scdl managerial accounting

1Introduction

Chapter 1INTRODUCTION

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

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

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

Providing the answers to the above questions is not possible unless the transactions relatingto the business are recorded in a systematic manner. Here the process of accounting comesinto the picture. According to American Institute of Certified Public Accountants, “Accountingis the art of recording, classifying and summarizing in a significant manner and in terms ofmoney, transactions and events which are of a financial character and interpreting the resultsthereof.” The process of recording the business transactions in a defined set of records, whichin technical words are called as Books of Accounts, is referred to as Book Keeping. Accountingrefers to the process of analyzing and interpreting the information already recorded in thebooks of accounts with the ultimate intention of answering the above stated questions.

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

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

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

2 Management Accounting

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

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

STREAMS OF ACCOUNTING

The process of Accounting gets split into three streams -

1. Financial Accounting

2. Cost Accounting

3. Management Accounting

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

Financial Accounting

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

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

(b) Financial Accounting is referred to as Historical form of accounting. In other words,financial accounting is concerned with recording of transactions which have alreadytaken place. No futuristic transactions and events, howsoever important and significantthey may be from business point of view. find any place in financial accounting andhence in financial statements.

3Introduction

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

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

(e) The information available from Financial Accounting, i.e. financial statement, is availableat a delayed point of time. E.g. Balance Sheets as on 31st March 2002 is available after31st March 2002 is over. The various legal provisions also allow sufficient time lag for thepreparation of financial statements. For decision-making purposes, immediate availabilityof financial data is a prerequisite which is not satisfied by financial accounting. In thissense, financial accounting has the limitation. Further, as sufficient time is allowed forthe preparation of financial statements, they are expected to be accurate.

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

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

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


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

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

l Valuation of Inventory

l Calculation of Depreciation

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

Cost Accounting

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

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

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

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

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

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

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

5Introduction

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

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

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

Management Accounting

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

Emergence of Management Accounting

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

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

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

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

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


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

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

As such, financial accounting and preparation of financial statements therefrom is no longerconsidered to be sufficient for successful and smooth running of business. The analysis andinterpretation of data available from financial accounting is also considered to be necessarywhich may not be directly available from financial accounting itself. Here comes into thepicture Management Accounting. Management Accounting deals with, the analysis andinterpretation of financial data with the ultimate intention to draw certain conclusions therefrom,in order to assist the management in the process of decision-making. To conclude, it may besaid that the role of management accounting has emerged due to the shortcomings of financialaccounting.

Definition of Management Accounting

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

Management Accounting Team of Anglo-American Council on Productivity has described theterm Management Accounting as “the presentation of accounting information in such a wayso as to assist management in the creation of policy and the day to day operation of anundertaking.”

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

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

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

7Introduction

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

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

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

Objects of Management Accounting

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

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

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

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

(4) Presenting to the management the operating and financial statements at reasonableintervals and interpreting the same to enable the management to take action/decisionsregarding future policy and operations.

Scope of Management Accounting

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

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

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


the business i.e. profit earned or loss incurred. The financial statements are mainlymeant for the outsiders dealing with the business.

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

(2) Cost Control Procedures : It deals with the various steps involved in the process ofcontrolling the cost. Thus, in turn it may deal with.

(a) Establishment of plans or budgets for the future.

(b) Comparison of actual performance with the planned or budgeted performance.

(c) Computation of variations between the planned and actual performance.

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

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

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

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

Disadvantages/Limitations of Management Accounting

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

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

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

9Introduction

(3) The installation and operation of management accounting requires a very elaborateorganisational structure and a large number of rules and regulations. It may make themanagement accounting system a costly proposition which can be implemented onlyby large scale organisations.

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

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

FINANCIAL ACCOUNTING AND COST ACCOUNTING COMPARED

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

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

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

Maintenance of cost accounting records is not a legal requirement except in case ofcertain company form of organizations where maintenance of cost accounting recordshas been made compulsory as per the provisions of Section 209 (1) (d) of the CompaniesAct, 1956.

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

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

1 0 Management Accounting

This relationship between Cost Accounting and Financial Accounting can be betterexplained with the help of the following illustration which states the presentation of theprofitability statement under both the sets accounting.

(a) Financial Accounting

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

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

To, Labour Cost 1,00,000

To, Factory Expenses 50,000

To, Gross Profit c/fd

(40% of sales) 2,00,000

5,00,000 5,00,000

To, Administration By Gross Profit

Expenses 90,000 C/f 2,00,000

To, Selling Expenses 50,000

To, Net Profit (12% of sales) 60,000

2,00,000 2,00,000

(b) Cost Accounting

Products

Total A B C

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

Labour Cost 1,00,000 15,000 30,000 55,000

PRIME Cost 2,50,000 35,000 80,000 1,35,000

Factory Expenses 50,000 20,000 10,000 20,000

FACTORY Cost 3,00,000 55,000 90,000 1,55,000

Administration Expenses 90,000 40,000 20,000 30,000

Selling Expenses 50,000 15,000 20,000 15,000

TOTAL COST 4,40,000 1,10,000 1,30,000 2,00,000

Profit 60,000 (-) 10,000 20,000 50,000

SALES 5,00,000 1,00,000 1,50,000 2,50,000

Profit % on sales 12% - 13.33% 20%

1 1Introduction

Financial Accounting and Management Accounting compared

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

(b) Financial Accounting considers only the historical financial transactions and does notconsider the non-financial transactions.

As Management Accounting aims at enabling the management to take the decisionsabout the future, it may consider future data as well as non-financial factors.

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

Management Accounting is not at all a legal requirement. Management is free to installor not to install a management accounting system. Further, these systems have theirown reporting formats.

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

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

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

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

(f) The reports generated by financial accounting which are in the form of financial statementsare available only after the relevant accounting period is over. E.g. Balance Sheet as on31st March 2002 is available after 31st March 2002. As such, financial accounting datamay not be available to the management for decision-making purposes. Moreover, asthe financial accounting data is available after a time lag, the financial statements arerequired to be accurate.


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

Cost Accounting and Management Accounting compared

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

Techniques of Management Accounting

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

l Marginal Costing (Break Even Analysis)

l Budgetary Control

l Standard Costing

l Uniform Costing

1 3Introduction

QUESTIONS

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

2. What do you mean by Management Accounting?

State the advantages and limitations of Management Accounting. How ManagementAccounting is related with other streams of accounting?


NOTES

1 5Basics of Financial Accounting

Chapter 2BASICS OF FINANCIAL ACCOUNTING

As stated earlier, financial accounting is the process of recording the past financial businesstransactions and calculating the net result of these transactions, with the intention tocommunicate the same to the various persons dealing with the business in the externalcapacity. However, financial accounting is the technical process. Before we consider thetechnicalities of financial accounting, let us consider some of the fundamental issues relatingto the financial accounting.

ACCOUNTING PRINCIPLES

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

a. Accounting Concepts

b. Accounting Conventions

Accounting Concepts

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

Business Entity Concept

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


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

Dual Aspect Concept

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

Liabilities AssetsCapital 50,000 Cash 50,000

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


Stock in Trade 40,000

50,000 50,000

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


Receivables 45,000

55,000 55,000

Going Concern Concept

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

Accounting Period Concept

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


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

Cost Concept

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

Money Measurement Concept

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

Matching Concept

This concept proposes that while calculating profit for the accounting period in a correctmanner, the expenses and costs incurred during the period, whether paid or not, should bematched with the revenues generated during the period. E.g. If the accounting period ends on31st March, the salaries for the month of March should be considered as cost for the yearending on 31st March, even if they are actually paid for in the month of April. Otherwise,calculation of the profits for the year ending on 31st March will go wrong as the income will befor 12 months while the expenses will be for 11 months only.

Accounting Conventions

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

Convention of Conservation

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


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

Convention of Materiality

This convention proposes that, while accounting for the various transactions, only thosetransactions will be considered which have material impact on profitability or financial statusof the organization and other insignificant transactions will be ignored. E.g. If the organizationpurchases some postal stamps, some of which remain unused at the end of the accountingperiod. According to matching concept, the cost of such non-used postal stamps should notbe considered as the item of cost. However as its impact on the overall profitability is likely tobe negligible, the cost of non-used postal stamps may be ignored treating the cost of purchasesas the expenditure. Which transactions should be treated as material ones is a subjectiveconcept and depends upon the judgment and knowledge of the accountant.

Convention of Consistency

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

SYSTEMS OF ACCOUNTING

a. Cash System of Accounting

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

b. Mercantile or Accrual System of Accounting

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


reflected in the books of accounts on which the organization may be required to paythe taxes also.

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

TYPES OF EXPENDITURE

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

a. Capital Expenditure

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

b. Revenue Expenditure

Revenue Expenditure indicates the amount of funds paid during a certain period withthe intention to receive the return during the same period. As such, the benefitsavailable from revenue expenditure are received during the same period during whichthey are paid for. The entire amount of revenue expenditure affects the ProfitabilityStatement.

c. Deferred Revenue Expenditure

Deferred Revenue Expenditure indicates the amount of funds paid which does notresult into the acquisition of any fixed asset. However, at the same time benefitsfrom this expenditure are not received during the same period during which they arepaid for. The examples of Deferred Revenue Expenditure are –

a. Initial Advertisement Expenditure

b. Research and Development Expenditure

c. In case of company form of organization, Preliminary Expenses or CompanyFormation Expenses.


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

GLOSSARY OF TERMS USED IN FINANCIAL ACCOUNTING

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

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

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

4. Voucher – Voucher is any documentary evidence to justify that a particular transactionhas taken place. The voucher can be internal voucher or external voucher.

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

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

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

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

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

10. Narration – Narration is the summarized explanation or description of the financialtransaction recorded in the books of accounts.

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

DOUBLE ENTRY SYSTEM OF ACCOUNTING

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

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

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

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

the Trial Balance.

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

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

TYPES OF ACCOUNTS

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


1. Personal Accounts - These are the accounts of persons with whom the organizationdeals in various capacities. In practical circumstances, personal accounts may consistof the following types of accounts –

Ø Accounts of the suppliers

Ø Accounts of the customers

Ø Bank / Financial Institutions

Ø Capital Account

2. Real Accounts – These are the accounts of assets and liabilities. In practicalcircumstances, real accounts may consist of the following types of accounts –

Ø Land Account

Ø Building Account

Ø Machinery Account

Ø Furniture Account

Ø Vehicles Account

Real Accounts may also consist of the accounts of some intangible assets like –

Ø Goodwill Account

Ø Patents and Trade Marks Account

3. Nominal Accounts – These are the accounts of incomes or expenses. In practicalcircumstances, nominal accounts may consist of following types of accounts –

Ø Salary Account

Ø Wages Account

Ø Printing & Stationary Account

Ø Insurance Account

Ø Telephone Expenses Account

Ø Interest paid or Received Account

Ø Commission paid or Received Account

RULES OF DOUBLE ENTRY BOOK KEEPING

While entering into various financial transactions in the records maintained by the organization,following basic rules for accounting are followed –

a. In case of Personal Accounts – Debit the Receiver, Credit the Giver

b. In case of Real Accounts – Debit What Comes in, Credit What Goes out

c. In case of Nominal Accounts – Debit all the expenses, Credit all the incomes


ANNEXURE

Depreciation Accounting

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

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

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

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

Need for Depreciation Accounting :

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

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

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

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


Methods for Calculating Depreciation :

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

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

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

(1) Straight Line Method :

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

Cost of asset - Estimated scrap value

Estimated life in years

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

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

Estimated life 10 years

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

10 years

= Rs. 10,000

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

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

According to this method, the depreciation is provided at a predetermined percentage, on thebalance of cost of asset after deducting the depreciation previously charged (usually termedas written down value).

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

Estimated scrap value Rs. 10,000

Cost of asset subjected to depreciation Rs. 1,00,000

Rate of depreciation 10%


The amount of depreciation is calculated as shown below.

Year Balance Cost Depreciation Written Downof Assets Value - WDV

Rs. Rs. Rs.

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

2 90,000 9,000 81,000

3 81,000 8,100 72,900

4 72,900 7,290 65,610

5 65,610 6,561 59,049

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

D = 1 -R

C

where n = number of years

R = Residual / Scrap Value

C = Cost of the asset

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

(3) Production Unit Method :

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

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

Estimated scrap value Rs. 10,000

Estimated number of units to be produced 50,000

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

∴ 50,000 units

= Rs. 2

n


If in a particular year, 7,000 units are produced, the depreciation to be charged will be :

7,000 units x Rs. 2 per unit = Rs. 14,000.

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

(4) Production Hour Method :

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


Estimated scrap value Rs.10,000

Estimated number of hours 25,000

∴ Rs. 1,10,000 - Rs. 10,000Rate of depreciation per hour =25,000 hours

= Rs. 4

If in a particular year, the machine works for 2,500 hours, the depreciation to be charged willbe :

2,500 hours x Rs. 4 per hour = Rs. 10,000

(5) Joint Factor Rate Method :

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


To be depreciated on time basis over life of the machinei.e. 10 year Rs. 50,000

Estimated number of units to be produced 50,000

Depreciation :

(a) On time basis - Rs. 50,000= Rs. 5,000 per year

10 years

(b) On usage basis - Rs. 50,000= Re. 1 per unit

50,000 units


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

Time basis Rs. 5,000

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

Rs. 11,000

(6) Annuity Method :

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

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

Life of the asset (n) 5 years

Rate of interest (r) 10%

Depreciation to be charged is calculated as below.

D =C x r

=1,00,000 x 0.10

= Rs. 26,3801 1

1 -(1 + r)n -1

1 -(1.10)5 -1

Year Cost/WDV Interest Total Depreciation WDV C/fd

Rs. Rs. Rs. Rs.

1 1,00,000 10,000 1,10,000 26,380 83,620

2 83,620 8,362 91,982 26,380 65,602

3 65,602 6,560 72,162 26,380 45,782

4 45,782 4,578 50,360 26,380 23,980

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

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

(7) Sinking Fund Method :

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


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

Life of the asset (n) 5 years

Rate of interest (r) 10%

Depreciation to be charged is calculated as below :

D =C x r

=1,00,000 x 0.10

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

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

Rs. Rs. Rs. Rs. Rs.

1 – – 16,380 16,380 16,380

2 16,380 1,638 16,380 18,018 34,398

3 34,398 3,440 16,380 19,820 54,218

4 54,218 5,422 16,380 21,802 76,020

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

(8) Endowment Policy Method :

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

(9) Revaluation Method :

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

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

(10) Renewal Method :

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


Practical considerations relating to depreciation

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

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

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

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

l Buildings - Factory Building as well as Administration Buildings

l Plant and Machinery

l Furniture

l Vehicles

l Computer Installations


The rates for calculation of depreciation are as below -

Nature of the Fixed Assets WDV SLM

Buildings - Factory 10% 3.63%

Buildings - Administrative 5% 1.63%

Plant and Machinery 15% 4.75%

Furniture 10% 6.33%

Vehicles 20% 9.5%

Computer Installations 40% 16.21%

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

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

(1) Is Depreciation a cost?

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

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

If the depreciation is provided under the Sinking Fund Method or EndowmentPolicy Method, sufficient funds may be available, at the end of life of theasset, equivalent to the original cost of the asset. As such, it can be said thatthese two methods make available the funds equivalent to the original cost ofthe asset at the end of life of the asset. However these funds may not besufficient to replace the asset due to the increased price of the same. Othermethods of charging the depreciation do not directly generate the funds requiredfor replacing the assets. The fact that the assets are depreciated to the extentof almost entire of the original cost of the same, does not indicate that thefunds are available for the replacement purpose. However, depreciation maybe viewed from one more angle. It is a charge to profits which reduces theprofits which can be distributed among the shareholders by way of dividends,thus conserving the business funds in the business itself. This may beconsidered to be a very very indirect way of interpretation that the depreciationinvolves a source of funds.


QUESTIONS

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

2. Distinguish between the following pairs of terms.

– Cash Basis of Accounting and Accrual Basis of Accounting

– Revenue Expenditure and Capital Expenditure

– Written Down Value Method and Straight Line Method of Depreciation

– Depreciation as per Companies Act and Income Tax Act

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

4. Write an essay on “Depreciation”.


NOTES

35Process of Accounting

Chapter 3PROCESS OF ACCOUNTING

JOURNALIZING

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

The Journal may look as stated below –

Journal

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

a b c d e

Account (To be Debited) – Dr.To, Account (To be Credited)

Narration

The Journal may be subdivided in the following five columns –

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

b. Particulars – It refers to titles of the account to be debited or credited. Title of theaccount to be debited starts from the extreme left and the abbreviation “Dr.” is written tothe extreme right of the same column on the same line. Title of the account to becredited is entered on the next line preceded by the words “To” leaving some space fromthe extreme left. In the same column on the next line, brief description of the transactionis written which is referred to as “Narration”. The narration conventionally starts with thewording “Being”.

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

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

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


Illustration

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

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

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

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

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

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

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

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

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

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

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

Solution

In the Books of Mr. Amit Sen


Cash A/c 10,000Machinery A/c 10,000Building A/c 30,000Furniture A/c 15,000

To, Capital A/c 65,000

(Business started with cash,machinery, building and furniture)

Advertisement A/c 1,000To, Cash A/c 1,000

(Being paid for neon sign boardinstalled)



Bank A/c 25,000To, Loan from Mrs. Sen A/c 25,000

(Being the amount borrowed fromMrs. Sen to open account with thebank)

Purchases A/c 7,000To, Cash A/c 7,000

(Being paid for cash purchases)

Purchases A/c 10,000To, Cash A/c 9,800

To, Discount Received 200

(Being purchases worth Rs. 10,000after getting 2% cash discount)

Cash A/c 14,250To, Sales 14,250

(Sold goods worth Rs. 15,000 afterallowing trade discount of 5%)

Purchases A/c 2,100To, Cash A/c 1,995To, Discount Received 105

(Paid Rs. 1,995 for goods purchasedafter getting 5% cash discount)

Drawings A/c 1,000To, Bank A/c 1,000

(Being donation paid to Chief Minister’sFund as Mr. Sen’s personal contribution)

No Journal Entry will be passed, as thetransaction is not a financial transaction.

Furniture A/c 450 To, Capital A/c 450

(Being the personal table fan broughtfor office use)


Compound Journal Entry

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

Illustration

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


1.4.2002 Cash A/c 10,000Machinery A/c 25,000Computer A/c 50,000

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

SUBSIDIARY BOOKS

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

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

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

The Cash and Bank Book may look as below –

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

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

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

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


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

The Sales Register may look as stated below –

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

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

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

The Purchases Return Register may look as stated below –

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

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

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

The Sales Return Register may look as stated below –

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

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

f. Journal Proper – This records all the residual transaction which cannot be entered intoany other subsidiary book.

The transactions which can be entered in the Journal proper are –

a. Opening Entries

b. Closing Entries

c. Rectification Entries

d. Adjustment Entries


LEDGER POSTING

If Journal or Subsidiary Books are the books which record of the transactions in the chronologicalorder, Ledger is the book where the transactions of the similar nature are pooled togetherunder one Ledger Account. Ledger or General Ledger as it is referred to in practicalcircumstances, maintains all types of accounts i.e. Personal, Real and Nominal. Whichevertransactions are recorded in the Journal or Subsidiary Books in chronological order, the sametransactions are posted in the Ledger, account wise. Thus, a ledger account can be definedas the record of all the transactions pertaining to a person, asset, liability, income or expenditurewhich have taken place during a specified period and shows the net effect of all thesetransactions finally. As such, the transactions are first entered into Journal or SubsidiaryBook when they take place and from there they are transferred to Ledger and this process iscalled as Ledger Posting.

The Ledger Account may be maintained in two ways –

Type I

Dr. Cr.

Date Particulars Folio Rs. Date Particulars Folio Rs.

Type II

Date Particulars Folio Debit Credit BalanceRs. Rs.

Control Ledgers

In practical circumstances, if the transactions of purchases and sales are very large, it maynot be feasible to carry the accounts of all the suppliers and customers in the Main or GeneralLedger. In such cases, apart from the Main Ledger or General Ledger, the Control Ledgers canbe maintained. Control Ledgers carry the individual accounts whereas the Main Ledger orGeneral Ledger records the consolidated effect of the individual transactions. As such, thebalance shown by the consolidated account in the Main Ledger or General Ledger has to tallywith the balances in the individual ledger accounts maintained in the control ledger. In practicalcircumstances, control ledgers may be maintained for the following purposes –

a. Sundry Debtors

b. Sundry Creditors

c. Advances to Staff


Balancing of Ledger Accounts

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

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

b. Calculate the difference between totals of both the sides.

c. If the total of debit side is heavier, place the difference on the amount column of creditside by writing “By Balance c/fd”. If the total of credit side is heavier, place the differenceon the amount column of debit side by writing the “To Balance c/fd”. If the balanceappears on the credit side, the account will be considered to have Debit Balance. If thebalance appears on the debit side, the account will be considered to have Credit Balance.

d. After balance is placed on the appropriate side, ensure that totals of both the sidesmatch with each other.

Illustration

Machinery Account


01.04.01 Balance b/fd 25,000 31.03.02 Depreciation 10,00010.04.01 Bank 70,000 31.03.02 Balance c/fd 85,000

(Balancing figure)

95,000 95,000

Steps explained –

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

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

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

Trial Balance

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


Format of Trial Balance

Trial Balance as on 31st March 2002

Name of the Account Debit Credit

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

PREPARATION OF FINAL ACCOUNTS FROM TRIAL BALANCE

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

a. Profitability Statement – This financial statement is referred to as “Profit and LossAccount” in more technical language. The purpose of this financial statement is to disclosethe result of operations of the business transactions during a given period of time. Assuch, by nature Profit & Loss Account is a period statement which relates to a specificduration of time. Hence, Profit and Loss Account is always referred to as “Profit andLoss Account for the year ended on 31st March 2002.”

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


PROFIT AND LOSS ACCOUNT

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

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

Manufacturing Account for the year ended on 31st March 2002

Particulars Amount Particulars Amount

Opening Stock Closing Stock

Raw Material Raw Material

Work in Progress Work in Progress

Purchases of Raw Material Cost of Production

Carriage Inward (Transferred to Trading Account)

Wages Paid

Power and Fuel

Consumable Stores

Manufacturing Expenses

Depreciation on ProductionAssets

Total Total

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


Trading Account for the year ended on 31st March 2002


Opening Stock Sales (Net of Sales Returns)Finished Goods

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

Gross Profit

Total Total

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

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


Administrative Expenses Gross Profit b/fdOffice SalariesPostage & Telephone Other IncomeTraveling & Conveyance Discount ReceivedLegal Charges Commission Received

Office RentDepreciation Non-Trading IncomeAudit Fees Interest ReceivedInsurance Rent ReceivedRepairs & Renewals

Abnormal IncomeSelling & Distribution Expenses Profit on the sale of assetsAdvertisementCarriage Outward

Free SamplesBad DebtsSales Commission


Particulars Amount Particulars AmountFinancial ExpensesInterest & Bank Charges

Other ExpensesLoss on the sale of assetsSalary to Working PartnersInterest on Capital

Provision for Taxation

Net Profit after Taxes

(Transferred to Capital Account)

Total Total

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

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


Dividend Paid Profit After Tax b/fd

Transferred to Reserves Amount withdrawn from Reserves

Balance transferred to Balance Sheet

Total Total

BALANCE SHEET

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

a. Liabilities

b. Assets


Liabilities

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

a. Capital

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

b. Long Term Liabilities

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

c. Current Liabilities

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

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

2. Advances received from customers – This amount may not be paid back to thecustomers. It gets adjusted with the final selling price. Till it is adjusted with theselling price, it appears as a current liability.

3. Outstanding Expenses – This amount indicates the expenses already incurredduring the relevant period but not paid for.

4. Income Received in Advance

5. Liability for taxes

Assets

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

a. Fixed Assets

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


b. Investments

This indicates the amount of funds invested by the organization outside the business.

c. Current Assets

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

Following is the specimen of Balance Sheet.

Balance Sheet as on 31st March 2002

Capital & Liabilities Amount Assets & Properties AmountCapital Fixed Assets

LandLong Term Liabilities BuildingLoan from Bank Machinery

FurnitureCurrent Liabilities Vehicles

Sundry Creditors ComputersAdvance from CustomersOutstanding Expenses InvestmentsIncome Received in Advance

Current Assets

StockSundry DebtorsCash BalanceBank BalancePrepaid Expenses

Total Total

Adjustments

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


to be reflected in the Trial Balance. As such, according to the Double Entry principles, theAdjustment Entries always have two effects. Following are some of the main adjustmententries made while preparing the final accounts from the Trial Balance.

a. Closing Stock

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

Closing Stock A/c Dr.To, Trading Account

b. Depreciation

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

Depreciation A/c Dr. To, Fixed Asset A/c

c. Outstanding Expenses

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

Expenses A/c Dr.To, Outstanding Expenses A/c


d. Prepaid Expenses

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

Prepaid Expenses A/c Dr.To, Expenses A/c

e. Accrued Income

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

Accrued Income A/c Dr. To, Income A/c

f. Income Received in Advance

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

Income A/c Dr.To, Income received in advance A/c

g. Bad Debts

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


of Bad Debts is debited to Profit and Loss Account, thus reducing the profits or increasingthe losses and the second effect is that the amount of Sundry Debtors is reduced. TheJournal Entry passed for this is –

Bad Debts A/c Dr.To, Sundry Debtors

h. Provision for Doubtful Debts

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

Profit and Loss Account Dr.To, Sundry Debtors A/c

i. Provision for Discount on Debtors

In some cases it is necessary to allow cash discount to the customers for making theearly payment. As the amount of debtors who are likely to avail the cash discount is notknown in advance, a provision is made in the books of account for the discount to beallowed to debtors. Accordingly, the first effect of this adjustment is that the amountequivalent to the provision for discount on debtors is written off to Profit and Loss Accountand the second effect is that the corresponding amount is reduced from the SundryDebtors in the Balance Sheet. The Journal Entry passed for this is –

Profit and Loss Account Dr.To, Sundry Debtors A/c

j. Interest on Capital

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


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

Interest on Capital A/c Dr.To, Capital A/c

k. Drawings

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

Drawing / Capital A/c Dr.To, Sales A/c

l. Deferred Revenue Expenditure Written Off

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

Deferred Revenue Expenditure Written Off A/c Dr.To, Deferred Revenue Expenditure A/c

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

m. Abnormal Loss due to fire etc.

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


Loss due to Fire Account Dr.To, Stock Destroyed Account

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

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

n. Goods Distributed as Free Samples

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

Advertisement A/c Dr.To, Sales A/c

o. Goods sent on approval basis

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

p. Commission payable to the manager

In some cases, commission is payable to the manager as a percentage of profit earnedby the business. The calculation of this commission may be made in two ways –

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


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

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

Commission A/c Dr.To, Commission Payable A/c

Illustration 1

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

Date Particulars

March2002

1 Started business with the capital of Rs. 50,000

2 Opened a Bank Account by paying Rs. 35,000

3 Purchased goods from Ajay on credit Rs. 20,000

5 Sold the goods to Vijay on credit Rs. 14,000

7 Paid Ajay by cheque Rs. 19,500 in full settlement

9 Received Rs. 13,000 from Vijay in full settlement by cheque

15 Purchased furniture of Rs. 10,000 and paid the amount by cheque

18 Paid for traveling expenses in cash Rs. 3,000

21 Sold the goods to Vinod for cash Rs. 10,000

25 Goods purchased from Ashok against cash Rs. 8,000

27 Cash deposited in bank Rs. 5,000

28 Amount withdrawn by cheque for personal purpose Rs. 3,000

30 Paid salary in cash Rs. 2,000

Adjustments –

a. Value of goods unsold on 31st March 2002, valued at cost, Rs. 17,000

b. Depreciate furniture @2%

c. Telephone bill for the month of March 2002 not yet paid Rs. 1,500


Solution

In the books of M/s Pam Industries

Date Particulars L.F. Debit – Rs. Credit – Rs.March 2002

1 Cash A/c Dr. 50,000To, Capital A/c 50,000(Capital introduced in the business)

2 Bank A/c Dr. 35,000To, Cash A/c 35,000(Opened Bank Account)

3 Purchases A/c Dr. 20,000 To, Ajay A/c 20,000(Goods purchased on credit)

5 Vijay A/c Dr. 14,000To, Sales A/c 14,000(Sold goods on credit)

7 Ajay A/c Dr. 20,000To, Bank A/c 19,500 To, Discount A/c 500(Paid Ajay in full settlement)

9 Bank A/c Dr. 13,000Discount A/c Dr. 1,000To, Vijay A/c 14,000(Received from Vijay in full settlement)

15 Furniture A/c Dr. 10,000To, Bank A/c 10,000(Furniture purchased against cheque)

18 Traveling Expenses A/c Dr. 3,000To, Cash A/c 3,000(Paid for traveling expenses)

21 Cash A/c Dr. 10,000To, Sales A/c 10,000(Sold goods for cash)

25 Purchases A/c Dr. 8,000To, Cash A/c 8,000(Goods purchased for cash)

27 Bank A/c Dr. 5,000To, Cash A/c 5,000(Cash deposited in bank)

28 Drawings A/c Dr. 3,000To, Bank A/c 3,000(Withdrawn for personal purpose)

30 Salary A/c Dr. 2,000To, Cash A/c 2,000(Paid salary in cash)


General Ledger of M/s Pam Industries for March 2002

Cash Account


1 To Capital A/c 50,000 2 By Bank 35,00021 To Sales 10,000 18 By Traveling Exp. 3,000

25 By Purchases 8,000

27 By Bank 5,00030 By Salary 2,000

31 By Balance c/fd 7,000

60,000 60,000

Bank Account


1 To Cash A/c 35,000 7 By Ajay 19,500

9 To Vijay 13,000 15 By Furniture 10,000

27 To Cash 5,000 27 By Drawings 3,00031 By Balance c/fd 20,500

53,000 53,000

Purchases Account


3 To Ajay 20,000 31 By Trading A/c 28,00025 To Cash 8,000

28,000 28,000

Sales Account


31 To Trading A/c 24,000 By Vijay 14,000

By Cash 10,000

24,000 24,000

Traveling Expenses Account


18 To Cash 3,000 31 By Profit & Loss A/c 3,000

3,000 3,000


Salary Account


30 To Cash 2,000 31 By Profit & Loss A/c 2,000

2,000 2,000

Telephone Expenses Account


31 To Outstanding Exp. 1,500 31 By Profit & Loss A/c 1,500

1,500 1,500

Discount Account


9 To Vijay 1,000 7 By Ajay 500

By Profit & Loss A/c 500

1,000 1,000

Depreciation Account


31 To Furniture 200 31 By Profit & Loss A/c 200

200 200

Ajay Account


7 To Bank 19,500 3 By Purchases 20,000

7 To Discount 500

20,000 20,000

Vijay Account


5 To Sales 14,000 9 By Bank 13,000

9 By Discount 1,000

14,000 14,000


Capital Account


28 To Bank 3,000 1 By Cash 50,000

31 To Balance c/fd 47,000

50,000 50,000

Outstanding Expenses Account


31 To Balance c/fd 1,500 31 By Telephone Exp. 1,500

1,500 1,500

Furniture Account


15 To Bank 10,000 31 By Depreciation 200

31 By Balance c/fd 9,800

10,000 10,000

Trial Balance as on 31st March 2002

Name of the Account Debit Credit

Cash 7,000

Bank 20,500

Purchases 28,000

Sales 24,000

Traveling Expenses 3,000

Salary 2,000

Telephone Expenses 1,500

Depreciation 200

Discount 500

Capital 47,000

Furniture 9,800

Outstanding Expenses 1,500

Total 72,500 72,500




Opening Stock Nil Sales 24,000

Purchases 28,000 Closing Stock 17,000

Gross Profit c/fd 13,000

Total 41,000 Total 41,000



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

Salary 2,000

Telephone Expenses 1,500

Discount 500

Depreciation 200

Profit carried to Capital Account 5,800



Capital & Liabilities Amount Assets & Properties Amount

Capital Fixed Assets

Balance 47,000 Furniture 10,000

Add : Profit for year 5,800 Less : Depreciation 200

52,800 9,800

Current Assets

Current Liabilities Stock 17,000

Outstanding Expenses 1,500 Cash 7,000

Bank 20,500



Illustration 2

From the following balances and information, prepare Trading and Profit & Loss Account of Mr. X for

the year ended 31st March 1998 and a Balance Sheet as on that date.

Particulars Dr. Rs. Cr. Rs.X’s Capital Account 10,000

Plant and Machinery 3,600

Depreciation on Plant and Machinery 400Repairs to Plant 520

Wages 5,400

Salaries 2,100Income Tax of Mr. X 100

Cash in Hand and at Bank 400

Land and Building 14,900Depreciation on Building 500

Purchases 25,000

Purchase returns 300Sales 49,800

Bank Overdraft 760

Accrued Income 300Salaries Outstanding 400

Bills Receivable 3,000

Provision for Bad Debts 1,000Bills Payable 1,600

Bad Debts 200

Discount on Purchases 708Debtors 7,000

Creditors 6,252

Opening Stock 7,400

70,820 70,820

Information –

a. Stock as on 31st March 1998 was Rs. 6,000

b. Write off further Rs. 600 for bad Debt and maintain a provision for bad Debts at 5% onDebtors.

c. Goods costing Rs. 1,000 were sent to customer for Rs. 1,200 on 30th March 1998 onsale or return basis. This was recorded as actual sales.

d. Rs. 240 paid as rent of the office were debited to Landlord Account and were included inthe list of Debtors.


e. General Manager is to be given commission at 10% of net profits after charging thecommission of works manager and his own.

f. Works manager is to be given commission at 12% of net profits before charging thecommission of General Manager and his own.

Solution



Opening Stock 7,400 Sales 49,800

Purchases 25,000 Less : Goods on approval 1,200 48,600

Less : Returns 300 24,700

Closing Stock 6,000

Wages 5,400 Add : Goods on approval 1,000 7,000





Salaries 2,100 Gross Profit b/fd 18,100Depreciation on Plant 400 Discount 708

Depreciation on Building 500

Repairs to Plant 520Rent 240

Bad Debts 200

Add : Additional Bad Debts 600Add : Provision for Bad Debts 248

Less : Existing Provision 1000 48

Commission to Works Manager 1,800

Commission to General Manager 1,200

Profit transferred to Capital A/c 12,000






Balance 10,000 Plant & Machinery 3,600

Add : Profit for year 12,000 Building 14,900

Less : Income Tax 100

21,900 18,500

Current Liabilities Current Assets

Creditors 6,252 Closing Stock (Including stock on 7,000

Bills Payable 1,600 Approval)

Overdraft 760 Cash 400

Outstanding Salaries 400 Debtors 7,000

Commission Payable 3,000 Less : Bad Debts 600

Less : Goods on approval 1,200

Less : Due from Landlord 240

4,960

Less: Provision for Bad Debt 248 4,712

Bills Receivables 3,000

Accrued Income 300


Working Notes :

Rs.

Profit before calculating the commission 15,000

Commission payable to Works Manager @12% 1,800

Commission payable to General Manager on 13,200

Commission payable to General Manager @10% 1,200

(Calculated as 13200 / 110 x 100)

Illustration 3

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


Particulars Dr. Rs. Cr. Rs.

Sundry Debtors 5,00,000

Sundry Creditors 2,00,000

Outstanding Liabilities for Expenses 55,000

Wages 1,00,000

Carriage Outwards 1,10,000

Carriage Inwards 50,000

General Expenses 70,000

Cash Discount 20,000

Bad Debts 10,000

Motor Car 2,40,000

Printing and Stationery 15,000

Furniture and Fittings 1,10,000

Advertisement 85,000

Insurance 45,000

Salesman’s Commission 87,500

Postage and Telephones 57,500

Salaries 1,60,000

Rates and Taxes 25,000

Drawings 20,000

Capital Account 14,43,000

Purchases 15,50,000

Sales 19,87,500

Stock as on 1st April 1990 2,50,000

Cash at Bank 60,000

Cash in Hand 10,500

36,30,500 36,30,500

The following adjustments are to be made –

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

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


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

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

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

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

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

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

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

Solution



Opening Stock 2,50,000 Sales 1987500

Purchases 1550000 Less : Goods on approval 75000 19,12,500

Less : Furniture purchased 50000 15,00,000

Closing Stock 725000

Wages 1,00,000 Add : Goods on approval 50000 7,75,000


Goods withdrawn 25,000

Gross Profit c/fd 8,12,500

Total 27,12,500 Total 27,12,500




Salaries 1,60,000 Gross Profit b/fd 8,12,500

Carriage Outwards 1,10,000

Advertisement 85,000 Loss transferred to Capital A/c 44,625

Insurance 45,000

Salesman’s Commission 95,625

Postage & Telephones 57,500

Rates & Taxes 25,000

Bad Debts 10000

Add : Additional Bad Debts 25000

Add : Provision for Bad Debts 20000 55,000


Cash Discount 20,000

Printing & Stationery 15,000

Depreciation 64,000

Previous Year Expenses 55,000

Total 8,57,125 Total 8,57,125




Balance 14,43,000 Motor Car 240000

Less : Loss for year 44,625 Less : Depreciation 48000 1,92,000

Less : Drawings 20,000

Less : Goods withdrawn 25,000 Furniture 110000

Add : Purchases 50000

13,53,375 Less : Depreciation 16000 1,44,000

Current Liabilities Current Assets

Creditors 2,00,000 Closing Stock (Including stock on 7,75,000

Outstanding Commission 8,125 Approval)

Cash at Bank 60,000

Cash in Hand 10,500

Debtors 500000

Less : Bad Debts 25000

Less : Goods on approval 75000

400000

Less: Bad Debt Provision 20000 3,80,000

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


Illustration 4

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


Hari’s Capital Account 76,690

Stock as on 1st January 1994 46,800

Sales 3,89,600

Returns Inwards 8,600

Purchases 3,21,700

Returns Outwards 5,800

Carriage Inward 19,600

Rent and taxes 4,700

Salaries and Wages 9,300

Sundry Debtors 24,000

Sundry Creditors 14,800

Bank Loan @14% 20,000

Bank Interest 1,100


Bank Balance 8,000

Discount Earned 4,440

Furniture and Fitting 5,000

Discount Allowed 1,800


Insurance 1,300

Postage and Telegram 2,330

Cash Balance 380

Travelling Expenses 870

Drawings 30,000

5,11,330 5,11,330


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


b. Provision for Bad and Doubtful Debts to be created at 5% and for Discount @2% onSundry Debtors.

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

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

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

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

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

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

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

Solution

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


Opening Stock 46,800 Sales 389600

Purchases 321700 Less : Returns Inwards 8600 3,81,000

Less : Personal purchases 600

Add : Unrecorded purchases 400 Closing Stock 78,600

Less : Returns Outwards 5800 3,15,700



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


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


Salaries and Wages 9,300 Gross Profit b/fd 77,500

Rent and Taxes 4,700 Discount Earned 4,440

Bank Interest 1100

Add : Outstanding 1700 2,800

Printing and Stationery 14400

Less : Prepaid 3600 10,800



Insurance 1,300


Travelling Expenses 870

Provision for Bad Debts 1,150

Discount on Debtors 437

Depreciation 500



Balance Sheet as on 31st December, 1994



Balance 76,690 Furniture & Fitting 5000

Add : Profit for year 34,503 Less : Depreciation 500 4,500

Less : Personal Purchases 600

Less : Drawings 30,000 Current Assets

Closing Stock 78,600

80,593 Prepaid Printing & Stationary 3,600

Bank Balance 8,000

Current Liabilities Cash in Hand 380

Creditors 14800 Debtors 24000

Add : Unrecorded Purchases 400 Less: Due to Ram 1000

Less : Due to Ram 1000 14,200 23000

Less: Bad Debt Provision 1150

Outstanding Interest 1,700 21850

Less: Discount 437 21,413

Bank Loan 20,000

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


Illustration 5

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


Capital 1,00,000

Drawings 12,000

Land and Building 90,000

Plant and Machinery 20,000

Furniture 5,000

Sales 1,40,000

Returns outwards 4,000

Debtors 18,400

Loan from Gajanand on 1.7.98 @6% p.a. 30,000

Purchases 80,000

Returns Inward 5,000

Carriage 10,000

Sundry Expenses 600

Printing and Stationery 500

Insurance Expenses 1,000

Provision for bad and doubtful Debts 1,000

Provision for Discount on Debtors 380

Bad Debts 400

Profit of textile Department 10,000

Stock of General Goods on 1st April, 1998 21,300

Salaries and wages 18,500

Creditors 12,000

Trade Expenses 800

Stock of Textile Goods on 31st March, 1999 8,000

Cash at Bank 4,600

Cash in Hand 1,280

2,97,380 2,97,380


Information –

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

b. Fire occurred on 23rd March, 1999 and Rs. 10,000 worth of general goods were destroyed.The insurance company accepted claim for Rs. 6,000 only and paid the claim money on10th April, 1999.

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

d. Received Rs. 6,000 worth of goods on 27th March ,1999, but the invoice of purchase wasnot recorded in Purchase Book.

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

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

g. Insurance prepaid amounted to Rs. 200.

Solution

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


Opening stock of General Goods 21,300 Sales 140000

Purchases 80000 Less : Return Inwards 5000 1,35,000

Less : Return Outwards 4000

Add : Unrecorded Purchases 6000 82,000 Goods withdrawn 2,000

Goods destroyed by fire 10,000

Carriage 10,000

Closing Stock of General Goods 27,300


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




Salaries & Wages 18,500 Gross Profit b/fd 61,000

Sundry Expenses 600 Profit of Textile Department 10,000

Printing & Stationery 500

Insurance 1000 Provision for Bad Debts 900

Less : Prepaid 200 800 Less : Existing 1000 100

Bad Debts 400

Add : Additional Bad Debts 400 800 Discount on Debtors 342

Trade Expenses 800 Less : Existing 380 38

Depreciation 6,050

Loss by Fire 4,000

Interest on Loan 1,350

Profit carried to Capital A/c 37,738


Balance Sheet as on 31st March, 1999Capital & Liabilities Amount Assets & Properties Amount


Balance 100000 Land & Building 90000

Less : Drawings 12000 Less: Depreciation 1800 88,200

Less : Goods withdrawn 2000 Plant & Machinery 20000

Add: Profit for year 37738 1,23,738 Less : Depreciation 4000 16,000

Furniture 5000

Loan from Gajanand 30,000 Less : Depreciation 250 4,750

Current Liabilities

Creditors 12000 Current Assets

Add : Unrecorded Purchases 6000 18,000 Stock of General Goods 27,300

Stock of Textile Goods 8,000

Outstanding Interest on Loan 1,350 Sundry Debtors 18400


18000

Less : Bad Debts Provision 900

17100

Less : Discount 342 16,758

Cash at Bank 4,600

Cash in Hand 1,280

Prepaid Insurance 200

Receivable from Insurance Company 6,000

Total 1,73,088 Total 1,73,088


Illustration 6

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

Debit Balances Rs. Credit Balance Rs.

Plant & Machinery 50,000 Sales 2,40,000

Opening Stock 30,000 Discount 2,000

Purchases 80,000 Sundry Creditors 20,000

Land & Building 85,000 Bills Payable 10,750

Carriage Inwards 1,700 Hira’s Loan Account 50,000

Carriage Outwards 2,500 Capital Accounts –

Wages 16,000 Hira 50,000

Sundry Debtors 50,000 Manik 25,000

Salaries 12,000

Furniture 18,000

Trade Expenses 6,000

Return Inwards 950

Advertisement Suspense 12,500

Discount 900

Partners’ Drawings -

Hira 3,000

Manik 2,000

Bills Receivable 20,000

Insurance 1,200

Bad Debts 1,000

Cash at Bank 5,000

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

You are required to prepare Trading and Profit & Loss Account of the firm for the year ended on31st March 1989 and the Balance Sheet on that date after taking into consideration followingadjustments –

a. Closing Stock Rs. 45,000.

b. Depreciate Plant @10% and Furniture @20%. Appreciate Land and Building toRs. 90,000.

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


d. Advertisement Suspense Account to be written off against revenue over five years.

e. Partners’ Drawings are to bear interest @10% p.a. Amounts were withdrawn on31st December, 1988.

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

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

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

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

Solution

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



Purchases 80,000 Less : Returns Inwards 950 2,39,050

Carriage Inwards 1,700 Closing Stock 45,000

Wages 16,000


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

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


Salaries 12,000 Gross Profit b/fd 1,56,350

Trade Expenses 6,000 Discount Received 2,000

Carriage Outwards 2,500 Interest on Drawings –

Insurance 1200 Hira 75

Less : prepaid 200 1,000 Manik 50

Discount 900

Bad Debts 1,000 Appreciation of Land & Building 5,000

Bad Debts Reserve 1,250

Advertisement 2,500

Salary Payable to Manik 3,000

Interest on Loan from Hira 1,500

Depreciation 8,600

Sub-Total 40,250



Contribution to National Defence Fund 61,613

Transferred to Capital Account

Hira 30,806

Manik 30,806

Total 1,63,475 Total 1,63,475

Balance Sheet as on 31st March, 1989



Hira’s Capital 50000 Land & Building 85000

Add : Profit for year 30806 Add : Appreciation 5000 90,000

Less : Drawings 3000 Plant & Machinery 50000

Less : Interest on Drawings 75 77,731 Less : Depreciation 5000 45,000

Furniture 18000

Less : Depreciation 3600 14,400

Manik’s Capital 25000

Add : Profit for year 30806 Current Assets

Add : Salary 3000 Closing Stock 45,000

Less : Drawings 2000 Sundry Debtors 50000

Less : Interest on Drawings 50 56,756 Less : Bad Debt Reserve 1250 48,750

Bills receivables 20,000

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

Prepaid Insurance 200

Current Liabilities

Sundry Creditors 20,000 Advertisement Suspense 12500

Bills Payable 10,750 Less : Transferred to revenue 2500 10,000

Interest on Hira’s Loan Account 1,500

Contribution to National Defence Fund 61,613

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

Illustration 7

Following is the Trial Balance of M/s. Pandit Brothers, a partnership firm, as on31st March, 1992.



Capital Account H. Pandit 1,00,000

Capital Account K. Pandit 1,00,000

Drawings H. Pandit 16,000

Drawings K. Pandit 16,000

Buildings 80,000

Furniture 20,000

Purchases 2,00,000

Sales 3,00,000

Stock (1st April, 1991) 50,000

Wages 44,000


Office Expenses 10,000

Salaries 50,000



Cash in Hand 400

Bank Overdraft 29,000


Total 5,41,000 5,41,000

Following further information relating to the firm is made available –

a. Stock at the end of the year on 31st march, 1992 was Rs. 1,14,500

b. There was a fire in the premises on 26th November, 1991 which damaged a portion ofstock and the loss was estimated at Rs. 17,500.

c. H. Pandit is in charge of purchases and is to be paid 2.5% commission on suchpurchases.

d. A steel table purchased on 1st February, 1992 for Rs. 3,000 was debited to purchasesaccount.

e. K. Pandit who looks after all other business aspects except purchases is entitled to acommission of 5% on net profits after charging commission on purchases due to H.Pandit and commission payable to himself.

f. Depreciation on Buildings @2.5% and on Furniture @10%

g. Profits or losses are shared equally.


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

Solution



Opening Stock 50,000 Sales 3,00,000

Purchases 200000

Less : Table Purchased 3000 1,97,000 Closing Stock 1,14,500

Wages 44,000

Carriage Inwards 28,000 Stock destroyed by fire 17,500

Commission on purchases 4,925


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



Salaries 50,000 Gross Profit b/fd 1,08,075



Stock destroyed by fire 17,500

Depreciation 4,050

83,150

Commission to K. Pandit 1,187

Profit transferred to Capital Account

H. Pandit 11,869

K. Pandit 11,869

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





H. Pandit Capital 100000 Building 80000

Add : Profit for year 11869 Less : Depreciation 2000 78,000

Add: Commission 4925 Furniture 20000

Less : Drawings 16000 1,00,794 Add : Purchases 3000


K. Pandit Capital 100000

Add : Profit for year 11869 Current Assets

Add: Commission 1187 Closing Stock 1,14,500

Less : Drawings 16000 97,056 Sundry Debtors 25,000

Cash in Hand 400

Current Liabilities



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

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

(108075 – 83150)—————————— x 5

105

Illustration 8

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


Capital 14,00,000

Drawings 75,000

Opening Stock 80,000

Purchases 16,20,000

Freight on purchases 15,000

Wages 1,10,000

Sales 25,00,000

Salaries 1,00,000



Travelling Expenses 23,000

Miscellaneous Expenses 35,000


Advertisement Expenses 25,000


Discounts 7,600 14,500

Bad Debts written off (after adjusting recovery of bad

debts of Rs. 6,000 written off in 1997) 14,000

Building 10,00,000

Machinery 75,000

Furniture 40,000

Debtors 1,50,000

Provision for Doubtful Debts 19,000

Creditors 1,60,000

Investments (12% Purchased on 1st October, 1999) 6,00,000

Bank Balance 83,900

40,93,500 40,93,500

Adjustments –

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

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

c. Machinery worth Rs. 35,000 purchased on 1st January, 1997 was wrongly written offagainst Profit & Loss Account. This asset is to be brought into account on1st January, 1999 taking depreciation at 10% per annum on straight line basis upto31st December, 1998.

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

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

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

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


Solution

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


Opening Stock 80,000 Sales 25,00,000

Purchases 16,20,000

Freight on purchases 15,000 Goods withdrawn 5,000

Wages 1,10,000

Closing Stock 2,25,000


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

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



Travelling Expenses 23,000 Bad Debts recovered 6,000

Miscellaneous Expenses 35,000 Provision for bad Debts 9000

Printing & Stationery 27,000 Less : Existing 19000 10,000

Advertisement Expenses 25,000 Income from investments 18,000

Postage and Telegram 13,000 Discount Received 14,500

Discount 7,600

Bad Debts 20,000

Depreciation 40,000

Sub-Total 2,90,600

Commission to Manager 31,567

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

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


Balance Sheet as on 31st December, 1999



Balance b/fd 1400000 Building 1000000

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

Less : Goods withdrawn 5000 Machinery 75000

Add : Profit for year 631333 Add : Capitalized 28000

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

Furniture 40000


Current Liabilities

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

Commission to Manager 31,567

Current Assets


Debtors 150000

Less : Bad Debt Provision 9000 1,41,000

Bank Balance 83,900

Investment Income outstanding 18,000

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

Note

Value of machine purchased – Rs. 35,000.

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

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

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


Illustration 9

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


Capital 8,00,000

Drawings 60,000


Purchases 15,95,000

Freight on Purchases 25,000

Wages (11 months up to 29th February, 2000) 66,000

Sales 23,10,000

Salaries 1,40,000

Postage, Telegrams, Telephones 12,000



Creditors 3,00,000

Investments 1,00,000

Discount Received 15,000

Debtors 2,50,000

Bad Debts 15,000


Building 3,00,000

Machinery 5,00,000

Furniture 40,000

Commission on sales 45,000

Interest on Investments 12,000

Insurance (Year up to 31st July 2000) 24,000

Bank Balance 1,50,000

34,45,000 34,45,000


Adjustments –


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

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

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

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

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

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

Solution




Purchases 1595000 Less : Sale of Investments 110000 22,00,000

Less: Machine Purchased 45000 15,50,000

Freight on Purchases 25000 Closing Stock 2,25,000

Less : Freight on Machinery 5000 20,000

Wages 66000


Gross Profit c/fd‘ 7,08,000

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





Postage, Telegrams, Telephones 12,000 Discount Received 15,000

Printing and Stationery 18,000 Interest on Investments 12,000

Miscellaneous Expenses 30,000 Profit on sale of Investments 10,000

Bad Debts 15000

Add : Additional 10000 25,000

Provision for Bad Debts 12000

Less : Existing Provision 8000 4,000

Commission on Sales 45000


Insurance 24000

Less : prepaid 8000 16,000

Depreciation 64,000

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

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




Balance b/fd 800000 Building 300000

Add : Profit for year 381000 Less: Depreciation 7500 2,92,500

Less : Drawings 60000 11,21,000 Machinery 500000

Add : Purchased 50000

Less: Depreciation 52500 4,97,500

Furniture 40000

Current Liabilities Less : Depreciation 4000 36,000

Creditors 3,00,000

Sales Commission outstanding 10,000 Current Assets

Wages Outstanding 6,000 Closing Stock 2,25,000

Debtors 250000


240000

Less : Bad Debts Provision 12000 2,28,000

Bank Balance 1,50,000

Prepaid Insurance 8,000

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


Illustration 10

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

Debit Balances Rs. Credit Balance Rs.

Opening Stock 23,400 Capital 54,050

Sales Returns 4,300 Sales 1,44,800

Purchases 1,21,550 Purchases Returns 2,900

Carriage Inwards 9,300 Sundry Creditors 7,400

Rent 2,850 Loan from Bank @12% 10,000

Salaries 4,650 Interest Received 725

Sundry Debtors 12,000 Discount Received 1,495

Printing & Stationery 1,700

Interest Paid 450

Advertisement 5,600

Cash at Bank 4,000

Investments at 5% on 1.4.93 2,500

Furniture on 1.4.93 900



Audit Fees 350

Fire Insurance Premium 300


Postage & Telegrams 435

Cash on Hand 190

Deposits @10% on 1.4.93 15,000

Drawings 5,000

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

Adjustments –

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


b. Purchases include furniture purchased on 1st January 1994 for Rs. 1,000.

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

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

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

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

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

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

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

Solution




Purchases 121550 Less : Goods returned 1500

Less : Purchase Returns 2900 Less : Sales Returns 4300 1,39,000

Less : Furniture Purchased 1000 1,17,650


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

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




Salaries 4,650 Gross Profit b/fd 27,950

Rent 2,850 Interest Received 725

Printing & Stationery 1,700 Add : Receivable 1000 1,725

Interest paid 450 Discount received 1,495

Add : Interest on Bank Loan 300 750

Advertisement 5,600



Audit Fees 350

Fire Insurance Premium 300


Postage & Telegrams 435

Depreciation 115

Reserve for Bad Debts 475






Balance 54050 Furniture 900

Less: Drawings 5000 Add : Purchases 1000

Add : Profit for year 7050 56,100 Less : Depreciation 115 1,785

Investments 2,500

Loan from Bank 10,000

Current Assets


Current Liabilities Sundry Debtors 12000

Sundry Creditors 7400 Less : Due to Roberts 1000

Less : Due to Roberts 1000 6,400 Less : Goods returned 1500

Outstanding Interest 300 Less : Bad Debts reserve 475 9,025

Cash on Hand 190

Cash at Bank 4,000

Deposits 15,000

Interest Receivable 1,000



QUESTIONS

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

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

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

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

a. Goods lost by fire

b. Goods distributed as free samples

c. Goods sent on approval basis

d. Bad Debts and Provision for Bad Debts

e. Interest on Capital

f. Prepaid Expenses and Outstanding Expenses


PROBLEMS

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




Capital Account 7,10,000

Drawings 52,450

Insurance 6,000


Salaries 1,50,000

Patents 75,000

Machinery 2,00,000

Freehold Land 1,00,000

Building 3,00,000

Stock on 1st April 1990 57,600

Carriage on Purchases 20,400

Carriage on Sales 32,000

Fuel and Power 47,300

Wages 1,04,800

Returns Outwards 5,000

Returns Inwards 6,800

Sales 9,87,800

Purchases 4,06,750

Cash at Bank 26,300

Cash in Hand 5,400

17,65,800 17,65,800


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

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

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


d. Wages include a sum of Rs. 20,000 spent on erection of a cycle shed for employees andcustomers.

e. Salaries for the month of March 1991 amounting to Rs. 15,000 were unpaid.

f. Insurance includes a premium of Rs. 1,700 on a policy, expiring on 30th September,1991.

Q.2. Mr. A, a Shopkeeper had prepared the following trial balance from his ledger as on31st March 1989.


Purchases 6,20,000Sales 8,30,000

Cash in Hand 4,200

Cash in Bank 24,000

Stock of Goods on 1st April, 1988 1,00,000

Mr. A’s Capital 5,77,200Drawings 8,000

Salaries 64,000

Postage and Telephone 23,000

Salesmen Commission 70,000

Insurance 18,000Advertising 34,000

Furniture 44,000


Motor Car 96,000

Bad Debts 4,000Cash Discount 8,000



Carriage Outwards 44,000

Wages 40,000Creditors 80,000

Debtors 2,00,000

14,87,200 14,87,200

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


a. Cost of goods in stock as on 31st March, 1989 Rs. 1,45,000

b. Mr. A had withdrawn goods worth Rs. 5,000 during the year.

c. Purchases include purchase of furniture worth Rs. 10,000.

d. Debtors include Rs. 5,000 Bad Debts.

e. Creditors include a balance of Rs. 4,000 to the credit of Mr. B in respect of which it hasbeen decided and settled with the party to pay only Rs. 1,000.

f. Sales include goods worth Rs. 15,000 sent to Ram & Co. on approval and remainingunsold as on 31st March 1989 and the cost of goods was Rs. 10,000.

g. Provision for bad debts is to be created at 5% on Sundry Debtors.

h. Depreciate furniture by 15% and Motor Car by 20%

i. The salesmen are entitled to a commission of 10% on total sales.

Q.3. From the following balances extracted from the books of Mr. Yellow, prepare Trading andProfit & Loss Account for the year ended 31st December, 1990 and a Balance Sheet ason that date.

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

1,77,692 1,77,692


Adjustments –

a. Closing Stock on 31st December, 1990 was valued at cost Rs. 25,000 (Market ValueRs. 16,200)

b. Rs. 6,000 paid to Mr. Red against Bill Payable were debited by mistake to Mr. Green’sAccount and included in the list of Sundry Debtors.

c. Travelling expenses paid to sales representative Rs. 5,000 for the month of December1990 were debited to his personal account and included in the list of Sundry Debtors.

d. Depreciation on furniture & fittings shall be provided at 10% per annum.

e. Provide for doubtful debts at 5% on Sundry Debtors.

f. Goods costing Rs. 1,500 used by the proprietor.

g. Salaries include Rs. 12,000 paid to sales representative who is further entitled to acommission of 5% on net sales.

h. Stationary charges Rs. 1,200 due on 31st December, 1990.

i. Purchases include opening stock valued at Rs. 7,000 (cost price)

j. Sales representative further entitled to an extra commission of 5% on net profit aftercharging his extra commission.

k. No depreciation need to be provided for computer as it had been purchased on31st December, 1990 and not put to use.

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


Capital 1,00,000

Furniture 20,000

Purchases 1,50,000

Debtors 2,00,000

Interest Earned 4,000

Salaries 30,000

Sales 3,21,000

Purchase returns 5,000

Wages 20,000

Rent 15,000

Sales Returns 10,000

Bad Debts written off 7,000



Creditors 1,20,000

Drawings 24,000



Insurance 12,000



Provision for Depreciation 2,000

5,58,000 5,58,000

Additional Information –

a. Depreciation furniture by 10% on original cost.

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

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

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

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

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

g. Closing Stock in Trade Rs. 60,000

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


Capital 14,00,000

Drawings 75,000


Purchases 16,20,000

Freight on purchases 15,000

Wages 1,10,000

Sales 25,00,000

Salaries 1,00,000






Advertisement Expenses 25,000


Discounts 7,600 14,500

Bad Debts written off (after adjusting recovery of baddebts of Rs. 6,000 written off in 1997) 14,000

Building 10,00,000

Machinery 75,000

Furniture 40,000

Debtors 1,50,000

Provision for Doubtful Debts 19,000

Creditors 1,60,000

Investments (12% Purchased on 1st October 1999) 6,00,000

Bank Balance 83,900

40,93,500 40,93,500

Adjustments –


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

c. Machinery worth Rs. 35,000 purchased on 1st January, 1997 was wrongly written offagainst Profit & Loss Account. This asset is to be brought into account on 1st January1999 taking depreciation at 10% per annum on straight line basis upto 31st December,1998.

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

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

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

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

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




Bills Receivables 18,500Goodwill 40,500

Land & Building 1,10,000

Plant & Machinery 40,000

Furniture 40,200

Motors 50,800Telephone Bills 11,200


Wages 2,000


Royalty 12,000Power & Fuel 12,800

Legal Charges 1,200

Audit Fees 4,090

Lighting 2,000

Salaries 3,500Repairs 110

Purchases 22,000

Rent 1,700

Cash in Hand 78,000

Depreciation Fund 8,000Outstanding Taxes 1,800

Bills Payable 2,200



Capital 1,50,000General Reserves 38,000

Bank Loan 1,00,000

Provident Fund 40,000

Purchases Returned 1,000

Sales 1,20,500Bank Loan 50,400

Outstanding Interest 1,200

5,21,000 5,21,000


Adjustments –

a. Interest on Capital 10%.

b. Closing Stock Rs. 75,000.

c. Goods costing Rs. 8,000 lost by fire and insurance company admitted a claim ofRs. 6,500.

d. Depreciation on Motors 10%, Furniture 20%, Plant & Machinery 5%.

e. Provide RDD 10% on Debtors.

f. Outstanding Wages Rs. 1,000.

g. Prepaid Telephone Bill Rs. 1,200.

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

Debit Balances Rs. Credit Balances Rs.

Wages & Salaries 6,000 Sales-Cash 8,000

Drawings 2,000 Sales-Credit 18,000Purchases 18,000 Capital 34,000

Sales Returns 300 Discount earned 340

Office Furniture 4,000 Purchases Returns 460

Buildings 12,000 Provision for Bad Debts 1,500

Office Expenses 800 Sundry Creditors 2,800Advertisement 500 Bank Overdraft 1,300

Opening Stock 5,000 Income from Investments 250

Rent and Taxes 400

Commission 200

Bills receivables 800Travelling Expenses 250

Trade Expenses 350

Bad Debts 190


Cash in Hand 1,800Investments 2,000

Fuel & Power (Factory) 1,060



Adjustments –

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

b. Rent outstanding was Rs. 120.

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

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

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

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

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


Salaries 16,500 Commission Received 1,250

Bad Debts 1,500 Sales 1,70,000

Opening Stock 12,500 Interest Received 2,250

Purchases 87,500 Provision for Bad Debts 1,750

Wages 5,000 Capital 1,00,000

Commission Paid 250 Loan taken on 1.10.97 @12% p.a. 12,500

Carriage Outwards 2,500

Octroi 7,000

Machinery 25000

Additions on 1.7.97 12500 37,500

Bank 22,500

Goodwill 25,000

Cash 15,000


Legal & Professional Fees 2,500

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

Adjustments –

1. Closing stock was valued at cost Rs. 37,500.

2. Outstanding salaries amounted to Rs. 1,500.

3. Commission received but not earned Rs. 250.


Q.9. From the following Trial Balance and adjustments, prepare Trading and Profit & LossAccount for the year ending 31st December, 1997 and Balance Sheet as on that date.


Opening Stock 25,000 Rent Received 1,500

Wages 5,000 Commission Received 750

Carriage 1,000 Miscellaneous Income 250

Salaries 3,800 Bad Debts recovered 1,000

Bad Debts 700 RDD 700

Purchases 1,10,000 Sales 2,00,000

Return Inwards 2,000 Return Outwards 1,000

Plant & Machinery 35,000 Bills Payable 7,500

Furniture as on 1st January, 1997 20,000 Capital 70,000

Furniture purchased 1.7.1997 5,000 Creditors 20,000

Investments 27,500

Patent Rights 3,500

Cash in Hand 750

Cash at Bank 13,250


Bills Receivables 10,000

Postage and Telegrams 200

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

Adjustments –

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

2. Salaries Outstanding Rs. 200.

3. Unearned commission Rs. 50.

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

5. Closing Stock Rs. 10,000.

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



Drawings - Melon 2,000 Capital - Melon 35,000

- Lemon 3,500 - Lemon 25,000

Land & Building 36,000 Sales 95,500

Machinery 18,000 Returns 1,300

Salaries 3,700 Bad Debts Reserve 800

Motor Car 10,500 Creditors 3,000

Trade Expenses 1,900 Commission 1,500

Carriage Inward 400 Bank Loan taken 0n 1.1.82 20,000

Royalties 1,800

Purchases 45,300

Return Inwards 2,500

Debtors 24,600

Discounts 1,000

Insurance 1,200

Stock on 1.7.81 23,800

Advertisement 3,000

Cash at Bank 2,900

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

Additional Information

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

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

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

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

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

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


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


Drawings – Hocus 14,450 Capital – Hocus 1,80,000

Drawings – Pocus 15,000 Capital – Pocus 1,50,000

Stock as on 1.1.82 2,00,000 Sales 4,00,000

Bills Receivables 25,000 Bills Payable 61,000

Purchases 2,75,000 Return Outwards 4,500

Returns Inwards 5,000 Sundry Creditors 1,40,000

Plant and Machinery 1,00,000

Furniture 45,000


Cash in Hand and at Bank 77,550

Salaries 12,000

Wages 19,000

Rent and Taxes 11,500

Insurance 3,000

Printing and Stationary 2,000


Power and Fuel 4,500

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

Additional Information.

a. Stock as on 31st December, 1982 was Rs. 1,60,000.

b. It is discovered that sales effected on 31st December, 1982 of the value of Rs. 2,000 hasnot been recorded in the books.

c. Stock worth Rs. 3,000 uninsured has been destroyed by fire.

d. Depreciate Plant & Machinery by 20% and Furniture by 5%

e. Provide for bad and doubtful debts Rs. 6,000.

f. Outstanding Expenses – Salaries Rs. 2,500, Wages Rs. 1,000.

g. Prepaid insurance Rs. 500.


Q.12. The Accountant of M/s. Kasturi Agencies extracted the following Trial Balance as on31st March, 1987.


Capital 1,00,000

Drawings 18,000

Buildings 15,000

Furniture 7,500

Motor Van 25,000

Bank Loan at 12% Interest 15,000

Interest paid on above 400

Sales 1,00,000

Purchases 75,000

Stock as on 1.4.86 25,000

Stock as on 31.3.87 32,000

Establishment Expenses 15,000

Freight Inwards 2,000

Freight Outwards 1,000

Commission Received 7,500


Bank Balance 20,500


2,28,500 2.68,500

The Accountant located the following errors but is unable to proceed further any more.

a. A totalling error in bank column of payment side of cash book whereby the column wasundercast by Rs. 500.

b. Interest on Bank loan paid for the quarter ending 31st December, 1986, Rs. 450, wasomitted to be posted in the ledger. There was no further payment of interest.

c. You are required to set right the Trial Balance and prepare the Trading and Profit andLoss Account for the year ended on 31st March, 1987 and the Balance Sheet on thatdate, after carrying out the following –

1. Depreciation is to be provided on the assets as follows :

l Buildings 2.5% p.a.

l Furniture 10% p.a.

l Motor Van 10% p.a.

2. Balance of interest due on the loan is also to be provided for.


NOTES

101Bank Reconciliation Statement

Chapter 4BANK RECONCILIATION STATEMENT

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

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

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

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

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

b. If the cheques deposited by the business organization get dishonoured, bankimmediately debits the same amount to the account. The business organizationmakes the entry of the same on the receipt of intimation from the bank. Till theentry is passed in the bank book, the bank book may show higher balance than thepassbook.


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

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

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

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

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

Preparation of Bank Reconciliation Statement

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


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

Following is the specimen of bank reconciliation statement –

Bank Reconciliation Statement as on ——

Bank Balance as per Bank Book

Add : a. Cheques issued but not presented

b. Amount credited in Pass Book but not in

Bank Book

c. Deposits made in the account directly

d. Wrong credits given by bank

Sub-Total

Less : a. Cheques deposited but not cleared

b. Interest/Bank Charges debited by bank

c. Direct payments made by bank not entered in

Bank Book

d. Cheques dishonoured not recorded in

Bank Book

e. Wrong debits given by bank

Sub-Total

Bank Balance as per Bank Statement or Pass Book

Following points should be remembered –a. If the bank reconciliation statement is prepared by starting with Bank Balance as per

Bank Statement or Pass Book, amounts added in the above specimen need to besubtracted and the amounts subtracted in the above specimen need to be added.

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

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


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

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

Illustration

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

Cash Book (Bank Column only)

Date Particulars Rs. Date Particulars Rs.

15.3.97 To Cash 36000 01.3.97 By Balance b/fd 40000

20.3.97 To Roy 24000 04.03.97 By John 2000

22.3.97 To Kapoor 10000 06.3.97 By Krishnan 400

31.3.97 To Balance c/fd 7640 15.3.97 By Kailash 240

20.3.97 By Joshi 35000

Total 77640 Total 77640

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

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

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

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

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

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

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

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

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


Solution

Bank Reconciliation Statement as on 31st March, 1997

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

Add : a. Cheques deposited but not cleared 10,000

b. Interest debited by bank not recorded in Cash Book 1,000

c. Bank Charges debited by bank not recorded in

Cash Book 340 11,340

Sub-Total 18,980

Less : a. Cheques issued but not presented 37,400

b. Interest on securities collected by bank not

Recorded on cash book 1,080

c. Credit transfer not recorded in cash book 200

d. Dividend collected by bank not recorded in

Cash Book 1,000 39,680

Bank Balance as per Bank Statement (Overdraft) 20,700

Illustration

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



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

03.3.97 To A 1,200 03.3.97 By Interest on Loan 80

05.3.97 To B 1,620 08.3.97 By Bank Charges 5

16.3.97 To C 600 12.3.97 By X 1,500

21.3.97 To Interest 700 21.3.97 By Y 200

24.3.97 To D 1,200 24.3.97 By Z 1,350

28.3.97 To E 3,500 28.3.97 By Drawings 800

29.3.97 To F 2,200 31.3.97 By Balance c/fd 15,315

31.3.97 To G 2.800



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

Date Particulars Withdrawals Deposits Dr/Cr Balance

01.4.97 Balance b/fd Cr 7,165

02.4.97 To Z 1,350 Cr 5,815

02.4.97 By E 3,500 Cr 9,315

03.4.97 By D 1,200 Cr 10,515

04.4.97 To Insurance Premium 700 Cr 9,815

05.4.97 To M 1,200 Cr 8,615

05.4.97 By Cash 1,000 Cr 9,615

06.4.97 By F 2,200 Cr 11,815

06.4.97 To Y 200 Cr 11,615

07.4.97 By G 2,800 Cr 14,415

07.4.97 To Interest 500 Cr 13,915

Solution

Bank Reconciliation Statement as on 31st March 1997

Bank Balance as per Bank Book 15,315

Add : Cheques issued but not presented

Mr. Z 1,350

Mr. Y 200 1,550

Sub-Total 16,865

Less : Cheques deposited but not cleared

Mr. E 3,500

Mr. D 1,200

Mr. F 2,200

Mr. G 2,800 9,700

Sub-Total

Bank Balance as per Bank Statement or Pass Book 7,165


Illustration

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


SolutionBank Reconciliation Statement as on 31st March, 1989

(Before making adjustments in the cash book)


Add : a. Cheques issued but not presented 1,000

b. Cheques issued but not presented 1,000

c. Cheques deposited but not recorded in cash book 1,000

d. Bank Interest credited not credited in cash book 150

e. Dividend collected not entered in cash book 1,000

f. Deposits made in bank not entered in cash book 500

g. Bank charges recorded twice in cash book 5 4,655

Sub-Total 11,655

Less : a. Cheques deposited but not cleared 250

b. Cheques issued but nor recorded in cash book 750

c. Cheques deposited but not cleared 1,600

d. Debit side of cash book overcast 500

e. Credit side of cash book undercast 800

f. Bank Interest debited not debited in cash book 50

g. Bill paid by bank not entered in cash book 1,500

h. Cheques dishonoured not recorded in cash book 1,000

i. Cheque wrongly debited by bank 50

Sub-Total 6,500



Particulars Rs. Particulars Rs.

To Balance b/fd 7,000 By Cheques issued 750

To Cheques deposited 1,000 By Debit side overcast 500

To Interest Received Account 150 By Credit side undercast 800

To Dividend Received Account 1,000 By Bank Charges 50

To Debtors 500 By Debtors (Dishonoured cheques) 1,000

To Bank Charges (debited twice) 5 By Creditors 1,500

By Balance c/fd 5,055



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



Sub-Total 7,055

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

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

Sub-Total


Illustration

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

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

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

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

d. A cheque drawn for Rs. 100 has been incorrectly entered as Rs. 10 in the cash book.

e. A debtor directly deposited into Sarkar’s bank account but not recorded in the cashbook Rs. 1,000.

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

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

h. Bank paid a Bill Payable for Rs. 1,450 but it was recorded in the cash book as Rs. 1,540.

i. The receipt column of cash book was overcast by Rs. 1,000.

j. Discount allowed Rs. 410 has been entered through mistake with the cheque in the bankcolumn of the cash book.

k. Pursuant to instructions dated 30th December, 1985, asking the banker to transferRs. 10,000 to fixed deposit account and entry for this was made in the cash book but thebank acted in January 1986.

l. The bank debited the account with Rs. 500 being the amount of cheque received from acustomer and returned unpaid but not entered in the cash book.

m. Cheques amounting to Rs. 300 though actually banked were not entered in the cash book.


Solution

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

Bank Balance as per Cash Book (Overdraft) 610

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

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

c. Payment side of cash book undercast 500

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

e. Receipt column of cash book overcast 1,000

f. Discount allowed treated as receipt of cheque

in the cash book 410

g. Cheque dishonoured 500 10,000

Sub-Total 10,610

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

b. Amount deposited by debtor in bank account 1,000

c. Bill Paid for Rs. 1,450 entered as Rs. 1,540 90

d. Cheques deposited but not entered in cash book 300

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

Bank Balance as per Bank Statement 3,780



To Debtor 1,000 By Balance b/fd 610

To Creditor 90 By Creditor 90

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

To Debtors 300 By Receipt side overcast 1,000

By Discount 410

By Debtors 500




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



Sub-Total 11,280

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

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

Sub-Total 7,500

Bank Balance as per Bank Statement or Pass Book 3780

Illustration

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


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

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

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

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

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

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

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

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

30.4.02 By Balance c/fd 19,500

38,000 38,000


Pass Book

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

01.4.02 By Balance b/fd Cr. 12,500

02.4.02 To Cheque 183 4,000 Cr. 8,500

06.4.02 By Cheque 8,000 Cr. 16,500

06.4.02 To Cheque 184 3,200 Cr. 13,300

10.4.02 By Cheque 1,500 Cr. 14,800

16.4.02 By Cheque 3,400 Cr. 18,200

17.4.02 To Cheque 187 800 Cr. 17,400

20.4.02 By Cheque 4,600 Cr. 22,000

24.4.02 By Cheque 3,800 Cr. 25,800

28.4.02 To Cheque 185 6,000 Cr. 19,800

28.4.02 To Cheque 189 1,000 Cr. 18,800

30.4.02 By Interest 100 Cr. 18,900

30.4.02 By Deposit (K.Sen) 3,000 Cr. 21,900

30.4.02 To Charges 10 Cr. 21,890

You are required to prepare a Bank Reconciliation Statement as on 30th April 2002.

SolutionBank Reconciliation Statement as on 30th April, 2002

Bank Balance as per Cash Book 19,500

Add : a. Cheques issued but not presented

(Rs. 1,000 + Rs. 2,000 + Rs. 500) 3,500

b. Deposited by K.Sen 3,000

c. Interest credited by bank, not in cash book 100

6,600

Sub-Total 26,100

Less : a. Cheques deposited but not cleared

(Rs. 1,200 + Rs. 3,000) 4,200

b. Bank Charges debited by bank 10

Sub-Total 4,210



Illustration

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

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

Balance b/fd Cr. 21,000

Gopal Brothers 212 4,000 Cr. 17,000

Madhu Industries 5,000 Cr. 22,000

N Traders 213 7,200 Cr. 14,800

Ram Gopal Sons 7,500 Cr. 22,300

Gopal Brothers 215 4,100 Cr. 18,200

Ourselves 216 2,400 Cr. 15,800

Dividend Warrants 500 Cr. 16,300

Incidental Charges 10 Cr. 16,290

Interest on Loan 900 Cr. 15,390

Lal Chand 217 1,000 14,390

It is understood that –

a. Cheque no. 214 drawn in favour of T.W.Traders for Rs. 2,100 was not yet presented to the bank.

b. Advice regarding the incidental charges, interest on loan and dividend warrants reachedFun Fare Limited only in July.

c. Cheque favouring Lal Chand was towards rent for the month of June.

From the above data you are required to prepare a cash book (bank column only) of Fun FareLimited and a bank reconciliation statement in their books at the end of the month.

Solution :Cash Book (Bank Column only)


30.6.88 To Balance b/fd 21,000 30.6.88 By Gopal Brothers 4,000

To Madhu Industries 5,000 By N Traders 7,200

To Ram Gopal 7,500 By T W Traders 2,100

By Gopal Brothers 4,100

By Cash 2,400

By Rent 1,000


33,500 33,500


Bank Reconciliation Statement as on 30th April, 2002

Bank Balance as per Cash Book 12,700


b. Dividend collected by bank, not in cash book 500

2,600

Sub-Total 15,300

Less : a. Incidental charges debited by bank 10

b. Interest on Loan debited by bank 900

Sub-Total 910


QUESTIONS

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

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

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


PROBLEMS

Q. 1

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

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

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

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

d. Bank charges Rs. 250 was debited by bank but accounted in the books of Mukesh on4th April, 1992.

e. An amount of Rs. 1,00,000 representing collection of Mukesh’s cheques was wronglycredited to the personal account of Mukesh by the bank in their bank statement.

Q. 2

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

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

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

c. Cheques worth Rs. 1,400 were deposited in the bank on 28th December, 1993 but hadnot been credited by the bank. In addition to this, one cheques for Rs. 500 was enteredin the cash book on 30th December, 1993 but was banked on 3rd January, 1994.

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

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

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

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


Q. 3

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

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

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

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

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

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

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

Q. 4

On 31st January, 1988, my cash book showed a bank overdraft of Rs. 12,500. On comparingit with the pass book, following differences were located –

a. Cash and cheques amounting Rs. 1,340 were sent to bank on 27th January, but chequesworth Rs. 230 were credited on 2nd February and one cheque for Rs. 45 was returned bythem as dishonoured on 4th February.

b. During the month of January, I issued cheques worth Rs. 1,760 to my creditors. Out ofthese, cheques worth Rs. 1,370 were presented for payment on 5th February.

c. According to my standing orders, the bankers have paid during the month of January thefollowing –

• Life insurance premium Rs. 170

• Driving license fee Rs.40

d. My bankers have collected Rs. 150 as dividend on the shares.

e. My bankers have given me wrong credit for Rs. 150.

f. A bill receivable for Rs. 100 discounted with the bank in December, 1987 has beendishonoured on 31st January, 1988.

g. Interest charged by the bank Rs. 125.

Prepare a bank reconciliation statement on 31st January, 1988.


Q. 5

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

Particulars Rs.

Bank Overdraft as per Cash Book 80,000

Cheques deposited as per bank statement but not entered in cash book 3,000

Cheques recorded for collection but not sent to the bank 10,000

Credit side of bank column cast short 1,000

Bank charges recorded twice in the cash book 100

Customers’ cheques returned as per bank statement only 4,000

Cheques issued but dishonoured on technical grounds 3,000

Bills collected by bank directly 20,000

Cheques received entered twice in cash book 5,000

Q. 6

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

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

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

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

d. A cheque for Rs. 1,000 was issued to a creditor on 27th March 1999, but by mistake thesame was not recorded in the cash book. The cheque was however duly encashed on31st March, 1999.

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

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


Q. 7

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

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

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

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

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

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

Q. 8

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

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

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

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

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

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

Q. 9

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

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

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


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

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

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

Q. 10

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

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

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

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

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

e. Cheques paid into the bank but not cleared before 31st December, 1998 Rs. 2,412.

f. A Bill Receivable originally discounted with the bank in November 1998 is dishonouredRs. 800.

