COST ACCOUNTING

[For B.Com. (Pass & Hons.) Fourth Semester and B.Com. (Financial Services) Third Semester
Students of G.N.D. University and also useful for allied courses of other universities]

S.P. JAIN K.L. NARANG

Ex-Associate Professor in Commerce Formerly Head
Shaheed Bhagat Singh College Department of Commerce
(University of Delhi) Government College, Chandigarh and
Sheikh Sarai, Phase II, New Delhi Principal, Government College
Kapurthala (Punjab)

SIMMI AGRAWAL MONIKA SEHGAL

Ph.D. FCA, ACMA Associate Professor
Director, Institute of Financial Education & Learning Post-Graduate Govt. College for Girls
Ghaziabad (U.P.) Sector 42, Chandigarh (U.T.)

BINOO GUPTA
Assistant Professor
P.G. Department of Commerce and Business
Administration
Hans Raj Mahila Mahavidyalaya, Jalandhar (Punjab)

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© 2017, Jain, S.P. ■ Narang, K.L. ■ Agrawal, Simmi ■ Sehgal, Monika

Fifth Revised Edition, 2024

Typesetting at : Times Printographic

PRINTED IN INDIA
At Kalyani Printings, B-15, Sector-8, NOIDA (U.P.)
and Published by Mrs. Usha Raj Kumar for
Kalyani Publishers, New Delhi-110 002
(ii )

Preface
Fifth Revised Edition

We are happy to present the fifth revised edition of the book before the readers according to the latest
syllabus of B.Com. (Pass & Hons.) fourth Semester and B.Com. (Financial Services) third Semester of
G.N.D. Univerisity.
In the developing economy like ours, the importance of Cost Accounting has been acknowledged by all
specially when optimum utilisation of resources is the crying need of the day. As a result the knowledge of Cost
Accounting to the commerce students has become absolutely necessary. In view of this, this subject is gaining
importance and thus has been included in B.Com. (Pass & Hons.) fourth Semester and B.Com. (Financial
Services) third Semester of G.N.D. Univerisity.
This book has primarily been written in the simple language and in a lucid style with a view to explaining
the principles and practice of Cost Accounting to the students. Numerous examples have been incorporated in
this book to illustrate the basic principles of the subject. A good number of practical problems are given at end
of each chapter for practice by students. These have been suitably graded and edited to include questions of
topical interest. Short/Long Answer Type questions have been added to make the subject-matter more clear to
the readers. Our endeavour is to prepare students for challenges lying ahead in academic and professional
world. This book will help the students to acquaint with basic concepts used in Cost Accounting and various
methods involved in Cost Ascertainment Systems and Cost Control.
All problems (given at the end of each chapter of this book) and their solutions have been given in a
separate book i.e. Problems and Solutions in Cost Accounting for the benefit of the readers.
We invite professors and students to visit our website www.spjainlearnings.com for updated articles
related to the subject. We also invite articles of interest, discussion points and any other updates related to the
syllabus which shall be uploaded on the website with acknowledgement and photograph of the author along
with the article.
We are thankful to many of our students and readers for their suggestions. We are also thankful to the
publishers for their efforts in bringing out the book in time.
Thank you for your continued support. We strive to uptodate the text thoroughly on continuous basis. Users
may give feedback and suggestions to us on E-mail : [email protected]. The authors will feel amply
rewarded for their efforts if students are benefited by it.
Readers are also requested to fill the attached feedback form, scan and mail to us.

2024 S.P. Jain

K.L. Narang
Simmi Agrawal
Monika Sehgal
Binoo Gupta
(iii)

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(iv)

Syllabus
B.Com. (Pass & Hons.) IVth Semester and B.Com. (Financial Services) IIIrd Semester of G.N.D. University

Time : 3 Hours Max. Marks : 50

Instructions for the Paper Setters

Eight questions of equal marks (Specified in the syllabus) are to be set, two in each of the four Sections (A-
D). Questions may be subdivided into parts (not exceeding four). Candidates are required to attempt five
questions, selecting at least one question from each Section. The fifth question may be attempted from any
Section.

SECTION-A
Introduction: Concept of Cost, Costing, Cost Accounting and Cost Accountancy, Limitations of Financial
Accounting, Origin and Objectives of Cost Accounting, Advantages and Limitations of Cost Accounting.
Difference between Financial and Cost Accounting, Cost Unit and Cost Centre, Elements of Cost, Material,
Labour and other Expenses Classification of Cost, Types of Costs and Preparation of Cost Sheet.

