer to Section
Methods of Valuing Purchases and Issues
3. The Economic Order Quantity (EOQ) is that the range of units that a corporation ought to raise
inventory with every order to attenuate the whole prices of inventory—such as holding prices, order
prices and absence prices. The EOQ is employed as a part of an eternal review inventory system
within which the amount of inventory is monitored in the least times and a hard and fast amount
is ordered every time the inventory level reaches a selected reorder purpose. The EOQ provides a
model for hard the suitable reorder purpose and therefore the optimum reorder amount to confirm
the fast replacement of inventory with no shortages. It will be a valuable tool for little business
homeowners UN agency got to build choices regarding what quantity inventory to stay to be had,
what percentage things to order every time and the way usually to reorder to incur all-time low
doable prices. Refer to Section Economic Order Quantity

@ 3.12 POST-UNIT READING MATERIAL

 https://www.investopedia.com/terms/e/economicorderquantity.asp
 https://courses.lumenlearning.com/wm-retailmanagement/chapter/determining-product-
inventory-levels/

3.13 TOPICS FOR DISCUSSION FORUMS

 Discuss with your friends the importance of accounting for material.

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 UNIT

04 Accounting for Labour

Names of Sub-Units

Accounting for Labour, Calculation of Direct and Indirect Cost of Labour, Understanding Different
Remuneration Methods, Labour Turnover Ratio, Overtime and Idle Time, Labour Efficiency, Capacity
and Volume Ratios

Overview
The unit begins by explaining accounting for labour. Further, it discusses calculation of direct and
indirect cost of labour. The module explains understanding different remuneration methods. The unit
explains labour turnover ratio, overtime and idle time. It also discusses labour efficiency, capacity and
volume ratios.

Learning Objectives

In this unit, you will learn to:

 Explain Accounting for labour
 Differentiate between direct and indirect cost of labour and its calculation
 Describe different remuneration methods
 State labour turnover ratio, overtime and idle time
 Explain labour efficiency, capacity and volume ratios
JGI JAIN
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Cost and Management Accounting

Learning Outcomes

At the end of this unit, you would:

 Assess accounting for labour
 Appraise between direct and indirect cost of labour and its calculation
 Evaluate different remuneration methods
 Analyse labour turnover ratio, overtime and idle time
 Examine labour efficiency, capacity and volume ratios

Pre-Unit Preparatory Material

 https://www.studocu.com/row/document/university-of-zambia/cost-accounting/accounting-for-
labour-costs/3779267
 https://wol.iza.org/uploads/articles/3/pdfs/do-labor-costs-affect-companies-demand-for-labor.
pdf

4.1 INTRODUCTION
Labour value or material value is another important part of value not solely as a result of the wage bill
in an exceedingly fashionable organisation is mostly substantial however additionally as a result of its
certain peculiar characteristics that different parts of value don’t have. An honest value accountant
must perceive the special options of labour value, the foremost vital of that is that there is nearly no
limit to the rise of output of this most vital issue of production

4.2 ACCOUNTING FOR LABOUR

Labour Accounting (LA) is employed to portion remuneration prices to the overall Ledger Chart of
Accounts. In LA, you’ll notice remuneration data regarding college, staff and biweekly workers, as well
as paid hourly wages for casual workers and students. The tool additionally contains regular payment
and tuition data for graduate students, college summer remuneration commitments and distributions,
and sponsored scientific research detail for effort news and certification compliance.

Note that collegian and college man hourly wages don’t seem to be managed in LA. Student wages are
applied to the acceptable chart string and entered in Time and Absence Management.

Labour Accounting Access

Request access to LA data within the Prime data Warehouse to look at, change, or to approve Labour
Accounting data within the application; or to look at LA reports within the data Warehouse.

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Labour Accounting Summary

Take the “Using Labour Accounting” category through the worker Learning Center to become conversant
in LA and manage commitments and distributions.

Labour Accounting Price Transfers

Understand the eventualities that need special handling by Finance and Treasury.

4.3 CALCULATION OF DIRECT AND INDIRECT COST OF LABOUR

The term “direct labour” refers to labour that is used directly in the production process. This means that
all employees who directly support and can be linked to the production of any product(s) are regarded
as direct labour.

For instance, in a manufacturing organisation, it would include factory personnel who are actively
involved in the assembly line, such as product assemblers, packing staff, machine operators, quality
control staff, etc. Direct labour may also include product managers and supervisors who are directly in
charge of monitoring the operations taking place on an assembly line for a particular product.