Q. 11

From the following particulars, ascertain the balance that would appear in the cash book ofMr. M. Ranganathan as on 31st December, 1998 –

a. Overdraft balance as per Pass Book Rs. 24,240.

b. Cheques amounting to Rs. 8,200 were paid into the bank on 28th December, 1998 out ofwhich only Rs. 600 was credited by the bank in the pass book till 31st December, 1998.

c. Cheques for Rs. 5,400 were issued on 28th December, 1998 out of which only onecheque for Rs. 800 was presented for payment.

d. There is a debit of Rs. 200 for interest and Rs. 50 for bank charges in the pass bookwhich have not been entered in the cash book.

e. Rs. 400 debited to bank account in the cash book has been omitted to be banked.

f. There was a wrong debit of Rs. 600 in the pass book.


Q. 12

On 30th June, 1990, the pass book of Sunil & Co. showed a balance of Rs. 9,800 as cash atbank –

a. Prior to that date, they had issued cheques amounting to Rs. 3,500, of which, chequesamounting to Rs. 1,900 have so far been presented for payment.

b. Out of the cheques for Rs. 2,000 paid by him into the bank before that date, only chequesfor Rs. 1,200 were credited in the pass book.

c. He had also received a cheque for Rs. 680 which although entered in the cash book hadbeen omitted to be paid into bank.

d. The bank had collected dividend directly and credited them.

Q. 13

From the following particulars, prepare a Bank Reconciliation Statement as on 28th February,1989. Thiru Pandiyan had an overdraft balance of Rs. 80,500 as shown by the bank columnsof the cash book. Cheques amounting to Rs. 10,000 had been paid into the bank on 24thFebruary, 1989 but of these only Rs. 7,500 were credited in the pass book. He had issuedcheques amounting to Rs. 25,000, of which Rs. 20,000 worth only seem to have been presented.The bank has debited in the pass book Rs. 750 for interest. A cheque for Rs. 600 which wasdebited in the bank column in the cash book has been omitted to have been presented. Anentry appears in the pass book for Rs. 3,000 for a direct deposit by a customer of ThiruPandiyan.

Q. 14

On 31st March 1991 the cash book of Mr. X showed a bank balance of Rs. 14,850. Whileverifying with the pass book, the following facts were noted –

a. Cheques sent in for collection before 31st March, 1991 and not credited by bank amountedto Rs. 845.

b. Cheques issued before 31st March, 1991 but not presented for payment amounted to Rs. 885.

c. The banker has debited a sum of Rs. 100 towards the bank charges and credited Rs. 250for interest received and Rs. 1,000 for dividend collected.

d. The banker has given a wrong credit for Rs. 250.

e. Mr. Y has paid into the bank a sum of Rs. 300 on 28th March, 1991 which has not beenentered in the cash book.

f. A cheque for Rs. 200 sent for collection returned dishonoured has not been entered inthe cash book.


Q. 15

Find out the balance as per pass book from the following particulars –

a. Bank overdraft as per cash book on 30th April, 1992 was Rs. 2,000.

b. Cheque issued but not presented for payment Rs. 1,350.

c. Cheques deposited but not yet collected by the banker Rs. 500.

d. Bank charges Rs. 80 debited by the bank not yet entered in the cash book.

e. Interest on investments collected by the bankers and credited in the pass book amountedto Rs. 905.

Q. 16

From the following particulars, ascertain the balance that would appear in the cash book of Bas on 31st December, 1998, before and after making necessary adjustments –

a. Overdraft as per pass book as on 31st December 1998 Rs. 13,880.

b. Interest on overdraft for six months ending 31st December 1998 not yet entered in thecash book Rs. 240.

c. Bank charges for the above period not yet entered in the cash book Rs. 60.

d. Cheques drawn but not encashed by customers before 31st December, 1998 Rs. 3,300.

e. Cheques paid into the bank but not cleared before 31st December, 1998 Rs. 4,340.

f. A Bill Receivable, discounted with the bank in November, dishonoured on 31st December,1998 Rs. 1,000.

Q. 17

From the following particulars taken on 31st December, 1989, you are required to prepare abank reconciliation statement to reconcile the bank balance shown in the cash book with thatshown in the pass book –

a. Balance as per pass book on 31st December, 1989 Rs. 1,027 (Credit).

b. Four cheques drawn on 31st December but not cleared till January Rs. 1,144.

c. Interest on overdraft not entered in the cash book Rs. 51.

d. Three cheques received on 30th December, 1989 and entered in the bank column ofcash book but not lodged in bank for collection till 3rd January, Rs. 5,280.

e. Cost of cheque book Rs. 5 entered twice erroneously in cash book in November.

f. A Bill Receivable for Rs. 250 on 29th December, 1989 was passed to the bank forcollection on 28th December, 1989 and was entered in the cash book forthwith, whereasthe proceeds were credited in the pass book only in January following.


g. Chamber of Commerce subscription Rs. 10 paid by bank on 1st December, 1989 hadnot been entered in the cash book.

h. Bank Charges of Rs. 5 had been debited in the pass book twice erroneously.

Q. 18

On 30th June, 1981, the pass book of M/s Thin and Short showed a balance of Rs. 2,000 atthe bank. They had sent cheques amounting to Rs. 10,000 to the bank before 30th June, 1981but it appears from the pass book that cheques worth Rs. 9,000 had been credited before thatdate. Similarly, out of the cheques for Rs. 5,000 issued during the month of June, cheques forRs. 4,000 were presented and paid in July. The pass book showed the following payments –

a. Rs. 320 as premium according to standing instructions.

b. Rs. 2,000 against a promissory note as per the instructions.

The pass book showed that the bank had collected Rs. 1,800 as interest on GovernmentSecurities. The bank had charged as interest Rs. 50 and incidental expenses Rs. 20. Therewas no entry in the cash book for the payment of interest etc. A bill sent for collection wasreturned dishonoured on 29th June amounting to Rs. 600.

Prepare the Bank Reconciliation Statement as on 30th June, 1981.

Q. 19

From the following particulars, prepare a bank reconciliation statement showing the balanceas per pass book on 31st March, 1989.

a. Cheques for Rs. 7,900 was paid into bank in March, 1989 but were credited only in April,1989.

b. Cheques for Rs. 11,000 were issued in March, 1989 but were cashed in April, 1989 only.

c. A cheque for Rs. 1,000 which was received from a customer was entered in the bankcolumn of the cash book in March, 1989 but the same was paid into the bank in April,1989 only.

d. The pass book shows a credit of Rs. 2,500 for interest and a debit of Rs. 500 for bankcharges.

e. The bank balance as per cash book was Rs. 1,80,000 on 31st March, 1989.


Q. 20

From the following particulars, prepare a bank reconciliation statement as at 31st December, 1991.

a. As on 31st December, 1991, bank overdraft as per cash book Rs. 2,49,900.

b. Interest debited in the bank pass book only Rs. 27,870.

c. Cheques issued but not presented for payment Rs. 66,000.

d. Draft deposited in the bank but not yet credited in the pass book Rs. 13,500.

e. Dividend collected by the bank Rs. 42,500 has not yet been entered in the cash book.

f. A direct payment into the bank by a customer Rs. 16,000 has not been recorded in thecash book.

g. Bank column on the debit side of the cash book has been undercast by Rs. 3,500.

Q. 21

From the following particulars, prepare a bank reconciliation statement showing the balanceas per cash book as on 31st December, 1997.

The following cheques were paid into the bank in December 1997 but were credited by thebank in January, 1998.

• Premnath Rs. 350

• Shaym Lal Rs. 250

• Ram Lal Rs. 200

The following cheques were issued by the firm in December, 1997 but were presented forpayment in January, 1998.

• Suresh Rs. 400

• Ramesh Rs. 450

A cheque for Rs. 100 which was received from a customer was entered in the bank column ofcash book in December, 1997 but was omitted to be banked in the month of December, 1997.The pass book shows a credit of Rs. 100 for interest and a debit of Rs. 20 for bank charges.

The bank balance as per pass book was Rs. 6,200 as on 31st December, 1997.

Q. 22

According to the cash book of Gopi, there was a balance of Rs. 44,500 standing to his crediton 30th June, 1996. On investigation you find that –

1. Cheques amounting to Rs. 60,000 issued to creditors have not been presented for paymenttill that date.


2. Cheques paid into bank amounting to Rs. 1,05,000 out of which cheques amounting toRs. 55,000 only collected by the bank up to 30th June, 1996.

3. A dividend of Rs. 4,000 and rent amounting to Rs. 6,000 received by the bank andentered in the pass book but not recorded in the cash book.

4. Insurance premium (up to 31st December, 1996) paid by the bank Rs. 2,700 not enteredin the cash book.

5. The payment side of the cash book had been undercast by Rs. 50.

6. Bank charges Rs. 50 shown in the pass book had not been entered in the cash book.

7. A bill payable for Rs. 2,000 has been paid by the bank but is not entered in the cashbook and bill receivable for Rs. 6,000 has been discounted with the bank at a cost ofRs. 100 which has also not been recorded in the cash book.

You are required –

a. to make appropriate adjustments in the cash book.

b. To prepare a statement reconciling it with the bank pass book.

Q. 23

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



01.3.97 To Balance b/fd 1,000 02.3.97 By Drawings 500

03.3.97 To D 750 03.03.97 By K 700

05.3.97 To A 250 08.3.97 By Rent 450

16.3.97 To M 800 12.3.97 By P 650

21.3.97 To N 2,500 21.3.97 By S 330

24.3.97 To R 1,700 24.3.97 By H 900

28.3.97 By Wages & Salaries 770

31.3.97 By Balance c/fd 2,700



Extracts of Pass Book of Mr. XIn the books of Bank of Baroda, Pune

Date Particulars Withdrawals Deposits Dr/Cr Balance

01.4.97 Balance b/fd Cr 1,280

02.4.97 P 650 Cr 630

02.4.97 N 2,500 Cr. 3,130

04.4.97 C 350 Cr. 2,780

04.4.97 Pal 500 Cr. 3,280

05.4.97 M 800 Cr. 4,080

07.4.97 S 330 Cr. 3,750

09.4.97 H 900 Cr. 2,850

11.4.97 Sen 300 Cr. 3,150

11.4.97 Bose 470 Cr. 3,620

Prepare a Bank Reconciliation Statement as on 31st March, 1997.

Q. 24

On 31st December, 1982, the bank column of the cash book of P shows a debit balance ofRs. 922. On examination of cash book and statement, you find that –

a. Cheques amounting to Rs. 1,260 issued before 31st December and entered in the cashbook were not presented for payment till that date.

b. Cheques amounting to Rs. 500 entered in the cash book as sent to the bank on31st December were entered in the bank statement after that date.

c. A cheque from a debtor for Rs. 146 had been dishonoured prior to 31st December but norecord appeared in the cash book.

d. A dividend warrant for Rs. 76 was paid direct to the bank and nothing appeared in thecash book.

e. Bank interest and charges amounting to Rs. 84 were not entered in the cash book butappeared in the bank statement.

f. There was no entry in the cash book for a club membership subscrption Rs. 20 paid bybanker’s order in November, 1982.

g. Bank charges for a cheque book received by P Rs. 2 were entered in the cash booktwice.


h. A cheque for Rs. 54 drawn by Q had been charged to P’s account in error.

Make appropriate adjustment in the cash book to bring down the correct balance and preparea bank reconciliation statement reconciling the corrected cash book balance with the balanceas per bank statement.

Q. 25

When Sweetex Limited received its bank statement for the period ended 30th June, 1984, thisdid not agree with the balance shown in the cash book of Rs. 2,972 in the company’s favour.An examination of the cash book and bank statement disclosed the following –

a. A deposit of Rs. 492 paid on 29th June 1984 had not been collected by the bank until1st July, 1984.

b. Bank charges amounting to Rs. 17 had not been entered in the cash book.

c. A debit of Rs. 42 appeared in the bank statement for an unpaid cheque which had beenreturned marked “out of date”. The cheque had been re-dated by the customer of SweetexLimited and paid into the bank again on 3rd July, 1984.

d. A standing order for payment of an annual subscription amounting to Rs. 10 had notbeen entered in the cash book.

e. On 25th June, 1984, managing director had given the cashier a cheque for Rs. 100 topay into his personal account at the bank. The cashier had paid the same into company’saccount by mistake.

f. On 27th June, two customers of Sweetex Limited had paid direct to the company’s bankaccount Rs. 499 and Rs. 157 respectively for the payment of goods supplied. The adviceswere not received by the company until 1st July and were not entered in the cash bookuntil that date.

g. On 30th March, 1984, the company had entered into a hire purchase agreement to payby banker’s order a sum of Rs. 26 on the 10th day of each month, commencing April. Noentries had been made in the cash book.

h. A cheque for Rs. 364 received from Mr. B and paid into the bank had been entered twicein the cash book.

i. Cheques issued amounting to Rs. 4,672 had not been presented to the bank for paymentuntil 30th June, 1984.


j. A customer of the company who received a cash discount 2.5% on his account ofRs. 200 paid the company a cheque on 10th June. The cashier in error entered the grossamount in the bank column of the cash book.

After making the adjustments required by the foregoing, the bank statement reconciled withthe balance in the cash book.

You are required –

1. to show the necessary adjustments in the cash book of Sweetex Limited bringing downthe correct balance on 30th June, 1984.

2. to prepare a Bank Reconciliation Statement


NOTES

129Rectification of Errors

Chapter 5RECTIFICATION OF ERRORS

The errors in accounting can be classified into the following main groups –

a. Errors of Omission – These errors refer to a situation where a transaction is totallyomitted to be recorded in the subsidiary book or partially omitted while posting fromsubsidiary books to the ledger.

b. Errors of Commission – These errors refer to wrong posting or totalling errors,calculation errors or errors in carrying forward etc. Following are the examples of errorsof commission –

l Posting of wrong amounts

l Posting to wrong side of account

l Posting to wrong account

l Wrong totalling of subsidiary books or ledger accounts

l Errors while carrying forward figures from one page to another page

c. Errors of Principle – These errors refer to wrong classification of income or expenditure.Following are the examples of errors of principle –

l Purchases of fixed assets recorded in the Purchases Register

l Revenue expenditure treated as capital expenditure

l Capital receipt treated as revenue income

l Revenue receipt treated as capital receipt

d. Compensating Error – These errors refer to a situation where excess or less debits inone or more accounts are compensated by equal amount of excess or less credits inone or more accounts. Due to these errors arithmetical accuracy of the Trial Balancedoes not get affected.


EFFECT OF ERRORS ON TRIAL BALANCE

Tallying of Trial Balance is the primary indication about the arithmetical accuracy of the booksof account. However, it cannot be the conclusive evidence of the total accuracy of the books ofaccounts maintained. This is due to the fact that certain errors as stated above do not affectthe trial balance. As such, locating the errors requires a lot of skills, particularly when they donot affect the agreement of trial balance.

Errors affecting Trial Balance

Following errors may affect the agreement of Trial Balance –

a. Wrong totalling of subsidiary books – If the total of any subsidiary books is takenwrongly but the posting to the individual accounts is made correctly, it will affect theagreement of trial balance. Eg. Total of Purchase Register for the month of March istaken as Rs. 1,50,000 instead of Rs. 1,55,000. Posting to the individual accounts ofsuppliers total to the correct amount of Rs. 1,55,000, but the Purchases Account isdebited by Rs. 1,50,000, the trial balance will not agree.

b. Posting on the wrong side of an account – If a transaction is posted on the wrongside of the account, the trial balance will not agree. Eg. A payment of Rs. 10,000 madeto M/s. Pam Industries is posted on the credit side of M/s. Pam Industries Account, thetrial balance will not agree.

c. Omission of posting an amount in the ledger – If an amount is entered in the journalor subsidiary book but not posted in the ledger, the trial balance will not agree. Eg. Acash payment of Rs. 1,500 for the conveyance expenses has been entered in the cashbook but is not debited to Conveyance Account, the trial balance will not agree.

d. Posting of wrong amount – If an amount is wrongly posted to an account, the trialbalance will not agree. Eg. A cash payment of Rs. 1,500 for the conveyance expenseshas been correctly entered in the cash book, but while posting the same to the ConveyanceAccount, it is posted as Rs. 150, the trial balance will not agree.

e. Error in balancing – If an error has been committed while calculating the closing balanceof cash book or a ledger account, the trial balance will not agree.

Errors not affecting the Trial Balance

Following types of errors may not affect the agreement of Trial Balance.

a. Errors of Principle – If the revenue expenditure is treated as capital expenditure or ifrevenue receipt is treated as capital receipt or if capital expenditure is treated as revenueexpenditure or if capital receipt is treated as revenue receipt, it will not affect the agreement


of trial balance. Eg. An amount of Rs. 10,000 paid for maintenance of machinery. Insteadof posting this amount to Machinery Maintenance Account, it is debited to MachineryAccount, the trial balance will still agree but it will not show a true and fair view.

b. Errors of Omission – If a transaction is totally omitted while making the entries in thebooks of accounts, it will not affect the agreement of trial balance. Eg. A bill for thepurchase of material worth Rs. 15,000 has been received, but it is not entered in thePurchase Register at all, the trial balance will still agree but it will not show a true and fairview.

c. Errors of Commission – If an amount is posted to the correct side of a wrong account,it will not affect the agreement of trial balance. Eg. A payment is Rs. 25,000 made toMr. Salim is debited to the account of Mr. Sham, the trial balance will still agree but it willnot show a true and fair view.

d. Recording of wrong amount in the books of prime entry or subsidiary books – Ifa transaction is wrongly entered in the book of prime entry or the subsidiary book andthen correctly posted to the correct account, it will not affect the agreement of trialbalance. Eg. Stationary worth Rs. 4,500 has been purchased but it is entered as Rs.4,700 in the cash book, the trial balance will still agree but it will not show a true and fairview.

e. Compensating Errors – If one type of error is compensated by the error of the oppositenature, it will not affect the agreement of trial balance. Eg. While balancing the travelingexpenses account, the closing debit balance is taken as Rs. 1,40,000 instead ofRs. 1,50,000. Similarly, while balancing the sales account, the closing credit balance istaken as Rs. 28,90,000 instead of Rs. 29,00,000. The trial balance will still agree but itwill not show a true and fair view.

Steps in locating the errors

If the errors result into the disagreement of trial balance, following steps should be taken tolocate the errors.

a. Total of all the subsidiary books and cash book should be checked carefully. Similarly,the total of trial balance should be checked carefully.

b. It should be ensured that all the opening balances have been correctly brought forward inthe current year’s books of account.

c. It should be ensured that all the ledger accounts have been properly balanced and thebalances of all the ledger accounts have been reflected in the Trial Balance.

d. If an amount of Rs. 24,000 is debited to a certain account instead of crediting the sameto the same account, the difference between the debit side and credit side of trial balance


will be Rs. 48,000. As such, the difference in trial balance should be halved to locatesuch errors.

e. If the difference in the trial balance is divisible by 9 without any reminder, it may indicatethe transposition or transplacement of the amounts. Eg. If the cash payment of Rs. 176is posted as Rs. 167, the difference in the trial balance will be divisible by 9.

f. The trial balance of the current year can be compared with the trial balance of the previousyear to locate certain highlighting error.

How to rectify the errors

The errors should be rectified by any one of the following methods –

I. In some cases, if the trial balance does not agree but the books have to be closed, thedifference is placed to a Suspense Account and the trial balance is tallied. If the creditside of the trial balance is heavy by Rs. 50,000 and same amount is placed on the debitside of Suspense Account. Subsequently, attempts are made to locate the errors andthe rectification entries are routed through the Suspense Account. After all the errorshave been located, the balance in Suspense Account will become zero. It should beremembered that the Suspense Account is operated till the errors are located and finallythe balance in Suspense Account has to become zero. Further, only the errors affectingthe agreement of trial balance are routed through the Suspense Account.

Illustration

A merchant while balancing his books of account finds that, the trial balance shows excesscredit of Rs. 1,700. Being required to prepare the final accounts, he places the difference to anewly opened Suspense Account which he carries forward. In the next accounting year, thefollowing errors are discovered –

a. Goods bought from Narayan amounting to Rs. 5,000 had been posted to the credit ofNarayan as Rs. 5,500.

b. An item of Rs. 1,000 entered in the sales returns book was posted to the debit of Pandeywho had returned the goods.

c. Sundry items of furniture sold for Rs. 26,000 had been entered in the sales book. Ignoredepreciation and profit or loss on the sale.

d. Discount amounting to Rs. 200 from a creditor had been duly entered in the creditor’saccount, but not posted to discount account.

Draft journal entries necessary for rectifying the abovementioned errors. Prepare the SuspenseAccount and show the ultimate effect of the errors on the last year’s profit by preparing theProfit and Loss Adjustment Account.


Solution

a. Goods bought from Narayan had been posted to the credit of Narayan Account byRs. 5,500 instead of Rs. 5,000. As such, Narayan Account has been credited more byRs. 500. As such, this excess credit needs to be reversed by passing following entry –

Narayan A/c. Dr. 500To, Suspense A/c. 500

b. Goods supplied to Pandey worth Rs. 1,000 should have appeared on the debit side ofPandey’s account. Instead of that the entry has been made on the credit side of Pandey’saccount. This excess credit needs to be reversed by passing the following entry –

To Suspense A/c. Dr. 2,000Pandey A/c. 2,000

c. As the amount of furniture sold has been entered in the sales book, sales account hasbeen wrongly credited. This wrong credit needs to be reversed by debiting sales account.The journal entry to be passed is –

Sales A/c. Dr. 26,000To Furniture A/c. 26,000

d. Discount received from the creditor has been entered in the creditor’s account but discountaccount has not been credited. As such, the error will be rectified by passing the followingentry –

Suspense A/c. Dr. 200To Discount Received A/c. 200

Suspense Account


1 To Balance b/fd 1,700 1 By Narayan A/c. 5001 To Discount Recd. A/c. 200 1 By Pandey A/c. 2,000

To Balance c/fd 600

2,500 2,500

II. The errors which affect two accounts and which do not affect the agreement of trialbalance may be rectified by passing the rectification entries. The basic principle forrectifying the errors by this means suggests the following steps to be taken –

a. What is the wrong entry passed ?


b. What should be the correct entry to be passed ?

c. Nullify the wrong effect by reversing the same and reinstate the correct by passingthe rectification entry.

Illustration

Pass necessary journal entries to rectify the following errors –

a. An amount of Rs. 200 withdrawn by the proprietor for his personal use has been debitedto trade expenses account.

b. A purchase of goods from Nathan amounting to Rs. 300 has been wrongly enteredthrough the sales book.

c. A credit sale of Rs. 100 to Santhanam has been wrongly passed through the purchasebook.

d. Rs. 150 received from Malhotra have been credited to Mehrotra.

e. Rs. 375 paid on account of salary to the cashier Dhawan stands debited to his personalaccount.

f. A contractor’s bill for the extension of premises amounting to Rs. 2,750 has been debitedto building repairs account.

g. On 25th June, goods of the value of Rs. 500 were returned by Akashdeep and were takeninto stock but the returns were entered in the books under date 3rd July i.e. after theexpiration of the financial year on 30th June.

h. A bill of Rs. 200 for old office furniture sold to Sethi was entered in the sales daybook.

i. The periodical total of the sales book was cast short by Rs. 100.

j. An amount of Rs. 80 received on account of interest was credited to commission account.


Solution

a Wrong Entry Trade Expenses A/c 200To Cash A/c 200

Correct Entry Drawings A/c 200To Cash A/c 200

Rectification Entry Drawings A/c 200To Trade Expenses A/c 200

b Wrong Entry Nathan A/c 300To Sales A/c 300

Correct Entry Purchases A/c 300To Nathan A/c 300

Rectification Entry Sales A/c 300Purchases A/c 300

To Nathan A/c 600

c Wrong Entry Purchases A/c 100To Santhanam A/c 100

Correct Entry Santhanam A/c 100To Sales A/c 100

Rectification Entry Santhanam A/c 200To, Purchases A/c 100To Sales A/c 100

d Wrong Entry Cash A/c 150To Mehrotra A/c 150

Correct Entry Cash A/c 150To Malhotra A/c 150

Rectification Entry Mehrotra A/c 150To Malhotra A/c 150

e Wrong Entry Dhawan A/c 375To Cash A/c 375

Correct Entry Salary A/c 375To Cash A/c 375

Rectification Entry Salary A/c 375To Dhawan A/c 375

f Wrong Entry Building Repairs A/c 2,750To Cash A/c 2,750

Correct Entry Building A/c 2,750To Cash A/c 2,750

Rectification Entry Building A/c 2,750To Building Repairs A/c 2,750

g Wrong Entry No entry passed


Correct Entry Sales returns A/c 500To Akashdeep A/c 500

Rectification Entry Sales returns A/c 500To Akashdeep A/c 500

h Wrong Entry XYZ A/c 200To Sales A/c 200

Correct Entry XYZ A/c 200To Furniture A/c 200

Rectification Entry Sales A/c 200To Furniture A/c 200

i Wrong Entry No entry passed

Correct Entry Suspense A/c 100To Sales A/c 100

Rectification Entry Suspense A/c 100To Sales A/c 100

j Wrong Entry Cash A/c 80To Commission A/c 80

Correct Entry Cash A/c 80To Interest A/c 80

Rectification Entry Commission A/c 80To Interest A/c 80

QUESTIONS

1. It is said that tallying of Trial Balance is not the conclusive proof of accuracy of the booksof account. Why ?

2. What are errors in financial accounting ? What are the different types of errors ?

3. What do you mean by Suspense Account? How is it operated in financial accounting?Can the balance of Suspense Account appear in the Trial Balance in ideal situations?

4. What are errors in financial accounting? Do all the errors affect the Trial Balance? Statethe errors that affect the Trial Balance and the errors that do not affect the Trial Balance.

PROBLEMS

Q.1

Ganesh drew a Trial Balance of his operations for the year ended 31st March 1992. There wasa difference in the Trial Balance which he closed with a Suspense Account. On a scrutiny bythe Auditors, the following errors were found –

a. Purchases day book for the month of April 1991, was undercast by Rs. 1,000.


b. Sales day book of October 1991 was overcast by Rs. 10,000.

c. A furniture purchased for Rs. 8,100 was entered in the Furniture Account as Rs. 810.

d. A bill for Rs. 10,000 drawn by Ganesh was not entered in the Bills Receivable Book.

e. A machinery purchased for Rs. 10,000 was entered in the purchase day book.

Pass necessary journal entries to rectify the same and ascertain the difference in the TrialBalance that was shown under the Suspense Account in respect of the above items.

Q.2

A bookkeeper while preparing his Trial Balance finds that the debit exceeds by Rs. 7,250.Being required to prepare the final accounts, he places the difference to a Suspense Account.In the next year, the following mistakes were discovered –

a. A sale of Rs. 4,000 has been passed through the Purchase daybook. The entry incustomer’s account has been correctly recorded.

b. Goods worth Rs. 2,500 taken away by the proprietor for his use has been debited toRepairs Account.

c. A bill receivable for Rs. 1,300 received from Krishna has been dishonoured on maturitybut no entry passed.

d. Salary Rs. 650 paid to a clerk has been debited in his Personal Account.

e. A purchase of Rs. 750 from Raghubir has been debited to his account. Purchase Accounthas been correctly debited.

f. A sum of Rs. 2,250 written off as depreciation on furniture has not been debited toDepreciation Account.

Draft the Journal Entries for rectifying the above mistakes and prepare Suspense Account.

Q.3

The accountant of X prepared the Trial Balance for the year ended 31st March 1996. But therewas a difference and the accountant put the difference in Suspense Account. Rectify thefollowing errors found and prepare the Suspense Account.

a. The total of the Returns Outward book, Rs. 420 has not been posted in the ledger.

b. A purchase of Rs. 350 from Y has been entered in the sale book. However, Y’s accounthas been correctly entered.


c. A sale of Rs. 390 to Z has been credited to his account as Rs. 290.

d. Old furniture sold for Rs. 5,400 has been entered as Rs. 4,500 in sales account.

e. Goods taken by proprietor, Rs. 500 have not been entered in the books at all.

Q.4

A bookkeeper finds the difference in the Trial Balance amounting to Rs. 1,000 and puts it inthe Suspense Account. Later on he detects the following errors –

a. Purchased goods from Ravi but entered into Sales Book.

b. Received one bill for Rs. 25,000 from Arun but recorded in Bills Payable Book.

c. An item of Rs. 3,500 relating to prepaid rent account was omitted to be brought forward.

d. An item of Rs. 2,000 in respect of purchase returns, had been wrongly entered in thepurchase book.

e. Rs. 25,000 paid to Hari against our acceptance were debited to Harish Account.

f. Bills received from Janaki for repairs done to radio Rs. 2,500 and radio supplied forRs. 45,000 were entered in the Purchase Book as Rs. 46,000.

Give rectifying journal entries with full narration and prepare Suspense Account.

Q.5

There is a difference in the Trial Balance of Shri Om. Subsequently, the following errors werefound to have been committed. Pass journal entries to rectify them and ascertain the differencein the Trial Balance.

a. A sale of Rs. 2,000 to Shanti & Co. was credited to their account.

b. The Returns Inward Book had been cast Rs. 1,000 short.

c. A sale of Rs. 10,000 had been passed through the Purchase Day Book. The customer’saccount, had, however been correctly debited.

d. Rs. 3,750 paid for wages to workmen for making showcases had been charged to WagesAccount.

e. A purchase of Rs. 6,710 had been posted to the debit of the creditor’s account asRs. 6,170. The creditor was Paras & Co.


Q. 6

There was difference in the Trial Balance of Shri Arihant which was put to newly openedSuspense Account. Subsequently, the following mistakes were discovered. Pass journal entriesto rectify them and ascertain the difference in the Trial Balance.

a. Materials costing Rs. 700 in the erection of machinery and the wages paid for amountingto Rs. 400 were included in the Purchase Account and Wages Account respectively.

b. Goods sold under credit terms Rs. 16,900 to Mohan were recorded properly in the SalesBook but were debited to his account as Rs. 19,600 and carriage outward freight paidRs. 700 chargeable from him were posted to Sales Expenses Account.

c. Sales Returns by Yogesh Rs. 2,300 were correctly recorded in the Sales Returns Bookfrom where they were debited to Yogesh Account by Rs. 3,200.

d. Old furniture originally purchased for Rs. 1,800 written down to Rs. 1,100 was sold forcash Rs. 1,700 and was credited to Furniture Account.

e. Machinery purchased on credit Rs. 17,000 was recorded in Purchase Book and transportcharges for the machine Rs. 1,200 were debited to Trade Expenses Account.

Q.7

Give journal entries to rectify the following errors –

a. Rs. 2,500 paid for the purchase of a radio set for the personal use of the proprietordebited to general expenses account.

b. Rs. 1,300, the amount of sale of old machinery, has been posted to sales account.

c. A sum of Rs. 160 paid by way of rent has been debited to landlord’s personal account.

d. Rs. 245 cost of repairing the floor of room has been charged to buildings account.

e. A payment of Rs. 250 made to Harish Brothers for cash purchase of goods from himstands debited to his account.

Q.8

Rectify the following errors by passing necessary journal entries –

a. Goods taken by the proprietor Rs. 1,500 for gift to his daughter were not recorded at all.

b. Rs. 1,500 received from Praveen against debts previously written off as bad debts havebeen credited to his personal account.


c. Received interest Rs. 150 posted to loan account.

d. A cheque received from Amar, a debtor, for Rs. 2,000 was directly received by the proprietorwho deposited it into his personal bank account.

Q.9

While preparing the final accounts for the year ended 31st March 1995, Mr. Smart could notget his Trial Balance agreed. He transferred the difference to Suspense Account and preparedthe final accounts. In April 1995, following errors were discovered in the books of accounts forthe year 1994-95 –

a. The sales book for January 1995 was undercast by Rs. 1,000.

b. Entertainment expenses Rs.150 incurred on 5th January 1995 were omitted to be postedfrom cash book to the ledger.

c. Discount column on the receipt side of the cash book for February 1995 was added asRs. 2,230 instead of Rs. 2,130.

d. A purchase from Mr. Sumer for Rs. 8,200 on 3rd March 1995 was correctly recorded inthe purchase book. But the supplier was wrongly debited for the purchase.

Pass the necessary journal entries to rectify the above-mentioned errors without affecting theprofit for the year 1995-96. Also prepare Suspense Account and Profit & Loss AdjustmentAccount. Assume that all the errors have been located.

Q.10

An accountant could not tally the Trial Balance. The difference was temporarily placed toSuspense Account for preparing the final accounts. The following errors were discovered lateron –

a. The sales book was undercast by Rs. 350.

b. Entertainment expenses Rs. 95 though correctly entered in the cash book were omittedto be posted in the ledger.

c. Commission of Rs. 25 paid was posted twice, once to discount account and again tocommission account.

d. A sales of Rs. 139 to Ramnath, though correctly entered in the sales book was postedwrongly to his account as Rs. 193.


You are required to pass the necessary journal entries in the books of the next accountingyear so as not to affect the profit of that year.

Q.11

The Trial Balance of N Ltd. does not tally. In order to give it a semblance of agreement, theaccountant of the company transfers the difference to a newly opened Suspense Account.Later on, he discovers the following errors –

a. An item of Rs. 5,850 paid for purchase of a new typewriter for the accounts departmenthas been wrongly passed through the purchases book.

b. An item of Rs. 780 in the sales book has been posted as Rs. 960 in the customer’saccount.

c. An addition in the returns inward book has been cast Rs. 240 short.

d. An item of Rs. 450 appearing in the discount column on the credit side of the cash bookhas been posted to the credit side of the concerned personal account as Rs. 540.

e. A bill of exchange for Rs. 2,650 accepted by R & Co. and later discounted with the bankhas been returned by the bank as dishonoured. On dishonour, the amount of the bill hasbeen debited to sales account.

Give journal entries to rectify the above mentioned errors and also show the Suspense Account.

Q.12

Pass journal entries to rectify the following errors –

a. A purchase amounting to Rs. 1,000 made for a staff member was recorded in the purchasesbook.

b. Wages paid to workers for installing machinery, Rs. 750 were debited to wages account.

c. A dishonoured bill receivable for Rs. 5,000 returned by the bank with whom it wasdiscounted was credited to bank and debited to bills receivable account.

d. A sum of Rs. 1,000 drawn by the proprietor for his personal use was debited to travelingexpenses account.


Q.13

Pass journal entries to rectify the following errors –

a. A sum of Rs. 100 paid to Suresh was debited to Subhash.

b. A credit sale of Rs. 587 was recorded in the sales book as Rs. 857.

c. Goods sold to Prem for Rs. 170 were returned by him, but no entry was passed in thebooks.

d. A bill receivable for Rs. 2,000 accepted by Vimal was recorded in bills payable book.

e. Repairs of furniture amounting to Rs. 500 were debited to furniture account.

Q.14

Pass journal entries to rectify the following errors and prepare Suspense Account.

a. Rs. 1,080 received from Mohan was posted to the debit of his account.

b. Rs. 200 being purchase returns were posted to the debit of purchases account.

c. Rs. 400 received as discount was posted to the debit of discount account.

d. Rs. 1,148 paid for repairs of motor car was debited to motor car account as Rs. 148.

e. Rs. 400 paid to Suresh was debited to Satish.

Assume that there are no other errors.

Q.15

On 28th February 1999, the Trial Balance of X did not agree. X put the difference in a newlyopened Suspense Account. Subsequently, following errors were located –

a. The returns inward book for January 1999 had been cast Rs. 1,000 short.

b. A purchase of Rs. 1,671 had been posted to the debit of the creditor’s account asRs. 1,617. The creditor is Panna & Co.

c. A sale of Rs. 2,000 to Singhi & Co. was credited to the account of the customer.

d. A sale of Rs. 4,000 has been passed through the purchase book. The customer’s accounthas however been correctly debited.

e. While carrying forward the total of sales book from one page to the next, the amount waswritten as Rs. 1,76,658 instead of Rs. 1,67,568.


Pass journal entries to rectify the above-mentioned errors. Also prepare the Suspense Accountassuming that all the errors have been located.

Q.16

An accountant prepared a Trial Balance on 31st January 2000, which revealed a difference inthe books of account. He put the difference in a newly opened Suspense Account. DuringFebruary 2000, he detected the following errors –

a. The total of the returns outward book, Rs. 4,200 had not been posted in the ledger.

b. A purchase of Rs. 3,500 from Y had not been entered in the purchase book. However,Y’s account had been correctly credited with the amount.

c. A sale of Rs. 3,900 to Z had been credited to his account as Rs. 2,900.

d. Furniture sold for Rs. 5,400 had been entered as Rs. 4,500 in the sales book.

e. Goods worth Rs. 500 taken by the proprietor for personal use had not been recorded atall.

f. Wages paid for an installation of machinery Rs. 1,000 had been debited to wages account.

Pass journal entries to rectify the abovementioned errors and prepare Suspense Accountassuming that all the errors have been located.

Q.17

Give journal entries to rectify or adjust the following in the books of both the head office and thebranch.

a. Goods costing Rs. 16,000 purchased by branch, but payment made by head office. Thehead office has debited the amount to its own purchase account.

b. Branch paid Rs. 30,000 as salary to a visiting head office official. The branch has debitedthe amount to salaries account.

c. Depreciation, Rs. 50,000 in respect of branch assets whose accounts are kept in thehead office books is to be recorded by both the parties.

d. Expenses Rs. 70,000 to be charged to the branch for work done on its behalf by thehead office.


Q.18

On finding a difference between two sides of the Trial Balance, the accountant transferred theexcess debit of Rs. 770 to a suspense account. Subsequently, the following errors weredetected. Give journal entries to rectify the errors and show the suspense account.

1. Repairs to machinery Rs. 2,000 were debited to Machinery Account.

2. A sale of Rs. 900 to Patel was recorded in the Purchases Book.

3. The total of the Returns Inwards Book Rs. 400 was not posted.

4. A purchase of Rs. 590 from Sathe was posted to his account as Rs. 950.

5. The bank column of the receipt side of the cash book was undercast by Rs. 110.

6. A cash sale of Rs. 200 to Ramesh was entered both in the cashbook and sales book.

7. A credit purchase of Rs. 300 from Satish was omitted to be recorded.

8. Cash Rs. 150 paid to Brijmohan was posted twice to his account.

9. A credit balance of Rs. 450 to Malasingh’s account was carried forward as Rs. 540 onthe debit side.

10. The name of Vinod, a creditor, to whom we owed Rs. 500 was omitted from the list ofsundry creditors.

Q.19

Rectify the following errors –

1. Carriage on machinery is debited to Carriage Account Rs. 100.

2. Goods purchased from Sahani Rs. 531 was debited to his account as Rs. 351.

3. A television purchased for the workers’ canteen in the factory for Rs. 25,000 was debitedto Factory Expenses.

4. An amount of Rs. 15,000 paid for the construction of a new hall in the building wasdebited to Repairs Account.

5. The total of the Sales Book for the month of February was cast short by Rs. 10.

6. A credit sale of Rs. 575 to Mahendra was debited to Mohinder’s Account.

7. A sum of Rs. 500 paid to Poonawalla for salary was debited to his personal account.

8. A credit sale of Rs. 1,000 to Rashid was correctly entered in the Sales Book but wasposted to the credit of his account in the ledger as Rs. 100.

9. Goods sold to Devidas Rs. 590 was recorded in the Sales Book as Rs. 950.


NOTES

147Cost Accountancy [Basic Concepts and Principles]

Chapter 6COST ACCOUNTANCY

[BASIC CONCEPTS AND PRINCIPLES]

INTRODUCTION :

The Institute of Cost and Management Accountants, London has defined the Cost Accountancyas “The Application of Costing and Cost Accounting principles, methods and techniques tothe science, art and practice of cost control and the ascertainment of profitability as well aspresentation of information for the purpose of managerial decision making.”. The analysis ofthe above definition reveals the following facts.

(1) Cost Accountancy is a science, art and practice of a Cost Accountant. Science indicatesthe possession and the application of relevant systematic knowledge. Art indicates theskill and ability of the Cost Accountant. Practice indicates a continuous effort on the partof the Cost Accountant.

(2) The terms costing and cost accounting should not be confused. Costing indicates theprocess of ascertaining the costs which can be done arithmetically also. Cost accountingindicates the process of recording the costs in a formal and systematic manner with theintention of preparing statistical data therefrom to ascertain the cost.

(3) The objects of Cost Accountancy can be threefold.

(a) Ascertainment of cost and profitability with the help of various principles, methodsand techniques.

(b) Cost control – This indicates the process of controlling the costs of operating thebusiness. This process, in turn, involves the following stages. To plan the operations(which can be done by the establishment of budgets and standards), execute theplans, measuring the actual performance, comparison of planned and actualperformance, computing the variations between planned and actual performanceand taking the decisions to maintain favourable variations or to remove unfavourablevariations.


(c) Presentation of information to enable managerial decision making. Unless and untilthe results of any study or action are presented correctly to the person who takesthe decision in respect of the same, the study has no meaning.

CONCEPT OF COST CENTRE :

Cost Centre is defined as a location, person, or item of equipment (or a group of these) in orconnected with an undertaking, in relation to which costs may be ascertained and used for thepurpose of cost control. Correct identification of a cost centre is pre-requisite for the successfulimplementation of cost accounting process as the costs are ascertained and controlled withrespect to the cost centres. Similarly, correct identification of cost centre facilitates the fixationof responsibility in a correct manner. Eg. A person in-charge of a cost centre may be heldresponsible for the proper functioning and cost control in relation to that cost centre. As costcentres facilitate this control function, in many cases, they are termed as ‘ResponsibilityCentres’. There may not be any fixed principle for deciding the number and size of costcentres. It depends upon the nature and size of organisation, expenditure involved, requirementsof management from cost control point of view and so on. However, following pattern ofclassification may be followed to decide the cost centres.

(1) Impersonal and Personal Cost Centres :

An impersonal cost centre consists of location or item of equipment (or group of these).Eg. A region of sales, a branch, a department, a grinding machine and so on. A personalcost centre consists of a person or a group of persons. Eg. Finance Manager, SalesManager, Works Manager and so on.

(2) Production and Service Cost Centres :

Production cost centre is the one where the production activity is carried on. Eg. Machineshop, Paint shop, Assembly shop and so on.

Service cost centre is the one which assists the production activity. Eg. Store Dept.,Internal Transport Dept., Labour Office, Maintenance Dept., Accounts/Costing Dept.,and so on.

CONCEPT OF COST :

The term cost indicates the amount of expenditure (actual or notional) incurred on or attributableto, a given thing.

The term cost can be viewed from various angles.


(1) Direct Cost and Indirect Cost :

Direct Cost indicates that cost which can be identified with the individual cost centre. Itconsists of direct material cost, direct labour cost and direct expenses. It is also termedas Prime Cost.

Indirect Cost indicates that cost which cannot be identified with the individual cost centre.It consists of indirect material cost, indirect labour cost and indirect expenses. It is alsotermed as overheads. As it is not possible to identify these costs with individual costcentres, such identification is done in the indirect way by following the process of allocation,apportionment and absorption. (It is discussed in details in the following chapters).

(2) Fixed, Variable and Semi-variable/Semi-fixed Cost :

Fixed cost indicates that portion of total cost which remains constant at all the levels ofproduction, irrespective of any change in the later. As the volume of production increases,per unit fixed cost may reduce, but not the total fixed cost.

Variable cost indicates that portion of the total cost which varies directly with the level ofproduction. Higher the volume of production, higher the variable cost and vice versa,though per unit variable cost remains constant at all the levels of production.

Semi-variable or semi-fixed cost indicates that portion of the total cost which are partlyfixed and partly variable in relation to the volume of production.

(3) Controllable Cost and Uncontrollable Cost :

Controllable cost indicates that cost which can be controlled by a specific number ofperson(s) in the organisation. Eg. A person in charge of a responsibility centre may be inthe position to control the costs in relation to that responsibility centre.

Uncontrollable cost indicates that cost which cannot be controlled by a specific numberof person(s) in the organisation. Eg. The costs relating to one responsibility centre cannotbe controlled by a person who is in-charge of another responsibility centre.

It should be noted here that a clear-cut distinction between controllable and uncontrollablecosts may not be possible. The cost which is controllable for one person may not becontrollable by another one. In fact, no cost is completely uncontrollable. The degree ofcontrollability varies in relation to a particular individual and a level of management. In avery broad sense, it can be said that the variable costs are controllable at the lower levelof management while fixed costs are controllable at the top level of management.


(4) Normal Cost and Abnormal Cost :

Normal Cost indicates that cost which is normally incurred at a certain level of outputunder normal circumstances.

Abnormal cost indicates that cost which is normally not incurred at a certain level ofoutput under normal circumstances.

SPECIAL TYPES OF COST :

(a) Opportunity Cost :

In very simple language, opportunity cost is the cost of opportunity foregone. The resourcelike men, material, machine, money etc. may be having various alternative uses eachone having some specific yield or return. However, if they are used in one particular way,they cannot be used in any other way. Opportunity cost refers to the return or yieldwhich is not available if the resources are used in any specific manner. Eg. Mr. A has Rs.1,00,000 to invest. He is having two options open.

(i) Keep the same with some Bank in Fixed Deposit and get the interest of 10% p.a.

(ii) Invest the money in the business and get the return on investment of 12%.

If Mr. A decides to invest the money in business, he cannot get the interest onFixed Deposit from Bank. As such, opportunity cost of investing the money in thebusiness is in the form of lost interest on Fixed Deposits with the Bank. It shouldbe noted that the opportunity cost itself finds no place in the accounting process.However, it is required to be considered in the decision making process, for thecomparison purpose. The returns available from a proposal should be more thanthe cost of opportunity lost, then and then only the proposal can be accepted.

(b) Differential Cost :

Differential cost indicates increased or decreased cost due to the increased or decreasedvolume of operations. While assessing the acceptability of a proposed change, thedifferential costs are compared with differential revenues, and so long as differentialrevenues are more than the differential costs, the proposed change may be accepted.

(c) Sunk Cost :

Sunk cost indicates historical cost which is incurred in past. This type of cost is normallynot relevant in the decision-making process. Eg. While deciding about the replacementof a machine, the depreciated book value of the machine may not be relevant being in theform of sunk cost.


INSTALLATION OF COSTING SYSTEM :

At the outset, it should be noted that if it is decided to install a costing system in an organisationthere may not be any standard type of costing system applicable. The details of costingsystem may be required to be worked out in such a way that they satisfy the individualrequirements of the organisation. Following factors will have to be considered before installinga costing system.

(a) Nature of the Product :

Before installing the costing system, the nature of product in respect of which the systemis to be installed will have to be studied. If the product is material intensive, more stressmay be necessary on inventory control procedures, if the product is labour intensive,more stress may be necessary on control procedures and so on.

(b) Nature of the Organisation :

The nature of the organisation may be required to be studied from the various angles.

(1) Size and layout of the factory.

(2) Organisational structure of the organisation.

(3) The procedures presently followed in the respect of accounting of material cost,labour cost and overheads.

(4) Management requirements from the cost control point of view.

(c) Manufacturing Process :

Before installing the costing system, the technical process involved in the manufacturingof the product will have to be studied. This may involve the study from the stage ofdesigning of the product, the quantity, quality and mix of the materials used, the degreeof automation involved, the production control techniques implemented, the degree ofcomplexities involved in the production process and so on.

(d) Simplicity and Cost :

The costing system to be installed should be simple to understand and easy to operate.

The costing system should be economic in terms of cost of installing and operating thesystem, and the results obtained therefrom should justify the cost.


(e) Reporting systems :

The costing system should be designed in such a way that it generates proper reports ina proper way to facilitate cost control decisions from the management’s side. The reportingsystem should be based upon the principle of Management by Exception. Forms andrecords required to be maintained to facilitate correct reporting should be designed insuch a way that it involves minimum clerical work and minimum cost.

Some problems may arise while installing a costing system in an organisation. However, theyare faced mainly where the system is not properly planned, executed and communicated.These problems are definitely not of the costing principles as such and can easily be overcomeby having systematic planning and communication procedures. The problems which are usuallyfaced while installing a costing system can be stated as below.

(1) The costing system may not be suitable considering the nature of product and nature ofbusiness.

(2) The employees and the executives may resist the installation of the costing systemfeeling that it is meant for pointing out their drawbacks. This arises only out of ignoranceand suspicion.

(3) Lack of cost consciousness among the various levels of management.

(4) The cost involved in installing a costing system may be too high.

(5) Laxity on the part of various employees to complete the forms of cost office and toforward them to the cost office.


QUESTIONS

1. Explain the nature of Cost Accounting.

Explain the factors which need to be considered for installing a costing system for amedium sized engineering organisation.

2. Write short notes on –

a) Cost Centre

b) Opportunity Cost


NOTES

155Elements of Costs

Chapter 7ELEMENTS OF COSTS

In case of a typical manufacturing type of operation, the activity may consist of conversion ofraw material in the form of finished goods with the help of labour and other services and sellingthe finished goods in the market to earn the profits. In order to interpret the term cost correctlyand to ascertain the cost with respect to the centres, the cost attached with the manufacturingprocess may be subdivided into what is known as Elements of Cost. Broadly there can bethree elements of costs.

(A) Material :

This is the cost of commodities and materials used by the organization. It can be direct orindirect.

Direct Material indicates that material which can be identified with the individual cost centreand which becomes an integral part of the finished goods. It basically consists of all rawmaterials, either purchased from ourside or manufactured in house.

Indirect Material indicates that material which cannot be identified with the individual costcentre. This material assists the manufacturing process and does not become an integral partof finished goods. The examples of this type of material may be consumable stores, cottonwaste, oils and lubricants, stationery material etc.

(B) Labour :

This is the cost of remuneration paid to the employees of the organisation. It can be direct orindirect.

Direct Labour Cost indicates that labour cost which can be identified with the individual costcentre and is incurred for those employees who are engaged in the manufacturing process.

Indirect Labour Cost indicates that labour cost which cannot be identified with the individualcost centre and is incurred for those employees who are not engaged in the manufacturingprocess but only assist in the same. The examples of this type of cost are wages paid toforeman/storekeeper, salary of works manager, Accounts/Personnel department salaries etc.


(C) Expenses :

This is the cost of services provided to the organisation (and the notional cost of assetsowned). It can be direct or indirect.

Direct Expenses are those expenses, which can be identified with the individual cost centres.The examples of these expenses are hire charges of machinery/ equipments required for aparticular job, cost of defective work for a particular job etc.

Indirect Expenses are those expenses, which cannot be identified with the individual costcentres. The examples of these expenses are rent, telephone expenses, insurance, lightingetc.

The above elements of cost can be shown as below.

Cost

Material Labour Expenses

Direct Indirect Direct Indirect Direct Indirect

The aggregate of Direct Material Cost, Direct Labour Cost and Direct Expenses is termed as‘Prime Cost’.

The aggregate of Indirect Material Cost, Indirect Labour Cost and Indirect Expenses is termedas ‘Overheads’.

Overheads :

As discussed above, the aggregate of Indirect Material cost, Indirect Labour cost and IndirectExpenses is termed as ‘Overheads’. For the proper interpretation and presentation of cost,the term overheads may be further classified as below.

(a) Factory Overheads (Also termed as production/works/manufacturing overheads.)

(b) Office and Administration Overheads.

(c) Selling and Distribution Overheads.

(a) Factory Overheads :

These overheads consist of all overhead costs incurred from the stage of procurement ofmaterial till the stage of production of finished goods. They include :

l Indirect Material such as consumable stores, cotton waste, oil and lubricants etc.


l Indirect Labour Cost such as wages paid to foreman/storekeeper, works manager’ssalary etc.

l Indirect Expenses such as carriage inward cost, cost of factory lighting/powerexpenses, rent/insurance/repairs for factory building/machinery, depreciation onfactory building or machinery etc.

(b) Office and Administration Overheads :

These overheads consist of all overhead costs incurred for the overall administration ofthe organization. They include :

l Indirect Material such as stationery items, office supplies etc.

l Indirect Labour cost such as salaries paid to Accounts and Administration staff,Directors’ remuneration etc.

l Indirect Expenses such as postage/telephone, rent/insurance/repairs/depreciationon office building, general lighting, legal/audit charges, bank charges etc.

(c) Selling and distribution Overheads :

These overheads consist of all overhead costs insured from the stage of final manufacturingof finished goods till the stage of sale of goods in the market and collection of dues fromthe customers. They include :

l Indirect Material such as packing material, samples etc.

l Indirect Labour like salaries paid to sales personnel, commission paid to salesmanager etc.

l Indirect Expenses like carriage outwards, warehouse charges, advertisement, baddebts, repairs and running of distribution van, discount offered to customers etc.


The above classification of overheads can be shown as below :

Indirect Material

Factory Indirect Labour

Indirect Expense

Indirect Material

Overheads Office/Administration Indirect Labour

Indirect Expense

Indirect Material

Selling & Distribution Indirect Labour

Indirect Expense

Cost Sheet/Cost Statement :

The various elements/components of the cost as discussed above can be presented in theform of a statement, popularly known as ‘Cost Sheet’ or ‘Cost Statement’. The cost sheetmay be prepared separately for each cost centre and may have the columns like cost per unitor cost of previous period etc.

A Proforma cost sheet is shown below :

Direct Material Cost

Direct Labour cost

Direct Expenses

PRIME COST

Add : Factory Overheads

FACTORY/WORKS COST

Add : Office and Administration Overheads

TOTAL COST

Add : Selling and Distribution Overheads

COST OF SALES

Add : Profit

SALES


The above relationship among the various elements of costs can be explained in a better waywith the help of following diagram.

Note :

The difference between sales and factory/works cost is termed as ‘Gross Profit’ and thedifference between sales and cost of sales is termed as ‘Net Profit’ or ‘Operating Profit’. Assuch, the difference between Gross Profit and Office and Administration Overheads and Sellingand Distribution may be different from the ‘Net Profit’ or ‘Operating Profit’. This Net Profit maybe different from the net Profit as disclosed by the financial statement in the form of Profit andLoss Account. This is due to the fact that the Profit and Loss Account considers the variousnon-operating incomes/expenses or incomes/expenses of purely financial nature (as discussedbelow) while they may be ignored by the cost statement.

(a) Non-operating/Financial Incomes :

These represent incomes which arise not as a part of regular operations of the organisation.Eg. Profit on the sale of assets/investment, dividend received, windfall income etc. Dueto these, the operating profit as per cost statement may be less than profit as per Profitand Loss Account.

(b) Non-operating/Financial Expenses :

These represent expenses which arise not as a part of regular operations of theorganisation. Such expenses may be in the form of those incurred as a result of policy.

PROFIT

SELLING & DISTRIBUTIONOVERHEADS

ADMINISTRATIONOVEREHEADS

FACTORYOVERHEADS

DIRECTEXPENSES

DIRECTLABOUR

DIRECTMATERIAL S

ALE

S

CO

ST

OF

SA

LES

TOTA

L C

OS

T

FAC

TOR

Y C

OS

T

PR

IME

CO

ST


Eg. loss on the sale of assets/investment, good-will/ preliminary expenses written off,provision for Income Tax, Interest paid, Dividend paid etc. Due to these, the operatingprofit as per cost statement may be more than profit as per Profit and Loss Account.

As such cost structure may also be presented as below.

Sales

Less : Factory/Works Cost

Gross Profit

Less : Office and Administration Overheads

Selling and Distribution Overheads

Operating Profit

Less : Non-Operating/Financial Expenses

Add : Non-Operating/Financial Income

Net Profit (As per Profit and Loss Account)

It goes without saying that if an organisation maintains cost records and financial recordsseparately, there may be a need to reconcile the profits as disclosed by the cost records andthe profit as disclosed by the financial records.

ILLUSTRATIVE PROBLEMS

(1) From the following list of balances, prepare a statement showing Cost of Sales, GrossProfit, Operating Expenses, Operating Profit and Net Profit.

Rs.

Sales 7,80,000

Purchases 4,83,375


Salaries : Office 40,350

Selling 22,950 63,300

Rent and Taxes : Office 2,700

Selling 1,350 4,050

Stationery and Postage 3,850

Depreciation 13,950

Advertising 4,700

Selling expenses 2,350

Travelling expenses 3,000


Opening Stock 1,14,375

Sundry Expenses : Office 16,500

Selling 8,250 24,750


Dividend on shares 13,500

Profit and sale of shares 4,500

Loss on sale of shares 6,000

Solution :

COST STATEMENT

(A) Sales Rs. Rs.

Gross Sales 7,80,000

Less : Sales Returns 30,000

Net Sales 7,50,000

(B) Prime Cost (Material consumed)


Add : Purchases 4,83,375

5,97,750

Less : Closing stock 1,47,750

4,50,000

(C) Gross Profit (i.e. A-B) 3,00,000

(D) (a) Office and Administration Overheads

- Salaries 40,350

- Rent and Taxes 2,700

- Stationery and Postage 3,850

- Depreciation 13,950

- Travelling Expenses 3,000

- Sundry Expenses 16,500

80,350


(b) Selling and Distribution Overheads

- Salaries 22,950

- Rent and Taxes 1,350

- Advertising 4,700

- Selling Expenses 2,350

- Sundry Expenses 8,250

39,600 1,19,950

(E) Operating Profit (i.e. C-D) 1,80,050

(F) (a) Less : Non-operating Expenses

Dividend on shares 13,500

Loss on sale of shares 6,000 19,500

1,60,550

(b) Add : Non-operating Income

Profit on sale of shares 4,500

(G) Net Profit 1,65,050

Notes :

(a) From the available details, it appears that the above activity is a trading activity. As suchthere will be no factory overheads and prime cost will consist of only material cost.

(b) In want of sufficient information, depreciation and travelling expenses are treated asoffice and administration overheads.

(c) Dividend on shares may indicate the non-operating income also. However, in want ofsufficient information, it is treated as dividend paid by the company i.e. a part of non-operating expenses.

(2) From the books of accounts of M/s. Aryan Enterprises, the following details have beenextracted for the year ending March, 1994.

Rs.

Stock of Materials – Opening 1,88,000

– Closing 2,00,000

Materials purchased during the year 8,32,000

Direct Wages paid 2,38,400

Indirect Wages 16,000


Salaries to administrative staff 40,000

Freights – Inward 32,000

– Outward 20,000

Cash Discounts allowed 14,000


Repairs to Plant & Machinery 42,400

Rent, Rates and Taxes – Factory 12,000

– Office 6,400


Salesmens’ Salaries and Commission 33,600

Depreciation – Plant & Machinery 28,400

– Furniture 2,400

Directors’ Fees 24,000

Electricity Charges (Factory) 48,000

Fuel (for boiler) 64,000

General Charges 24,800

Manager’s Salary 48,000

The manager’s time is shared between the factory and the office in the ratio of 20:80.

From the above details, you are required to prepare :-

a. Prime Cost

b. Factory Overheads

c. Factory Cost

d. Administration Overheads

e. Selling Overheads

f. Total Cost

Solution :

COST SHEET

Direct Materials Cost Rs. Rs.


Add : Purchases 8,32,000

Less : Closing Stock 2,00,000

8,20,000

Add : Freight Inward 32,000


Rs. Rs.

8,52,000

Direct Wages 2,38,400

PRIME COST 10,90,400

Factory Overheads

Indirect wages 16,000

Repairs to Plant & Machinery 42,400

Rent, Rates and Taxes 12,000

Depreciation – Plant & Machinery 28,400

Electricity Charges 48,000

Fuel for boiler 64,000


2,20,400

FACTORY COST 13,10,800

Administration Overheads

Salaries 40,000

Rent, Rates and Taxes 6,400


Depreciation – Furniture 2,400

Directors’ Fees 24,000

General Charges 24,800


1,48,400

OFFICE COST 14,59,200

Selling Overheads

Freight Outward 20,000

Cash Discount allowed 14,000


Salesmens’ Salary & Commission 33,600

86,400

TOTAL COST 15,45,600


(3) An advertising agency has received an enquiry for which you are supposed to submit thequotation. Bill of Materials prepared by the Production Department for the job states thefollowing requirement of material :

Paper – 10 reams @ Rs. 1800 per ream

Ink & Other printing material – Rs. 5,000

Other consumables – Rs. 3,000

Some photography is required for the job. The agency does not have a photographer as anemployee. It decides to hire a professional photographer who is to be paid professional fees ofRs. 10,000.

Estimated job card prepared by the Production Department specifies that services of thefollowing employees will be required for the execution of the job. Monthly remuneration payableto these employees as indicated by the Personnel Department is also given.

Artist – 80 hours. Paid Rs. 12,000 p.m.

Copywriter – 75 hours. Paid Rs. 10,000 p.m.

Client Servicing – 30 hours. Paid Rs. 9,000 p.m.

You can assume that a month consists of 25 working days and one working day consists of6 working hours.

An amount of Rs. 4,000 will be required for the cost of primary packing material.

Production overheads are likely to be 40% of direct cost while selling and administrationoverheads are likely to be 25% of production cost. The agency expects the profit of 10% onbasic quotation price.

COST SHEET

Rs. Rs.

Direct Materials Cost –

Paper 18,000

Ink & Other printing material 5,000

Other Consumables 3,000

Primary Packing Material 4,000

30,000

Direct Labour Cost

Artist 6,400

Copywriter 5,000

Client Servicing 1,800

13,200


Direct Expenses

Photography Charges 10,000

DIRECT COST 53,200

Production Overheads 21,280

PRODUCTION COST 74,480

Selling & Administration Overheads 18,620

TOTAL COST 93,100

Profit 10,344

QUOTATION PRICE 1,03,444

(4) Pune Equipments Ltd. manufactured and sold 1,000 refrigerators in year ending31 December, 1984. The Trading and Profit & Loss Account is as below:

Trading and P&L Account for the year ending 31.12.84.

To, Cost of material 80,000 By, Sales 4,00,000

To, Direct wages 1,20,000

To, Manufacturing Cost 50,000

To, Gross Profit 1,50,000

4,00,000 4,00,000

To, Mgn. & Staff Salary 60,000 By, Gross Profit 1,50,000

To, Rent, Rates etc. 10,000

To, Selling Expenses 30,000

To, General Expenses 20,000

To, Income Tax 5,000

To, Net Profit 25,000

1,50,000 1,50,000

For the year ending 31.12.85, it is estimated that :

1. Output and sales will be 1,200 refrigerators.

2. Prices of the materials will rise by 20% on the previous year’s level.

3. Wages will rise by 5%.

4. Manufacturing cost will rise in proportion to combined costs of materials and wages.

5. Selling cost per unit will remain unchanged.

6. Other expenses will remain unaffected by the rise in output.


You are required to prepare a cost statement showing the price at which each refrigeratorshould be marked so as to show profit of 10% on the selling price.

Solution :

Cost Statement for the Year Ending 31.12.85

(Base - 1,200 Refrigerators)

Per Unit TotalRs. Rs.

Material Cost 96.00 1,15,200

Direct Wages 126.00 1,51,200

Prime Cost 222.00 2,66,400

Manufacturing Cost (25% of Prime Cost) 55.50 66.600

Factory Cost 277.50 3,33,000

Management & Staff Salary 50.00 60,000

Rent/Taxes and General Expenses 25.00 30,000

Selling Expenses 30.00 36,000

Cost of Sales 382.50 4,59,000

Profit (1/9th of Total Cost) 42.50 51,000

Sales 425,00 5,10,000

Note :

(1) Material Cost and Direct Cost increases both due to increase in volume and increase inprices.

(2) Calculation of manufacturing cost percentage -

Present Materials Cost Rs. 80,000

Present Direct Wages Rs. 1,20,000

Present Prime Cost Rs. 2,00,000

Present Manufacturing Cost Rs. 50,000

∴ Manufacturing Cost is 25% of Prime Cost.

(3) Expenditure in the form of income tax will be ignored being non-operating expenditure.


(5) The standard production for a particular work order is 20 units per day and piece ratewages is 60 paise per unit if daily production is 20 units or more. The rate is 50 paise perunit if production is less than 20 units. Cost of material is 30 paise per unit. It is proposedto charge factory overhead under one of the following methods.

(i) 100% on labour cost.

(ii) 80% on prime cost.

Tabulate the above data in the form of a suitable statement and indicate in the factorycost per unit, under each of the above methods if the daily production is (a) 15 units(b) 20 units (c) 25 units.

Solution :

COST SHEET

(a) No. of units produced per day 15 20 25

(b) Material cost (Rs) 4.50 6.00 7.50

(c) Labour cost (Rs) 7.50 12.00 15.00

(d) Prime cost i.e. b+c 12.00 18.00 22.50

Alternative I Alternative II

(a) No. of units produced per day 15 20 25 15 20 25

(b) Prime Cost (Rs) 12.00 18.00 22.50 12.00 18.00 22.50

(c) Factory overheads (Rs) 7.50 12.00 15.00 9.60 14.40 18.00

(d) Total factory cost i.e. b+c 19.50 30.00 37.50 21.60 32.40 40.50

(e) Factory cost per unit i.e. d/a (Rs) 1.30 1.50 1.50 1.44 1.62 1.62

Note :

According to Alternative I, Factory Overheads are charged

@ 100% on Labour Cost.

According to Alternative II, Factory Overheads are charged.

@ 80% on Prime Cost.


(6) X Ltd. manufactures four brands of toys A, B, C and D. If the Company limits themanufacture to just one brand, the monthly production will be-

A - 50000 Units B - 100000 Units

C - 150000 Units D - 300000 Units

You are given the following set of information, from which you are requested to find out theprofit or loss made on each brand showing clearly, the following elements.

(a) Direct cost (b) Works cost (c) Total cost

Brands

A B C D

Monthly Production (units) 6,750 18,000 40,500 94,500

Direct Wages (Rs.) 15,000 27,500 37,500 1,05,000

Direct Material Cost (Rs.) 50,000 92,500 1,27,500 3,80,000

Selling Price Per Unit (Rs.) 20 15 10 8

Factory overhead expenditure for the month was Rs. 1,62,000. Selling and distribution costshould be assumed @ 20% of works cost. Factory overhead expenses should be allocated toeach brand on the basis of the units which could have been produced in a month when a singlebrand production was in operation.

Solution :

From the information given, it is observed that

One unit of B is equivalent to 2 units of A.

One unit of C is equivalent to 3 units of A

One unit of D is equivalent to 6 units of A

Expressing the actual production in terms of unit equivalents of product A

Product A 6,750 units.

Product B 9,000 units equivalent of A

Product C 13,500 units equivalent of A

Product D 15,750 units equivalent of A

45,000


The factory overheads of Rs. 1,62,000 are to be distributed over 45,000 equivalent units ofproduct A. As such rate of factory overheads for one unit of Product A will be

Rs. 1,62,000

45,000 units= Rs. 3.60/per unit

As such, per unit factory overheads for other products will be -

Product B - Rs. 3.60/2 = Rs. 1.80/ per unit.

Product C - Rs. 3.60/3 = Rs. 1.20/ per unit.

Product D - Rs. 3.60/6 = Rs. 0.60/ per unit.

On this basis, the cost sheet for each product can be worked out as below.

A B C D

(a) Direct Material Cost 50,000 92,500 1,27,500 3,80,000

(b) Direct Wages 15,000 27,500 37,500 1,05,000

(c) Total Direct Cost i.e. a+b 65,000 1,20,000 1,65,000 4,85,000

(d) Factory Overheads 24,300 32,400 48,600 56,700

(e) Works cost i.e. c+d 89,300 1,52,400 2,13,600 5,41,700

(f) Selling/Distribution overheads 17,860 30,480 42,720 1,08,340

(g) Cost of Sales e+f 1,07,160 1,82,880 2,56,320 6,50,040

(h) Units Sold/Produced 6,750 18,000 40,500 94,500

(i) Units Selling Price - Rs. 20 15 10 8

(j) Total Sales Rs. 1,35,000 2,70,000 4,05,000 7,56,000

(k) Profit i.e. j-g 27,840 87,120 1,48,680 1,05,960

(7) A manufacturing company has an installed capacity of 1,20,000 units per annum. Thecost structure of the product manufactured is as under –

1. Variable Cost (Per unit)

Materials Rs. 8

Labour (subject to a minimum

of Rs. 56,000 per month) Rs. 8

Overheads Rs. 3

2. Fixed overheads Rs. 1,04,000 per annum


3. Semi variable overheads Rs. 48,000 per annum at 60% capacity which increase by Rs.6,000 per annum for increase of every 10% of the capacity utilization or any part thereof.

The capacity utilisation for the next year is estimated at 60% for 2 months, 75% for 6 monthsand 80% for the balance part of the year. If the company is planning to have a profit of 25% onthe selling price, calculate the estimated selling price for each unit of production. Assume thatthere is no opening or closing stock.

Solution :

Capacity Utilisation 60% 75% 80%

Months 2 6 4

No. of units 6000 7500 8000

Hence, total number of units will be –

6000 x 2 months + 7500 units x 6 months + 8000 units x 4 months = 89,000 units

Total

Materials (Rs.) 96,000 360,000 256,000 7,12,000

Labour 112,000 360,000 256,000 7,28,000

Overheads 36,000 135,000 96,000 2,67,000

Semi-variable Overheads 8,000 30,000 20,000 58,000

Fixed Overheads 1,04,000

Cost of Production 18,69,000

Per Unit Cost of Production i.e. 18,69,000/89,000 = Rs. 21

As profit is 25% on the selling price, selling price will be Rs. 28 per unit.

(8) AB & Co. manufactures two types of pens P and Q. The cost data for the year ended30th September, 1990 is as follows –

Direct Materials Rs. 4,00,000

Direct Wages Rs. 2,24,000

Production Overheads Rs. 96,000

Rs. 7,20,000

It is further ascertained that :

a. Direct Materials in type P cost twice as much direct materials in type Q.

b. Direct wages for type Q were 60% of those for type P.

c. Production overheads were of same rate for both types.


d. Administration overhead for each was 200% of direct labour.

e. Selling costs were 50 paise per pen for both types.

f. Production during the year –

Type P 40,000 units

Type Q 1,20,000 units

g. Sales during the year –

Type P 36,000 units

Type Q 1,00,000 units

h. Selling prices were Rs. 14 per pen for type P and Rs. 10 per pen for type Q.

Prepare a statement showing per unit cost of production, profit and total sales value and profitseparately for two types of pens P and Q.

Solution :

Cost Statement for the year ended on 30th September, 1990

Particulars P Q

Direct Material 1,60,000 2,40,000

Direct Wages 80,000 1,44,000

Production Overheads 24,000 72,000

Administration Overheads 1,60,000 2,88,000

a. Cost of Production 4,24,000 7,44,000

b. Production (Units) 40,000 1,20,000

c. Per Unit Cost of Production (Rs.) 10.60 6.20(Being a/b)

d. Sales (Units) 36,000 1,00,000

e. Cost of Sales 3,81,600 6,20,000(Being d x c)

f. Selling Cost 18,000 50,000

g. Total Cost 3,99,600 6,70,000(Being e + f)

h. Per Unit Selling Price (Rs.) 14.00 10.00

i. Sales 5,04,000 10,00,000(Being d x f)

j. Profit 1,04,400 3,30,000


Working Notes :

a. Direct Materials

Let per unit direct materials cost of Q be Rs. X. Hence, per unit direct materials cost ofP will be 2X Total Direct Materials Cost will be – 40,000 units x 2X + 1,20,000 units x X= 4,00,000.

Solving for X, we get X = Rs. 2

Hence, Direct Materials Cost for P will be Rs. 1,60,000 and Direct Materials Cost for Qwill be Rs. 2,40,000.

b. Direct Wages

Let rate of labour be Rs. X for P Hence, rate of labour for Q will be 0.6X for Q

Total Direct Wages will be – 40,000 units x X + 1,20,000 units x 0.6X = 2,24,000

Solving for X, we get X = 2

Hence, Direct Wages Cost for P will be Rs. 80,000 and Direct Wages Cost for Q will beRs. 1,44,000.

(9) A company presently sells an equipment for Rs. 35,000. Increase in prices of labour andmaterial are anticipated to the extent of 15% and 10% respectively in the forthcomingyear. Material cost represents 40% of cost of sales and labour cost 30% of cost of sales.The remaining relate to overheads. If the existing selling price is retained, despite theincrease in labour and material prices, the company would face a 20% decrease in theexisting amount of profit on the equipment.

You are required to arrive at a selling price so as to give the same percentage of profit onincreased cost of sales, as before. Prepare a statement of profit/loss per unit showing the newselling price and cost per unit in support of your answer.

Solution :

Let cost of sales per unit be Rs. X. Then per unit profit will be 35000 – X.

Per unit cost structure will be as below –

Material Cost 0.4X

Labour Cost 0.3X

Overheads 0.3X

After the price increase, per unit cost structures will change as below –

Material Cost 0.44X

Labour Cost 0.345X

Overheads 0.3X


However, after the price increase and existing selling price remaining the same, the profit perunit will come down by 20%.

Hence, the following equation will emerge –

35,000 – (0.44X + 0.345X + 0.3X) = 0.8 (35,000 – X)

Solving for X, we get X = 24,561. Hence, the existing per unit cost of sales is Rs. 24,561.

As such, following is the per unit cost structure with the existing prices and after the priceincrease,

Existing Future

Materials Cost 9,825 10,808

Labour Cost 7,368 8,473

Overheads 7,368 7,368

Cost of Sales 24,561 26,649

Profit 10,439 8,351

Selling Price 35,000 35,000

Existing profit on cost of sales works out as –

10,439X 100 = 42.5%

24,561

If the same profit percentage is to be maintained after the cost increase, the new selling pricewill be –

26,649 + 42.5% of 26,649 = Rs. 37,975.

(10) A firm has purchased a plant for manufacturing a new product, the cost data for which isgiven below.

Estimated Annual Sales 24,000 units.

Estimated Costs

Material Rs. 4.00 per unit

Direct Labour Rs. 0.60 per unit.

Overheads Rs. 24,000 per year.

Administrative Expenses Rs. 28,800 per year.

Selling Expenses 15% of sales.

Calculate the selling price if profit per unit is Rs. 1.02.


Solution :

Let the selling price be Rs. X

Hence, total sales will be Rs. 24000X

The cost sheet will be as below –

Material Cost 24000 x Rs. 4.00 96,000

Direct Labour 24000 x Rs. 0.60 14,400

Overheads 24,000

Administrative Expenses 28,800

Selling Expenses 15% of sales 3,600X

Profit Re. 1.02 per unit 24,480

Hence,

24000X = 96000 + 14400 + 24000 + 28800 + 3600X + 24480

24000X = 187680 + 3600X

20400X = 187680

X = 9.20

Hence, selling price will be Rs. 9.20

QUESTIONS

1. What do you mean by Elements of Cost? Explain in details. Draw a standard format ofcost sheet for a machine tool manufacturing company. Assume suitable data.

2. How the cost is classified into various elements for presenting the same in the form of acost sheet. Prepare a standard format of cost sheet for a furniture making unit. Assumesuitable data.


PROBLEMS

(1) The following figures relates to the trading activities of Hind Traders for the year ended30.6.79. Prepare a statement showing net operating income.

Rs. Rs.

Sales 5,20,000 Office Salaries 27,000

Purchases 3,22,250 Rent 2,700

Opening Stock 76,250 Stationery & Postage 2,500

Closing Stock 98,500 Depreciation 9,300

Sales Returns 20,000 Other charges 16,500

Interest on Debentures 15,300 Provision for Tax 40,000

Advertising 4,700

Travelling 2,000

(2) From the following list of balances, prepare a statement showing net operating income.

Rs.

Sales 5,40,000

Purchases 1,60,000


Purchases Returns 10,000



Rent Received 1,50,000

Profit on sale of asset 1,00,000


Manufacturing Expenses 30,000

Selling Expenses 10,000

Depreciation 13,000

Interest on Loan 2,000

Income Tax 150


(3) A Ltd. is a company which is engaged in the business of executing the various jobs asper the customer requirements. It has received one job from one of the customers forwhich it is required to submit the quotation. The Production Manager of the companyhas worked out the following details of the cost in respect of the said job –

Raw Materials Rs. 40,000

Bought Out Components Rs. 50,000

Primary Packing Material Rs. 5,000

Consumable Stores Rs. 4,000

Direct Workers 400 Labour Hours @ Rs. 30 per hour

Royalty Payable 20% of Direct Material

Other Factory Overheads 15% of Prime Cost

Support from administrative staff 100 Man-hours @ Rs. 50 per hour

Other administration overheads 15% of Factory Cost

Selling Overheads 10% of Total Cost

What selling price should be quoted by the Company if it intends to earn a profit of 20% onselling price?

(4) Honesty Engineering Works has a machining shop in which it manufactures two AutoParts P1 and P2 out of forgings F1 and F2. For the quarter ending December 1993,following cost data are available –

Consumption of Raw Materials - F1 1,50,000

- F2 2,00,000

Wages and Salaries 1,53,000

Stores and Spares 12,000

Repairs and Maintenance 15,000

Power 16,000

Insurance 8,000

Depreciation 50,000

Factory Overheads 68,000

Administration Overheads 64,400

Distribution Overheads 75,000

Total Cost 8,11,400


You are given further information –

a. Production and Sales of P1 and P2 were as under -

P1 P2

Production (Pieces) 6,000 4,000

Sale of above pieces (Rs.) 4,80,000 5,20,000

b. Direct wages paid were Rs. 36,000 incase of P1 and Rs. 32,000 for P2. This is used forapportioning Wages and Salaries and Factory Overheads.

c. Following machine hours were utilized in production of these products –

P1 – 550 P2 – 450

d. Stores & Spares, Repairs & Maintenance, Power, Insurance and Depreciation are chargedto cost of both the products on the basis of machine hours used.

e. Administration Ovcrheads are apportioned on the basis of respective conversion costswhile Distribution Overheads on the basis of their sales realizations.

f. All the production was sold out.

Required – Prepare cost sheets of both the products and work out profit earned of each ofthem.

(5) The cost of manufacturing 5,000 units of a commodity comprises Material Rs. 20,000,Wages Rs. 25,000, Chargeable Expenses Rs. 400. Fixed Overheads Rs. 16,000, VariableOverheads Rs. 4,000.

For manufacturing every 1,000 extra units of the commodity, the cost of productionincreases as follows.

1. Materials : Proportionately.

2. Wages : 10% less than proportionately.

3. Chargeable Expenses : No extra cost.

4. Fixed Overheads : Rs. 200 extra.

5. Variable Overheads : 25% less than proportionately.

Calculate the estimated cost of producing 8,000 units of the commodity and show byhow much it would differ if a flat rate of factory overhead were charged.

(6) The following is the profit and loss account of a manufacturing company for the year1987-88 (figures in lakhs).


Rs. Rs.

Materials 48 Sales 96

Wages 36 Closing Stock of

Factory overheads 24 finished goods 18

Gross Profit c/d 12 Work in Progress (at cost)

Materials 3.00

Labour 1.80

Works Expenses 1.20 6

120 120

Administration Expenses 6 Gross Profit b/d 12

Goodwill and Preliminary Interest Received 1

Expenses written at 2

Net Profit 5

13 13

During the year 6000 units were manufactured and 4800 units were sold. The costing recordsshow that works expenses have been charged @ Rs. 300 per article,and administrationexpenses @ Rs. 150 per article. The costing books show a profit of Rs. 12 lakhs.

Prepare cost sheet and show the reconciliation

(7) A firm manufactured and sold 500 units during the year ended on 31st March, 2001. Thesummarised Trading and Profit & Loss Account is as below :


Material Consumed 40,000 Sales 2,00,000

Direct Labour 60,000

Manufacturing Cost 25,000

Gross Profit 75,000

2,00,000 2,00,000

Management Expenses 30,000 Gross Profit 75,000

Rent 5,000


Selling Expenses 15,000

Net Profit 15,000

75,000 75,000


For the year 2001-2002, the estimates are :

a. Output and sales will be 600 units.

b. Material prices will increase by 20% over the previous year.

c. Direct Labour rate will rise by 5%.

d. Manufacturing expenses will increase in proportion to prime cost.

e. There will be no change in selling expenses per unit.

f. Rise in output will not affect other expenses.

Prepare a statement showing the price in such a way that profit will be 20% on selling price.

(8) Following costs were incurred in producing 800 MT of M.S. Rods –

Materials 2,80,000

Labour 1,00,000

Processing Charges 1,00,000

Total Cost 4,80,000

Of the total output, 10% was defective and had to be sold after a discount of 10% off thenormal price. The scrap arising out of the production realized a sum of Rs. 8,760. The saleprice is calculated to yield 15% profit on sales. You are required to find out the normal price aswell as the discounted price of per MT of M.S. Rods.