SECTION-B
Contract Costing—Meaning, Features and Rules regarding the Calculation of Profits in case of Complete and
Incomplete Contracts alongwith the Treatment of Work-in-progress.
Process Costing—Meaning, Features, Normal and Abnormal Loss/Gains, Inter-process Profits and Equivalent
Production.

SECTION-C
Reconciliation of Cost and Financial Accounts.
Marginal Costing—Meaning and Various Concepts—Fixed Cost, Variable Cost, Contribution, P/V Ratio, Break-
even Point, Margin of Safety, Managerial Applications.

SECTION-D
Standard Costing—Definition and Meaning of Various Concepts Advantages and Limitations of Standard
Costing.
Variance Analysis—Material, Labour and Overheads Variances only.
Budget and Budgetary Control—Definition, Meaning and Objectives of Budgetary Control.
Advantages and Disadvantages of Budgetary Control, Types of Budget.
(v)

Contents

SECTION A

1. Nature and Scope of Cost Accounting A/1·1—1·41

2. Cost—Analysis, Concepts, Classifications and Cost Sheet A/2·1—2·36

SECTION B

1. Contract Costing B/1·1—1·58

2. Process Costing B/2·1—2·68

SECTION C

1. Reconciliation of Cost and Financial Accounts C/1·1—1·43

2. Marginal Costing and Break-Even Analysis C/2·1—2·62

3. Applications of Marginal Costing C/3·1—3·53

SECTION D

1. Standard Costing and Variance Analysis D/1·1—1·77

2. Budgetary Control D/2·1—2·83

SECTION A

CHAPTER

1
Nature and Scope of Cost
Accounting
LEARNING OBJECTIVES

To define the Cost Accounting and its relationship to Financial Accounting and Management
Accounting.
To understand cost accounting system and its installation
To explain briefly the cost accounting standards with framework.
To define and understand Generally Accepted Cost Accounting Principles (GACAP).

Introduction
In today’s interconnected world, the business environment has undergone a significant
transformation. Companies now face intense competition on a global scale, making it imperative for
them to gain a competitive edge. This objective can be accomplished by focusing on two key factors:
(i) Cost Effectiveness and (ii) Quality Consciousness. Achieving cost effectiveness and maintaining
high-quality standards are crucial elements for the success of any business enterprise. However, to
accomplish these goals, management must possess accurate and detailed knowledge about costs. It is
essential for management to ensure that cost savings do not come at the expense of compromising
quality.
Traditional accounting approaches often fall short in providing the necessary information to
support modern business objectives. They rely on historical cost data, which may not accurately
reflect current and future costs. To overcome these limitations, businesses need to adopt advanced
cost accounting techniques that provide more precise and up-to-date cost information. Quality
consciousness is of utmost importance as it ensures customer satisfaction and long-term success.
While cost reduction is a vital consideration, management must prioritise maintaining high quality
standards.
A/1·2 NATURE AND SCOPE OF COST ACCOUNTING

Detailed knowledge about costs is essential for effective decision-making. Management requires
timely and accurate cost information to make informed choices regarding pricing, product mix,
process improvements, and resource allocation. Traditional accounting methods may not provide the
necessary granularity to understand costs at a more detailed level, hindering decision-making
processes. By adopting advanced cost accounting techniques, integrated information systems, and
key performance indicators, companies can gain the insights needed to enhance cost effectiveness and
quality.
Recognising the limitations of traditional accounting, modern accounting practices are evolving
to meet the demands of the global economy. These practices include the adoption of advanced
costing methods, integration of non-financial performance metrics, and the use of technology-driven
information systems. Cost accounting is indispensable in today’s business landscape. It provides the
necessary tools and information for businesses to achieve cost effectiveness, maintain quality
consciousness, and gain a competitive edge. By leveraging cost accounting techniques and practices,
businesses can make informed decisions, optimise resource allocation, control costs, and ultimately
enhance their overall performance and success in the global economy.
Cost accounting is a specialised branch of accounting that focuses on the identification, analysis,
and control of costs within an organisation. It plays a crucial role in providing valuable information
for decision-making, cost control, and performance evaluation. In this chapter, we will delve into the
nature and scope of cost accounting, exploring its fundamental concepts, objectives, and the diverse
areas it encompasses.