All costs associated with employing direct labour, such as wages, social security premiums and other
financial advantages provided to direct labour employees/workers, are included in the total cost of
direct labour. The following formula is typically used to apply the direct labour cost to the manufactured
goods:
Cost of direct labour allocated = (Total direct labour cost/Total man hours employed) × Man hours
on specific product
Total direct labour cost divided by total man hours worked equals the cost of direct labour allocated

Employees who are not directly involved in the main industrial process are considered to be performing
indirect labour. These individuals do additional tasks or processes that are essential to the entity’s overall
operation. No specific product’s manufacture may be linked directly to indirect labour’s activities (s).

Indirect labour includes everything from salespeople to security guards to cleaners to office and
administrative staff. Even if any of these workers are located in a plant, their work will still be considered
indirect labour because it cannot be directly connected to the primary production activity.

Indirect labour costs are considered part of overhead costs and are appropriately distributed to the
manufactured goods using factors like machine hours and direct labour hours.

The formula for this allocation would be:

Cost of indirect labour allocated = (Total indirect labour cost/Total of basis i.e., machine or labour
hours etc.) × Basis utilised for specific product

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Cost and Management Accounting

4.4 UNDERSTANDING DIFFERENT REMUNERATION METHODS

The definition of compensation was necessary as payment for the labour and services provided. Every
company organisation needs to have a proper system in place for paying its employees. Wages serve as
the compensation for labour. The employees put out effort and get compensated for it.

There are 2 primary methods of labour compensation:

a. Time Rate System
b. Piece Rate System

The time rate system pays employees according to the number of hours they put in. Additionally,
payment can be made daily, weekly, or monthly. The quantity or calibre of work performed under this
approach is not taken into consideration. Following creation of hourly payments, the following formula
is used to determine total earnings due:
Wages = [No. of hours worked with x Rate per hour into Piece Rate System]

According on the quantity of work completed, this method of payment pays wages. The following
formula is used to determine pay and fix a rate per unit of production: Wages = [Rate per unit x No. of
units created.]

Each time rate system and piece rate system in incentive plans has strengths and shortcomings. Plans
for incentives aim to combine the best aspects of each system. Underneath this methodology, staff is
paid in proportion to the work done by them. The speed is fastened per unit of output, per article, per
goods, etc. The first purpose of incentive arrangement is to induce an employee to supply additionally
to earn a better wage. Naturally, manufacturing additional within the same amount of your time ought
to end in higher pay money for the employee. Owing to a larger variety of units created, it ought to
additionally end in lower value per unit for fastened manufactory value and additionally for labour
value.

4.5 LABOUR TURNOVER RATIO, OVERTIME AND IDLE TIME

 Labour turnover ratio: Labour turnover, additionally called staffing turnover, refers to the
magnitude relation of variety of workers who leave a corporation through attrition, dismissal or
resignation to the full variety of workers on the payroll in this amount.
 Overtime: Overtime is that the quantity of wages purchased operating on the far side traditional
operating hours as mere by Factories Act or by a mutual agreement between the staff union and
therefore the management. It is a common practice to pay money for overtime work on higher
rates. Hence, payment of overtime consists of 2 components, the traditional wages e.g., the same old
quantity and therefore the further payment i.e., the premium. This quantity of additional payment
paid to an employee underneath overtime is thought as overtime premium.
 Idle time: Idle time refers to the labour time purchased however not utilised on production. It, in
fact, represents the time that wages are paid, however throughout that no output is given out by
the employees. This is often the amount throughout that employees stay idle. Some idle times are
governable and a few idle times can’t be controlled in spite of economical management.

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4.6 LABOUR EFFICIENCY, CAPACITY AND VOLUME RATIOS

Let’s discuss the terms one by one.
 Labour efficiency: Labour efficiency magnitude relation tell us regarding however efficiently labour
are operating the efficiency magnitude relation is calculated on the idea what’s expected from
labour and the way is actual performance. If the result are below the 100% then we say that labour
are below activity once the result are higher than 100% we are saying that labour performance is
beyond the expectation and if the result’s 100% the labour performance is up to expectation. Labour
efficiency is very important as a result of labour involve a high production cost so the labour ought
to be operating efficiently and efficiency ratio give effective information for the labour performance.
Labour efficiency magnitude relation is a very important issue whereas calculative the bonus for
the workers. The bonus is additionally a very important tool to boost the potency of the employee.
Efficiency is extremely vital as a result of low potency meaning that you just are paying for wasted
time. The some employee has tendency to waste time and potency magnitude relation may be
accustomed to establish those employee or cluster of employee. The low potency means that you are
paying a lot more and obtaining less.
 Labour capacity ratio: It is difficult to tell at what level an entity is operating and how well it is using
its many resources. Capacity utilisation is vital issue as a result of beneath utilisation of capacity
could be a loss for the entity and especially just in case of labour beneath utilisation of capability
implies that there are some over employment.
If there’s over employment and also the cash is being paid it technically shows a poor management
and also the management ought to review the quantity of labour needed and create applicable call
during this regard.
The beneath utilisation might also flow from to the shortage of demand particularly just in case
of season primarily based industries. Some industries don’t seem to be willing to scale back the
workers because of shortage of demand as a result of losing the worker associated hiring once more
additionally involve price what is more it needs coaching and skill isn’t a visible possibility. Under
utilisation attainable however over utilisation of capability isn’t possible in contrast to potency
magnitude relation wherever the over potency is feasible. Technically the solution of capability
magnitude relation would be forever equal or 100%.
 Volume ratios: The production volume ratio measures however the particular production output
for an amount, measured in direct labour hours, compares with budgeted for a cost centre. It’s
calculated as:
(Expected direct labour hours of actual output ÷ budgeted direct labour hours) × 100 percent.
A magnitude relation of > 100 percent can indicate higher than budget production volume and
contrariwise.