(9) In a factory, the methods mentioned below are adopted for the allocation of office andselling overheads.

(a) Advertisement and Sales Promotion - On Factory Cost figures.

(b) Credit and Collection Expenses - On Sales figures.

(c) Direct Selling Costs - On Sales figures.

(d) Other items - On Factory Cost figures.

The factory deals with five different types of products viz. B, C, D, E and F. The followinginformation has been collected from its books.


Particulars B C D E F

Rs. Rs. Rs. Rs. Rs.

Direct Materials 24,000 48,000 66,000 33,000 40,500

Direct Wages 27,000 36,000 57,000 24,000 34,500

Sales 1,12,500 1,65,000 2,62,500 1,09,500 1,60,500

Factory overhead charges are 80% of direct wages. Office and sales expenses are :

Rs.

Direct Selling Costs 81,000

Other Items 53,280

Credit and Collection Expenses 8,100

Advertisement and Sales Promotion 79,920

Prepare a statement showing the costs incurred and the profit earned in respect of eachproduct. (Calculations may be made to the nearest rupee).


NOTES

183Material Cost

Chapter 8MATERIAL COST

Material cost is the first and probably the most important element of cost. In case of somespecific types of industries, say cement, sugar, chemicals, iron and steel etc., the materialscost forms a very significant portion of the overall cost of production.

The term material refers to all commodities which are consumed in the production process.The materials which can be consumed in the production process can be basically classifiedas:

(i) Direct Materials

(ii) Indirect Materials

The meaning of both these terms has already been discussed. The basic objective of costaccounting i.e. ascertainment of cost and control of cost is equally applicable to material costas well. The ascertainment of material cost is made from basically two documents i.e. theinvoice of the supplier of material and material requisition slip specifying material issued fromstores department to production department. However, a whole lot of organisational proceduresare also involved in the process, which affect the material cost, either directly or indirectly.E.g. Purchases from improper source of supply may be expensive, non-availability of materialin time may result into hold ups and so on. As such, a proper study of the various proceduresinvolved in case of the movement of materials and a proper control thereon enables anorganisation to exercise the control on a sizeable manufacturing cost.

The movement of material may involve the following stages.

(a) Procurement of materials.

(b) Storing the material till it is required for consumption.

(c) Issue of the material for consumption.

(A) Procurement of Materials : Though the practices may differ from organisation toorganisation, normally, the process of purchasing the materials involves the followingstages.


(1) Purchase Requisition : It is an indication given to the purchases department topurchase certain material. It is issued either by storekeeper (in respect of materialrequired for regular production purposes) or by production department (in respect ofspecial materials required). Following particulars must appear in purchase requisition.

(i) Material to be purchased : It should be clearly specified. To make it morespecific, in addition to the description of the material required, code numbershould also be specified.

(ii) When it is required : Unless the material is required for regular productionpurposes (when the storekeeper himself will place the purchase requisition assoon as it reaches the ordering level), purchase requisition should mentionthe last date by which the material is required. Ideally, the material should bepurchased whenever the market for the same is favourable.

(iii) How much to be purchased : Purchase requisition should state the quantityof the material required. Before deciding the quantity of material to bepurchased, the principle which should be kept in mind is that there should notbe any overstocking or understocking of materials as both these situationsinvolve costs.

Overstocking may have following consequences :

- Blocking of working capital.

- Risk of deterioration of quality and obsolescence.

- More storage facilities.

- Additional Insurance Cost.

- More material handling and upkeeping.

- Risk of breakage/pilferage etc.

Understocking may have following consequences :

- Production hold ups, resulting into disturbed delivery schedules.

- Frantic eleventh hour purchases which may result into unfavourable pricesand quality.

- Payment for idle time to workers.

Before deciding the quantity to be purchased, consideration will have to begiven to the following factors also :

(i) Quantity already ordered.

185Material Cost

(ii) Quantity reserved. There may be the case that a particular quantity, thoughin hand, might have been reserved for a particular job which is not availablefor other purposes. In such cases, this quantity is such, as if it is not instock.

(iii) Funds availability - Amounts which are kept aside for drawing up purchasebudget should be considered.

The purchase requisition should be signed by Head of the Department drawing the same.

A standard form of Purchase Requisition is as shown below :

PURCHASE REQUISITION

To : Purchase Department From : Department

No. :

Date :

Please purchase the material stated below.

Sr. No. Description Code No. Quantity Required Quantity on hand Remarks

Signed by : Storekeeper Approved by

For the use of Purchase Department only

Date P.O. No. Name of Supplier Delivery Date Remarks

Signed : Purchase Manager

(2) Selection of Source of Supply :

For this purpose, the purchase department may call for the quotations from the prospectivesuppliers of a certain type of material. In practice, following types of quotations may becalled for :

(a) Single Tender : It is addressed to only one selected source when there is onlyone source of supply available.


(b) Limited Tender : It is addressed to a limited number of suppliers known to bereliable sources on the basis of data maintained by the purchase department.

(c) Open Tender : It is open to all who can supply specified quality and quantity of therequired material. Tenders are called by giving advertisements in the newspapers,journals etc.

(d) Global Tender : Anybody from any part of the world can respond to these tenders.

To discourage unreliable and unwanted sources from quoting, some tender deposit may beinsisted upon.

Comparative Statements :

After receiving the tenders as stated above, a comparison has to be made among the variousavailable sources so that the best possible source can be selected. All the offers are tabulatedin a comparative statement. The authority which is authorised to accept the tender should bespecified. The criteria for selecting the final source of supply may depend upon the terms ofoffer which can be compared in respect of price offered, quality, other terms (like Sales Tax,Octroi, Freight etc.), terms of delivery, terms of payment, guarantee offered by the supplier,goodwill of the supplier etc. Lowest quotation may not necessarily be the best quotation.

(3) Purchase Order :

The contractual obligation between the supplier and purchaser starts from purchaseorder. It is drawn in favour of the supplier by the purchase department. It may specify anumber of facts.

- Material to be supplied (Description as well as code numbers and quality).

- Quantity to be supplied.

- Price and other terms (e.g. excise duty, sales tax, octroi, insurance, packing andtransportation etc.).

- Cash and trade discount.

- Instructions in respect of delivery.

- Guarantee clause.

- Liquidated damages clause.

- Escalation clause.

- Inspection clause.

- Method of settlement of disputes.

- Details in respect of letters of credit, import licence etc.

- Details in respect of interest payable in the event of late payment of dues.

187Material Cost

Ideally, purchase orders should be serially numbered. Normally, four or five copies ofPurchase Orders are drawn, to be distributed as below :

- One to Supplier.

- One to User Department.

- One to Stores Department.

- One to Accounts/Costing Department.

- One with Purchase Department.

A standard form of Purchase Order is as shown below :

PURCHASE ORDER

No. –

Date –

Requisition No.–

Date –

Please supply the following material on such terms and conditions as stated therein.

Description Code No. Quantity Rate Rs. Value Rs. Delivery Date Remarks

Delivery : Goods to be delivered at –

Extra as applicable –

Excise Duty

Sales Tax

Packing Charges

Insurance

Terms of payment

For ——————(Purchasing Company)

Purchase Manager


(4) Receipt and Inspection : After material is received from the supplier, the quantityreceived actually, is compared with quantity ordered. Variations, if any, are taken up withthe supplier again. Excess material received may be dealt with in any of the followingways :

– Accept all the material received.

– Accept the material ordered and return the excess to the supplier.Before accepting,material may be subjected to inspection. The extent of inspection may vary frommaterial to material.

(5) Checking invoice and accounting for purchases : The supplier’s invoice received forthe supply of material is subjected to scrutiny before a voucher is passed for the samefor making the entry in the books of accounts. For this purpose, the supplier’s invoicemay be compared alongwith the following documents.

(a) Purchase Order.

(b) Goods Received Note.

(c) Inspection Report.

If the quantity and/or rate as per purchase order and invoice match with each other, theinvoice of the supplier is passed for making the entry in the books of accounts. If thequantity and/or rate as per purchase order and invoice differ from each other, the differenceis adjusted by raising a debit or credit note in favour of the supplier.

(B) Storing and Issue of Material : After the material is received, inspected and approved,the process of storing comes into operation which deals with storing the material in goodcondition till it is required for use by production departments and issuing the samewhenever required.

As far as the movement of the material from the stores point of view is concerned, therecan be basically four types of movements.

(1) Receipt of material.

(2) Issue of material

(3) Return of material from Production Department to Stores Department.

(4) Transfer of material.

(1) Receipt of Material :Usually the receipt of material is accompanied by deliverychallan given by the supplier. On receipt of the material, quantity received is checkedwith the quantity ordered by the Stores Department. The received material may beinspected, before acceptance either by separate inspection department or by Stores

189Material Cost

Department itself. A document known as Goods Received Note or Goods ReceivedReport (GRN or GRR) is prepared to record the details of the material received. Theusual form in which GRN or GRR is prepared is as below :

GOODS RECEIVED NOTE

No.

Date

S. No. Description Code Qty. Recd. Qty. Accepted Qty. Rejected Remarks

Prepared by Received by Inspected by Store Keeper

It may be prepared in quadruplicate to be distributed as follows.

– One copy to Purchases Department for comparing with purchases order and approvingthe invoice of the supplier.

– One copy to Accounts Department for making the payment of supplier’s invoice.

– One copy to Costing Department for pricing and entering in stores record.

– One copy to be retained by Stores Department.

Ideally, GRN/GRR should be serially numbered in order to locate the material which is physicallyreceived but for which invoice is not received.

Discrepancies in material receipts :

The material physically received when compared with material ordered as per the purchaseorder may reveal certain discrepancies which may take any of the following forms.

(1) Quantity received in excess.

(2) Quantity received in short.

(3) Quantity received of different quality.

Excess quantity received may be retained and accepted, if required, with the approval of thepurchase department. Alternatively, if it is not accepted, it may be returned to the supplier withGoods Returned Note. The usual form in which Goods Returned Note is prepared is as below:


GOODS RETURNED NOTE

To : No.

Date :

Following material supplied by you vide your D.C. No.____________ and InvoiceNo.____________against our Purchase Order No. ______________is being returned toyou for the reasons stated below:

Description Quantity Reasons

Signature

Usually, three copies of Goods Returned Note are prepared to be distributed as below :

- One copy to the Supplier.

- One copy to the Purchase Department.

- One copy to be retained by the Stores Department.

Excess Quantity Accepted : If excess quantity is already billed in the invoice, it will beapproved and paid. If not, either the supplier may be asked to give a supplementary invoice orcredit note may be issued to the supplier for amending the amount.

Excess Quantity Returned : If excess quantity is already billed in the invoice, debit note maybe issued to the supplier for amending the amount.

In case the quantity received is short, purchase department may take up the case with thesupplier or carrier or insurer as per the terms of purchases. If quantity short supplied is billedin the invoice, invoice is suitably amended and debit note is issued to the supplier.

If quantity received is of different quality and is rejected in inspection, it can either be retainedor returned. It may be retained by accepting some mutually decided concessional price. Thevariation in prices may be adjusted by issuing either the credit note or debit note in favour ofthe supplier.

(2) Issue of Material : Here, the issue of material refers to issue of material from storesdepartment to production department. The material should not be issued from the storesunless a proper authority in writing is produced before the stores department. Usually,this authority is in the form of Material Requisition Note or Material Requisition Slip.

191Material Cost

The normal contents of this note/slip are :

– Number and date (Ideally, they should be serially numbered).

– Department demanding the material.

– Description and code of material demanded.

– Quantity of material demanded.

– Signature of authority approving the demand.

– Signature of the person receiving the material.

Normally one note/slip is prepared for requisitioning a single item of material.

The usual form in which it is prepared is as below :

MATERIAL REQUISITION NOTE

Production/Job Order No. No.

Bill of Materials No. Date :

Department :

Description Code Qty. Unit Cost (for costing Dept. only)Rate per unit Amount Rs.

Authorised Issued Received Entered and Valuedby by by by

Normally, it is prepared in three copies.Two copies to Stores Department which in its turnpasses one copy to Costing Department for pricing while second copy is retained by theStores Department. One copy is for demanding department.

(3) Return of material :

There can be some situations, when material once issued to production departments isreturned back to the stores. It can happen in the following circumstances.

(a) Material issued in excess of requirement.

(b) Scrap or defective work arising out of the production processes.

Under these circumstances, a document in the form of Materials Returned Note is prepared,which is to record return of unused materials. The usual form in which this document isprepared is as below :


MATERIALS RETURNED NOTE

Production/Job Order No. No.

Bill of Materials No. Date :

Department :

Description Code Qty. Unit Cost (for costing Dept. only)Rate per unit Amount Rs.

Authorised Received Postedby by by

As far as the valuation of the returned material is concerned, it may be treated as the freshreceipt of the material or alternatively, it may be treated as the negative(minus) issues.

(4) Transfer of Materials :In some situations, considering the urgency for the requirementof the material, it may be necessary to transfer the material from one production/joborder to another. Such transfer of material is usually accompanied by preparing a documentin the form of Material Transfer Note. The usual form in which this document is preparedis as below :

MATERIAL TRANSFER NOTE

No.

Date :

From…………Dept. To…………..Dept.

Production/Job Production/Job

Order No. Order No.

Description Code No. Qty. Cost (for costing Dept. only)Rate per unit Amount Rs.

Authorised Received Enteredby by by

193Material Cost

Transfer of materials does not result into any fresh issue of material. However, material transfernotes will have to be valued and considered in order to compute the material cost as per thejob orders and production orders.

PROPER CONDUCT OF STORAGE FUNCTION

As discussed earlier, proper conduct of storage function requires that material should beproperly stored in good condition till it is required for use by production departments andshould be issued whenever required. This proper conduct is ensured by what is known as“Perpetual Inventory System”. The aims of the perpetual inventory system are two fold.

(1) Recording receipts and issues in such a way so as to know at any time, the stock inhand, in quantity and/or value, without the need of physical counting. This aim is achievedby maintaining what is called as Bin Card and Stores Ledger.

(2) Continuous verification of physical stock at regular intervals.

Bin Card

It is only a quantitative record of receipts, issues and closing balance of an item of material.Separate bin card is maintained for each item of material. The usual form in which a bin cardis maintained is as below.

BIN CARD

Description Maximum level

Code No. Minimum level

Location/Unit Recorder level

Date Document No. Receipt Issue Balance Remarks

Entries in receipts column are made on the basis of Goods Received Note or Material ReturnedNote. Entries in issues column are made on the basis of Material Requisition Note. After everyentry of either receipts or issues, the balance quantity is calculated and recorded so that thebalance can be known at any point of time. The levels indicated on bin card enable the storesdepartment to keep a watch on balance and replace the material as soon as it reaches thereorder level.


Ideally, bin card should be placed alongwith the material. But it may not be possible in all thecases, then bin cards are placed at a centrally located place but within stores departmentonly.

Stores Ledger

Like Bin Card, it is maintained to record all receipts and issue transactions of material but withthe exception that it records not only the quantities received or issued or in stock but also thefinancial expressions of the same. The usual form in which the stores ledger is maintained isas following :

STORES LEDGER

Description Maximum level

Code No. Minimum level

Location/Unit Recorder level

Date Document No. Receipts Issues Balance Remark

Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.

By summing up the amounts appearing in the ‘issues’ column of stores ledger, one can getthe cost of material issued to Production Department which forms the ‘Material Cost’.

As in case of bin card, separate store ledger sheets are maintained in case of each item ofmaterial. The stores ledger sheets are maintained either in loose form or in bound book form.

Bin Card Vs. Stores Ledger :

If the stores ledger is having all the information mentioned in a bin card plus some additionalinformation is also available, the next question which arises is why is it necessary to maintainboth bin card and stores ledger simultaneously as it will be only duplication of work. In thesituations of computerized inventory accounting system, maintenance of bin card and sotresledger simultaneously can be avoided. However, in the situations of manual inventory accountingsystem, it will be ideal to maintain bin card and stores ledger simultaneously due to thefollowing reasons.

(1) Bin card is maintained by stores department while stores ledger is maintained by costingdepartment.

195Material Cost

(2) Bin card is not an accounting record but only a quantity record and as such is notconcerned with the financial implications of stores transactions.

(3) Maintenance of stores ledger provides a second check on maintenance of bin cards.

Reconciliation of Bin Card and Stores Ledger :

As the source documents for the entries in Bin Card and Stores Ledger are the same, theclosing balances disclosed by both of them should match with each other. But in practice,they may not match due to the following reasons.

(1) Arithmetical error in calculating balance.

(2) Non-posting of certain document in either of these documents.

(3) Posting on wrong bin card or stores ledger sheet.

(4) Treating receipts transaction as issue transaction or vice versa.

If the closing balance as per bin card and stores ledger is not matching, the very purpose ofmaintaining these two documents simultaneously will be defeated. As such, it is necessaryto reconcile both balances at regular intervals by keeping all the postings upto date. If thebalances as on a particular day are not matching, all the previous transactions should bechecked to locate differences.

Valuation of Material Movements :

As discussed above, the stores ledger considers not only the movement of material in termsof quantity but also in terms of its financial implications. As such, it is necessary that all thepossible movements of material are valued properly and are expressed in terms of money. Wewill consider this problem under the following heads.

(a) Valuation of receipts.

(b) Valuation of issues.

(c) Valuation of returns from production department to stores department.

(a) Valuation of receipts :

Valuation of receipts is relatively an easy task, as the invoice or bill received from thesupplier of the material is available as a starting point. Following propositions should beconsidered for this purpose.

(1) The price as billed by the supplier will be the valuation of the receipts. The tradediscount is deducted from the basic price and all other amounts as billed by thesupplier are added viz. Excise Duty, Sales Tax, Octroi Duty, Transport/Insurancecharges etc. There are different opinions in respect of the treatment of cash discount.One opinion says that cash discount should be ignored being purely of financialnature while valuing the receipts, while another opinion says that it should beconsidered while valuing the receipt of the material.


(2) In some cases, more than one item of material are included in one single bill andsome costs are jointly incurred for all the items of material. Such joint costs maybe distributed on the basis of basic price of the material.

(3) In case of the imported material, the cost of the material consists of basic price(which may be stated in foreign currency and should be converted in Indian Rupees),Customs Duty, Clearing Charges, Transport Charges, Octroi Duty etc. In somecases, the point of receipt of imported material and the point of making the paymentof invoice amount may be different. As such, rate of foreign currency may be differentat the time of payment of customs duty and at the time of payment of invoiceamount. In such cases, the rate of exchange existing at the time of making thepayment of invoice amount should be considered for valuing basic cost of materialimported.

Illustration :

The particulars relating to 1,200 kgs. of a certain raw material purchased by a company duringJune, were as below.

(a) Lot prices quoted by suppliers and accepted by the company for placing the purchaseorder.

Lot upto 1000 kgs. @ Rs. 22 per kg. For

Between 1000 - 1500 kgs. @ Rs. 20 per kg. Supplies

Between 1500 - 2000 kgs @ Rs. 18 per kg. to Factory

(b) Trade Discount 20%.

(c) Additional charge for containers @ Rs. 10 per drum of 25 kgs.

(d) Credit allowed on return of containers @ Rs. 8 per drum.

(e) Sales Tax at 10% on raw material and 5% on drums.

(f) Total freight paid by the purchaser Rs. 240,

(g) Insurance at 2.5% (on net invoice value) paid by the purchaser.

(h) Stores Overheads applied at 5% on total purchase cost of material.

The entire quantity was received and issued to production :

The containers are returned .in due course. Draw up a suitable statement to show :

(a) Total cost of material purchased.

(b) Unit cost of material issued to production.

}

197Material Cost

Solution :

(a) Statement showing cost of purchases

Basic Cost Rs. Rs.

1,200 kgs x Rs. 20/kg. 24,000

Less : Trade Discount @ 20% 4,800

19,200.00

Container Cost :

48 Drums x Rs. 10 /Drum 480.00

19,680.00

Sales Tax :

10% on Rs. 19,200 1,920.00

5% on Rs. 480 24.00

1,944.00

21,624.00

Other charges

Insurance 2.5% on Rs. 21,624.00 540.60

Freight 240.00

22,404.60

Less : Credit for drums returned

Rs. 8 per Drum x 48 Drums 384.00

TOTAL COST 22,020.60

Add : Stores Overheads 5% 1,101.03

23,121,63

(b) Unit cost for valuation of issues

Rs. 23,121.63.= Rs. 19.268/kg.

1,200 kgs.

Illustration :

The particulars related to the import of Sealing Ring made by AB & Co. during December 85are given below.

(a) Sealing Ring 1,000 pieces invoiced @ £ 2 CIF, Bombay Port.

(b) Customs Duty was paid @ 100% on invoice value (which was converted to Indian Currencyby adopting an Exchange Rate of Rs. 17.20 per £)


(c) Clearing charges : Rs. 1,800 for the entire consignment

(d) Freight charges : Rs. 1,400 for transporting the consignments from Bombay Port toFactory premises.

It was found on inspection that 100 pieces of the above material were broken and thereforerejected. There is no scrap value for the rejected part. No refund of the broken material wouldbe admissible as per the terms of contract. The management decided to treat 60 pieces asnormal loss and the rest 40 pieces as abnormal loss. The entire quantity of 900 pieces wasissued to production.

Calculate :

(a) Total cost of material.

(b) Unit cost of material issued to production.

Also state briefly how the value of 100 pieces rejected in inspection will be treated in costs.

Solution :

Total Cost of Material

(1) Invoice Price Rs.

UK £ - 1,000 pieces x £2 = £ 2,000

- £ 2,000 x Rs. 17.2 per UK £ 34,400

(2) Customs Duty @ 100% 34,400

(3) Clearing Charges 1,800

(4) Freight charges 1,400

Total Cost 72,000

As loss of 40 pieces is considered as abnormal loss, it will be transferred to Costing Profit andLoss Account.

Rs. 72,000∴ Abnormal Loss = X 40 pieces

1,000 pieces

= Rs. 2,880

Balance of the cost (i.e. Rs. 72,000 - Rs. 2,880 = Rs. 69,120)Includes cost of units treated asnormal loss i.e. 60 pieces.

This cost will be borne by good pieces.

199Material Cost

Rs. 69,120∴ Unit cost of good pieces =

900 pieces

= Rs. 76.80(b) Valuation of Issues :

This is a more complex process than the valuation of the receipts. It is because of thereason that the material may be issued out of the various lots which might have beenpurchased at various prices. As such, a problem may arise as to which of the receiptprices should be used to value the material requisition notes. Various methods may beused for this purpose, main methods of which may be discussed as below.

(a) First In First Out (FIFO)Under this method, the price of the earliest available lot isconsidered first and if that lot is exhausted, the price of the next available lot isconsidered. It should be remembered that the physical issue of the material maynot be made out of the said lots, though it is presumed that it is made out of theselots as stated above.

Illustration :

Following transactions have taken place in respect of a material during March 1990.

Date :

1 Opening Balance 500 units @ Rs. 6 per unit.

5 Purchased 100 units @ Rs. 7 per unit.

7 Issued 400 units.


19 Issued 250 units.

22 Issued 50 units.

25 Purchased 300 units @ Rs. 7.50 per unit.


Prepare the Stores Ledger assuming that the issues are valued on FIFO basis.


Stores Ledger

Description/Code No. Maximum level

Unit Minimum level

Location Re-order level

Date Particulars RECEIPTS ISSUES BALANCE

Qty. Rate Rs. Qty. Rate Rs. Qty. Rate Rs.Rs. Rs. Rs.

1 Op. Bal. 500 6 3,000

5 GRN No. 100 7 700 500 6

100 7 3,700

7 MRN No. 400 6 2,400 100 6 1300

100 7

9 GRN No. 300 8 2,400 100 6

100 7 3700

300 8

100 6

19 MRN No. 100 7 1700 250 8 2,000

50 8

22 MRN No. 50 8 400 200 8 1,600

25 GRN No. 300 7.5 2,250 200 8

300 7.5 3850

30 MRN No. 200 8

50 7.5 1975 250 7.5 1,875

Value of closing stock is Rs. 1,875 which considers latest available market price of the material.

The advantages of this method are as below :

(a) It is simple to operate.

(b) It considers the valuation of closing stock at the current market prices.

(c) It can be conveniently applied if transactions are not too many and the prices of thematerial are fairly steady.

}}}

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201Material Cost

The objections raised against this method are as below :

(a) Calculations become complicated if the lots are received frequently and at varying prices.

(b) Costs may be wrongly presented if the price of different lots of material are used forpricing issues to various batches of production.

(c) In case of varying prices, the pricing of issues does not consider current market prices.

(b) Last In First Out (LIFO) :

Under this method, the price of the latest available lot is considered first and if that lot isexhausted, the price of the lot prior to that is considered. Here also, it should beremembered, that the physical issue of the material may not be made out of the saidlots, though it is presumed that it is made out of the lots as stated above.

Illustration :


Date:

1 Opening Balance 500 units @ Rs. 6 per unit.


7 Issued 400 units.



22 Issued 50 units.



Prepare the stores ledger assuming that the issues are valued on LIFO basis.


Stores Ledger


Unit Minimum level




1 Op. Bal. 500 6 3,000

5 GRN No. 100 7 700 500 6 3,700

100 7

7 MRN No. 100 7 2,500 200 6 1,200

300 6

9 GRN No. 300 8 2,400 200 6 3,600

300 8

19 MRN No. 250 8 2,000 200 6 1,600

50 8

22 MRN No. 50 8 400 200 6 1,200

25 GRN No. 300 7.5 2,250 200 6 3,450

300 7.5

30 MRN No. 250 7.5 1,875 200 6 1,575

50 7.5

Value of closing stock is Rs. 1,575 which consists of 200 units valued at Rs. 6 per unit whichhappens to be the earliest available price of the material i.e. price of the opening balanceavailable.

The advantages of this method are as below :

(a) It is simple to operate.

(b) The cost of materials issued considers fairly recent and current prices. The prices quotedon this cost fairly represent its real cost.

(c) It can be conveniently applied if transactions are not too many and prices of the materialare fairly steady.

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203Material Cost

The objections raised against this method are as below :

(a) Calculations become complicated if the lots are received frequently and at varying prices.

(b) Costs may be wrongly presented if the price of different lots of material are used forpricing issues to various batches of production.

(c) In case of falling prices in the market, this method may give wrong results.

(C) Average Price Method :

Both the above methods i.e. FIFO and LIFO, consider the exact or actual cost for valuingthe issue of material. However these methods may prove to be disadvantageous if thetransactions are too many and are at varying prices. In such cases, instead of consideringthe exact or actual cost, average cost may be considered to lessen the effect of variationin prices, either upward or downward.

E.g. Assume a situation as below :

Mar. 1 - Received - 1500 units @ Rs. 10 - Rs. 15,000

Mar. 15 - Received - 1600 units @ Rs. 30 - Rs. 48,000

On March 20, 1800 units were issued to production.

If FIFO method is followed to price the issues, the issues will be valued as below.

1500 units @ Rs. 10 per unit Rs. 15,000


Rs. 24,000

The issues will be considerably under-valued and closing stock will be considerably overvalued, as compared to the current market prices.

If LIFO method is followed to price the issues, the issues will be valued as below.

1600 unite @ Rs. 30 per unit Rs. 48,000


Rs. 50,000

The closing stock will be considerably under valued as compared to the current prices.

To lessen the effect of such drastic price variation, both on the valuation of issues as wellas of closing stock, instead of considering the actual/exact price of Rs. 10 per unit orRs. 30 per unit, average price may be taken into consideration.

There are mainly two ways in which average prices may be considered.


(1) Simple Average Method :Under this method, the simple average of the prices of thelots available for making the issues is considered for pricing the issues. After the receiptof new lot, a new average price is worked out. It should be remembered in this connectionthat, for deciding the possible lots out of which the issues could have been made, themethod of First In First Out is followed.

Illustration :


Date :

1 Opening Balance 500 units @ Rs. 6 per unit


7 Issued 400 units.



22 Issued 50 units.



Prepare the stores ledger assuming that the issues are valued on Simple Average basis.

Stores Ledger


Unit Minimum level




1 Op. Bal. 500 6 3,000

5 GRN No. 100 7 700 600 3,700

7 MRN No. 400 6.5 2,600 200 1,100

9 GRN No. 300 8 2,400 500 3,500

19 MRN No. 250 7 1,750 250 1,750

22 MRN No. 50 7 350 200 1,400

25 GRN No. 300 7.5 2,250 500 3,650

30 MRN No. 250 7.30 1,825 250 1,825

205Material Cost

This method is suitable if the material is received in uniform quantity.If the material quantity ofeach lot varies widely, this method may lead to wrong results.

(2) Weighted Average Method :As stated above, the simple average method of valuationof issues may lead to wrong results, if the quantity of each lot of material received varieswidely. Eg. Assume the following situation.

Mar. 1 Received 100 units @ Rs. 10 Rs. 1,000

Mar. 10 Received 5,000 units @ Rs. 30 Rs. 1,50,000

Rs. 1,51.000

On March 20, 4800 units were issued to production. As both the lots are possible lots formaking the issue, the average of prices of both the lots will be taken into account ifsimple average method is considered. Hence, per unit issue price will be -

Rs. 10 + Rs. 302

i.e. Rs. 20

As such, the issue quantity will be priced at : 4,800 units x Rs.20 i.e. Rs. 96,000, whichwill be incorrect, as considering the quantity of issue, the price of the material receivedon March 10 should get more weightage.

To overcome this drawback of simple average method, weighted average method may beused which considers not only the price of each lot but also the quantity of the same.

Though this method involves considerable amount of clerical work, in practice, this methodproves to be very useful in the event of varying prices and quantities. In practice, thecalculation of weighted average rate proves to be very simple. The products of quantityand price divided by the total quantity of all lots, just before the issue, gives the unit pricein respect of the subsequent issues.

Illustration :


Date :

1 Opening Balance 500 units @ Rs. 6 per unit


7 Issued 400 units.



22 Issued 50 units.




Prepare the Store Ledger assuming that the issues are valued on Weighted Average Basis.

Stores Ledger


Unit Minimum level




1 Op. Bal. 500 6.00 3,000

5 GRN No. 100 7 700 600 6.16 3,700

7 MRN No. 400 6.16 2,467 200 6.16 1,233

9 GRN No. 300 8 2,400 500 7.27 3,633

19 MRN No. 250 7.27 1,817 250 7.27 1,816

22 MRN No. 50 7.27 363 200 7.27 1,453

25 GRN No. 300 7.5 2,250 500 7.41 3,703

30 MRN No. 250 7.41 1,851 250 7.41 1,852

(d) Highest In First Out :This method assumes that the stock should always be shown atthe minimum value and hence the issues should always be valued at the highest value ofreceipts. E.g. Assume a situation as follows.

Mar. 1 Purchased 100 units @ Rs. 12



On March 20, 120 units are issued to production and they will be valued at Rs. 18 perunit being the highest price. This method is not very popular. It always overvalues theissues and undervalues the closing stock. This method may be useful in case of theorganisations dealing with monopoly products which is a rare possibility.

207Material Cost

(e) Market Price : Under this method, market price is considered to be the base for pricingthe issues. In this case, market price may be treated as latest purchase price, realisableprice or replacement price. This method is used mainly in respect of obsolete stockitems or non-moving stock items.

The defect in respect of this method is that the price concessions obtained in respect ofbulk purchases are not reflected in cost of material.

(f) Specific Price :

If the material is purchased against a specific job or production order, the issue of materialis priced at actual purchase price.

This method can be adopted if purchase prices are fairly stable.

(g) Standard Price :

This is the normal or ideal price which will be paid in the normal circumstances, basedon the basis of estimated market conditions, transportation costs and normal quantity ofpurchases. Any issue of material will be priced at standard prices irrespective of actualprices. This enables the simplification of accounting system with reduced clerical workand also enables to decide the efficiency of purchase department,

(c) Valuation of Returns :

This indicates the material returned by production departments to stores department

The way in which returned material may be valued can be as below :

(a) At the same price at which issued :

The original price of issue will be a base for valuing the returns for which originalmaterial requisition note will be the base.

(b) At the current price of issues :

The method which is followed for valuing the issue on the same date is consideredfor valuing the returns.

This will avoid the clerical efforts, but at the same time the track of original issue ofmaterial can’t be maintained.

Treatment of shortages :

In some cases, the physical verification of stock may reveal that the physical stock is lessthan the stock as per stores ledger. For proper accounting, the shortage has to be treated asan issue so that the book stock can be brought down to the level of physical stock. The


valuation of this shortage is done as if it is an issue of material. The treatment given to thevaluation of shortages in Cost Accounts depends upon the nature of the shortage i.e. NormalShortage or Abnormal Shortage.

Inventory Control :

The object of inventory control is to reduce the investment in inventory without affecting theefficiency in the area of production and sales. It should be remembered that the object is notonly to reduce the investment in inventory. If that would have been the object, no organisationwould have maintained inventory of any kind, thereby making the investment in inventory asNil. However, that is not the ultimate object as it is likely to affect the production and salesfunction adversely. E.g. If sufficient stock of raw material is not available, the productionactivity is likely to be interrupted. If sufficient stock of finished goods is not available, it maynot be possible for the organisation to serve the customers properly and they may shift to thecompetitors. The object of inventory control is to avoid the situation of over investment as wellas under investment. The level of inventories should be maintained at the optimum level.

Techniques of Inventory control

(1) Economic Order Quantity :

It indicates that quantity which is fixed in such a way that the total variable cost ofmanaging the inventory can be minimised. Such cost basically consists of two parts.First, Ordering Cost (which in turn consists the costs associated with the administrativeefforts connected with preparation of purchase requisitions, purchase enquiries,comparative statements and handling of more number of bills and receipts) Second,Carrying Cost i.e. the cost of carrying or holding the inventory (which in turn consists ofthe cost like godown rent, handling and upkeep expenses, insurance, opportunity costof capital blocked i.e. interest etc.) There is a reverse relationship between these twotypes of costs i.e. If the purchase quantity increases, ordering cost may get reduced butthe carrying cost increases and vice versa. A balance is to be struck between these twofactors and it is possible at Economic Order Quantity where the total variable cost ofmanaging the inventory is minimum.

It is possible to fix the Economic Order Quantity with the help of mathematical formula.The following assumptions may be made for this purpose.

Let Q be Economic Order Quantity.

A be Annual Requirement of material in units.

O be cost of placing an order (which is assumed to remain constant irrespective ofsize of order.)

C be cost of carrying one unit per year.

209Material Cost

Now, if A is the annual requirement and Q is the size of one order, the total number oforders will be A/Q and the total ordering cost will be - A/Q x O

Similarly, if the size of one order is Q and if it is assumed that the inventory is reduced ata constant rate from order quantity to zero when it is repurchased, the average inventorywill be Q/2 and the cost of carrying one unit per year being C, the total carrying cost willbe Q/2 X C.

Thus, Total Cost = Ordering Cost + Carrying Cost

A Q= X O + X C

Q 2

The intention is that the value of Q should be such that the total cost should be minimum.Hence, taking the first derivative of the equation with respect to Q and setting the resultto zero,

do 1 C= AO ( – ) + = O OR

dq Q2 2

Q = 2 x A X O Where

C

Q = Economic Order Quantity

A = Annual Requirement in Units

O = Cost of Placing an Order

C = Cost of Carrying One Unit Per Year

Illustration :

A manufacturer uses 200 units of a component every month and he buys them entirely fromoutside supplier. The order placing and receiving cost is Rs. 100 and annual carrying cost isRs. 12. From this set of data, calculate Economic Order Quantity.

Solution :

EOQ = 2 x A x OC

= 2 x 2400 x 100

12

= 200 units

√

√√


In some cases, the carrying cost may be expressed as an annual percentage of the unit costof purchases, in which case, the calculation of Economic Order Quantity takes the followingform.

EOQ = 2 x A x O where

C x i

A = Annual Requirement in units

O = Cost of placing an order

C = Unit purchase price

i = Carrying cost expressed as a percentage of unit purchase price.

Illustration :

From the Following data, work out the EOQ of a particular component.

Annual Demand : 5000 Units

Ordering Cost : Rs. 60 per Order

Price per Unit : Rs. 100

Inventory carrying Cost : 15% on average inventory,

Solution :

EOQ = 2 x 5000 x 60

15% of 100

= 200 units

The total cost of managing inventory will be

Ordering Cost - 5000X 60 i.e. 25 X 60 Rs. 1,500

200

Carrying Cost -200

X 15% of 100 Rs. 1,5002

(Based on average inventory) Rs. 3,000

Now, the next question is whether the purchases in Economic Order Quantity really reducethe total cost of managing inventory to the minimum, We can verify this, by trial and errormethod, by considering the above results.

√

√

211Material Cost

Order No. of Ordering Carrying TotalQuantity Orders Cost Cost Cost

A/Q A/Q x O Q/2 x CiRs. Rs. Rs.

50 100 6,000 375 6,375

100 50 3,000 750 3,750

200 25 1,500 1,500 3,000250 20 1,200 1,875 3,075

1,000 5 300 7,500 7,800

1,250 4 240 9,375 9,615

2,500 2 120 18,750 18,870

It can be observed from the above, that the order size of 200 units proves to be the mosteconomic one in terms of minimum total cost. If the purchases are made in any other way, thesame may not necessarily result into minimum total cost.

Illustration :

Kapil Motors purchase 9,000 motor spare parts for its annual requirements, ordering one-month usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15and the carrying charges are 15% of the average inventory per year. You have been asked tosuggest a more economical purchasing policy for the company. What advice would you offerand how much would it save the company per year.

Solution :

Present Policy :

Number of Orders =Annual Requirement

Order size

= 9000= 12

750

Ordering Cost = 12 X 15 = 180 ...(1)

Carrying Cost =Order Size

X Cost Price X Carrying cost in %2

= 750X 15% of Rs. 20

2

= 375 X 3 = 1,125 ...(2)

Total Cost i.e. 1 + 2 = 180 + 1125 = 1305 ...(3)


Proposed Policy :

To purchase in Economic Order Quantity

EOQ =2 x A x O

C x i

=2 x 9000 x 15

15% of 20 = 300 units

Now, the revised total cost will be

Number of Orders = 9000 = 30300

Ordering Cost = 30 x 15 = 450 ...(4)

Carrying Cost =300 X 15% of 20 ...(5) 2

= 150 X 3 = 450

Total Cost i.e. 4 + 5 = 450 + 450 = 900 ...(6)

Thus, purchases in Economic Order Quantity will result into the yearly saving of Rs. 405 (i.e.Rs. 1305 - Rs. 900)

(2) Fixation of Inventory Levels :

Fixation of various inventory levels facilitates initiating of proper action in respect of themovement of various materials in time so that the various materials may be controlled ina proper way. However, the following propositions should be remembered.

(i) Only the fixation of inventory levels does not facilitate the inventory control. Therehas to be a constant watch on the actual stock level of various kinds of materials sothat proper action can be taken in time.

(ii) The various levels fixed are not fixed on a permanent basis and are subject torevision regularly.

The various levels which can be fixed are as below.

(1) Maximum Level :

It indicates the level above which the actual stock should not exceed. If it exceeds, itmay involve unnecessary blocking of funds in inventory. While fixing this level, followingfactors are considered.

√√

213Material Cost

(i) Maximum usage.

(ii) Lead time.

(iii) Storage facilities available, cost of storage and insurance etc.

(iv) Prices for the material.

(v) Availability of funds.

(vi) Nature of material e.g. If a certain type of material is subject to Government regulationsin respect of import of goods etc., maximum level may be fixed at a higher level.

(vii) Economic Order Quantity.

(2) Minimum Level :

It indicates the level below which the actual stock should not reduce. If it reduces, it mayinvolve the risk of non-availability of material whenever it is required. While fixing thislevel, following factors are considered.

(i) Lead time.

(ii) Rate of consumption.

(3) Re-order Level:

It indicates that level of material stock at which it is necessarily to take the steps forprocurement of further lots of material. This is the level falling in between the two extremesof maximum level and minimum level and is fixed in such a way that the requirements ofproduction are met properly till the new lot of material is received.

(4) Danger Level :

This is the level fixed below minimum level. If the stock reaches this level, it indicates theneed to take urgent action in respect of getting the supply. At this stage, the companymay not be able to make the purchases in a systematic manner but may have to makerush purchases which may involve higher purchases cost.

Calculation of various Levels :

The various levels can be decided by using the following mathematical expressions.

(1) Re-order Level : Maximum Lead Time x Maximum Usage.

(2) Maximum Level : Reorder Level + Reorder Quantity - (Minimum Usage X MinimumLead Time).


(3) Minimum Level : Reorder Level - (Normal Usage x Normal Lead Time.)

(4) Average Level : Maximum Level + Minimum Level.

(5) Danger Level : Normal Usage x Leadtime for emergency purchases.

Note : It should be noted that the expression of the Reorder Quantity in the calculation ofMaximum Level indicates Economic Order Quantity.

Illustration :

Two components X and Y are used as follows.

Normal usage – 50 units per week each.

Minimum usage – 20 units per week each.

Maximum usage – 75 units per week each.

Reorder quantity – X - 400 units

Y - 600 units

Recorder period – X - 4 to 6 weeks

Y-2 to 4 weeks

Calculate for each component :

a. Reorder level

b. Minimum level

c. Maximum level

d. Average stock level.

Solution :

(1) Reorder Level :

Maximum Lead time x Maximum Usage

X = 6 weeks x 75 units = 450 units

Y = 4 weeks x 75 units = 300 units.

(2) Minimum Level :

Reorder Level – (Normal Usage x Normal Leadtime)

X = 450 units – (50 units X 5 weeks) = 200 units.

Y = 300 units – (50 units x 3 weeks) = 150 units

215Material Cost

(3) Maximum Level :

Reorder Level + Reorder Quantity - (Minimum Usage x Minimum Leadtime)

X = 450 units + 400 units - (25 units x 4 weeks) = 750 units.

Y = 300 units + 600 units - (25 units x 2 weeks) = 850 units.

(4) Average Stock Level :

Minimum Level + Maximum Level2

200 units + 750 unitsX = = 475 units

2

150 units + 850 unitsY = = 500 units

2

As stated above, the expression of the Reorder Quantity in the calculation of Maximum levelindicates Economic Order Quantity. Hence, in some cases, it may be necessary to decidethe Economic Order Quantity before fixing the inventory levels.

Illustration :

Shriram Enterprises manufactures a special product ‘ZED’

The following particulars are collected for the year 1986.

(a) Monthly demand of ZED - 1000 units.

(b) Cost of placing an Order - Rs. 100.

(c) Annual carrying cost per unit - Rs. 15.

(d) Normal Usage 50 units per week.

(e) Minimum Usage 25 units per week.

(f) Maximum Usage 75 units per week.

(g) Re-order period 4 to 6 weeks.

Compute from the above:

(1) Re-order Quantity.

(2) Re-order Level.

(3) Minimum Level.

(4) Maximum Level.

(5) Average Stock Level.


Solution :

(1) Reorder Quantity :

2 x A x O whereC

A = Annual Requirement

O = Ordering cost per cost

C = Carrying cost per unit per year

∴ EOQ = 2 x 12000 x 10015

= 400 units

(2) Reorder Level :

Maximum Lead Time x Maximum Usage.

∴ 6 weeks X 75 units = 450 units

(3) Minimum Level :

Reorder Level - (Normal Usage x Normal Lead Time)

∴ 450 units - (50 units X 5 weeks) = 200 units

(4) Maximum Level :

Reorder Level + Reorder Quantity – (Minimum Usage X Minimum Leadtime)

∴ 450 units + 400 units - ( 25 units X 4 Weeks) = 750 units.


Minimum Level + Minimum Level

2

∴ 200 units + 750 units= 475 units

2

There may be one more way in which the various inventory levels may be fixed and for thisdetermination of the safety stock (also called as minimum stock or buffer stock) is essential.Safety stock is that level of stock below which the actual should not be allowed to fall. Thesafety stock may be calculated as -

√

√

217Material Cost

(Maximum Usage X Maximum Leadtime) less

(Normal Usage X Normal Leadtime)

According to this method, the various inventory levels as discussed above may be fixed asbelow.

(1) Minimum Level :

It is equal to safety stock.

(2) Maximum Level :

It can be calculated as - Safety Stock + EOQ.

(3) Reorder Level :

It can be calculated as :

Safety Stock + (Normal Usage x Normal Leadtime)


It can be calculated as -

Minimum Level + Maximum Level2

= Safety Stock + Safety stock + EOQ2

= Safety Stock + EOQ2

Illustration :

You have been asked to calculate the following levels for Part No. 007 from the informationgiven thereunder:

(a) Re-ordering level, (b) Maximum level

(c) Minimum level, (d) Danger level,

(e) Average level.

The ordering quantity is to be calculated from the following data :

(i) Total cost of purchasing relating to the order Rs. 20.

(ii) Number of units to be purchased during the year 5,000

(iii) Purchase price per unit including transportation costs Rs. 50.


(iv) Annual cost of storage of one unit Rs. 5.

Lead Times : Average ... 10 days

Maximum .. 15 days

Minimum .. 6 days

Maximum for emergency purchases ... 4 days

Rate of consumption:-

Average .. 15 units per day

Maximum .. 20 units per day

Solution :

Working Notes :

(a) Calculation of Safety Stock :

(Maximum Usage x Maximum Leadtime) - (Normal Usage x Normal Leadtime)

= (20 units x 15 days) - (15 days x 10 days)

= 300 units - 150 units

= 150 units.

(b) Calculation of EOQ :

2 x A x O where

C

A = Annual requirement

O = Ordering cost per order

C = Carrying cost per unit per year.

Hence,

EOQ = 2 X 500 X 205

= 200 units.

(1) Reordering Level :



= 150 units + (15 units X 10 days)

= 150 units + 150 units = 300 units.

√

√

219Material Cost

(2) Maximum Level :


Safety Stock + EOQ

= 150 units + 200 units = 350 units.

(3) Minimum Level :

It is equal to Safety Stock

= 150 units.

(4) Danger Level :

Normal Usage X Leadtime for emergency purchases

= 15 units X 4 days = 60 units.


It can be calculated as

EOQSafety Stock +

2

200= 150 units + units = 250 units

2

(3) Inventory Turnover :

Inventory turnover indicates the ratio of materials consumed to the average inventoryheld. It is calculated as below :

Value of material consumed

Average inventory heldwhere

Value of material consumed can be calculated as :

Opening Stock + Purchases - Closing Stock.

Average inventory held can be calculated as :

Opening Stock + Closing Stock

2

Inventory turnover can be indicated in terms of number of days in which average inventoryis consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio.


Illustration :

From the following data for the year ended 31st December, 1986, calculate the inventoryturnover ratio of the two items and put forward your comments on them.

Material A Material B

Rs. Rs.

Opening Stock 1.1.86 10,000 9,000

Purchases during the year 52,000 27,000

Closing Stock 31.12.86 6,000 11,000

Solution :

Inventory turnover ratio = Value of material consumed

Average Inventory held


Inventory Turnover = 56,000 25,000

8,000 10,000

= 7 2.5


Inventory Turnover Period = 365 365

7 2.5

= 52 days 146 days

A high inventory turnover ratio or low inventory turnover period indicates that maximum materialcan be consumed by holding minimum amount of inventory of the same, thus indicating fastmoving items. Thus high inventory turnover ratio or lower inventory turnover period will alwaysbe preferred.

Thus, knowledge of inventory turnover ratio or inventory turn over period in case of varioustypes of material will enable to reduce the blocked up capital in undesirable types of stocksand will enable the organisation to exercise proper inventory control.

(4) ABC Analysis :

This technique assumes the basic principle of “Vital Few Trivial Many” while considering theinventory structure of any organisation and is popularly known as “Always Better Control”. It isan analytical method of inventory control which aims at concentrating efforts in those areaswhere attention is required most. It is usually observed that, in practice, only a few number ofitems of inventory prove to be more important in terms of amount of investment in inventory or

221Material Cost

value of consumption, while a very large number of items of inventory account for a verymeager amount of investment in inventory or value of consumption. This technique classifiesthe various inventory items according to their importance. E.g. A Class consists of only asmall percentage of total number of items handled but are most important in nature. B Classitems include relatively less important items. C Class items consist of a very large number ofitems which are less important. The importance of the various items may be decided on thebasis of following factors.

(i) Amount of investment in inventory.

(ii) Value of material consumption.

(iii) Critical nature of inventory items.

An example of ABC Analysis can be given as below.

Class No. of items % of total Value/ % of Total Value/No. of Consumption Consumptionitems Rs.

A 300 6 5,60,000 70

B 1500 30 1,60,000 20

C 3200 64 80,000 10

5000 100 8,00,000 100

In order to exercise proper inventory control, A Class items are watched very closely andcontrol is exercised right from initial stages of estimating the requirements, fixing minimumlevel/leadtimes, following proper purchase/ storage procedures etc. Whereas in case of CClass of items, only those inventory control measures may be implemented which arecomparatively simple, elaborate and inexpensive in nature.

Advantage of ABC Analysis :

(a) A close and strict control is facilitated on the most important items which constitute amajor portion of overall inventory valuation or overall material consumption and due tothis the costs associated with inventions may be reduced.

(b) The investment in inventory can be regulated in a proper manner and optimum utilisationof the available funds can be assured.

(c) A strict control on inventory items in this manner helps in maintaining a high inventoryturnover ratio.However it should be noted that the success of ABC analysis dependsmainly upon correct categorisation of inventory items and hence should be handled byonly experienced and trained personnel.


(5) Bill of Materials :

In order to ensure proper inventory control, the ‘basic principle to be kept in mind is that propermaterial is available for production purposes whenever it is required. This aim can be achievedby preparing what is normally called as “Bill of Materials”.

A bill of material is the list of all the materials required for a job, process or production order.It gives the details of the necessary materials as well as the quantity of each item. As soon asthe order for the job is received, bill of materials is prepared by Production Department orProduction Planning Department.

The form in which the bill of material is usually prepared is as below :

BILL OF MATERIALS

No. Date of Issue Production/Job Order No.

Department authorised

S. No. Description Code Qty. For Department Use only Remarks

of Material No. Material Date Quantity

Requisition No. demanded

The functions of bill of materials are as below :

(1) Bill of material gives an indication about the orders to be executed to all the personsconcerned.

(2) Bill of material gives an indication about the materials to be purchased by the PurchasesDepartment if the same is not available with the stores.

(3) Bill of material may serve as a base for the Production Department for placing the materialrequisitions ships.

(4) Costing/Accounts Department maybe able to compute the material cost in respect of ajob or a production order. A bill of material prepared and valued in advance may serve asa base for quoting the price for the job or production order.

223Material Cost

(6) Perpetual Inventory System :

As discussed earlier, in order to exercise proper inventory control, perpetual inventorysystem may be implemented. It aims basically at two facts.

(1) Maintenance of Bin Cards and Stores Ledger in order to know about the stock inquantity and value at any point of time.

(2) Continuous verification of physical stock to ensure that the physical balance andthe book balance tallies.

The continuous stock taking may be advantageous from the following angles :

(1) Physical balances and book balances can be compared and adjusted without waitingfor the entire stocktaking to be done at the year-end Further, it is not necessary toclose down the factory for Annual stocktaking.

(2) The figures of stock can be readily available for the purpose of periodic Profit andLoss Account.

(3) Discrepancies can be located and adjusted in time.

(4) Fixation of various levels and bin cards enables the action to be taken for theplacing the order for acquisition of material.

(5) A systematic maintenance of perpetual inventory system enables to locate andslow and non-moving items and to take remedial action for the same.

(6) Stock details are available correctly for getting the insurance of stock.


(1) The following informative is extracted from the Stores ledger in respect of Material X

Opening Stock Nil

Purchases

Jan. 1 100 @ Re. 1 per unit

Jan. 20 100 @ Rs. 2 per unit

Issues

Jan. 22 60 for Job W 16

Jan. 23 60 for Job W 17

Complete the receipts and issues valuation by adopting the First In First Out, Last In First Outand Weighted Average method. Tabulate the values allocated to Job W 16 and 17 and theclosing stock under the methods aforesaid.


Solution :

(a) Valuation of receipts : (For all methods)

Jan. 1 100 x 1.00 = Rs. 100

Jan. 20 100 x 2.00 = Rs. 200

200 units Rs. 300

Weighted Average Rate =Rs. 300

= Rs. 1.50/Unit200 units

(b) Valuation of Issues/Closing Stock

(1) IssuesFIFO LIFO Weighted Average

Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.Date Unit Rs. Rs. Unit Rs. Rs. Unit Rs. Rs.

Jan. 22-W16 60 1.00 60.00 60 2.00 120.00 60 1.50 90.00Jan.23-W17 40 1.00 40.00 40 2.0 80.00 60 1.50 90.00

20 2.00 40.00 20 1.00 20.00140.00 220.00 180.00

(2) ClosingStock 80 2.00 160.00 80 1.00 80.00 80 1.50 120.00

(c) Values allocated to individual jobs

W 16 W 17

Rs. Rs.

FIFO 60 80

LIFO 120 100

Weighted Average 90 90

(2) From the records of an oil distributing company, the following summarised information isavailable for the month of March 1986.

Sales for the month - Rs. 19,25,000

Opening Stock as on 1-3-86 - 1,25,000 Litres @ Rs. 6.50 litre

Purchases (including freight and insurance)

March 5 -1,50,000 litres @ Rs. 7.10 litre

225Material Cost

March 27 - 1,00,000 litres @ Rs. 7.00 litre.

Closing stock as on 31-3-86 - 1,30,000 litres

General Administrative expenses for the month Rs. 45,000

On the basis of the above information, work out the following using FIFO and LIFOmethods of inventory valuation assuming pricing of issues is being done at the end of themonth (after all receipts during the month).

(a) Value of Closing Stock as on 31-3-86

(b) Cost of goods sold during March 86

(c) Profit or Loss for March 86.

Solution :

(a) Value of Closing Stock

(1) FIFO :

Under this method, the value of closing stock will constitute the value of latest available lot forconsumption, earlier lots assumed to have been consumed. As such, value of closing stockwill be:

Purchased on 27-3-86 1,00,000 Its. x Rs. 7.00 = Rs. 7,00,000

Purchased on 5-3-86 30,000 Its. x Rs. 7.10 = Rs. 2,13,000

Rs. 9,13.000

(2) LIFO :

Under this method, the value of closing stock will constitute the value of earliest available lotfor consumption, latest lots assumed to have been consumed. As such, value of closing stockwill be :

Opening Stock on 1-3-86 1,25,000 Its. x Rs. 6.50 = Rs. 8,12,500

Purchased on 5-3-86 5,000 Its. x Rs. 7.10 = Rs. 35,500

Rs. 8,48,000


(b) Cost of goods sold during March 1986

FIFO LIFORs. Rs.

Opening Stock 1,25,000 Its. x Rs. 6.50 8,12,500 8,12,500

Purchases 17,65,000 17,65,000

25,77.500 25,77,500

Less : Closing Stock (as per ‘a’ above) 9,13,000 8,48,000

16,64,500 17,29,500

The value of purchases is calculated as below :

Purchased on 5-3-86 – 1,50,000 X Rs. 7.10 = Rs. 10,65,000

Purchased on 27-3-86 – 1,00,000 X Rs. 7.00 = Rs. 7.00,000

Rs. 17,65,000

(c) Profit or Loss for March 1986

FIFO LIFORs. Rs.

(1) Sales 19,25,000 19,25,000

Total Cost

Cost of goods sold 16,64,500 17,29,500

Administrative Expenses 45,000 45,000

17,09,500 17,74,500

(2) Profit (1 - 2) 2,15,500 1,50,500

(3) A company uses annually 50,000 units of an item each costing Rs.1.20. Eacholder costs Rs. 45 and inventory carrying costs 15% of the annual average inventoryvalue.

(a) Find EOQ

(b) If the company operates 250 days a year, the procurement time is 10 days, andsafety stock is 500 units, find reorder level, maximum, minimum and averageinventory.

227Material Cost

Solution :

(a) Economic Order Quantity

2 X A X O

Ci

= 2 X 50,000 X 45

15% of 1.20

= 5,000 units

(b) (1) Reorder Level :


= 500 units + (200 units x 10 days) = 2,500 units

(2) Maximum Level :

Safety stock + EOQ

= 500 units + 5,000 units

= 5,500 units

(3) Minimum Level

It is equal to safety stock i.e. 500 units

(4) Average Level

Safety Stock + EOQ

2

= 500 units +5000 units

2

= 3000 units

(4) M/s. Kailas Pumps Ltd. uses about 75,000 valves per year and the usage is fairly constantat 6,250 per month. The valve costs Rs. 1.50 per unit when purchased in quantities andinventory carrying cost is 20%. The average inventory investment on annual basis. Thecost to place an order and to process the delivery is Rs. 18. It takes 45 days to receivefrom the date of an order and minimum stock of 3,250 valves is desired. You are requiredto determine -

√√


a. The most economical order quantity and the number of orders in year.

b. The reorder level

c. The most economic order quantity if valve costs Rs. 4.50 each instead of Rs. 1.50each.

Solution :

(a) Economic Order Quantity :

2 x A x O

EOQ = Ci

=2 x 75,000 x 18

= 3,000 units20% of 1.50

Number of Orders :

Annual Consumption

EOQ

=75,000 units

= 253,000 units

(b) Reorder Level :

Safety stock + (Normal Usage x Normal Leadtime)

= 3,250 units + (6,250 units x 1.5 months)

= 12,625 units

(c) Revised EOQ

(If unit cost is Rs. 4.50 instead of Rs. 1.50)

2 x A x OEOQ =

Ci

= 2 x 75,000 x 18

20% of 4.50

= 1,732 units

√√

√√

229Material Cost

(5) The Purchase Department of your Organisation has received an offer of quantity discountson its orders of materials as under :

Price Per Tonne Tonnes

1,200 Less than 500

1,180 500 and less than 1000

1,160 1000 and less than 2000

1,140 2000 and less than 3000

1,120 3000 and above.

The annual requirement for the material is 5000 tonnes. The delivery cost per order is Rs.1,200 and the stock holding cost is estimated at 20% of material cost per annum. You arerequired to advice the Purchase Department the most economic purchase level.

Solution :

As the price discount varies with lot size, EOQ will have to be decided by Trial and ErrorMethod.

Lot Size Price per Purchase Ordering Carrying Total

(Units) Tonne-Rs. Cost for Cost Cost Cost

Q P 5,000 Rs.

1 2 3 4 5 6(3+4+5)

100 1200 60,00,000 60,000 12,000 60,72,000

250 1200 60,00,000 24,000 30,000 60,54,000

500 1180 59,00,000 12,000 59,000 59,71,000

625 1180 59,00,000 9,600 73,750 59,83,350

1,000 1160 58,00,000 6,000 1,16,000 59,22,000

1,250 1160 58,00,000 4,800 1,45,000 59,49,800

2,000 1140 57,00,000 3,000 2,28,000 59,31,000

2,500 1140 57,00,000 2,400 2,85,000 59,87,400

3,000 1120 56,00,000 2,000 3,36,000 59,38,000

4,000 1120 56,00,000 1,500 4,48,000 60,49,500

5000 QTonnes X 1200 X P X 20% Rs. Q 2


It will be observed, that if the purchases are made in the lot size of 1,000 units it proves to bemost economical.

(6) (a) A company needs 24,000 units of raw materials which costs Rs. 20 per unit andordering cost is expected to be Rs. 100 per order. The company maintains safetystock of 1 month’s requirements to meet emergency. The holding cost of carryinginventory is supposed to be 10% per unit of average inventory. Find out :

1. Economic lot size.

2. Ordering cost

3. Holding cost

4. Total cost

(b) The supplier of raw material has agreed to supply the goods at a discount of 5% inprice on a lot size of 4,000 units. Find whether the concession price should beavailed.

Solution :

(a) (1) Economic Lot Size

2 x A x O

Ci

= 2 x 24,000 x 100

10% of 20

= 1,550 units (Approx.)

(2) Ordering Cost

Annual Requirement X Ordering cost per orderEOQ

= 24,000X 100 = Rs. 1,548 (Approx.)

1550

(3) Holding Cost :

As the company maintains safety stock of one month’s requirement, the average inventoryheld at any point of time will not only be EOQ/2 but safety stock + EOQ/2. Assumingthat the usage of raw material is steady throughout the year i.e. 2,000 units per month,holding cost will be :

√√

231Material Cost

(Safety Stock + EOQ/2) / Carrying cost per unit per year

= (2,000 units + 1,550 units

) X 10% of Rs. 20

2

= 2,775 units X Rs. 2

= Rs. 5,550

(4) Total cost :

Cost of material 24,000 x 20 = Rs. 4,80,000

Ordering Cost = Rs. 1,548

Holding Cost = Rs. 5,550

Total Cost = Rs. 4,87,098

(b) Revised Total Cost : (with 5% discount)

(1) Ordering Cost :

As order size is going to be 4,000 units, total 6 orders will be placed. Hence total ordering costwill be -

6 orders x Rs. 100 per order i.e. Rs. 600

(2) Holding Cost :

The holding cost will be as below :

(Safety Stock + Order Size

) x Carrying cost per unit per year2

= (2,000 units + 4000 units

) x 10% of Rs. 19 2

= Rs. 7,600

(3) Total Cost :

Total Cost of material - 24,000 x 19 = Rs. 4,56,000

Ordering Cost = Rs. 600

Holding Cost = Rs. 7,600

Total Cost = Rs. 4,64,200


Conclusion :

If purchased in Economic Lot Size, total cost (including material cost) is Rs. 4,87,098.

If purchased in Lot Size of 4,000 units with 5% discount, total cost (including material cost) isRs. 4,64,200.

As purchases in Lot Size of 4,000 units result in the saving of Rs. 22,898 (i.e. Rs. 4,87,098 -Rs. 4,64,200) that alternative will be preferred.

QUESTIONS

1. Explain the various steps in which a raw material moves in a manufacturing organizationtill it gets consumed in the production. Give the format of various documents which areprepared in the process.

2. Write a detailed essay on -

a) Valuation of Receipts

b) Valuation of Issues

c) Valuation of Returns

233Material Cost

PROBLEMS

(1) The following is the record of receipts and issues of certain material in a factory duringthe week ending May 1979.

Opening balances 100 tons at Rs. 10 per ton.

Issued 60 tons.

Received 120 tons at Rs. 10 per ton

Issues - 50 tons (Stock verifier reported shortage of 2 tons)

Received back from order 20 tons (originally issued at Rs. 9.90)

Issued 80 tons.

Received 44 tons at Rs. 10.20 per ton.

Issued 66 tons.

Received 44 tons at Rs. 10.20 per ton.

Issued 66 tons.

From the above particulars prepare stores ledger separately under e method chargingissues at weighted and simple average method.

(2) Following transactions appeared in a specified material during month of August 1980.

Date Particular Quantity (Tons) Rate per ton

1 Opening balance 100 24

4 Purchased 50 26

5 Issued 30

12 Issued 40

13 Purchased 30 25

19 Issued 40

25 Issued 30

30 Purchased 40 28

31 Issued 30

The stock verifier noticed shortage in stock on 26th August of 5 tons and on 29th Augustof 4 tons. Write up stores ledger by charging issues by FIFO and by weighted averagemethods.

(3) The following is the history of the receipt and issue of materials in a factory duringFebruary 1980,


Feb. 1 Opening balance -500 tons at Rs. 25

2 Issued 70 tons

4 Issued 100 tons

8 Issued 80 tons

13 Received from vendor 200 tons at Rs. 24.50

14 Refund of surplus from a work order 15 tons at Rs. 24

16 Issued 180 long


24 Issued 304 tons


26 Issued 112 tons

27 Refund of surplus from a work order 12 tons at Rs. 24.50

28 Received from vendor 100 tons at Rs. 25

Issues are to be priced on the principle of LIFO and simple average method. The stockverifier of the factory noted that on the 15th he had found a shortage of 5 tons and on 27thanother shortage of 8 tons. Write out complete stores ledger account in respect of thematerial.

(4) A cloth manufacturer commenced the business on 1.1.82. Textile materials used includetwo types - M & N. During 6 months ending on 30.6.82, transactions were asfollows :

Date Purchased (Mtrs.) Issued (Mtrs.)

M N Rates per Mt. M N

4.1.82 1000 10

6.1.82 1600 15

7.1.82 700

12.1.82 1200

18.3.82 2300 12

28.3.82 1420

16.4.82 3000 16

22.4.82 2860

26.5.82 800 9.50

1.6.82 1580

2.6.82 1000 17.50

8.6.82 1300

235Material Cost

You are required to prepare stores ledger account for M type of material by chargingissues by LIFO method and N type of material by charging the issues on weightedaverage method.

(5) The stores ledger account of material C in the books of Saurabh and Sweta Ltd. revealedfollowing transactions for September 1984,

Sept. 1 Opening stock 200 kgs at Rs. 7.50 per kg.

5 Received from supplier 400 kgs at Rs. 7.75 per kg GRN 448

8 Issued to Production Dept. 240 kgs SR No. 883

10 Received from supplier 500 kgs at Rs. 7.90 per kg. GRN 45








You are required to price the issues and draw out the closing balance in the storesledger account under the pricing method in which the material costs charged to productionwould be closely related to current prices.

(6) Record the following transactions in a store ledger and show the cost of consumptionand closing stock by using FIFO method of pricing issues.

For the month of January 1985 :

Jan. 1 Opening Stock 300 units at Jan. 11 Issues 400 unitsRs. 9.70 per unit 20 Issues 210 units

3 Purchases 250 units at 29 Issues 100 unitsRs. 9.80 per unit

15 Purchases 300 units atRs. 10.50 per unit

25 Purchases 150 units atRs. 10.30 per unit


(7) Prepare a stores ledger account on the basis of FIFO method.

Jan. 1 Opening stock 250 units @ Re. 1 each

3 Purchased 100 units @ Rs. 1.05 each


6 Issued 400 units


12 Issued 150 units

13 Issued 100 units

16 Purchased 100 units @ Re. 1 each


31 Issued 300 units

(8) The following is a summary of the receipts and issues of a material in a factory during amonth.

1st Opening Balance 500 units at Rs. 25 per unit.

3rd Issued 70 units.

4th Issued 100 units.


13th Receipts 200 units at Rs. 24.50 per unit (Supplier)

14th Returned to stores 15 units at Rs. 24 per unit.






27th Returned to stores 12 units at Rs. 24.50 per unit

28th Received from supplier 100 units at Rs. 25 per unit.

Stock verification revealed that on 15th there was a shortage of 5 units and another on27th of 8 units. Prepare Stores Ledger Account on the basis of FIFO basis.

237Material Cost

(9) Following is an extract of receipts and issues for the month of January 1989 of amanufacturing company.

Date 2 Purchased 8,000 units @ Rs. 2

4 Purchased 1,000 units @ Rs. 2.50

6 Issued 4,000 units

10 Purchased 12,000 units @ Rs. 3




25 Purchased 9,000 units @ Rs. 2.75


Draw up store Ledger Account by LIFO method showing balance as on 31.1.89

(10) The transactions in connection with the materials are as follows :

Days Receipts Issues (Units)Unit Rate per unit Rs.

1st 40 15.00 -

2nd 20 16.50 -

3rd - - 30

4th 50 14.30 -

5th - - 20

6th - - 40

Calculate the cost of material issued under FIFO method and Weighted Average methodof issue of materials.

(11) From the following details of stores receipts and issues of Material EXE in a manufacturingunit, prepare the stock ledger using “Weighted Average” method of valuing the issues.

Nov. 1 Opening Stock 2,000 units (S) Rs. 5.00 each

Nov. 3 Issued 1,500 units to production

Nov. 4 Received 4,500 units @ Rs. 6.00 each

Nov. 8 Issued 1,600 units to production.

Nov. 9 Returned to stores 100 units by production department (from the issues of Nov. 3)



Nov. 19 Returned to supplier 200 units out of the quantity received on Nov. 4Nov. 20Received 1,000 units @ Rs. 7 each.

Nov. 24 Issued to production 2,100 units


Nov. 29 Issued to Production 2,800 units (Use rates upto two decimal places)

(12) The following are the transactions in respect of purchases and issues of componentsforming part of an assembly of a product manufactured by a firm which requires, toupdate its cost of production very often for bidding tenders and finalising cost pluscontracts.

Date Quantity Particulars1986 (in Nos.)

January 5 1,000 Purchased @ Rs. 1.20 each

11 2,000 Issued

February 1 1,500 Purchased @ Rs. 1.30 each

18 2,400 Issued

26 1,000 Issued

March 8 1,000 Purchased @ Rs. 1.40 each

17 1,500 Purchased @ Rs. 1.30 each

28 2,000 Issued.

The stock on 1st January 1986 was 5,000 Nos. valued at Rs. 1.10 each. State themethod you would adopt in pricing the issues of components giving reasons. What valuewould you place on stocks as on 31st March which happens to be the financial year endand how would you treat the difference in value, if any, on the stock account.

(13) The following are the extract from the transactions on the bin card of Job No. 12-3-89 forMarch 1987

Date On order Receipt Rate Issue Balance

2 - 40 25.00 - 40

6 - - - 20 20

8 - 50 28.00 - 70

12 - - - 30 40

15 - 30 24.00 - 70

18 50 - 26.00 - 70

28 - - - 50 20

239Material Cost

Find out the pricing of material issue under LIFO, FIFO and simple average method.

(14) XYZ Ltd. requires 20,000 units of product A per annum. The purchase price is Rs. 4 perunit. The inventory carrying cost is 20% per annum and the cost of ordering is Rs. 100per order. Advise the company, on how many times they should order in a year, so as tominimise the cost of product A?

(15) A Manufacturer buys certain essential spares from outside suppliers at Rs. 40 per set.Total annual requirements are 45000 sets. The annual cost of investment in inventory is10% and costs like rent, stationery, insurance, taxes etc. per unit per year work to Re.1, cost of placing an order is Rs. 5. Calculate the Economic Order Quantity.

(16) Following information relating to a type of raw material is available.

Annual Demand 2,400 units

Unit Price Rs. 2.40

Ordering cost per order Rs. 4.00

Storage cost 27% p.a.

Interest Rate 10% p.a.

Lead Time Half month

Calculate Economic Order Quantity and total annual inventory cost in respect of theparticular raw material.

(17) From the particulars given below, you are required to compute.


(b) Maximum Level

(c) Minimum Level

(d) Re-ordering Level

(e) Average stock Level

(i) Quantity required annually 3,000 units @ Rs. 5 per unit.

(ii) Interest and cost of storing 10%.

(iii) Cost of placing an order Rs. 30 per order.

(iv) Consumption per week Normal 60 units

Maximum 70 units

Minimum 50 units.

(v) Lead time (in weeks) Normal 5Maximum 6Minimum 4


(18) The Stock-Ledger Account for material X in a manufacturing concern reveals the followingdata for the quarter ended September 30, 1989.

Receipts Issues

Quantity Price Quantity AmountUnits Rs. Units Rs.

July 1 Balance b/d

1.600 2.00 – –

July 9 3,000 2.20 – –

July 13 – – 1,200 2,556

August 5 – – 900 1,917

August 17 3,600 2.40 – –

August 24 – – 1,800 4,122

September 11 2,500 2.50 – –

September 27 – – 2,100 4,971

September 29 – – 700 1,656

Physical verification on September 30, 1989 revealed an actual stock of 3,800 units. You arerequired to :

(a) Indicate the method of princing employed in the above.

(b) Complete the above account by making entries you would consider necessary includingadjustments, if any, and giving explanations for such sdjustments.

(19) Following information is available in respect of two components A and B.

Particulars A B

Normal Usage Units 50 50

Minimum Usage Units 25 25

Maximum Usage Units 75 75

Lead Time Week 4-6 2-4

Annual Consumption Units 9,000 6,250

Ordering cost per order Rs. 45 100

Carrying cost per unit per year Rs. 9 5

Calculate for each component.

241Material Cost

(i) Re-order level

(ii) Minimum level

(iii) Maximum level

(iv) Average level

(20) P. Ltd. uses three types of materials, A, B and C for production of X, the final product.The relevant monthly data for the components are as given below :

A B C

Normal Usage (Units) 200 150 180

Minimum Usage (Units) 100 100 90

Maximum Usage (Units) 300 250 270

Re-older Quantity (Units) 750 900 720

Re-order period (Months) 2 to 3 3 to 4 2 to 3

Calculate for each component.

(1) Re-order Level

(2) Minimum Level

(3) Maximum Level

(4) Average stock Level

(21) The following data are available from the records of M/s. Naveen Industries Ltd. using twotypes of materials A and B for the manufacture of their product.

A B

Normal Usage (Units per month) 250 200

Minimum Usage (Units per month) 100 200

Maximum Usage (Units per month) 350 400

Reorder Quantity (Units) 900 1000

Reorder Period (Months) 2 to 3 3 to 4

Compute for each type of material, the following levels.

(1) Reorder Level

(2) Minimum Level

(3) Maximum Level

(4) Average Stock Level


(22) Following details are available in respect of a material.

(i) Ordering cost per order Rs. 45

(ii) Annual consumption 9,000 units

(iii) Carrying cost per unit per year Rs. 9

(iv) Lead Times - Average - 10 days

Minimum 6 days

Maximum 15 days

Maximum for emergency purchases 4 days

(v) Rate of consumption - Average 15 units per day

Maximum 20 units per day

Calculate :

(i) Reordering Level

(ii) Maximum Level

(iii) Minimum Level

(iv) Average Level

(23) Certain purchased part of which annual requirements are 8000 units, involves orderingcost equal to Rs. 12.50 per order, cost per piece Re. 1 and the annual carrying cost20%. In addition, average daily usage is 32 units (based on 250 operating days peryear), lead time is 10 days and safety stock has been calculated to be 100 units.

Calculate :


(b) Reorder point

(24) (i) XYZ Company buys in the lot of 500 boxes which is a 3 months supply. The costper box is Rs. 125 and the ordering cost is Rs. 150. The inventory carrying cost isestimated at 20% of unit value. What is the total annual cost of the existing inventorypolicy?

(ii) How much money could be saved by employing the economic order quantity?

(25) To decided to buy an item, the following data is given.

Annual Demand 600 units

Ordering Cost - Rs. 400

Holding Cost - 40%

243Material Cost

Cost per unit - Rs. 15

Discount 10% if the order quantity is 500

What should be the decision? Justify your answer.

(26) A manufacturer requires 10 lakhs components for use during the next year which isassumed to consist of 250 working days. The cost of storing one component for oneyear is Rs. 4 and the cost of placing order is Rs. 32. There must always be a safetystock equal to two working days usage and the lead time from the supplier, which hasbeen guaranteed, will be 5 working days throughout the year.

Assuming usage takes place steadily throughout the working days, delivery takes placeat the end of the day and orders are placed at the end of working day, you are required tocalculate.

(i) Economic Order Quantity.

(ii) Reorder point.

(27) Anil Company buys its annual requirement of 36,000 units in six instalments. Each unitcosts Re. 1 and the ordering cost is Rs. 25. The inventory carrying cost is estimated at20% of the unit value. Find the total cost of the existing inventory policy. How muchmoney can be saved by using Economic Order Quantity?

(28) A Company, for one of the A class items, placed 6 orders each of size 200 in a year.Given ordering cost Rs. 600, holding cost 40%, cost per unit Rs. 40, find out the loss tothe Company by not operating scientific inventory policy. What are your recommendationsfor the future?

(29) A manufacturer has to supply his customers 600 units of his product per year. Shortagesare not allowed and the inventory carrying cost amounts to Rs. 0.60 per unit per year.The set up cost per run is Rs.80. Find

(a) The Economic Order Quantity

(b) The minimum average yearly cost.

(c) The optimum number of orders per year.

(30) A purchase manager has decided to place order for minimum quantity of 500 numbers ofa particular item in order to get a discount of 10%. From the records, it was found that inthe last year, 8 orders each of size 200 number have been placed. Given Ordering costRs. 500 per order, Inventory carrying cost 40% of the inventory value and cost per unitRs. 400, is the purchase manager justified in his decision. What is the effect of hisdecision on the company?


(31) A publishing house purchases 2000 units of a particular item per year at a unit cost ofRs. 20, the ordering cost per order is Rs. 50 and the inventory carrying cost is 25%. Findthe optimal order quantity and minimum total cost including purchase cost.

If a 3% discount is offered by the supplier for purchase in lots of 1000 or more, should thepublishing house accept the proposal?

(32) Calculate for each Component A and B the following -

(a) Reorder Level

(b) Maximum Level

(c) Minimum Level

(d) Average stock Level

Normal Usage - 300 units per week each.

Maximum Usage - 450 units per week each

Minimum Usage - 150 units per week each

Reorder Quantity - A - 2,400 units

B - 3,600 units

Reorder Period - A - 4 to 6 weeks

B - 2 to 4 weeks

245Material Cost

NOTES


NOTES

247Labour Cost

Chapter 9LABOUR COST

Labour Cost is another important element of cost in the manufacturing cost. It is importantelement of cost eventhough the production is material intensive. The basic factor which givesrise to the labour cost is the remuneration paid to workers. However, the objective of costaccounting (i.e. cost ascertainment with respect to the individual cost centre and cost control)can not be fulfilled properly unless and until the functions performed by the related departmentsare properly considered. These functions can be stated as below :

(1) Personnel Department : This ensures the availability of correct workers to perform thejobs which are best suited for them. This is done by selecting them properly and trainingthem properly. This department may also be involved with maintenance of records of jobclassification/ wage rates payable to workers, preparation of wages sheet and proceduralaspects of wage payment.

(2) Time Keeping Department : This is concerned with recording of workers time. This isnot only for the purpose of wage calculations but also for the purpose of cost analysisand apportionment of cost over various jobs. The main functions performed by thisdepartment are time keeping and time booking.

(3) Cost Accounting Department : This department accumulates and classifies cost datawith respect to labour cost from the analysis of wages sheet and presents the reports tomanagement to facilitate the control over labour cost.

The starting point for ascertaining the labour cost is in the form of Time Keeping and Time Booking.

Time Keeping :

This is the process of recording attendance time of the workers. It is the responsibility of TimeKeeping Department which may function as separate department in some cases or else mayfunction as the part of Personnel Department. Attendance time recording may be necessaryas the payment of wages may depend on the attendance. Even when the payment of wagesdoes not depend on time attended, say in case piece rate payment, the recording of timeattended may be necessary from the following angles.


(1) To Maintain discipline.

(2) Though the regular wages may not depend upon the time attended, in some cases, theother payments like overtime wages, dearness allowance etc. may be linked with theattendance.

(3) The fringe benefits like Pension, Gratuity on retirement. Provident Fund etc. may dependon the continuity of service which will be available only if time attended is recordedproperly.

(4) Attendance records may be required for research and other purposes.

Methods of Time Keeping :

For the purpose of time keeping, various methods may be followed, though the selection of themethod may depend upon nature of organization and policy of management. Main such methodsmay be stated as below:

(1) Hand-Written Method :

Under this method, names of the workers are recorded in the attendance register withprovision of various columns for various days. The attendance of the worker may berecorded either by calling out his name or by physical check. Alternatively, the workersthemselves may sign in the attendance register.

This method, though simple, has become outdated. This method can also result inmalpractices with the collusion between workers and time keeping/ personnel department.Also recording of late coming, overtime, short leave etc. may involve more clerical workand may be subject to errors.

(2) Token or Disc Method :

Under this method, each worker is allotted an identification number and a disc or tokenbearing that number. Immediately before the scheduled opening time, all the tokens/discs will be placed at the factory gate. Every incoming worker will take out his tokenand drop it in a separate box or hang it on a separate board. The tokens/discs notremoved will indicate that the said worker is absent. Similar procedure is followed whilethe workers leave the factory. In addition to the physical handling of tokens/ discs, it willbe required to record the attendance time separately.

Though it is an improved method, as compared to manual/handwritten method, it is alsosubject to errors.mistakes and frauds. Further care should be taken to see that a workerdoes not remove the disc/token of his absent fellow in addition to his own.