Historical Overview of Cost Accounting

The early development of cost accounting can be traced back to the Industrial Revolution, a
period of significant industrial growth in the late 18th and early 19th centuries. As industries
expanded, there arose a need to track and control costs associated with production. During this time,
various techniques and practices were developed to measure and allocate costs, improve efficiency,
and support decision-making. These early developments laid the groundwork for modern cost
accounting, which has evolved to become an essential tool for businesses in managing costs,
evaluating performance, and making informed decisions.
The development of cost accounting as a discipline has been influenced by the contributions of
several key figures throughout history. These individuals have made significant advancements in
cost accounting theory, practices, and techniques, shaping its evolution into the modern discipline it
is today. Some notable figures include :
1. Frederick Winslow Taylor (1856-1915) : Taylor, an American engineer and management
consultant, is considered the father of scientific management. He emphasised the importance
of analysing and improving work processes to enhance efficiency and reduce costs.
2. Henry Ford (1863-1947) : Ford, an American industrialist and founder of Ford Motor
Company, revolutionised manufacturing through the implementation of the assembly line,
leading to significant cost reductions and increased efficiency.
3. Henry Metcalfe (1885-1956) : Metcalfe, an engineer and management consultant introduced
the concept of standard costs in the early 1900s. He emphasised the importance of setting
predetermined standards for materials, labour, and overhead costs as a basis for measuring
and controlling performance.
NATURE AND SCOPE OF COST ACCOUNTING A/1·3

4. Ronald A. Fisher (1890-1962) : Fisher, a British statistician and economist, developed

statistical methods for analysing cost data, providing valuable insights into cost behaviour
and the relationship between costs and factors affecting them.
5. Eric Kohler (1902-1988) : Kohler, a German-born management accountant, introduced the
concept of direct costing (now variable costing), which facilitated decision-making and cost
control by separating fixed and variable costs.
6. William J. Vatter (1922-2010) : Vatter, an American management accountant and academic,
emphasised integrating cost accounting with management principles and decision-making
processes, highlighting its role in strategic planning, performance measurement, and control.
These key figures, among others, have shaped the development of cost accounting by introducing
innovative concepts, techniques, and theories. Their contributions have expanded the understanding
of cost behaviour, cost control, and decision-making in business organisations. Their work continues
to influence modern cost accounting practices, providing a foundation for effective cost management
and informed decision-making.

Evolution of Cost Accounting

The evolution of cost accounting can be traced back to the early stages of industrialisation when
businesses began to recognise the need for a systematic approach to track and control costs. Over
time, cost accounting has undergone significant developments to adapt to the changing needs of
organisations. The key stages in the evolution of cost accounting are :
1. Traditional Cost Accounting : In the late 19th and early 20th centuries, cost accounting
primarily focused on allocating costs to products based on direct labour and material inputs.
The emphasis was on determining product costs for inventory valuation and financial
reporting purposes. Techniques such as job costing and process costing were commonly used
during this period.
2. Activity-Based Costing (ABC) : In the 1980s and 1990s, the limitations of traditional cost
accounting became apparent. The emergence of complex manufacturing processes and
indirect costs that could not be accurately allocated using traditional methods led to the
development of activity-based costing. ABC aimed to allocate indirect costs based on the
activities that consumed resources, providing a more accurate picture of product costs and
profitability.
3. Strategic Cost Management : With the increasing emphasis on global competition and the
need for organisations to manage costs strategically, cost accounting expanded its scope to
include strategic cost management. This approach involved analysing costs in relation to
value creation and competitive advantage. Techniques like target costing, value chain
analysis, and life-cycle costing gained prominence during this period.
4. Lean Accounting : As the principles of lean manufacturing gained traction, the need for cost
accounting methods that aligned with lean principles emerged. Lean accounting aimed to
eliminate waste, improve efficiency, and measure performance in lean manufacturing
environments. It emphasised the use of value streams, just-in-time inventory systems, and
cost tracking methods that focused on value-added activities.
5. Activity-Based Management (ABM) and Beyond : Cost accounting has evolved beyond just
cost allocation and reporting. Activity-Based Management (ABM) integrates cost information
A/1·4 NATURE AND SCOPE OF COST ACCOUNTING

with operational decision-making processes. It involves identifying value-adding activities,

analysing cost drivers, and making informed decisions to improve performance and resource
allocation.
6. Technology and Advanced Analytics : The advent of technology has revolutionised cost
accounting. Advanced analytics, automation, and enterprise resource planning (ERP) systems
have enabled real-time cost tracking, improved accuracy in cost estimation, and enhanced
decision-making capabilities. Cost accounting has become more data-driven, enabling
organisations to analyse large volumes of data and extract valuable insights.
Cost accounting has evolved from traditional allocation methods to a more strategic and dynamic
discipline. It has adapted to the changing business landscape, incorporating techniques that align
with the needs of modern organisations. Today, cost accounting plays a vital role in enabling
organisations to make informed decisions, optimise costs, and achieve their strategic objectives.