The production volume magnitude relation may be more analysed by:

 The number of hours worked compared with budget (measured by the capability exercise ratio).
 The potency with that the output is made (measured by the potency ratio).

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Cost and Management Accounting

Conclusion 4.7 CONCLUSION

 Labour Accounting (LA) is employed to portion remuneration prices to the overall Ledger Chart of
Accounts.
 The term “direct labour” refers to labour that is used directly in the production process. This means
that all employees who directly support and can be linked to the production of any product(s) are
regarded as direct labour.
 Employees who are not directly involved in the main industrial process are considered to be
performing indirect labour.
 Total direct labour cost divided by total man hours worked equals the cost of direct labour allocated.
 Indirect labour costs are considered part of overhead costs and are appropriately distributed to the
manufactured goods using factors like machine hours and direct labour hours.
 The time rate system pays employees according to the number of hours they put in.
 Labour turnover refers to the magnitude relation of variety of workers who leave a corporation
through attrition, dismissal or resignation to the full variety of workers on the payroll in this amount.
 Idle time refers to the labour time purchased however not utilised on production.
 The production volume ratio measures however the particular production output for an amount,
measured in direct labour hours, compares therewith budgeted for a cost centre.

4.8 GLOSSARY

 Substantial: Of considerable importance, size, or, worth

 Utilisation: The action of making practical and effective use of something
 Efficiency: The ability to do a task with little to no waste, effort, or energy
 Remuneration: A sum of money given to someone as compensation for job completed

4.9 CASE STUDY: NOBLE METAL GIRI MERA BANjARMASIN

Case Objective
This study aims to form a web-based direct labour accounting system.

Direct labour costs are a part of the wage or wage system that’s given to workers concerned within the
production method or bound services. Corporations ought to regulate the direct labour price system,
from the design, placement, arrangement, recording to payment of wages to those workers. Noble
metal Giri Mera Banjarmasin could be a distributor company that distributes Charcoal product from
the producers to shoppers. Labour is directly concerned within the method of sorting quality charcoal
from the producers, then commercialism it to the shoppers. Determination of direct labour wages is
finished manually with stand out in scheming the daily financial gain that has been done by the workers

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and is paid weekly. This becomes an obstacle in managing the accounting system. This study aims to
form a web-based direct labour accounting system to work out wages supporting the group action
of employees who are gift and therefore the calculation of what quantity work is earned per day. The
results of this study will confirm and record labour price payment reports supporting the group action.

Questions
1. Does labour costs are a part of the wage?
(Hint: Direct labour costs are a part of the wage or wage system that’s given to workers concerned
within the production method or bound services.)
2. What is the aim of this study?
(Hint: This study aims to form a web-based direct labour accounting system to work out wages
supported the group action of employees who are gift and therefore the calculation of what quantity
work is earned per day.)

4.10 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. Define accounting for labour.
2. Explain labour efficiency.
3. Explain Indirect cost of labour.

4.11 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. Labour Accounting (LA) is employed to portion remuneration prices to the overall Ledger Chart of
Accounts. In LA, you’ll notice remuneration data regarding college, staff and biweekly workers, as
well as paid hourly wages for casual workers and students. The tool additionally contains regular
payment and tuition data for graduate students, college summer remuneration commitments and
distributions and sponsored scientific research detail for effort news and certification compliance.
Refer to Section Accounting for Labour