249Labour Cost

(3) Time Recording Clock Method :

Under this method, every worker is alloted individual ticket number and a clock cardwhich bears that ticket number. The cards are placed on two racks on either side of thetime recording clock denoting separately ‘In’ rack and ‘Out’ rack. At the opening time, allthe cards are placed in ‘Out’ rack. On arrival, worker takes out his own card, puts it in theslot available on the time clock recorder which punches the time on that card, andplaces the card in ‘In’ rack. All the cards, left in the ‘Out’ rack indicate absent workers.At the time of departure, he removes the card from In’ rack, gets it punched and placesit in ‘Out’ rack.

Though, this method involves heavy capital outlay initially, it has certain advantagesalso.

(1) It is economical in the sense it avoids clerical work: involved in manual/handwrittenmethod.

(2) It is clean, safe and quick and has printed records to avoid disputes.

(3) Chances of fraudulent entries being made can be avoided.

Time Booking :

The ultimate aim of costing is to decide the cost of each cost centre. As such, recording oftime attended is not sufficient. Equally important is to record the time spent for individual costcentres. This process is in the form of time booking. The methods followed for this purpose,may be considered as below :

(a) Daily time sheets :

Under this method, each worker is provided with a daily time sheet on which time spent byhim on various jobs/work orders is expected to be mentioned. If the worker works on variousjobs in a particular day, the daily time sheets move along with the worker. The entries on thesame may be made by the worker himself or by the foreman.

This method may be conveniently used if the worker works on various jobs of short duration.Say in case of maintenance jobs.

This method is disadvantageous in the sense that it involves considerable paper work. Theform in which the daily time sheets may be prepared is as below :


DAILY TIME SHEET

(b) Weekly Time Sheets :

Under this method also; one sheet is alloted to each worker but instead of recording the workdone for a day only, record of time for all the jobs during the week is made. These types of timesheets are useful for intermittent types of jobs like building or construction work. It involvescomparatively less paper work. The form in which weekly time sheets may be prepared is asbelow.

WEEKLY TIME SHEET

Name of Employee

Employee No. Date :

Job No. Dept. Time Record Time taken

ON OFF

Checked by Cost office reference

Name of Employee Week ending on...

Employee No.

Day Job No. Time Time Standard Rate AmountOn Off taken

TOTAL


251Labour Cost

(c) Job Card :

Under this method, the details of time are recorded with reference to the jobs or production/work orders undertaken by the workers rather than with reference to individual workers, andthis facilitates the computation of labour cost with reference to jobs or production/work orders.There may be two ways in which job card may be maintained.

(1) According to first method, each job or production/work order is alloted a number. Whena worker takes up a job, the time of starting and finishing the job is entered on the cardmeant for that worker. The summary of this card states the total time taken by thatworker for that job. In order to compute the total time booked for the job as a whole, allcards of all the workers with respect to that job are required to be analysed. The form inwhich this card may be prepared is as below.

JOB CARD

Name of Employee Job No.

Employee No.

Day Time Time Standard Rate AmountON OFF Taken Rs. Rs.

FRI

SAT

SUN

MON

TUE

WED


(2) According to this method, a job card is prepared for each job production/work orderaccepted by the organization for execution. It describes the various operations/stagesinvolved in the execution of the job. Time taken by the various workers to complete thejob is entered on the card. This provides the information about the time taken by variousworkers to complete a particular job.


The form in which this card may be prepared is as below.

JOB CARD WITH OPERATIONS

Job No. Drawing No.

Job Description

Operation Employee ON OFF Time Rate AmountNo. taken

Cutting12

Drilling12

Grinding12

Painting12

Assembly123

TOTAL


Reconciliation of time attended and time booked

If a combined time and job card is maintained, the problem of reconciliation will be relativelysimple as both the details will be available on the same card. In other cases, at the end of thewage period or at a shorter interval also, the total time attended has to be compared with thetime booked on job cards on the various jobs. If the time booked as per the job cards, is lessthan the attendance time, this indicates the idle time during which the worker has not doneany work, though he was present in the factory.

253Labour Cost

Methods of remunerating the workers :

Remuneration to workers indicate the reward for labour and services. The remuneration maybe paid in monetary terms (which in turn may be in direct form or indirect form) or non-monetary terms. The remuneration paid in the monetary form may be by way of basic wagesor salaries and other allowances and may be paid either on time basis or on work basis.However, payment of only basic wages or salaries may not be sufficient enough to induce theworkers to work efficiently, hence they may be remunerated in the form of some incentives. Incase of remuneration in non-monetary form, the workers may not receive anything in the frommoney but they may get facilities which induce them to stay with the organization. It may bein the form of the provision of health or welfare or recreational facilities, provision of workingconditions and so on. We will discuss these methods of remuneration under the followingheads.

(1) Remuneration on Time Basis i.e. Time Rate System.

(2) Remuneration on Work Basis i.e. Payment by Results.

(3) Incentive/Bonus Systems.

(a) Individual Incentive Systems

(b) Group Incentive Systems.

(4) Indirect monetary remuneration

(a) Profit sharing

(b) Co-partnership

(5) Non-monetary incentives

Principles of a good wage payment system :

(1) As a general rule, if the efficiency of the workers can be measured in the objective terms,the wages receivable by a worker should be in conformity with his efficiency. Otherwisean efficient worker is likely to be demotivated from working efficiently. At the same time,the standards fixed to measure the efficiency of a worker should be normal which can beattained by a normal worker under normal conditions.

(2) The wage payment system should be clearly defined and communicated to the workersleaving no scope for any ambiguity. At the same time, a good wage payment systemshould be simple to understand and easy to operate.

(3) No upper limit should be imposed on the wages which can be earned by an efficientworker.


(4) A good wage payment system will not punish the workers for the matters beyond thecontrol of the workers. E.g. Workers should not be punished in terms of reduced wagesdue to the circumstances like machinery break down or power failures etc.

(5) A good wage payment system should be reasonably permanent in nature. Frequentchanges in the same should be avoided. If any changes are proposed to be made insystem of wages payment, they should not be thrust upon the workers by force, butshould be implemented by having mutual discussions with and due approval from theworkers.

(6) Wage payment system should be properly tied up with quality control procedures toensure that the workers are paid only for good and quality production.

(7) The basic objective of the wage payment system should be to get maximum cooperationfrom the workers, improve the morale and productivity of the workers and to minimize thecost of supervision and labour turnover.

(8) The wage payment system should take into consideration the external obligations towhich the organization may be subjected to. These obligations may be in the form ofvarious statutes like Minimum Wage Act and the agreement entered into with the workersand so on.

(A) Time Rate System :

Under this, a worker is paid on the basis of time attended by him. He is paid at a specific rateirrespective of the production achieved by him. The pay rate may be fixed on daily basis,weekly basis or monthly basis.

This type of remuneration system is helpful in the following circumstances.

(a) If the output of the worker is beyond his control e.g. His speed depends upon speed of amachine or speed of other workers.

(b) If the output can’t be measured or standard time can’t be fixed e.g. Maintenance work.

(c) If close supervision is possible.

(d) If quality, accuracy and precision in work is of prime importance e.g. Artist, Ad-agencyperson.

The time rate system of remunerating the workers is useful due to the following features :

(a) Useful for highly efficient and highly inefficient workers.

(b) Easy for calculations.

(c) Easy to understand for the worker.

(d) Assurance of minimum wages.

255Labour Cost

The time rate system has one most important disadvantage attached to it that the efficiencyof the worker is disregarded while paying remuneration to him. To avoid this difficulty, somevariations as discussed below can be applied in practice.

(i) High Wage Plan :

Under this system, timely wage rate of the workers may be fixed at such a level which ishigher as compared to wages paid to workers in the same industry or locality. Suitable workingconditions are provided. Correspondingly, a high standard of efficiency is expected from theworkers.

Those who are not able to come up to the standard, are taken off the scheme.

(ii) Differential Time Rate :

Under this method, different hourly rates are fixed for different levels of efficiency. Up to acertain level of efficiency, normal day rate is applicable which gradually increases as efficiencyincreases. This can be illustrated as below :

Up to 80% efficiency : Re. 1.00 per hour (Normal Rate)

80% to 90% efficiency : Rs. 1.25 per hour



(B) Payments by results :

Under this system, workers are paid according to the production achieved by them. In manycases, time attended is not material. These methods can be reclassified as below.

(a) Straight Piece Rate System :

Under this method, each job, production or unit of production is termed as a piece and the rateof payment is fixed per piece. The worker is paid on the basis of production achieved irrespectiveof the time taken for its performance. Thus, the earnings of the worker can be computed as :Wages = No. of units produced x Piece Rate per unit This method can be suitably applied ifthe production is of standard or repetitive nature. It can’t be applied if the production can’t bemeasured in suitable units.

It can be seen that the crux of this method is to decide the time required to complete a piece.The fixation of this time should be done in such a way that within that much time, a normalworker can complete the piece. This can be done either on the basis of previous experience oron the basis of time and motion study.


(b) Piece Rate With Guaranteed Time Rate :

Under the straight piece rate system, the remuneration of a worker depends upon the productionachieved. If the production is less due to some factors beyond his control, he is likely to bepenalised. To remove this difficulty, it may be decided that he will be paid on time rate if hispiece rate earnings fall below time rate earnings, so that the worker is assured of minimumearnings on time basis. However, if this guaranteed time rate payment is too high, the incentiveto increase output to get piece rate payment is less.

(c) Differential Piece Rate System :

Under this system, higher rewards are guaranteed to more efficient workers. The piece ratesare fixed in such a way that normal piece rate is paid for work performed within and upto thestandard level of efficiency. If efficiency exceeds the standard, payment at higher piece rate ismade.

This can be illustrated as below :

Up to 83% efficiency - Normal Piece Rate.

Up to 100% efficiency - 10% above normal piece rate.

Above 100% efficiency - 30% above normal piece rate.

This method offers more inducement to the workers to work more efficiently and earn higherwages. But it is complicated to understand and expensive to operate.

Following systems use this principle of differential piece rates.

(1) Taylor Differential Piece Rate System :

This was introduced by F.W. Taylor. It provides two piece rates, a low piece rate for outputbelow standard and a high piece rate for output above standard and does not provide for anyguaranteed time rate payment. Eg. If standard output is 10 units and piece rate is Re.l perunit, the total wages are :

(i) If actual hourly output is 8 units i.e. below standard, the piece rate is say 80% of normalpiece rate i.e. Re. 0.80. Hence total wages are 8 units x Re. 0.80 = Rs.6.40.

(ii) If actual hourly output is 12 units i.e. above standard, the piece rate is say 120% ofnormal piece rate i.e. Rs. l.20.

Hence, total wages are 12 units x Rs.l.20 = Rs. 14.40.

The basic defect with this system is that eventhough the efficiency of the worker is belowstandard even marginally, he is punished heavily and even though the efficiency of the workeris above standard even marginally, he is benefited to a very great extent.

257Labour Cost

(2) Merrick Differential Piece-rate System :

To remove the defect existing in case of Taylor’s System which heavily punishes the workerwho produces below standard, the Merrick System provides for three piece rates Eg.

Efficiency Piece rate

Up to 83% Normal

Up to 100% 110% of normal piece rate

Above 100% 130% of normal piece rate

It should be noted that under this method also, no guaranteed time rate payment is provided.

Illustration :

The following particulars relate to a company.

Piece Rate - 6 paise per unit. Production of the workers

M - 125 units per day

N - 80 units per day

O - 150 units per day

Standard production per day 120 units.

Calculate the wages of the workers on the basis of Merrick’s Differential piece rate system,when basic piece rate is guaranteed below the standard and workers get 108% of the basicpiece rate between 100% and 120% of the basic piece rate above 120% efficiency.

Solution :

Calculation of total wages :

(a) Worker M :

Actual production 125 units i.e. 104% efficiency.

∴ Applicable piece rate - 108% of normal i:e. 6.48 paise per unit.

∴ Total wages : 125 units x 6.48 paise = 810 paise i.e. Rs. 8.10

(b) Worker N :

Actual production 80 units i.e. below the standard.

∴ Applicable piece rate : basic piece rate i.e. 6 paise per unit

∴ Total wages : 80 units x 6 paise = 480 paise i.e. Rs. 4.80


(c) Worker O :

Actual production 150 units i.e. 125% efficiency.

∴ Applicable piece rate - 120% of normal i.e. 7.20 paise per unit.

∴ Total wages 150 units x 7.20 paise = 1080 paise i.e. Rs. 10.80

(3) Gantt Task Bonus System :

This system is a combination of time rate and piece rate and provides for minimum time ratepayment. A high task or standard is set. The wage structure may be fixed as below.

Output below standard - Minimum time rate payment.

Output at standard - Time wages plus some increase in wage rates.

Output above standard - High piece rate for entire output.

(C) Individual Incentive Systems :

In case of time rate systems, the losses due to inefficiency of workers or benefits due toefficiency of workers are suffered or enjoyed by the employer alone. Similarly in case of piece-rate systems, the losses due to inefficiency of workers or benefits due to efficiency of workersare suffered or enjoyed by the worker alone. (The employer may be indirectly affected in theform of increased or decreased per unit overheads.) The incentive systems differ from boththese systems in such a way that the financial advantages arising out of the efficiency ofworkers are enjoyed by both employer as well as workers. There are various systems bywhich the incentive may be paid to workers. We will consider following main systems.

(a) Halsey Premium System :

Under this system, if the actual time taken is equal to or more than standard time, worker ispaid at the time rate. If actual time is less than standard time, the worker, in addition to timewages for hours actually worked, gets a bonus payment. The bonus is equivalent to the wagesfor the time saved in the decided percentage to be shared with the employer The percentageallowed to worker may vary from 30% to 70% (usually 50%). The total wages payable to theworker under this system, can be computed as below.

AH X HR +(SH - AH) X HR

Assuming 50% - 50% sharing2

Where - AH - Actual hours

SH - Standard hours

HR - Hourly rate

259Labour Cost

(b) Halsey - Weir Premium System :

This system is a deviation of Halsey Premium System only with the exception that the ratio ofsharing between the worker and the employer is fixed as 1/3 : 2/3. The computation of totalwages is the same as in case of Halsey Premium System, except the change in this ratio.

(c) Rowan Premium System :

Under this system also, guaranteed time rate payment is made. The amount of bonus paid isa percentage of hourly rate which is in proportion to the time saved. The total wages payableto the workers under this system can be computed as below :

AH X HR +SH - AH

X AH X HRSH

Where AH - Actual Hours

SH - Standard Hours

HR - Hourly Rate

Comparative study of Halsey and Rowan System :

Comparative study of total wages under both these systems reveals that if time saved is lessthan 50% of the standard time. Rowan system assures more wages than those under Halseysystem. But if time saved exceeds 50% of the standard time, Halsey system proves to bemore beneficial. In Rowan System a less efficient worker gets the same bonus as a moreefficient worker. As such Rowan System may be implemented in case of loose fixation ofstandards. The fall in bonus as time saved increases, offsets the damage done by loosestandards.

Illustration :

The following are the particulars given to yon.

Standard time .. 10 hours.

Time rate .. Re. 1 per hour.

Prepare a comparative table under Halsey Premium System and Rowan Premium System, iftime taken is 9 hours, 8 hours, 6 hours, 5 hours 4 hours and 3 hours. Also calculate theamount of total wages and labour cost per hour under two methods. What conclusions do youdraw from the table.


Solution :

Hours Halsey Premium system Rowan Premium system.taken Wages = Actual Hours x Hourly rate Wages = Actual Hours x Hourly rate

+ 1/2 (Time Saved x Hourly rate) + Time Saved/Time Allowed Actual Hoursx Hourly rate

(a) 9 Wages = 9x1+1/2 (I x 1) Wages = 9 x 1 + 1/10 x 9 x 1= Rs. 9.50 = Rs. 9.90

(b) 8 Wages = 8x1+1/2 (2 x 1) Wages = 8 x 1+ 2/10 x 8 x 1= Rs. 9 = Rs. 9.60

(c) 6 Wages = 6x1+1/2 (4 x 1) Wages = 6 x 1 + 4/10 (6 x 1)= Rs. 8 = Rs. 8.40

(d) 4 Wages = 4 x 1 1/2 (6 x 1) Wages = 4 x 1 + 6/10 (4 x 1)= Rs. 7.00 = 6.40

(e) 3 Wages = 3 X l+ 1/2 (7 x 1) Wages = 3 x 1 + 7/10 (3 x 1)= Rs. 6.50 = Rs. 5.10

Conclusion :

It can be concluded from the above table that so long as time saved is less than 50% ofstandard time, the total wages are more under Rowan Premium system than under HalseyPremium System. If the time saved is more than 50% of standard time, Halsey system provesto be more beneficial in terms of the total wages.

The other systems for making the payment of premium can be briefly described as below.

(a) Barth Premium System :

Under this system, the wages payable to the workers are computed as below.

Wages = Hourly Rate x √ Standard Hours x Actual Hours

Eg. Standard Hours are 10

Actual hours are 8

Hourly rate is Rs. 2 per hour.

Total wages will be

2 x √10x8

= Rs. 17.89

261Labour Cost

It should be noted that this system does not provide for any guaranteed time wages. Thissystem is suitable for beginners or apprentices.

(b) Emersons’s Efficiency Bonus System :

Under this system the wages payable to the workers are computed as below.

Wages = Actual Hours x Hourly Rate

+ Bonus Percentage x Actual -Hours x Hourly rate.

For calculating bonus percentage, following directions are provided.

Efficiency Bonus

(1) Below 66.2/3 % No bonus is payable. Only the guaranteed time

wages are payable.

(2) 66.2/3% to 100% In Addition to time wages, bonus is paid at different percentagesincreasing rapidly to 20% at 100% efficiency.

(3) Above 100 % In addition to time wages and bonus @ 20%, 1% bonus foreach 1% increase in efficiency beyond 100% is paid.

Eg. 101 % efficiency - 21 % Bonus

110 % efficiency - 30 % Bonus

120 % efficiency - 40 % Bonus & so on.

The efficiency percentage can be calculated as below.

(1) On time basis :

Standard Hoursx 100

Actual Hours

(2) On output basis :

Actual outputx 100

Standard output

Eg. Standard Hours are 10

Actual Hours are 8

Hourly Rate is Rs. 2 per hour.


Efficiency percentage will be as below.

Standard Hours 10

Actual Hours 8

∴ Bonus percentage will be 45%

Total Wages = 8 x 2+ 45% of 8 x 2

= 16 + 45% of 16

= 16 + 7.20

= Rs. 23.20

It can be seen that the abovestated system is similar to that of piece rate with guaranteedtime rate. This system may be suitable for non efficient workers for improving their efficiency.

(c) Bedaux Point System :

Under this system, the standard time is divided into standard minutes, each standard minuteidentified as Bedaux Point or B. The wages payable to the worker are computed as below.

Wages = Actual Hours x Hourly Rate +75 % of BS x Hourly Rate

60

Where BS indicates the number of B’s saved i.e. the difference between B’s earned andstandard B’s allowed for the job.

Eg. Standard points for a job - 400 points in 8 hours.

Hourly Rate - Rs. 3 per hour.

Wages = 8 x 3 + 75% of (450 - 400) x 3

60

= 24 + 75% of 2.50

= 24 + 1.875

= Rs. 25.875.

It should be noted that a very accurate system of work study is required for this system. It isdifficult to understand and involves a lot of clerical efforts.

X 100 = X 100 = 125%

263Labour Cost

(d) Accelerating Premium System :

Under this system, incentive increases at a fast rate with the increase in output. Total wagespayable to the worker are computed as below.

Y = 0.8 X2 where

Y = Earnings X = Efficiency.

i.e. If efficiency is 140%, the earnings will be :

140 1400.8 x100 100

x 1.568 of basic wages i.e.

100% wages, 56.8% bonus.

Eg. Standard hours are 10

Actual Hours are 8

Hourly rate is Rs. 2 per hour.

∴ Efficiency percentage will be

10/8 x 100 = 125%

125 125Earnings = 0.8 x

100x

100

= 1.25

∴ Earnings will be 125% of basic wages i.e 100% basic wages, 25% bonus.

Basic, wages - 8 x 2 = 16

Bonus - 25% of Rs. 16 = 4

Total Wages = 20

This system is very difficult to understand.

(e) Baum Differential Plan :

This is a combination of Taylor’s differential piece rate system and Halsey system and is alsoknown as Milwaukee Plan.

x


(f) Diemer System :

This is a combination of Halsey System and Gantt system.

(D) Group Incentive System :

In many cases, the output of the individual workers cannot be measured though the output ofa group of workers can be measured. In such cases, the individual time rates or in somespecified proportion depending upon the skill of the workers or equally, can be applied.

(E) Indirect Monetary Remuneration :

This may take the following two forms.

(a) Profit Sharing :

According to this method, the workers, are entitled to share in profits earned by anorganisation, in addition to the regular wages, at a specified percentage. The legalprovisions in this regard are enacted by way of Payment of Bonus Act, 1965. Accordingto the provisions of this Act, all the employees drawing a monthly remuneration ofRs. 2,500 or less are entitled to a bonus at the minimum rate of 8.33% of wages of thesubject to the maximum ceiling of 20 % of the wages. It should be noted that the statutoryrequirement of the payment of bonus does not depend on the profit earned necessarily,as the bonus is payable eventhough there are no profits. It is also worth noting that thestatutory requirement of payment of bonus is the specific percentage of the wages orsalaries paid to the workers and hence remains unaffected by any changes, either upwardsor downward, in the profits earned by the organisation.

(b) Co-partnership :

According to this method, the workers are granted ownership rights in the operations ofthe organisation by which the workers are in the position to control the affairs of theorganisation. In corporate organisations, it may be in the form of offering the shares ofthe company to the workers or granting of loans to the workers to buy company’s shares,according to which the workers get the voting rights to control the affairs of the company.The workers get dividend on the shares as bonus. With the help of this method, themorale of the workers is increased. However, certain objections are raised against thismethod. First, the increase in earnings is too small. Second, the shareholding of theworkers is too small to control the affairs of the company. Third, the workers are notrewarded according to the individual efficiency.

265Labour Cost

(F) Non-monetary Incentives :

The intention of these incentives is to attract better workers, retain the existing workers,encourage loyalty, reduce labour turnover, provide better working conditions to workers and soon. Various benefits as stated below may be granted to the workers, either free or at reducedrates, remaining amount being contributed by the workers.

(1) Health and safety services.

(2) Education and training to workers and their children.

(3) Canteen facility.

(4) Pension, superannuation fund etc.

(5) Loans at reduced rate of interest.

IMPORTANT TERMS IN CASE OF LABOUR COST :

(A) Labour Turnover :

In every business organisation, the process of employees leaving the organisation and newworkers being recruited is a normal feature. Labour Turnover indicates this change in labourforce showing a highly increasing trend or highly decreasing trend. Labour turnover showingsharp increasing trend may involve the reduction in labour productivity and increasing costs.Too low a labour turnover trend may be due to inefficient workers who would not like to leavethe organisation.

Causes of labour turnover :

The causes of labour turnover can be broadly classified as below :

(a) Avoidable causes :

(1) Dissatisfaction with job.

(2) Dissatisfaction with remuneration.

(3) Dissatisfaction with working conditions.

(4) Dissatisfaction with hours of work.

(5) Relationship with supervisors and workers.

(b) Unavoidable causes :

(1) Betterment/Personal.

(2) Illness or accident.

(3) Move from locality.


(4) Discharge.

(5) Marriage.

(6) Retirement.

(7) Death.

(8) National service.

Costs of labour turnover

The cost of labour turnover may be classified under two headings.

(a) Preventive Costs :

These refer to all the costs which may be incurred by the organisation to keepworkers happy and discourage them from leaving the job. This, in turn, may include thecosts like :

(1) Cost of Personnel Administration - To maintain good relations with the workers.

(2) Cost of medical services- To keep the workers and their families in healthy condition,as healthy workers are assets for the organisation who contribute towards higherefficiency and productivity.

(3) Costs of welfare activities - To give facilities like transport, canteen etc.

(4) Other incentive schemes like pension, provident fund, superannuation fund, Bonusetc.

(b) Replacement Costs :

These refer to the costs incurred for recruitment and training of new workers and theresulting losses, wastages and reduced productivity due to the inefficiency andinexperience of new workers.

This in its turn may include the costs like-

(1) Inefficiency of new workers.

(2) Cost of selection and placement.

(3) Training costs.

(4) Loss of output due to delay in getting new workers

(5) Increased spoilage and defectives.

(6) Cost of tools and machine breakages.

267Labour Cost

Measurement of labour turnover :

There are three methods for measuring the labour turnover.

(1) Separation Method

Under this method, it is computed as :

No. of Separations in a periodX 100

Average no. of workers

(2) Replacement Method

Under this method, it is computed as

No. of Replacements in a periodX 100

Average no. of workers.

(3) Flux Method

Under this method, it is computed as -

No. of separations + No. of replacementX 100

Average no. of workers

Illustration :

From the following data given by Personnel Department, calculate the labour turnover rate byapplying :

(a) Separation Method

(b) Replacement Method

(c) Flux Method

No. of workers on pay-roll

- At the beginning of the month 900

- At the end of the month 1,100

During the month, 10 workers left, 40 persons were discharged and 150 workers were recruited.Of these 25 workers are recruited in the vacancies of those leaving while the rest were for anexpansion scheme.


Solution :

Calculation of Labour Turnover

(1) Separation Method

No. of separations in a periodX 100

Average No. of workers

= 50

X 100 = 5

1000

∴ Monthly Turnover Rate : 5%

Annual Turnover Rate : 5 X365

= 60.83% 30

(2) Replacement Method :

No. of replacements in a periodX 100


25= X 100 = 2.5%

1000

Monthly turnover Rate : 2.5%

365Annual Turnover Rate : 2.5 X = 30.42%

30

(3) Flux Method :

No. of separations + No. of replacementsX 100


50 +25= = 100 = 7.5%

1,000

Monthly Turnover Rate : 7.5%

365Annual Turnover Rate : 7.5 X = 91.25%

30

269Labour Cost

Working Notes :

Average number of workers is calculated as -

No. of workers at beginning + No. of worker at end

2

=900 + 1,100

2

= 1,000

(B) Idle Time :

It indicates the time for which wages are paid to the workers but during which no production isobtained. To exercise proper control on idle time, causes of the same should be analysedproperly and studied from its controllability point of view.

The causes of idle time can be analysed as below :

(a) Productive causes :

These can be further classified as :

(i) Due to machine breakdown.

(ii) Power failures.

(iii) Waiting for tools, work or raw materials.

(iv) Waiting for instructions.

These causes are supposed to be controllable causes and can be controlled if plannedproperly.

(b) Administrative causes :

Some idle time may be caused due to administrative decisions. E.g. the organisation ishaving excess machine capacity or during the depression period, it is not having sufficientwork to be performed, but it has decided not to get rid of trained workers temporarily. Assuch cost of idle time is accepted.

(c) Economic causes :

Economic causes may be of seasonal nature, cyclical nature or industrial nature. E.g. ifthe product manufactured is of a seasonal nature, for other periods of the year, thecapacity may remain unused, unless some other product to take care of slack season isintroduced. In case it is not possible to make alternate use of such idle capacity, some


idle time is unavoidable. In case of cyclical causes, the causes are similar to seasonalfluctuations but these causes are beyond the control of management.

Treatment of idle time cost :

If Idle time payment is normal and controllable, it should be classified as overheads. If it ispossible to allocate the same to some department, it should be allocated and absorbed in theproduction department cost.

If idle time is normal and uncontrollable, the labour rates should be suitably modified. E.g. iftime attended is 8 hours but time booked is only 7.5 hours and labour cost is Rs. 1.5 per hour,the hourly labour rate should be computed as -

8 hours X Rs. 1.5i.e. Rs. 1.60

7.5 hours

If idle time payment is uncontrollable and abnormal, it should not be considered as a part ofmanufacturing cost but should be written off to Costing Profit and Loss Account.

(C) Internal Control Problems in Labour Cost :

In today’s world, labour is one of the most important factors of production, and contributing toa very great extent to the cost of production. As such, it will be the intention of every organisationto have proper control on the labour cost. The implementation of various Internal ControlProcedures indicate the following of all those methods and procedures which ensures fluentand smooth running of the operations of the organisation and also of achieving protection ofassets, prevention of errors and frauds, proper recording of information whenever necessary.

The cost of labour may be high due to the various reasons stated below :

(1) Excess staffing - Having more staff than the requirement.

(2) Lack of experienced and efficient personnel.

(3) Excessive remuneration pattern - Settlement of the wage rates or piece rates on higherside which may not be justified on the basis of efficiency of workers.

(4) Clerical errors or fraudulent practices taking place in the area of time keeping, computationof wages payable, procedure for payment of wages to the workers etc.

(5) Idle time or unusual overtime wages.

(6) Increase of spoilage due to lack of proper supervision and inspection.

(7) High labour turnover.

After locating the reasons for increasing labour costs, attempts can be made to keep thesame in control after following various internal control measures as discussed below.

271Labour Cost

(1) To avoide the problem of excess staffing, the employment of the workers should bemade only after the receipt of labour placement requisition from the concerned department.After the receipt of this requisition, it should be seen, whether it is possible to meet therequirement of said department with the help of existing staff only or at least by transferringthe existing excess staff in other departments. Before proceeding with the actual processof selection of the staff, care should be taken to decide in advance about the nature ofwork which may be assigned to the individual employee.

(2) To ensure that correct personnel is employed to work in the correct places, care shouldbe taken to analyse the requirements of the job and then to select the personnel whichsuits these requirements. This process may be in the form of ‘job evaluation.’

Selection of the proper personnel may not be enough. To train the selected personnel toextract maximum of their efficiency is equally necessary.

(3) The problem of setting the excessive rate structure in the form of higher time rate orpiece rates or bonus rates may be avoided by setting the standards in the most scientificmanner. For this purpose, the techniques like time and motion study, work study etc.may be implemented.

(4) To avoid the clerical errors or fraudulent practices in the areas of wage sheet preparationor wage payments, proper internal check procedures may be implemented, so that thework of one person is properly checked by another person. For this, following steps maybe taken :

(a) Time recording clock should be installed, wherever possible. Proper supervision isrequired to ensure that one person punches his own card only.

(b) The terms of remuneration should be set and made known to the workers in veryvery clear terms.

(c) Proper internal checks should be executed while preparing the wages sheets.Cashier should not be allowed to handle the wages sheets and the person preparingthe sheets should not be allowed to prepare wage packets. Personnel officer/managershould check and authorize the wages sheets.

(d) The wages should be paid to workers after they are properly identified. The wagesshould not be paid to any other person, unless proper authorization letter is producedin exceptional circumstances.

(e) Distribution of wages should be made in all the departments at a time so as toavoid the possibility of one person being present at two places.


(5) Existence of idle time should be properly analyzed according to controllability. The causesof controllable idle time should be attempted to be avoided.

If it is necessary to work overtime, it should be properly authorized and should be paidand accounted for properly. Care should be taken to see that proper returns are obtainedfor making overtime wages payment.

(6) If the labour cost is higher due to spoilage of work which in turn may be due to lack ofproper supervision or inspection, it is a cost which can very will be controlled by havingproper supervision or inspection.

(7) The causes of labour turnover should be analysed according to normality. All the avoidablecauses of labour turnover should be paid proper attention. Higher trend of labour turnoveradds to the costs in two ways mainly. It reduces the labour productivity and at the sametime, increases the costs. If the workers have the grievances which are of avoidablenature, say dissatisfaction with remuneration or other benefits or working hours or workingconditions or job itself or relations with the fellow workers or the supervisors, attemptscan be made to avoid those causes of labour turnover.


(1) The standard hours for job X is 100 hours. The job can be completed by A in 60 hours, byB in 70 hours and by C in 95 hours.

The bonus system applicable to the job is as follows :

% of time saved to time allowed Bonus

Saving upto 10% 10% of time saved

Saving from 11% to 20% 15% of time saved

Saving from 21% to 40% 20% of time saved

Saving from 41% to 100% 25% of time saved.

Rate of pay per hour is Rs.1 Calculate the total earnings of each worker and also therate of earnings per hour.

273Labour Cost

Solution :

A B C

(1) Standard Hours 100 100 100

(2) Actual Hours 60 70 95

(3) Hours Saved 40 30 5

(4) % Hours saved 40% 30% 5%

(5) Applicable bonus rate

(% of wages for time saved) 20% 20% 10%

(6) Hourly Rate (Rs.) 1 1 1

(7) Basic wages (Rs.) - 2 x 6

i.e. Actual Hours x Hourly rate 60 70 95

(8) Wages for time saved (Rs.) - 3 x 6

i.e. Hours Saved x Hourly Rate 40 30 5

(9) Bonus (Rs.) - 8 x 5

i.e. Wages for time saved x Bonus Rate 8 6 0.5

(10) Total - (Rs.) 7+ 9 68 76 95.5

Note :

It is assumed that the amount of bonus is not decided on rates of bonus on cumulative basis.

(2) During one week X makes 200 units. He receives wages for a guaranteed 44 hours perweek at a rate of Rs. 1.50 per hour. Estimated time to produce one unit is 15 minutes.Time allowed is increased by 20% allowance on estimated time, under incentive scheme.Calculate earnings as per :

(i) Time rate

(ii) Piece rate

(iii) Rowan scheme

(iv) Halsey scheme

Solution :

(i) Time Rate :

No. of Hours X Hourly Rate

= 44 Hours x Rs. 1.50 = Rs. 66


(ii) Piece Rate :

Hourly RateUnits produced X

Units per hour

= 200 units XRs. 1.50

= Rs. 754 units

(iii) Rowan Scheme :

Time SavedActual Hours X Hourly Rate + X Actual Hours X Hourly rate

Time Allowed

16 Hours= 44 Hours x Rs. 1.50 + X 44 Hours X Rs. 1.50

60 Hrs

= Rs. 66 + Rs. 17.60

= Rs. 83.60

(iv) Halsey Scheme :

Actual Hours X Hourly Rate + 1/2 (Time Saved X Hourly Rate)

= 44 Hours X Rs. 1.50 + 1/2 (16 Hours X Rs. 1.50)

= Rs. 66 + Rs. 12

= Rs. 78

Working Notes :

For incentive scheme, time allowed is increased by 20% of estimated time

Estimated time is 15 minutes per unit

∴ For incentive scheme, time allowed will be -

15 minutes + 20% = 18 minutes

Time allowed for 200 units will be -

18 minutes X 200 units = 60 Hours

60 minutes

Actual time taken is 44 Hours.

Hence, time saved will be 16 hours ( i.e. 60 hours - 44 hours)

275Labour Cost

It is assumed that the allowance of 20% is available only in case of incentive systemsand not in case of time rate or piece rate systems.

(3) In a factory under bonus system, bonus hours are credited to the employee in theproportion of time taken which time saved bears to time allowed. Jobs are carried forwardfrom one week to another. No overtime is worked and payment is made in full for all unitsworked on, including those subsequently rejected. From the following information, youare required to calculate for each employee.

(1) Bonus hours and amount of bonus earned.

(2) Total wages cost.

(3) Wage cost of each unit (good) produced.

Employee A B C

Basic wage rate per hour Rs. 5 Rs. 8 Rs. 7.5

Units issued for production 2,500 2,200 3,600

Time allowed for 100 units 2H 36M 3H 1H 30M

Time taken 52H 75H 48H

Rejections 100 units 40 units 400 units

Solution :

The description of the bonus system indicates that it is Rowan system of incentive payment.

A B C

(1) Time allowed for 100 units 156 min. 180 min. 90 min.

(2) Units issued for production 2,500 2,200 3,600

(3) Time allowed for actual production 65 hours 66 hours 54 hours

(4) Time taken 52 hours 75 hours 48 hours

(5) Time saved i.e. 3-4 13 hours - 6 hours

(6) Hourly basic wage rate (Rs.) 5 8 7.5

(7) Basic wages i.e. 4 x 6 (Rs.)

Time taken x Hourly rate 260 600 360

(8) Bonus earned : (Rs.)

Time Hourly Time savedX X

taken rate Time allowed 52 - 40

(9) Total wages i.e. 7 + 8 (Rs.) 312 600 400


A B C

(10) Rejections (units) 100 40 400

(11) Good units i.e. 2-10 2,400 2,160 3,200

(12) Wages per good unit i.e. 9/11 Re. 0.13 Re. 0.28 Re. 0.125

(4) From the following particular, you are required to work out the earnings of a worker under.

(a) Straight Piece Rate

(b) Differential Piece Rate

(c) Halsey Premium Scheme (50% Sharing)

(d) Rowan Premium Scheme

Weekly working hours - 48

Hourly wage rate - Rs. 7.50

Piece Rate per unit - Rs. 3.00

Normal time taken per piece - 20 minutes

Normal output per week - 120 pieces

Actual output for the week - 150 pieces

Differential piece rate - 80% of piece rate when output below normal and120% of piece rate when output above normal.

Solution :

(a) Straight Piece Rate :

Actual output x piece rate per unit

= 150 pieces x Rs. 3

= Rs. 450

(b) Differential Piece Rate :

Actual output is more than normal output. Hence, piece rate will be 120% of normalpiece rate.

∴ Applicable piece rate 120% of Rs. 3 i.e. Rs. 3.60

∴ Wages = Actual output x Applicable piece rate per unit

= 150 piece x Rs.3.60

= Rs. 540

277Labour Cost

(c) Halsey Premium Scheme :

Actual Hours X Hourly Rate +(Time Saved x Hourly Rate)

2

= 48 hours X Rs. 7.50 +2 hours X Rs. 7.50

2

= Rs. 360 + Rs. 15/2

= Rs. 367.50

(d) Rowan Premium Scheme :

Time SavedActual Hours x Hourly Rate + X Actual Hours X Hourly Rate

Time Allowed

2 hours= 48 hours X Rs.7.5 + X 48 hours x Rs. 7.50

50 hours

= Rs. 360 + Rs. 14.40

= Rs. 374.40

Note :

Time saved is calculated as below :

Normal time per piece - 20 minutes

Pieces per hour - 3

Pieces produced - 150

Hours allowed for pieces produced - 50

i.e. 150/3

Actual hours taken - 48

Hours saved - 2

(5) In an engineering workshop, 15 persons work in a group. If the weekly production of thegroup exceeds 120 units per hour (which is standard), each man gets a bonus in additionto his hourly earnings.

Bonus regulation - Each worker’s share should be 1/2 of the percentage in excess ofstandard production. The bonus shall be payable at this percentage of wage rate Rs.1.50per hour. There is no relationship between individual workers’ hourly rate and bonus rate.


The following is a weekly output :

Day Hours worked Output in units

Monday 150 24,700

Tuesday 160 25,500

Wednesday 145 17,060

Thursday 155 18,050

Friday 170 28,900

Saturday 160 21,150

940 1,35,360

Compute

a. The rate and amount of bonus for the week.

b. Total earnings of David who worked 40 hours during the week and his basic wage wasRs. 1.20 per hour and that of Abdulla who worked for 48 hours and his basic wage wasRs. 1.25 per hour.

Solution :

(a) Actual Production for the week 1,35,360 units

Standard production i.e. 940 x 120 1,12,800 units

Excess Production 22,560 units

22,560Excess production percentage = X 100 = 20%

1,12,800

Bonus percentage for the group = 1/2 of 20%

= 10%

Bonus Rate : 10% of Rs. 1.50

= Re. 0.15 per hour

279Labour Cost

(b) (1) Total Earnings of David :

Basic wages - 40 hours x Rs. 1.20 hours Rs. 48.00

Bonus - 40 hours x Re. 0.15/hour Rs. 6.00

Rs. 54.00

(2) Total Earnings of Abdulla :

Basic wages - 48 hours x Rs. 1.25/hour Rs. 60.00

Bonus - 48 hours x Rs. 0.15/hour Rs. 7.20

Rs. 67.20

(6) Two fitters, a labourer and a boy, undertake a job on piece rate basis for Rs. 1,290. Thetime spent by each of them is 220 ordinary working hours. The rates of pay on time ratebasis are Rs. 1.50 per hour for each of the two fitters. Re. 1 per hour for the labourer andRe. 0.50 per hour for the boy. Calculate :

(a) The amount of piece-work premium and the share of each worker, when the piecework premium is divided proportionately to the wages paid.

(b) The selling price of the above job on the basis of following data - Cost of DirectMaterials is Rs. 2,010, works overhead at 20% of Prime Cost, selling overhead at10% of works cost and Profit at 25% of cost of sales.

Solution :

(A) (1) wages payable on time basis

Fitter 220 hrs. x 2 x Rs. 1.50 = Rs. 660

Labourer 220 hrs. x Re. 1 = Rs. 220

Boy 220 hrs. x Re. 0.50 = Rs. 110

Basic Wages = Rs. 990

(2) Price of the job Rs. 1,290

(3) Premium received i.e. b - a Rs. 300

(4) Share of each worker -

FittersRs. 300

X Rs. 660 Rs. 200.00Rs. 990


LabourerRs. 300

X Rs. 220 - Rs. 66.67Rs. 990

BoyRs. 300

X Rs. 110 - Rs. 33.33Rs. 990

Rs. 300.00

(b) Fixation of selling price :

Cost of Direct Material Rs. 2,010.00

Cost of Labour Rs. 1,290.00

Prime Cost Rs. 3,300.00

Works Overheads

(20% of Prime Cost) Rs. 660.00

Works Cost Rs. 3,960.00

Selling Overheads

(10% of works cost) Rs. 396.00

Cost of Sales Rs. 4,356.00

Profit (25% on cost of sale) Rs. 1,089.00

Selling Price Rs. 5,445.00

(7) A worker, whose daily work wages is Rs. 2.50 an hour, received production bonus underthe Rowan scheme. He carried out the following works in a 48 hours week.

Job 1 - 1,500 items at 4 hours per 1000



Job 4 - 1,500 items for which no “Standard time” was fixed and it was arranged thatthe worker would be paid a bonus of 25%. Actual time taken on the job was4 hours.

Job 5 - 2,000 items at 8 hours per 1000, each item was estimated to be half finished.

Job No. 2 was carried out on a machine running at 90% efficiency and an extra allowanceof 1/9th of actual time was given to compensate the worker.

281Labour Cost

4 hours were lost due to power cut. Calculate the earnings of the worker, clearly stating yourassumptions for the treatment given by you for the hours last due to power cut.

Solution :

(a) Calculation of time allowed

Job 1 - 6 hours

Job 2 - 6 hours

Job 3 - 54 hours

Job 4 - 5 hours

Job 5 - 8 hours

79 hours

(b) Time taken 44 hours

(Except idle time)

(c) Time saved 35 hours

(d) Total wages (As per Rowan system)

Time savedTime taken X Hourly rate + X Time taken X Hourly Rate

Time allowed

35 hours= 44 hours X Rs. 2.50 + X 44 hours X Rs. 2.50

79 hours

= Rs. 110 + Rs. 48.73

= Rs. 158.73

(e) Idle time wages (At hourly rate)

4 hours X Rs. 2.50

= Rs. 10

(f) Total earnings - i.e. d + e

Rs.158.73 + Rs. 10.00

= Rs.168.73


Note :

(1) The idle time is not treated for computing time taken. For idle hours, the worker will getthe wages at normal hourly rate.

(2) Time allowed for Job 2, Job 4 and Job 5 is calculated as below :

(a) Job 2 :

Time taken for 1,800 units 5.40 hour

Add :Extra allowance 1/9 0.60 hour

Time allowed 0.60 hour

(b) Job 4 :

Time taken for 1500 units 4 hours

Add : Allowance @ 25 1 hour

Time allowed 5 hours

(c) Job 5 :

Time taken for 2000 16 hours

Each item half finished

∴ Equivalent finished units 1,000

∴ Time for equivalent finished units 8 hours

QUESTIONS

1. Explain the various steps in the process of identifying the direct labour cost with theindividual cost center.

2. What do you mean by idle time. Explain in details the cost accounting treatment of idletime.

3. Explain the term “Labour Turnover”. What are the causes responsible for labour turnover?Explain the costs of labour turnover. How the Labour turnover is measured?

283Labour Cost

PROBLEMS

(1) During the first week of March, 1984 the workman Mr. Saurabh manufactured 300 articles.He receives wage for a guaranteed 48 hours week at the rate of Rs. 4/- per hour. Theestimated time to produce one article is 10 minutes and under incentive scheme thetime allowed is increased by 20%. Calculate his gross wages according to :

(a) Piece work with guaranteed weekly wage.

(b) Rowan premium bonus and

(c) Halsey premium bonus 50% to workman.

(2) Calculate total monthly remuneration of three workers A, B and C from the followingdata.

(a) Standard production per month per worker 1,000 units.

(b) Actual production during the month

A - 850 units, B - 750 units, C - 950 units.

(c) Piece rate is Re. 0.10 per unit.

(d) Additional production bonus is Rs. 10 for each percentage of actual productionexceeding 80% over standard.

(Example 79% Nil, 80% - Rs. 10, 81% - Rs. 20 and so on)

(e) Dearness allowance fixed Rs. 60 per month.

(3) Following are the particulars as regards a worker who worked on jobs No. 122 and 133.

Job No. Time allowed Time taken

122 26 hours 20 hours

133 26 hours 30 hours

His normal and basic rate of wages was Rs. 28 per day of 8 hours and the dearnessallowance was Rs. 42 per week of 48 hours.

Calculate the amount payable to him by showing your workings on the following basis.

(a) Time basis.

(b) Halsey Incentive Plan basis (Bonus at 50% of time saved)

(c) Rowan Incentive Plan basis.


(4) Standard time fixed for a job is 40 hours and time rate is Rs. 4 per hour. You are requiredto prepare a comparative table under Halsey Plan 50 - 50 and Rowan Plan, if actual timetaken is 36 hours, 32 hours, 24 hours, 16 hours and 12 hours.

The table should clearly show (a) Bonus payable, (b) Total earnings, (c) Effective rate ofearnings per hour.

(5) Calculate the earnings of a workman under Halsey Premium Plan and Rowan PremiumPlan for executing a piece of work in 60 hours as against 75 hours allowed. His hourlyrate is 25 paise and under Halsey system, he is to be paid bonus at 50% of time saved.In addition, he gets a dearness allowance for Re. 1 per day of 8 hours worked.

(6) From the following information, calculate the earnings of A, B and C under Halsey andRowan premium bonus plans.

A B C

Standard time in hours per 100 units 35 40 42

Wages per unit of output Rs. 2 Rs. 3 Rs. 4

Wage rate per hour Rs. 7 Rs. 8 Rs. 10

Actual hours taken 50 48 46

Actual no. of units produced 200 150 125

(7) The firm employs 5 workers at an hourly rate of Rs. 2.00. During the week they workedfor 4 days for a total period of 40 hours each and completed a job for which standard timewas 48 hours for each worker.

Calculate the labour cost under the Halsey Method and Rowan Method of incentive PlanPayments.

(8) Compute the total time wages and total earnings of a worker, the rate earned per hourand the bonus per hour in respect of three workers X,Y, and Z under the Halsey-Weirbonus plans. The following are the particulars supplied.

Standard Time : 20 hours.

Hourly Rate of Wages : Re. 1.00 per hour.

Time Taken X = 16 hours, Y = 12 hours and Z = 10 hours.

285Labour Cost

(9) The three workers Govind, Ram and Shyam produced 80, 100 and 120 pieces of aproduct X on a particular day in May 1987 in a factory. The time allowed for 10 units ofProduct X is 1 hour and their hourly rate is Rs. 4. Calculate for each of these threeworkers the following :

(a) Earnings for the day

(b) Effective rate of earnings per hour under

(i) Straight piece Rate

(ii) Halsey Premium Bonus (50% sharing)

(iii) Rowan Premium Bonus methods of Labour Remuneration

(10) A worker takes 6 hours to complete a job under a scheme of payment by results. Thestandard time allowed for the job is 9 hours. His wage rate is Rs. 1.50 per hour. Materialcost of the job is Rs. 16 and the overheads are recovered at 150% of the total directwages. Calculate the factory cost of the job under - (a) Rowan and (b) Halsey scheme ofincentive payments.

(11) In an engineering concern, the employees are paid incentive bonus in addition to theirnormal wages at hourly rates. Incentive bonus is calculated in proportion of time taken totime allowed, of the time saved. The following details are made available in respect ofemployees X, Y and Z for a particular week.

X Y Z

Normal Wages (Rs. per hour) 4.00 5.00 6.00

Completed units of production 6000 3000 4800

Time Allowed (per 100 units) 0.8 hr. 1.5 hrs. 1 hr.

Actual time taken (hours) 42 40 48

You are required to work out for each employee

(a) The amount of bonus earned.

(b) The total amount of wages received.

(c) The total wages cost per 100 units of output.


(12) A workman whose basic rate of pay under Rowan plan of premium bonus is Rs. 2 perhour. In addition, he receives a cost of living bonus of Rs. 33 per week of 66 hours onactual hours worked. During a week, he does the following jobs.

(i) Job A for which 30 hours are allowed in 20 hours.

(ii) Job B for which 36 hours are allowed in 20 hours.

During this week, his waiting time was 4 hours.

Calculate his earnings and amount to be charged to each job.

(13) An operator engaged on a machine, receives an ordinary day rate of Rs. 1.60 per day of8 hours. The standard output has been fixed at 80 pieces per hour (time as fixed forpremium bonus.) On a certain day, the output of a worker on this machine is 800 pieces.Find the labour cost per 100 pieces and the wages that should have been actuallyearned by the workman under the following -

(a) If a bonus of Re. 0.23 is paid per 100 of extra output.

(b) If paid on straight piece work basis at the standard rate.

(c) If Halsey Premium System is adopted.

(14) In a manufacturing concern, 20 workmen work in a group. The concern follows a groupincentive bonus system whereby each workman belonging to the group is paid a bonuson the excess output over the hourly production standard of 250 pieces, in addition to hisnormal wages at hourly rate. The excess of production over the standard is expressedas a percentage and two thirds of this percentage is considered to be the share of theworkman and is applied to the normal hourly rate of Rs. 6.00 (Considered only for purposeof computation of bonus.) The output data for a week are stated below.

Days Manhours worked Output (in pieces)

Monday 160 48,000

Tuesday 172 53,000

Wednesday 164 40,000

Thursday 168 52,000

Friday 160 46,000

Saturday 160 42,000

984 2,81,000

287Labour Cost

You are required to -

(a) Work out the amount of bonus for the week and the average rate of which each workmanis to be paid the same.

(b) Compute the total wages including bonus payable to Ram Jadhav who worked for 48hours at an hourly rate of Rs. 2.50 and to Francis Williams who worked for 52 hours at anhourly rate of Rs. 3.00.

(15) Following data for the month of October 1990 is available for a company.

No. of workers on payroll on 1st October, 90 - 1450

No. of workers on payroll on 31st October 90 - 1550

During the month 10 workers left the company, 70 persons were discharged and 200workers were recruited. Of these workers, 40 workers were recruited in the vacancies ofthose who had left and the remaining were recruited for an expansion programme.

Calculate the labour turnover rate by using -

(i) Separation Method

(ii) Replacement Method

(iii) Flux Melhod


NOTES

289Overhead Cost

Chapter 10OVERHEAD COST

It has already been discussed that the term cost can be basically classified as Direct Costand Indirect Cost. Direct Cost indicates all those costs which can be identified with theindividual cost centre and indirect cost indicates all those costs which cannot be identifiedwith the individual cost centre. The total of indirect costs are termed as overheads.

There may be various ways in which the overheads may be classified.

(1) Elementwise Classification :

As the cost can be basically classified as per the Elements of Cost i.e. Material Cost,Labour Cost and Expenses, the indirect cost i.e. overheads may be classified as per theelements of cost. This classification of overheads takes the form of :

(a) Indirect Material

(b) Indirect Labour

(c) Indirect Expenses.

The meaning and the type of expenses included in this classification have already beendiscussed in the chapter on Cost Sheet.

(2) Functionwise Classification :

Under this classification, the overheads are classified according to the functions theyperform. This classification of overheads takes the form of :

(a) Factory Overheads (also termed as production or works or manufacturing overheads)

(b) Administration Overheads.

(c) Selling and Distribution Overheads.The meaning and the type of expenses includedin this classification have already been discussed in the chapter on Cost Sheet.

(3) Variabilitywise Classification :

(i) Fixed overheads : These overheads indicate the costs which remain unaffectedby variations in volume of output. E.g. Rent, Insurance on building, salary to


administrative staff etc. Per unit cost of overheads may reduce as the volume ofoutput increases but the total overheads remain constant.

(ii) Variable overheads : These overheads indicate the costs which vary directly inproportion to volume of output. E.g. Consumable stores, nuts/bolts, loose toolsetc. Per unit cost of overheads remains the same but total overheads may increaseor decrease as per volume of output.

(iii) Semi-variable overheads : These overheads indicate those which are neitherfixed nor variable in nature. These may remain fixed at certain levels of activity whilemay vary proportionately at other levels of activity. E.g. maintenance cost, power,electricity, supervision cost etc.

(4) Controllabilitywise Classification :

Under this classification, the overheads are classified according to their controllablenature. This classification takes the form of :

(a) Controllable overheads.

(b) Uncontrollable overheads.This classification has already been discussed.

(5) Normalitywise Classification :

Under this classification, the overheads are classified according to the fact as to whetherthe overheads are normally incurred at a certain level of output under normal circumstances.This classification takes the form of :

(a) Normal overheads.

(b) Abnormal overheads.

This classification has already been discussed.

It should be noted in this connection, that the above classification refers to the classificationof same amount of overheads in different forms to suit the individual requirements. E.g. For thepurpose of preparing the cost statement, overheads may be classified according to functionswhile for the purpose of marginal costing applications, overheads may be classified accordingto variability.

Procedure for Charging the Overheads :

The basic aim of costing is to find out the cost of each cost centre. The cost of each costcentre can be either the direct cost or the indirect cost. The direct cost can be identified withthe individual cost centre and hence poses no difficulties. To charge the indirect costs i.e.overheads to the individual cost centres is the major problem. For this, the following proceduremay be followed.

291Overhead Cost

(A) Allocation/Primary Apportionment :

There can be some overheads which are incurred for the company as a whole, i.e. for all thedepartments. i.e. Production as well as Service departments. To identify the common costswith the individual departments is the first stage problem. This can be solved in two ways.

(1) If at all it is possible to identify some overheads with the individual departments theyshould be identified by following the procedure of allocation of overheads.

E.g. Wages paid to the maintenance department workers can be obtained from wagessheet and can be allocated to maintenance department. Similarly, cost of indirect materialcan be allocated to individual departments by pricing material requisition slips.

(2) It may not be possible in all the cases to allocate the overheads, i.e. in case of commonexpenses for the entire factory. In this case, they can be apportioned among the variousdepartments on some suitable basis, i.e. to all production as well as service departments.This process is in the form of Primary apportionment or distribution of overheads.The selection of the base on which overheads are or should be apportioned depends onthe following principles :

(a) Service or use basis : If the benefit obtained by various departments from theoverheads can be measured, overheads can be apportioned on that basis.

(b) Survey basis : If amount of services rendered can’t be measured, survey basismay be applied. E.g. If it can be noted that a supervisor is giving 60% of his servicesto department ‘A’ and 40 % to department ‘B’, his wages can be apportioned onthat basis.

(c) Ability to pay basis : In this case, the apportionment may depend upon the factorslike total sales/profitability. It may not be fair in some cases as most efficientdepartments may have to bear higher amounts of overheads, though actual overheadsof that department may be lower than those of other departments.

The usual bases which can be selected for Primary Apportionment may be as below :

Item of expenditure Base

(1) Canteen expenses/Staff Supervision Number of workers.

(2) Rent/Taxes Area

(3) Power HP/KWh

(4) General Lighting Number of light points/area

(5) Depreciation Value of assets

(6) Supervision Number of Employees/wages paid


(7) Telephone expenses Number of telephone calls made

(8) Fire Insurance. Value of stocks held/value of Assets.

Illustration :

The Omega Co, is having four departments. A, B, and C are production departments and D isa servicing department. The actual costs for a period are as follows.

Rs.

Rent 2,000

Repairs 1,200

Depreciation 900

Light 200

Supervision 3,000

Insurance 1,000

Employees Insurance (Employer’s liability) 300

Power 1,800

The following data are also available in respect of departments.

Dept. A Dept. B Dept. C Dept. D

Area sq. ft. 150 110 90 50

Number of workers 24 16 12 8

Total wages (Rs.) 8,000 6,000 4,000 2,000

Value of plant (Rs.) 24,000 18,000 12,000 6,000

Value of stock (Rs.) 15,000 9,000 6,000 –

Apportion the cost to the various departments on the most equitable method.

293Overhead Cost

Solution :

Apportionment of Overheads

Particulars Base Total Dept. Dept. Dept. Dept.Rs. A B C D

Rs. Rs. Rs. Rs.

Rent Area sq. ft. 2,000 750 550 450 250

Repairs Total wages 1,200 480 360 240 120

Depreciation Value of Plant 900 360 270 180 90

Light Area – sq. ft. 200 75 55 45 25

Supervision No. of workers 3,000 1,200 800 600 400

Insurance Value of stock 1,000 500 300 200 -

Employees’ Insurance(Employer’s Liabilities) No. of workers 300 120 80 60 40

Power Value of Plant 1,800 720 540 360 180

10,400 4,205 2,955 2,135 1,105

Notes :

It is assumed that the insurance is payable only on stock. Had it been assumed that it ispayable on stock as well as plant, the base would have been the combined value of stock andplant.

For the apportionment of power cost, Kwh/HP rating would have been an ideal base. Asrelevant data is not available, it is apportioned on the basis of value of plant.

Repairs are apportioned on the basis of total wages assuming that repair charges consist ofmainly labour charges.

(3) Secondary Apportionment :

With the process of primary apportionment or distribution, the loading of overheads for allthe departments i.e. production as well as service departments can be obtained. Nextstep is to transfer the overheads of non-production departments to production departments,as the various cost centres move through the production departments only. This is in theform of ‘Secondary apportionment or distribution of overheads’.


The usual bases which can be selected for the secondary apportionment may be asbelow :

(1) Maintenance Dept. - Number of hours worked.

(2) Stores Dept. - Number of requisitions.

(3) Purchase Dept. - Number of Purchase orders

(4) Building Service Dept. - Area

(5) Welfare/ Canteen and other facilities - Number of employees.

(6) Personnel or Time keeping Dept. - Number of employees.

(7) Internal Transport - Weight/value of goods moved.

While apportioning the overheads of non-production departments to productiondepartments, the problem will be there if non-production departments are rendering theservices inter-se.

There can be two ways to handle the situation like this -

(A) Ignore the services given by one service department to another. The defects involved withthis method are very obvious.

Illustration :

Following figures are extracted from the accounts of M/s. Vasant Works for the month ofJuly 1983.

Production Depts. Service Depts.P1 P2 S1 S2 S3

Indirect Material 280 140 170 350 160

Indirect Wages 324 312 296 190 218

Power and Light Rs. 3,000

Supervision Charges Rs. 2,200

Rent and Taxes Rs. 500

Insurance on assets Rs. 60

Depreciation at 12% p.a. on capital value of assets to be considered. From the above informationand the following departmental data, prepare overhead recovery rates for the productiondepartments PI and P2 on the basis of direct labour hours. The expenses of service departmentsshould be apportioned straight to the production depts. with the information that SI is toolroom, S2 is maintenance dept. and S3 is stores dept.

295Overhead Cost

Departmental Data : P1 P2 S1 S2 S3

Area (sq. ft.) 400 200 100 200 100

Capital Value of Assets (Ps.) 8000 4000 7000 5000 6000

Kilowatt Hours 4000 3000 1000 1000 1000

Number of employees 150 100 75 100 125

Direct Labour Hours 5000 5000

Number of requisitions 1000 300

Solution :

Statement showing apportionment of overheads

Items Base P1 P2 S1 S2 S3Rs. Rs. Rs. Rs. Rs.

Indirect Material Allocation 280 140 170 350 160

Indirect wages Allocation 324 312 296 190 218

Power & Light Kilowatt Hrs 1200 900 300 300 300

Supervision No. of employees 600 400 300 400 500

Rent & Taxes Area 200 100 50 100 50

Insurance on Assets Value of assets 16 8 14 10 12

Depreciation Value of assets 80 40 70 50 60

2700 1900 1200 1400 1300

Dept. S1 Labour Hours 600 600 (-)1200

Dept. S2 Labour Hours 700 700 (-)1400

Dept. S3 No. of requisitions 1000 300 (-)1300

5,000 3,500

(B) If it is decided to consider the services rendered by one service department to another,the first problem will be to decide the percentage in which services are given by servicedepartments inter-se. After such percentage is decided, the secondary apportionmentcan be made by either of the following methods.

(i) Simultaneous Equation Method : Under this method the amount of overheads ofeach production department can be obtained by solving simultaneous equations.


(ii) Repeated Distribution Method : Under this method service dept. overheads aredistributed to other departments, production as well as service, on agreed percentageand this process is repeated till the figures of service departments are exhausted orare too small to consider further apportionment.

Illustration :

A company has 3 production depts. and 2 service depts. and for a period departmentaldistribution summary has the following totals.

Production Depts. A ..Rs. 800 B Rs. 700 C. Rs. 500

Service Depts. 1 ....Rs. 234 2.. Rs. 300

The expenses of service depts. are charged out on a percentage basis as :

A B C 1 2

Service Dept. 1 20% 40% 30% - 10%

Service Dept. 2 40% 20% 20% 20%

You are required to show the apportionment of overheads.

Solution :

(a) Simultaneous Equation Method :

Let x = total overheads of Dept. 1

y = total overheads of Dept. 2

∴ x = 234+ 2/10 y

and y = 300 1/10 x

∴ 10 x = 2340 + 2y ...(1)

and 10 y = 3000 + x ...(2)

Rearranging equation 2 and multiplying equation I by 5

– 10y = 11700 - 50x

10y = 3000 + x

Adding 0 = 14700 – 49x

∴ 49 x = 14700

∴ x = 300 ...(3)

However, Y = 300 + 1/10 x

Y = 300 + 1/10 x 300

Y = 330 ...(4)

297Overhead Cost

Total overheads can be apportioned on the basis of agreed percentages to productiondepartments as below.

Total Dept. A Dept. B Dept. CRs. Rs. Rs. Rs.

As per Primary appointment 2,000 800 700 500

Dept. 1 (90% of Rs. 300) 270 60 120 90

Dept. 2 (80% of Rs. 330) 264 132 66 66

2534 992 886 656

(b) Repeated Distribution Method :

Dept. A Dept. B Dept. C Dept. 1 Dept. 2Rs. Rs. Rs. Rs. Rs.

As per Primary appointment 800 700 500 234 300

Dept. 1 47 94 70 (-) 234 23

Dept. 2 129 65 64 65 (-) 323

Dept. 1 13 26 20 (-) 65 6

Dept. 2 3 1 2 - (-) 6

992 886 656 - -

(3) Absorption :

The process of secondary apportionment of overheads, ensures the loading of overheadsto production departments. Now the next stage is that each job or product should get theloading of the overheads while it is moving through the production department and thisprocess is in the form of Absorption or Recovery of overheads. There can be a number ofmethods for absorbing the overheads but the ultimate selection of method has to bemade after considering various factors like type of industry, nature of products,manufacturing process, requirements and policy of management, cost of operating thesystem etc.

The various methods which can be considered for deciding the rates of overhead absorptionare as below :

(1) Direct Materials Cost Percentage Rate :

This is calculated as :

Amount of overheads to be absorbedX 100

Direct Materials cost


E.g. If production overheads to be absorbed are Rs. 25,000/-

and Direct materials cost is Rs. 50,000, the absorption rate will be :

25,000X 100 i.e. 50%

50,000

Now if the direct materials cost of a job is Rs. 500, it will be getting the loading ofoverheads to the extent of 50% of direct materials cost, i.e. Rs. 250. This method isuseful if materials cost forms a major part of production cost and is normally used ifmaterials costs are stable and equipments used remain unchanged.

This method leads to unsatisfactory results due to following reasons.

(i) There can be some situations where material prices vary without any change in theamount of over heads, in which case, this method may show wrong results.

(ii) If this method is used, a job using expensive material may get high loading ofoverheads as compared to a job using cheap material, which may not be fair.

(2) Direct Wages Percentage Rate :


Amount of overheads to be absorbedX 100

Direct wages cost

E.g. If the production overheads to be absorbed are Rs. 10,000 and direct wages cost isRs. 40,000, the absorption rate will be :

10,000X 100 i.e. 25%

40,000

Now if the direct wages cost of a job is Rs. 400, it will be getting the loading of overheadsto the extent of 25% of direct wages cost, i.e. Rs. 100. This method is useful if labourcost forms a major part of production cost and also if the work performed by all theworkers is uniform, ratio of skilled and unskilled workers is constant and labour rates donot fluctuate widely.

The problem with this method is that there is very little relationship between direct wagesand overhead expenses. It may give wrong results if the workers vary in ability.

299Overhead Cost

(3) Prime Cost Percentage Rate :


Amount of overheads to be absorbed X 100

Prime Cost

E.g. if the production overheads to be absorbed are Rs. 16,000 and prime cost isRs. 80,000, the absorption rate will be :

16,000 X 100 i.e. 20%

80,000

Now if the prime cost of a job is Rs. 250, it will be getting the loading of overheads to theextent of 20% of prime cost, i.e. Rs. 50.

This method is useful in this sense that it considers both the materials cost as well aslabour cost.

(4) Labour Hour Rate :


Amount of overheads to be absorbed

Labour hours required for production.

E.g. if production overheads to be absorbed are Rs. 50,000 and labour hours worked are100,000, the absorption rate will be :

Rs. 50,000i.e. Re. 0.50 per labour hour.

100,000

Now, if a job requires 20 labour hours to complete it, the loading of overheads to thesame will be Re. 0.50 per labour hour i.e. Rs. 10/-.

This method is useful if labour is the most important element of cost.

However, additional records are required to be kept for time booking per job. Further, ifmachinery forms a dominant portion in production cost, this method may lead to wrongresults.


(5) Machine Hour Rate :


Amount of overheads to be absorbed

Number of Machine Hours

E.g. if production overheads to be absorbed are Rs. 20,000 and machine hours workedas 5000, the absorption rate will be

Rs, 20,000i. e. Rs. 4 per machine hour.

5,000

Now if a job requires 25 machine hours to complete, the loading of overheads to the same willbe Rs. 4 per machine hour, i.e. Rs. 100.

If the machine use accounts for a large element of cost in the overall production cost, then thismethod can be used conveniently. This rate can be considered to be useful and ideal especiallyin the days of high mechanisation and automation.

While computing the machine hour rate, it is necessary to consider the various overheadsrequired to be incurred for running a machine or group of machines treating the same asdistinct cost centres.

Illustration :

Following information relates to activities of a production dept. of a factory for a certain period.

Direct Materials used Rs. 4,000

Direct wages Rs. 6,000

Direct Labour hours worked

(Including 20,000 hrs. of Machine operations) 24,000

Overheads chargeable to the dept. Rs. 5,000

For order No. 156 carried out in dept. relevant figures were.

Direct Materials used Rs. 200

Direct wages Rs. 165

Direct labour hours

(Including 800 machine hours) 820

Calculate the overheads chargeable to Order No. 156 by 5 cost rates.

301Overhead Cost

Solution :

Calculation of overhead absorption rate

(a) Direct Material Cost percentage :

Amount of overheadsX 100

Direct Material Cost

=Rs. 5,000

X 100 = 125%Rs. 4,000

(b) Direct Labour Cost percentage :


Direct Labour Cost

=Rs. 5,000

X 100 = 83 1/3%Rs. 6,000

(c) Prime Cost percentage :


Prime Cost

=Rs. 5,000

X 100 = 50%Rs. 10,000

(d) Labour Hour Rate :

Amount of overheads

Direct Labour Hours

=Rs. 5,000

= Re. 0. 2083 / Labour Hour.24,000

(e) Machine Hour Rate

Amount of overheads

Machine Hours

=Rs. 5,000

= Rs 0.25 / Machine Hour.20,000


The overheads chargeable to Order No. 156 and the total cost of the same can be calculatedas below :

Material Labour Overheads TotalRs. Rs. Rs. Rs.

(a) Direct Material

Cost percentage 200.00 165.00 250.00 615.00

(b) Direct Labour

Cost percentage 200.00 165.00 137.50 502.50

(c) Prime Cost percentage 200.00 165.00 182.50 547.50

(d) Labour Hour Rate 200.00 165.00 170.83 535.83

(e) Machine Hour Rate 200.00 165.00 200.00 565.00

Illustration :

Compute the machine hour rate from the following data.

Cost of the machine Rs. 1,00,000

Installation charges Rs. 10,000

Estimated scrap value after the expiry of life (15 years) Rs. 5,000

Rent and Rates for the shop per month Rs. 200

General lighting for the shop per month Rs. 300

Insurance charges for the machine per annum Rs. 960

Repairs and Maintenance expenses per month Rs. 1,000

Power consumption 10 Units per hour.

Estimated working hours per annum 2,200

(This includes setting up time of 200 hours)

Rate of power per 100 Units Rs. 20

Shop supervisor’s salary per month Rs. 600

The machine occupies 1/4 of the total area of the shop. The supervisor is expected to devote1/5 of the total time for the supervision of the machine.

303Overhead Cost

Calculation of Machine Hour Rate :

(a) Standing Charges Rs.

Depreciation 7,000.00

Rent and Rates 600.00

General lighting 900.00

Insurance Charges 960.00

Repairs and Maintenance 12,000.00

Shop Supervisor’s salary 1,440.00

Annual standing charges 22,900.00

Annual Machine Hours (Excluding setting up time) 2000

Hourly standing charges Rs. 11.45

(b) Running charges :

Power Expenses

Rate of power 20 paise per unit.

Power consumption - 10 units per hour.

Hourly power expenses Rs. 2.00

(c) Machine Hour Rate i.e. a + b Rs. 13.45

Working Notes :

(1) It is assumed that during the setting up time, the machine will not be used for theintended purpose and hence the said time is ignored for the calculation of machine hourrate.

(2) It is assumed that the depreciation is charged on straight-line basis.

Hence, it is calculated as :

Cost of Machine + Installation charges – Estimated scrap value

Estimated life of machine

=Rs. 100,000 + Rs. 10,000 – Rs 5000

= Rs. 7,000 p.a.15 years

(3) It is assumed that the Repairs and Maintenance expenses are incurred only for themachine.


Actual V/s. Predetermined Overhead Absorption Rates

The overhead absorption rates can be considered on actual basis or predetermined basis. Forcomputing the absorption rates on actual basis, the actual data for the previous period isconsidered, i. e. Actual overheads, actual direct materials/wages cost, actual prime cost,actual labour hours worked, actual machine hours worked etc. However, the actual overheadabsorption rates have certain limitations.

(1) The actual details are available only after the end of actual accounting period and requireddetails may not be available either for proper control of overheads or for price fixation.

(2) If the production is of seasonal nature, overhead absorption rates will not be constantmonthwise and comparison of production costs monthwise will be difficult.

As such, it is customary to consider predetermined overheads absorption rates instead ofactual overhead absorption rates. By predetermined rates it is meant that instead of consideringactual data in respect of Direct Materials/Wages/Prime Cost or Labour/Machine Hours,estimations are made in respect of the same and predetermined overhead absorption rate isapplied whenever computations are to be made in respect of product cost of a job.

Under Absorption or Over Absorption of Overheads

If the organization follows the policy of considering predetermined overhead absorption rates,it may face the problem of under or over absorption of overheads if the actual overheads to beabsorbed or the bases for the absorption, i.e. Materials/ Wages/ Prime cost or Labour/MachineHours etc. vary from the assumption. E.g. A Company considers the overhead absorption rateas a direct materials cost percentage rate. It is decided that predetermined overhead absorptionrate should be considered for the forthcoming year 1989. As such, the predetermined overheadrate was estimated on the basis of following details.

i.e.Estimated amount of overheads

X 100Estimated Direct Materials cost

i.e. Rs. 10,000X 100 i.e. 20%

Rs. 50,000

Now, on this basis all the jobs moving through that department during 1989 will be getting theloading of overheads @ 20% of Direct Materials Costs.

After the year 1989 ended, the actual details are computed and it is found out that whereasDirect Materials cost was as estimated, i.e. Rs. 50,000, the actual amount of overheads wasreduced to Rs. 9,000. As such, the rate at which the overheads should have been absorbed,should have been

305Overhead Cost

Rs. 9,000X 100, i.e. 18% and not 20% as originally considered

Rs. 50,000

Such situation gives rise to the under absorption or over absorption of overheads.

The situation of under absorption arises if the overheads absorbed are less than the actualoverheads. The situation of over absorption arises if the overheads absorbed are more than theactual overheads.

E.g. Overheads Actual RemarksPeriod Absorbed Overheads

Rs. Rs.

I 7,500 9,000 Underabsorption

II 10,000 8,000 Overabsorption.

Causes :

Under absorption of overheads may take place due to the reasons like.

– Actual overheads being more than the estimated overheads or

– Actual output or hours worked being less than those as estimated.

Over absorption of overheads may take place due to the reasons like

– Actual overheads being less than the estimated overheads OR

– Actual output or hours worked being more than those as estimated.

Treatment of Under or Over Absorbed Overheads :

The overheads which are under or over absorbed may be treated in either of the followingways –

(1) Use of supplementary rate : If the amount of under or over absorbed overheads isconsiderably significant, the cost of the cost centres may be adjusted by means of theuse of supplementary overhead absorption rate. This method of treating the over or underabsorption of overheads is most important where the cost is considered as a base forquoting selling prices, E.g. Cost plus contracts.

E.g. The predetermined overhead absorption rate, for the forthcoming period of months,was decided as below.

Amount of overheads= Rs. 50,000 = Rs. 2 / Labour Hour.

Total labour Hours 25,000


A mid term review of 6 monthly operations revealed that whereas the total labour hoursduring the period were 12,500, the amount of overheads incurred was Rs. 30,000. Theoverheads actually absorbed will be 12,500 hours x Rs. 2 i.e. Rs. 25,000. Consideringthe same trend of amount of overheads, the total annual overheads are likely to beRs. 60,000, out of which Rs. 25,000 are already absorbed. As such, for the remaining 6months, the overhead absorption rate may be calculated as :

Revised amount of overheads

Number of Labour Hours

=Rs. 60,000 – Rs. 25,000

12,500

=Rs. 35,000

= Rs. 2.80 / Labour Hour. 12,500

(2) Carrying over to remaining period : In case of seasonal types of organization, theoverheads under or over absorbed during a certain period may be carried over to theremaining part of the accounting period with the hope that they may be compensatedduring the remaining period of time.

(3) Writing off to Costing Profit and Loss Account : In case of the under or over absorptionof the overheads arising out of the abnormal circumstances, they are written off to CostingProfit and Loss Account.

Illustration :

The budgeted working conditions of a cost centre are as follows :

Normal working per week - 42 hours

No. of machines - 14

Normal weekly loss of hours on maintenance etc. - 5 hours per machine

No. of weeks worked per year - 48

Estimated annual overheads - Rs. 1,24,320

Estimated direct wage rate - Rs. 4 per hour.

Actual result in respect of a 4 week period are :

Wages incurred - Rs. 9,000

Overheads incurred - Rs. 10,200

Machine hours produced - 2,000

307Overhead Cost

You are required to calculate :

(a) The overhead rate per machine hour

(b) The amount of under or overabsorption of wages and overheads.

Solution :

(a) Normal working hours per year – 42 weekly hours per machine(For all 14 machines) x 14 machines x 48 weeks

= 28,224 machine hours.

(b) Hours lost on maintenance – 5 hours per week x 14 machinesx 48 weeks = 3,360 machinehours.

(c) Effective machine hours i.e., a - b – 24,864 machine hours.

(d) Estimated annual overheads – Rs. 1,24,320

(e) Machine hour rate i.e., d / c – Rs. 5

(f) Overheads absorbed – 2000 machine hours x Rs. 5– = Rs. 10,000

(g) Overheads actually incurred – Rs. 10,200

(h) Overheads underabsorbed

i.e., g - f – Rs. 200

WAGES

(a) Labour hours for 4 weeks – 42 hours x 4 week = 168 hours

(b) For 14 machines – 168 hours x 14 machines= 2,352 hours

(c) Estimated direct wage rate – Rs. 4 per hour

(d) Estimated direct wages for4 weeks i.e., b x c – Rs. 9,408

(e) Wages actually incurred – Rs. 9,000

(f) Wages overabsorbedi.e., d-e – Rs. 408

Control Over Overheads :

As the basic intention of cost accounting is to exercise the control over the costs and as theoverheads is a part of cost, cost accounting procedures attempt to control the overheads also.For this purpose, the following propositions should be remembered :

(1) The success of procedures to control the overheads largely depends upon the correctclassification of the overheads. This classification can be done from the various angles.


(a) Functionwise : This takes the form of classification in the form of factory overheads,administration overheads and selling and distribution overheads.

(b) Variabilitywise : This takes the form of classification in the form of fixed overheads,variable overheads and semi-fixed or semi – variable overheads.

(c) Normalitywise : This takes the form of classification in the form of normal overheadsand abnormal overheads.

Fixed overheads normally arise as a result of policy and are largely uncontrollable at the lowerlevel of management. They can be controlled at the top level of management. However, thevariable overheads can be controlled at the lower or middle level of management as well.

Most of the administration overheads are fixed in nature and can be controlled mainly at topmanagement level. However, the factory overheads can be controlled at lower or middlemanagement level also.

(2) After the correct classification of overheads, use may be made of following two techniqueswith the intention to exercise proper control over overheads.

(a) Budgetary control

(b) Standard costing

Both these techniques are discussed in details in the following chapters.

However, both these techniques necessarily involve the following stages in the processof implementation.

(i) Planning : This lays down the course of action to be taken in future.

In case of budgetary control, it is in the form of the budgets and in case of standardcosting, it is in the form of the standard cost.

(ii) Implementation of plan : This indicates actual steps to execute the plan. For this,downward communication may be necessary from top management level to lowermanagement level.

(iii) Measuring actual performance, comparison with plans and computingvariances : Measurement of actual performance may be in terms of actual costs oractual output. Actual costs and actual output is compared with the planned performanceand variations, if any are calculated.

(iv) Analysis of variances and decision making : Variations between actual performanceand planned performance is required to be analysed as to the causes and proper correctiveactions are required to be taken to remove unfavourable variations or maintain favourablevariations.

309Overhead Cost

(3) Classification of overheads as fixed and variable, facilitates the preparation of flexiblebudgets which provides proper base for comparison in the form of budgeted overheadsfor any level of activity actually attained. Flexible budgets may be treated as an improvedmethod to control the overheads.


(1) Meera Industries Limited is a single product organization having a manufacturing capacityof 6,000 units per week of 48 hours. The output data vis-a-vis different elements of costfor three consecutive weeks are given below :

Units Direct Direct Total factory overheadsProduced Material Labour (Variable and Fixed)

Rs. Rs. Rs.

2,400 4,800 6,000 37,200

2,800 5,600 7,000 38,400

3,600 7,200 9,000 40,800

As a cost Accountant, you are asked by the company to work out the selling price assuminglevel of 4,000 units per week and a profit of 20% on selling price.

Solution :

It can be observed that an increase in production by 400 units increases the total factoryoverheads by Rs. 1,200 indicating that per unit variable overheads are Rs. 3. Hence, at theactivity level of 2,400 units, the total variable overheads are Rs. 7,200 i.e. 2400 units x Rs.3per unit, out of total overheads of Rs. 37,200. Hence, the balance amount represents fixedoverheads. It should be noted that the direct material cost and direct labour cost representsthe variable cost of production. At 2,400 units, per unit cost is as below :

Direct material - Rs. 4800 / 2400 units = Rs. 2 / per unit.