Cost Accounting in India

The history of cost accounting in India can be traced back to the early 20th century when
industrialisation began to shape the country’s business landscape. Professionals who had acquired
knowledge from British accounting systems introduced concepts like standard costing and cost
control in industries such as textiles, steel, and engineering. In 1959, the Institute of Cost and Works
Accountants of India (ICWAI), now known as the Institute of Cost Accountants of India (ICAI), was
established to promote and regulate the profession of cost accountancy. The ICWAI/ICAI developed
Cost Accounting Standards (CAS) to ensure uniformity and transparency in cost accounting
practices. The Companies Act, 2013, introduced provisions requiring certain companies to maintain
cost records and undergo cost audits, with compliance required in industries like manufacturing,
mining, processing, and services. Over time, cost accounting in India has integrated with financial
reporting, aligning with Indian Accounting Standards (Ind AS). Cost management has gained
importance, and techniques such as target costing, activity-based costing, and value analysis are
widely used. Technological advancements have also influenced cost accounting practices, with the
adoption of ERP systems, cost management software, and advanced analytics. Today, cost accounting
continues to be a crucial aspect of financial management and decision-making in Indian
organisations, enabling them to optimise costs and improve operational efficiency.
Cost accounting emerged as a response to the limitations of financial accounting in providing
detailed and actionable cost information for managerial decision-making. While financial accounting
focuses on recording and reporting historical financial transactions, cost accounting provides a
deeper understanding of the costs associated with producing goods or providing services. The key
reasons why cost accounting was needed and the limitations of relying solely on financial
accounting are :

(i) Cost Ascertainment : Financial accounting alone does not provide a comprehensive picture
of costs incurred in the production process. Cost accounting helps in determining the cost of
materials, labour, and overheads associated with specific products, services, or activities. It
enables businesses to identify cost drivers, analyse cost behaviour, and allocate costs
accurately.
(ii) Cost Control and Management : Financial accounting focuses on the overall financial
performance of a company, but it may not provide sufficient information for effective cost
NATURE AND SCOPE OF COST ACCOUNTING A/1·5

control and management. Cost accounting allows businesses to monitor and control costs by
identifying cost variances, analysing cost trends, and implementing cost reduction strategies.
It helps in optimising resource allocation and improving operational efficiency.
(iii) Decision-Making : Financial accounting reports, such as income statements and balance
sheets, provide a summarised view of financial performance but lack detailed cost
information. Cost accounting plays a crucial role in decision-making by providing insights
into the profitability of products, services, customers, and business segments. It helps in
setting prices, evaluating the viability of new projects, and determining the optimal product
mix.
(iv) Performance Evaluation : Financial accounting primarily focuses on external reporting, while
cost accounting aids in internal performance evaluation. By comparing actual costs with
budgeted or standard costs, businesses can assess their cost performance, identify
inefficiencies, and take corrective actions. Cost accounting enables the measurement of
profitability at various levels, such as individual products, departments, or projects.
(v) Pricing and Profitability Analysis : Financial accounting may not provide accurate
information for pricing decisions and profitability analysis. Cost accounting helps businesses
determine the true costs of products or services, including both direct and indirect costs. It
facilitates understanding the cost structure, identifying cost drivers, and establishing
appropriate pricing strategies to ensure profitability.
(vi) Cost Transparency and Cost Reduction : Financial accounting statements may not provide
sufficient visibility into the cost elements of products or services. Cost accounting enhances
cost transparency by providing detailed information on various cost components, enabling
businesses to identify areas of wastage or inefficiency. This information is crucial for
implementing cost reduction measures and improving overall profitability.
Cost accounting addresses the limitations of financial accounting by providing detailed and
actionable cost information for managerial decision-making. It enables businesses to ascertain costs
accurately, control and manage costs effectively, make informed decisions, evaluate performance, and
improve overall profitability. By complementing financial accounting, cost accounting enhances the
understanding of an organisation’s cost structure and aids in strategic planning and operational
efficiency.