2. Labour efficiency magnitude relation tell us regarding however efficiently labour are operating
the efficiency magnitude relation is calculated on the idea what’s expected from labour and the
way it is actual performing. If the result are below the 100% then we say that labour are below
activity once the result are higher than 100% we are saying that labour performance is beyond the
expectation and if the result’s 100% the labour performance is up to expectation. Labour efficiency
is very important as a result of labour involve a high production cost so the labour ought to be
operating efficiently and efficiency ratio give effective info for dominant the labour performance.
Refer to Section Labour Efficiency, Capacity and Volume Ratios
3. Employees who are not directly involved in the main industrial process are considered to be
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Cost and Management Accounting
performing indirect labour. These individuals do additional tasks or processes that are essential to
the entity’s overall operation. No specific product’s manufacture may be linked directly to indirect
labour’s activities.
Indirect labour includes everything from salespeople to security guards to cleaners to office
and administrative staff. Even if any of these workers are located in a plant, their work will still
be considered indirect labour because it cannot be directly connected to the primary production
activity. Refer to Section Calculation of Direct and Indirect Cost of Labour

@ 4.12 POST-UNIT READING MATERIAL

 http://www.jiwaji.edu/pdf/ecourse/management/methods%20of%20remuneration.pdf
 https://www.accountingnotes.net/cost-accounting/labour/labour-turnover-definition-causes-and-
effects/4591

4.13 TOPICS FOR DISCUSSION FORUMS

 Discuss with your friends about the importance of accounting for labour.

8
 UNIT

05 Accounting for Overheads

Names of Sub-Units

Concept and Classification of Overheads, Factory Overhead, Fixed –Semi Variable and Variable,
Accounting for Overheads, Apportionment of Service Department’s Overheads to Producing
Departments, Production Overhead Absorption Rates, Selecting an Absorption Rate

Overview
This unit starts with the explanation of concept and classification of overheads, Factory overhead and
fixed –semi variable and variable cost. Further, it explains accounting for overheads, apportionment
of service department’s overheads to producing departments and production overhead absorption
rate. It also discusses how to select an appropriate absorption rate.

Learning Objectives

In this unit, you will learn to:

 Explain concept and classification of overheads
 Discuss factory overhead, fixed –semi variable and variable
 Describe accounting for overheads
 Define apportionment of service department’s overheads to producing departments
 Express production overhead absorption rates
 Indicate selecting an absorption rate
JGI JAIN
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Cost and Management Accounting

Learning Outcomes

At the end of this unit, you would:

 Assess concept and classification of overheads
 Analyse factory overhead, fixed –semi variable and variable
 Appraise accounting for overheads
 Evaluate apportionment of service department’s overheads to producing departments
 Examine production overhead absorption rates
 State selecting an absorption rate

Pre-Unit Preparatory Material

 https://kfknowledgebank.kaplan.co.uk/acca/chapter-8-accounting-for-overheads
 https://icmai.in/upload/CASB/icwaicas3.pdf

5.1 INTRODUCTION
Overheads could be outlined as all indirect prices incurred for the assembly of products or services.
Overheads are well-known in accounting nomenclature as ‘On Cost’, ‘Burden’, Indirect Expenses, etc.

Overheads are indirect prices. Indirect price can’t be copied to any unit. These prices are incurred for
variety of units then can’t be known with a price unit. Indirect prices are that which can’t be allotted
to any explicit price unit however is usually distributed to or absorbed by price units on an acceptable
basis. Overhead is additionally referred to as “on price, burden or load”.

According to the word of price line, CIMA, London, overhead is outlined as “the combination of indirect
material price, indirect wages and indirect expenses”.

In the words of Weldon, overhead is also outlined as “the price of indirect materials, indirect labour and
such alternative expenses as well as services that can’t handily be charged direct to specific price units”.

Therefore, overhead includes:

 Indirect prices, that can’t be, by their nature, copied to specific units of production.
 Direct prices, that is thus little in quantity that it’s inexpedient to trace them to specific units of
production.
Overhead = Indirect material + Indirect labour + Indirect expenses

5.2 CONCEPT AND CLASSIFICATION OF OVERHEADS

Overhead is that the mixture of indirect material, indirect labour and indirect expenses. It refers to any
value that isn’t directly because of a price unit.

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The term indirect means that cannot be allotted, however which might be parcelled out to or absorbed by
value centres or value units. All those values/expenses that don’t seem to be capable of being attributed
on to a selected product or service or cost centre area unit referred to as indirect costs/expenses.

We typically see that some material prices (identified as indirect materials), some labour prices (identified
as indirect labour), rents, depreciation prices, salaries of workers, deposit prices, etc are of such nature.
These prices are together referred to as overheads.

Classification of Overhead

Under purposeful classification, the overhead expense is identified under a specific heading that
supports the aim of the expenditure and the duties that are carried out by the incurred expense.