Direct Labour - Rs. 6000 / 2400 units = Rs. 2.5 per unit

The cost sheet for the production of 4000 units can be worked out as below :


Cost Sheet - 4000 units


Direct Material Cost 2.00 8,000

Direct Labour Cost 2.50 10,000

Variable Overheads 3.00 12,000

Fixed Overheads 7.50 30,000

Total Cost 15.00 60,000

Add : Profit i.e. 20% of selling price of

Or 25% of total cost 3.75 15,000

Sales 18.75 75,000

(2) XYZ Ltd., a manufacturing company, having an extensive marketing net work throughoutthe country, sells its products through four zonal sales offices viz. A,B,C and D. Thebudgeted expenditure for the year are given below :

Rs.

Sales Manager’s salary 1,20,000

Expenses relating to Sales Manager’s office 80,000

Travelling salesmen’s salaries 3,20,000



Godown Rent-Zone A 15,000

B 25,200

C 9,800

D 18,000

68,000

Insurance on inventories 20,000

Commission on sales @ 5% on sales 6,00,000

311Overhead Cost

The following further particulars are also available :

A B C D

Sales (Rs. in lakhs) 36 48 16 20

No. of salesmen 5 6 2 3

Total mileage covered 6000 14000 4500 5500

Allocation of Advertisement 30% 30% 20% 20%

Average stock (Rs. in lakhs) 6 8 4 2

Based on the above details, compute zonewise selling overheads, as a percentage to sales.

Solution :

Calculation of Sales Overheads - Zone wise

Items Base Total A B C D

Rs. Rs. Rs. Rs. Rs.

1. Sales Sales 1,20,000 36,000 48,000 16,000 20,000Manager’s Salary

2. Expenses of Sales Sales 80,000 24,000 32,000 10,667 13,333Manager’s office

3. Travelling salesmen’s No. of Salesman 3,20,000 1,00,000 1,20,000 40,000 60,000Salaries

4. Travelling Expenses Mileage covered 36,000 7,200 16,800 5,400 6,600

5. Advertisement Allocation 30,000 9,000 9,000 6,000 6,0006. Godown Rent Allocation 68,000 15,000 25,200 9,800 18,000

7. Insurance on Average stock 20,000 6,000 8,000 4,000 2,000inventories

8. Sales Commission Sales 6,00,000 1,80,000 2,40,000 80,000 1,00,000

Total

Overheads 12,74,000 3,77,200 4,99,000 1,71,867 2,25,933

Sales in Lakhs Rs. 120 36 48 16 20

Overheads as % of sales 10.62% 10.48% 10.40% 10.74% 11.30%

(3) The following yearly charges are incurred in respect of a machine where work is done bymeans of 5 machines of exactly same type.

(1) Rent and Rates Rs. 4,800

(2) Depreciation on each machine Rs. 500

(3) Repairs & maintenance of 5 machines Rs. 1,000

(4) Power consumed (as per meter at 5 paise per unit) Rs. 3,000

(5) Electric charges for the shop Rs. 450


(6) Two attendants looking after 5 machines and are

paid Rs. 700 per year each Rs. 1,400

(7) Supervision – One supervisor looking after 5 machines and paid Rs. 3,000

(8) Sundry supplies for the shop Rs. 450

The machine uses 10 units of power per hour. Calculate the machine hour rate.

Solution :

Calculation of Machine Hour Rate

Rs.

(a) Standing charges :

Rent and Rates 960

Depreciation 500

Repairs and Maintenance 200

Electricity charges 90

Attendants salary 280

Supervisor’s Salary 600

Sundry Supplies 90

Annual standing charges 2,720

Annual Machine Working Hours 1,200

Hourly Standing Charges Rs. 2.27

(b) Running charges :

Power charges - Rate of power - 5 paise per unit

Power consumption - 10 units per hour

Hourly power expenses Rs. 0.50

(c) Machine Hour Rate i.e. a + b Rs. 2.77

Working Notes :

Number of machine working hours are calculated as below :

(a) Total power cost for the shop - Rs. 3.000

(b) Power cost relating to the machine - Rs. 600

(c) Rate of power - 5 paise per unit

313Overhead Cost

(d) Total power consumption in units -Rs. 600

= 12.000 unitsPaise 5

(e) Rate of power consumption - 10 units per hour

(f) If total units consumed are 12.000 and if rate of power consumption is 10 units perhour, it means that the machine must have worked for 1,200 hours.

(4) From the following data, work out the predetermined machine hour rates for departmentsA and B of a factory.

Preliminary Estimates of Expenses

Total Dept. A Dept. BRs. Rs. Rs.

Power 15,000 – –

Spare Parts 8,000 3,000 5,000

Consumable Stores 5,000 2,000 3,000

Depreciation on Machinery 30,000 10,000 20,000

Insurance on Machinery 3,000 – –

Indirect Labour 40,000 – –

Building Maintenance 7,000 – –

The final estimates are to be prepared on the basis of above figures after taking into considerationthe following factors :

(1) An increase of 10% in the price of spare parts.

(2) An increase of 20% in the consumption of spare parts for Department B only.

(3) Increase in the straight–line method of depreciation from 10% on the original value ofmachinery to 12%.

(4) 15% general increase in wage rates.

The following information is available

Dept. A Dept. B

Estimated Direct Labour Hours 80,000 1,20,000

Ratio of K W Rating 3 2

Estimated Machine Hours 25,000 30,000

Floor Space (sq. ft.) 15,000 20,000


Solution :

Calculation of machine hour rate

Expenses Base Total Dept. A Dept. BRs. Rs. Rs.

Power KW Rating 15,000 9,000 6,000

Spare Parts Allocation and adjustment forFinal Estimates 9,900 3,300 6,600

Consumable stores Allocation 5,000 2,000 3,000

Depreciation on Machinery Allocation and adjustments for

Final Estimates 36,000 12,000 24,000

Insurance on Machinery Ratio of depreciation 3,000 1,000 2,000

Indirect Labour Direct Labour Hours and

adjustment for Final Estimates 46,000 18,400 27,600

Building Maintenance Floor space 7,000 3,000 4,000

1,21,900 48,700 73,200

Estimated Machine Hours – 25,000 30,000

Machine Hour Rate Rs. – 1.948 2.44

Working Notes :

(1) Spare Part Cost Total Dept A Dept B

Original Estimate 8,000 3,000 5,000

+ Extra consumption 1,000 - 1,000

9,000 3,000 6,000

+ 10% Price Increase 900 300 600

9,900 3,300 6,600

(5) The factory overhead costs of four production departments of a company engaged inexecuting job orders, for an accounting year, are as follows :

Depts. Rs.

A 19,300

B 4,200

C 4,000

D 2,000

315Overhead Cost

Overhead has been applied as under

Dept A - Rs. 1.50 per machine hour for 14,000 hours

Dept B - Rs. 1.30 per Direct Labour Hour for 3,000 hours

Dept C - 80% of Direct Labour cost of Rs. 6,000

Dept D - Rs. 2 per piece for 950 pieces.

Find out the amount of departmentwise under or over absorbed factory overheads.

Solution :

(a) Factory Overheads absorbed

Dept. Rs. Base

A 21,000 Rs. 1.50 per Machine Hour for 14,000 hours

B 3,900 Rs. 1.30 per Direct Labour Hour for 3,000 hours

C 4,800 80% of Direct Labour cost of Rs. 6,000

D 1,900 Rs. 2 per piece for 950 pieces

(b) Calculation of under or over absorption

Dept. Overheads Overheads Over UnderIncurred Absorbed Absorption Absorption

Rs. Rs. Rs. Rs.

A 19,300 21,000 1,700 -

B 4,200 3,900 - 300

C 4,000 4,800 800 -

D 2,000 1,900 - 100

29,500 31,600 2,500 400

Net Over absorption Rs. 2,100

(6) In a factory, annual average charges for direct wages amount to Rs. 4,80,000. Followingare some of the expenses incurred in factory.

a. Works Manager’s salary Rs. 50,000

b. Factory Rent Rs. 36,000. The total area is 45,000 Sq. Ft. out of which shop is in40,000 Sq. Ft.

c. Wages of Peons and Sweepers Rs. 7,000

d. Other factory overheads Rs. 53,000


A work order is executed in a shop’s part occupying an area of 6,000 Sq. Ft. and costsRs. 10,000 in wages. If the total wages for all work orders executed in the shop amount toRs. 1,60,000, calculate the total amount of factory overheads charges to be allocated to thiswork order.

Solution :

Factory Rent Rs. 36,000

Rent of shop Rs. 32,000 i.e., Rs. 36,000 X40,000 Sq. ft.

45,000 Sq. ft.

Rent for that area of shop where work order is executed. i.e.

Rs. 32,000 X6,000 Sq. ft.

= Rs. 4,80040,000 Sq. ft.

Apportionment of rent to work order on the basis of wages -

Rs. 10,000X Rs. 4,800 = Rs. 300

Rs. 160,000

Other factory overheads

Rs.

Works Manager’s Salary 50,000

Factory Rent (Balance) 4,000

Wages of Peons /Sweepers 7,000

Others 53,000

1,14,000

Apportionment of overheads to works order on the basis of wages

Rs. 10,000X Rs. 1,14,000 = Rs. 2,375

Rs. 4,80,000

Factory overheads chargeable to the work order

Rent Rs. 300

Factory overheads Rs. 2,375

Rs. 2.675

317Overhead Cost

(7) Superclass Co. Ltd. has three production departments X, Y and Z and two serviceDepartments A and B.

The following estimated figures for a certain period have been made available.

Rs.

Rent and Rates 10,000

Lighting and Electricity 1,200


Power 3,000

Depreciation of machinery 20,000

Other expenses and sundries 20,000

The following further details are also available.

Total X Y Z A B

Floor space (Sq. Mts.) 10,000 2,000 2,500 3,000 2,000 500

Light Points (Nos.) 120 20 30 40 20 10

Direct wages (Rs.) 20,000 6,000 4,000 6,000 3,000 1,000

Horsepower of machines 300 120 60 100 20 –

Cost of Machinery (Rs.) 1,00,000 24,000 32,000 40,000 2,000 2,000

Working Hours – 4,670 3,020 3,050 – –

The expenses of the service departments are to be allocated as follows.

X Y Z A B

A 20% 30% 40% - 10%

B 40% 20% 30% 10% -

You are required to calculate the overhead absorption rate per hour in respect of the threeproduction departments.

What will the total cost of an article with material cost of Rs. 50 and direct labour cost ofRs. 40 which passes through X, Y and Z for 2, 3 and 4 hours respectively.


Solution :

Primary Apportionment of Overheads

Expenses Base X Y Z A BRs. Rs. Rs. Rs. Rs.

Rent & Rates Floor space 2000 2500 3000 2000 500

Lighting & Electricity Light points 200 300 400 200 100

Indirect wages Direct wages 900 600 900 450 150

Power HP of machines 1200 600 1000 200 -

Depreciation Cost of machines 4800 6400 8000 400 400

Other expenses Direct wages 6000 4000 6000 3000 1000

Direct wages(Only Service Depts.) Allocation – – – 3000 1000

15100 14400 19300 9250 3150

Secondary Apportionment of Overheads

Result of Primary Apportionment

X - Rs. 15,100 Y - Rs. 14,400 Z - Rs. 19,300

A - Rs. 9,250 B - Rs. 3,150

Let X = Total overheads of Dept. A

Y = Total overheads of Dept. B

∴ X = 9,250 + Y/10

Y = 3,150 + X/10

∴10 X = 92,500 + Y ...(1)

10 Y = 31,500 + X ...(2)

Multiplying equation 1 by 10 and rearranging :

-10 Y = 9,25,000 - 100 X

10 Y = 31,500 + X

Adding, 0 = 9,56,500 - 99X

∴ 99X = 9,56,500

∴ X = 9,662 ...(3)

∴ Y = 4,116 ...(4)

319Overhead Cost

Total overheads can be apportioned to production departments at agreed percentages tocalculate the overhead absorption rate as below :

Total X Y ZRs. Rs. Rs. Rs.

As per Primary apportionment 48,800 15,100 14,400 19,300

Dept A – 90% of Rs. 9662 8,696 1,933 2,898 3,865

Dept B – 90% of Rs. 4116 3,704 1,647 822 1,235

61,200 18,680 18,120 24,400

Working Hours - 4,670 3,020 3,050

Labour Hour Rate Rs. 4.00 6.00 8.00

Calculation of Total Cost

Rs.

Direct Material Cost 80

Direct Labour Cost 40

Overheads

Dept X - 2 Hrs x Rs. 4/ Hour = Rs. 8

Dept Y - 3 Hrs x Rs. 6/ Hour = Rs. 18

Dept 2 - 4 Hrs x Rs. 8/ Hour = Rs. 32

58

178

(8) The expenses of a machine cost centre for a particular month are as under.

(i) Power - Rs. 50,000

(ii) Maintenance and Repairs - Rs. 10,000

(iii) Machine operator’s wages - Rs. 2,000

(iv) Supervision - Rs. 6,000

(v) Depreciation - Rs. 40,000


Other particulars are given below :

Products Rate of Production Production Units

A 30 Units per hour 1,800

B 10 Units per hour 500

C 6 Units per hour 300

D 4 Units per hour 260

The entire production was to be offered to Government on ‘Cost Plus 20%’ basis. MaterialCosts per unit are -

A - Rs. 40, B - Rs. 60, C - Rs. 100 and D - Rs. 300

Prepare a statement showing product wise ‘cost’ and ‘offer price’.

Solution :

Total Cost of Machine Centre

Rs.

Power 50,000

Maintenance and Repairs 10,000

Machine operator’s wages 2,000

Supervision 6,000

Depreciation 40,000

1,08,000

On the basis of rate of production and number of units produced of each product, number ofmachine hours used can be calculated as below :

Product Rate of Production Production Machine Hours(Units) used

A 30 Units per hour 1,800 60

B 10 Units per hour 500 50

C 6 Units per hour 300 50

D 4 Units per hour 260 65

225

∴ Machines Hour Rate =Rs. 1,08,000

= Rs. 480 Machine Hour225 Machine Hour

321Overhead Cost

Calculation of per unit total cost and offer price

Product Material Machine Cost Total Profit OfferCost Machine Machine Total Cost 20% of Price

Hours Hour Machine TotalRate Cost Cost

1 2 3 4 5 6(2+5) 7 8Rs. Rs. Rs. Rs. Rs. Rs. Rs.

A 40.00 1/30 480 16.00 56.00 11.20 67.20

B 60.00 1/10 480 48.00 108.00 21.60 129.60

C 100.00 1/6 480 80.00 180.00 36.00 216.00

D 300.00 ¼ 480 120.00 420.00 84.00 504.00


QUESTIONS

1. Discuss the factors which would create unabsorbed factory overheads and overabsorbedfactory overheads.

2. Mention the broad principles on which overhead expenses are generally apportioned.Upon what basis would you apportion the following expenses to individual cost centresin an engineering unit?

(a) Rent

(b) Power

(c) Fire Insurance Premium

(d) Lighting

3. Explain the term underabsorption and overabsorption of overheads. Explain any threemethods of absorbing production overheads into the cost of production.

4. Distinguish between actual and predetermined rates for absorption of factory overheads.Cite the major problems involved in using actual rates and discuss how predeterminedrates eliminate this problem.

5. How do you deal with under or over absorption of overheads? Mention the various itemsthat go into –

(a) Manufacturing overheads.

(b) Administration overheads.

(c) Selling overheads.

(d) Distribution overheads.

6. What basis would you recommend for the apportionment of the following items of expensesto production departments, giving justification for the suggested one.

(a) Internal Transport.

(b) Air-Conditioning.

(c) General Factory Maintenance.

(d) Stores.

(e) Rent.

(f) Labour office.

7. What is meant by apportionment of overheads? What can be considered as a good basefor apportioning the following overheads with reference to a Diesel Engine ManufacturingCompany?

323Overhead Cost

(i) Internal Transport

(ii) Time Keeping expenses

(iii) Shop supervision

(iv) Power, lighting and other utilities

Short Notes :

(a) Machine Hour Rate –

(b) Control of overheads –

(c) Underabsorption and overabsorption of overheads –

(d) Treatment of overabsorption of overheads –

(e) Primary and Secondary apportionment of overheads –

PROBLEMS

(1) A certain type of factory produces a uniform type of article and has a capacity to produce1,500 units per week of 48 hours. Following data shows different elements of costs for 3weeks of 48 hours each when output has changed from one week to another.

Units Produced Direct Material Direct Labour Factory Overheads(Fixed & Variable)

Rs. Rs. Rs.

400 800 1,600 3,800

500 1,000 2,000 4,000

800 1,600 3,200 4,600

You are asked to find out selling price per unit when weekly output is 1,000 units and a profitof 8.33% on selling price will be made.

(2) A factory is having three production departments A, B and C and two service departments-Boiler House and Pump Room. The Boiler House has to depend upon the Pump Roomfor the supply of water and the Pump room in its turn is dependent on the boiler house forsupply of steam power for driving the pump. The expenses incurred by the productiondepartments during a period are A – Rs. 8,00,000, B – Rs. 7,00,000 and C - Rs. 5,00,000.

The expenses for boiler house is Rs. 2,34,000 and the pump room is Rs. 3,00,000.

The expenses of the boiler house and pump room are apportioned to the productiondepartments on the following basis.


A B C BH PR

Expenses of BH 20% 40% 30% - 10%

Expenses of PR 40% 20% 20% 20% -

Show clearly as to how the expenses of boiler house and pump room would be apportioned toA, B and C departments. Use an Algebrical equation.

(3) The overheads distribution summary for the month of September 1980 disclosed followingoverheads expenses for departments mentioned below :

Production Depts. Service Depts.

A B C D E

Overheads Rs. 7,810 Rs. 12,543 Rs. 4,547 Rs. 4,000 Rs. 2,600

Expenses of service departments D and E are apportioned as follows.

A B C D E

D 30% 40% 20% - 10%

E 10% 20% 50% 20% -

You are required to find out the total cost of each production dept. by charging the respectivecosts of service depts. by simultaneous equations method.

(4) The primary distribution of expenses disclosed the following details in respect of productiondepartments PI, P2 and P3 and Service Departments S1 and S2

Dept. P1 P2 P3 S1 S2

Overheads (Rs.) 6.300 7,400 2,800 4,500 2,000

The services given by S1 and S2 are as follows.

Dept. P1 P2 P3 S1 S2

S1 40% 30% 20% - 10%

S2 30% 30% 20% 20% -

Find out the overheads to production Departments by using simultaneous equations method.

(5) A company has three production cost centres A, B and C and two service cost centresX and Y. Costs allocated to service cost centres are required to be apportioned to the

325Overhead Cost

production centres to find out cost of production of different products. It is found thatbenefit of service cost centres is also received by each other along with the productioncost centres. Overhead costs as allocated to the five cost centres and estimates ofbenefits of service cost centres received by each of them are as under -

Cost Centres Overhead Costs Estimates of benefitsas allocated received from service

Rs. centres %

X Y

A 80,000 20 20B 40,000 30 25C 20,000 40 50X 20,000 - 5Y 10,000 10 -

Required -

Work out final overhead costs of each of the production departments including apportionedcost of service centres using -

a. Continuous Distribution Method

b. Simultaneous Equations Method

(6) The following particulars related to the production department of a factory for the monthof June 1985.

Rs.

Material Used 80,000

Direct Wages 72,000

Direct Labour Hours Worked 20,000

Hours of Machine operation 25,000

Overhead charges allocated to the department 90,000

Cost data of a particular work order carried out in the above department during June 1985 aregiven below.

Rs.

Material Used 8,000

Direct wages 6,250

Labour hours booked 3,300

Machine hours booked 2,400


What would be the factory cost of the work order under the following methods of chargingoverheads?

(i) Direct Labour Cost Rate

(ii) Machine Hour Rate

(iii) Direct Labour Hour Rate

(7) The following information is extracted from the budget of A Ltd. for 1985.

Factory Overheads .. Rs. 62,000

Direct Labour cost .. Rs. 1,00,000

Direct Labour hours .. 1,55,000

Machine hours .. 50,000

The following details are available for job 195

Direct Material Cost Rs. 45

Direct Labour Cost Rs. 50

Direct Labour hours 40

Machine hours 30

You are required to work out the overhead application rates and ascertain the cost of job 195by using the following methods of overheads absorption.

(1) Direct Labour Hours Rate, (2) Direct Labour Cost, (3) Machine Hour Rate

(8) Atlas Engineering Ltd. accepts a variety of jobs which require both manual and machineoperations. The budgeted Profit and Loss Account for the period 1996-97 is as follows :

(Rs. in Lakhs)

Sales 75

Cost :

Direct Materials 10

Direct Labour 5

Prime Cost 15

Production Overhead 30

Production Cost 45

Other Overheads 15

60

Profit 15

327Overhead Cost

Other budgeted data -

Labour Hours for the period 2,500

Machine Hours for the period 1,500

No. of jobs for the period 300

An enquiry has been received recently from a customer and the production department hasprepared the following estimate of the prime cost required for the job -

Direct Material 2,500

Direct Labour 2,000

Prime Cost 4,500

Labour Hours required = 80

Machine Hours required = 50


a. Calculate by different methods, six overhead absorption rates for absorption of productionoverhead and comment on the suitability of each.

b. Calculate the production overhead cost of the order based on each of the above rates.

c. Give your recommendation to the company.

(9) A company has two production departments and two service departments. The datarelating to a period are as under :

Production Depts. Service Depts.PD1 PD2 SD1 SD2

Direct Materials (Rs.) 80000 40000 10000 20000

Direct Wages (Rs.) 95000 50000 20000 10000

Overheads (Rs.) 80000 50000 30000 20000

Power requirement

at normal capacity

operation (kwh) 20000 35000 12500 17500

Actual power consumption

during the period (Kwh) 13000 23000 10250 10000

The power requirement of these departments are met by a power generation plant. The saidplant incurred an expenditure, which is not included above, of Rs. 1,21,875 out of which a sumof Rs. 84,375 is variable and the rest fixed.


After apportionment of power generation plant costs to four departments, the service departmentoverheads are to be redistributed on the following bases :

PD1 PD2 SD1 SD2

SD1 50% 40% – 10%

SD2 60% 20% 20% –

You are required to :

a. Apportion the power generation plant costs to the four departments.

b. Re-apportion service department cost to the production departments.

c. Calculate the overhead rates per direct labour hour of production departments, given thatthe direct wages rate’s of PD1 and PD2 are Rs.- 5 and Rs. 4 respectively.

(10) Following information is extracted from the cost records of Hilton Ltd. which specialisesin the manufacture of automobile spares. The parts are manufactured in Department Aand assembled in Department B.

Total Dept. A Dept. B

Direct Labour hours worked 80,000 30,000 50,000

Machine Hours worked 30,000 25,000 5,000

Machine Horse Power 400 353 47

Book Value of Machines (Rs.) 50,000 40,000 10,000

Floor Space (Sq.Ft.) 20,000 10,000 10,000

Direct Material 65,000 50,000 15,000

Direct Labour 90,000 40,000 50,000

Factory Rent 15,000 - -

Supervision 6,000 2,500 3,500

Depreciation on Machines 5,000 - -

Power 4,000 - -

Repairs to Machines 2,000 1,600 400

Indirect Labour 4,000 2,000 2,000

The prime cost of batch B-401 has been booked as under

Total Dept. A Dept. B

Materials 3,200 2,700 500

Labour 7,500 3,000 4,500

329Overhead Cost

Direct Labour hours worked on Batch B-401 were 2,500 in Department A and 5,000 inDepartment B. Machine hours worked on this batch were 1,250 in Department A and 600 inDepartment B. Allocate overhead expenditure and calculate the cost of each unit in Batch B-401 which consists of 1,000 units.

(11) Strongman Ltd. has three production departments A,B and C and two service departmentsX and Y. The data available for the month of March 1991 concerning the organization

Rs.

Rent 15,000

Municipal Taxes 5,000

Electricity 2,400


Power 6,000

Depreciation on Machinery 40,000

Canteen Expenses 30,000

Other Labour related costs 10,000

Following particulars are also available -

Total A B C X Y

Floor Space (Sq. Mts.) 5,000 1,000 1,250 1500 1,000 250

Light Points (Nos.) 240 40 60 80 40 20

Direct Wages (Rs.) 40,000 12,000 8,000 12,000 6,000 2,000

HP of Machines 150 60 30 50 10 –

Cost of Machines (Rs.) 20,0000 48,000 64,000 80,000 4,000 4,000

Working Hours – 2,335 1,510 1,525 – –

The expenses of Service Departments are to be allocated in following manner -

A B C X Y

X 20% 30% 40% – 10%

Y 40% 20% 30% 10% –

You are requested to calculate the overhead absorption rate per hour in respect of the threeproduction departments.


(12) A company has 3 production departments A, B and C and two service departments Xand Y. The following data are extracted from the records of the company for a particulargiven period.

Rs.

Rent and Taxes 25,000

General Lighting 3,000

Indirect Wages 7,500

Power 7,500

Depreciation on Machinery 50,000

Sundries 50,000

Additional data departmentwise

Total A B C X Y

Direct Wages (Rs.) 50000 15000 10000 15000 7500 2500

HP of Machines 150 60 30 50 10 –

Cost of Machines (Rs. in Lakhs) 12.50 3.00 4.00 5.00 0.25 0.25

Floor Space (Sq.Mts.) 10000 2000 2500 3000 2000 500

Lighting Points (Nos.) 60 10 15 20 10 5

Production Hours – 6226 4028 4066 – –

Sundries can be apportioned on the basis of Direct Wages.

Service Departments’ expenses allocation -

A B C X Y

X 20% 30% 40% – 10%

Y 40% 20% 30% 10%


a. Compute the overhead rate of production departments using repeated distribution method.

b. Determine the total cost of a product whose direct material cost and direct labour costare Rs. 150 and Rs. 150 respectively and which would consume 4 hours, 5 hours and 3hours in departments A, B and C respectively.

(13) Universal Ltd. has four production departments A, B, C and D and two service departmentsviz. Transport and Power Supply.

331Overhead Cost

Particulars of expenses of the respective departments are as follows :

A Rs. 2,000

B Rs. 1,800

C Rs. 1,600

D Rs. 1,400

Transport Rs. 1,100

Power Supply Rs. 760

The service department’s expenses are charged out on a percentage basis as given below :

A B C D Transport Power

Transport 10% 30% 20% 20% - 20%

Power 30% 20% 30% 10% 10% -

Using the above information, apportion the service department overheads to various productiondepartments using

a. Simultaneous Equations Method

b. Repeated Distribution Method

(14) A shop has 2 newly purchased machines, each occupying equal area of space. One is4 - spindle drilling machine and the other is 6-spindle drilling machine costing Rs. 80,000and Rs. 1,00,000 respectively. Following are the expenses for one year :

a. Rent Rs. 40,000

b. Rates and Taxes Rs. 17,000

c. Lighting and heating Rs. 12,600

d. power expenses

- 4 spindle machine Rs. 10,000

- 6 spindle machine Rs. 15,000

e. Administration expenses Rs. 38,000

f. Running and Maintenance Rs. 80,000

The life of each machine is 10 years without any salvage value. Each machine works for 45hours a week for 50 weeks in a year. 250 hours per machine are used for repairs. Running andrepairs expenses are shared between two machines on the basis of power expenses.

You are required to prepare statement showing computation of Machine Hour Rate.


(15) Calculate the machine hour rate in respect of machine No. 179 from the followingparticulars :

Cost of machine Rs. 20,000

Estimated Life 15,000 hours

Estimated scrap value Rs. 500/-

Estimated working hours per annum 2200

Estimated hours required for maintenance 100 (included in above)

Setting up time (Hours) 100 (included in above)

Power 20 units @ Rs.0.17 per unit

Repairs and maintenance per annum Rs. 1500/-

No. of operators (looking after also 3 other machines) 2

Wages per operator per month Rs. 150/-

Chemical required for operating the machine Rs. 100/- p.m.

Overheads chargeable to the machine Rs. 200/- p.m.

Insurance premium -1% p.a. on the cost of machine.

(16) You are required to calculate the composite machine hour rate from the following particularsin respect of a jig boring machine whose scrap value is Rs. 50,000 after its working life of10 years.

1. Cost of the machine - Rs. 2,00,000

2. Importation charges & Customs duty etc.- Rs. 50,000

3. Working hours per year - 2,000

4. Repairs & Maintenance charges - 50% of depreciation charge.

5. Lubricating oil - Rs. 20 per working day of 8 hours

6. Consumable stores - Rs. 500 per month of 25 working days.

7. Power 10 units per working hour at Re. 0.30 per unit

8. Wages of the operator - Rs. 1,000 per month of 25 working days.

333Overhead Cost

(17) From the particulars furnished below, compute a machine hour rate :

Name of the Equipment - Single spindle Automat

Date of purchase - 1.4.1983

Cost - Rs. 75,000

Estimated Life - 10 years

Depreciation - 15% on original cost

Insurance - Rs. 4,000 p.a.

Repairs - Rs.1,800 p.a.

Consumable stores - Rs. 1,500 p.a.

Rent - Rs. 2,400 p.a.

Superintendence - Rs. 2,500 p.a.(l/5th for the machine)

The machine can work for 200 hours in a month and had actually worked for 80% of the normalworking hours. Cost of oils and greases consumed per hour is Rs.4.50,

(18) A dept. is having 3 machines. The figures indicate the departmental expense of thesemachines. Calculate the machine hour rate from the data below :

Depreciation of machines Rs. 12,000

Rent Rs. 2,880

Repairs to machines Rs. 4,000

Insurance of machines Rs. 800

Indirect wages Rs. 6,000

Power Rs. 6,000

Lighting Rs. 800

Misc. Expenses Rs. 4,200

Rs 36,680


Other information :

M/c1 M/c2 M/c3

Direct wages– Rs. 1,200 2,400 2,400

Power units 30,000 10,000 20,000

No. of workers 4 8 8

Light points 8 24 48

Space occupied (Sq. Ft.) 400 800 800

Cost of machine Rs. 3,00,000 1,20,000 1,80,000

Hours worked 200 300 300

(19) Following particulars relate to a machine :

Rs.

Purchase Price of machine 80,000

Installation Expenses 20,000

Rent per Quarter 3,000

General Lighting for the total area 200 per month

Supervisor’s salary 6,000 per quarter

Insurance premium 600 per annum

Estimated repairs 1,000 per annum

Estimated consumable stores 800 per annum

Power 2 units per hour @ Rs. 50 per 100 units

The estimated life of the machine is 10 years and the estimated scrap value isRs. 20,000. The machine is expected to run 20,000 hours in its life time. The machineoccupies 25% of the total area. The supervisor devotes l/6th of his time for the machine.You are required to work out machine hour rate.

(20) From the following particulars, calculate the machine hour rate of machine installed in aDepartment.

Cost of Machine Rs. 16,000

Estimated scrap value after the expiryof its life (15 years) Rs. 1,000

335Overhead Cost

Estimated working hours of the machine per year 2,000

Monthly salary of a foreman engaged in supervisionof this machine and other two identical machines. Rs. 1,500

Repails and Maintenance of the machine Rs. 2,400 per year

Insurance premium for the machine Rs. 120 per year

Departmental rent and rates are Rs. 1,200 per year. The space occupied by the machineis l/6th of the floor space of the department. Power consumption of the machine is 2units per hour @ 10 paise per unit.

(21) A machine costing Rs. 20,000 is expected to work for 10 years and at the end of whichthe scrap value is estimated Rs. 2,000, installation charges amount to Rs. 200. repairsover 10 years life is expected Rs. l,800 and the machine is expected to run for 2.190hours in a year.

Its power consumption would be 15 units per hour at Rs. 5 per 100 units. The machineoccupies l/4th of the area of the department and has two points out of ten for lighting. Theforeman has to devote l/3rd of his time for this machine. The rent for the department isRs. 300 p.m. and charges for lighting Rs. 80 p.m. The foreman is paid salaryRs. 960 p.m. Find out the hourly rate assuming insurance is 1% per annum and expenseson oil etc. Rs. 9 per month.

(22) Following data is available relating to a company for a certain month.

Territory

I II III

Selling Expenses (Rs.) 7,600 4,200 6,240

Distribution Costs (Rs.) 4,000 1,800 2,000

No. of units sold 16,000 6,000 10,000

Sales (Rs.) 76,000 28,000 52,000

The company adopts sales basis and quantity basis for application of selling and distributioncosts respectively.

Compute -

(a) The territorywise overhead recovery rates separately for Selling and Distribution costs.

(b) The amounts of selling and distribution cost chargeable to a consignment of 2,000 unitsof a product, sold in each territory at Rs. 4.50 per unit.


(23) A machine is purchased for cash at Rs. 9,200. Its working life is estimated to be 18,000hours after which its scrap value is estimated at Rs. 200. It is assumed from the pastexperience that

a. The machine will work for 1,800 hours annually.

b. The repair charges will be Rs. 1,080 during the whole period for life of the machine.

c. The power consumption will be 5 units per hour at 6 paise per unit.

d. Other annual standing charges are estimated to be -

1. Rent of department (machine l/5th) 780

2. Light (12 points in the department, 2 points engaged in the machine) 288

3. Foreman’s salary (l/4th of his time is occupied in the machine) 6000

4. Insurance premium for machine 36

5 Cotton Waste 60

Find out the machine hour rate on the basis of above data for allocation of the works expensesto all jobs for which the machine is used.

(24) The following particulars relate to a new machine purchased.

Purchase Price of the machine Rs. 4,00,000

Installation Expenses Rs. 1,00,000

Rent per Quarter Rs. 15,000

General Lighting for the total area Rs. 1,000 p.m.

Foreman’s Salary Rs. 30,000 p.a.

Insurance Premium for the machine Rs. 3,000 p.a.

Estimated repair for the machine Rs. 5,000 p.a.

Estimated Consumable Stores Rs. 4,000 p.a.

The estimated life of the machine is 10 years and the estimated value at the end of 10 yearsis Rs. 1,00,000. The machine is expected to run 20,000 hours in its life time. The machineoccupies 25% of the total area. The foreman devotes l/6th of his time for the machine.

Calculate the machine hour rate for the machine.

337Overhead Cost

(25) A manufacturing unit has added a new machine to its fleet of five existing machines. Thetotal cost of purchase and installation of the machine is Rs. 7,50,000. The machine hasan estimated life of 15 years and is expected to realise Rs. 30,000 as scrap at the endof its working life.

Other relevant data are as follows :

a. Budgeted working hours are 2,400 based on 8 hours per day for 300 days. This includes400 hours for plant maintenance.

b. Electricity used by the machine is units per hour at a cost of Rs. 2 per unit. No currentis drawn during maintenance.

c. The machine requires special oil for heating which is replaced once in every month at acost of Rs. 2,500 on each occasion.

d. Estimated cost of maintenance of the machine is 500 per week of 6 working days.

e. 3 operators control the operations of the entire battery of six machines and the averagewages per person amounts to Rs. 450 per week plus 40% fringe benefits.

f. Departmental and general overheads allocated to the operation during the last year wereRs. 60,000. During the current year it is estimated that there will be an increase of12.5% of this amount. No incremental overhead is envisaged for the installation of thenew machine.

You are required to compute the machine hour rate for the recovery of the running cost of themachine.

(26) The following annual charges are incurred in respect of a machine in a shop wheremanual labour is almost nil and where work is done by means of five machines of exactlysimilar type and specification.

(a) Rent and Taxes (Proportionate to the floor space occupied) for the shop - Rs. 4,803.

(b) Depreciation on each machine - Rs. 500.

(c) Repairs and maintenance for five machines - Rs. 1,000

(d) Power consumed @ 6.25 paise per unit for the shop Rs. 3,750.

(e) Electric charges for light in the shop - Rs. 540.

(f) Attendants - There are two attendants for the five machines and they are each paidRs. 60 per month.

(g) Supervision - There is one supervisor in the shop for the five machines and he is paidRs. 250 per month.


(h) Sundry supplies such as lubricants, jute and cotton waste etc. for the shop - Rs. 494.

(i) Hire Purchase - Instalment payable for the machine (including Rs. 300/- as interest) -Rs. 1,200.

(j) The machine uses 10 units of power per hour. Calculate the machine hour rate for theyear.

(27) In a manufactring concern ABC Ltd., die machine shop has 8 identical machines mannedby 6 operators. The machines cannot be worked without an operator wholly engaged onthem. The total cost of the machines are Rs. 8,00,000.

Following information relates to a six monthly period ended 30th June, 1990.

Normal available hours per month 208

Absenteeism (without pay) hours

per month. 18

Leave (with pay) hours per month 20

Normal idle time (unavoidable)

hours per month 10

Average rate of wages per day of 8 hours Rs. 20

Production hours 15% on wages

Power and Fuel consumption Rs. 9,000

Supervision and Indirect Labour Rs. 3,300

Electricity Rs. 1,200

The following particulars are on a yearly basis.

Repairs and Maintenance 3% of value of machines

Insurance Rs. 42,000

Depreciation 10% of original cost.

Other factory expenses Rs. 12,000

Allocated General Management

Expenses Rs. 63,670

You are required to work out a comprehensive machine hour rate for the machine shop.

339Overhead Cost

(28) In a factory, the following particulars have been extracted for the quarter ending 30thJune, 2001 in respect of Production Department P1, P2 and P3 and service DepartmentsS1 and S2. Compute the departmental overhead rate for each of the productiondepartments, assuming that overheads are absorbed as a percentage of direct wages.

Particulars P1 P2 P3 S1 S2

Direct Wages (Rs.) 30000 45000 60000 15000 30000

Direct Material (Rs.) 15000 30000 30000 22000 22000

No. of Workers 150 225 225 75 75

Power (KWHrs.) 6000 4500 3000 1500 1500

Asset Value 60000 40000 30000 10000 10000

Light Points 10 16 4 6 4

Area in Sq. Fts. 150 250 50 50 50

Expenses for the period were –

Power Rs. 1,100

Lighting Rs. 200

Stores overheads Rs. 800

Staff Welfare Rs. 3,000

Depreciation Rs. 36,000

Rent Rs. 550

General Overheads Rs. 12,000

Apportion general overheads in the proportion of direct wages. Apportion the expenses of S1according to direct wages and those of S2 in the ratio of 5 : 3: 2 to the production departments.

(29) A Ltd. has 3 production departments A, B and C and 2 service departments D and E.The following are the figures of the company.

Rs.

Rent and Rates 5,000/-

General lighting 600/-

Indirect wages 1,500/-

Power 1,500/-

Depreciation of Machinery 10,000/-

Sundry Expenses 10,000/-


The following further details are available :

A B C D E

Floor Space (Sq.Ft) 2000 2500 3000 2000 500

Light points 10 15 20 10 5

Direct wages (Rs.) 3000 2000 3000 1500 500

Value of Machinery (Rs.) 60,000 80,000 1,00,000 5,000 5,000

H.P. of Machines 60 30 50 10 –

Sundry expenses are apportioted on the basis of direct wages

The expenses of D and E are allocated as under :

A B C D E

D 20% 30% 40% - 10%

E 40% 20% 30% 10% -

Find the rate per hour if the working hours are as under :

A Department 6226

B Department 4028

C Department 4066

(30) In a light engineering factory, the following particulars have been collected for the threemonthly period ended 31.12.80. Compute the departmental overhead rates for each ofthe production departments assuming that the overheads are recovered as a percentageof direct wages.

Production Dept. Service Dept.

A B C D E

Direct wages Rs. 2,000 3,000 4,000 1,000 2,000

Direct materials Rs. 1,000 2,000 2,000 1,500 1,500

Staff Nos. 100 150 150 50 50

Electricity Kwh. 4,000 3,000 2,000 1,000 1,000

Light points Nos. 10 16 4 6 4

Asset value Rs. 60,000 40,000 30,000 10,000 10,000

Area occupied Sq.Ft. 150 250 50 50 50

341Overhead Cost

The expenses for the period were :

Motive power Rs. 550

Lighting power Rs. 100

Stores overhead Rs. 400

Amenities to staff Rs. 1,500


Repairs and Maintenance Rs. 3,000

General overheads Rs. 6,000

Rent and Taxes Rs. 275

Apportion the expenses of service dept. E proportionate to direct wages and that of servicedept. D in the ratio of 5 : 3 : 2 to depts A, B and C respectively.


NOTES

343Marginal Costing

Chapter 11MARGINAL COSTING

In the conventional system of cost ascertainment, the direct cost may be identified with theindividual cost center. However, the indirect costs i.e. the overheads are identified with theindividual cost center on the most equitable basis. This results into some problems in theprocess of managerial decision-making.

a. The above process does not take into consideration the behaviour of cost. All the costsin the practical circumstances do not behave in the same manner. Some of the coststend to remain constant despite the changes in the level of activity or volume of operations.These types of costs are comparatively irrelevant in the managerial decision-making.

b. The above process results into the under absorption or over absorption of overheads.

The said limitations have given rise to a managerial decision making technique that basicallytries to classify the costs based upon the behaviour of cost. The technique is referred to asMarginal Costing. The basic proposition made by this technique is that the costs should beclassified on the basis of behaviour of the costs. From this angle, the costs can be viewed asfixed costs and variable costs,

Fixed Cost is the cost that tends to remain constant irrespective of the level of activity orvolume of operations. Fixed Cost tends to vary with time rather than with level of activity. Basiccharacteristic feature of fixed cost is that this cost in terms of amount may remain constant atall the levels of activities, however per unit fixed cost goes on decreasing with the increasinglevel of activity and vice-a-versa.

Variable Cost is the cost that varies in direct proportion with the level of activity or volume ofoperations. Basic characteristic feature of variable cost is that variable cost in terms of amountmay increase or decrease with the changing level of activity or volume of operations. However,per unit variable cost remains constant.

In practical circumstances, some costs may not be entirely fixed or entirely variable. They aretechnically in the form of semi-fixed costs or semi-variable costs. For the purpose of marginalcosting, the semi-fixed costs or semi-variable costs are required to be classified in the individual


components of fixed cost and variable cost. For segregating the semi-fixed or semi-variablecost into the individual components of fixed cost and variable cost, various techniques ormethods may be available viz.

l Comparison by period or level of activity

l Range or High and Low method

l Analytical method

l Scattergraph method

l Lease Square method

Based upon the above discussions, let us make some calculations for a manufacturingorganization manufacturing and selling a single product, operating at various levels of activities.

Level of Activity – Units 1000 1500 2000

Per Unit Selling Price – Rs. 100 100 100

Total Sales – Rs. 1,00,000 1,50,000 2,00,000

Variable Cost – Rs. 60,000 90,000 1,20,000

Fixed Cost – Rs. 30,000 30,000 30,000

Total Cost – Rs. 90,000 1,20,000 1,50,000

Per Unit Variable Cost – Rs. 6 6 6

Per Unit Fixed Cost – Rs. 3 2 1.5

Per Unit Total Cost – Rs. 9 8 7.5

It can be observed from the above calculations that if the fixed cost is included in the calculationof total cost, per unit total cost becomes non-comparable with the changes in the level ofactivity in one cost-period to another cost-period. To avoid this non-comparability, it is necessaryto eliminate the fixed costs while determining the total cost.

As such, the technique of Marginal Costing proposes that fixed cost tends to remain stagnantat least over a shorter period of time and hence should be ignored in the entire decisionmaking process. As such, marginal costing considers only the variable cost as the relevantcost in the decision making process.

The Concept

Marginal Cost is defined as the amount at any given volume of output by which the aggregatecosts are changed if the volume of output is increased or decreased by one unit. The aggregatecost consists of both fixed cost and variable cost. As in the short run, fixed costs remainconstant irrespective of changes in the volume, aggregate costs may increase or decrease

345Marginal Costing

with the changes in volume, specifically due to variable cost. As such, in simple words,marginal cost indicates Per Unit Variable Cost.

Marginal Costing is defined as the ascertainment, by differentiating between fixed and variablecosts, of the marginal costs and of the effect on profit of changes in volume and type of output.

Basic assumptions made by Marginal Costing

The entire technique of Marginal Costing is based upon the following assumptions.

a. Variable Cost varies in direct proportion with the level of activity. However, per unit variablecost remains constant at all the levels of activities.

b. Per unit selling price remains constant at all the levels of activities.

c. Whatever is produced by the organization is sold off. In other words, there are no variationsdue to the stock.

Features of Marginal Costing

1. The product costs are classified as fixed costs and variable costs. Semi-variable costsare also classified in their individual components of fixed cost and variable cost.

2. Only variable costs are considered while computing the product costs. The closing stockof finished goods and semi-finished goods is valued after considering variable costs only.

3. Fixed costs are written off during the period of incurrence and hence do not find the placein product cost determination or inventory valuation.

4. Prices of the product are based on variable costs only.

5. Profitability of the products or departments is decided in terms of marginal contribution.

Marginal Costing and Cost-Volume-Profit Relationship

The definition of the term “Marginal Costing” requires the computation of-

a. Marginal Cost

b. Cost-Volume Profit Relationship

a. Determination of Marginal Cost

As stated earlier, the marginal cost is the additional cost for manufacturing one additionalunit, which is nothing else but the variable cost per unit. Thus the marginal cost orvariable cost includes the direct cost plus the variable overheads. Fixed overheads getclubbed with the fixed cost.


b. Cost Volume-Profit Relationship :

The intention of every business activity is to earn the profit and to maximize the profit.Determination of the profits depends upon the interplay between the following factorsand there exists a close relationship among these factors :

(1) Selling price per unit and total sales amount.

(2) Total cost which in its turn may be in the form of variable cost or fixed cost.

(3) Volume of sales

Cost-Volume-Profit Analysis aims at studying the relationships existing among thesefactors and its impact on the amount of profits.

The relationships existing among these factors may be basically presented in two forms.

(a) In statement or report form

(b) In graphical form, the graphs or charts taking the form of break even chart, contributionbreak even chart or profit chart.

Form of operating statement :

Under the marginal costing technique, the operating statement takes the form as specifiedbelow.

(a) In case of a single product company

Rs.

Sales x

Less : Marginal cost

Direct Material Cost x

Direct Labour Cost x

Direct Expenses x

Variable Overheads x

x

Contribution x

Less : Fixed costs x

Profit x

347Marginal Costing

(b) In case of a multi product company

Product Product Product TotalA B C

Rs. Rs. Rs. Rs.

Sales x x x x

Less : Marginal cost

Direct Material cost x x x x

Direct Labour cost x x x x

Direct Expenses x x x x

Variable Overheads x x x x

Contribution x x x x

Less : Fixed costs x

Profit x

Basic concepts in Marginal Costing :

(1) Basic equation of Marginal Costing :

The basic intention of the business is to earn the profit which is the excess of sales overthe total costs.

∴ Profit = Sales - Total Cost

However, total cost can be either fixed cost or variable cost. As such the basic equationtakes the following forms.

∴ Profit = Sales - (Variable Cost + Fixed Cost)

∴ Profit = Sales - Variable cost - Fixed cost

∴ Profit + Fixed cost = Sales - Variable cost.

This is the basic equation of marginal costing.

Both the expressions of Sales - Variable Cost and

Profit + Fixed cost are technically termed as contribution.

∴ Sales - Variable Cost = Contribution = Fixed Cost + Profit

∴ Contribution - Fixed cost = Profit


(2) Contribution :

As discussed earlier, the term contribution can be expressed in two ways basically :

(a) Sales - Variable Cost

(b) Fixed cost + Profit

As in the short period, fixed costs are ineffective due to their stagnant nature, variablecost becomes the most important cost in deciding the profitability. As such, the situationwhich generates higher contribution is treated as profitable situation.

Further, the term contribution, plays an important role in a situation where there are morethan one products and the profits on individual products cannot be ascertained due tothe problems of apportionment of fixed costs to different products. This is due to the factthat the fixed costs are ignored by marginal costing.

(3) Profit Volume (P/V) Ratio :

This ratio indicates the contribution earned with respect to one rupee of sales. As such,it is expressed as

ContributionX 100

Sales

As in the short run, fixed cost remains the same, if there is any change in profits, that isonly due to change in contribution. Hence P/V ratio may also be expressed as :

Change in ProfitsX 100

Change in Sales

E.g. Sales price is Rs. 10 per unit, variable cost is Rs.6 per unit, and fixed costs areRs.300, we observe that for 100 and 150 units, P/V Ratio works out as :

100 Units 150 UnitsRs. Rs.

Sales 1,000 1,500

Variable cost 600 900

Contribution 400 600

Fixed cost 300 300

Profit 100 300

349Marginal Costing

Hence, P/V Ratio is

Contribution 400 600X 100 = X 100 = X 100

Sales 1,000 1,500

OR i.e. 40% = 40%

Increase in ProfitsX 100 i.e.

200X 100 = 40%

Increase in Sales 500

The fundamental property of P/V Ratio is that it remains constant at all the levels ofactivities, provided per unit sales price and variable cost remains constant. It should benoted that P/V Ratio remains unaffected by any variation in fixed costs though overallprofits may change due to this variation.

A high P/V Ratio indicates that a slight increase in sales without corresponding increasein fixed costs will result in higher profits and vice-versa. This is a pointer to increasedsales promotion efforts to increase sales volume.

A low P/V Ratio indicates low profitability so that efforts can be made to increase theprofits by increasing selling price or by reducing variable cost. Overall profitability mayalso be increased by concentrating more on products having high P/V Ratio.

Note : The basic expression of P/V Ratio i.e.Contribution/Sales may lead to other usefulconclusion as -

(a) Sales x P/V Ratio = Contribution

(b) Contribution= Sales

P/V Ratio

(4) Break Even Point (BEP) :

This is a situation of no profit no loss. It means that at this stage, contribution is justenough to cover the fixed costs i.e. Contribution = Fixed Cost. It also means thatcontribution generated by all sales beyond Break Even Point will directly result intoprofits. As such, it will be intention of every business to reach the Break Even Point, asearly as possible.

The Break Even Point may be expressed in two ways.

(a) In terms of quantity –Fixed Costs

Contribution per unit


(b) In term of amount –Fixed Costs

P/V Ratio

(5) Margin of Safety :

These are the sales beyond Break even point. A business will like to have a high marginof safety because this is the amount of sales which generates profits. As such, thesoundness of the business is indicated by the margin of safety. A high margin of safetyindicates that the Break Even Point is much below the actual sales and even if there isreduction in sales, business will be still in profits. A low margin of safety accompaniedby high fixed cost and high P/V Ratio indicates that efforts are required to be made forreducing the fixed cost or increasing sales volume. A low margin of safety accompaniedby a law P/V Ratio indicates that efforts are required to be made for reducing the variablecost or increasing the selling price.

Margin of safety may be expressed as below :

Margin of Safety = Sales - Break Even Sales

= Sales -Fixed cost

P/V Ratio

Margin of Safety =Sales x P/V Ratio - Fixed Cost

P/V Ratio

=Contribution - Fixed Cost

P/V Ratio

= Profit

P/V Ratio

Margin of safety may be expressed as a ratio or as a percentage. E.g. If actual sales areRs.l,00,000 and Break Even Sales are Rs.60,000, Margin of Safety will be

Sales - Break Even Sales X 100

Sales

i.e.1,00,000 - 60,000 40,000

X 100 = = X 1001,00,000 1,00,000

i.e. 40% of Sales

351Marginal Costing

Illustrations :

(1) Following details are available :

Sales Total CostRs. Rs.

Period I 39,000 34,800

Period II 43,000 37,600

Calculate variable cost, fixed cost and contribution for each period.

Solution :

As Sales - Total Cost = Profit, we know as below :

Sales Total Cost ProfitRs. Rs. Rs.

Period I 39,000 34,800 4,200

Period II 43,000 37,600 5,400

As P/V Ratio =Increase in Profits

X 100Increase in Sales

= 5,400 - 4,200X 100 =

1,200X 100 = 30%

43,000 - 39,000 4,000

As Sales x P/V Ratio = Contribution,For period I, Contribution = 39,000 x 30% = 11,700

For period II, Contribution = 43,000 x 30% = 12,900

As Sales - Contribution = Variable Cost,

For period I, Variable Cost = 39,000 - 11,700 = 27,300

For period II, Variable Cost = 43,000 - 12,900 = 30,100

As Contribution - Profit = Fixed Cost,

For period I, Fixed Cost = 11,700- 4,200 = 7,500

For period II. Fixed Cost = 12,900 - 5,400 = 7,500

To summarise,

Period I Period IIRs. Rs.

Contribution 11,700 12,900

Variable cost 27,300 30,100

Fixed cost 7,500 7,500


(2) Following details arc available :

Sales ProfitRs. Rs.

Period I 2,00,000 20,000

Period II 3,00,000 40,000

Find out Break even Sales

Solution :

We know that P/V Ratio =Increase in Profits


P/v Ratio =20,000

X 100 = 20%100,000

Margin of safety =Profit

P/V Ratio

For period I, Margin of Safety is =20,000

= 1,00,00020%

As Break Even Sales = Sales - Margin of Safety.

Considering Period I,

Break Even Sales = 2,00,000 - 1,00,000

= 1,00,000

(3) Following details are available:

Actual Sales Rs. 20,000

Break Even Sales Rs. 10,000

Fixed Cost Rs. 5,000

Find out the profit at actual sales,

Solution :

At break Even Point, Contribution = Fixed Cost

At Break Even Point, sales are Rs. 10,000 and contribution Rs. 5,000

353Marginal Costing

However we know that,

P/V Ratio =Contribution

X 100 =5,000

X 100= 50%Sales 10,000

We also know that. Sales x P/V Ratio = Contribution,

∴ At actual sales of Rs. 20,000

Contribution = 20,000 x 50%

= 5,000

We know that Contribution - Fixed cost = Profit

∴ Profit = 10,000 - 5,000

= 5,000

(4) Following details are available:

Break Even Sales Rs. 20,000

Fixed cost Rs. 10,000

Profit Rs. 5,000

Find out the margin of safety.

Solution :

At Break Even Point, Fixed Cost = Contribution

∴ When sales are Rs. 20,000, Contribution is Rs. 10,000

However, we know that -

ContributionX 100 = P/V ratio

Sales

P/V Ratio =10,000

X 100 = 50%20,000

We also know that,

Margin of safety =Profit

P/V Ratio

=5,000

= 10,00050%


(5) Find, out the Break Even Point and Profit if sales are Rs. 50,00,000 and P/V Ratio is50% and Margin of safety is 40%.

Solution :

Sales are Rs. 50,00,000 and Margin of safety is 40% of sales, hence margin of safety is Rs.20,00,000. As Break Even Sales = Sales – Margin of Safety.

BEP = Rs. 50,00,000 - Rs. 20,00,000 = Rs. 30,00,000

We know that,

Margin of Safety =Profit

P/V Ratio

∴ Margin of Safety x P/V Ratio = Profit

As Margin of Safety is Rs. 20,00,000 and P/V Ratio is 50%,

Profit = 20,00,000 x 50% = 10,00,000

GRAPHICAL PRESENTATION OF COST-VOLUME-PROFIT RELATIONSHIPS

As discussed earlier, the Cost-Volume-Profit relationships may be expressed in the form ofvisual aids like graphs and charts. There may be various ways in which these charts andgraphs can be prepared depending upon the purpose for which they are prepared. We willdiscuss three of these ways.

(1) Simple Break Even Chart

It can be prepared as below.

Y

O X

TC

TS

SL

BEP

VOLUME

MOS

LOSSFC

a

}CO

ST/

RE

VE

NU

E

355Marginal Costing

TS = Total Sales Line

TC = Total Cost Line

BEP = Break Even Point

SL = Selected Level of Activity

FS = Fixed Cost

MOS = Margin of Safety

Angle a = Angle of Incidence.

Note : It will be observed from the above chart, that the angle formed by total sales line andtotal cost line is termed as Angle of Incidence. As the difference between total sales and totalcost is in the form of profits, higher the angle of incidence better will be the situation.

The limitation of Simple Break Even Chart is that contribution cannot be shown separately. Assuch, the following type of Break Even Chart may be prepared i.e. Contribution Break EvenChart.

(2) Contribution Break Even Chart :

This is a chart where the contribution is shown more clearly and specifically than in asimple break even chart. It can be prepared as below.

Y

O X

TC

TS

SL

BEP

VOLUME

MOS VC

a

}CO

ST/

RE

VE

NU

E

FC

TS = Total Sales Line

TC = Total Cost Line


SL = Selected Level of Activity

C = Contribution

PC = Fixed Cost

VC = Variable Cost

MOS = Margin Of Safety

Angle a = Angle of Incidence.

VC


(3) Profit Graph :

In case of this type of break even chart, horizontal axis represents sales volume andvertical axis represents profit or loss. The diagonal line represents contribution. Thepoint where the contribution line cuts horizontal axis indicates sales at the Break EvenPoint indicating that at this point, there is no profit or no loss.

PL

SALES

BEP

FC

PL}

PL = Profit LineFC = Fixed Cost

P = Profit Area

L = Loss Area


PRACTICAL APPLICATIONS OF MARGINAL COSTING :

The technique of marginal costing can be profitably employed in the following situations.

(1) Evaluation of Performance :

The performance of various segments of a business, say a department or a product or abranch and so on, can be evaluated with the help of marginal costing and the evaluationof the performance will be based upon the contribution generating capacity of thesesegments. If the fixed costs are apportioned over these segments on any basiswhatsoever, it will be ignored while evaluating the performance.

357Marginal Costing

Illustration :

Following details are available in respect of 3 products.

ProductsA B C

Rs. Rs. Rs.

Sales 1,00,000 1,50,000 2,50,000

Total Cost

Variable Cost 90,000 1,00,000 1,50,000

Fixed cost (Apportioned

on the basis of sales) 20,000 30,000 50,000

Total Cost 1,10,000 1,30,000 2,00,000

∴ Profit (Loss) (10,000) 20,000 50,000

As product A is incurring the losses, it is decided to close down its production. Advise themanagement,

Solution :

It will not be advisable to close down the production of product A, because it is generating thepositive contribution

(i.e. Rs. 1,00,000 - Rs. 90,000 = Rs. 10,000)

Closing down of product A will mean loss of contribution generated by it, fixed cost stillremaining the same. Assuming that the production of product A is closed down, what will bethe effect on profitability? Let us verify by applying marginal costing principles.

Product B Product C TotalRs. Rs. Rs.

Sales 1,50,000 2,50,000 4,00,000

Variable Cost 1,00,000 1,50,000 2,50,000

∴ Contribution 50,000 1,00,000 1,50,000

Fixed costs 1,00,000

∴ Profits 50,000

It means that existing total profits of Rs. 60,000 will reduce to Rs. 50,000 which will affectprofitability adversely.


(2) Profit Planning :

Marginal costing, through the calculations of P/V Ratio, enables the management toplan the activities in such a way that the profits can be maximised or to maintain aspecific level of profits. As such, this technique helps the planning of profits.

Illustration :

(1) M/s. C and P Ltd. Produces and sells industrial containers and packing cases. Due tocompetition, the company proposes to reduce the selling price. If the present level ofprofit is to be maintained, indicate the number of units to be sold if the proposed reductionin price is (a) 10% and (b) 15%. The following information is available:

Rs. Rs.

(1) Present Sales (30,000 Units) 6,00,000

(2) Variable Cost (30,000 Units) 3,60,000

(3) Fixed Cost 1,40,000

5,00,000

(4) Net Profit 1,00,000

Solution :

The present cost structure can be stated as below:


Sales 20 6,00,000

Variable Cost 12 3,60,000

Contribution 8 2,40,000

Fixed Cost 1,40,000

Net Profit 1,00,000

If the price is reduced by 10% or 15%, the per unit cost structure is going to changeas below :

Present 10% Price Reduction 15% Price Reduction

Rs. Rs. Rs.

Sales 20 18 17

Variable Cost 12 12 12

Contribution 8 6 5

359Marginal Costing

If the present level of profits is to be maintained i.e. Rs. 1,00,000, the revised total contributionwhich the sales will have to generate with reduced per unit contribution will be Expected Profit+ Fixed Cost, and the number of units which will have to be sold will be :

Expected Profit + Fixed Cost

Revised per unit contribution

As such, the number of units which will have to be sold in the above cases of price reductionwill be -

10% Price Reduction 15% Price Reduction

Rs. 1,00,000 + Rs. 1,40,000 Rs. 1,00,000 + Rs. 1,40,000

Rs. 6 Rs. 5

=Rs. 2,40,000

=Rs. 2,40,000

Rs. 6 Rs. 5

= 40,000 Units = 48,000 Units

(2) Per Unit cost structure of a single product manufacturing company is as below :

Selling Price Rs. 100

Direct Material Rs. 60

Direct Labour Rs. 10

Variable overheads Rs. 10

Number of Units sold in the year are 5,035. As per the agreement with the employee’sunion, there will be an increase of 10% in Direct wages.

Work out -

(a) How many more units have to be sold next year to maintain same quantum ofprofits.

(b) By what percentage the selling price has to be raised to maintain same P/V Ratio?


Solution :

The present profitability structure is as below :

(i) Total number of units sold 5,035

(ii) Per unit cost structure

Selling price Rs. 100

Variable cost

Direct Material Rs. 60

Direct Labour Rs. 10

Variable Overheads Rs. 10

Rs. 80

Contribution per unit Rs. 20

(iii) Total Contribution Rs. 1,00,700

In the next year, the per unit Direct Labour Cost will be more by 10% i.e. Rs. 11 per unit whichwill reduce the per unit contribution to Rs. 19.

Alternative (a) :

If the same quantum of profits is to be maintained, same amount of contribution will have to begenerated with reduced per unit contribution.

As such, number of units required to be sold will be :

=Amount of contribution

Revised per unit contribution

=Rs. 1,00,700

Rs. 19

= 5.300 Units

Hence, the company will have to sell 265 units more (i.e. 5,300 Units - 5,035 Units) to maintainsame quantum of profits.

Alternative (b) :

At present, when selling price is Rs. 100, contribution is Rs. 20 meaning that per unit variablecost is Rs. 80.

In future, the variable cost is likely to be Rs. 81 per unit instead of Rs. 80. Accordingly, theselling price will also be required to be increased if it is intended that the same P/V Ratioshould be maintained.

361Marginal Costing

The new selling price will be :

Rs. 81X 100 = Rs. 101.25

Rs. 80

As such, the selling price has to be raised by 1.25% to maintain the same P/V Ratio.

The profitability structure will be -

Selling Price Rs. 101.25

Variable Cost Rs. 81.00

Contribution Rs. 20.25

P/V Ratio =Contribution per unit X 100Selling Price per unit

20.25 X 100 = 20%

101.25

(3) Fixation of Selling Price :

The technique of marginal costing may be applied in the area of price fixation in such away that prices fixed should cover atleast the variable cost. As in the short run, the fixedcost is a stagnant cost, it can be ignored, though it can not be ignored in the long runbecause of the simple fact, that it is a cost. In the short run, the prices fixed above thevariable cost may generate some positive contribution which may help in the recovery offixed cost. However, if the fixed cost is ignored in the long run, it may put the businessinto serious troubles as the business will never be able to earn the profits.

In this connection, following propositions should be kept in mind.

(a) In some exceptional circumstances viz. during the phase of depression, seriouscompetition in the market, to introduce the new product in the market by keepingthe price as low as possible in the initial stages, to dispose off the product whichmay deteriorate in quality etc., it may be necessary to fix the selling price evenbelow the variable cost, however it is a deliberate decision taken by the management.

(b) The above principle is equally applicable while fixing the export price as well. Theexport price over and above the variable cost will result into increased amounts ofprofits if the fixed costs can be taken care of by the inland sales and if the homemarket is not likely to get affected by the export price fixed. However, if certainspecific costs, either fixed or variable, are required to be incurred specifically for theexecution of the export order, they will have to be recovered while fixing the exportprice as if it is a part of the variable cost.


Illustration :

(1) The operating statement of a company is as follows :

Rs.

Sales (80,000 Units @ Rs. 15) 12,00,000

Costs – Variable

Materials 2,40,000

Labour 3,20,000

Overheads 1,60,000

7,20,000

Fixed 3,20,000

Total Costs 10,40,000

Profit 1,60,000

The plant capacity is 1,00,000 units. A customer from U.S.A. is desirous of baying 20,000units at a net price of Rs. 10 each unit. Advice the company whether or not offer should beaccepted? Will your advice be different if the customer is a local one?

Solution :

At present, variable cost per unit is Rs. 9 i.e.

Rs. 7,20,000

80,000 units

So long as the export price is more than Rs. 9, it is going to generate additional contributionwhich is going to increase the profits, as the fixed costs are already covered by the localsales. As the export price offered is Rs. 10 i.e., Re. 1 more than the variable cost per unit, thecompany should accept the offer. The advice will be the same even it the customer is a localone, provided the price discrimination, i.e. Rs. 15 per unit for 80,000 units and Rs. 10/- per unitfor 20,000 units is not going to adversely affect the current market for 80,000 units at thecurrent price of Rs. 15. If the company accepts the export offer of Rs. 10 per unit, the revisedprofitability structure will be as below:

Rs.

Sales : 80,000 units @ Rs. 15 12,00,000

20,000 units @ Rs. 10 2,00,000

14,00,000

363Marginal Costing

Costs : Variable

1,00,000 units @ Rs. 9 9,00,000

Fixed 3,20,000

Total costs 12,20,000

Profit 1,80,000

The revised amount of profit will be more by Rs. 20,000 as compared to the existing amount ofprofits. Hence, the export order should be accepted by the company.

(4) Make or buy decision :

If the management is facing problem to decide whether a component or a product shouldbe manufactured in house which can be purchased from an outside source as well, thetechnique of marginal costing may render useful assistance. E.g. The following costdata is made available in respect of two components A and B.

Component A Component BRs. per unit Rs. per unit

If manufactured

Variable Cost 30 30

Fixed Cost 25 20

55 50

If purchased 40 25

If the above data is viewed from total cost point of view, without considering theclassification of cost like fixed or variable, it may be concluded that the purchaseproposition may be profitable for both the components A and B. However, the conclusionmay be misleading as the total cost in case of component A, if purchased, is not goingto be only Rs. 40 per unit, but it is going to be Rs. 65 (i.e. Rs. 40 purchase price per unitplus Rs. 25 fixed cost per unit) which being more than present total cost, manufacturingproposition will be beneficial. On the other hand, in case of component B, total cost, ifpurchased, is going to be Rs. 45/- per unit (i.e. Rs. 25 purchase price per unit plus Rs.20 fixed cost per unit) which being less than present total cost, buying proposition will bebeneficial.

The above conclusions may be simplified in the following way :

If Purchases Price < Variable Cost, go in for purchase proposition.

If Purchase Price > Variable Cost, go in for manufacturing proposition.


Before taking any make or buy decision only on the basis of marginal cost analysis,following points should also be taken into consideration.

(1) If buying proposition is beneficial in case of a component or product, the final decisionto buy may depend on other factors also viz. whether the supplier is reliable one,whether the supplier can assure required quality, whether the supplier can assureuninterrupted supply etc.

(2) If it is decided to buy a component or a product which was being manufactured tillnow, the manufacturing capacity released should be profitably used for some otherpurposes. If it is decided to manufacture a companent which was being purchasedtill now, there may be two possibilities. One, production capacity used for samecomponent or product may be diverted to manufacture another component orproduct. In this case, the loss of contribution of that another component or productshould be considered as a part of cost. Second, if additional production facilitiesare required to be acquired for the manufacturing proposition, the additional fixedcosts attached with the manufacturing proposition should be considered.

(5) Optimising product mix :

Product mix refers to the proportion in which various products of a company can be sold.If a concern is dealing in a number of products, a problem which usually arises is todecide a mix or proportion in which the sales of the various products should be made sothat the profits can be maximized. Such a problem can be solved by studying thecontributions generated by the various products individually and by selecting that mixwhich generates the maximum total contribution.

Illustration :

Following information has been made available from the cost records of Universal AutomobilesLtd. manufacturing spare parts

Direct Materials per unitX Rs. 8Y Rs. 6

Direct wagesX 24 hours @ 25 paise per hour.Y 16 hours @ 25 paise per hour.

Variable overheads - 150% of wages

Fixed overheads - Rs. 750

Selling priceX Rs. 25Y Rs. 20

365Marginal Costing

The Directors want to be acquainted with the desirability of adopting any one of the followingalternative sales mixes in the budget for the next period.

(a) 250 units of X and 250 units of Y

(b) 400 units of Y only

(c) 400 units of X and 100 units of Y

(d) 150 units of X and 350 units of Y

State which of the alternatives you would recommend to management.

Solution :

Productwise Profitability Structure

Product X Product YRs. Rs.

(1) Selling Price per unit 25 20

(2) Variable cost per unit

Direct Material 8 6

Direct Wages 6 4

Variable Overheads 9 6

23 16

(3) Contribution per unit 2 4

Evaluation of various alternative sales mixes as per Total Contribution

Alternative Product X Product Y TotalRs. Rs. Rs.

a. 250 x 2 = 500 250 x 4 = 1,000 1,500

b. — 400 x 4 = 1,600 1,600

c. 400 x 2 = 800 100 x 4 = 400 1,200

d. 150 x 2 = 300 350 x 4 = 1,400 1,700

Fixed overheads are going to be the same in all these alternatives. As such, the alternativewhich generates maximum contribution is the maximum profitable one.As alternative d i.e.150 units of X and 350 mills of Y generates maximum of contribution, it will be recommendedto the management.


(6) Cost control :

Marginal costing is necessarily a technique of cost classification and cost presentation.The segregation of total costs as fixed costs and variable costs itself facilitates the costcontrol. Variable costs are the controllable costs at the lower level of management whereasfixed costs can be controlled only on the top level of management and that too, to alimited extent only. Classification of costs as fixed costs and variable costs enables themanagement to concentrate on the controllable costs. At the same time, the fixed costsare not completely ignored. The only thing is that they are collected and reported separatelyas an amount deducted from total contribution. As such, the fixed costs can also becontrolled as they can be programmed and estimated in advance.

(7) Flexible Budget Preparation :

Marginal costing technique and more particularly the classification of costs as fixed andvariable, facilitates the preparation of flexible budgets which is discussed in details in thechapter ‘Budgetary Control’.

PROBLEM OF KEY FACTOR :

Under the marginal costing technique, profitability is measured in terms of the contributionand the products generating maximum contribution or having maximum P/V Ratio are treatedas the maximum profitable products. As the intention of every business is to maximize theprofits, the company will concentrate maximum on the products having highest P/V Ratio andwill thus maximize the profits. However, in practice, there may be some factors which maycome into play which may restrict the company’s intention or capability to maximize theprofits E.g. In case of the products having highest P/V Ratio, market may be limited, or incase of a maximum profitable product, raw material may not be available. These factors are inthe form of ‘Key Factor’ or ‘Limiting Factor’ or ‘Scarce Factor’. A key factor is defined as thefactor which, at a particular point of time or over a period, will limit the volume of output. Thekey factor may be in various forms viz. sales/market, material, labour, machine availability andso on. In order to evaluate the profitability of a product under key factor situations, the contributionper unit of key factor is the basic criteria. A product generating maximum contribution per unitof key factor is the maximum profitable product.

367Marginal Costing

Illustration :

From the following details, which product would be recommended if time is the key factor.

Product A Product B

Direct Material per unit Rs. 24 Rs. 14

Direct Labour @ Rs. 2 per hour Rs. 20 Rs. 30

Variable Overheads (% of labour cost) 200% 300%

Selling Price per unit Rs. 150 Rs. 200

Solution :

Product A Product B

(1) Selling Price Unit Rs. 150 200

(2) Variable Cost per unit Rs.

Direct Material 24 14

Direct Labour 20 30


84 134

(3) Contribution per unit Rs. 66 66

(4) Number of labour hours 10 15

(5) Contribution per labour hour Rs. 6.6 4.4

As labour hours is the key factor and contribution per labour hour is more in case of product A,it will be recommended for production.

Multiplicity of Key Factors

In practice, more than one key factors may come into play and any decision regarding productmix ascertainment or profitability ascertainment will have to be decided on the basis ofconsideration of multiplicity of key factors. The situation of multiplicity of key factors is a morecomplex situation, the solutions to which may be found in the more advanced techniques likelinear programming.


Illustration :

Following data is available to decide the product mix.

A B C

Raw material per unit 10 kgs 6 kgs 15 kgs.

Labour Hours required 15 25 20

(Rate Rs. 1 per hour)

Selling price per unit Rs. 125 100 200

Maximum production

Possible Units 6,000 4,000 3,000

1,00,000 kgs of raw material is available at Rs. 10 per kg. Maximum production hours are1,84,000 with a facility for a further 15,000 hours on overtime basis at twice the normal wagerate.

Solution :

Product A Product B Product C

(1) Selling Price per units Rs. 125 100 200

(2) Variable cost

Material 100 60 150

Labour 15 25 20

115 85 170

(3) Contribution per unit Rs. 10 15 30

(4) Contribution per Kg of Raw material - Rs. 1.00 2.50 2.00

(5) Contribution per labour hrs Rs. 0.66 0.60 1.50

Considering the contribution per kg of raw material as well as per labour hour, the rankingsamong the various products will be as below.

I - Product C

II - Product B

III - Product A

Hence, the available raw material and labour hours will be used for the manufacture of ProductC and Product B respectively.

369Marginal Costing

Product Units Raw Material Kgs. Labour Hours No.

C 3,000 45,000 60,000

B 4,000 24,000 1,00,000

69,000 1,60,000

Hence, the balance of raw material and labour hours available for manufacturing of Product Awill be as below.

Raw Material - Kgs. - 31,000 kgs. (i.e. 1,00,000 kgs - 69,000 kgs)

Labour Hours - 24,000 (i.e. 1,84,000 - 1,60,000)

Plus 15,000 extra hours by paying double the normal wage rate.

If extra labour hours are used for the manufacture of product A by paying double the normalwage rate, the cost structure of product A will be as below :

(1) Selling Price per unit Rs. 125


Material Rs. 100

Labour Rs. 30

Rs. 130

(3) Contribution per unit (-) Rs. 5

As there cannot be the positive contribution generated, it will not be advisable to use thelabour hours which require the payment of wages at double the normal wage rate. As such,product A will be manufactured by utilising the labour hours which require the payment ofwages at the normal wage rate only i.e. 24,000 hours with the help of which 1,600 units of A(24,000 Hours/ 15 Hours per unit) can be manufactured. As such, the final product mix will beas below.

Product A 1,600 Units

Product B 4,000 Units

Product C 3,000 Units

Note : One alternate solution is possible to solve the problem of key factors. If the labourhours which require the payment of wages at double the normal wage rate can be utilised forthe manufacture of Product C, its cost structure will be as below.


(1) Selling Price Per Unit Rs. 200


Material Rs. 150

Labour Rs. 40

Rs. 190

(3) Contribution per unit Rs. 10

As such, apparently it may be possible to utilise the labour hours carrying double the normalwage rate for manufacturing product C and utilise the released labour hours carrying thenormal wage rate for manufacturing Product A (i.e. 15,000 hours) In this case, the final productmix will be as below.

Product A – 2,600 Units

Product B – 4,000 Units

Product C – 3,000 Units

The calculation of total contribution generated under both those alternatives is as below.

Alternative I

Product No. of Units Contribution Total ContributionPer Unit Rs. Rs.

A 1,600 10 16,000

B 4,000 15 60,000

C 3,000 30 90,000

1,66,000

Alternative II

Product No. of Units Contribution Total ContributionPer Unit Rs. Rs.

A 2,600 10 26,000

B 4,000 15 60,000

C 2,250 30 67,500

C 750 10 7,500

1,61,000

As in the second alternative, the total contribution generated is less than the one generated inthe first alternative, the second alternative can not be accepted. As such, it will be advisablefor the company not to utilise the labour hours requiring the payment of wages at double thenormal wage rate.

371Marginal Costing

LIMITATIONS OF MARGINAL COSTING

(1) The classification of total cost as variable cost and fixed cost is difficult. No cost can becompletely variable or completely fixed. In some cases, the cost which is considered tobe variable, may not be variable in practical terms E.g. Direct Labour Cost. Under normalsituations this cost is treated as variable cost. However, in India, considering thetremendous legal backing the workers are having, the direct labour cost may not bevariable in nature. As such, it may be necessary to consider the direct labour cost as apart of fixed cost.

(2) Under the marginal costing, the fixed costs are eliminated for the valuation of inventory offinished goods and semi-finished goods, inspite of the fact that they might have beenactually incurred. As such, it is not correct to eliminate the fixed costs. Further, such anelimination affects the profitability adversely.

(3) In the age of increased automation and technological development, the component offixed costs in the overall cost structure may be sizeable. Any technique like marginalcosting which ignores the fixed costs altogether, may not be proper under thesecircumstances as a major portion of cost is not taken care of.

(4) Marginal costing technique does not provide any standard for the evaluation of performance.In that sense, the techniques of budgetory control and standard costing may be consideredto be better techniques from cost control point of view.

(5) Fixation of selling price on marginal cost basis may be useful for short term only. Herealso, an undue importance given to only variable cost may result into taking on heavybusiness with low margin which in turn may increase the fixed costs. As such, over thelong run, the prices should be decided on total cost basis only. Fixation of selling priceon the marginal cost basis in the long run may be dangerous. Moreover, consideration offixed costs may be necessary in price fixation under certain circumstances like costplus contracts unless a very high percentage over the marginal cost is considered totake care of both fixed costs as well as profit margin.

(6) Marginal costing does not take into consideration the fixed overheads, as such theproblem of under or over absorption of fixed overheads can be avoided. But the problemof under or over absorption of variable overheads cannot be avoided.

(7) Marginal costing can be used for assessment of profitability only in the short run. However,in the long run, one has to consider the fixed costs also in order to assess the profitability.Moreover, interpretation of the term ‘short run’ is a subjective concept. For how long thedecision can be taken on the basis of marginal costing principles cannot be decided inthe objective manner.



(1) Profit and sales for the year 1984 are as follows. Profit Rs. 18,000, Sales Rs. 2,40,000.

In 1985, the sales increased by Rs. 40,000 and the profit naturally increased by Rs.8,000.

You are required to calculate.

(1) P/V Ratio

(2) Sales required to achieve a profit of Rs. 1,00,000.

(3) Sales at Break even Point.

Solution :

We know that

P/V Ratio =Increase in Profits


P/V Ratio = 8,000X 100 = 20% ...(a)

40,000

We also know that Sales x P/V Ratio = Contribution

and Contribution - Profit = Fixed Cost.

Applying this to the information available for the year 1984

2,40,000 x 20% = Rs. 48,000 is the contribution and

48,000 - 18,000 = Rs .30,000 is the fixed cost

If the company wants to achieve the profit of Rs. 1,00,000 the total contribution which will haveto be generated will be Expected Profit + Fixed cost

i.e. Rs. 1,00,000 + Rs. 30,000

i.e. Rs. 1,30,000

We know that Sales = Contribution

P/V Ratio

As such sales required to achieve a profit of Rs. 1,00,000 will be

Expected Profit + Fixed Cost

P/V Ratio

373Marginal Costing

=1,00,000 + 30,000

20%

=1,30,000

= Rs. 6,50,000 ...(b)20%

We know that

Break Even Point = Fixed Cost

P/V Ratio

∴ Sales at Break Even Point =30,000

20%

= Rs. 1,50,000 …(c)

(2) The Directors of Sports Material Manufacturing Co. gives the following information.

Sales - (1,00,000 Units) - Rs. 1,00,000

Variable Costs - Rs. 40,000

Fixed Costs - Rs. 50,000

(a) Find out P/V Ratio, Break Even Point and Margin of Safety.

(b) Evaluate the effects on P/V Ratio, Break Even Point and Margin of safety of thefollowing -

(i) 20% increase in physical sales volume.

(ii) 10% increase in fixed costs.

(iii) 5% decrease in variable costs.

(iv) 10% increase in selling price.

Solution :

(A) Present profitability structure is as below.

Sales - 1,00,000 Units

Per Unit (Rs.) Total (Rs.)

Sales 1.00 1,00,000

Variable Costs 0.40 40,000

Contribution 0.60 60,000

Fixed Costs 50,000

Profit 10,000


(1) P/V Ratio

ContributionX 100 =

60,000X 100 = 60%

Sales 1,00,000

(2) Break Even Point

Fixed Cost=

50,000= Rs. 83,333

P/V Ratio 60%

(3) Margin of Safety

Profit=

10,000 = Rs. 16,667P/V Ratio 60%

(B) Effect of 20% increase in Physical Sales Volume. Revised Profitability structure will beas below.