Financial Accounting vs. Cost Accounting

Both financial and cost accounting are the branches of accounting whose main object is to provide
information by recording the business transactions systematically and scientifically so that it may
serve the purpose of the management for policy formulation and controlling and to provide
necessary protection to the outsiders. Both are based on double entry system and their roles are
supplementary. The ordinary Trading Account is a locked storehouse of most valuable
information, to which cost system is the key. In case of financial accounting stress is on the
ascertainment and presentation of profits earned or losses incurred in the business. Due to this
reason, in financial accounting the transactions are recorded, classified and analysed in a subjective
manner, i.e., according to the nature of expenditure. They do not provide the information on the
relative effectiveness of products, processes, human resources, equipments and other factors of
production. The provision of accounting and financial data at macro level does not provide tools for
indepth analysis for performance in terms of cost efficiency. Thus, Financial accounting treats costs
A/1·6 NATURE AND SCOPE OF COST ACCOUNTING

very broadly, while cost accounting does this in much greater detail. In order to illustrate this fact, let
us examine the following statement :
Particulars Under Financial Accounting Under Cost Accounting
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Total Product A Product B Product C

(1) (2) (3) (4) (5)
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R
Materials 1,50,000 48,000 37,000 65,000
Wages 70,000 15,000 25,000 30,000
Other Expenses 50,000 15,000 18,000 17,000
———————————— ———————————— ———————————— ————————————

Total Cost 2,70,000 78,000 80,000 1,12,000

———————————— ———————————— ———————————— ————————————

Sales 3,00,000 1,02,400 1,08,000 89,600

Profit
(Sales – Cost) 30,000 24,400 28,000 (–)22,400
Profit (%) on Sales 10 23.8 25.9 —

Financial accounting (See Column 2) reveals an apparently satisfactory profit of R 30,000 which
represents 10% of sales. However, the information is too general to be of great use to the
management, who needs to know the profit or loss of each product so that policy decision can be
made. With this end in view and assuming that three products A, B and C were manufactured, cost
accounting records could reveal a position something like this (See Column 3 to 5) :
The information (under cost accounting) clearly reveals to the management that products A and
B are obtaining approximately 24% and 26% profit but product C is pulling down the total profit to
10%. Thus management may : (a) investigate thoroughly product C to find out possible economies, (b)
stop production of C, (c) increase selling price of C, (d) produce C as a loss leader, i.e., produce and
sell in the hope of encouraging consumers also to buy A and B provided there are no changes in plant
capacity, plant utilisation, volume of sales etc. The cost accountant points out the facts and where
possible, suggests remedies; management must make the final decision on policy. For example, if
course (b) were followed, the overhead which had been absorbed by Product C, may have to be
absorbed by Products A and B or if course (c) were followed, market research may have to be
conducted to determine consumer reactions to increase in selling price.

Distinction Between Financial Accounting and Cost Accounting

Main differences between financial accounting and cost accounting are given as under :
Point of Distinction Financial Accounting Cost Accounting
(1) Purpose It provides information about the business It provides information to management for
in a general way. It tells about the profit proper planning, operation, control and
and loss and financial position of the decision-making.
business to owners and other outside par-
ties.
(2) Form of These accounts are kept in such a way as These accounts are generally kept
Accounts to meet the requirements of Companies voluntarily to meet the requirements of
Act and Income Tax Act. management. But now Companies Act
has made it obligatory to keep cost
records in some manufacturing industries.
NATURE AND SCOPE OF COST ACCOUNTING A/1·7