Overheads can be classified as follows:

Factory Overheads

Administration or workplace Overheads

Selling Overheads

Distribution Overheads

Selling and Distribution Overheads

Figure 1: Classification of Overhead

 Factory Overheads: The indirect expenses (overheads) incurred at intervals the works space is
classified as works overheads.
 Administration or workplace Overheads: The indirect expenses (overheads) incurred at intervals
body space are classified as administrative or workplace overheads.
 Selling Overheads: The indirect expenses (overheads) incurred regarding the sales activities are
classified as merchandising overheads.
 Distribution Overheads: Distribution overheads are the unscheduled costs (overheads) incurred in
connection with the delivery of the goods or services.
 Selling and Distribution Overheads: The indirect expenses (overheads) incurred regarding the
sales activities yet as distributing the merchandise or service are classified beneath one head as
“Selling and distribution overheads”.

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Cost and Management Accounting

5.3 FACTORY OVERHEAD, FIXED, SEMI VARIABLE AND VARIABLE

Factory overhead can be divided into three sub-categories:

Factory Overhead

Fixed Cost Variable cost Semi-Variable cost

Figure 2: Factory Overhead

Fixed Cost

A cost that does not modify in short period of time, irrespective of modification in the production
level can be termed as fixed cost. This price is sometimes a continuing price for a basic operation of
companies or in alternative words it’s a basic operating expense of a business that is crucial and can’t
be avoided. The worth of fixed costs determines the value of the merchandise and therefore the profit
and loss incurred by the business.

Variable Cost

These are the prices that change because the total cost to the organisation once the output (number
of things or services created by the unit/business) varies. In alternative words, we are saying that a
variable price varies in just an equivalent proportion because the output varies.

Therefore, as sales increase the variable prices can increase. For instance, a variable price for a shop
would be the value of the flour. Similar to this, in alternative enterprises, both the raw materials and the
product of the company decide the variable price. For instance, when receiving massage therapy, oil is
also applied and the cost of one or two towels for the restroom is also included. This might stand in for
the variable pricing.

Thus, we often assume that the prices that vary directly in relation to changes in the volume of
production or output are the variable prices. Therefore we will say that the price that changes within
the same proportion because the units created, is that the variable price. A number of the samples of
variable price are direct expenses, direct labour, direct material etc.

Semi-Variable cost

This price could be a price that has components of each fixed costs moreover because the variable
cost. Thus, cost that contains the elements of each the mounted moreover because the variable price is
alleged to be a semi-variable cost. In alternative words, we are saying that a price that is still restored to

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a definite level of production and modifications with the change within the volume of production on the
far side this level could be a semi-variable cost. We are able to see the mounted half as a base level price
that’s forever incurred whereas because the variable portion of the price is an extra cost that changes
as we alter the degree of production.

5.4 ACCOUNTING FOR OVERHEADS

Overhead is those prices needed to run a business; however that can’t be directly attributed to any
specific enterprise, product, or service. Thus, overhead prices don’t directly result in the generation of
profits. Overhead continues to be necessary, since it provides important support for the generation of
profit-making activities. As an example, a high-end haberdasher should pay a considerable quantity for
rent (a form of overhead) so as to be settled in adequate facility for the sale of garments. The haberdasher
should pay overhead to form the right retail surroundings for its customers.

Samples of overhead are

Accounting and Administrative

Depreciation
legal expenses salaries

Licenses and
Insurance Property taxes
government fees

Rent Utilities

Figure 3: Overhead Samples

A business ought to set its semi-permanent product costs at levels that account for each its overhead
prices and direct prices. Doing this permits it to earn a profit on a semi-permanent basis. However, it’s
is feasible to ignore overhead prices for the valuation of special one-time deals, wherever the minimum
worth purpose solely has got to exceed the relevant direct prices.

5.5 APPORTIONMENT OF SERVICE DEPARTMENT’S OVERHEADS TO PRODUCING

DEPARTMENTS (REPEATED AND SIMULTANEOUS EQUATION METHOD)
Repeated distribution methodology could be an accounting technique within which prices of every
service department are repeatedly allotted to production departments in keeping with affordable
percentages till the balance left in commission department’s columns reaches zero.

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Cost and Management Accounting

The need to apportion service department prices to different departments arises because of the very
fact that service departments aren’t profit centers on their own. So as to appraise the performance of
departments, the prices incurred by service departments are allotted to profit earning divisions on an
inexpensive basis.

Where none of the service departments get pleasure from different service departments, the price
allocation is uncomplicated. However, if service departments use services of different service
departments, the price allocation gets a touch difficult. There are varieties of techniques which can be
used for this method and recurrent distribution methodology is one among them.

Assume a corporation contains a bound variety of production departments and 2 service departments,
A and B that get pleasure from one another. So as to reapportion the service department prices to
production department’s mistreatment recurrent distribution methodology, we tend to follow the steps
given below:

Start by allocating the upper service value initial, let or not it’s A.

Allocate department B’s prices to any or all production departments and department A.

Since the balance in department A not remains zero once reallocation of department B’s value, we’ve
got to repeat the method by allocating department A’s value once more to production departments and
department B.