Sales – 1,20,000 Units


Sales 1.00 1,20,000



Fixed Costs 50,000

Profit 22,000

(1) P/V Ratio

ContributionX 100 =

72,000X 100 = 60%

Sales 1,20,000


Fixed Cost=

50,000= Rs. 83,333

P/V Ratio 60%


Profit=

22,000 = Rs. 36,667P/V Ratio 60%

375Marginal Costing

(C) Effect of 10% increase in fixed costs. Revised profitability structure will be as below :


Per Unit (Rs.) Total Rs.

Sales 1.00 1,00,000



Fixed Costs 55,000

Profit 5,000

(1) P/V Ratio

ContributionX 100 =

60,000 X 100 = 60%

Sales 1,00,000


Fixed Cost=

55,000= Rs. 91,667

P/V Ratio 60%


Profit = 5,000 = Rs. 8,333P/V Ratio 60%

(D) Effect of 5% decrease in variable costs. Revised profitability structure will be as below.



Sales 1.00 1,00,000



Fixed Costs 50,000

Profit 12,000

(1) P/V Ratio

ContributionX 100 =

62,000 X 100 = 62%

Sales 1,00,000



Fixed Cost=

50,000= Rs. 80,645

P/V Ratio 62%


Profit=

12,000= Rs. 19,355

P/V Ratio 62%

(E) Effect of 10% increase in selling price. Revised Profitability structure will be as below.



Sales 1.10 1,10,000



Fixed Costs 50,000

Profit 20,000

(1) P/V Ratio

ContributionX 100 =

70,000X 100 = 63.64%

Sales 1,10,000


Fixed Cost=

50,000= Rs. 78,567

P/V Ratio 63.64%


Profit=

20,000= Rs. 31,426

P/V Ratio 63.64%

Note : The difference between Sales and Break Even Point is not matching with Margin ofSafety, due to the rounding off differences.

(3) From the following figures find out the break even volume.

Selling Price per tonne Rs. 69.50

Variable Cost per tonne Rs. 35.50

Fixed Expenses Rs. 18,02,000

377Marginal Costing

If this volume represents 40% capacity, what is the additional profit for an added production of40% capacity, the selling price of which is 10% lower for 20% capacity production and 15%lower, than the existing price, for the other 20% capacity.

Solution :

Selling Price per Unit Rs. 69.5

Variable cost per Unit Rs. 35.5

Contribution per Unit Rs. 34.0

Break Even Point=

Fixed Cost

(in terms of quantity) Contribution per Unit

=Rs. 18,02,000

Rs. 34

= 53,000 Units

Additional production of 53,000 units is envisaged, which can be classified in two parts forconvenience purposes.

Part I Part II

Selling Price per Unit Rs. 62.55 59.075

Variable Cost per Unit Rs. 35.50 35.500

Contribution per Unit Rs. 27.05 23.575

Number of Units 26,500 26,500

Total Contribution Rs. 7,16,825.00 6,24,737.50

As the fixed cost is already covered till the break even point, the contribution beyond the breakeven point will directly result into profit. Hence, additional profit will be Rs. 7,16,825.00 +Rs. 6,24,137.50 = Rs. 13,41,562.50.

(4) The Quality Product Ltd. manufacture and markets a single product Following data isavailable.

Rs. Per Unit

Material 16

Conversion (Variable) 12

Dealer’s Margin 4

Selling Price 40

Fixed Cost - Rs. 5,00,000

Present Sales - 90,000 Units

Capacity Utilisation - 60%


There is acute competition. Extra efforts are necessary to sell. Suggestions have been madefor increasing sales.

(a) By reducing sales price by 5%.

(b) By increasing dealers’ margin by 25% over the existing rate.

Which of these two suggestions would you recommend if the company desires to maintainpresent profits. Give reasons.

Solution :

The present profitability statement will be as below, when 90,000 units are being sold.


(a) Sales 40 36,00,000

(b) Variable Costs

Material 16 14,40,000

Conversion 12 10,80,000

Dealer’s Margin 4 3,60,000

32 28,80,000

(c) Contribution – a – b 8 7,20,000

(d) Fixed cost 5,00,000

(e) Profit – c – d 2,20,000

Alternative I – To reduce selling price by 5%. In this alternative the profitability structure will berevised as below.

Selling Price per Unit Rs. 38

Variable Cost per Unit Rs. 32

Contribution per Unit Rs. 06

If the company wishes to maintain the same profits, the total contribution which the sales willhave to generate with the reduced amount of per unit contribution will be Expected Profits +Fixed Cost. And total number of units to be sold will be -

No. of Units to be sold =Expected Profit + Fixed Cost

Revised contribution per Unit

=2,20,000 + 5,00,000

6

= 1,20,000 Units

379Marginal Costing

Alternative II -

To increase the dealer’s margin by 25%. In this alternative, the variable cost will be more byRs. 1 and the profitability structure will be revised as below.

Selling Price per Unit Rs. 40

Variable cost per Unit Rs. 33

Contribution per Unit Rs. 07

If the company wishes to maintain the same profits, the total contribution which the sales willhave to generate with the reduced amount of per unit contribution will be Expected Profits +Fixed Cost. And total number of units to be sold will be -

No. of Units to be sold = Expected Profit + Fixed CostRevised contribution per unit

= 2,20,000 + 5,00,0007

= 1,02,857 Units

Acute competition in the market is the basic problem area. As such, the company will like toaccept the alternative where less number of units will be required to be sold, the profitsremaining the same under both the alternatives.

As Alternative II requires 1,02,857 Units to be sold vis-a-vis 1,20,000 units required to be soldunder Alternative I, the company will prefer Alternative II.

Note : It is assumed that both the alternatives are exclusive alternatives i.e. Even when sellingprice is reduced by 5%, the dealer’s margin is unaffected and vice versa.

(5) Frazer Ltd. manufactures and sells a product, the selling price and raw material cost ofwhich have remained unchanged during the past two years. The following are the relevantdata:

Particulars Year 1 Year 2

Quantity sold (Kgs.) 100 150

Sales Value Rs. 20,000 ?

Raw Material Rs. 10,000 ?

Direct Wages Rs. 3,000 ?

Factory Overheads Rs. 5,000 Rs. 5,700

Profit Rs. 2,000 Rs. 2,550


During year 2, direct wage rates increased by 50% but there was a saving of Rs. 300 in fixedfactory overheads.

Required :

What quantity in Kgs. the company should have produced and sold in year 2 in order tomaintain the same amount of net profit per Kg. as it earned during the year 1?

Solution :

The Profitability statement for both the years is as below -

Year 1 Year 2

Quantity Sold (Kgs.) 100 150

Sales (Rs.) 20,000 30,000

Variable Cost

Raw Material 10,000 15,000

Direct Wages 3,000 6,750

Variable Factory Overheads 2,000 3,000

Total Variable Cost 15,000 24,750

Contribution 5,000 5,250

Fixed Cost 3,000 2,700

Profit 2,000 2,550

Profit per Kg. (Rs.) 20 17

Per Unit Variable Cost in Year 2 works out to Rs. 165 i.e. Rs. 24,750 / 150 Kgs.

Let us assume that the quantity to be sold in Year 2 is X Kgs.

Hence, the profitability statement will be -

200X - 165X - 2700 = 20X

Solving for X, we get the value of X to be 180 Kgs.

Hence, the company should have produced and sold 180 Kgs. in year 2 in order to maintainthe same amount of net profit per Kg. as it earned during Year 1.

Working Note -

Factory Overheads in Year 1 were Rs. 5,000 which became Rs. 5,700 in Year 2 with theinformation that there was a saving of Rs. 300 in fixed factory overheads. Assuming that therewas no saving, the factory overheads would have been Rs. 6,000 in Year 2. Hence, the datawould have been as below -

381Marginal Costing

Year 1 Year 2

Quantity Sold (Kgs.) 100 150

Factory Overheads (Rs.) 5,000 6,000

For the increased quantity of 50 Kgs. the overheads would have increased by Rs. 1,000. Itmeans that the variable factory overheads are Rs. 20 per unit.

(6) Garden Products Limited manufacture the “Rainpour” garden pour. The accounts of thecompany for the year 1981 are expected to reveal a profit of Rs. 14,00,000 from themanufacture of “Rainpour” after charging fixed costs of Rs. 10,00,000. The “Rainpour” issold for Rs.50 per unit and has a variable unit cost of Rs. 20. Market sensitivity testssuggest the following responses to price changes.

Alternatives Selling Price Quantity soldReduced by increased by

A 5% 10%

B 7% 20%

C 10% 25%

Evaluate these alternatives and state which, on profitability consideration, should be adoptedfor the forthcoming year, assuming cost structure unchanged from 1981.

Solution :

At present, the expected profit is Rs. 14,00,000 after recovering the fixed cost of Rs. 10,00,000.Hence, the total expected contribution is Rs. 24,00,000 i.e. Rs. 14,00,000 + Rs. 10,00,000.

Per Unit cost structure is as below.

Selling Price Rs. 50

Variable Cost Rs. 20

∴ Contribution Rs. 30

If total contribution is Rs. 24,00,000 and per unit contribution is Rs. 30, it means that thepresently expected sales in terms of quantity are 80,000 units.


In the light of above, the results of the various alternatives can be calculated as below.

Alternatives Revised Selling Revised contribution Revised sold Revised total

Price Per Unit Per Unit Per Unit Quantity contribution1 2 3 4 5(3x4)

A 47.50 27.50 88,000 24,20,000

B 46.50 26.50 96,000 25,44,000

C 45.00 25.00 100,000 25,00,000

As profitability is the criteria on which the various alternatives are to be evaluated, AlternativeB will be selected, as it generates maximum contribution, fixed cost remaining the sameunder all the alternatives.

(7) Shri Kiron manufactures Lighters. He sells his product at Rs. 20 each and makes profitof Rs. 5 on each lighter. He worked 50% of his machinery capacity at 50,000 lighters.The cost of each lighter is as under.

Rs.

Direct Material 6

Wages 2

Works Overheads 5 (50% fixed)

Sales Expenses 2 (25% variable)

His anticipation for the next year is that the cost will go up as under.

Fixed Charges 10%

Direct Labour 20%

Material 5%

There will not be any change in selling price. There is an additional order for 20,000 lighters inthe next year.

What is the lowest rate he can quote so that he can earn the same profit as the current year?

383Marginal Costing

Solution :

The profitability statement in the current year is as below :

Sales – 50,000 Units


(A) Sales 20.00 10,00,000

(B) Variable Costs

Direct Material 6.00 3,00,000

Wages 2.00 1,00,000

Works overheads 2.50 1,25,000

Sales Expenses 0.50 25,000

11.00 5,50,000

(C) Contribution – (A – B) 9.00 4,50,000

(D) Fixed Costs

Works Overheads 2.50 1,25,000

Sales Expenses 1.50 75,000

2,00,000

(E) Profits (C – D) 2,50,000

In the next year, material cost will increase by 5% i.e., by 30 paise and direct labour cost willincrease by 20% i.e., by 40 paise. As such, the total variable cost will increase by 70 paise.Hence, the total variable cost will be Rs. 11.70 per unit. The revised profitability structure for50,000 unit will be :

Selling price per unit Rs. 20.00

Variable cost per unit Rs. 11.70

∴ Contribution per unit Rs. 8.30

∴ Total contribution Rs. 4,15,000

In the next year, fixed charges will increase by 10% i.e., total fixed charges of Rs. 2,00,000 inthis year will become Rs. 2,20,000.

As we know that Contribution - Fixed Charges = Profit, the profit generate by 50,000 units willbe –

Rs. 4,15,000 – Rs. 2,20,000 = Rs. 1,95,000


If in the next year, the company wants to earn the same total profits as in the current year i.e.Rs. 2,50,000 there will be a shortfall of Rs. 55,000 i.e., Rs. 2,50,000 - Rs. 1,95,000 and theshortfall will have to be recovered by additional 20,000 units proposed to be sold in the nextyear. Hence, over and above the variable cost, each of these additional units will have torecover the profit of :

Rs. 55,000= Rs. 2.75 per Unit

20,000 units

Hence, the lowest rate which can be quoted will be : Expected variable cost per unit in thenext year + Expected profit per unit in the next year

i.e., Rs. 11.70 + Rs. 2.75 = Rs. 14.45 per unit

(8) Following details are available in respect of a single product manufacturing companyoperating at 75% capacity.

Units Sold 15,000

Selling Price Per Unit Rs. 12.5

Material Cost Rs. 3 per Unit

Labour hours required 2 per unit

Labour hour rate Re. 1 per hour

Variable expenses 200% of labour cost

Fixed cost Rs. 20,000

The company has received an offer to export 8,000 units. Due to the Government backing, thematerial will be available at a price lower by 25% than the existing price. An additional expenditureof Rs. 10,000 will have to be incurred for execution of this export order. But an export incentiveis available from the Government which will be equivalent to 25% of the export price. Whatminimum price should be charged if it is intended that per unit exported should earn a clearmargin of Rs. 2 and the profits from inland sales remaining the same. Ignore the benefitsavailable as per the provisions of Income Tax Act, 1961 and the time required to receive theexport incentive in cash since the date of actual export. Assume that Selling price in inlandmarket cannot be increased.

385Marginal Costing

Solution :

Present cost structure is as below:

Sales -15,000 Units


(A) Selling price 12.50 1,87,500

(B) Variable Costs

Material Cost 3.00 45,000

Labour Cost 2.00 30,000

Variable Expenses 4.00 60,000

9.00 1,35,000

(C) Contribution (A - B) 3.50 52,500

(D) Fixed Cost 20,000

(E) Profit (C – D) 32,500

When sales are 15,000 Units, capacity utilisation is 75%. It means that maximum 20,000units can be sold both in inland or export market. The export order received is for 8,000 units.Now, the company has two alternatives.

Alternative I : Accept the export order only for 5,000 units which can be manufactured.

Alternative II : Accept the export order for 8,000 units by reducing the inland sales by3,000 units.

Alternative I : Only 5,000 Units to be exported.

The amounts which export price will have to cover are as below:

Per Unit (Rs.)

Material Cost 2.25

Labour Cost 2.00

Variable Expenses 4.00

Additional Expenditure (Rs. 10,000

distributed over 5,000 units) 2.00

Expected margin 2.00

12.25

The above amount can be covered either by way of export price of the export incentive whichis 25% of export price. If we assume export price to be Rs. x, the following relationship isestablished.


x + 25% of x = 12.25

i.e. x +x

= 12.254

i.e. 5x= 12.25

4

i.e. x = 9.80

Hence, export price should be minimum Rs. 9.80.

Alternative II :

8,000 units to be exported, inland sales being only 12,000 units.If 8,000 units are to beexported, inland sales will be less by 3,000 units, which will result in the loss of contributionof Rs. 10,500 (i.e. 13000 units x Rs. 3.50 per unit) This loss of contribution also will have to becovered by the units to be exported, as the selling price in the inland market can not beincreased. As such per unit amount to be covered by export price is as below:

Rs. 12.25 (As calculated in Alternative 1) plus

Rs. 10,500= Rs. 1.3125

8,000 units

= Rs. 12.25 + Rs. 1.3125

= Rs. 13.5625

This amount can be covered either by way of export price or by export incentive, which is 25%of export price. Assuming export price to be Rs. x,

x + 25% of x = 13.5625

∴ x + x = 13.56254

∴ 5x = 13.56254

∴ x = 10.85

Hence export price should be minimum Rs. 10.85

387Marginal Costing

(9) A Ltd. operating at 75% level of activity produces and sells two products X and Y. Thecost sheets of these two products are as under :

Particulars Product X Product Y

Units produced and sold 3,000 2,000

Selling Price Per Unit (Rs.) 115 95

Cost :

Direct Materials 10 20

Direct Labour 20 20

Factory Overheads (40% fixed) 25 15

Administration & Selling

Overheads (60% fixed) 40 25

Total Cost Per Unit 95 80

Factory overheads are absorbed on the basis of machine hour rate which is the limiting factor.The machine hour rate is Rs. 10 per hour.

The company receives an offer from Japan for the purchase of Product X at a price of Rs. 87.50per unit. Alternatively, the company has another offer from Bangkok for the purchase of ProductY at a price of Rs. 77.50 per unit. In both the cases, a special packing charge of Rs. 2.50 perunit has to be borne by the company. The company can accept either of the two export ordersby utilising the balance of 25% of its capacity.

Advise the company with the detailed workings as to which proposal should be accepted andprepare a statement showing the overall profitability of the company after incorporating theexport proposal suggested by you.

Solution :

The existing profitability structure as per marginal costing works out as below -

Product X Product Y

Selling Price 115 95

Variable Cost -

Direct Materials 10 20

Direct Labour 20 20

Factory Overheads 15 9

Administration & Selling Overheads 16 10

61 59

Contribution 54 36


Hence, Total Contribution -

Product X - 3000 Units x Rs. 54 per unit = Rs. 1,62,000

Product Y - 2000 Units x Rs. 36 per unit = Rs. 72,000

Rs. 2,34, 000

Fixed Cost can be calculated as below:

Product X - 3000 Units x Rs. 34 per unit = Rs. 1,02,000


Rs. 1,44,000

Hence, profit i.e. Contribution - Fixed Cost Rs. 90,000. As Factory Overheads as absorbed onthe basis of machine hour rate and as machine hour rate is Rs. 10, Product X takes 2.5 hoursand Product Y takes 1.5 hours. Hence, the total number of hours consumed by the existinglevel of activity can be calculated as below:

Product X - 3000 Units x 2.5 hours per unit = 7,500 hours

Product Y - 2000 Units x 1.5 hours per unit = 3,000 hours

10,500 hours

As 10,500 hours are equivalent to 75% level of activity, balance number of hours available forthe execution of the export order are 3,500 which is equivalent to balance 25% level of activity.With the balance number of hours available, the maximum number of units which can bemanufactured for export order work out as below:

Product X - 3,500 hours / 2.5 hours per unit = 1,400 units

Product Y - 3,500 hours / 1.5 hours per unit = 2,333 units

The contribution generated by the units to be exported can be worked out as below :

Product X Product Y

Selling Price 85 75(Net of packing charge)

Variable Cost 61 59

Contribution 24 16

Total contribution generated by executing the export order can be worked out as below:

Product X - 1400 Units x Rs. 24 per unit = Rs. 33,600


389Marginal Costing

As the contribution generated by exporting Product Y is higher, it will be profitable to exportProduct Y. Hence, the total profitability works out as below:

Existing Profits Rs. 90,000

Contribution generated by exports Rs. 37,328

Total Profits Rs. 1,27,328

(10) A Ltd. manufactures three different products and the following information has beencollected from the books of account.

ProductS T Y

Sales Mix 35% 35% 30%Selling Price Rs. 30 Rs. 40 Rs. 20Variable Cost Rs. 15 Rs. 20 Rs. 12

Total Fixed costs Rs. 1,80,000Total Sales Rs. 6,00,000

The company has currently under discussion a proposal to discontinue the manufacture ofproduct Y and replace it with product M, when the following results are anticipated:

ProductS T M

Sales Mix 50% 25% 25%Selling Price Rs. 30 Rs. 40 Rs. 30Variable Cost Rs. 15 Rs. 20 Rs. 15

Total Fixed Cost Rs. 1,80,000Total Sales Rs. 6,40,000

Will you advice the company to changeover to production of M? Give reasons for your answer.

Solution :

PRESENT PROFITABILITY STRUCTURE :

ProductS T Y

Rs. Rs. Rs.

(1) Sales 2,10,000 2,10,000 1,80,000(2) Selling Price per Unit 30 40 20(3) Variable Cost per Unit 15 20 12(4) Contribution per Unit 15 20 8(5) Units Sold (1/2) 7,000 5,250 9,000(6) Total Contribution (4X5) 1,05,000 1,05,000 72,000

= Rs. 2,82,000


PROPOSED PROFITABILITY STRUCTURE :

ProductS T M

Rs. Rs. Rs.

(1) Sales 3,20,000 1,60,000 1,60,000(2) Selling Price per Unit 30 40 30(3) Variable cost per Unit 15 20 15(4) Contribution per Unit 15 20 15(5) Units Sold (1/2) 10,667 4,000 5,333(6) Total contribution (4X5) 1,60,005 80,000 79,995

= Rs. 3,20,000

As the total contribution in the proposed alternative i.e. to change over to production of M islikely to be more than in the present situation, the company should change over to productionof M.

(11) The budgeted results of A Co. Ltd. include -

Product Sales Value (Rs.) P/V Ratio (%)

A 50,000 50

B 80,000 40

C 1,20,000 30

Fixed overheads for the period were Rs. 1,00,000. The Directors are worried about the resultsof the company. They have requested you to prepare a statement showing the amount of lossexpected and recommend a change in the sales of each product or in total mix which willeliminate the expected loss.

Solution :

We know that -

(1) Sales x P/V Ratio = Contribution

(2) Contribution - Fixed Cost = Profit

Product Sales Value (Rs.) P/V Ratio Contribution

A 50,000 50% 25,000B 80,000 40% 32,000C 1,20,000 30% 36,000

2,50,000 93,000

Less Fixed Cost 1,00,000Profit (-) 7,000

391Marginal Costing

Hence, the expected loss is Rs. 7,000.

To eliminate the expected loss, the sales of individual products may be increased, dependingupon the P/V Ratio. The additional sales required to be achieved will be calculated as -

Loss to be eliminated

P/V Ratio

Hence, additional sales will be as below :

Product A - 7,000/50% = Rs. 14,000.

Product B - 7.000/40% = Rs. 17,500.

Product C - 7,000/30% = Rs. 23,333.

As an alternative, the overall sales may also be increased to eliminate the expected loss asstated below:

At present, overall P/V Ratio is -

ContributionX 100 =

93,000X 100 = 37.2%

Sales 2,50,000

To cover the expected loss, the additional sales which will be required to be made will be -

Expected Loss=

7,000= Rs. 18,817

Overall P/V Ratio 37.2 %

These additional sales may be increased in the existing proportion only i.e. 50,000 : 80,000 :1,20,000. Hence, the productwise additional sales and the contribution generated by theseadditional sales will be as below :

Product Additional Sales P/V Ratio ContributionRs. Rs.

A 3,763 50% 1,882

B 6,021 40% 2,408

C 9,033 30% 2,710

18,817 7,000

(12) A Ltd. been producing a standard mix as below :

Product X 15,000 units.

Product Y and Z 10,000 units.


The total variable costs amount to Rs. 2,09,000 and the variable cost ratio among the productsis 1 : 1.5 : 1.75 respectively per unit The fixed, charges amount to Rs. 2 per unit. Selling pricesare Rs. 6.40 for X, Rs. 7.60 for Y and Rs. 10.70 for Z.

It is desired to change the mix as below :

Product Mix 1 Mix 2 Mix 3

X 18,000 15,000 22,000

Y 12,000 6,000 8,000

Z 7,000 13,000 8,000

Which mix should be recommended?

Solution :

The variable cost ratio among products X, Y and Z is I : 1.5: 1.75 respectively per unit. If all theproducts are expressed in terms of Product X, it can be as below :

Product X - 15,000 units

Product Y - 15,000 units (10,000 x 1.5)

Product Z - 17,500 units (10,000 x 1.75)

47,500 Units

Total Variable cost is Rs. 2,09,000.

Hence, per unit variable cost will be as below:

Product X -Rs. 2,09,000

= Rs. 4.4047,500

Product X - Rs. 4.40 X 1.5 = Rs. 6.60

Product Z - Rs. 4.40 X 1.75 = Rs. 7.70

Product X Product Y Product ZRs. Rs. Rs.

Selling Price 6.40 7.60 10.70

Less : Variable Cost 4.40 6.60 7.70

Contribution 2.00 1.00 3.00

393Marginal Costing

The total contribution generated by various alternative mixes will be as below :

MIX 1 Rs.

X 18,000 x 2 36,000

Y 12,000 x 1 12,000

Z 7,000 x 3 21,000

69,000

Mix 2

X 15,000 x 2 30,000

Y 6,000 x 1 6,000

Z 13,000 x 3 39,000

75,000

Mix 3

X 22,000 x 2 44,000

Y 8,000 x 1 8,000

Z 8,000 x 3 24,000

76,000

As Mix 3 generates maximum contribution, it will be recommended. Fixed cost will be ignored,as it will be same under all the circumstances.

(13) A firm can produce three different products from the same raw material using the sameproduction facilities. The requisite labour is available in plenty at Rs.8 per hour for all theproducts. The supply of raw material which is imported at Rs.8 per Kg. is limited to10,400 Kgs. for the budget period. The variable overheads are RS.5.60 per hour. Thefixed overheads are Rs. 50,000. The selling commission is 10% on sales.

a. From the following information, you are required to suggest the most suitable salesmix which will maximise the firms's profits. Also determine the profit that will beearned at that level :

Product Market Demand Selling Price Labour Hours Raw MaterialUnits Per unit (Rs.) Per Unit (Rs.) Per Unit (Kgs.)

x 8,000 30 1 0.7

y 6,000 40 2 0.4

z 5,000 50 1.5 1.5

b. Assume, in the above situation, if additional 4,500 Kgs of raw material is madeavailable for production, should the firm go in for further production, if it will result in


the additional fixed overheads of Rs.20,000 and 25% increase in the rates per hourfor labour and variable overheads ?

Solution :

The profitability statement is as below :

X Y Z

Selling Price per unit 27.00 36.00 45.00(Net of commission)Variable Cost per unit

Raw Material 5.60 3.20 12.00Direct Labour 8.00 16.00 12.00Variable Overheads 5.60 11.20 8.40

Total Variable Cost 19.20 30.40 32.40

Contribution per unit 7.80 5.60 12.60

Contribution per Kg. of 11.14 14.00 8.40Raw Material

As availability of raw material is the key factor, the order of preference among the products willbe Y, X and Z.

6,000 units of Y consume 2,400 Kgs. of material.

Balance left for X and Z are 8,000 Kgs.

8,000 units of X consume 5,600 Kgs. of material.

Balance left for Z are 2,400 Kgs.

With 2,400 Kgs. of material, maximum possible production for Z will be 1,600 units i.e.2,400 / 1.5

Hence, the most suitable sales mix and -said sales mix will be -

Product No. of Units Contribution Total ContributionPer Unit

Rs. Rs.Y 6,000 5.60 33,600X 8,000 7.80 62,400Z 1,600 12.60 20,160

1,16,160Less : Fixed Cost 50,000

Profit 66,160

395Marginal Costing

If additional 4,500 Kgs. of raw material is made available, the additional 3,000 units of Z can besold. However, the profitability per unit of Z will be different as below :

Selling Price 45.00

Variable Cost –

Direct Material 12.00

Direct Labour 15.00

Variable Overheads 10.50

Total Variable Cost 37.50

Contribution 7.50

Total Contribution generated by these 3,000 units will be Rs. 22,500 i.e. 3,000 units x Rs. 7.50per unit. As the fixed overheads are also likely to increase by Rs. 20,000, the additional 3,000units will generate positive contribution of Rs. 2,500. Hence, it is advisible to go for furtherproduction with the additional raw material available.

(14) The following particulars are obtained from the records of a factory manufacturing ProductsA and B.

Product A Product B(Per unit) (Per Unit)

Selling Price 100 200

Material Cost at Rs. 10 per Kg. 20 50

Wages @ Rs. 3 per hour 30 60

Variable overheads 10 20

Total fixed costs : Rs. 5,000

State which of the product is better to be produced and why in the following cases:

(a) If total sales in units is key factor

(b) If total sales in value is key factor

(c) If law material is in short supply

(d) If labour hours is the Limiting factor

(e) If raw material available is 2,000 kgs. and maximum sales of each product is 500 units,advice about the sales mix.


Solution :

Product A Product BPer Unit Per Unit

Rs. Rs.

(1) Selling Price 100 200

(2) Variable cost :

Material 20 50

Wages 30 60


60 130

(3) Contribution (1 - 2) 40 70

(4) P/V ratio (3/1) 40% 35%

(5) Material consumption 2 Kgs. 5 Kgs.

∴ Contribution per kg. of material 20 14

(3/5)

(6) Labour Hours 10 20

∴ Contribution per labour hour 4 3.5

(3/6)

(a) If total sales in units is the key factor, Product B will be better as its per unitcontribution is more.

(b) If total sales in value is the key factor, Product A will be better as its P/V Ratio ismore.

(c) If raw material is in short supply, Product A will be better as its contribution per Kg.of material is more.

(d) If labour hours is the limiting factor, Product A will be better as its contribution perlabour hour is more.

(e) If total available raw material is 2,000 Kgs., it will first utilised to manufacture ProductA as its contribution per Kg. of material is more. However the maximum salespotential of Product A is restricted to 500 units which consumes 1,000 Kgs. ofmaterial (i.e. 500 units x 2 Kgs. per unit). Remaining material of 1,000 Kgs. can beused for the manufacture of Product B, with the help of which only 200 units ofProduct B can be manufactured i.e.,

1,000 Kgs= 200 Units

5 Kgs. per Unit

397Marginal Costing

Hence, the desirable product mix will be

500 units of Product A

200 units of Product B

(15) Small-Tools Factory has a plant capacity adequate to provide 19,800 hours of machineuse. The plant can produce all A type tools or all B type tools or a mixture of the twotypes. The following information is relevant.

Per Type A B

Selling Price Rs. 10 15

Variable Cost Rs. 8 12

Hours required to produce 3 4

Market conditions are such that no more than 4,000 A type tools and 3,000 B type toolscan be sold in a year. Annual fixed costs are Rs. 9,900.

Compute the product mix that will maximize the net income to the company and findthat maximum net income.

Solution :

It is a situation of multiplicity of key factors, first key factor being availability of machine hoursand second one being market conditions. The contribution per machine hour can be computedas below :

A B

Selling Price Per unit Rs. 10 15

Variable cost per mat Rs. 8 12

∴ Contribution per unit Rs. 2 3

Machine hours required per unit 3 4

∴ Contribution per machine your Rs. 0.66 0.75

Ranking when machine hours availability is key factor II I

As such, tool B will be produced to the maximum possible extent i.e. 3,000 units and thebalance machine hours should be utilised for the production of tool A.


The net income can be worked out as below:

Tool Units Machine hours Contribution Totalrequired per unit contribution

Rs. Rs.

B 3,000 12,000 3 9,000

A 2,600 7,800 2 5,200

19,800 14,200

Less : Annual fixed costs 9,900

Net Profit 4,300

(16) An umbrella manufacturer makes an average net profit of Rs. 2.50 per piece on a sellingprice of Rs. 14.30 by producing and selling 6,000 pieces or 60% of the potential capacity.His cost of sales is as follows:

Per UnitDirect material Rs. 3.50Direct wages Rs. 1.25Works overheads Rs. 6.25 (50% fixed)Sales overheads Rs. 0. 80 (25% varying)

During the current year, he intends to produce the same number but anticipates that his fixedexpenses will go up by 10% while rate of direct labour and direct material will increase by 8%and 6% respectively. But he has no option of increasing the selling price. Under this situationhe obtains an offer for a further 20% of capacity. What minimum price will you recommend foracceptance to ensure the manufacturer an overall profit of Rs. 16,730?

Solution :

Profitability structure

Previous year Current Year

Per Unit Total Per Unit TotalRs. Rs. Rs. Rs.

(1) Selling Price 14.30 85,800 14.30 85,800

(2) Variable Cost

Direct Material 3.50 21,000 3.71 22,260

Direct Wages 1.25 7,500 1.35 8,100

Works Overhead 3.125 18,750 3.125 18,750

Sales Overheads 0.20 1,200 0.20 1,200

8.075 48,450 8.385 50,310

399Marginal Costing

Previous year Current YearPer Unit Total Per Unit Total

Rs. Rs. Rs. Rs.

(3) Contribution (1 – 2) 6.225 37,350 5.915 35,490

(4) Fixed Cost

Works Overheads 3.125 18,750 - 20,625

Sales Overheads 0.60 3,600 - 3,960

3.725 22,350 24,585

(5) Profit (3 – 4) 2.50 15,000 10,905

From the above, it can be seen that the present sales of 6,000 units will generate a total profit(after recovering the fixed cost) of Rs. 10,905. If it is intended that the overall profit should beRs. 16,730, there will be a shortfall of Rs. 5,825 which will have to be covered by the additional2.000 units to be sold. As such, every additional unit to be sold will have to generate a clearmargin of Rs. 2.9125 i.e., Rs. 5,825/2,000 units.

Hence the minimum price to be recommended will be Revised per unit variable cost + Expectedper unit margin i.e., Rs. 8.385 + Rs. 2.9125

i.e., Rs. 11.2975

(17) The cost profile of a company, manufacturing only one product, is as under :

Rs.


Direct Labour 1.50

Variable factory overheads 0.40

7.50

Fixed factory overhead is budgeted at Rs. 3,30,000 for an annual sales of 4,00,000 units.Selling,Distribution and Administration costs are budgeted at Rs. 1,80,000.

Capital employed is Rs. 4,50,000 in fixed assets and 50% of sales in current assets.

Determine a selling price for the product to yield 20% return on capital employed.

Solution :

Let us assume that the selling price per unit is Rs. X. Hence, total sales will beRs. 4,00,000 X.


The total amounts to be covered by this amount of sales will be -

Rs.

Variable Cost - 4,00,000 x 750 30,00,000

Fixed Factory overheads 3,30,000

Selling Distribution and Administration cost 1,80,000

Profit 90,000 + 40,000 x

36,00,000 + 40,000 x

Note :

Profit is calculated as below :

Expected yield - 20% of capital employed where

Capital employed = 4,50,000 + 50% of sales

= 4,50,000 + 50% of 4,00,000 x

= 4,50,000 + 2,00,000 x

Hence, Profit = 20% (4,50,000 + 2,00,000 x)

= 90,000 + 40,000 x

Thus,

4,00,000 x = 36,00,000 + 40,000 x

= 3,60,000 x = 36,00,000

x = Rs. 10

Hence the selling price for the product should be Rs. 10 per unit.

(18) V Ltd. produces two products ‘P’ and ‘Q’. The draft budget for the next month is asunder.

P Q

Budgeted Production and sales (Units) 40,000 80,000

Selling Price Rs / Unit 25 50

Total Costs Rs / Unit 20 40

Machine Hours / Unit 2 1

Maximum Sales Potential (Units) 60,000 100,000

The fixed expenses are estimated at Rs. 9,60,000 per month. The company absorbs fixedoverheads on the basis of machine hours which are fully utilised by the budgeted productionand cannot be further increased.

401Marginal Costing

When the budget was discussed, the Managing Director stated that the product mix shouldbe altered to yield optimum profit.

The Marketing Director suggested that he could introduce Product ‘C’, each unit of which willtake 1.5 machine hours.

However, a processing vat involving a capital outlay of Rs. 2,00,000 is to be installed for theprocessing of product ‘C’. The additional fixed overheads relating to the processing vat wasestimated to be Rs. 60,000 per month. The variable cost of Product ‘C’ was estimated of Rs.21 per unit.

Required -

(i) Calculate the profit as per draft budget for the next month.

(ii) Revise the product mix based on data given for ‘P’ and ‘Q’ to yield optimum profit.

(iii) The company decides to discontinue either product P or Q whichever is giving lowerprofit and proposes to substitute product ‘C’ instead. Fix the selling price of Product ‘C’in such a way so as to yield 15% return on additional capital employed besides maintainingthe same overall profits as envisaged in (ii) above.

Solution :

At present, the utilisation of the machine hours is as below.

Product P - 40,000 units x 2 = 80,000 Hrs.

Product Q - 80,000 units x 1 = 80,000 Hrs.

1,60,000 Hrs.

Fixed Expenses are Rs. 9,60,000 per month and are absorbed on the basis of utilisation ofmachine hours.

Hence, Machine Hour Rate =Rs. 9,60,000

= Rs. 6/Hr.1,60,000 Hrs.

As such, the fixed overheads absorbed by the product (which must have been included in thetotal cost.) are as below :

Product P - 2 Hrs. x Rs. 6 = Rs. 12

Product Q - 1 Hr. x Rs. 6 = Rs. 6


Hence, the cost structure of the products can be amended as below :

Product P Product QRs. Rs. Rs. Rs.

Selling Price / Unit 25 50

Less : Variable cost 8 34

Fixed Cost 12 6

Total Cost 20 40

Profit 5 10

(1) Profit as per draft budget for the next month are

(a) Sales - P - 40,000 Unit x Rs. 25/ Unit Rs. 10,00,000

Q - 80,000 Units x Rs. 50/ Unit Rs. 40,00,000

Rs. 50,00.000

(b) Variable Cost - P - 40,000 Units x Rs. 8/ Unit Rs. 3,20,000

Q - 80,000 Units x Rs. 34/ Unit Rs. 27,20,000

Rs. 30,40.000

(c) Contribution a – b Rs. 19,60,000

(d) Fixed Expenses Rs. 9,60,000

(e) Profit c – d Rs. 10,00,000

(2) Revised Product Mix to yield Optimum Profit.

The machine hours are available in limited quantity and hence are the key factor ofproduction.

The revised cost structure of the products is as under.

Prod. P Prod Q.

Selling Price - Rs./ Unit 25 50

Variable Cost - Rs./ Unit 8 34

Contribution Rs./ Unit 17 16

Machine Hours/ Unit 2 1

Contribution Rs./ Machine Hour 8.5 16

As the contribution per unit of key factor i.e. Machine Hour is more in case of Product Q, theavailable machine hours will be utilised for the manufacture of Product Q subject to its maximumsales potential.

403Marginal Costing

Thus, the revised product mix will be:

Product Machine Hours Machine UnitsHours/Unit

Product Q - 1,00,000 Units x 1 Hr. = 1,00,000 1 1,00,000

Product P - 1,60,000 Hrs. – 1,00,000 Hrs. = 60,000 2 30,000

The revised profitability will be -

(a) Sales - Q 1,00,000 Units x Rs. 50/ Unit Rs. 50,00,000

- P 30,000 Units x Rs. 25/ Unit Rs. 7,50,000

Rs. 57,50,000

(b) Variable Cost - Q 1,00,000 Units X Rs. 34/ Unit Rs. 34,00,000

P 30,000 Units x Rs. 8/ Unit Rs. 2,40,000

Rs. 36,40,000

(c) Contribution a-b Rs. 21,10,000

(d) Fixed Expenses Rs. 9,60,000

(e) Profit c-d Rs. 11,50,000

(3) Calculation of Selling Price of Product C :

The various amounts to be covered by the sales of product C are as below:

Variable cost - 40,000 Units x Rs. 21/ Unit Rs. 8,40,000

Fixed Expenses to be absorbed -

40,000 Units x Rs. 6/ Machine Hour x 1.5 Hrs/ Unit Rs. 3,60,000

Additional fixed overheads Rs. 60,000

Yield on capital employed

15% on Rs. 2,00,000 Rs. 30,000

Deficit of Profit Rs. 1,50,000

Rs. 14,40,000

Hence, the per unit selling price will be-

Rs. 14,40,000 = Rs. 36/ Unit

40,000 units


Notes :

(1) As availability of machine hours is the key factor and the contribution per machine houris less in case of Product P, it will be discontinued. Production of Product Q will becontinued subject to its maximum sales potential. As such, 1,00,000 units of product Qwill be produced and sold, thus leaving 60,000 machine hours for the production andsales of product C. As one unit of product C consumes 1.5 Machine Hours, maximum40,000 units of product C can be produced and sold i.e.,

60,000 Machine Hours

1.5 Machine Hrs./Unit

(2) It is assumed that Product Q will continue to absorb the fixed expenses at the currentrate of absorption. Hence, the profit generated by product Q will be as below:

(a) Sales - 1,00,000 Units x Rs.50/ Unit Rs. 50,00,000

(b) Variable Cost - 1,00,000 Units x Rs. 34/ Unit Rs. 34,00,000

(c) Contribution - a-b Rs. 16,00,000

(d) Fixed Expenses absorbed -

1,00,000 units x Rs. 6/ Machine Hr. Rs. 6,00,000

(e) Profit c-d Rs. 10,00,000

As the profit is desired to be maintained at Rs. 11,50,000 the deficit should becovered by the sales of product C

(3) As the fixed overhead relating to the processing vat will be incurred specifically due toProduct C, it will be as if the variable cost of Product C.

405Marginal Costing

QUESTIONS

1. What do you understand by the terms Break Even Point, Contribution and Margin ofSafety? Explain your answer by drawing a chart with assumed figures.

2. How does Break Even Analysis help in business decisions?

3. Describe the importance of the following terms in relation to marginal costing.

(a) Break Even Point

(b) Profit Volume Ratio

(c) Margin of Safety

4. Explain what is meant by Break Even Analysis? Discuss -

(a) The assumptions that are involved in this technique

(b) The various uses of this technique.

5. Explain any four circumstances in which the technique of marginal costing will help themanagement in taking decisions. What are the limitations of this technique?

6. “The rate of earning profit mainly depends upon the magnitude of the angle of incidenceprojected on break even chart.”- Explain as to whether this statement is correct. Whatmeasures can be adopted to increase the magnitude of angle of incidence.

7. Write a critical note about uses, applications, advantages and limitations of MarginalCosting technique.

8. “The work of separating the overheads into fixed and variable costs is purely academic,but practically very difficult and as such the technique of Marginal Costing is of very littleuse in managerial decisions.” How will yon make out a case for introducing the techniqueof Marginal Costing when encountered with the above argument?

9. Discuss the most important areas of managerial decisions opened up by the applicationof marginal costing technique.

10. Write Short Notes on -

(a) Profit Volume Ratio-

(b) Contribution

(c) Break Even Point -

(d) Margin of Safety -

(e) Marginal Costing -

(f) Importance of Break Even analysis -


PROBLEMS

(1) Following information is made available to you about a company for two periods.

Period. Sales (Rs) Profit (Rs)

(I) 1,20,000 9,000

(II) 1,40,000 13,000

Find out

(a) Profit Volume Ratio

(b) Break Even Point for sales

(c) Profit when sales are Rs. 1,00,000

(d) Sales required to earn a profit of Rs. 20,000

(e) Safety Margin in period II

(2) The sales turnover and profits during two periods are as under.

Period I - Sales Rs. 20 Lakhs, Profit Rs. 2 Lakhs

Period II - Sales Rs. 30 Lakhs, Profit Rs. 4 Lakhs

Calculate:

(1) P/V Ratio

(2) The sales required to earn the profit of Rs. 5 Lakhs

(3) Following figures relate to a company manufacturing a varied range of products :

Total Sales Total Cost

Year ended 31st Dec., 1987 22,23,000 19,83,600

Year ended 31st Dec., 1988 24,51,000 21,43,200

Assuming stability in price with variable costs carefully controlled to reflect predeterminedrelationship and an unvarying figure for fixed costs, calculate :

(a) The profit volume ratio to reflect the rates of growth for profits and sales.

(b) Fixed Costs.

(c) Fixed Cost as % to Sales.

(d) Break even point

(e) Margin of safety for the year 1987 and year 1988.

407Marginal Costing

(4) Gee Ltd. has two factories producing an identical product and realising the same sellingprice net i.e. Rs.60 per unit. The costs in the two factories can be summarised asfollows.

Factory A Factory B

Capacity (Units) (Rs.) 1,00,000 1,50,000

Variable Cost per unit (Rs.) 20 15

Fixed Costs per annum (Rs.) 20,00,000 45,00,00

The demand for the product is 2,00,000 units. State how much should be produced ateach factory.

(5) Calculate the Break Even Point in units and in rupees and also arrive at Margin of Safetyratio from the following information.

Estimated sales (1,00,000 Units) Rs. 20,00,000

Variable Cost Rs. 12,00,000

Fixed Cost Rs. 4,00,000

Rs.16,00,000

Net Profit Rs. 4,00,000

(6) From the following data relating to a company, calculate :

(1) Break Even Sales

(2) Sales required to earn a profit of Rs.6,000 per period

Period Total Sales Total Costs

Rs. Rs.

1 42,500 38,700

2 39,200 36,852

(7) (a) A company budgets a production of 5,00,000 units at a variable cost of Rs. 20each. The fixed costs are Rs. 20,00,000. The selling price is fixed to yield 25%profit on cost.

Calculate -

(i) Break Even Point (ii) P/V Ratio

(b) If the selling price is reduced by 20% find -

(i) The effect of the price reduction on the break even point and the P/V Ratio

(ii) The number of units required to be sold at the reduced selling price to obtainan increase of 20% on the budgeted profit.


(8) (1) The following figures for profit and sales are obtained from the account of XYZ Co.Ltd. -

Year Sales (Rs.) Profit (Rs.)

1985 20,000 2,000

1986 30,000 4,000

Calculate -

(a) P/V Ratio

(b) Fixed Cost

(c) Break Even Sales

(d) Sales to earn a profit of Rs. 5.000

(2) Calculate all the above figures, if the company has a fixed overhead of Rs. 1,000 inaddition to the expenses considered above.

(9) The following data are obtained from the records of a company.

First Year Second Year

Rs. Rs.

Sales 80,000 90,000

Profit 10,000 14,000

Calculate :

(a) P/V Ratio

(b) Break Even Point

(c) Profit or loss when sales amount to Rs. 50,000

(d) Sales required to earn a profit of Rs. 19,000

(e) Sales position if company sustained a loss of Rs. 19,000

(10) The following figures relating to the performance of a company for Year I and Year II areavailable. Assuming that the ratio of variable costs to sales and the fixed costs are thesame for both the years, ascertain -

a. Profit Volume Ratio

b. Amount of the fixed costs

c. Break Even Point

d. Budgeted profit for Year III if the budgeted sales are Rs. 1 Crore.

Total Sales Total CostsYear I Rs. 70 Lakhs Rs. 58 LakhsYear II Rs. 90 Lakhs Rs. 66 Lakhs

409Marginal Costing

(11) S Ltd. furnishes you the following information relating to the half year ending 30th June1980.

Rs.

Fixed Expenses 50,000

Sales Value 2,00,000

Profit 50,000

During the second half of the year, the company has projected a loss of Rs. 10,000.Calculate -

(1) The P/V Ratio, Break Even Point and Margin of safety for six months-ending 30thJune 1980.

(2) Expected sales volume for the second half of the year assuming that selling priceand fixed expenses remain unchanged in the second half year also.

(3) The break even point and margin of safety for the whole year 1980.

(12) PQ Limited has been offered a choice to buy a machine between A and B. You arerequired to compute :

(a) Break Even Point for each of the machines.

(b) The level of sales at which both machines earn equal profits.

(c) The range of sales at which one is more profitable than the others.

The relevant data is given below :

Machines

A B

Annual output in units 10,000 10,000

Fixed Cost (Rs.) 30,000 16,000

Profit at above level of production (Rs.) 30,000 24,000

The market price of the product, is expected to be Rs.10 pet Unit

(13) The following is the basic cost of a firm ABC.

(1) (i) Fixed Operating Cost Rs. 2,500

(ii) Sales Price (Per Unit) Rs. 10

(iii) Variable Cost (Per Unit) Rs. 5

Determine BEP in units and rupees


(2) If fixed operating cost increases to Rs. 3,000, what will be the new BEP ( in Units)?

(3) If sale price increases to Rs. 12.50 and the variable operating cost to Rs.7.50, whatwould be the impact on BEP?

(14) A Ltd. manufactures & sells four types of products under the brand names -P, Q, R andS. Sales mix in value comprises. 33.33%, 41.66%,16.66% and 8.33% of P, Q, R and Srespectively. The total budgeted sales (100%) are Rs. 60,000 per month.

Operating Costs are -

Variable Costs

Product P - 60% of selling price

Product Q - 68% of selling price

Product R - 80% of selling price

Product S - 40% of selling price

Fixed Costs : Rs. 14,700 per month

Calculate the BEP for the products on an overall basis i.e. in total

(15) Following information is presented by the costing department to the managementaccountant of the company.

1. Contribution Rs. 10,000

2. Fixed Cost Rs. 5,000

3. P/V Ratio 1/3

The Management Accountant is asked to find out the margin of safety if P/V Ratio isbrought down to 1/2.

(16) A company produces and sells 100 units of A at Rs. 20. Marginal cost per unit is Rs. 12and the fixed costs are Rs. 300 per month. It is proposed to reduce the price by 20%.Find out the additional sales required to earn the same amount of profits as before.

(17) A ball pen manufacturer has developed a new ball pen with unique features. Hisdevelopment executive has suggested three possible retail price viz. Rs.15 for superstar, Rs.10 for deluxe and Rs. 7.50 for economy model. His marketing manager opinesthat the whole sellers and retailers have to be given at least 30% discount.

The estimated fixed cost would be around Rs.70,000 and the variable cost per unit wouldbe Rs. 3.50

(a) Calculate breakeven point for each model of ball pen.

(b) How much should the manufacturer sell in order to make a profit of Rs. 21,000?Work out for each model of ball pen.

411Marginal Costing

(18) ABC Pvt. Ltd. manufactures and sells a standard product at fixed selling price. Thebudgeted figures for 1986-87 are as under.

Production and sales - 2,00,000 Units.

Variable cost - Rs. 56 Per Unit

Fixed Cost - Rs. 48,00,000

Profit Margin - 33.33% of selling price.

You are required to determine sales at break even both in terms of quantity and value forthe budget year 1986-87 at the above selling price.

(19) The Laila Shoe Company sells five different styles of ladies chappals with identical purchasecost and selling price. The company is trying to find out the profitability of openinganother store which will have the following expenses and revenues.

Per Pair (Rs)

Selling Price 30.00

Variable cost 19.50

Salesmen’s commission 1.50

Total Variable Cost 21.00

Annual Fixed expenses are :

Rent Rs. 60,000

Salaries Rs. 2,00,000

Advertising Rs. 80,000

Other fixed expenses Rs. 20,000

Rs. 3,60,000

Required :

a. Calculate the annual break even point in units and in value. Also determine theprofit or loss if 35,000 pairs of chappals are sold.

b. The sales commissions are proposed to be discontinued, but instead a fixed amountof Rs. 90,000 is to be incurred in fixed salaries. A reduction in selling price of 5% isalso proposed. What will be the break even point in units ?

c. It is proposed to pay the stores manager 50 paise per pair as further commission.The selling price is also proposed to be increased by 5%. What would be the breakeven point in units?


d. Refer to the original data. If the stores manager were to be paid 30 paise commissionon each pair of chappal sold in excess of the break even point, what would be thestore’s net profit if 50,000 pairs were sold ?

(20) Speedy Airline can carry a maximum of 10,000 passengers per month on one of itsroutes at a fare of Rs. 85. Variable costs are Rs. 10 per passenger and fixed costs areRs. 3,00,000 p.m. calculate

(1) Break Even quantity

(2) Break Even sales

(3) Break Even Percentage of capacity.

(4) Suppose that the management sets a profit target of Rs. 2,00,000

What would be the required profit before taxes to achieve this profit target, if the corporatetax rate of the company is 46%.

(21) Three firms X, Y and Z manufacture the same product. The selling price is Rs.8 per unitof the product equal for all the firms. The fixed costs for the firms X, Y and Z respectivelyare Rs. 80,000 Rs. 2,00,000 and Rs. 3,30,000 while the variable costs per unit are Rs. 6,Rs. 4 and Rs. 3

(a) Determine the break even point for all the firms in units.

(b) How much profits are earned by the firms if each of them sells 80,000 units?

(c) What will be the impact percentagewise .on profits if sales increase by 20%.

(22) Merry Manufacturers Ltd. has supplied you the following information in respect of one ofits products.

Rs.

Total Fixed costs 18,000

Total Variable Costs 30,000

Total Sales 60,000

Units Sold 20,000

Find out (a) Contribution per unit (b) Break Even Point (c) Margin of Safety (d) Profit (e)Volume of sales to earn a profit of Rs. 24,000.

413Marginal Costing

(23) From the following information relating to Quick Standards Ltd., you are required to findout - (a) Contribution (b) BEP in units (c) Margin of Safety (d) Profits.

Rs.

Total fixed costs 4,500

Total variable costs 7,500

Total sales 15,000

Units sold 5,000 (Units)

Also calculate the volume of sales to earn a profit of Rs. 6,000

(24) Bindra Ltd. is running its plant at present at 50% of capacity. The management hassupplied you the following details.

Cost of production per unit

Rs.

Direct Material 4

Direct Labour 2

Variable Overheads 6

Fixed Overheads (fully absorbed) 4

16

Production per month 40,000 Units

Total cost of products 40,000 Units x Rs. 16 = Rs. 6,40,000

Sales Price 40,000 Units x Rs. 14 = Rs. 5,60,000

Loss Rs. 80,000

An exporter offers to purchase 10,000 units per month @ Rs. 13 per unit and the companyis hesitating in accepting the offer due to the fear that it will increase its already largeoperating losses.

Advice whether the company should accept or decline this offer.

(25) Mega Corporation manufactures and sells three products to the automobile industry. Allthe products must pass through a machining process, the capacity of which is limited to20,000 hours per annum, both by equipment design and government regulation.


Following additional information is available.

Product X Product Y Product Z

Selling Price Rs./Unit 1,900 2,400 4,000

Variable cost Rs./Unit 700 1,200 2,800

Machining requirements hrs/Unit 3 2 1

Maximum possible sales units 10,000 2,000 1,000

Required - A statement showing the best possible production mix which would providethe maximum profits for Mega Corporation, together with supporting workings.

(26) (a) A company’s turnover in a year was Rs. 50,00,000, its profit was Rs. 500,000 andits P/V Ratio was 40% What is the break even point?

(b) A factory furnishes the following figures.

August 84 September 84

Output (Units) 50,000 55,000

Total Cost (Rs.) 6,70,000 7,10,000

What is the amount of fixed expenses per month?

(27) (a) Calculate the Break Even Point from the following data.

(i) Sales Price per unit Rs. 10

(ii) Variable cost per unit Rs. 6

(iii) Fixed overheads Rs.20,000

(b) Calculate the revised Break Even Point if -

(i) Sales price is increased to R.11 per unit

(ii) Sales price is reduced to Rs.9 per unit

(iii) Variable cost increased to Rs.7 per unit

(iv) Variable cost reduced to Rs.5 per unit

(v) Fixed overheads rise to Rs.25,000

(vi) Fixed overheads fall to Rs.15,000

(28) The Modern Machine Co. Ltd. places before yon the following figures

Sales (Rs.) Profit (Rs.)

1974 2,00,000 10,000

1975 1,80,000 2,000

415Marginal Costing


(a) Calculate profit or loss when sales amount to Rs. 1,50,000 and Rs-3,00,000.

(b) Calculate Profit Volume Ratio.

(c) Determine sales at Break Even Point.

(29) The selling price of a product is Rs.40 which yields a margin of 20%. The total fixedexpenditure are Rs. 10,000 a month. What should be the level of sales to yield an annualprofit of Rs.20,000?

(30) The following is the annual profit plan of XYZ Company.

(1) Budgeted sales(2,00,000) units @ Rs. 25) 50,00,000

(2) Budgeted Costs Fixed Variable

Direct Material 9,00,000Direct Labour 10,00,000Factory Overheads 7,00,000 3,00,000Administrative Expenses 6,00,000 1,00,000Distribution Expenses 5,00,000 3,00,000

18,00,000 26,00,000 44,00,000

Budgeted Profit 6,00,000

Production capacity - 2,40,000 Units.

(A) (a) Determine the break even point in rupees.

(b) Would you accept an export order for 60,000 units @ Rs. 20 per unit andwhy?

(c) Briefly enumrate the basic assumptions underlying break even analysis.

(B) Compute BEP in the following independent situations if -

(i) a 10% increase is effected in fixed costs

(ii) a 10% increase is effected in variable costs

(iii) a 10% increase in fixed costs and 5% decrease in-variable costs is effected.

(31) You are the company Accountant of Machine Manufacturing Ltd. which was incorporatedin February 1979. The company has started production from 1st January 1980.

It was proposed that the company will produce and sell 8,000 units in the first year of itsoperations. Estimated costs of production are given below.


Raw Materials Rs. 20 per unit

Direct Labour Rs. 10 per unit

Other variable costs 200% of direct labour

Fixed costs Rs.1,50,000

(1) The company fixed a target to earn a profit of Rs. 1,50,000 in the first year.

(2) Further, the company expects that annual fixed costs will increase by Rs. 1,00,000in the second year of operations. The marketing manager has planned to spend asum of Rs. 80,000 on promotion and advertising in the second year, keeping in viewthe target of the company to earn a profit of Rs. 2,50,000 in the second year ofoperations. It is expected that direct material, direct labour and other variable costswill not change in the second year.

(3) The company wishes to sell the product in the second year at a price of Rs.75 perunit.

Advice the company about the following :

(a) Selling price for the first year.

(b) Sales turnover ( in Units) for the second year.

(32) The Asian Industries specialise in the manufacture of small capacity of Motors. The coststructure of a motor is as under.

Material Rs. 50

Labour Rs. 80

Variable Overheads 75% of labour cost.

Fixed overheads of the company amount to Rs. 2.40 lakhs per annum.

The sale price of the motor is Rs. 230 each.

(a) Determine the number of motors that have to be manufactured and sold in a year tobreak even.

(b) How many motors have to be made and sold to make a profit of Rs.1 lakh per year?

(c) If the sale price is reduced by Rs. 15, how many motors will have to be sold tobreak even?

(33) Repographics Ltd. manufactures a document reproducing machine which has the variablecost structure as follows :

Material Rs. 40

Labour Rs. 10

Overheads Rs. 4

Selling price per unit is Rs. 90

417Marginal Costing

Sales during the current year are expected to be Rs. 13,50,000 and fixed overheadsRs. 1,40,000.

Under a wage agreement, an increase of 10% is payable to all direct workers from thebeginning of the forthcoming year, whilst material costs are expected to increase by7.5%, variable overheads by 5% and fixed overhead costs by 3%.

You are required to calculate :

a. The new selling price if the current Profit Volume Ratio is to be maintained.

b. The quantity to be sold during the forthcoming year to yield the same amount ofprofit as the current year, assuming the selling price to remain at Rs. 90.

(34) Cookwell Ltd.manufactures pressure cookers the selling price of which is Rs. 300 perunit. Currently the capacity utilisation is 60% with a sales turnover of Rs. 18 lakhs. Thecompany proposes to reduce the selling price by 20% but desires to maintain the sameprofit position by increasing the output. Assuming that the increased output could bemade and sold, determine the level at which the company should operate, to achieve thedesired objective.

The following further data are available.

(a) Variable cost per unit Rs.60

(b) Semi variable cost (including a variable element of R1. 10 per unit) Rs. 1,80,000

(c) Fixed cost Rs. 3,00,000 will remain constant Upto 80% level. Beyond this, anadditional of Rs. 60,000 will be incurred.

(35) The MYZ Co. has the following budget for the year 1986-87.

Rs.

Sales (1,00,000 Units a Rs.20) 20,00,000

Variable Cost 10.00,000

Contribution 10,00,000

Fixed cost 4,00,000

Net Profit 6,00,000

From the above set of information find out,

(a) The adjusted profits for 1986-87 if the following two sets of changes are introducedand also suggest which plan should be implemented.


Plan A Plan B

Increase in Price 20% Decrease in Price 20%

Decrease in Volume 25% Increase in Volume 25%

Increase in variable cost 10% Decrease in Variable cost 10%

Increase in fixed cost 5% Decrease in fixed cost 5%

(b) The P/V Ratio and break even points under the two plans referred above.

(36) A review made by the top management of Sweat and Struggle Ltd. which makes onlyone product, of the result of the first quarter of the year revealed the following details :

Sales in units 10,000

Loss in Rs. 10,000

Fixed Cost (For the year Rs.1,20,000) in Rs. 30,000

Variable cost per unit in Rs. 8

The Finance Manager who feels perturbed suggests that the company should at leastbreak even in the second quarter with a drive for increased sales. Towards this, thecompany should introduce a better packing which will increase the cost by Re. 0.50 perunit.

The sales manager has an alternative proposal. For the second quarter, additional salespromotion expenses can be increased to the extent of Rs. 5,000 and a profit of Rs. 5,000can be aimed with increased sales.

The production manager feels otherwise. To improve the demand, the selling price perunit has to be reduced by 3%. As a result, the sales volume can be increased to attaina profit level of Rs. 4,000 for the quarter.

The Managing Director asks you as a Cost Accountant to evaluate these three proposalsand calculate the additional sales volume that would be required in each case, in order tohelp him take a decision.

(37) Following is the summarised Trading account of a manufacturing concern which makestwo products X and Y.

419Marginal Costing

Summarised Trading Account for the four months to 30th April 1984

X Y TotalRs. Rs. Rs.

Sales 10,000 4,000 14,000

Less : Cost of Sales

(a) Direct costs

Labour 3,000 1,000

Material 1,500 1,000

4,500 2,000 6,500

5,500 2,000 7,500

Indirect costs

(a) Variable Expenses 2,000 1,000 3,000

3,500 1,000 4,500

(b) Fixed Expenses

Common to both

X and Y 1,250 1,250 2,500

Net Profit 2,250 (-)250 2,000

(a) These costs tend to vary in direct proportion to physical output.

(b) These costs tend to remain constant irrespective of physical outputs of X and Y.It has been the practice of the concern to allocate these costs equally betweenX and Y.

The following proposals have been made by the Board of Directors for your considerationas financial advisor.

(1) Discontinue Product Y.

(2) As an alternative to (1), reduce the price of Y by 20%. (It is estimated that thedemand then will increase by 40%.)

(3) Double the price of X (It is estimated that the demand then will reduce by threefifths.)

You are required to recommend the proposal to be taken after evaluating each ofthese three proposals.


(38) A Multi-Product company has the following costs and output data for the last year.

Product X Product Y Product Z

Sales Mix (in value) 40% 35% 25%

Selling Price per unit Rs. 20 Rs. 25 Rs. 30

Variable cost per unit Rs. 10 Rs. 15 Rs. 18

Total Fixed cost Rs. 1,50,000

Total Sales Rs. 5,00,000

The company proposes to replace Product Z by Product S. Estimated cost and outputdata are -

Product X Product Y Product S

Sales Mix (in value) 50% 30% 20%

Selling Price per Unit Rs. 20 Rs. 25 Rs. 28

Variable cost per Unit Rs.10 Rs. 15 Rs. 14

Total fixed cost Rs. 1,50,000


Analyse the proposed change and suggest what decision the company should take.

Also state the break even point for the company as a whole in the two situations.

(39) A manufacturer has planned his level of production at 50% of his plant capacity of 30,000units. At 50% of the capacity, his expenses are as follows.

(a) Direct Labour Rs.11,160

(b) Direct Material Rs. 8,280

(c) Variable and other manufacturing expenses Rs. 3,960

(d) Total fixed expenses regardless production Rs. 6,000

The home selling price is Rs.2.00 per unit. Now, the manufacturer receives a tradeenquiry from overseas for 6,000 units at a price of Rs. 1.45 per unit If you were themanufacturer, would yon accept or reject the offer? Support your statement with suitablecost and profit details.

(40) A manufacturer sells his product at Rs.5 each variable costs are Rs.2 per unit and thefixed costs amount to Rs.60,000.

(a) Calculate the break even point

(b) What would be the profit if he sells 30,000 units?

(c) What would be the BEP if he spends Rs.3,000 on advertisement?

(d) How much should the manufacturer sell to make a profit of Rs.30,000 assuming hespends Rs.3,000 on advertisement?

421Marginal Costing

(41) Texemat Private Limited has been manufacturing track suits for athletes currently, itsoutput is around 70% of its rated capacity of 19,000 units per annum. One exporter hasapproved the sample and has offered to buy 5000 units at a special price of Rs. 150 persuit. At present, the company has been selling the track suit @ Rs.210.The standardcost per unit is as under. .

Cost Items Rs.

(a) Cloth and other materials 82

(b) Labour 25

(c) Fixed cost 42

(d) Administrative variable cost 11

Total Cost 160

(a) Should the company accept the offer?

(b) What would be your advice if the exporter offers to buy 10,000 units instead of 5000units?

(42) The variable cost structure of a product manufactured by a company during the currentyear is as under -

Rs. Per Unit

Material 120

Labour 30

0verheads 12

The selling price per unit is Rs. 270 and the fixed cost and sales during the current yearare Rs. 14 Lakhs and Rs. 40.50 Lakhs respectively.

During the forthcoming year, the direct workers will be entitled to a wage increase of 10%from the beginning of the year and the materials cost, variable overhead and fixed overheadare expected to increase by 7.5%, 5% and 3% respectively.

The following are required to be computed -

a. New selling price in the forthcoming year if the current P/V ratio is to be maintained.

b. Number of units that would be required to be sold during the forthcoming year so asto yield the same amount of profit in the current year, assuming that the sellingprice per unit will not be increased.


(43) A company currently operating at 80% capacity has the following particulars.

Rs.

Sales 32,00,000

Direct Materials 10,00,000

Direct Labour 4,00,000

Variable Overheads 2,00,000

Fixed Overheads 13,00,000

An export order has been received that would utilise half the capacity of the factory. Theorder cannot be split i.e. it has either to be taken in full and executed at 10% below thenormal domestic prices or rejected totally.

The alternatives available to the management are :

a. Reject the order and continue with the domestic sales only (as at present) or

b. Accept the order, split capacity between overseas and domestic sales and turnaway excess domestic demand or

c. Increase capacity so as to accept the export order and maintain the present domesticsales by -

i) buying an equipment that will increase the capacity by 10%. This will result inan increase of Rs. 1,00,000 in fixed costs and

ii) work overtime to meet the balance of required capacity. In that case, labourwill be paid at one and half times the normal wage rate.

Prepare a comparative statement of profitability and sugget the best alternative.

(44) A company produces a single product which is sold by it presently in the domesticmarket at Rs. 75 per unit. The present production and sales is 40,000 units per monthrepresenting 50% of the capacity available. The cost data of the product was as under -

Variable cost per unit Rs. 50

Fixed costs per month Rs. 10 Lakhs

To improve the profitability, the management has 3 proposals on hand as under -

a. to accept an export supply order for 30,000 units per month at a reduced price ofRs. 60 per month, incurring additional variable costs of Rs. 5 per unit towards theexport packing, duties etc.

b. to increase the domestic market sales by selling to a domestic chain stores 30,000units at Rs. 55 per unit retaining the existing sales at existing price

423Marginal Costing

c. to reduce the selling price for the increased domestic sales as advised by the salesdepartment as under

Reduce selling price per unit by Rs. Increase in sales expected (units)

5 10,000

8 30,000

11 35,000

Prepare a table to present the results of the above proposals and give your commentsand advice on the proposals.

(45) A company producing a single product sells it at Rs. 50 per unit. Unit variable cost isRs. 35 and fixed cost amounts to Rs. 12 Lakhs per annum. With this data, you arerequired to calculate the following, treating each independent of the other -

a. P/V Ratio and the Break Even Point

b. “New Break Even Sales if variable cort increase by Rs. 3 per unit, without increasein the selling price.

c. Increase in sales required if profits are to be increased by Rs. 2.40 lakhs

d. Percentage increase/decrease in sales volume to offset

l An increase of Rs. 3 in the variable cost per unit

l A 10% increase in selling price without affecting existing profits quantum

e. Quantum of advertisement expenditure permissible to increase sales by Rs. 1.20Lakhs without affecting profits quantum.

(46) A manufacturer of fountain pens selling in the market at Rs.100 per dozen makes anaverage net profit of 20% on sales by producing 50,000 dozen per annum against acapacity of 75,000 dozens. His cost sheet for 1984 was as under.

Cost per dozen in Rs.

Direct Materials 36

Direct Wages 30

Works overheads

(50% of this is variable) 10

Sales overheads

(25% of this is variable) 4

In 1985, he anticipates his fixed costs to increase by 6%, cost of direct materials by 5%,and labour (with whom an agreement has been concluded) by 10%. Market enquiriesrevealed that the selling price of the product and quantity will remain unchanged in 1985.


An inquiry has been received for the supply of 10,000 dozens to a customer. What couldbe the lowest quotation, if the business wants to make a minimum profit of Rs. 8 lakhsin 1985? Give detailed workings.

(47) The following figures relate to the current year’s position in an engineering industry operatingat 70% capacity level.

Break Even Point - Rs.80 Crores

P/V Ratio - 40%

Margin of Safety - Rs 20 crores

The board at its last meeting have taken a decision to increase the output to 98%capacity level with the following modifications.

(i) Reduction in selling price by 5%

(ii) Increase in fixed cost by Rs.8 crores (Including depreciation on additions butexcluding interest burden.).

(iii) Reduction in variable cost by 5% of sales.

(iv) Additional finance for capital expenditure and working capital Rs.20 crores.

(a) You are required to determine the revised sales figure necessary to yield theexisting quantum of profits plus additional profit of Rs.4 crores on account ofincreased activity and 20% Interest burden on fresh capital inputs.

(b) Also determine the revised -

(i) Break Even point

(ii) P/V Ratio

(iii) Margin of safety.

(48) The following data are obtained from the records of a factory-

Rs. Rs.

Sales 4,000 Units @ Rs.25 each 1,00,000

Materials consumed 40,000

Variable Overheads 10,000

Labour overheads 20,000

Fixed overheads 18,000

88,000

Net Profit 12,000

425Marginal Costing

Calculate :

(1) The number of units by selling which the company will neither loose or gain anything.

(2) P/V Ratio and Margin of Safety at present level.

(3) The extra units which should be sold to obtain the present profit if it is proposed toreduce the selling price by (a) 20% and (b) 25%.

(4) The selling to be fixed price to bring down its break even point to 500 units underpresent condition.

(5) The sales required to earn profit of Rs.60,000 at the present selling price of Rs.25per unit,

(49) You are given the following data pertaining to a factory.

Present (1986) Forecast (1987)

Sales (in Units) 10,000 15,000

Fixed cost (in Rs.) 25,000 25,000

Loss (in Rs.) 5,000 –

Profit (in Rs.) – 5,000

For the above working purposes, variable cost of sales has been taken at Rs.7 per unitupto 15000 units and it shall be Rs.8 per unit beyond 15,000 units.

You are required to state as to —

(1) What percentage of increase in sales is required to cover additional 50 paise perunit towards extra packing cost in 1987 for achieving the additional sales target?

(2) What percentage of increase in sales is required to maintain budgeted profit with aprice reduction of 25 paise per unit?

(3) What percentage of increase in sales is required to meet additional publicityexpenses of Rs. 2,000 and also maintain the targeted profits?

(4) What is the maximum increase in fixed cost (additional depreciation) per period tojustify the proposal for buying a new machine which will reduce variable cost ofsales by Rs. 2 per unit at all levels? Sales to remain at 10,000 units and thetargeted profit to be achieved.

(The above situations have to be considered independently of each other.)

(50) The anticipated sales of Electronic Corporation Ltd. is Rs. 4,00,000 and unit sales priceof product is Rs.20 each. The cost of direct material is Rs.9 each and the labour cost isRs.3 each and other variable expenses are Rs.3 per unit. The company is earning a netprofit of 5% and to improve the profitability, following propositions were discussed in theExecutive Committee Meeting,


(a) The present administration set up is on the regional basis and it was felt thatcentralisation will reduce the fixed cost by Rs. 12,000.

(b) The production manager has agreed that he will try to Work on a cost reductionprogramme which will reduce the cost by Re.1 per unit but there will be little impacton the quality which will be negligible to the customer.

The sales manager opposed the two proposals and suggests that it may be possible toincrease the number of units sold by 20% provided the selling price is reduced by 5%.Alternatively, if the selling price is increased by 10%, the sales number of units will bereduced by 5%.

As the Accountant of the company, discuss in detail the various pros and cons of theproposals and also put forward any other proposal to improve the situation.

(51) Zed Ltd. reported the following figures for 1983 and 1984.

1983 1984

Sales Rs. 50,00,000 Rs. 60,00,000

Total Cost Rs. 45,00,000 Rs. 52,00,000

The company anticipated that in 1985.

(i) Variable cost rates, on the average, would record an increase of 10% over the 1984levels.

(ii) Sales would record an increase of 20% over the 1984 level in volume.

(iii) Selling prices on the average would be increased by 5%.

(iv) In addition, another Rs.10 Lakhs of sale (1984 level) would be made to Governmentat a special discount of 10% thereof.

(v) Fixed costs would increase by Rs. 3,00,000.

Ascertain the expected profit/loss in 1985. If the increase in fixed costs mentionedabove arises only if sales to Government is made, would you recommend the sale to bemade? What is the P/V Ratio for 1985, at normal sales? Give workings.

(52) Two business AB Ltd. and CD Ltd. sell same type of product in the same type of market.Their budgeted profit and loss account for the year 1984 is as follows :

427Marginal Costing

AB Ltd. CD Ltd.Rs. Rs. Rs. Rs.

Sales 1,50,000 1,50,000

Cost Fixed 15,000 35,000

Variable 1,20,000 1,00,000

1,35,000 1,35,000

Net Profit 15,000 15,000


(a) Calculate the Break Even Point of each business.

(b) State winch business is likely to earn greater profits in condition of-

(i) Heavy demand for the product

(ii) Low demand for the product

(53) In a factory producing two different kinds of articles, key factor is the availability of labour.From the following information for the factory for 1986. show which product is moreprofitable.

Product A Product Bcost per Cost perUnit Rs. Unit Rs.

Material 5.00 5.00

Labour 6 hrs @ Rs. 0.50 3.00 –

3 hrs @ Rs. 0.50 – 1.50

Overheads - Fixed (50% of labour) 1.50 0.75

- Variable 1.50 1.50

11.00 8.75

Selling Price 14.00 11.00

Profit 3.00 2.25

Total Production per month (Units) 500 600

Maximum capacity per month 4,800 hours

Maximum capacity of product B 1,000 Units


(54) (a) The following particulars are extracted from the records of a company.

Product A Product Bper Unit per Unit

Sales Rs. 1.00 Rs. 1.20

Consumption of material 2 kgs 3 kgs.

Material Cost Rs. 10 Rs. 15

Direct Wages Cost Rs. 15 Rs. 10

Direct Expenses Rs. 5 Rs. 6

Machine hours used 3 : 2

Overhead Expenses

Fixed Rs. 5 Rs. 10

Variable Rs. 15 Rs. 20

Direct Wages per hour is Rs.5. Comment on profitability of each product (both use thesame raw material) When -

(i) Total Sales Potential is limited.

(ii) Raw Material is in short supply.

(iii) Production capacity ( in terms of machine hours) is the limiting factor.

(b) Assuming raw material is the key factor, availability of which is 10,000 kgs. andmaximum sales potential of each product being 3,500 units, find out the productmix which will yield the maximum profit.

(55) The following particulars are available from a manufacturing unit

A B C

Units Sold 80,000 80,000 2,00,000

Sales Rs. 40,000 Rs. 80,000 Rs. 50,000

Material Cost Rs. 20,000 Rs. 30,000 Rs. 25,000

Labour Cost Rs. 6,000 Rs. 10,000 Rs. 8,000

Variable Expenses Rs. 4,000 Rs. 4,000 Rs. 5,000

Fixed overheads. Rs. 7,000 Rs. 10,000 Rs. 5,000

The key factor of production is an imported raw material and the consumption of thematerial in product A is 400 litres. Product B is 1,000 litres and Product C is 600 litres.The sales manager gives an assurance that it is possible for him to sell whatever produced.The management of the company has decided to close down one product line and

429Marginal Costing

concentrate on two lines to increase the profitability of the company. As the companyAccountant, prepare a report to the Directors recommending the closure of one of thelines which is not more profitable.

(56) Ambika Condiments bring out 2 products “SUCHI and RUCHI which are popular in themarket. The management has the option to alter the sales mix of the 2 products from thefollowing combinations -

Option SUCHI (units) RUCHI (units)

I 800 600

II 1,600 –

III – 1,300

IV 1,100 500

The per unit production cost/sales data are –

SUCHI (units) RUCHI (units)

Direct Materials (Rs.) 25 30

Direct Labour (hours) 10 12

Selling Price (Rs.) 75 90

Variable factory overheads are 100% of direct labour cost for both products.

Labour rate is Rs. 2 per hour.

Common fixed overheads for both products Rs. 10,000.


a. Prepare a marginal cost statement for the two products.

b. Evaluate options and identify the most profitable sales mix.

(57) From the following particulars, find the most profitable product mix and prepare a statementof profitability of that product mix.

Product A Product B Product C

Units budgeted to be produced and sold 1,800 3,000 1,200

Selling Price per unit (Rs.) 60 55 50

Requirement per unit :

Direct Materials (Kgs) 5 3 4

Direct Labour (Hours) 4 3 2

Variable Overheads (Rs.) 7 13 8

Fixed Overheads (Rs.) 10 10 10

Maximum possible units of sales 4,000 5,000 1,500


Cost of material per Kg is Rs. 4 and labour hour rate is Rs. 2. All the three products areproduced from the same direct material using the same types of machines and labour.Direct labour which is the key factor is limited to 18,600 hours.

(58) The Skyrock Ltd. produces and sells three types of products P, Q, and R. Themanagement committee has decided to discontinue the production of Q since there isnot much profit in it. From the following set of information, find out the profitability of theproducts and give your short comments on the decision of the management.

Product Selling Direct Direct WagesPrice Material Per unit

Per unit Per unit Dept. A Dept. B Dept. CRs. Rs. Rs. Rs. Rs.

P 300 60 20 15 10

Q 275 30 20 20 10

R 305 70 12 10 20

The absorption rate of overheads on the Direct Wages are

Dept. A Dept. B Dept. C

Variable Overheads 150% 120% 200%

Fixed overheads 200% 240% 150%

(59) You had asked your accountant to prepare fair budgets based on different economicforecasts. After doing part A the work, he fell sick. Incomplete workings done by himwere as under.

Economic Forecast Depressed Average Good Excellent

Variable Cost (Rs. ‘000) 40 60 90 140

There are fixed costs of Rs.72,000 and P/V Ratio is 60%. Calculate.

(a) The profit or loss at each of the four levels.

(b) The break even point in sales value and

(c) The sales value at which a profit of Rs .15000 would be made.

(60) Following is the abridged Profit and Loss Account of W Ltd. for 1987

(Rs. in Lakhs)

Sales (10 Lakhs Units @ Rs. 2.50 Per unit) 25.00

Less : Variable Cost 16.00

Contribution 9.00

Less : Fixed Costs 9.20

Loss: (-) 0.20

431Marginal Costing

S. Ltd. approaches W Ltd. which has spare capacity and offers to purchase 2 lakh unitsfrom W Ltd. If W Ltd. accepts this offer, it will save Rs. 0.25 per unit in sales commission.Existing scales will continue as above. What is the price per unit on this special offerthat W Ltd. must charge in order that an Overall profit of Rs. 50,000 can be earned ontotal sales.

(61) The profit of a company works out to 12.5% on capital employed in 1986. The details areas follows.

Rs. ‘000s

Sales 500

Direct Material 250

Direct Labour 100

Variable overheads 40

Capital Employed 400

(a) Forecast for 1987 indicates sales will increase by 10%, selling price will go up by4% and cost elements will go down by 2%. Assuming no change in the capitalemployed, calculate the return on capital employed.

(b) The new sales manager who has joined the company recently estimates for thenext year a profit of about 23% on capital employed, provided the volume of sales isincreased by 10% and simultaneously there is an increase in selling price of 4%and an overall cost reduction in all elements of cost by 2%.

Find out by computing in details the cost and profit for the next year. Whether theproposal of sales manager can be adopted?

(62) A multi product company has the following costs and output data for the last year.

ProductsX Y Z

Sales Mix 40% 35% 25%

Selling Price Rs. 20 25 30

Variable cost per unit Rs. 10 15 18

Total Fixed cost Rs. 1,50,000


The company proposes to replace Product Z by product S. Estimated cost and outputdata are :


ProductsX Y S

Sales Mix 50% 30% 20%

Selling Price Rs. 20 25 28

Variable cost per unit Rs. 10 15 14

Total Fixed cost Rs 1,50,000


Analyse the proposed change and suggest what decision the company should take.

(63) The following set of information is presented to you by your client AB Ltd.

(1) Direct Materials ( per unit ) X-Rs. 20 Y- Rs.l8.

(2) Direct Wages (per unit) X - Rs.6 Y- Rs. 4

(3) Fixed expenses during the period are expected to be Rs. 1,600

(4) Variable expenses are allocated to products @ 100% of Direct Wages.