(3) Recording It classifies, records and analyses the It records the expenditure in an objective
transactions in a subjective manner i.e. manner i.e. according to the purposes for
according to the nature of expenses. which the costs are incurred.
(4) Control It lays emphasis on the recording aspect It provides a detailed system of control for
without attaching any importance to materials, labour and overhead costs with
control. the help of standard costing and
budgetary control.
(5) Periodicity of It reports operating results and financial It gives information through cost reports
Reporting position usually at the end of the year. to management as and when desired.
(6) Analysis of Financial accounts are the accounts of the Cost accounting is only a part of the
Profit whole business. They are independent in financial accounts and discloses profit or
nature and disclose the net profit or loss loss of each product, job or service.
of the business as a whole.
(7) Reporting of The costs are reported in aggregate in The costs are broken down on a unit
Costs financial accounts. basis in cost accounts.
(8) Nature of Financial accounts relate to commercial Cost accounts relate to transactions
Transactions transactions of the business and include connected with the manufacture of goods
all expenses viz., manufacturing, office, and services and include only those ex-
selling and distribution etc. Financial ac- penses which enter into the production.
counts are concerned with external Cost accounts are concerned with
transactions i.e. transactions between the internal transactions which do not form
business concern on one side and third the basis of payment or receipt of cash.
parties on the other. These transactions
form the basis for payment or receipt of
cash.
(9) Information Monetary information is only used (i.e. Non-monetary information like units is
only monetary transactions are recorded). also used ( i.e. it deals with monetary as
well as non-monetary information).
(10) Fixation of Financial accounts are not maintained Cost accounting provides sufficient data
with the object of fixing selling prices. for fixation of selling prices.
Selling Price
(11) Figures Financial accounts deal mainly with actual Cost accounts deal partly with facts and
facts and figures. figures and partly with estimates.
(12) Reference In devising or operating a system of No such reference is possible. Guidance
financial accounting reference can be can be had only from a body of conven-
made in case of difficulty to the company tions followed by cost accountants.
law, case decisions and to the canons of
sound professional practice.
(13) Relative Financial accounts do not provide Cost accounts provide valuable
Efficiency information on the relative efficiencies of information on the relative efficiencies of
various workers, plants and machinery. various workers, plants and machinery.
(14) Stock Valuation Stocks are valued at cost or market price, Stocks are valued at cost.
whichever is less.
A/1·8 NATURE AND SCOPE OF COST ACCOUNTING

(15) Type of Science Financial accounting is a positive science Cost accounting is not only a positive
because it is subject to legal rigidity with science but also a normative science
regard to the preparation of the financial because it includes techniques of bud-
statements. getary control and standard costing.
Costing is an empirical science, that is to
say, the rules which govern it are largely
conditioned by the operations, personnel
and policy of the undertaking with respect
to which its techniques are to be applied.

Key Terms
Cost, cost accounting, cost accountancy, and costing are key terms in the field of cost accounting.
These terms hold significant relevance in understanding the intricacies of cost management and
decision-making within organisations. These terms and their interrelationships are discussed below.
Cost : Cost refers to the monetary value of resources consumed or sacrificed to achieve a specific
objective. It encompasses various elements such as raw materials, labour, overheads, and other
expenses incurred in the production or provision of goods and services. Costs can be classified into
direct costs, which are directly attributable to a specific product or service, and indirect costs, which
cannot be easily traced to a particular cost object.
Cost Accounting : Cost accounting is the process of collecting, analysing, summarising, and
evaluating various alternative courses of action. Its goal is to advise the management on the most
appropriate course of action based on the cost efficiency and capability. Cost accounting involves the
collection, analysis, interpretation, and presentation of cost-related information. It focuses on the
measurement, allocation, and control of costs within an organisation. Cost accounting systems and
techniques help businesses determine the cost of products, services, processes, and activities,
enabling effective decision-making, performance evaluation, and cost control. Cost accounting
provides managers with valuable insights into cost behaviour, cost trends, and the profitability of
different products or business segments.
Cost Accountancy : Cost accountancy is a specialised profession that encompasses the application of
cost accounting principles, methods, and techniques to assist management in making informed
decisions. Cost accountancy is the science, art and practice of a cost accountant. It is science because it is a
body of systematic knowledge having certain principles which a cost accountant should possess for
proper discharge of his responsibilities. It is an art as it requires the ability and skill with which a cost
accountant is able to apply the principles of cost accountancy to various managerial problems.
Practice includes the continuous efforts of a cost accountant in the field of cost accountancy. Cost
accountants, also known as management accountants, play a vital role in cost analysis, budgeting,
cost control, and performance measurement. They apply their expertise to optimise resource
allocation, enhance operational efficiency, and contribute to strategic decision-making within an
organisation.
Costing : Costing is the process of determining the total cost of producing a specific product,
providing a service, or carrying out an activity. It involves identifying and quantifying all the cost
elements associated with the cost object, including direct costs and indirect costs. Costing techniques,
such as job costing, process costing, and activity-based costing, enable businesses to allocate costs
accurately, assess profitability, and set appropriate prices.
NATURE AND SCOPE OF COST ACCOUNTING A/1·9