Until the balance in any service department is small, this technique of reallocating the service
department pricing will continue.

Simultaneous Equation Methodology

In concurrent equation methodology of allocation of service department prices, we tend to establish

equation and solve them to get the ultimate balances of production departments. This methodology
accurately allocates service department prices within the given percentages.

5.6 PRODUCTION OVERHEAD ABSORPTION RATES

Overhead absorption is outlined because the allotment of overheads to price units. Once the number of
overheads has been determined on the planned basis for every price centre, consequent step is to charge
it to production.

This involves taking every price centre and applying its overheads to all or any the product that labour
under it. This application of overheads is named absorption, which may be outlined because the
charging of overheads to production.

All product, jobs, or services labour less than one or additional manufacturing price centres. Therefore,
it becomes necessary to charge overheads to the price of product, jobs and processes per bound well-
established norms and scientific reasoning.

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This ensures that the price concerning a value centre should be absorbed as per the set norms. The
method of such charging to or ill of the overheads within the price of production is named overhead
absorption.

5.7 SELECTING AN ABSORPTION RATE

A major consider choosing the absorption rate to be used could be a thought of the practical applicability
of such a rate. This will rely upon however simple it’s to gather the info needed. It is usually accepted
that a time-based technique ought to be used where attainable, i.e. the machine hour rate or the labour
hour rate ought to be thought of for choice. This is because many overhead prices do increase with time,
as an example, indirect wages, rent and rates. Therefore, it is sensible to aim to soak up overheads in
keeping with however long a value unit takes to manufacture.

In addition to those general concerns, every absorption technique has its own benefits and disadvantages
as indicated below:

Rate per unit

Direct labour hour rate

Machine hour rate

Direct wages price percentage

Direct materials price percentage

Figure 4: Methods of Overhead Absorption

 Rate per unit: This is that the easiest way to use however it’s solely appropriate once all cost units
made within the amount are identical. Since this doesn’t typically happen in application, then this
technique isn’t used or applied in apply.
 Direct labour hour rate: This is one among the favoured technique as its time-based. It is most
acceptable in labour-intensive price centres, that are getting rarer nowadays and therefore the
technique is not widely used than it’s been in the past.
 Machine hour rate: This in true that one among the favoured technique as it’s time-based. It is most
acceptable in price centres wherever machine activity predominates and is therefore more widely
used than the direct labour hour rate.

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Cost and Management Accounting

 Direct wages price percentage: This technique may be acceptable as to some extent it is also time-
based. A higher direct wages price might indicate an extended time taken and therefore a bigger
incidence of overheads throughout this point.
 Direct materials price percentage: This isn’t a really logical technique for absorption rates because
there’s no reason why the next material price ought to result in a price unit apparently acquisition
a lot of production overhead cost.

Conclusion 5.8 CONCLUSION

 Overheads could be outlined as all indirect prices incurred for the assembly of products or services.
 Overhead is also outlined as “the price of indirect materials, indirect labour and such alternative
expenses as well as services that can’t handily be charged direct to specific price units”.
 Overhead = Indirect material + Indirect labour + Indirect expenses
 Overhead is that the mixture of indirect material, indirect labour and indirect expenses. It refers to
any value that isn’t directly because of a price unit.
 The indirect expenses (overheads) incurred at intervals the works space is classified as works
overheads.
 The indirect expenses (overheads) incurred at intervals the works space is classified as works
overheads.
 The indirect expenses (overheads) incurred at intervals body space are classified as administrative
or workplace overheads.
 The indirect expenses (overheads) incurred regarding the sales activities are classified as
merchandising overheads.
 Distribution overheads are the unscheduled costs (overheads) incurred in connection with the
delivery of the goods or services.
 The indirect expenses (overheads) incurred regarding the sales activities yet as distributing the
merchandise or service are classified beneath one head as “Selling and distribution overheads”.
 A cost that does not modify in short period of time, irrespective of modification in the production
level can be termed as fixed cost.
 Variable costs are the prices that change because the total cost to the organisation once the output
(number of things or services created by the unit/business) varies.
 Semi variable could be a price that has components of each fixed costs moreover because the cost
is variable.
 The need to apportion service department prices to different departments arises because of the very
fact that service departments aren’t profit centres on their own.
 In concurrent equation methodology of allocation of service department prices, we tend to establish
equation and solve them to get the ultimate balances of production departments.
 The different methods of selecting an absorption rate include rate per unit, direct labour hour rate,
machine hour rate, direct wages price percentage, and direct material price percentage.

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5.9 GLOSSARY

 Merchandise: The goods that organisations bought to sell to the customers

 Acquisition: An asset or object bought or obtained, typically by a library or museum
 Taxes: The amount paid to government as a compulsory expense
 Overhead: Indirect expense of production
 Apportionment: Distributing cost to different departments based on any specific method

5.10 CASE STUDY: COST AND MANAGEMENT ACCOUNTING

Case Objective
This case shows various calculations regarding cost and management accounting.