(5) Sales Price (Per Unit) X - Rs.40 Y- Rs.30

(6) Proposed Sales mixes -

(i) 100 Units of X and 200 units of Y

(ii) 150 Units of X and 150 Units of Y

(iii) 200 Units of X and 100 Units of Y

As a Cost Accountant, you are requested to present to the management of AB Ltd. thefollowing.

(a) The unit marginal cost and unit contribution.

(b) The total contribution and resultant profit from each of the above sales mixes,

(c) The proposed sales mixes to earn a profit of Rs.300 and Rs.600 with the total salesof X and Y being 300 units.

(64) An enthusiastic marketing manager suggests to his managing director that if only he ispermitted to reduce the selling price of a product by 20%, he would be able to achieve a30% increase in sales volume. The Managing Director, finding that the sales volumeexceeds in percentage the extent of required reduction in price, gives the clearance. Youare given the following information.

Present selling price per unit Rs. 7.50

Present volume of sales 2,00,000 Nos.

Total variable costs Rs. 10,50,000

Total fixed costs Rs. 3,60,000

433Marginal Costing

Assuming no changes in the cost in the continuing period,

(i) Examine the consequences of the Managing Director’s decision assuming that30% increase in sales is realised.

(ii) At what volume of sales can the present quantum of profits be achieved after effectingthe price reduction.

(65) SV Ltd. has budgeted the manufacture of 30,000 units of its only product ‘A’ for the nextquarter.

The capacity of the factory has not been fully utilised.

The variable cost per unit of product ‘A’ is as under :

Rs.


Direct Wages (Rs.4 per hour) 36.80

Factory variable overheads 27.60Selling variable overheads 18.00

Product A is sold at Rs.200 per unit. Fixed overheads for the quarter are Rs. 15,00,000.

At present, the company manufactures component ‘P’ one unit of which is used in eachunit of Product ‘A’. The cost of this component is already included in the cost structureof Product ‘A’ as aforesaid. Anyhow, the cost per batch of 1000 units of component ‘P’ isseparately supplied as under.

Rs.

Direct Material 6,000Direct Wages 4,800

Factory variable overheads 3,600

Fixed overheads apportioned to the component 3,600

18,000

It is proposed to utilise the spare capacity by manufacture of 1,500 units of product ‘B’for export. The details are as under :

Export selling price Rs. 228 per unit

Direct Material cost Rs. 80 per unit

Direct labour 16 hours per unit

Variable expenses applicable to this product - Rs. 20 per unit.

Factory variable overheads have to be charged, calculated on the basis of Direct LabourHour Rate applicable to Product A.

It has to be noted that component ‘P’ is not used in the manufacture of product ‘B’.



(i) Present a statement showing the profit as originally envisaged in the budget.

(ii) State whether component P should be manufactured or bought from the market ifthis can be procured at a price of Rs. 16 per unit.

(iii) Calculate the contribution on account of accepting the export order of product ‘B’.

(66) A small scale manufacturer produces an article at the operated capacity of 10,000 unitswhile the normal capacity of his plant is 14,000 units. Working at a profit margin of 20%on sales realisation, he has formulated his Budget as under -

10,000 14,000

Rs. Rs.

Sales Realisation 2,00,000 2,80,000Variable overheads 50,000 70,000

Semi- Variable overheads 20,000 22,000

Fixed overheads 40,000 40,000

He gets an order for a quantity equivalent to 20% of the operated capacity and even onthis additional production, profit margin is desired at the same percentage on salesrealisation as for production to operated capacity.

Assuming prime cost is constant per unit of production, what should be the minimumprice to realise this objective?

(67) The executives of B Co., a small manufacturer of one product are developing the annualprofit plan. They have just reviewed the “First Cut” at the annual income statement andare concerned with the Rs. 1,10,000 indicated profit on a sales volume of 20,000 units.The fixed cost structure of Rs.9,90,000 appears to be high and they have some doubtsabout departing from the unit sale price of Rs.100. There is a general agreement that the“Profit target should be Rs. 2,20,000”. This case deals with several tentative alternativessuggested during the meeting of the executive’s committee that just reviewed the tentativeprofit plan.

You are required to compute -

(a) The budgeted break even point in rupees and in units and the number of units thatwould have to be sold to earn the target profit?

(b) You are also required to respond directly to each of the following two alternativesunder consideration by the management. Consider each independent of the otherand state any assumptions that you would like to make.

Alternative 1 - A sale price increase of 15% is contemplated, the sales executiveestimates that this will cause a drop in units that can be sold by 15%. What would bethe new breakeven point in Rs. and in units? What would be the new profit figure?

How many units would have to be sold to earn the target profit?

435Marginal Costing

Alternative 2 - A decrease in fixed costs of Rs-55,000 and a decrease of variable costsof 6% are contemplated. What would be the new BEP in Rs. How many units must besold to earn the target profit.

(68) Stoner company uses three different components (Materials) in manufacturing its primaryproduct. Stoner manufactures two of the components and purchases one (designatedas component 1) from outside suppliers. The company is currently developing the annualprofit plan. Sales are highly seasonal, component 2 cannot be acquired from outsiders,however component 3 can be purchased. The three components have criticalspecifications. The annual profit plan provided data for the following computations.

Component 3 Unit Cost(at 12,000 units)

Rs.

Material (Direct) 1.40

Labour (Direct) 2.20

Fixed overheads (apportioned) 0.40

Annual machine rental(Special machine used only for component 3) 0.50

Variable factory overhead 1.00

Average storage cost per year (fixed) 0.40

Total 5.90

Average inventory level 500 units.

The Purchase Manager investigated outside suppliers and found one that would sign aone year contract to deliver “12,000 quality units as needed during the year at Rs.5.20per unit”. Serious consideration is being given to this alternative. Should Stoner make orbuy component 3? Explain the relevant factors influencing your decision.

(69) From the following data, which product would you recommend to be manufactured in thefactory when-(1) Time is the key factor.

(2) Raw material is in short supply.

(3) Sales potential in units is a limiting factor.

(4) Sales potential in value is a limiting factor.

Per unit of Product A Per unit of Product BRs. Rs.

Direct Material(Rs. 2 per Kg.) 24 14

Direct Labour(Rs. 1 per Hour) 2 3

Variable Overheads 4 6Selling Price 100 110


NOTES

437Budgetary Control

Chapter 12BUDGETARY CONTROL

INTRODUCTION :

Budget and Budgetary control :

The term ‘Budget’ is defined as a financial and/or quantitative statement, prepared prior to adefined period of time, of the policy to be pursued during that period for the purpose of attaininga given objective.

The analysis of this definition reveals the following characteristics of the budget.

(1) It may be prepared in terms of quantity or money or both.

(2) It is prepared for a fixed or set period of time.

(3) It is prepared before the defined period of time commences.

(4) It spells out the objects to be attained and the policies to be pursued to achieve thatobjective.

The term ‘Budgetary Control’ is defined as the establishment of budgets, relating theresponsibilities of executives to the requirements of a policy and the continuous comparisonof actual with budgeted results, either to secure by individual action the objective of that policyor to provide the basis for its revision.

The analysis of this definition reveals the following facts about budgetary control.

(1) It deals with the establishment of the budgets..

(2) It deals with the comparison of budgeted results with the actual results.

(3) It deals with computation of the variations and the actions to be taken for maintaining thefavourable variations, removing the adverse variation or revising the Budgets themselves.


ADVANTAGES OF BUDGETARY CONTROL :

(1) It is a powerful tool available to the management for the purpose of cost control andmaximization of profits through the same. It enables the management to utilize theavailable resources in the most profitable manner.

(2) A budget sets the plan of action. Plans in respect of various functional areas of operationsare expressed in the form of the budgets. As such, the Budgetary Control systems actsas a means of declaration of the policies of the management.

(3) It acts a means of communication. The plans and objects laid down by top levelmanagement are communicated to middle level and lower level management by way ofthe budgets. As such, each and every person working in the organisation is aware of hisduties and responsibilities in relation to those of the others. This maximizes the utilizationof resources.

(4) It acts as a means of improving the co-ordination. The budgets prepared in the variousfunctional areas of operations are prepared in such a way that the efforts are co-ordinatedin the direction of achievement of common and defined objective. It develops the teamspirit and help of various people can be sought to solve the common problem.

(5) The comparison between the budgeted results and the actual results may reveal theareas where there are adverse variations which may be identified as weak areas ordelicate areas. As such, efforts can be made to remove these adverse variations, keepingaside the areas where there are no variations. This enables the concentration of efforts ofthe management on a smaller portion of activities which facilitates ‘Management byexception.’

(6) Budgetary control system enables the delegation of authority and makes possible theprinciples of Responsibility Accounting.

(7) It is a powerful tool available to the management for Performance Appraisal. The executivesresponsible for those functions where there is favourable variation may be rewarded,whereas the executives responsible for those functions where there is adverse variationmay be punished. In this sense, budgetary control system provides a basis forestablishment of the incentive systems.

Pre-requisites for the implementation of Budgetary Control

If the organization decides to install the Budgetary Control system as a cost control technique,it will have to comply with the following preliminaries.


(1) Deciding the Budget Centre :

A Budget Centre is that section of the organization with respect to which the budgets willbe prepared. A Budget centre may be in the form of a product or a department or abranch of the company and so on. Budget centre should be clearly defined and establishedas the budgets will be prepared with respect to each and every Budget Centre.

(2) Deciding the Budget Period :

A Budget Period is that period of time for which the budget will be prepared and operated.The selection of the Budget Period should be made very carefully- Too long a budgetperiod makes the correct estimation more difficult while too short a budget period mayprove to be more costly. The selection of Budget Period may depend upon the nature ofoperations and the purpose of preparing the budgets. As such, in case of industries likethe ones engaged in generation and distribution of electricity, transport operations etc.where capital expenditure is too high, budgets may be prepared even for a period of 5 to10 years, while in case of industries like the ones engaged in manufacturing of motorvehicles or radios etc., where the customer demand may change more frequently, thebudget period may be shorter. Similarly, a sales budget may be prepared for a period of5 years, whereas the short term cash budget may be prepared on weekly or even dailybasis.

(3) Establishment of Accounting Records :

There should be an efficient and proper system of accounting so that the information anddata as required for the efficient implementation of the Budgetary Control system will beavailable in time.

(4) Organization for Budgetary Control :

A properly prepared organization chart may make the duties and responsibilities of eachlevel of executive very clear to himself. The budgetary control organization will be headedby a senior executive in the form of budget controller or budget officer. In small or mediumsized organizations, he himself will be involved in all types of works involved with thebudgetary control system.

However, in case of large organizations, be may have a budget committee under himwhich may consist of Chief Executive, budget officer himself and heads of maindepartments. The role of budget committee may be only advisory and its decision maybecome binding only if accepted by the Chief Executive. The functions performed by thebudget committee can be broadly stated as below.

(a) To receive and scrutirize the functional budgets.


(b) To revise the functional budgets, if necessary.

(c) To approve the revised budgets.

(d) To receive the budget reports and comparative statements.

(e) To locate the responsibilities and recommend the corrective and remedial action.

The usual and normal organization for the budgetary control may be expressed by wayof the following organization chart.

Chief Executive

Budget Officer

Budget committee

Production Personnel Finance Purchase SalesManager Manager Manager Manager Manager

(5) Preparation of a budget mannual :

A budget mannual is a document setting out the responsibilities of the persons engagedin and the forms and procedures required for the budgetary control. A budget manualenables the standardization of the methods and procedures in relation to the budgetarycontrol. It should be well written, indexed and divided into the sections. It may be inbound book form or loose leaf form. A budget mannual may contain the following particulars.

(a) Introduction of principles and objectives of budgetary control and the definitions andbrief explanations.

(b) Duties and responsibilities of the various executives and the organization chart.

(c) Functions and duties of budget officer and budget committee.

(d) Scope of the budget and areas to be covered, whether budget will be a fixed budgetor flexible budget.

(e) Accounts codes, budget center codes and other codes operated.

(f) The forms of reports and statements to be used.

(g) The last date for submission of budgets.

(h) Budget diagrams.


(6) Determination of Budget Key Factor :

A budget key factor is that the impact of which should be assessed first before otherfunctional budgets are prepared to ensure that other functional budgets are capable offulfillment. The key factor may take various forms Eg.Sales, Raw material, Labour,Production capacity, availability of funds and Government restrictions. Once the keyfactor is established, the budget with respect to that function will be prepared first andthe other budgets will be prepared to conform to that Eg. If sales is the key factor, thesales manager will prepare and submit sales forecast first. The production manager willthen decide whether it is possible to produce the quantity to meet sales demand. Incase of the situations where there are more than one key factors, the importance of keyfactors themselves will be assessed first. The problem of multiplicity of key factors maybe solved with the help of techniques like linear programming, operations research etc.

TYPES OF BUDGETS :

There can be basically four areas in which management can function and the types of budgetscan be studied with respect to these functional areas of management viz. Sales/Marketing,production, personnel and finance.

(A) Sales/Marketing :

The budgets in this area may be of following types.

(I) Sales Budget :

It is a forecast of total sales expressed in terms of quantity and or money. It is inevitablythe interplay between two factors i.e. sales quantity and selling price. Sales quantitymay be forecasted after taking into consideration various factors.

(1) Analysis of Past Trend : Analysis of the past trend over the last 5-10 years, mayreveal the long term trends, seasonal trends and the cyclical trends. With the helpof this trend analysis, the future trend can be established. For this purpose, referencecan be made to the reports published by trade organizations and Governmentpublications.

(2) Reports by Salesmen : Being in the actual field, probably the sales staff may bebest able to estimate the quantity which can be sold in the market. Before usingthis estimate as an official sales forecast, necessary adjustments may be madefor error of judgment or to avoid the possibility of overestimation on the part of thesalesmen.

(3) Market Research and Market Survey : This is a very specialized techniqueavailable to assess which of the company’s products can be sold, in which market,


in what quantity and at what selling price. Such an analysis will facilitate thepreparation of sales forecast areawise, productwise, salesmenwise and channel ofdistribution wise.

(4) General Economic Conditions : General Trade and Business conditions affectthe sales forecast of the company. They may be in the form of competition fromother companies, supply condition for material and labour, trade conditions of thecustomers of the company and so on.

Selling price at which products of the company can be sold may depend uponvarious factors viz.

(1) Cost price of the product

(2) Selling price charged by the competitors.

(3) Expected amount of profits.

(4) Advertisement and other sales promotion efforts carried out by the company.

If the company envisages to sell higher quantity than the past sales or the existingproduction capacity, and if some capital investment proposal is involved to increasethe production, then the feasibility of the proposal and the availability of funds mayalso be required to be considered. If the sales forecast is less than the past salesbut the top management insists upon a certain amount of additional profits, thenthe possibility of increasing the selling price or selling efforts and reduction in thecost price may be required to be considered.

(II) Selling and Distribution Cost Budget :

It shows the selling and distribution cost for selling the quantities considered in salesbudget. The sales manager, the distribution manager, the advertising manager and thefinance manager will be the persons involved in the preparation of this budget. Thisbudget may be prepared on the principles of flexible budgeting (as discussed later in thischapter) for each head of selling and distribution costs, on the basis of volume of salesto be achieved.

(III) Advertising Cost Budget :

This cost is closely associated with sales. The intention of incurring this cost is toincrease the sales. However, the result of incurring this cost i.e. increased sales maynot be immediate and even if there is increase in sales, it is difficult to measure theportion of increased sales which is due to advertising cost. As such, normally, advertisingcost budget is established in the form of a fixed amount for a specific period.


The various ways in which the amount of budgeted advertising cost can be decided areas below :

(1) Percentage of Sales or Profits : Here the advertising cost may be decided as afixed percentage of sales or profits. However, the past data may not be suitable inview of recent business situations.

(2) Funds Available : Here the advertising cost depends upon the capability of thecompany to spend on advertising. This may be a hypothetical method and may notnecessarily consider the relationship between advertising cost and benefits therefrom.

(3) Competitor’s Policy : Here the advertising cost may depend upon the amountwhich the competitors are spending on advertising. This method may pose somedifficulty as the amount spent by competitors may not be known and it may bewrong to assume that the company may be able to derive the same benefits fromadvertising as the competitors derive.

(B) Production :

The budgets in this area may be of following types :

(I) Production Budget :

It is a forecast of production for the budget period. It may be prepared from two angles.

(i) Production Budget in terms of Quantity.

(ii) Production Budget in terms of money i.e. the production Cost Budget furtherclassified under each element of cost such as Direct Material Cost, Direct LabourCost and Overheads Cost.

The material cost can be estimated by preparing the materials budget which indicatesthe estimated quantities as well as costs of various materials required for carrying outproduction as per production budget.

The labour cost can be estimated by preparing Direct Labour Cost budget which indicatesthe direct labour requirements required to produce the quantity as specified in theproduction budget. For the purpose of this budget, labour requirement in terms of numberof workers of different grades will be decided first. Afterwards, the rates of pay andallowances will be considered to decide the labour cost. The production overheads canbe estimated by preparing production overhead budget which indicates all items ofproduction overheads classified as fixed, variable and semi-variable. The process ofallocation and apportionment can be followed to decide the loading of overheads to eachbudget centre. Following factors will have to be considered before preparing the productionbudget in terms of quantity’.


(1) Coordination with Sales Forecast : Before the quantity to be produced is decided,it will be necessary to confirm whether it is possible to sell the quantity which isproduced during the budget period. If it is not possible to sell whatever can beproduced, inspite of all the sales promotion efforts, then the production budgetshould be adjusted to conform to the sales forecast. If the expected sales exceedexisting production capacity, possibility of overtime working or extra shift workingshould be considered.

(2) Production Capacity : Production Budget estimates the quantity to be produced.If it is not possible to produce the quantity with the existing capacity available, itwill be necessary to increase the capacity by incurring additonal capital expenditure.

(3) Consideration of Stocks : Whatever is to be sold need not be produced necessarilly.The quantity to be produced, after giving due consideration to the sales forecast,may depend upon the opening and closing stock of finished goods. The quantity tobe produced during the budget period may be decided as -

Estimated Closing stock of finished goods.

Add : Quantity to be sold,

Less : Opening Stock of Finished Goods.

(4) Management Policy : Sometimes, the policy decisions taken by the managementare required to be considered before setting the production budget Eg. It will have tobe considered whether certain components are decided to be produced instead ofpurchasing or vice versa.

(II) Purchases Budget :

It is a forecast of quantity and value of materials, direct or indirect, required to be purchasedduring the budget period. It is needless to state that the purchases budget is closelyconnected to the production budget. Following factors are required to be consideredbefore setting the purchases budget,

(1) Orders already placed for the purchases of materials.

(2) Material already purchased but reserved for some specific purposes.

(3) Opening and closing stocks.

(4) Storing facilities and economic order quantity.

(5) Availability of funds.

(6) Prices of the materials.


(C) Personnel :

In this functional area, the budget to be prepared takes the form of a personnel budget, whichindicates the requirement of personnel or labour force, either direct or indirect, to conform tothe sales forecast and the production budget. The labour requirement may be decided interms of number and grade of workers, number of labour hours, rupee value etc. Considerationis also required to be made of the overtime working or shift working. This budget may alsoindicate the training plans for new workers.

(D) Finance :

The most important budget which is prepared under this functional area is the cash budget. Itis an estimate of the expected cash receipts and cash payments during the budget period.Thus by preparing the cash budget, it is possible to predict whether at any point of time, thereis likely to be excess or shortage of cash. If the shortage of cash is estimated, it may berequired to arrange the cash from some other source. If the excess of cash is estimated, itmay be possible to explore the investment opportunities. Before preparing the cash budget,following principles should be kept in mind.

(i) The period for which cash budget is prepared should be selected very carefully. There isno fixed rule as to the period to be covered by the cash budget. It may vary from companyto company depending upon the individual requirements. As a general rule, the periodcovered by the cash budget should neither be too long or too short. If it is too long, it ispossible that the estimate will not be accurate. If it is too short, the factors which arebeyond the control of management will not be given due consideration.

(ii) The items which should appear in the cash budget, should be carefully decided. Naturally,all those items which do not involve cash flow will not be considered while preparing thecash budget. Eg. As the cost of depreciation does not involve any cash outflow, it doesnot affect the cash budget, though the amount of depreciation affects the determinationof tax liability which involves cash outflow.

A cash budget may be prepared in any of the following three methods.

(1) Receipts and Payments Method : This method is useful for short term estimations.It lists the various estimated sources of cash receipts on one hand and the variousestimated applications of cash on the other.

While preparing the cash budget by this method, the various items appearing onthe same may be classified under the following two categories :

(i) Operating Cash Flows : These are the items of cash flow which arise as aresult of regular operations of the business.


(ii) Non operating Cash Flows : These are the items of cash flow which ariseas the result of other operations of the business.

The standard items which may appear on the cash budget prepared by this method maybe stated as below :

Cash Inflow Cash OutflowOperating : Operating :

Cash sales Payment to creditorsCollection from debtors Cash Purchases of raw materialsInterest/Dividend received Wages/Salaries

Various kinds of overheads.(To the extent they are actually paid)

Non-operating Non-operating

Issue of shares/debentures Redemption of shares/debentures.Receipt of loans/borrowings Loan InstallmentsSales of Fixed Assets Purchases of Fixed AssetsSales of Investments Interest

TaxesDividends.

Thus, finally cash budget appears in the form of opening cash balance, to whichvarious estimated cash receipts are added, the estimated cash payments beingdeducted from this sum to arrive at the closing cash balance.

(2) Balance Sheet Method : This method is useful for long term estimates. Accordingto this method, the budgeted Balance Sheet is prepared for the following budgetperiod, after considering the various terms viz. Capital, Long Term Liabilities, Currentliabilities, Fixed Assets, Current Assets, but except cash. After both the sides ofBalance Sheet are balanced, the balancing figure indicates the estimated cashbalance in hand at the end of that period. This method does not consider theexpenses and assumes the regular pattern of inflow and outflow of cash. Further, itindicates the cash requirement only at the end of budget period, any excess orshortage of cash during the budget period are not considered.

(3) Adjusted Profits/Losses Method : This method also is useful for long termestimates. According to this method, the cash budget is prepared in the followingway to show the estimated cash balance at the end of the budget period.


Opening cash balance.

Add : Profit before depreciation, provisions and other non-cash expenses.Add : Decrease in Current Assets or Increase in Current Liabilities.Add : Capital Receipts.Add : Receipt of loans/borrowingsLess : Capital ExpenditureLess : Repayment of loan installmentsLess : Payment of dividends/taxesLess : Increase in Current Assets or Decrease in Current LiabilitiesIn other words, cash budget prepared as per this method is in the form of cash flowstatement.

(E) Miscellaneous Budgets :

In addition to the various budgets as described above, which can be prepared in primefunctional areas of marketing, production, personnel and finance, some other types ofbudgets may also be prepared.

(I) Overheads Cost Budget :

It indicates the various types of overheads to be incurred during the budget period.For the correct establishment of overheads cost budget, it will be necessary toclassify the various overheads. In order to exercise proper control on the overheads,it will be necessary to analyse the overheads as fixed, variable and semi-variable.The semi-variable overheads are further required to be split into fixed and variableelements.

(II) Capital Expenditure Budget :

It is the plan of proposed investment in the fixed assets. It is closely related to thesales budget, production budget and cash budget. As such, capital expenditurebudget should be properly coordinated with other functional budgets.

The capital expenditure may be required to be incurred for the replacement purposesor expansion purposes. The requirements of capital expenditure may be basicallyreceived from the various functional executives viz. production manager, salesmanager, finance manager and so on. If the investment in fixed assets is consideredto be economically and financially feasible, then the arrangement is required to bemade for the acquisition of the same. If the cash budget reveals the excess fundsavailable, it may not be necessary to arrange the funds for acquiring the fixedassets from outside source. However, if no excess cash balance is available, thenit may be necessary to borrow the funds from some outside source.


(F) Master Budget :

After all the functional budgets are prepared individually and are properly coordinated witheach other, the master budget can be prepared by incorporating all the functional budgets.The ultimate incorporation of all the functional budgets takes the form of budgeted Profit andLoss Account and the Budgeted Balance Sheet.

It may involve the presentation of current year’s budgeted figures as well as those of theprevious year showing clearly why there is a change.

FIXED AND FLEXIBLE BUDGETS :

Any budget in any functional area of operation can be established as a fixed budget or aflexible budget. A fixed budget is established for a specific level of activity and is not adjustedto the actual level of activity attained at the time of comparison between the budgeted andactual results. Naturally, fixed budget is established only for a short period of time where thebudgeted level of activity is expected to be attained to the maximum possible extent. Fixedbudgets are more suitable for fixed expenses i.e. the expenses which have no relation with thelevel of activity. The fixed budgets do not indicate that they cannot be changed at all. A fixedbudget can be revised if the actual level of activity is likely to differ widely from the budgetedlevel of activity. The fixed budget cannot be used as a effective tool of cost control whilecomputing the variations between the budgeted result and the actual result, the variancecannot be explained properly and it is not possible to say whether the variance is due to thechanges in the level of activity or due to the efficiency or inefficiency of the executive responsiblefor the execution of the budget. A flexible budget is designed to change with the fluctuationsin the level of activity and provides a basis for comparison for any level of activity actuallyattained. A flexible budget is more elastic, and practical. It can be properly used as an effectivetool for evaluation of performance and cost control. It explains the variations between thebudgeted results and actual results stating the variations which are due to changes in the levelof activity (which is beyond the control of operating executive) and which are due to theoperational efficiency or inefficiency (for which the operating executive is responsible.)

For the purpose of establishment of the flexible budgets, it is necessary to classify the costsas fixed costs, variable costs and semi-variable costs. The fixed costs remain the same at allthe levels of activity whereas the variable costs change directly in proportion to the level ofactivity. So far as the semi-variable costs are concerned, each item of cost is examined andclassified into its fixed and variable elements and a trend is established regarding the natureand behavior of each item of cost.


(1) An estimate shows that there is a market for 10,00,000 units of an electric bell. Two bigcompanies producing this electric bell will probably divide 80% of the market. Among


other companies, producing the bell, Ghatanad Ltd. should get 15% of the total market.60% of the Ghatanad sales will probably be evenly divided between the first and lastcalendar quarters, with twice as many sales being made in the second quarter as in thethird.

The bell sells for Rs.30 an unit, with the manufacturing cost as follows. The cost isworked out with reference to normal working capacity for the production which is 1,50,000bells a year.

Direct Materials Cost Rs. 15.00

Direct Labour Cost Rs. 7.50

Variable overheads cost Rs. 2.50

Fixed overhead cost Rs. 1,00,000

Prepare a sales budget for the year showing cost of production and gross profit bycalendar quarters. Assume no change in the inventory levels during the year.

Solution :

SALES BUDGET

Particulars Qtr. I Qtr. II Qtr. III Qtr. IV Total

(A) Sales - Units 45,000 40,000 20,000 45,000 1,50,000

Rs. 13,50,000 12,00,000 6,00,000 13,50,000 45,00,000

(B) Cost of Production

Direct Materials Rs. 6,75,000 6,00,000 3,00,000 6,75,000 22,50,000

Direct Labour Rs. 3,37,500 3,00,000 1,50,000 3,37,500 11,25,000

Variable Overheads Rs. 1,12,500 1,00,000 50,000 1,12,500 3,75,000

Fixed Overhead Rs. 25,000 25,000 25,000 25,000 1,00,000

11,50,000 10,25,000 5,25,000 11,50,000 38,50,000

(c) Gross Profit i.e. A - B 2,00,000 1,75,000 75,000 2,00,000 6,50,000

Note : It is assumed that the fixed overheads are apportioned evenly over the various quarters.

(2) XYZ Ltd. manufactures product C and G. During January, it expects to sell 5,000 Kgs ofC and 20,000 Kgs of G at Rs. 20 and Rs. 10 each respectively.

Direct materials A, B and E are mixed in equal proportion to produce product C. Materials D,B and E are mixed in the proportion of 5:3:2 to produce product G. There is no loss of weightin the production.


Actual and budgeted inventories in quantities and costs for the month are as follows :

Opening Inventory Desired Closing Anticipated Cost Kgs. Inventory Kgs. per kg.

Material A 1,500 1,000 5.50

B 1,000 2,000 5.00

D 10,000 3,000 1.00

E 5,000 6,000 3.50

Product C 1,000 500 –

G 5,000 6,000 –

You are required to prepare (i) the production budget (ii) the materials purchase budget, indicatingthe expenditure on raw materials for January.

Solution :

(A) Production Budget : January 1987

Product C Product G

Anticipated Sales - kgs. 5,000 20,000

Desired closing stock - kgs 500 6,000

5,500 26,000

Less : Opening stock kgs. 1,000 5,000

Production during month kgs. 4,500 21,000

(B) Materials Purchase Budget - January 1987

A B D E(a) Requirement for production

(As per production Budget)For product C - kgs 1,500 1,500 – 1,500For product G - kgs. – 6,300 10,500 4,200Total requirement - kgs. 1,500 7,800 10,500 5,700

(b) Desired closing stock - kgs 1,000 2,000 3,000 6,000(c) Sub total a +b kgs 2,500 9,800 13,500 11,700(d) Opening stock kgs 1,500 1,000 10,000 5,000(e) To be purchased during month kgs. c - d 1,000 8,800 3,500 6,700(f) Anticipated cost per kg. Rs. 5.50 5.00 1.00 3.50(g) Anticipated cost of purchases Rs. 5,500 44,000 3,500 23,450


(3) Lookahead Ltd. produces and sells a single product. Sales budget for the calender year1987 by quarter is as under -

Quarter No. of units to be sold

I 12,000

II 15,000

III 16,500

IV 18,000

The year 1987 is expected to open with an inventory of 4,000 units of finished product andclose with an inventory of 6,500 units. Production is customarily scheduled to provide for twothird of the current quarter ‘ s sales demand plus one third of the following quarter’s demand.Thus production anticipates sales volume by about one month.

The standard cost details for one unit of the product is as below

Direct Materials 10 Ibs @50 paise per Ib.

Direct Labour 1 hour 30 minutes @Rs. 4 per hour.

Variable Overheads 1 hour 30 minutes @Re. 1 per hour.

Fixed Overheads 1 hour 30 minutes @Rs. 2 per hour, based on a budgeted production volumeof 90,000 direct labour hours for the year.

a. Prepare a production budget for 1987, by quarters, showing the number of units to beproduced and the total costs of direct material, direct labour, variable overheads andfixed overheads.

b. If the budgeted selling price per unit is Rs. 17, what would be the budgeted profit for theyear as a whole ?

c. in which quarter of the year is the company expected to break even ?

Solution :

a. Production Budget

We know that Opening Stock + Production - Sales = Closing Stock

Hence we know that

Closing Stock + Sales - Opening Stock = Production


Q1 Q2 Q3 Q4

Opening Stock 4000 5000 5500 6000

Production 13000 15500 17000 18500

Sales 12000 15000 16500 18000

Closing Stock 5000 5500 6000 6500

Hence, the total production for all the quarters will be 64,000 units.

b. Production Cost Budget -

Direct Materials 64000 units x Rs. 5 = 3,20,000

Direct Labour 96000 hours x Rs. 4 = 3,84,000

Variable Overheads 96000 hours x Re. 1 = 96,000

Total Variable Cost 8,00,000

Fixed Cost 1,80,000

Total Cost 9,80,000

Total Variable Cost for 64000 units is Rs. 8,00,000. Hence, per unit variable cost isRs. 12.50.

c. Calculation of Profit

Sales 61500 units @Rs. 17 per unit 10,45,500

Variable Cost of units sold

61500 units @Rs. 12.50 per unit 7,68,750

Contribution 2,76,750

Less : Fixed Cost 1,80,000

Profit 96,750

d. Break Even Point

Per Unit Selling Price is Rs. 17 and Per Unit Varaible Cost is Rs. 12.50. Hence, Per UnitContribution Rs. 4.50.

As Fixed Cost is Rs. 1,80,000, Break Even Point in units will be 180000 / 4.50 = 40000units. This target is achieved by the company in Quarter 3, hence the company isexpected to break even in Quarter Three.

(4) A single product company estimated its sales for the next year quarterwise as under -

Rs.


Quarter Sales units

I 30,000

II 37,500

III 41,250

IV 45,000

The opening stock of the finished goods is 10,000 units and the company expects to maintainthe closing stock of finished goods at 16,250 units at the end of the year. The productionpattern in each quarter is based on 80% of the sales of the current quarter and 20% of thesales of the next quarter.

The opening stock of raw materials in the begining of the year is 10,000 Kgs. and the closingstock at the end of the year is required to be maintained at 5,000 Kgs. Each unit of finishedoutput requires 2 Kgs. of raw material.

The company proposes to purchase the entire annual requirement of raw materials in the firstthree quarters in the proportion and at the prices given below -

Quarter Purchases of raw materials Price per Kg.

% of total annual requirement Rs.

in quantity

I 30% 2

II 50% 3

III 20% 4

The value of the opening stock of raw materials in the beginning of the year is Rs. 20,000.

You are required to present the following for the next year, quarterwise -

a. Production Budget in units.

b. Raw Materials consumption budget in quantity.

c. Raw Materials purchase budget in quantity and value.

Solution :

a. Production Budget

We know that Opening Stock + Production - Sales = Closing Stock Hence we know that

Closing Stock + Sales - Opening Stock = Production


Q1 Q2 Q3 Q4

Opening Stock 10000 11500 12250 13000

Production 31500 38250 42000 48250

Sales 30000 37500 41250 45000

Closing Stock 11500 12250 13000 16250

Hence, the total production for all the quarters will be 1,60,000 units.

b. Raw Materials Consumption Budget

Production Budget is 1,60,000 units. Each unit of the final product requires 2 Kgs. of rawmaterial. Hence, the raw material consumption budget in quantity will be 3,20,000 Kgs.

c. Raw Materials Purchase Budget

Total quantity of raw materials to be purchased will be

Closing Stock + Consumption - Opening Stock

5000 + 320000 - 10000 = 315000

The quarterwise purchases will be as below -

Q1 30% of 315000 Kgs. i.e 94500 Kgs. @Rs. 2 per Kg. = 1,89,000

Q2 50% of 315000 Kgs. i.e. 157500 Kgs. @Rs. 3 per Kg. = 4,72,500

Q3 20% of 315000 Kgs. i.e. 63000 Kgs. @Rs. 4 per Kg. = 2,52,000

9,13,500

Hence, total purchase budget in terms of value is Rs. 9,13,500.

(5) A private Limited company is formed to take over a running business. It has decided toraise Rs.55 Lakhs by issue of Equity shares and the balance of the capital required inthe first six months is to be financed by a financial institution against an issue for Rs.5Lakhs 8% Debentures (Interest payable annually) in its favour.

Initial outlay consists of

Freehold premises Rs. 25 Lakhs

Plant & Machinery Rs. 10 Lakhs

Stock Rs. 6 Lakhs

Vehicle & Other items Rs. 5 Lakhs

Payments on the above items are to be made in the month of incorporation. Sales duringthe first 6 months ending on 30th June are estimated as under.


January Rs. 14 Lakhs April Rs. 25 Lakhs

February Rs. 15 Lakhs May Rs. 26.50 Lakhs

March Rs. 18.50 Lakhs June Rs. 28 Lakhs

Lag in payment - Debtors 2 months

- Creditors 1 month

Other information :

(1) Preliminary expenses Rs.50,000 (Payable in February)

(2) General Expenses Rs.50,000 p.m.(Payable at the end of each month)

(3) Monthly wages (payable on 1st day of next month) Rs. 80,000 p.m. for first3 months and Rs. 95,000 p.m. there after.

(4) Gross Profit rate is expected to be 20% on sales.

(5) The shares and debentures are to be issued on 1st January.

(6) The stock levels throughout is to be the same as the outlay.

Prepare cash budget for the 6 months ended 30th June.

Solution :Cash Budget

(For 6 month sending 30th June)

(Rs. in Lakhs)Jan. Feb. Mar. Apr. May Jun

(A) Cash InflowIssue of shares 55.00 – – – – –Issue of Debentures 5.00 – – – – –Collection from Debtors – – 14.00 15.00 18.50 25.00

60.00 – 14.00 15.00 18.50 25.00(B) Cash Outflow

Fixed Assets 40.00 – – – – –Stock (Initial) 6.00 – – – – –Preliminary Expenses – 0.50 – – – –Sundry Creditors – 10.40 11.20 14.00 19.05 20.25General Expenses 0.50 0.50 0.50 0.50 0.50 0.50Wages – 0.80 0.80 0.80 0.95 0.95

46.50 12.20 12.50 15.30 20.50 21.70(C) Net cash Inflows

(A-B) 13.50 (12.20) 1.50 (0.30) (2.00) 3.30Opening Balance – 13.50 1.30 2.80 2.50 0.50+ Surplus for the month 13.50 (12.20) 1.50 (0.30) (2.00) 3.30Closing Balance 13.50 1.30 2.80 2.50 0.50 3.80


Working Notes :

(1) It is assumed that the company is incorporated in January.

(2) Assuming that the company is carrying on manufacturing operations, the purchasesay for the month of January are computed as below.

Sales for January 14.00

Less Gross profit @ 20% 2.80

Cost of goods 11.20

Less wages for January 0.80

Purchases 10.40

(6) A newly started company “Green Co. Ltd.” wishes to prepare cash budget from January.Prepare a cash budget for the first 6 months from the following estimated revenue andexpenditure.

Month Total Material Wages OverheadsSales Production Selling &

DistributionRs. Rs. Rs. Rs. Rs.

Jan. 20,000 20,000 4,000 3,200 800

Feb. 22,000 14,000 4,400 3,300 900

Mar. 24,000 14,000 4,600 3,300 800

Apr. 26,000 12,000 4,600 3,400 900

May 28,000 12,000 4,800 3,500 900

June 30,000 16,000 4,800 3,600 1000

Cash balance on 1st January was Rs.10,000. A new machine is to be installed atRs.30,000 on credit, to be repaid by two equal installments in March and April.

Sales commission @ 5% on total sales is to be paid within the month following actualsales. Rs. 10,000 being the amount of second call may be received in March. Sharepremium amounting to Rs. 2,000 is also obtainable with 2nd call.

Period of credit allowed by suppliers 2 month

period of credit allowed to customers 1 month

Delay in payment of overheads 1 month

Delay in payment of wages 1/2 month

Assume cash sales to be 50% of total sales.


Solution :

Cash Budget of Green Co. Ltd.

Jan. Feb. Mar. Apr. May Jun.(A) Cash Inflows

Cash sales 10,000 11,000 12,000 13,000 14,000 15,000

Collection from debtors - 10,000 11,000 12,000 13,000 14,000

Share Capital (2nd call) - - 10,000 - - -

Share Premium - - 2,000 - - -

10,000 21,000 35,000 25,000 27,000 29,000

(B) Cash Outflows

Sundry Creditors - - 20,000 14,000 14,000 12,000

Wages For current month 2,000 2,200 2,300 2,300 2,400 2,400

For last month - 2,000 2,200 2,300 2,300 2,400

Production Overheads - 3,200 3,300 3,300 3,400 3,500

Selling & Distribution

Overheads - 800 900 800 900 900

Instalment for Machine

purchased - - 15,000 15,000 - -

Sales commission - 1,000 1,100 1,200 1,300 1,400

2,000 9,200 44,800 38,900 24,300 22,600

(C) Net Cash Inflowsor outflows(A-B) 8,000 11,800 (-) 9800 (-) 13,900 2,700 6,400

Opening cash balance 10,000 18,000 29,800 20,000 6,100 8,800

+ Surplus for month 8,000 11,800 (-) 9,800 (-) 13,900 2,700 6,400

Closing cash balance 18,000 29,800 20,000 6,100 8,800 15,200

(7) Prepare a cash budget for the quarter ended 30th September 1987 based on the followinginformation

Cash at Bank on 1st July 1987 Rs. 25,000

Salaries and wages estimated monthly Rs. 10,000

Interest Payable August 1987 Rs. 5,000


June July August SeptemberRs. Rs. Rs. Rs.

Estimated Cash sales - 1,40,000 1,52,000 1,21,000

Credit Sales 1,00,000 80,000 1,40,000 1,20,000

Purchases 1,60,000 1,70,000 2,40,000 1,80,000

Other Expenses - 20,000 22,000 21,000

(Payable in same month)

Credit sales are collected 50% in the month of sales are made and 50% in the month following.Collection from credit sales are subject to 5% discount if payment is received in the month ofsales and 2.5% if payment is received in the following month.

Creditors are paid either on a prompt or 30 days basis. It is estimated that 10% of the creditorsare in the prompt category.

Solution :

Cash Budget(For Quarter ending September 1987)

July August SeptemberRs. Rs. Rs.

(A) Cash InflowsCash Sales 1,40,000 1,52,000 1,21,000Collection from Debtors

Last month 48,750 39,000 68,250Current month 38,000 66,500 57,000

2,26,750 2,57,500 2,46,250

(B) Cash OutflowsSundry Creditors

Prompt Basis 17,000 24,000 18,000Others 1,44,000 1,53,000 2,16,000

Salaries & wages 10,000 10,000 10,000Other Expenses 20,000 22,000 21,000Interest - 5,000 -

1,91,000 2,14,000 2,65,000

(C) Net Cash Inflow (A-B) 35,750 43,500 (18,750)

Opening Balance 25,000 60,750 1,04,250+ Surplus for the month 35,750 43,500 (18,750)Closing Balance 60,750 1,04,250 85,500


Working Notes :

It is assumed that salaries and wages are paid in the same month.

(8) From the following information you are required to prepare a cash budget for six monthsfrom January 1987 to June 1987, Month by month, showing also the cash credit facilityavailable from the Bank. Opening overdrawn balance is Rs. 1,50,000.

Month Sales Materials Wages Prod. Selling & Adm.

Purchases Expenses Dist. Expases

ExpensesRs. Rs. Rs. Rs. Rs. Rs.

January 1,44,000 50,000 20,000 12,000 8,000 3,000

February 1,94,000 62,000 24,200 12,600 10,000 3,400

March 1,72,000 51,000 21,200 12,000 11,000 4,000

April 1,77,200 61,200 50,000 13,000 13,400 4,400

May 2,05,000 74,000 44,000 16,000 17,000 5,000

June 2,17,400 77,600 46,000 16,400 18,000 5,000

Following further information is available.

(1) Out of total sales, 50% are cash sales and balance 50% is received in the month followingmonth of sale.

(2) Payment for purchase of assets is to be made Rs.16,000 in February, Rs. 25,000 inMarch and Rs. 50,000 in April.

(3) Proceeds from sales of scrap are to be received in May, amounting to Rs.6,000.

(4) Dividend of Rs. 90,000 is to be paid in June.

(5) Sales commission is to be paid at 3% of total sales in same month in which sales aremade.

(6) Suppliers for materials are paid in the month following the month of purchases of materials.

(7) Cash credit facility granted is Rs. 2,00,000.

(8) Wages are paid in the same month.

(9) Creditors of Production, Selling & Distribution and Administration expenses are givenone month’s credit period.


Solution :

Jan. Feb. Mar. Apr. May Jun.

87 87 87 87 87 87

(A) Cash Inflows

Cash sales 72,000 97,000 86,000 88,600 1,02,500 1,08,700Collection from debtors - 72,000 97,000 86,000 88,600 1,02,500

Sales of scrap - - - - 6,000 -

72,000 1,69,000 1,83,000 1,74,600 1,97,100 2,11,200

(B) Cash OutflowsCreditors for Materials - 50,000 62,000 51,000 61,200 74,000

Wages 20,000 24,200 21,200 50,000 44,000 46,000

Production Expenses - 12,000 12,600 12,000 13,000 16,000Sales & Dist. Expenses - 8,000 10,000 11,000 13,400 17,000

Admin Expenes - 3,000 3,400 4,000 4,400 5,000

Purchases of Assets - 16,000 25,000 50,000 - -Dividend - - - - - 90,000

Sales Commission 4,320 5,820 5,160 5,316 6,150 6,522

24,320 1,19,020 1,39,360 1,83,316 1,42,150 2,54,522

(c) Net Cash

inflows oroutflows

(A-B) 47,680 49,980 43,640 (-)8,716 54,950 (-) 43,322

Opening over drafting 1,50,000 1,02,320 52,340 8,700 17,416 (-) 37,534+Surplus/Deficit

for the month 47,680 49,980 43,640 (-) 8,716 54,950 (-) 43,322

Closing overdrawing 1,02,320 52,340 8,700 17,416 (-) 37,534 5,788

Note :

Eventhough, the Cash Credit Facility is granted to the extent of Rs.2,00,000, the company isnot likely to utilise it fully. At the end of June 1987, the overdrawn balance is likely to be onlyRs.5,788.

(9) ABC Co. Ltd. wishes to arrange overdraft facilities with its bankers during the period Aprilto June 1987 when it will be manufacturing mostly for stock. Prepare a cash budget forthe above period from the following data, indicating the extent of the bank facility thecompany will require at the end of each month.


Month Sales Purchases WagesRs. Rs. Rs.

February 1,80,000 1,24,800 12,000

March 1,92,000 1,44,000 14,000

April 1,08,000 2,43,000 11,000

May 1.74,000 2,46,000 10,000

June 1,26,000 2,68,000 15,000

Additional Information :

(1) All Sales are Credit Sales 50% of Credit Sales are realised in the month following thesales and the remaining 50% in the Second month following.

(2) Creditors are paid in the month following the month of purchases.

(3) Cash at Bank of 1.4.87 (Estimated) Rs.25,000.

Solution :

Cash Budget of ABC Co. Ltd.

Apr. 87 May 87 June 87

(A) Cash Inflows

Sundry Debtors

First 50% 96,000 54,000 87,000

Second 50% 90,000 96,000 54,000

1,86,000 1,50,000 1,41,000

(B) Cash Outflows

Sundry Creditors 1,44,000 2,43,000 2,46,000

Wages 11,000 10,000 15,000

1,55,000 2,53,000 2,61,000

(C) Net Cash Inflows

or outflows (A-B) 31,000 (-) l,03,000 (-) l,20,000

(D) Estimated Cash Surplus

or shortage

Opening Cash Balance 25,000 56,000 (-) 47,000

+ Surplus/Deficit for the month 31,000 (-) l,03,000 (-) l,20,000

Closing cash balance 56,000 (-) 47,000 (-) 1,67,000


Note : It can be seen that the company will be required to arrange for the bank finance ofRs. 47,000 at the end of May 1987 and an additional amount of Rs.1,20,000 at the end ofJune 1987.

(10) The manager of a Repairs and Maintenance Department has submitted the followingbudget estimates that are to be used to construct a flexible budget to be used during thecoming budget year.

Details of cost Planned at 6000 Planned at 9000direct repairs direct repairs

hours hours

Employee Salaries 30,000 30,000

Indirect Repair Materials 40,200 60,300

Miscellaneous Costs 13,200 16,800

a. Prepare a flexible budget for the department up to activity level of 10,000 repair hours(use increment of 1000).

b. What would be the budget allowance at 8,500 repair hours?

Solution :

8500 Hours 10000 Hours

Employee Salaries 30,000 30,000

Indirect Repair Materials 56,950 67,000

Miscellaneous Costs 16,200 18,000

1,03,150 1,15, 000

Working Notes :

From the analysis of the costs, it is observed that -

a. Employee salaries is a fixed cost as they remain constant for both 6000 repair hours and9000 repair hours.

b. Indirect repair materials is a variable cost as it proportionately increases from 6000hours to 9000 hours.

c. Miscellaneous costs is a semi-variable cost. This cost neither remained constant norincreased proportionately the activity level of 6000 hours to 9000 hours. The cost increasedby Rs. 3,600 for the increase of 3000 hours. means that the variable portion of this costis Rs. 1.20 hour. Hence, out of total miscellaneous cost of Rs. 13,200 for 6000 hours,Rs. 7,200 is variable portion and balance 6,000 is the fixed portion.


(11) Viveka Elementary School has a total of 150 students consisting of 5 sections with 30students per section. The school plans for a picnic around the city during the week endto places such as the zoo, the amusement park, the planetarium etc. A private transportoperator has come forward to lease out the buses for taking the students. Each bus willhave a maximum capacity of 50 (excluding 2 seats reserved for the teacher accompanyingthe students). The school will employ 2 teachers for each bus paying them an allowanceof Rs. 50 per teacher. It will also lease out the required number of buses. The followingare the other cost estimates -

Cost per student

Rs.

Breakfast 5

Lunch 10

Tea 3

Entrance fee at zoo 2

Rent Rs. 650 per bus.

Special permit fee Rs. 50 per bus.

Block entrance fee of the planetarium Rs. 250.

Prizes to the students for games Rs. 250.

No costs are incurred in respect of the accompanying teachers (except the allowance ofRs. 50 per teacher).

You are required to prepare -

a. A flexible budget estimating the total cost for the levels of 30, 60, 90, 120 and 150students. Each item of cost is to be indicated separately.

b. Compare the average cost per student of these levels.

c. What will be your conclusions regarding the break even level of students if the schoolproposes to collect Rs. 45 per student?


Solution :

No. of Students 30 60 90 120 150

a. Variable Cost 600 1200 1800 2400 3000

b. Semi-fixed costs

Rent of the bus 650 1300 1300 1950 1950

Permit Fees 50 100 100 150 150Allowances to teachers 100 200 200 300 300

c. Fixed Costs

Entrance Fees 250 250 250 250 250

Prizes to students 250 250 250 250 250

Total Costs 1900 3300 3900 5300 5900

Average Cost per student 63.33 55.00 43.33 44.17 39.33

Total CostNo. of students

(12) Prepare the flexible budget for overheads on the basis of data given below. Ascertain theoverheads rates at 50%, 60% and 70% capacity.

At 60% capacityRs.

Variable Overheads

Indirect Material 6,000

Indirect Labour 18,000

Semi-Variable Overheads

Electricity

(40% fixed, 60% variable) 30,000

Repairs and Maintenance

(80% fixed, 20% variable) 3,000

Fixed Overheads :

Depreciation 16,500

Insurance 4,500

Salaries 15,000

Total Overheads 93,000

Estimated Direct Labour Hours 1,86,000


Solution :

Calculation of Overheads Rates

50% 60% 70%Capacity Capacity Capacity

Rs. Rs. Rs.

Variable Overheads

Indirect Material 5,000 6,000 7,000

Indirect Labour 15,000 18,000 21,000

Semi Variable Overheads

Electricity 27,000 30,000 33,000

Repairs and Maintenance 2,900 3,000 3,100

Fixed Overheads

Depreciation 16,500 16,500 16,500

Insurance 4,500 4,500 4,500

Salaries 15,000 15,000 15,000

Total Overheads 85,900 93,000 1,00,100

Estimated Direct

Labour Hours 1,55,000 1,86,000 2,17,000

Overhead Rate

(Labour Hour Rate) Re.0.55 Re.0.50 Re.0.46

(13) A Factory can produce 60,000 units per annum at its 100% capacity. The estimatedcosts of production are as under.

Direct Materials Rs. 3 per unit.

Direct Labour Rs. 2 per unit

Indirect Expenses

Fixed Rs. 1,50,000 per annum

Variable Rs. 5 per unit

Semi-variable Rs. 50,000 per annum up to 50% capacity and anextra expenses of Rs. 10,000 for every 20% increasein capacity or part thereof.

The factory produces only against orders. If the production programme of the factory is asindicated below, and the management desires to ensure a profit of Rs.1,00,000 for the year,work out the average selling price at which each unit should be quoted.


For three months of the year - 50% capacity

Remaining nine months of the year - 80% capacity

Solution :Calculation of total cost

50% 80% Totalcapacity capacity capacity

Number of units produced 7,500 36,000 43,500

Direct Material - Rs. 22,500 1,08,000 1,30,500

Direct Labour - Rs. 15,000 72,000 87,000

Variable Expenses - Rs. 37,500 1,80,000 2,17,500

Fixed Expenses 37,500 1,12,500 1,50,000

Semi-Variable Expenses - Rs. 12,500 32,500 45,000

Total Cost 1,25,000 5,05,000 6,30,000

Thus, the total cost during the year is likely to be Rs.6,30,000. If it is desired to earn a profitof Rs. 1,00,000 the total amount to be covered by the units to be sold will have to be Rs.7,30,000(i.e. Rs. 6,30,000 + Rs. 1,00,000). As the total units produced are estimated to be 43,500,the above amount will have to be covered by 43,500 units. Hence, the average selling price perunit will be

Rs.7,30,000= Rs. 16.78 per unit (approx.)

43,500

Notes :

(1) It is assumed that whatever units are produced can be sold.

(2) It is assumed that the production and the incidence of all the indirect expenses is equallyspread during the year.

(3) From the following particulars, prepare a flexible budget for the three months ending30th September showing the estimated sales, sales cost and profit for 60%, 80% and100% activity. Assume that all items produced are sold.

Fixed Expenses Rs.

Management salaries 4,20,000

Rent and Taxes 2,80,000

Depreciation on machinery 3,50,000

Sundry office cost 4,45,000

14,95,000


Rs.Semi-variable expenses

at 50% capacity

Plant Maintenance 1,25,000

Indirect Labour 4,95,000

Salesmens’ Salary & Expenses 1,45,000

Sundry Expenses 1,30,000

8,95,000

Variable Expenses

at 50% capacity

Materials 12,00,000

Labour 12,80,000

Salesmens’ Commission 1,90,000

26,70,000

Semi-variable expenses remain constant between 41% and 70% activity, increase by 10% ofthe above figures between 71% and 80% activity and increase by 15% of the above figuresbetween 81% and 100% activity. Fixed expenses remain constant whatever may be the levelof activity. Sales at 60% activity are Rs.51,00,000, at 80% activity are Rs. 68,00,000 and at100% activity are Rs.85,00,000.

Flexible Budget

60% 80% 100%capacity capacity capacity

Rs. Rs. Rs.

(A) Sales 51,00,000 68,00,000 85,00,000

(B) Sales Cost

(1) Fixed Expenses

Management Salaries 4,20,000 4,20,000 4,20,000

Rent and Taxes 2,80,000 2,80,000 2,80,000

Depreciation on Machinery 3,50,000 3,50,000 3,50,000

Sundry office cost 4,45,000 4,45,000 4,45,000

14,95,000 14,95,000 14,95,000


60% 80% 100%capacity capacity capacity

Rs. Rs. Rs.

(2) Semi Variable Expenses

Plant Maintenance 1,25,000 1,37,500 1,43,750

Indirect Labour 4,95,000 5,44,500 5,69,250

Salesmens’ Salary and Expenses 1,45,000 1,59,500 1,66,750

Sundry Expenses 1,30,000 1,43,000 1,49,500

8,95,000 9,84,500 10,29,250

(3) Variable Expenses

Material 14,40,000 19,20,000 24,00,000

Labour 15,36,000 20,48,000 25,60,000

Salesman’s Commission 2,28,000 3,04,000 3,80,000

32,04,000 42,72,000 53,40,000

Total Sales Cost 1 + 2 + 3 55,94,000 67,51,500 78,64,250

(C) Profit A - B (4,94,000) 48,500 6,35,750

(15) Based on sales foreast for the season, C Ltd. has prepared the following productionscheme for the coming month.

30,000 units of Product A and 20,000 units of product B. the manufacturing specificationsfor the products are as follows.

Product A Product B

2 Kgs. Material X @ Rs. 3 3 Kgs. Material W Rs. 8

1/2 Kg. Material Y @ Rs. 2 3/4 Kg. Material Y @ Rs. 2

2 hours direct labour @ Rs. 20 11/2 hours direct labour @ Rs. 20

To the direct labour hours, a 5% allowance for idleness (accounted for as overheads) shouldbe added. Indirect labour time is estimated to be 5% of direct labour hours (excluding idleness)and the wage rate for indirect labour is Rs. 15. The overhead estimate (not shown above) is asfollows

Fixed Cost per month


Insurance Rs. 8,000

Superintendence Rs. 30,000

Rs. 1,07,000


Variable Costs :

Rs 8 per direct labour hour.

Note : This rate includes the cost of idle lime and indirect labour.

It is planned to increase the inventory of raw material X by 4,000 Kgs and to decrease theinventory of raw material W by 2,000 Kgs. as of the begining after next month.

You are required to prepare and estimate of the amount of cash necessary for manufacturingoperations of the coming month.

Assume that the materials and wages cost are paid in the month of purchase.

Solution :

Computation of Requirement of Cash

(A) For Raw Material : (Both Products A & B) Rs. Rs.

X - 60,000 Kgs @ Rs. 3 1,80,000

Y - 30,000 Kgs @ Rs. 2 60,000

W - 60,000 Kgs @ Rs. 8 4,80,000

7,20,000

Add : Increase in stock of X 4,000 kgs @ Rs. 3 12,000

7,32,000

Less : Decrease in stock of W 2,000 Kgs @ Rs. 8 16,000

7,16,000

(B) For Direct Wages

Product A - 60,000 hours @ Rs. 20 12,00,000

Product B - 30,000 hours @ Rs. 20 6,00,000

18,00,000

(C ) For Overheads

(1) Idle Time - 5% of 90,000 hours i.e.

4,500 hours @ Rs. 20 90,000

(2) Indirect Labour - 5% of 90,000 hours i.e.

4,500 hours @ Rs. 15 67,500

(3) Variable Costs - 90,000 hours @ Rs. 8 7,20,000

(4) Fixed Overheads 1,07,000

9,84,500

35,00,500


(16) A company is at present working at 90% of its capacity and producing 13,500 units per-annum. It operates a flexible budgetary control system. The following figures (excludingmaterial and labour cost) are obtained from its budget :

90% 100%

(a) Sales Rs. 15,00,000 16,00,000

(b) Fixed Expenses Rs. 3,00,500 3,00,500

(c) Semi-Fixed Expenses Rs. 97,500 1,00,500

(d) Semi-Variable Expenses Rs. 1,42,000 1,49,500

Material and Labour Cost per unit are constant under present conditions. Profit margin is10% at 90% capacity :

(a) You are required to determine the cost of producing an additional 1,500 units.

(b) What would you recommend for an export price for these 1,500 units taking intoaccount that overseas prices are much lower than indigenous prices?

Solution :

Cost Sheet

90% Capacity 100% Capacity

Variable Cost

Material / Labour 8,10,000 9,00,000

Variable portion of

Semi-Fixed Expenses 27,000 30,000

Variable portion of

Semi-Variable Expenses 67,500 75,000

a. Total Variable Cost 9,04,500 10,05,000

Fixed Cost

Fixed Expenses 3,00,500 3,00,500

Fixed portion of

Semi-Fixed Expenses 70,500 70,500

Fixed portion of

Semi-Variable Expenses 74,500 74,500

b. Total Fixed Cost 4,45,500 4,45,500

c. Total Cost (a+b) 13,50,000 14,50,500

d. Profit 1,50,000 1,49,500

e. Sales 15,00,000 16,00,000


Hence, the cost of producing 1,500 units will be Rs. 1,00,500 i.e. Rs. 14,50,500less Rs. 13,50,000. Recommended export price for these 1,500 units will be Rs. 67 i.e.Rs. 1,00,500 / 1,500.

Working Notes :

a. Semi-Fixed Expenses

With every 10% capacity increase, semi-fixed expenses increase by Rs. 3,000. Thismeans that variable portion of semi-fixed expenses is Rs. 3,000 for 10% capacity. For90% capacity it will be Rs. 27,000 and for 100% capacity, it will be Rs. 30,000.

b. Semi-Variable Expenses

With every 10% capacity increase, semi-variable expenses increase by Rs. 7,500. Thismeans that variable portion of semi-fixed expenses is Rs. 7,500 for 10% capacity. For90% capacity it will be Rs. 67,500 and for 100% capacity, it will be Rs. 75,000.

(17) Develope the proforma (estimated) income statement for the months of October, Novemberand December of Ajax Lunatics Ltd. from the following information.

(a) Sales are projected at Rs. 2,50,000, Rs. 3,00,000 and Rs. 2,00,000 for October,November and December respectively.

(b) Cost of goods sold is Rs. 75,000 plus 20% of sales per month.

(c) Selling Expenses are 3% of sales.

(d) Rent is Rs. 7,500 per month. Administrative Expenses is 15% of sales per month.

(e) The company has Rs. 3,00,000 at 10% loan-The interest is payable monthly.

(f) Corporate tax rate is 60%

Solution :

Proforma (Estimated) Income Statement of Ajax Lunatics Limited.

October November December

(A) Sales 2,50,000 3,00,000 2,00,000

(B) CostCost of goods sold 1,37,500 1,50,000 1,25,000

Selling Expenses 7,500 9,000 6,000

Rent 7,500 7,500 7,500

Administretive Expenses 37,500 45,000 30,000

Interest on Loan 2,500 2,500 2,500

Total Cost 1,92,500 2,14,000 1,71,000

(C ) Profit before tax (A - B) 57,500 86,000 29,000

(D) Income Tax - 60% of C 34,500 51,600 17,400

(E) Profit after tax (C - D) 23,000 34,400 11,600


(18) M/s. Agarval fabricating and Manufacturing Co. Ltd. is presently working at 50% capacity,producing and selling, 1,000 units of a product. You are required to find out the profits theconcern will make by working at 60% and 80% capacity.

At 50% capacity, the selling price is Rs. 200 per unit. Whereas the product cost isRs. 160 as given below.

Rs.

Materials Cost 80

Direct wages 30

Factory overheads 30 (of which 60% is variable)

Selling and Admn. overheads 20 (of which 50% is fixed).

At 60% capacity, material prices go up by 10% and selling price reduced by 5%.

At 80% capacity, there is increase in labour cost by 10% and variable factory overheadsgo up by Rs. 2 per unit. The variable selling and administration overheads increase byRe. I per unit, the other costs and selling price remain unchanged as at 60%.

Flexible Budget

50% 60% 80%Capacity Capacity Capacity

(A) Number of units sold 1,000 1,200 1,600

Selling Price per unit Rs. 200 190 190

Sales Rs. 2,00,000 2,28,000 3,04,000

(B) Cost Rs.

(1) Materials Cost 80,000 1,05,600 1,40,800

(2) Direct Wages 30,000 36,000 52,800

(3) Variable Overheads

Factory 18,000 21,600 32,000

Selling & Administration 10,000 12,000 17,600

(4) Fixed Overheads

Factory 12,000 12,000 12,000

Selling & Administration 10,000 10,000 10,000

Total Cost 1,60,000 1,97,200 2,65,200

(C) Profit i.e. A - B 40,000 30,800 38,800


QUESTIONS

1. What do you mean by Budget and Budgetary Control? What are the advantages ofBudgetary Control as a cost control technique? What are the prerequisites for thesuccessful implementation of Budgetary Control System?

2. What is the meaning of Budget and Budgetary Control. State and explain various budgetswhich can be established in the following functional areas of operation -

a) Sales/Marketing

b) Production

c) Finance

3. Write short notes on -

a) Budget Manual

b) Fixed and Flexible Budgets

c) Cash Budget


PROBLEMS

(1) The sales manager of a manufacturing company expects to sell 25,000 units of a certainproduct.

The production director provides the following information. Two kinds of raw materials Xand Y are required for each unit of final product and 2 units of X and 3 units of Y arerequired for one unit of final product. The estimated opening balance at the commencementof next year are-

Final product - 5,000 units

X - 6,500 units

Y - 8,000 units

The desirable closing balance at the end of next year are -

Final Product - 7,000 units

X - 6,500 units

Y - 8,000 units

Draw the production budget for the next year.

(2) A Ltd. manufactures two products X and Y making the use of following raw materials inthe proportion shown.

Raw material Product X Product Y

Rl 80%

R2 20%

R3 50%

R4 50%

The finished weight of products X and Y are equal in weight of their ingredients. During amonth, it is expected that 1200 kgs. of X and 4000 kgs of Y will be sold.


Actual and budgeted inventories for the month are as below.

Material Actual Opening Stock Budgeted Closing Stock

Kgs. Kgs.

R 1 300 400

R 2 200 800

R 3 4000 6000

R 4 5000 4000

X 200 100

Y 1000 1200

The purchase price of materials is expected to be as below.

Cost Per Kg.

Rs.

R 1 50

R 2 40

R 3 10

R 4 20

All materials will be purchased on 1st of the month.

Prepare -(a) Production Budget.

(b) Purchases Budget.

(3) A Ltd. produces a standard product. The estimated cost per unit in given below.

Rs.

Raw materials 10

Direct wages 8

Direct Expenses 2

Variable Overhead 5

Fixed overheads are estimated to Rs. 70,000 selling price per umt is Rs. 40. Prepare aflexible budget at 50%, 70% and 90% level of activity. Assume that output at 100% levelof activity is 10,000 units.


(4) The following expenses relate to a cost centre operating at 80% of normal capacity(Sales are Rs.1,20,000) Draw up flexible Administration, Selling and Distribution costsbudget operating at 90%, 100% and 110% of normal capacity.

Administration Costs

Office Salaries Rs. 3,000

General Expenses 1.5% of sales


Rates and Taxes Rs. 1,750

Selling Costs

Salaries 4% of sales

Travelling Expenses 1.5% of sales

Sales Office Expenses 1% of sales

General Expenses 1% of sales

Distribution Costs

Wages Rs.3,000

Rent 0.5% of sales

Other Expenses 2% of sales

(5) The expenses budgeted for production of 10,000 units in a factory are furnished below.

Per Unit

Rs.

Materials 70

Labour 25

Variable Overheads 20

Fixed Overheads ( Rs.1,00,000) 10

Variable Expenses (Direct) 5

Selling Expenses (10% Fixed) 13

Distribution Expenses (20% Fixed) 7

Adinimstrative Expenses (Rs.50,000) 5

Total Cost of sale per unit 155

(to make and sale)

Prepare a budget for the production of

a. 8,000 units and b. 6,000 units.


Assume that administrative expenses are rigid for all levels of production.

(6) Following are the actuals for the year 1985.

Rs.

Sales 20,000 units @ Rs.3 per unit 60,000

Raw Material 26,500

Direct Labour Cost 5,000

Variable Overheads 8,000

Fixed Overheads 10,000

The management expects following estimate in 1986. Sales to increase to 30,000 units,selling price remaining unchanged. Raw materials prices increase by 10%, wage rate toincrease by 10% but labour productivity improves by 5%.

Fixed overheads are expected to increase by Rs. 2,000. You are required to prepare thebudget for 1986.

(7) Production costs of a factory for a year are as follows.

Direct Wages Rs. 90,000

Direct Materials Rs. 1,20,000

Production Overheads :

Fixed Rs. 40,000

Variable Rs. 60,000

During the forthcoming year, it is anticipated that :

(a) The average rate for direct labour remuneration will fall from 90 paise to 75 paise perhour.

(b) Production efficiency will be reduced by 5%.

(c) Price per unit of direct material and other materials and services which compriseoverheads will remain unchanged and

(d) Direct labour hours will increase by 33 1/3.

Draw up a budget and compute a factory overhead rate, the overheads being absorbedon a direct wages.

(8) ABC Ltd. manufacturing a single product is facing a severe competition in selling atRs. 50 per unit. The company is operating at 60% level of activity at which level sales areRs. 12,00,000. Variable costs are Rs.30 per unit. Semi variable costs may be considered


as fixed at Rs. 90,000 when output is nil and variable element is Rs.250 for each additional1% level of activity. Fixed costs are Rs, 1,50,000 at the present level of activity, but at thelevel of activity of 80% or above if reached, these costs are expected to increase byRs.5,000.

To cope with the competition, the management of the company is considering a proposalto reduce the selling price by 5%. You are required to :

(a) Prepare a statement showing the operating profit at levels of activity of 60%, 70%and 80%. Assuming that the selling price remains at Rs.50 per unit.

(b) If selling price is reduced by 5%, show the number of units which will be required tobe sold to maintain the present profits.

(9) A company, producing electronic watches, estimates the following factory overheadscosts for producing 5,000 Units

Indirect Materials Rs. 16,000

Indirect Labour Rs. 30,000

Inspection Cost Rs. 16,000

Heat, light & power Rs. 8,000

Expendable tools Rs. 8,000

Supervision Costs Rs. 8,000

Equipment depreciation Rs. 4,000

Factory Rent Rs. 4,000

Indirect labour, indirect material and expendable tools are entirely variable. Heat, lightand power and inspection costs are variable to the extent of 50% and 40% respectively.Other costs are fixed costs for a month. Prepare a flexible budget for overheads forproduction of 4,000 and 6,000 units per month. Also find out the average factory overheadsper unit for these two production levels.

(10) Anil and Avinash Enterprises is currently working at 50% capacity and produces 10,000units. Estimate the profits of the company when it works at 60% and 70% capacity.

At 60% capacity, the raw materials cost increases by 2% and the selling price fallsby 3%. At 70% capacity the raw materials cost increases by 4% and selling price fallsby 5%.

At 50% capacity, the product costs Rs. 180 per unit and is sold for Rs.200 per unit.


The unit cost of Rs. 180 is made up as below.

Materials cost Rs. 100

Wages Rs. 30

Factory overheads Rs. 20 (40% Fixed)

Administration overheads Rs. 30 (50% fixed)

(11) ABC Ltd. manufactures a single product for which market demand exists for additionalquantity. Present sale of Rs. 60,000 per month utilities only 60% capacity of the plant.Sales Manager assures that with a reduction of 10% in the price, he would be in aposition to increase the sale by about 25% to 30% .

The following data are available.

(a) Selling price - Rs. 10 per unit

(b) Variable cost - Rs. 3 per unit

(c) Semi-variable cost - Rs. 6,000 plus Rs.0.50 per unit

(d) Fixed coct - Rs. 20,000 at present level, estimated to be Rs.24,000at 80% output.

You are required to submit the following statements to the Board showing.

(1) The operating profits at 60%, 70% and 80% levels at current selling price and atproposed selling price.

(2) The percentage increase in the present output which will be required to maintainthe present profit margin at the proposed selling price.

(12) A manufacturing company has an installed capacity of 1,20,000 units per annum. Thecost structure of the products manufactured is as under :

(i) Variable Cost ( Per Unit)

Materials Rs. 8

Labour Rs. 8

(Subject to a minimum of Rs.56,000 per month)

Overheads Rs. 3

(ii) Fixed overheads are Rs. 1,04,000 per annum.

(iii) Semi variable overheads Rs.48,000 per annum at 60% capacity, which will increaseby Rs.6000 per annum for increase of every 10% of the capacity utilization or anypart thereof.


The capacity utilization for the next year is estimated at 60% for 2 months, 75% for 6months and 80% for the balance part of the year. If the company is planning to have aprofit of 25% on the selling price, calculate the estimated selling price for each unit ofproduction. Assume there is no opening or closing stock.

(13) The monthly budgets for manufacturing overhead of a concern for two levels of activitywere as follows -

Capacity 60% 100%

Budgeted Production (units) 600 1000

(Rs.) (Rs.)

Wages 1,200 2,000

Consumable Stores 900 1,500

Maintenance 1,100 1,500

Power and Fuel 1,600 2,000

Depreciation 4,000 4,000

Insurance 1,000 1,000

9,800 12,000


a. Indicate which of the items are fixed, variable and semi-variable.

b. Prepare a budget for 80% capacity.

c. Find out the total cost, both fixed and variable, per unit of output at 60%, 80% and100% capacity.

(14) From the following data, prepare a flexible budget for the production of 40,000 units,60,000 units and 75,000 units, distinctly showing variable and fixed costs as well astotal costs. Also indicate element wise cost per unit.

Budgeted output and budgeted cost per unit

Budgeted output 100000 units

Per unit cost Rs.

Direct Material 90

Direct Labour 45

Direct Variable Expenses 10

Manufacturing Variable Overheads 40

Fixed Production Overheads 5

Administration Overheads (Fixed) 5

Selling Overheads 10 (10% fixed)

Distribution Overheads 15 (20% fixed)


(15) The budget manager of Progressive Electrical Limited, is preparing a flexible budget forthe accounting year commencing 1st April 1995. The company produces one product -a component - Kaypee. Direct Material costs Rs. 7 per unit. Direct Labour averagesRs. 2.50 per hour and requires 1.60 hours to produce one unit of Kaypee. Salesmen arepaid a commission of Re. 1 per unit sold. Fixed selling and administration expensesamount to Rs. 85,000 per year.

Manufacturing overheads under specified conditions of volume have been estimated asfollows -

Volume of Production (units) 1,20,000 1,50,000

Rs. Rs.

Indirect Materials 2,64,000 3,30,000

Indirect Labour 1,50,000 1,87,500

Inspection 90,000 1,12,500

Maintenance 84,000 1,02,000

Supervision 1,98,000 2,34,000

Depreciation 90,000 90,000

Engineering Services 94,000 94,000

Total Manufacturing Overheads 9,70,000 11,50,000

Normal capacity of production of the company is 1,25,000 units. Prepare a budget oftotal cost at 1,40,000 units of output.

(16) Excellent Manufacturers can produce 4000 units of a certain product at 100% capacity.The following information is obtained from the books of accounts -

June 94 July 94Units produced 2,800 3,600

Rs. Rs.Repairs and Maintenance 500 560Power 1,800 2,000Shop Labour 700 900Consumable Stores 1,400 1,800Salaries 1,000 1,000Inspection 200 240Depreciation 1,400 1,400

The rate of production is 10 units per hour. Direct Materials cost is Re. 1 and DirectWages per hour is Rs. 4. You are required to -


a. Compute the cost of production at 100%, 80% and 60% capacity showing thevariable, fixed and semi-fixed items under the flexible budget.

b. Find out the overhead absorption rate per unit at 80% capacity.

(17) The following data are available for a manufacturing company for a yearly period -

Rs. in LakhsFixed Expenses -

- Wages and Salaries 9 .5

- Rent, Rates and Taxes 6.6

- Depreciation 7.4

- Sundry Administrative Expenses 6 .5Semi-Variable Expenses (at 50% capacity)

- Maintenance and Repairs 3 .5

- Indirect Labour 7 .9

- Sales Department Salaries 3 .8

- Sundry Administrative Salaries 2.8Variable Expenses (at 50% capacity)

- Material 21.7

- Labour 20.4

- Other Expenses 7.9

98.0

Assume that the fixed expenses remain constant at all levels of production, semi-variableexpenses remain constant between 45% and 65% of capacity increasing by 10% between65% and 80% capacity and by 20% between 80% and 100% capacity.

Sales at various levels are -

Rs. in Lakhs

50% capacity 100

60% capacity 120

75% capacity 150

90% capacity 180

100% capacity 200

Prepare a flexible budget for the year at 60% and 90% capacities and estimate theprofits at these levels of output.


(18) A factory is currently running at 50% capacity and produces 5,000 units at a cost ofRs. 90/- per unit as per details below :

Rs.

Material 50

Labour 15

Factory overheads 15 (Rs. 6/- fixed)

Administrative overheads 10 (Rs. 5/- fixed)

The current selling price is Rs. 100/- per unit.

At 60% working, material cost per unit increases by 2% and selling price per unit fallsby 2%.

At 80% working, material cost per unit increases by 5% and selling price per unit fallsby 5%.

Estimate profits of the factory at 60% and 80% working and offer your comments.

(19) On 30th September 1990, the Balance Sheet of Melodies Pvt. Ltd. retailers of musicalinstruments, was as under -

Liabilities Rs. Assets Rs.

Ordinary shares of Rs.10 Equipment (at cost) 20,000

each fully paid 20,000 Less : Depreciation 5,000

Reserves and surplus 10,000 15,000

Trade Creditors 40,000 Stock 20,000

Proposal Dividend 15,000 Trade Debtors 15,000

Balance at Bank 35,000

85,000 85,000

The company is developing a system of forward planning and on 1st October 1990, itsupplies the following information.

Credit Sales Cash Sales Credit PurchasesRs. Rs. Rs.

Sept. 90 (Actual) 15,000 14,000 40,000

Oct. 90 (Budget) 18,000 5,000 23,000

Nov. 90 (Budget) 20,000 6,000 27,000

Dec. 90 (Budget) 25,000 8,000 26,000

All trade debtors are allowed one month’s credit and are expected to settle promptly. Alltrade creditors are paid in the month following delivery.


On 1st October 1990, all the equipment was replaced at a cost of Rs. 30,000.Rs. 14,000 was allowed in exchange for the old equipment and a net payment ofRs. 16,000 was made. Depreciation is to be allowed at the rate of 10% per annnm. Theproposed dividend will be paid in December 1990.

The following expenses will be paid-

Wages Rs. 3,000 per month.

Administration Rs. 1500 per month.

Rent Rs. 3600 for the year to 30th September 1991 (to be paid in October, 1990)

The gross profit percentage on sales is estimated at 25%.

You are required -

(1) To prepare cash budget for the months of October, November and December.

(2) To prepare Income Statement for the three months ended 31st December 1990.

(20) Develop Performa income statement for the months of July, August and September for acompany for the following information.

(a) Sales are projected at Rs. 2,25,000, Rs. 2,40,000 and Rs. 2,15,000 for July, Augustand September respectively.

(b) Cost of goods sold is Rs.50,000 plus 30% of selling price per month.

(c) Selling Expenses are 3% of sales.

(d) Rent is Rs. 7,500 per month, administrative expenses for July are expected to beRs. 60,000 but are expected to rise 1% per month over the previous month’sexpenses.

(e) The company has Rs.3,00,000 of 8% loan interest payable monthly.

(f) Corporate Tax rate is 70%.

(21) The projected sales and purchases of ABC Ltd. for the months July to November 1983are

Sales (Rs.) Purchases (Rs.)

July 6,20,000 3,80,000

August 6,40,000 3,33,000

September 5,80,000 3,50,000

October 5,60,000 3,90,000

November 6,00,000 3,40,000


The wages are expected to be Rs.100,000 per month. The management is expected topay two months wages as bonus during October 1983. The company is expected to payadvance income tax Rs. 90,000 before 15th September 1983. The company has orderedin June 1983 for a machine costing Rs. 16,00,000. The Bank has agreed to finance thepurchase of the machine which is expected to be delivered in January 1984. The companyhas advanced 5% in June 1983 and they have agreed to pay another 10% advance after3 months. The company extends 2 months credit for the customers and enjoys onemonth credit from the suppliers. The general expenses for the company is Rs.60,000 permonth payable at the end of each month. The company anticipates to receive dividendsof 10% for the investments of 90,000 shares of Rs. 10 each during October 1983.

The company anticipates to have an overdraft of Rs. 40,000 on 1st September 1983(limit sanctioned is Rs. 55,000). Draw a cash budget for September 83 to November 83for approaching bankers for a short term further credit.

(22) From the following budgeted data of ABC Ltd., prepare cash budget for the quarterending 31st December 1984.

Month Sales Purchases Wages Misc. Exp.

August 1,20,000 84,000 10,000 7,000

September 1,30,000 1,00,000 12,000 8,000

October 80,000 1,04,000 8,000 6,000

November 1,16,000 1,06,000 10,000 12,000

December 88,000 80,000 8,000 6,000

Additional information :

Cash on hand on 1,10.84 Rs. 5,000

Sales – 20% realised in the month of sale. Discount allowed 2%. Balance realised insubsequent month.

Purchases - These are paid in the following the month of supply.

Wages - 25% in arrears paid in the following month.

Misc. Expenses - Paid a month in arrears.

Rent - Rs.1,000 per month paid quarterly in advance, due in October.

Income Tax - Instalments of Rs. 25,000 due on or before 15.12 84.

Income from investment - Rs. 5,000 received quarterly April, July, October etc.

Insurance claim - Rs. 72,936 receivable in December.


(23) A firm expects to have to Rs. 30,000 in Bank on 1.10.86 and requires you to prepare anestimate of cash position during the three months October 86 to December 86. Thefollowing information is supplied to you.

Month Sales Purchases Wages Factory Office SellingExp. Exp. Exp.

Rs. Rs. Rs. Rs. Rs. Rs.

August 40,000 24,000 6,000 3,000 4,000 3,000

September 46,000 28,000 6,500 3,500 4,000 3,500

October 50,000 32,000 6,500 4,000 4,000 3,500

November 72,000 36,000 7,000 4,000 4,000 4,000

December 84,000 40,000 7,250 4,250 4,000 4,000

Other information :

(1) 25% of the sales are for cash, remaining amount in the month following that of sale.