The following information relates to a factory’s production department for the month of June 2022:

Particulars Amount Hours

Material 80,000
Direct wages 72,000
Direct labour hours 20,000
Machine hours 25,000
Overhead allocated to departments 90,000

Following are the cost data related to June 2022:

 Material used: 8,000  Labour hours used: 3,300
 Direct wages: 6,250  Machine hours: 2,400

Questions

Calculate the factory cost of work order under following methods:

1. Direct labour cost rat
2. Machine hour rate
3. Direct labour hour rate

Solution:

1. Direct labour cost rate: Overhead/ Basis = (90,000/72,000)X100 = 125%

2. Machine Hour rate: Overhead/ Basis = (90,000/25,000)X100 = `3.6 Per machine hour
3. Direct labour hour rate: Overhead/ Basis = (90,000/20,000)X100 = `4.50 Per direct labour hour

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Cost and Management Accounting

5.11 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1. Define the concept and classification of overheads.
2. Define factory overhead, fixed –semi variable and variable?.
3. Explain accounting for overheads.
4. Discuss how to select an absorption rate.
5. Explain production overhead absorption rates.

5.12 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

1. Overhead is that the mixture of indirect material, indirect labour and indirect expenses. It refers to
any value that isn’t directly because of a price unit.

The term indirect means that cannot be allotted, however which might be parcelled out to or
absorbed by value centres or value units. Refer to Section Concept and Classification of Overhead
2. A cost that does not modify in short period of time, irrespective of modification in the production
level can be termed as fixed cost, as sales increase the variable prices can increase and semi variable
cost could be a price that has components of each fixed costs moreover because the cost varies.
Refer to Section Factory Overhead, Fixed, Semi Variable and Variable
3. Overhead is those prices needed to run a business; however that can’t be directly attributed to any
specific enterprise, product, or service. Refer to Section Accounting for Overheads
4. Absorption rate can be selected using following methods:
 Rate per unit
 Direct labour hour rate
 Machine hour rate
 Direct wages price percentage
 Direct materials price percentage
Refer to Section Selecting an Absorption Rate
5. Overhead absorption is outlined because the allotment of overheads to price units. Once the number
of overheads has been determined on the planned basis for every price centre, consequent step is to
charge it to production. Refer to Section Production Overhead Absorption Rate

@ 5.13 POST-UNIT READING MATERIAL

 https://corporatefinanceinstitute.com/resources/knowledge/accounting/overheads/
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 https://www.accountingtools.com/articles/overhead-application

5.14 TOPICS FOR DISCUSSION FORUMS

 Discuss the uses of appropriate method for allocation overhead cost to different departments, how
an appropriate allocation can help an organisation in managing cost?

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 A WARM WELCOME

Cost and Management Accounting

Standard Costing
Unit – 8
Prof. Krishna Gayathri
Standard costing
A standard cost is the planned unit cost of a product or service
It is an indication of what a unit of product or service should cost.
Types of cost standards

✔ Basic standards
✔ Ideal standards
✔ Attainable standards
✔ Current standards.
Variance Analysis
A company has prepared the following standard cost card:
Rs per unit
Materials (4 kg at Rs4.50 per kg) 18
Labour (5 hrs at Rs5 per hr) 25
Variable overheads (5 hrs at Rs2 per hr) 10
Fixed overheads (5 hrs at Rs3 per hr) 15
Rs 68
Budgeted selling price Rs 75 per unit.
Budgeted production 8,700 units
Budgeted sales 8,000 units
The actual results are as follows:

Sales: 8,400 units for Rs613,200

Production: 8,900 units with the following costs:

Materials (35,464 kg) 163,455

Labour (Paid 45,400hrs; worked 44,100 hrs) 224,515
Variable overheads 87,348
Fixed overheads 134,074

Prepare a flexed budget and calculate the total variances

 A WARM WELCOME

Cost and Management Accounting

Modern methods of Management Accounting

Unit – 9
Prof. Krishna Gayathri
Advanced Costing techniques
Activity Based Costing
Charges overheads to products on a casual basis using cost drivers.

Cost Pools
Cost drivers
How to determine ABC

1. Identify OH into cost pools

2. Identify appropriate cost drivers
3. Collect cost into pools based on activity
4. Charge costs to units of production based on cost driver volume

Cost driver rate = total driver cost pool

cost driver volume
U co. manufactures 3 products A, B and C. Data for the period just ended is as follows:

A B C
Production (units) 20,000 25,000 2000
Sales price (per unit) Rs 20 Rs 20 Rs 20
Labour Hours (per unit) 2 1 1
Material cost (per unit) Rs 5 Rs 10 Rs 10

Labour is paid at the rate of Rs 5 per labour hour.

Overheads were as follows:
Rs
Set Up costs 90,000
Receiving costs 30,000
Despatching costs 15,000
Machine costs 55,000
190,000
Cost driver data:
A B C
Machine hours per unit 40000 50000 4000
No. of set ups 10 13 2
No. of deliveries received 10 10 2
No. of orders despatched 20 20 20

Required:

a) Calculate the cost per unit absorbing all overheads using ABC approach.
Target costing
Estimate a market driven selling price for a new product
Reduce this figure by a firm’s required level of profit
Produce a target cost figure for product designer’s to meet
Reduce costs to provide a product that meets that target cost
P plc is considering whether or not to launch a new product. The sales department
have determined that a realistic selling price will be Rs 20 per unit. P have a
requirement that all products generate a gross profit of 40% of selling price.

Calculate the target cost.

Life Cycle Costing

Is the profiling of the costs over a product’s life, including the pre-production stage
Tracks and accumulated the actual cost and revenue of each product from inception to
abandonment
 A company is planning a new product. Market research suggests that demand for the product would last
for 5 years. At a selling price of Rs 10.50 per unit they expect to sell 2,000 units in the first year and
12,000 units in each of the other four years. The company wishes to achieve a mark up of 50% on cost. It
is estimated that the lifetime costs of the product will be as follows:

Manufacturing costs - Rs 6.00 per unit

Design and development costs - Rs 60,000
End of life costs - Rs 30,000

Calculate:
(a) the target cost for the product.
(b) the lifecycle cost per unit and determine whether or not the product is worth making.
 A WARM WELCOME

Cost and Management Accounting

Financial Statements and Ratio Analysis

Unit – 10
Prof. Krishna Gayathri
 Presenting economic resources of the entity

Objectives Presenting the claims against the entity

of financial
reporting Presenting the changes in economic
resources and claims against the entity

Underlying assumption: Going concern

WHAT IS GAAP?

◼ GAAP = Generally Accepted Accounting Principles

◼ A set of financial accounting standards and reporting
guidelines used to prepare accounts
◼ May or may not have legal authority
◼ A dynamic concept.
SOURCES OF GAAP

◼ Regulatory framework
◼ Statute (e.g. Companies Acts)
◼ Accounting standards
◼ IFRSs
◼ UK FRS
◼ USA FAS
◼ Other sources
◼ Best practice
◼ Industry groups.
Rules based GAAP

Principles based GAAP

Users

• Providers of capital and their advisers

• Employees and their representatives
• Lenders
• Suppliers and other trade creditors
• Customers
• Governments and their agencies
• Public

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❖ Nature of Financial Statements:

❑ Identifying and recording transactions

❑ Analyzing
❑ Summarizing and reporting in financial statements

❖ Objectives of Financial Statements:

✔ Gross profit/loss
✔ Net profit/loss
✔ Financial Position
✔ Comparing performance
✔ Plan for future
✔ Liquidity

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Limitations of financial statements

• Problems of historical cost information

• Creative accounting
• Intra group transactions
• Seasonal trading
• Asset acquisitions
• Acquisitions and disposals

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Ratios can be classified as:
❑ Profitability

❑ Activity

❑ Liquidity

❑ Return on Capital Employed

❑ Gearing

❑ Investor

❑ Cashflow

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 Profitability
Gross margin Gross profit ÷ revenue %

Higher ratios implies:

✔ More efficient performance
✔ More efficient controlling of direct costs
✔ Better sales mix

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 Profitability
Operating Profit (net profit before interest and tax) margin Operating profit ÷ revenue %

Higher ratios implies:

✔ More efficient performance
✔ More efficient controlling of selling and administration costs

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 Profitability
Net Profit margin Net profit ÷ revenue %

Higher ratios implies:

✔ More efficient performance
✔ More efficient controlling of borrowing and borrowing costs
✔ Better sales mix

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Liquidity
Current ratio Current Assets ÷ Current Liabilities
Quick ratio Current assets – inventory/ Current liabilities

Higher ratios implies:

✔ Better cashflow

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Liquidity
Inventory days inventory ÷ cost of sales × 365

Receivable days receivables ÷ credit sales × 365

Payable days payables ÷ credit purchases × 365

Working Capital Cycle Inventory days + Receivables days – Payables days

Lesser the length of cycle, more solvent the business

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Solvency
Gearing Total long term debt ÷ Shareholders equity x 100
Or
Total long term debt ÷ Shareholders equity + Total long term debt

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Limitations of ratio analysis

• Effect of choice of accounting policies

• Changes in accounting policy
• Manipulation
• Historic accounts
• Inflation

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