(2) Suppliers supply goods at 2 months credit.

(3) Delay in the payment of wages and all other expenses one month.

(4) Income Tax of Rs.l0,000 is due to be paid in December.

(5) Preference shares dividend of 10% on Rs.l ,00,000 is to be paid in October.

(24) Mr. Ashok Kumar, the Finance Manager of Mazumdar Castings Ltd. is preparing thecash budget for the first six months of 1982, on the basis of the following information :

(i) Costs and Price remains unchanged.

(ii) Out of the total sales, cash sales are 25%, the balance being credit sales. 60% ofthe credit sales are collected in the month after sales, 30% are collected in thesecond month, and the balance 10% in the third month after sale. He does notexpect any bad debts.

(iii) The Gross Profit Margin is expected to be 20%

(iv) Actual sales and forecast sales are as follows :

Oct. 81 Rs. 12,00,000 Mar. 82 Rs. 8,00,000

Nov. 81 Rs. 14,00.000 April 82 Rs. 12,00,000

Dec. 81 Rs. 16,00,000 May 82 Rs. 12,00,000

Jan. 82 Rs. 8,00,000 Jun. 82 Rs. 8,00,000

Feb. 82 Rs. 8,00,000 Jul. 82 Rs. 10,00,000


(v) Anticipated Cash Purchases, there being no Credit Purchases:

Jan 82 Rs. 6,40,000 April 82 Rs. 9,10,000

Feb. 82 Rs. 7,00,000 May 82 Rs. 6,40,000

Mar. 82 Rs. 10,00,000 Jun. 82 Rs. 9,60,000

(vi) Wages and salaries to be paid in cash :

Jan 82 Rs. 1,40,000

Feb. 82 Rs. 1,60,000

Mai. 82 Rs. 2,00,000

Apr. 82 Rs. 2,20,000

May 82 Rs. 1,60,000

Jun 82 Rs. 1,40,000

(vii) Interest on 20,00,000 8% Debentures was due on June 30, 1982 (half yearly)

(viii) Excise deposit due on March 31, 1982 Rs. 3,00,000.

(ix) Acquisition of plant and equipment planned for May 1982 Rs. 10,00,000.

(x) Miscellaneous Expenses on a cash basis every month at Rs. 15,000 plus 10% ofsale.

(xi) The company will have a cash balance of Rs. 5,00,000 on 31.12,81. Mr. AshokKumar believes that this is a high level and is planning on a continuous balance ofRs. 4,00,000

(a) Prepare the Cash budget for six months to June 1982 .

(b) If additional finance is required, recommend the type of finance to be obtained.

(25) A company has its cost of goods of 70% of its sales, 70% of this cost is paid in themonth of the sale and the balance in the next month. Salary and administrative expensesamount to Rs. 40,000 per month plus 5% of sales. These expenses must be paid duringthe month following the month when expenses are actually incurred . The company hasalso 10% Debentures of Rs. 1,50,000 and interest has to be paid in 4 quarters fromJanuary onwards. The company gives its actual and forecast sales as below.

Actual Sales Rs. Forecast sales Rs.

January 2,00,000 May 2,00,000

February 2,00,000 June 2,50,000

March 3.00,000 July 2,50,000

April 3,00,000 August 3,00,000


You are required to prepare a cash flow schedule for six months from March onwards.

(26) Following details are available in case of Pam Industries Ltd.

Actual Sales Rs. Estimated sales Rs.

January 65,000 May 1,05,000

February 75,000 June 1.20,000

March 90,000 July 1,25,000

April 80,000 August 1,35,000

Consider the following additional information :

(1) Cash sales are 50 per cent of the total sales. The remaining 50 per cent will becollected equally during the following two months.

(2) Cost of goods manufactured is 70 per cent of sales. 90 per cent of this cost is paidduring the first month after incurrence and the balance is paid in the followingmonth.

(3) Sales and administrative expenses are Rs. 15,000 per month plus 10 per cent ofsales. All these expenses are paid during the month of incurrence.

(4) Half- yearly interest of 6 per cent on Rs. 4,50,000 Debentures is paid during July.

(5) Rs. 60,000 are expected to be invested in fixed assets during July.

(6) A dividend of Rs. 15,000 will be paid in July.

(7) An income tax of Rs. 15,000 will be paid in July.

It is the policy of the company to have a minimum cash balance of Rs. 30,000/-.Accordingly as on 30th April, the actual cash balance was Rs. 30,000/-.

The Management wishes to know whether it will be required to borrow during the quarterending on 31st July and if so when and how much.

(27) Prepare a cash budget for the three months ending 30th June 1986 from the informationgiven below.

(a) Month Sales Materials Wages OverheadsRs. Rs. Rs. Rs.

February 14,000 9,600 3,000 1,700

March 15,000 9,000 3,000 9,900

April 16,000 9,200 3,200 2,000

May 17,000 10,000 3,600 2,200

June 18,000 10,400 4,000 2,300


(b) Credit terms are :

Sales/Debtors - 10% of sales are on cash, 50% of the credit sales are collectednext month and balance in the month following

Creditors - Materials - 2 months

Wages - 1/4 month

Overheads - 1/2 month

(c) Cash and Bank balance on 1st April 1986 is expected to be Rs.6,000.

(d) Other relevant information :

(i) Plant and Machinery will be installed in February 1986 at a cost of Rs. 96,000. Themonthly instalments of Rs. 2,000 is payable from April onwards.

(ii) Dividend @ 5% on preference share capital of Rs.2,00,000 will be paid on 1st June.

(iii) Advance to be received for sale of vehicle Rs. 9,000 in June.

(iv) Dividends from investment amounting to Rs. 1,000 expected to be received in June

(v) Income Tax advance is to be paid in June - Rs. 2,000.

(28) Prepare a cash budget of XYZ Ltd. on the basis of the six months commencing fromApril 1989.

(1) Cost and prices remain unchanged.

(2) Cash sales are 25% of the total sales and balance 75% will be credit sales.

(3) 60% of credit sales are collected in the month following the sales, balance 30%and 10% in the two following months thereafter. No bad debts are anticipated.

(4) Sales forecasts are as follows - (Rs. in lakhs)

Jan. 89 - 12 Feb. 89 - 14 March 89 - 16

April 89 - 6 May 89 - 8 June 89 - 8

July 89 - 12 August 89 - 10 Sept. 89 - 8

Oct. 89 -12

(5) Gross Profit margin 20%

(6) Anticipated purchases - (Rs. in lakhs)

April 89 - 6.40 May 89 - 6.40 June 89 - 9.60

July 89 - 8.00 August 89 - 6.40 Sept. 89 - 9.60


(7) Wages and Salaries to be paid - (Rs. in lakhs)

April 89 - 1.20 May 89 - 1.60 June 89 - 2.00

July 89 - 2.00 August 89 - 1.60 Sept. 89 - 1.40

(8) Capital expenditure for plant and machinery planned for September 1989 isRs. 1,20,000.

(9) Company has a cash balance of Rs. 4,00,000 as at 31st March, 1989 and willmaintain it in future also at minimum level.

(10) The Company can borrow on monthly basis.

(11) Rent is Rs. 8,000 per month.

(29) Lal and Company has given the forecast sales for January 1989 to July 1989 and actualsales for November and December 1988 as under. With the other particulars given,prepare a Cash Budget for the five months i.e. from January 1989 to May 1989.

(1) Sales

November 88 1.60 Lakhs April 89 2.00 Lakhs

December 88 1.40 Lakhs May 89 1.80 Lakhs

January 89 1.60 Lakhs June 89 2.40 Lakhs

February 89 2.00 Lakhs July 89 2.00 Lakhs

March 89 1.60 Lakhs

(2) Sales 20% cash and 80% credit, payable in the third month (January sales inMarch).

(3) Variable expenses 5% on turnover, time lag half month.

(4) Commission 5% on credit sales payable in the third month.

(5) Purchases being 60% of the sales of the third month, payment will be made on 3rdmonth of purchases.

(6) Rent and other expenses Rs. 6,000 paid every month.

(7) Other Payments -

Fixed Assets Purchases - March Rs. 1,00,000

Taxes - April Rs. 40,000

(8) Opening cash balance Rs. 50,000


NOTES

493Standard Costing

Chapter 13STANDARD COSTING

INTRODUCTION :

The determination of the actual cost on the basis of various costing records maintained is nodoubt important, but such actual cost (or historical cost) involves some limitations as to itsutility.

(1) The actual cost information is available only after the completion of the job, process orservice and hence is of no practical utility from control point of view, as no basis isprovided with which the actual costs can be compared.

(2) There are various kinds of managerial decisions where cost is an inevitable basis E.g.price fixation or submission of quotations. However if the details of actual cost are availabletoo late, such cost details are of no practical utility for the purpose of price fixation orsubmission of quotation.

(3) The actual costs may be affected due to the inefficient functioning. The actual costs maybe excessive due to abnormal expenses, avoidable wastes, inefficient use of labour andexcessive use of materials. As such, actual costs are not useful for providing a yardstickfor measuring efficiency of performance.

(4) Actual costing is comparatively expensive as it involves the maintenance of variousrecords and documents. The above stated limitations involved with the determination ofactual costs has given rise to the technique of standard costing.

CONCEPT OF STANDARD COST AND STANDARD COSTING :

The term ‘standard cost’ has been defined as a pre-determined cost which is calculated fromthe management’s standards of efficient operation and the relevant necessary expenditure.

The term ‘standard costing’ has been defined as ‘the preparation and use of standard costs,their comparison with actual costs and the measurement and analysis of variances to theircauses and points of incidence.’


Thus, standard cost is the normal cost under the ideal circumstances. It may be used as abase for the purpose of price fixation and submission of quotations. Moreover, the standardswhen compared with the actual cost may also be used as tools for cost control and as ayardstick for measuring efficiency of performance, which is possible with standard costingsystem. As such, the process of standard costing involves the following stages.

(1) Predetermination of technical data related to production i.e. details of materials andlabour operations required for each product, the quantum of inevitable losses, level ofactivity etc.

(2) Predetermination of standard costs in full details under each element of cost i.e. Labour,Material and Overhead.

(3) Comparison of actual performance and costs with standards and working out the variancesi.e. the difference between the actual and the standards.

(4) Analysis of variances in order to determine the reasons for deviations of actuals from thestandards.

(5) Presentation of information to the appropriate level of management to enable suitableaction being taken, or revision of standards.

It should be noted in this connection that standard costing is not a separate system ofaccounting but only a technique used with the intention of controlling the costs. Though it canbe used in case of all methods of costing like job costing, process costing etc.; it can be moreeffective in case industries producing the standard products on continuous basis.

Advantages of standard costing :

(1) Standard costing provides a yardstick with reference to which the efficiency/inefficiencyin performance may be established. This facilitates the basic management function ofcost control.

(2) Standard costing provides the incentive and motivation to work with greater effort forachieving the standard.

(3) Standard costs may be used as the basis for the process of price fixation, filing thetenders and offering the quotations. If the prices are to be quoted on cost plus basis,actual costs may not be available in which case standard costs can be the base forfixation of selling prices.

(4) Standard costing system facilitates delegation of authority and fixation of responsibilityfor each individual or department. This also tones up the general organization of theconcern.

495Standard Costing

(5) Variance analysis and reporting is based on the principle of management by exception.The top management may not be interested in details of actual performances but only inthe variations from the standard, so that corrective measures may be taken in time.

(6) When constantly reviewed, the standards provide means for and encourage action forcost reduction. Focus on out of control situations, leads to cost reduction through theimproved methods, improved quality of products, better material and workers, effectiveselection and use of capital resource etc.

(7) A properly laid down system of standard costing may facilitate the correct implementationof the technique of budgetary control which also is a good system of cost control.

Limitations of standard costing :

(1) Establishment of standard costs is difficult in practice. Even though, standards are fixedafter defining properly, there is no guarantee that the standards established will have thesame tightness or looseness as envisaged.

(2) In the course of time, even in a short period, the standards become rigid. It may not bepossible to maintain the standards to keep pace with the changes in manufacturingconditions. Revision of standards is costly.

(3) Sometimes, standards set create adverse effects. If standards are set tightly and thereis non-achievement of the same, it creates frustration.

(4) The standard costing may not be suitable in all types of organizations e.g.

(i) In case of small concerns- Where the production cannot be properly scheduled. Insmall concerns, personal contacts may be more effective than the standard costing.

(ii) In case of industries having non-standardized products.

(iii) In case of industries having repair jobs which keep changing as per customerrequirements.

(iv) In case of industries where products take more than one accounting period tocomplete e.g. contract jobs.

(5) Due to the play of random factors, it may be difficult to properly examine the varianceand distinguish between controllable and uncontrollable variances. e.g. Adverse labourtime variance may be due to poor grade of labour, poor quality of material, defective plantand machinery and lack of trained workers.

(6) Lack of interest in standard costing on the part of the management makes the systemineffective and can’t be used as a proper means of cost control.


Standard costing and budgetary control compared :

Both standard costing and budgetary control are the best possible tools available to themanagement for the purpose of controlling the costs. Both the techniques involve the processof setting the targets or standards, measurement of actual performance, comparison of actualperformance with targets or standard set, computation and analysis of variations and theattempts to maintain favorable variations and remove unfavorable variations. The technique ofbudgetary control can be used effectively if the system of standard costing is prevailing. Thus,both the techniques complement each other but are not necessary dependent upon eachother. On the other hand, in spite of the various similarities, both the techniques differ fromeach other in certain respects.

(1) System of budgetary control may be operated even if no standard costing system is inuse in the concern.

(2) Budgets are the ceilings or limits on expenses above which actual expenditure shouldnot normally exceed and if it does, the planned profits will be reduced. Standard costsare minimum targets to be attained by the actual performance.

(3) Budgets may be prepared in the various areas of activities like sales, production,purchases, capital investment etc. Whereas standard costing specifically relates to thefunction of production and manufacturing costs.

(4) A more searching analysis is required to be made in case of standard costing variancesthan in case of budgetory control variances. Variances in case of budgets may point outefficiency or inefficiency. But variances in case of standard costing provide material forfurther probe and investigation.

(5) The scope of standard costing is much wide than that of budgetary control. Adherenceto budgeted performance may indicate that the business is out of difficulties. A genuineattempt to attain the standards always provides the scope for improved performance.

(6) Budgets are based upon the future or estimated costs which may be used for forecastingthe requirements of various factors of production like material, labour, finance etc. Standardcosts are planned or ideal costs under the ideal situations as to operating efficiency,capacity level attainment and so on. Standard costs may not be necessarily useful forforecasting purposes.

Preliminaries for Establishing Standard Costing System :

Before the standard costing system is established in an organization, the following preliminarieswill have to be complied with.

497Standard Costing

(1) Establishment of cost centres :

As explained before, a cost centre is any unit with respect to which the costs will beascertained. If the standard costing system is to be implemented, the cost centresshould be defined very clearly so that the responsibility can be fixed in case of nonstandard performance.

(2) Design of Accounts :

As the standard costing essentially involves the process of comparing the actualperformance to standard performance and computation of variances therefrom, theaccounts should be designed in such a way that the information about the actualperformance is available as correctly as possible and as speedily as possible. For thispurpose, the codification of accounts may be considered.

(3) Establishment of standards :

This is probably the most critical part of the implementation of standard costing i.e. toestablish the standards with respect to the individual elements of cost i.e. Direct MaterialCost, Direct Labour Cost and Overheads. It is necessary to exercise maximum carewhile establishing the standards as wrongly established standards may defeat the purposeof standard costing.

Following steps are involved in the process of establishing the standards.

(a) Study of technical and operational details of the organization like the manufacturingprocess, levels of managements and their responsibilities, units and nature of inputs andoutputs, details regarding wastes and losses, expected efficiency and capacity utilizationetc.

(b) Study of existing cost accounting systems and formats in use.

(c) Decision about the types of standards to be used. It may be noted that there may bevarious types of standards.

Basic Standards :

These are established for an unaltered use over a longer period of time and they don’t reflectthe current conditions. These types of standards are not useful from the cost control point ofview and can be used in case of industries where technical processes are fully established orin case of those types of costs which are fixed in nature viz. rent, remuneration to managerialpersonnel etc.


Current Standards :

These are established for a shorter period of time and are adaptable to change in currentconditions. As current conditions are likely to change, the current standards are also subjectto revision as per the changes in current conditions.

Current standards may be of three types.

Ideal Standards :

These are the standards which are set which are attainable under the most favourable conditionspossible and assumes the maximum utilization of various factors of production (like men,material and machines) which is not practicable and attainable. Thus, the ideal standards aregenerally theoretical in nature and the variances always show an unfavorable trend. The basiclimitation of these types of standards is that the constant non achievement of these standardscauses frustration among the staff and the constant reporting of unfavorable variances ispresumed which results into lost impact of system itself.

Expected Standards :

These are the standards which are anticipated to be attained during the budget period. Theseare based upon the expected performance based upon the conditions which are likely toprevail during the budget period. Allowances are provided for the unavoidable deviations fromthe ideal performance e.g. Labour time wastage, excess material use, break down of machineryetc. Thus, these standards are more realistic in nature and are more useful from cost controlpoint of view.

Normal Standards :

These are the standards which may be anticipated to be achieved in future, over a longerperiod of time, considering the past performance. As such, the inefficiencies of the pastperformance, if any, get reflected in these types of standards. Further, the problems faced inestimating the future over a longer period of time also restrict the use of these standards forcost control purposes.

After the consideration of various types of standards which may be used, the process ofestablishment of standards with respect to various elements of costs comes into operation.As discussed above, the standards may be set for the various elements of costs i.e. DirectMaterial Cost, Direct Labour Cost and Overheads.

(a) Direct Material Cost :

Setting the Standard Cost for Direct Material, involves two stages i.e. To decide PriceStandard and to decide Use Standard.

499Standard Costing

Price Standard :

It may involve the consideration of following factors.

(i) Current market conditions and likely changes.

(ii) Prices of current supply orders.

(iii) Prices of long term supply contracts.

Along with the basic prices, it may involve the consideration of the factors like discount,packing charges, insurance, sales tax, octroi etc. It may be the primary responsibility of thePurchase Department to supply the details required for this purpose.

Use Standard :

It may be the primary responsibility of Engineering or Design Department to supply the detailsrequired for this purpose, on the basis of standard bill of material.This may involve the processof product study. Sufficient provisions should be made for unavoidable scrap or wastages.

(b) Direct Labour Cost :

Setting the standard cost for Direct Labour involves two stages i.e. To decide the wagerate standard and to decide Labour Efficiency standard.

Wage Rate Standards :

It may involve the consideration of following factors.

(i) The system of wages payments prevailing i.e. Piece Rate Wages or Time Rate Wages

(ii) Systems prevailing for bonus payments

(iii) The provisions of agreements with workers covering a future period of time.

(iv) Provisions of various laws and guidelines governing the fixation of wage rates

(v) Grades of workers required and likely trends of market conditions in respect of availabilitythereof.

Labour Efficiency Standards :

It may be decided on the basis of the consideration of following factors.

(i) Records of past performance.

(ii) Time and motion study considering the details in respect of an average worker as thebase.


(iii) Trial Runs, specifically in respect of a new product. Sufficient provision should be madein respect of the unavoidable idle time.

(c) Overheads Cost :

Setting the standard cost of overheads involves the following stages.

(i) Estimation of standard overheads cost.

(ii) Estimation of standard level of activity ( in terms of labour hours, machine hours orunits of production)

(iii) Estimation of standard overhead absorption rate which may be decided as below.

Standard Overhead Cost

Standard Level of Activity

Thus, the standard absorption rate may be per unit of production, per labour hour or permachine hour.

For better control purposes, the standards for overhead cost may be decided separately forfixed overheads and variable overheads, as fixed overbeads are normally uncontrollable at thelower level of management.

(4) Reporting of Variances :

The basic intention of implementation of standard costing system as a cost controldevice is not complete till the variances computed in respect of each element of cost areproperly reported to the relevant level of management for the decision making purposes.For this purpose, the following propositions should be considered.

(a) For effective cost control, the organizational structure should be clearly defined andresponsibility of each individual should be clearly defined.

(b) The reports reporting the variances should be simple, clear and quick.

(c) The computation and analysis of variances in respect of each element of costshould be accurate. A wrong analysis of variances may result into misleadingconclusions.

(d) For more effectiveness, the variances should be segregated as controllable variancesand non controllable variances. However, the analysis of uncontrollable variancesshould be made with the same care as in case of controllable variances.

(e) The reporting of variances should contain a comparison with the planned results.

501Standard Costing

(f) The format and the contents of reports reporting the variances may depend uponthe level of management to whom reports are being made, The reports to topmanagement would be obviously formal containing only the broad details and finalresults. The reports to lower level of management may contain the full analysis ofeach variance showing the causes therefor and locating the responsibilities therefor.

ANALYSIS OF VARIANCES :

As stated earlier, the process of standard costing involves the establishment of standardcosts and the computation of actual costs under each element of cost and the comparisonbetween standard costs and actual costs. The difference between standard cost and actualcost is termed as ‘Variance’. If the actual cost is less than the standard cost, the variance isa favourable variance. If the actual cost is more than the standard cost, the variance is aunfavorable or adverse variance. The utility of standard costing as a technique of cost controlis not complete only by the computation of variances unless these variances are furtheranalysed as to the causes responsible for these variances. The basic objective of varianceanalysis is to classify the variances as controllable and uncontrollable ones E.g. If materialactually used is in excess of standard quantity or if time actually taken by the workers is morethan standard time, the variance will be an unfavorable one for which the responsibility can beassigned on the executives concerned. However if the variances occur due to general strike,general increase in wage rates, devaluation of currency, change in customers’ demands etc.,the variances will be uncontrollable ones for which no responsibility can be assigned to anyexecutive. By concentrating most on controllable and adverse variances, it is possible for themanagement to exercise control through exception which is the basic objective of standardcosting. Thus, the stress can be laid on variances only and no further action will be necessaryin cases where standard costs are matching with the actual costs, provided that the conditionsunderlying the fixation of standards remain unchanged.

The variances arising in one period may be compared with a variances in the previous periodfor a better control.

Thus a detailed analysis of variances, specifically the controllable ones, as to the causesleading to these variances, and the corrective actions required to be taken to reduce thesevariances enables the management to exercise proper cost control. However, it does notmean that the favourable variances need no investigation. A constant occurrence of favourablevariance may indicate incorrect fixation of standards that need to be revised. A constantfavourable variance may be due to a genuine improvement in performance or due to themanufacture of sub- standard products.

We will discuss the variance under each element of cost.


(A) MATERIAL COST VARIANCE :

It is the difference between standard material cost and actual material cost. It may befurther analysed as -

(i) Material Price Variance

(ii) Material Usage Variance

(i) Material Price Variance :

It’s that portion which is due to difference between standard price specified and actualprice paid. It is calculated as -

Actual Quantity (Actual Price - Standard Price)

The causes for this may be traced as

(1) Change in price of material.

(2) Change in quantity of purchase or uneconomical size of parchase order.

(3) Rush order to meet shortage of supply or purchase in less favourable market.

(4) Failure to take advantage of off season prices.

(5) Failure to get cash/trade discounts.

(6) Weak purchase organization.

(7) Payment of excess/less freight.

(8) Transit losses/discrepancies if prices include them.

(9) Change in quality or specification of material purchased.

(10) Use of substitute materials at different prices.

(11) Change in pattern or amount of taxes or duties.

From the above, it can be seen that the responsibility for this type of variance may benormally placed on Purchase Department. However, there may be some situations wherethe responsibility for this type of variance can not be placed on purchase department.E.g. When the purchases are made in uneconomic quantities due to the lack of workingcapital.

(ii) Material Usage Variance :

It is that portion which is due to the difference between standard quantity specified andactual quantity used. It’s calculated as -

503Standard Costing

Standard Price (Actual Qantity - Standard Qantity)

The causes to this may be traced as :

(1) Inefficient or careless use of materials.

(2) Change in specification/design of the product.

(3) Inefficient/inadequate inspection of materials.

(4) Change in quality of material or purchases of inferior material.

(5) Production inefficiency resulting in wastages.

(6) Use of substitute materials.

(7) Theft/pilferage of materials.

(8) Inefficient labour not able to handle material properly.

(9) Defective machines and not proper maintenance of the same.

(10) Change in the composition of material mix. If more than one materials are mixed toget the final product, any change in the standard mix may result into materialusage variance. It may arise in case of textile, chemical, rubber industries etc.

(11) Change in the yield. If a certain amount of standard output is expected from someinputs, any variance in actual output may result in material usage variance. It mayarise in case of processing industries.

The material usage variances may further be analysed in the following ways:

(a) Materials Mix Variance :

As stated above, it is that part of usage variance which may arise due to change in thestandard composition of material mix where more than one materials are required to bemixed together to get the final product. This may be a peculiar feature of the industrieslike textile, chemical, rubber etc. The actual mix of materials may be different than thestandard mix due to non - availability of specified material. Increased proportion of costlymaterial in the mix results into adverse materials mix variance and vice-versa.

This variance is calculated as -

Standard price (Actual mix - Standard mix)


(b) Materials Yield Variance :

As stated above, it is that part of usage variance which may arise due to differencebetween standard yield expected and the actual yield obtained, where a certain specifiedyield is expected from a given input of materials. This may be a peculiar feature of theprocessing industries. A low actual yield indicates consumplion of materials in excessof standards set resulting into an adverse variance and vice versa.

This variance is calculated as :

Standard Yield Price (Actual Loss - Standard Loss)

Where standard yield price is calculated as :

Total Standard Cost

Total Standard Output

Illustration : I

Material Standard Actual

Qty. Price Total Qty. Price TotalKgs. Rs. Rs. Kgs. Rs. Rs.

A 500 6.00 3,000 400 6.00 2,400

B 400 3.75 1,500 500 3.60 1.800

C 300 3.00 900 400 2.80 1,120

1200 1300

Less : 10% Actual

Normal Loss 120 Loss 220

1,080 5,400 1080 5,320

Calculate material cost variances.

Solution :

(A) Material Cost Variance

Standard Material Cost - Actual Material Cost.

∴ 5,400 - 5,320

= 80 (Favourable)

505Standard Costing

(B) Material Price Variance

AQ (AP - SP) Where AQ = Actual Quantity.

AP = Actual Price SP = Standard Price

Material A = 400 (6.00 - 6.00) = Nil

Material B = 500 (3.60 - 3.75) = 75 (Favourable)

Material C = 400 (2.80 - 3.00) = 80 (Favourable)

155 (Favourable)

(C) Material Usage Variance

SP (AQ - SQ) Where SP = Standard Price

AQ = Actual Quantity SQ = Standard Quantity

Material A = 6.00 (400 - 500) = 600 (Favourable)

Material B = 3.75 (500 - 400) = 375 (Adverse)

Meterial C = 3.00 (400 - 300) = 300 (Adveise)

75 (Adverse)

(D) Materials Mix Variance

Standard Price (Actual Mix - Standard Mix)

Material A = 6.00 (400 - 541.67) = 850 (Favourable)

Material B = 3.75 (500 - 433.33) = 250 (Adverse)

Material C = 3.00 (400 - 325) = 225 (Adverse)

375 (Favourable)

Note : The standard mix is calculated as below.

When total input is 1,200 Kgs, the Materials A,B, and C are mixed in the proportion of 500Kgs,, 400 Kgs and 300 Kgs. respectively. When total input is 1,300 Kgs. the materials shouldhave been mixed in the following proportion.

500Material A =

1200X 1300 = 541.67 Kgs.

400Material B =

1200X 1300 = 433.33 Kgs.

300Material C =

1200X 1300 = 325.00 Kgs.


(E) Materials Yield Variance

Standard Yield Price (Actual Loss - Standard Loss)

5 (220 - 130)

= 450 (adverse)

Note : Standard Yield Price is calculated as below

Total standard cost = Rs. 5400 = Rs.5/Per Kg.Total standard output 1080 Kgs.

Check :

Material Cost Variance = Materials Price Variance + Material Usage Variance

Materials Usage Variance = Materials Mix Variance + Materials Yield Variance

80 (F) = 155 (F) + 375 (F) + 450 (A)

Where, F indicates favourable and A indicates adverse variance.

LABOUR COST VARIANCES :

It is the difference between standard direct wages specified and actual wages paid. It is furtheranalysed as -

(i) Wage/Labour Rate Variance : It is that portion which is due to difference betweenstandard pay of wages specified and actual rate paid. It is calculated as -

Actual Hours (Actual Rate - Standard Rate)

The causes of this may be traced as

(1) Change in wage structure or piece-work rate.

(2) Variation due to different grades of workers and their wages differing from thosespecified.

(3) Use of different methods of payment e.g. Actual payment on time basis whereasstandards are set on piece rate basis.

(4) Employment of casual/temporary workers to meet seasonal demands.

(5) New workers not being allowed full normal wages.

(6) Overtime or night shift allowance more or less than standard.

(7) Composition of gang as regards the skill and rates of wages different than specifiedstandards.

507Standard Costing

Though the responsibility of wages/labour rate variances can be placed on PersonnelDepartment, in practice, this type of variance is usually an uncontrollable one.

(ii) Labour Efficiency Time Variance : It is that portion which is due to difference betweenstandard labour hours specified and the actual labour hours expended.

It is calculated as :

Standard Rate (Actual Hours - Standard Hours)

The causes of this may be traced as :

(1) Lack of proper supervision.

(2) Poor working conditions.

(3) Delays due to waiting for materials, tools, instructions etc, if not treated as idletime.

(4) Defective tools, equipments etc.

(5) Machine break down if not treated as idle time.

(6) Work on new machines requiring less time.

(7) Basic inefficiency of workers due to lack of morale, insufficient training, faultyinstructions etc.

(8) Use of non-standard material requiring higher lime for processing.

(9) Operations not provided for and booking them under direct wages.

(10) Wrong selection of workers.

(11) Increase in labour turnover.

(12) Incorrect recording of performance i.e. time or output.

The labour efficiency variance may be further analysed in the following manner.

(a) Idle Time Variance : It is the standard cost of actual hours recorded as idle time due toabnormal circumstances like strike, lock out, power failure, machinery breakdown etc. It iscalculated as -

Standard rate x Idle Hours

This type of variance is normally calculated separately and not kept only as a part of efficiencyvariance, as the employees should not be blamed for inefficiency when the idle time arisesdue to circumstances beyond their control, say power failure. It is needless to state that thisvariance is always unfavorable and needs further investigation as to the causes for abnormalidle time.


(b) Labour Mix Variance (Gang Composition Variance) :

It indicates that part at efficiency variance which arises due to change in Actual Gang of labourfrom that of Standard Gang of labour if various grades of labour are included in a gang and ifcertain grades of labour are not available. It is calculated as :

Standard Rate (Revised Standard Hours- Actual Hours)

Where the revised standard hours indicate the actual labour hours divided in the ratio ofstandard hours. It should be noted that if the idle time variance is calculated separately, theidle time hours should be excluded from actual total hours in standard ratio.

(c) Labour Yield Variance :

In many cases, this variance is calculated separately which indicates the effect on labour costof actual yield or output being different from standard yield or output.

In numerical terms, it is equal to revised efficiency variance i.e. after separating Mix Varianceand Idle Time Variance from Efficiency Variance, which is calculated as -

Standard Rate (Standard Hours - Revised Standard Hours)

Illustration 2 :

Following details are available from the records of A Ltd. for a month regarding the standardlabour hours and rates of an hour for a product

Hours Rate per hour Rs. Total Rs.

Skilled 10 3.00 30.00

Semi- Skilled 8 1.50 12.00

Unskilled 16 1.00 16.00

58.00

The actual production for the product was 1,500 units for which the actual hours worked andrates were as below.

Hours Rate per hour Rs. Total Rs.

Skilled 13,500 3.50 47,250

Semi- Skilled 12,600 1.80 22,680

Unskilled 30,000 1.20 36,000

509Standard Costing

Compute :

(a) Labour Cost Variance

(b) Labour Rate Variance

(c) Labour Efficiency Variance

(d) Labour Mix Variance

(a) Labour Cost Variance :

Solution :

Standard Actual

Hours Rate per Hr. Total Hours Rate per Hr. Total Rs.

Skilled 15,000 3.00 45,000 13,500 3.50 47,250

Semi-Skilled 12,000 1.50 18,000 12,600 1.80 22,680

Unskilled 24,000 1.00 24,000 30,000 1.20 36,000

51,000 87,000 56,100 1,05,930

Actual Cost - Standard Cost

∴ 1,05,930 - 87,000 = 18,930 (A)

(b) Labour Rate Variance :

Actual Hours (Actual Rate - Standard Rate)

13,500 (3.50 - 3.00) = 6,750 (A)

12,600 (1.80 - 1.50) = 3,780 (A)

30,000 (1.20 - 1.00) = 6,000 (A)

16,530 (A)

(c) Labour Efficiency Variance :

Standard Rate (Actual Hours- Standard Hours)

3.00 (13,500 - 15,000) = 4,500 (F)

1.50 (12,600 - 12,000) = 900 (A)

1.00 (30,000 - 24,000) = 6,000 (A)

2,400 (A)


(d) Labour Mix Variance :

Standard Rate (Actual Hours - Revised Standard Hours)

3.00 (13,500 - 16,500) = 9,000 (F)

1.50 (12,600 - 13,200) = 900 (F)

1.00 (30,000 - 26,400) = 3,600 (A)

6,300 (F)

OVERHEAD COST VARIANCES :

The analysis of overheads variances is different and the most complex task than the calculationof material and labour variances. It is so due to the fact that establishment of a standardoverhead absorption rate is difficult as a part of total overheads is fixed, which affects theoverhead absorption rate with the change in volume.

It should be noted in this connection that the overhead absorption rate can be computed in thefollowing way.

(a) If the overhead rate is expressed in terms of labour hours.

Hourly Rate =Budgeted Overhead Cost

Budgeted Labour Hours

(b) If the overhead rate is expressed in terms of units produced

Unit Rate =Budgeted Overhead cost

Budgeted output in units

As the overheads can be either the variable overheads or fixed overheads, the overhead costvariances may be seperately calculated for variable overheads and fixed overheads.

Variable Overheads Variance :

It is that amount of overheads which change directly with the level of activity and per unitvariable overheads remain constant. As such, the variable overheads are not affected with thechange in volume of operations.

The common method of analyzing the variable overheads variances is shown in the chartbelow.

Overhead Cost Variance

Expenditure Variance Efficiency Variance

511Standard Costing

(a) Overheads Cost Variance

It is the difference between standard overheads cost absorbed and actual overheadscost incurred. It is calculated as -

Standard Hours forX

Standard Hourly

Actual production Rate– Actual Overhead

(b) Overheads Expenditure Variance :

It is the difference between the standard allowance for the output achieved and actualoverheads cost incurred.

It is calculated as -

Revised Budgeted Overheads for Actual Hours - Actual Overheads

(c) Overhead Efficiency Variance :

It is due to the difference between budgeted efficiency of production and actual efficiencyattained. It is calculated as -

Standard Hourly Standard Hours forRate X Actual production

– Actual Overheads

Fixed Overheads Variances :

In modern times, especially in the days of rapid mechanization of production processes, thefixed overheads form a major portion of the production cost. As such, it is necessary that themanagement is properly informed about the standard fixed overheads or any deviationstherefrom. The common method of analyzing the fixed overheads variances is shown in thechart below.

Overhead Cost Variance

Expenditure variance Volume Variance

Efficiency Capacity Calender

Variance Variance Variance

As each of the above variances can be computed either on the basis of units of production oron the basis of hours. We will first study the nature of the above variances and then themethods of computation.

[

[


(a) Overhead Cost Variance :

It is the difference between the total standard overheads cost absorbed in the outputachieved and the total actual overheads cost. Thus, it can be seen that the overheadscost variance is simply the under or over absorption of overheads.

(b) Expenditure Variance :

It is the difference between the standard allowance for the output achieved and the actualoverheads cost incurred.

The causes of this variance may be

(1) Change in the quality/ price of indirect material.

(2) Change in the labour rates for indirect workers or change in the grade of indirectworkers.

(3) Change in the rate of power, insurance and other overheads.

(c) Volume Variance :

It is that protion of the overhead variance which is due to the difference between thebudgeted level of output and the actual level of output.

The causes of this variance may be as below.

(1) Labour problems like strikes, lockouts etc.

(2) Material shortage

(3) Machinery Breakdown

(4) Waiting for tools/instructions/material

(5) Power failure.

(6) Change in the demand for product

It will not be out of place to mention here that in case of the variable overheads, per unitor per hour overheads remain constant and are not affected by the change in the level ofoutput. As such, volume variance does not arise in case of variable overheads.

(d) Efficiency Variance :

It is that portion of the overhead variances, as a part of volume variance, which is due tothe difference between budgeted efficiency of production and the actual efficiency attained.The causes of this variance may be as below.

513Standard Costing

(1) Poor working conditions.

(2) Change in the labour performance

(3) Defective and faulty tools.

(4) Incorrect Machine operations.

(5) Defective or inferior material.

(e) Capacity Variance :

It is that portion of the overhead variances, as a part volume variance, which is due to theworking at higher or lower capacity than standard.

The causes of this variance may be as below.

(1) Seasonal variations.

(2) Shortage of labour force.

(3) Abnormal idle time due to the reasons like power failures, strikes, lock outs etc.

(4) Change in the customer demand.

(f) Calender Variance :

It is that portion of overhead variances, as a part of volume variance, which is due to thedifference between the number of working days in the budget period and the actualnumber of working days in the period in which the budget is applied.

Calender Variance arises only if there is abnormal increase or decrease in the number ofworking days, as the normal holidays are already considered while setting the standard.Thus, the declaration of an unexpected day as holiday may result into calender variance.

COMPUTATION OF FIXED OVERHEADS VARIANCES :

As discussed earlier, the fixed overheads variances may be computed on the basis of units ofproduction or on the basis of hours.

(A) On the basis of units of production :

(1) Overheads Cost Variance :

Standard Overhead Cost - Actual Overhead Cost

(2) Expenditure Variance :

Budgeted Overhead Cost - Actual Overhead Cost


(3) Volume Variance :

Standard Rate per unit X [Actual Production - Budgeted Production]

(4) Efficiency Variance :

Standard Rate per unit X [Actual Production - Standard Production in Actual Hours]

(5) Capacity Variance:

Standard Rate X Standard Production – Revised Budgetedper unit in Actual Hours Production

(6) Calender Variance :

Standard Rate per unit X [Revised Budgeted Production - Budgeted Production]

ILLUSTRATION 3 :

An Engineering Company has furnished you the following data

Budget ActualJuly 1986

No of working days 25 27

Production in Units 20,000 22,000

Fixed overheads in Rs. 30,000 34,000

Budgeted fixed overhead rate is Rs. 1 per hour. In July 1986, the actual hours worked were31,500.

Calculated the following variances.

(a) Total overheads Variance

(b) Expenditure Variance

(c) Volume Variance

(d) Efficiency Variance

(e) Capacity Variance

(f) Calender variance

Solution :

(1) Total Overheads Variance :

Standard Overheads Cost - Actual Overheads Cost

∴ 33,000 - 34,000

= 1,000 (A)

[

515Standard Costing


Budgeted Overheads Cost - Actual Overheads Cost

∴ 30,000 - 34,000

= 4,000 (A)


Standard Rate per unit x [Actual Production - Budgeted Production]

∴ 1.5 X (22,000 - 20,000)

= 3,000 (F)


Standard Rate per unit x [Actual Production - Standard Production in Actual Hours]

∴ 1.5 X ( 22,000 - 21,000)

= 1.500 (F)

(5) Capacity Variance :

Standard Rate per unit x [Standard Production in Actual Hours - Revised BudgetedProduction]

∴ 1.5 X (21,000 - 21,600)

= 900 (A)


Standard Rate per Unit x [Revised Budgeted Production - Budgeted Production]

∴ 1.5 x (21,600 - 20,000)

= 2,400 (F)

Check :

Volume variance = Efficiency Variance + Capacity Variance + Calender Variance

3000 (F) = 1500 (F) + 900 (A) + 2400 (F)

Total Variance = Expenditure Variance + Volume Variance

1000 (A) = 4000 (A) + 3000 (F)

Working Note :

(A)

(1) Standard Rate per unit is calculated as below

Budgeted Overhead Cost

Budgeted Production


∴ 30,00020,000

Rs. 1.5 Per Unit

(2) Standard Production in actual hours is calculated as below :

Budgeted overheads are Rs.30,000, while budgeted fixed overhead rate is Rs. l per hour.Therefore, budgeted hours are 30,000, while budgeted production is 20,000 units. Itmeans that one unit requires 1.5 hours.(standard) As actual hours worked are 31.500,the standard production in those many hours will be -

31,500= 21,000 Units

1.5(3) Revised Budgeted Production is calculated as below.

Budgeted Number of working days are 25 while budgeted production is 20,000 units. Itmeans that standard production in one day is -

20,000 Units = 800 Units25 days

As actual number of working days is 27, the standard production in those many days willbe -

800 units x 27 days = 21,600 units

(B) On the basis of hours :






Standard Hourly Rate x [Standard Hours for Actual Production - Budgeted Hours]


Standard Hourly Rate x [Standard hours for Actual Production - Actual Hours]


Standard Hourly Rate x [Actual Hours - Revised Budgeted Hours]


Standard Hourly Rate x [Revised Budgeted Hours - Budgeted Hours]

517Standard Costing

ILLUSTRATION : 4

An engineering company has furnished you with the following data.

Budget Actual (July 1986)

No. of working days 25 27

Production in Units 20,000 22,000

Fixed 0verheads (in Rs.) 30,000 34,000

Budgeted fixed overhead rate is Rs. 1 per hour. In July 1986, the actual hours worked were31,500.

Calculate the following variances

(a) Total Overheads Variance

(b) Expenditure Variance

(c) Volume Variance

(d) Efficiency Variance

(e) Capacity Variance

(f) Calender Variance

Solution :

Calculation of overhead variances will be as below.

(1) Total Overhead Variance :

Standard Overheads - Actual Overheads

∴ 33,000 - 34,000 = 1,000 (A)


Budgeted Overheads - Actual Overheads.

∴ 30,000 - 34,000 = 4,000 (A)


Standard Hourly Rate X [Standard Hours for Actual Production - Budgeted Hours]

= 1 (33,000 - 30,000) = 3,000 (F)


Standard Hourly Rate (Standard hours - Actual hours)

∴ 1 (33,000 - 31,500)

= 1,500 (F)



Standard Hourly Rate (Actual hours - Revised Budgeted Hours)

∴ 1 (31,500 - 32,400)

= 900 (A)


Standard Hourly Rate (Revised Budgeted Hours - Budgeted Hours)

∴ 1 (32,400 - 30,000)

= 2,400 (F)

Check :

Volume Variance = Efficiency Variance + Capacity Variance + Calender Variance.

3000 (F) = 1500 (F)+900 (A)+ 2400 (F)

Total Overhead Cost Variance = Expenditure Variance + Volume Variance

1000 (A) = 4000 (A) + 3000 (F)

Working Notes :

(1) Standard rate per hour is known to be Rs. 1.

As Budgeted overheads are Rs.30,000, Budgeted Hours will be 30,000.

(2) Budgeted Hours are known to be 30,000 for the Budgeted production of 20,000 units,indicating that standard time required for one unit is 1 1/2 hours.

If the actual production is 22,000 units, the standard time required for actual productionwill be 33,000 hours.

(3) The budgeted number of working days are 25 and budgeted hours are 30,000, indicatingthat the standard hours available in one day are 1,200.

If the company has actually worked for 27 days, the revised budgeted hours will be32,400 i.e. 1,200 hours per day x 27 days.

SALES VARIANCES :

While standard costing principles are mainly applied in the area of costs i.e. Material cost,Labour cost and overheads cost, some companies calculate the sales variances also which isthe difference between budgeted sales and actual sales and its impact on profits.

There may be two ways to calculate sales variances.

(A) The turnover/value method.

(B) The margin/profit method.

519Standard Costing

(A) The Turnover/Value Method :

The common method of analysing sales variances under this method is shown in thechart below.

Sales Value Variance

Sales Price Variance Sales Volume Variance

Mix Variance Quantity Variance

(1) Sales Value Variance :

It is the difference between the budgeted sales and the actual sales.


Actual Sales - Budgeted Sales

(2) Sales Price Variance :

It is that portion of sales variance which is due to the difference between standardprice specified and the actual price charged.


Actual Sales Volume x [Actual Price - Standard Price]

(3) Sales Volume Variance :

It is that portion of sales variance which is due to the difference between the standardquantity specified and the actual quantity sold.


Standard Price x [Actual sales volume - Standard sales volume]

(4) Sales Mix Variance :

It is that portion of sales volume variance which may arise due to change in actualcomposition of sales mix from the standard composition of sales mix, where morethan one products are dealt with.


Standard Sales - Revised Standard Sales

Where -

Standard Sales are actual quantity sold at budgeted price. Revised Budgeted salesare standard sales rearranged in the budgeted ratio.


Note : It should be noted that the sales mix variance, under turnover method will alwaysbe zero. This is so because though the sales mix is varied, the actual sales at budgetedprice are rearranged in the budgeted ratio.

(5) Sales Quantity Variance :

It is that portion of sales volume variance, which may arise due to the difference betweenstandard value of actual sales at standard mix and budgeted sales. It is calculated as -

Revised Standard Sales - Budgeted Sales.

Illustration 5 :

Standard Actual

Product Qty. Sale Price Total Qty. Sale Price TotalRs. Rs. Rs. Rs.

A. 500 5 2,500 500 5.40 2,700

B. 400 6 2,400 600 5.50 3,300

C. 300 7 2,100 400 7.50 3,000

1200 7,000 1500 9,000

Calculate the Sales Variances.

Solution :

(A)

(1) Sales Value Variance :

Actual Sales - Budgeted Sales

∴ 7,000 - 9,000 = 2,000 (F)


Actual Sales Volume (Actual Price - Standard Price)

A - 500 (5.40 - 5.00) = 200 (F)

B - 600 (5.50 - 6.00) = 300 (A)

C - 400 (7.50 - 7.00) = 200 (F)

100 (F)

521Standard Costing


Standard Price (Actual Sales Volume - Standard Sales Volume)

A - 5 (500 - 500) = Nil

B - 6 (600 - 400) = 1200 (F)

C - 7 (400 - 300) = 700 (F)

1900 (F)



Where standard sales are actual quantity at standard price and Revised standard sales arestandard sales rearranged in budgeted ratio.

Standard Sales Revised Standard Sale

Qty. Price Rs. Total Rs. Ratio Total

A 500 5 2500 35.71% 3178

B 600 6 3600 34.29% 3052

C 400 7 2800 30.00% 2670

8900 8900

Ratio is calculated as below

A -2500

X 100 = 35.71%7000

B - 2400 X 100 = 34.297000

C - 2100 X 100 = 30%7000

∴ Sales Mix Variance -

A 2500 - 3178 = 678 (A)

B 3600 - 3052 = 548 (F)

C 2800 - 2670 = 130 (F)

Nil


(5) Sales Quantity Variance

Revised Standard Sales - Budgeted Sales :

A 3178 - 2500 = 678 (F)

B 3052 - 2400 = 652 (F)

C 2670 - 2100 = 570 (F)

= 1900 (F)

Check :

Sales Value Variance = Sales Price Variance + Sales Mix Variance + Sales Quantity Variance

= 2000 (F) = 100(F)+Nil +1900 (F)

(B) The Margin / Profit Method :

This method of sales variances measures the effect of actual sales and budgeted sales onprofit. As this method does not consider the cost variances, all costs are assumed to bestandard costs. The common method of analysing sales variances under this method isshown in the chart below.

Total Sales Margin Variance

Sales Margin Price Variance Sales Margin Volume Variance

Sales Margin Sales MarginMix Variance Quantity Variance

(1) Total Sales Margin Variance :

It is the difference between actual margin (by considering standard costs) and budgetedmargin.


Actual Profit - Budgeted Profit

(2) Sales Margin Price Variance :

It is that portion of total sales margin variance which is due to the difference betweenstandard price of actual sales made and actual price.

It is calculated as

Actual Profit - Standard Profit

523Standard Costing

(3) Sales Margin Volume Variance :

It is that portion of total sales-margin variance which is due to the difference betweenstandard profit and budgeted profit.


Standard Profit - Budgeted Profit.

(4) Sales Margin Mix Variance :

It is that portion of sales margin volume variance which is due to the difference betweenstandard profit and revised standard profits.


Standard Profit - Revised Standard Profit.

(5) Sales Margin Quantity Variance :

It is that portion of sales margin volume variance which is due to the difference betweenbudgeted profit and revised standard profits.

It is calculated as-

Revised Standard Profits - Budgeted Profit.

Illustration 6 :

A Ltd. has budgeted the following sales for the month

A - 900 units at Rs. 50 per unit.

B - 650 units at Rs, 100 per unit.

C - 1200 units at Rs. 75 per unit.

Actual sales were -

A - 950 units at Rs. 58 per unit.

B - 700 units at Rs. 90 per unit.

C - 1200 units at Rs. 80 per unit.

Costs per unit of A, B and C were Rs. 40, Rs. 88 and Rs.60 respectively.

Compute the Sales Margin variances.


Solution :

SALES COST OF SALES PROFIT

Product Qty Price Total Per unit Total Per unit TotalRs. Rs. Rs. Rs. Rs.

BUDGET

A 900 50 45,000 40 36,000 10 9,000

B 650 100 65,000 88 57,200 12 7,800

C 1200 75 90,000 60 72,000 15, 18,000

2,00,000 1,65,200 34,800

ACTUAL

A 950 58 55,100 40 38,000 18 17,100

B 700 90 63,000 88 61,600 2 1,400

C 1200 80 96,000 60 72,000 20 24,000

2,14,100 1,71,600 42,500

Standard sales and revised standard sales are calculated as below

STANDARD SALES :

SALES COST OF SALES PROFIT

Product Qty Price Total Per unit Total Per unit TotalRs. Rs. Rs. Rs. Rs.

A 950 50 47,500 40 38,000 10 9,500

B 700 100 70,000 88 61,600 12 8,400

C 1200 75 90,000 60 72,000 15 18,000

2,07,500 1,71,600 35,900

REVISED STANDARD SALE

Product Revised RevisedStandard sales Standard profit

Rs. Rs.

A 46,688 9,338

B 67,437 8,092

C 93,375 18,675

2,07,500 36,105

525Standard Costing

Calculation of Variances

(1) Total Sales Margin Variance :

Actual Profit - Budgeted Profit

∴ 42,500 - 34,800 = 7,700 (F)

(2) Sales Margin Price Variance


∴ 42,500 - 35,900 = 6,600 (F)

(3) Sales Margin Volume Variance

Standard Profit - Budgeted Profit.

∴ 35,900 - 34,800 = 1,100 (F)


Standard Profit - Revised Standard Profit.

∴ 35.900 - 36,105 = 205 (A)


Revised Standard Profit - Budgeted Profit

∴ 36,105 - 34,800 = 1,305 (F)


(1) Following standard and actual data relates to a manufacturing concern.

Material Standard

X 40 kgs. at Rs. 6 240

Y 60 kgs. at Rs. 4 240

480

Standard output is 80% of input i.e. 80 units. Process loss is 20%.

Material Actual

X 600 kgs. at Rs. 4

Y 400 kgs. at Rs. 6

Actual output is 70% of input i.e. 700 units. Process loss is 30%.


Calculate

(1) Cost variance

(2) Price variance

(3) Total Quantity usage variance

(4) Mix variance

(5) Revised usage variance

Solution :

(1) Cost Variance :

Actual Material Cost - Standard material Cost

∴ 4800 - 4200 = 600 (A)

(2) Price Variance :


X 600 (4-6) = 1200 (F)

Y 400 (6-4) = 800 (A)

400 (F)

(3) Total Usage Variance :

Standard Price (Actual Quantity - Standard Quantity)

X - 6 ( 600 - 350) = 1500 (A)

Y - 4 ( 400 - 525) = 500 (F)

1000 (A)

(4) Mix Variance :

Standard Price (Actual Mix- Revised Standard Quantity

X - 6 (600 - 400) = 1200 (A)

Y - 4 (400-600) = 800 (F)

400 (A)

(5) Revised Usage Variance :

Standard Price (Revised Standard Quantity - Standard Quantity)

X - 6 (400 - 350) = 300 (A)

Y - 4 ( 600 - 525) = 300 (A)

600 (A)

527Standard Costing

(6) Yield Variance :

Standard Cost per unit (Actual Loss - Standard Loss)

∴ 6 (300 - 200) = 600 (A)

Check :

Cost Variance = Price Variance + Mix Variance + Yield Variance

600 (A) = 400 (F) + 400 (A) + 600 (A)

Notes :

(1) Standard Cost is calculated as below .

Standard input for the output of 80 units is 100 kgs.

If the actual output is 700 units, the standard input for the same will be -

700 X 100 = 875 kgs.

80

The standard proportion of the materials is 40% for X and 60% for Y. As such, for thestandard input of 875 kgs, the standard proportion will be -

X - 40% of 875 kgs i.e. 350 kgs.

Y - 60% of 875 kgs i.e. 5:25 kgs.

The standard cost will be as follows.

Material Standard Standard CostQuantity Price Rs.

kgs. Rs.X 350 6 2,100Y 525 4 2,100

4.200

(2) Revised standard quantity is calculated as below.

Total input is 1000 kgs. The standard proportion of the materials is 40% for X and 60%for. Y. As such, the revised standard quantity should have been -

X - 40% of 1000 kgs. i.e. 400 kgs.

Y - 60% of 1000 kgs. i.e. 600 kgs.


(3) The standard material cost of a normal mix of one tonne of chemical X is based on

Chemical Usage Kgs. Price per Kg.A 240 6B 400 12C 640 10

During a month, 6.25 tonnes of X were produced from

Chemical Consumption Cost(Tonnes) (Rs.)

A 1.6 11,200B 2.4 30,000C 4.5 47,250

Analyse the variances.

Solution :

Calculation of standard cost

Chemical Quantity Rate per kg. Total Costkgs. Rs. Rs.

A 1500 6 9,000B 2500 12 30,000C 4000 10 40,000

79.000

Calculation of Actual cost

Chemical Quantity Rate per kg. Total costkgs. Rs. Rs.

A 1600 7 11,200B 2400 12.5 30,000C 4500 10.5 47,250

88,450

(1) Material Cost Variance :

Standard Cost - Actual Cost

∴ 79,000 - 88,450

= 9,450 (A)

529Standard Costing

(2) Material Price Variance :


A - 1600 (7-6) = 1,600 (A)

B - 2400 (12.5-12) = 1,200 (A)

C - 4500 (10.5 - 10) = 2,250 (A)

5,050 (A)

(3) Material Usage Variance :

Standard Price (Actual Quantity - Standard Quantity)

A - 6 (1,600 - 1500) = 600 (A)

B - 12 (2,400 - 2500) = 1200 (F)

C - 10 (4,500 - 4000) = 5000 (A)

4,400 (A)

(4) Material Mix Variance :

Standard Price (Actual Mix - Standard Mix)

A - 6 (1,600 - 1593.75) = 37.5 (A)

B - 12 (2,400 - 2656.25) = 3075.0 (F)

C - 10 (4500 - 4250) = 2500.0 (A)

537.5 (F)

Note : The standard mix is calculated as below. When total input is 8000 kgs. Chemicals A,B and C are mixed in the proportion of 1500 kgs, 2500 kgs and 4000 kgs respectively. Whentotal input is 8500 kgs, the chemicals should have been mixed in the following proportion.

1500Chemical A - X 8500 = 1593.75 kgs.

8000

2500Chemical B - X 8500 = 2656.25 kgs.

8000

4000Chemical C - X 8500 = 4250 kgs.

8000


(5) Material Sub-usage Variance :

Standard Price (Standard Quantity - Standard Mix)

A - 6 (1500 - 1593.75) = 562.5 (A)

B - 12 (2500 - 2656.25) = 1875.0 (A)

C - 10 (4000 - 4250) = 2500.0 (A)

4937.5 (A)

(6) XYZ forecasts its overhead expenditure for a period as under.

Rs. 30,000 for 10,000 hours.

Rs. 27,500 for 9,000 hours.

Rs. 25,000 for 8,000 hours.

The normal volume of activity is 10,000 hours. During a period 8,750 hours were utilised for atotal overhead expenditure of Rs. 28,750 of which fixed overheads totalled to Rs. 5,250. Thestandard utilisation of labour should have been less by 5%.

How will you analyse the overhead variance.

Solution :

From the variation of total overheads, it is noted that for the variation of 1,000 hours. Theoverheads very to the extent of Rs. 2,500. Thus, indicates that the rate of variable overheadsis Rs. 2.50 per hour. At the normal level of activity, the distribution of overheads will be asbelow.

Variable Overheads - 10,000 hours x Rs.2.50 Rs. 25,000

Fixed Overheads - Balance Rs. 5,000

Rs. 30,000

Variable Overheads Variances :


Standard Hours for X Standard Hourly Rate - Actual Overheads

actual production

∴ 8930 X 2.50 - 23.500

= 22,325 - 23,500 = 1,175 (A)

[

531Standard Costing


[Revised Budgeted Overheads for Actual hours] - Actual Overheads.

∴ 8,750 x 2.50 - 23,500

= 21,875 - 23,500 = 1,625 (A)


[Standard Hours for Actual Production - Actual Hours] x Standard Hourly Rate

∴ [8,930 - 8.750] x 2.50

= 450 (F)

Notes :

(a) Total overheads cost actually incurred is Rs. 28,750 out of which fixed overheads areRs. 5,250. Hence, balance is variable overheads i.e.

Rs. 28,750 - Rs. 5,250 = Rs. 23,500

(b) Standard Hourly Rate is calculated as below.

Total Budgeted Variable Overheads/Total Budgeted Hours.

=Rs. 25,000 Rs. 2.50 per hour. 10,000

(c) Standard-hours for actual production are calculated as below.

Actual overheads are Rs. 23,500. As the standard hourly rate is Rs.2.50 per hour, theideal hours should have been

Rs. 32,500 = 9,400

Rs. 2.50

However, standard utilisation should have been less by 5%.

Hence, standard hours will be 95% of 9,400 hours i.e. 8,930 hours.

(d) Revised budgeted overheads for Actual Hours are worked out as below.

Actual hours are 8,750 and standard hourly rate is Rs. 2.50 per hour.

Hence, the revised budgeted overheads should have been Rs. 21,875 i.e. 8,750 x 2.50.


Check :

Overheads Cost Variance = Expenditure Variance + Efficiency Variance

1175 (A) = 1625 (A) + 450 (F)

Fixed Overheads Variance :



∴ 4,987.5 - 5,250 = 262.5 (A)

(2) Overheads Expenditure Variance :


∴ 5000 - 5250 = 250 (A)

(3) Overheads Volume Variance :

Standard Hourly Rate x [Standard Hours for Actual Production - Budgeted Hours]

∴ 0.50 X (9,975 - 10,000) = 0.50 x 25

= 12.5 (A)

(4) Overheads Efficiency Variance :

Standard Hourly Rate x [Standard Hours for Actual Production - Actual Hours]

∴ 0.50 X (9,975 - 8750) = 0.50 x 1225

= 612.5 (F)

(5) Overheads Capacity Variance :

Standard Hourly Rate X [Actual Hours - Budgeted Hours]

∴ 0.50 X (8,750 - 10,000) = 0.50 x 1250

= 625 (A)

Notes :

(a) Standard Hourly Rate is calculated as below,

Total Budgeted Fixed Overhead

Total Budgeted Hours

Rs. 5,000= Rs. 0.50 per hour

10,000

533Standard Costing

(b) Standard Hours for actual production are calculated as below.

Actual Overheads are Rs. 5,250. As the standard hourly rate is Rs, 0.50 per hour, theideal hours should have been 10,500.

However, standard utilisation should have been less by 5%. Hence, standard hours willbe 95% of 10,500 hours i.e. 9,975 hours.,

(c) Standard overheads cost is calculated as

Standard Hours x Standard Hourly Rate

∴ 9,975 x 0.50 = 4,987.50

(d) As the details of capacity variation due to the change in the number of working days isnot known, calender variance cannot be calculated. As such, the calculation of capacityvariance is made on the basis of comparison between actual hours and budgeted hours.

Check :

Overheads Cost Variance = Expenditure Variance + Efficiency Variance + Capacity Variance.

= 262.5 (A) = 250 (A)+612.5 (F)+625 (A)

(4) The sales manager a company engaged in the manufacture and sale of three products P,Q and R gives you are following information for the month of October 1982.

Budgeted Sales :

Product Units sold Selling Price StandardPer unit Margin per

Rs. unit Rs.

P 2,000 12 6

Q 2,000 8 4

R 2,000 5 1

Actual Sales

P - 1,500 units for Rs. 15,000

Q - 2,500 units for Rs. l7,500

R - 3,500 units for Rs. 21,000

You are required to Calculate the following variances

(i) The Sales Price Variance

(ii) The Sales Volume Variance

(iii) The Sales Quantity Variance

(iv) The Sales Mix Variance


Solution :

(A) As per Turnover/ Value Method :


Actual Sales Volume (Actual Price - Standard Price)

P - 1,500 (10 - 12) = 3,000 (A)

Q - 2,500 (7 - 8) = 2,500 (A)

R - 3,500 (6 - 5) = 3,500 (F)

2,000 (A)


Standard Price (Actual Sales Volume - Standard Sales Volume)

P - 12 (1,500 - 2,000) = 6,000 (A)

Q - 8 ( 2,500 - 2,000) = 4,000 (F)

R - 5 (3,500 - 2,000) = 7,500 (F)

5,500 (P)



Where standard sales are actual quantity at standard price and revised standard salesare standard sales rearranged in budgeted ratio.

Standard Sales Revised Standard SalesQty. Price Rs. Total Rs. Ratio Total Rs.

P 1,500 12 18,000 1/3 18,500

Q 2,500 8 20,000 1/3 18,500

B 3,500 5 17,500 1/3 18,500

55,500 55,500

Sales Mix Variance :

P 18,000 - 18,500 = 500 (A)

Q 20,000 - 18,500 = 1,500 (F)

R 17,500 - 18,500 = 1,000 (A)

NIL

535Standard Costing

(4) Sales Quantity Variance :

Revised Standard Sales - Budgeted Sales :

P - 18,500 - 2,000 x 12 = 5,500 (A)

Q - 18,500 - 2,000 x 8 = 2,500 (F)

Q - 18,500 - 2,000 X 5 = 8,500 (F)

5,500

(B) As per Margin/ Profit Method

Cost per unit = Selling price per unit - Contribution per unit

P 12 - 6 = 6

Q 8 -4 = 4

R 5 -l = 4

PRODUCT SALES COST OF SALES PROFIT

Qty. Price Rs. Total Rs. Per unit Rs. Total Rs. Per unit Rs. Total Rs.

Budgeted

P 2,000 12 24,000 6 12,000 6 12,000

Q 2,000 8 16,000 4 8,000 4 8,000

R 2,000 5 10,000 4 8,000 1 2,000

50,000 28,000 22,000

Actual

P 1,500 10 15,000 6 9,000 4 6,000

Q 2,500 7 17,500 4 10,000 3 7,500

R 3,500 6 21,000 4 14,000 2 7,000

53,500 33,000 20,500

Standard sales and revised standard sales are calculated as below :

Standard Sales

P 1,500 12 18,000 6 9,000 6 9,000

Q 2,500 8 20,000 4 10,000 4 10,000

R 3,500 5 17,500 4 14,000 1 3,500

55,500 33,000 22,500


Revised Standard Sales

Revised Standard Revised StandardSales Rs. Profit Rs.

P 25,680 12,840

Q 17,120 8,560

R 10,700 2,140

53,500 23,540

(1) Sales Margin Price Variance :


∴ 20,500 - 22,500 = 2,000 (A)

(2) Sales Margin Volume Variance :

Standard Profit - Budgeted Profit

∴ 22,500 - 22,000 = 500 (F)


Standard Profit - Revised Standard Profit

∴ 22,500 - 23,540 = 1,040 (A)


Revised standard Profit - Budgeted Profit

∴ 23,540 - 22,000 = 1,540 (F)

QUESTIONS

1. What do you mean by standard costing?

Differentiate between Standard Costing and Budgetary Control as cost control techniques.state the advantages and limitations of standard costing.

2. What do you understand by standard costing?

What preliminaries will have to be complied with before introducing the technique ofstandard costing.

3. Describe the procedure of establishing standard costs in the area of materials cost,labour cost and overheads cost.

4. What do you mean by variances and variance analysis. Explain the various factorsaffecting the variances in the area of materials cost, labour cost and overheads cost.

537Standard Costing

PROBLEMS

1. The standard materials cost to produce a tonne of chemcial X is

300 kgs of material A @ Rs. 10 per kg.

400 kgs of material B @ Rs. 5 per kg.

500 kgs of material C @ Rs. 6 per kg.

During the period 100 tones of chemical X were produced from the usage of

35 tonnes of material A for a cost of Rs.9,000 per tonne

42 tonnes of material B for a cost of Rs. 6,000 per tonne

53 tonnes of material C for a cost of Rs. 7,000 per tonne

Calculate price, mix and usage variances.

2. Mixers Ltd. is engaged in producing a standard mix using 60 kgs. of chemical X and 40kgs of chemical Y. The standard loss of production is 30%. The standard price of X isRs.5 per kg. and of Y is Rs. 10 per kg.

The actual mixture and yield were as follows.

X 80 kgs. @ Rs. 4.50 per leg and

Y 70 kgs @ Rs.8.00 per kg.

Actual yield 115 kgs.

Calculate material variances (Price, Usage, Yield, Mix)

3. Given that the cost standards for material consumption are 40 kgs at Rs. 10 per kg.,compute the variance when the actuals are

a. 48 kgs @ Rs. 10 per kg.

b. 40 kgs @ Rs. 12 per kg.

c. 48 kgs @ Rs. 12 per kg.

d. 36 kgs @ Rs. 10 per kg.

4. The standard cost of material for manufacturing a unit of a particular product FEE isestimated as follows.

16 kgs of raw material @ Re. 1 per kg.

On completion of the unit, it was found that 20 kgs of raw material costing Rs.1.50 perkg. has been consumed. Compute material variances (price, usage, cost)

5. A company manufacturing ‘distempers’ operates a standard costing system. The standardcost for one of the products of the company shows the following materials standards.


Materials Quantity Standard Price Total Rs.per kg Rs.

A 40 75 3,000B 10 50 500C 50 20 1,000

Material cost per unit (Total) 4,500

The standard input mix is 100 kgs and the standard output of the finished product is 90kgs.

The actual results for a period are

Material Used.

A - 2,40,000 kgs @ Rs. 80/kg

B - 40,000 kgs. @ Rs. 52/kg

C - 2,20,000 kgs @ Rs. 21/kg

Actual output of the finished product - 4,20,000 kgs.

Yon are required to calculated the material price, mix and yield variance.

6. In a factory 100 workers are engaged and the average rate of wages is 50 paise. Standardworking hours per week are 40 and the standard performance is 10 units per gang hour.

During a week in March, wages paid for 40 workers were at the rate of 50 paise per hour,10 workers at 70 paise per hour and 40 workers at 40 paise per hour. Actual output was380 units.

Factory did not work for 5 hours due to breakdown of machinery. Calculate appropriatelabour variances

7. The standard cost of a unit shows the following costs of material and labour

Material 4 pices @ Rs. 5.00

Labour 10 hours @ Rs. 1.50

5,700 units of the product were manufactured during the month of March 1987 with thefollowing material and labour costs.

Material 23,000 pieces at Rs. 4.95

Labour 56,800 hours at Rs. 1.52

539Standard Costing

You are required to calculate

(1) Material Price variance

(2) Material Cost variance

(3) Material Usage variance

(4) Labour Rate variance

(5) Labour Efficiency variance

(6) Labour Cost variance

8. The standard labour component and the actual labour component engaged in a week fora job are as under.

Skilled Semi Skilled UnskilledWorkeis Workers Workers

(a) Standard number of workers

in the gang 32 12 6

(b) Standard wage rate per hour (Rs.) 3 2 I

(c) Actual number of workers employed 28 18 4

in the gang during the week.

(d) Actual wage rate per hour (Rs.) 4 3 2

During the 40 hours working week, the gang produced 1800 standard hours of work.

Calculate the following variances.

(i) Labour cost variance

(ii) Labour efficiency variance

(iii) Labour rate variance

(iv) Labour mix variance

9. Items Budget Actual

No. of working days 20 22

Month hours per day 8,000 8,400

Output per manhour in units 1.0 0.9

Overhead cost (Rs.) 1,60,000 1,68,000

Calculate overhead variances.

10. From the following data of A Co. Ltd. relating to budgeted and actual performance for themonth of March 87, compute the Direct Material and Direct Labour cost variances.


Budgeted data for March :

Units to be manufactured 1,50,000

Units of direct material required

(Based on standard rates) 4,95,000

Planned purchases of Raw Materials (Units) 5,40,000

Average unit cost of Direct Material Rs.8

Direct Labour hours per unit of finished goods 3/4 hr.

Direct Labour cost (Total) Rs. 29,92,500

Actual data at the end of March :

Units actually manufactured 1,60,000

Direct Material cost

(Purchase cost based on units actually issued) Rs. 43,41,900

Direct Material cost

(Purchase cost based on units actually purchased) Rs. 45,10,000

Average unit cost of Direct Material Rs.8.20

Total Direct Labour hours for March 1,25,000

Total Direct Labour cost for March. Rs. 33,75,000

11. The following details relating to the Product X during the month of March 1989 are available.You are required to compute the material and labour cost variance and also to reconcilethe standard and the actual cost with the help of such variances.

Standard cost per unit

Materials 50 kgs. @ Rs. 40 per kg.

Labour 400 hours @ Rs. 1.00 per hour.

Actual cost for the month -

Material 4900 kgs @ Rs. 42 per kg.

Labour 39,600 hours @ Rs. 1.10 per hour

Actual production - 100 units.

541Standard Costing

12. Following data are available in respect of a particular department for weekly operations:

Standard output for 40 hours week - 2,000 units

Standard fixed overheads - Rs. 2,000

Actual output - 1,800 units

Actual hours worked - 32

Actual fixed overheads -Rs. 2,250

Calculate overhead variances

13. Dustfree Products manufactures and sells a patented vaccum cleaner for domestic useand the following data is available for October 1983.

Actual Standard

Direct Labour hours 10,500 10,000(10 hrs. per unit)

Direct Labour cost (Rs.) 21,500 2.10 per hourDirect Material (Tonnes) 550 540Direct Material cost (Rs.) 52,250 100 per Tonne

Actuals Budgeted(For October) (For the year)

Overheads: Fixed 6,200 72,000Variable (varies with volume 15,200 216,000

of production)

Overhead is budgeted for normal activity of 1,44,000 hours of direct labour per annum,equally phased.

Compute labour, material and overheads variances.

14. The budgeted and actual sales of a concern manufacturing and marketing a single productare furnished below.

Budgeted sales Actual salesQty. Price per Amount Qty. Price per unit Amount

Units Rs. Rs. units Rs. Rs.

10,000 3.00 30,000 5,000 3.00 15,000

8,000 2.50 20,000

Ascertain,

(a) Sales Price Variance

(b) Sales Volume Variance.


17. From the following information about sales, calculate

(a) Total Sales Variance

(b) Sales Price Variance

(c) Sales Volume Variance

(d) Sales Mix Variance

(e) Sales Quantity Variance

Standard ActualProduct Nos. Rate (Rs.) Rs. Nos. Rate (Rs.) Rs.

A 5,000 5 25,000 6,000 6 36,000

B 4,000 6 24,000 5,000 5 25,000

C 3,000 7 21,000 4,000 8 32,000

12,000 70,000 15,000 93,000

18. Budgeted and actual sales for a month of two products A and B were as below

Budget ActualUnits Unit Price Units Unit Price

Rs. Rs.

A 3,000 10.00 2,500 10.00

1,000 9.50

B 5,000 2.00 4,000 2.00

1,200 1.90

Budgeted costs for the products A and B were Rs.8 and Rs. 1.50 respectively. Work outthe following variances.

(a) Sales Value Variance

(b) Sales Volume Variance

(c) Sales Price Variance

(d) Sales Mix Variance

(e) Sales Qunatity Variance

19. X Ltd. operates a budgetory control and standard costing system.

From the following data calculate

(a) Sales Variance

(b) Sales Volume Variance

(c) Sales Price Variance

543Standard Costing

Budgeted ActualProduct Units to be Sales Value Units sold Sales value

Rs. Rs.

A 100 1,200 100 1,100

B 50 600 50 600

C 100 900 200 1,700

D 75 450 50 300

325 3,150 400 3,700

20. The records of an engineering company indicate the following for the month of April 1986

Standards Factors Unit cost (Rs.)

Direct Materials 4 gallons @ Rs. 1.20 4.80

Direct Labour 3 hours @ Rs. 1.80 5.40

Factory overheads Rs.0.60 per labour hour 1.80

Total manufacturing cost 12.00

Activity for the month of April 1986 -

(1) Production during the month of April 1986 has been 6,500 units with no beginningor ending work in progress inventories.

(2) Materials purchased 32,000 gallons @ Rs. 1.18 per gallon. Used in production25,600 gallons.

(3) Labour hours worked 20,000. Average hourly wage rate Rs. 1.75

(4) Factory overheads - Total overheads costs incurred Rs. 12,500

Calculate material variances, labour variances and total variance for factory overheads.

21. A factory supplies the following figures of production and overheads for September 1983

Budgeted Actual

Production (Units) 50,000 52,000

Variable overheads (Rs.) 4,00,000 4,10,000

Fixed overheads (Rs.) 6,00,000 6,20,000

Number of hours 2,00,000 2,20,000

Work out the variances that are involved.


22. It is estimated that in the manufacture of a product, for each ton of material consumed,100 articles should be produced. The Standard Price per ton of material is Rs. 10. Duringthe first week of January, 200 tons of materials were issued to the production department,the purchase price of which was Rs. 10.50 per ton. The actual output for the period was20,500 units.

Calculate the Material Variances.

545Standard Costing

NOTES


NOTES

547Uniform Costing

Chapter 14UNIFORM COSTING

It refers to the use of same costing principles and methods by several undertakings. It’s not aseparate method of cost accounting but only a particular technique which applies the usualaccounting methods like process costing, job costing, standard costing, budgetory costingand marginal costing. Main feature of uniform costing is that whenever a particular method ofcosting is applied it is applied uniformly in a number of concerns in the same industry or evendifferent but similar industries. This enables cost and accounting data of the member undertakingsto be compiled on a comparable basis so that useful and crucial decisions can be taken. Itattempts to establish uniform methods so that comparison of performances in the variousundertakings can be made to the common advantages of all the constituent units.

Scope of Uniform Costing :

Uniform costing methods may be advantageously applied -

(i) In single organisation having a number of branches, each of which may be a separatemanufacturing unit. In this case, the head office controls the operations of the uniformcosting methods.

(ii) In a number of concerns in the same industry bound together through a trade associationor otherwise. In this case, the procedure for uniform costing may be devised and controlledby the association or any other central body prescribed for this purpose.

(iii) In industries which are similar such as gas and electricity, cotton, jute and woolentextiles.

Requisites for uniform costing :

The success of uniform costing will depend upon the following :

(1) There should be a spirit of mutual trust and policy of give and take.

(2) There should be free exchange of ideas and methods.


(3) Bigger units should be ready to share with smaller ones, improvements, achievementsof efficiency and know how.

(4) There should not be any hiding or withholding of information.

(5) There should be no rivalry, competition or sense of jealousy among the members.

Advantages of uniform costing :

(1) Uniform costing is a useful tool for management control. Performances of individual unitscan be measured against norms set for the industry as a whole.

(2) It avoids cut throat competition by ensuring that competition among the members willproceed on healthy lines.

(3) Weaker units in the industry can take the advantage of the efficient methods of productionand production control of better managed units so as to increase their own efficiency.

(4) The fruits of the research and development programmes which can be carried out only bythe bigger units, may be shared by the smaller units.

(5) By showing one best way of doing things, it creates cost consciousness and providesthe best system of cost control or cost presentation in the entire industry.

(6) Prices based on uniform costing may be taken to be reliable and representative of thewhole industry. This creates customer confidence and improves relations betweencustomer and business.

(7) It assists in educating the less informed units as regards the cost accounting methods.

(8) In India, where public undertakings operate alongwith the private sector undertakings,uniform costing enables a comparitive assessment to be made of the two sectors.

(9) Uniform costing enables the furnishing of suitable statistics to the Government wherevercalled upon to do so. This may be required by Government for effective price control or togive protection or subsidy to a particular industry etc.

(10) It simplifies the work of wage boards set up to fix minimum wages and fair wages for anindustry.

549Uniform Costing

Disadvantages of Uniform Costing :

(1) The practices and methods followed by various units in the industry may vary from oneunit to another. The factors for such differences like location, age, capital investment andcondition of plant, degree of mechanisation etc. may be so wide from each other that tohave a uniform costing system suitable for big as will as small units becomes impossible.

(2) For small units, cost of installation and operation of uniform costing system may not becommensurate to the advantages therefrom.

(3) If some reservations are made while giving certain information by some units or if someinformation is withheld on the grounds of secrecy or privacy, the statistics presentedcannot be relied upon.

(4) It may create conditions which are likely to develop monopolistic tendencies within theindustry. Prices may be raised arbitrarily and supplies curtailed.

Fields covered by uniform costing :

Considering the basic nature of uniform costing as discussed above, it goes without sayingthat the success of uniform costing system depends upon the extent to which uniformity canbe brought about in various areas. The various areas in which uniformly can be attempted tobe brought are as discussed below.

(1) Method of cost accounting to be implemented viz. job costing, process costing, unitcosting and so on.

(2) Costing Techniques employed i.e. marginal costing, standard costing etc.

(3) Methods of pricing the issues from stores. viz. FIFO, LIFO, Weighted Average and soon.

(4) Method followed for valuation of inventories.

(5) Methods followed for inventory control.

(6) Method followed for charging depreciation viz. written down value, straight line etc.

(7) Methods of remunerating the workers.

(8) Treatment given to certain specific types of costs like bonus, idle time wages and so on.

(9) Methods for apportionment and absorption of overheads and treatment given to under orover absorption of overheads.

(10) Treatment given to material scrap, wastes, spoilages and defectives.


(11) Treatment given to research and development costs.

(12) Definition of the term capacity for setting overhead absorption rates.

(13) Procedure for classification and codification of accounts.

(14) Items to be excluded from cost accounts.

Uniform Cost Manual :

It is a document which lays down the cost accounting plans and procedures to be followed bythe constituent units. This document once circulated among the constituent units helps toguide them to formulate their system of accounting in such a way that the principles of uniformcosting can be uniformly and correctly applied.

The various contents of an uniform cost manual can be stated us below :

(1) Introduction : This part may state the objects and purposes of uniform cost system,advantages derived therefrom and the cooperation expected from constituent units.

(2) Organisation : This part may include the organisation for establishing and running theuniform cost system. E.g. whether the system is to be established and run by outsidecost consultants or by those internal to the various constituent units.

(3) Cost Accounting System : This part includes accounting systems and procedures tobe followed lo bring about uniformity E.g. classification and codification of accounts,definition of a cost centre and cost unit, relationship between cost and financial accounting,items to he included in or excluded from cost accounting, collection of various costs viz.material, labour and overheads and so on.

(4) Presentation of information : This part may include the forms and contents of variouscost and financial ratios, presentation of various production and operation costs and soon.

(5) Miscellaneous : This part may include any of their information to be communicated tothe constituent units but not included in any of the above mentioned sections.

551Uniform Costing

QUESTIONS

1. What are the advantages and limitations of uniform costing?

2. Write short notes -

Uniform Costing Manual

3. What do you mean by Uniform Costing? What are the various advantages anddisadvantages of Uniform Costing? State the pre-requisites for the success of UniformCosting. Explain the various areas where uniform costing can be used.


NOTES

scdl managerial accounting

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