Difference Between Costing and Cost Accounting

Main differences between costing and cost accounting are given as under :
Basis of Costing Cost Accounting
Distinction
(1) Nature It is a technique and process of ascertaining It is regarded as a specialised branch of
costs. accounting.
(2) Scope Costing techniques include principles and It involves classification, accumulation,
rules which govern the procedure of assignment and control of costs.
ascertaining the cost of products/services.
(3) Process The process of costing consists of routines of It involves establishment of budgets,
ascertaining costs by historical or standard costs or actual costs of operations,
conventional costing, standard costing or classification, recording and appropriate
marginal costing. allocation of expenditure.

The Institute of Cost Accountants of India (ICAI), formerly known as the Institute of Cost and
Works Accountants of India (ICWAI), is the regulatory body responsible for managing the cost
accounting profession in India. It was established in 1959 under an Act of Parliament. The primary
objective of the institute is to promote, regulate, and develop the profession of cost and management
accountancy in the country. ICAI is responsible for setting standards, conducting examinations, and
providing education and training for aspiring cost accountants. It offers professional courses leading
to the designation of a Cost and Management Accountant (CMA). ICAI plays a vital role in ensuring
the competence, ethical conduct, and professional development of cost accountants in India.

Definition and Purpose of Cost Accounting

Cost accounting can be defined as a branch of accounting that focuses on capturing, analysing, and
interpreting cost-related information to aid in managerial decision-making and control. It involves the
collection, classification, measurement, and reporting of costs associated with producing goods or providing
services. The primary purpose of cost accounting is to provide management with accurate and timely
cost information that can assist in planning, controlling, and evaluating business operations. Cost
accounting helps in determining the cost of products or services, assessing profitability, identifying
cost-saving opportunities, and supporting strategic decision-making.
C.I.M.A. London defines cost accounting as " the establishment budgets, standard cost and
actual cost of operations, processes, activities or products and the analysis of variances, profitability
or the social use of funds". Thus, cost accounting relates to the collection, classification, ascertainment
of cost and its accounting and control relating to the various elements of cost.

Features of Cost Accounting

Cost accounting encompasses several features that distinguish it from other branches of
accounting. These features are designed to capture, analyse, and interpret cost-related information to
support managerial decision-making and control. Here are the key features of cost accounting :
(i) Cost Collection : Cost accounting emphasises the collection of cost data from various sources
within the organisation. It involves the systematic recording of costs incurred for materials,
labour, overheads, and other cost elements. Accurate cost collection ensures that all relevant
costs are captured and attributed to the appropriate cost objects.
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(ii) Cost Classification : Cost accounting involves the classification of costs based on various
criteria such as their nature, behaviour, function, or relevance to specific products, services,
or activities. This classification enables businesses to track and analyse different types of costs
and understand their impact on profitability.
(iii) Cost Measurement : Cost accounting focuses on measuring costs using appropriate
techniques and methods. It involves assigning costs to specific cost centres, cost objects, or
activities. This process may include allocating indirect costs using allocation bases such as
labour hours, machine hours, or square footage. Accurate cost measurement allows for a
better understanding of cost behaviour and facilitates decision-making.
(iv) Cost Analysis : Cost accounting emphasises the analysis of cost data to derive meaningful
insights. Cost analysis involves studying cost behaviour, cost-volume-profit relationships,
cost variances, and cost drivers. It helps identify cost-saving opportunities, assess cost
efficiency, and support pricing decisions. Cost analysis techniques such as break-even
analysis, variance analysis, and contribution margin analysis are commonly used in cost
accounting.
(v) Cost Estimation and Forecasting : Cost accounting facilitates the estimation and forecasting
of costs. By analysing historical cost data, cost accountants can make predictions about future
costs, allowing for effective budgeting and planning. Cost estimation techniques, such as
regression analysis or learning curve analysis, are employed to forecast costs accurately.
(vi) Cost Control : Cost accounting plays a vital role in cost control efforts. It involves monitoring
and comparing actual costs with budgeted or standard costs, identifying cost variances, and
taking corrective actions. Cost control techniques help in minimising wastage, improving
operational efficiency, and maximising profitability.
(vii) Cost Reporting : Cost accounting provides comprehensive cost reports to aid in decision-
making and performance evaluation. Cost reports may include statements such as cost of
goods manufactured, job costing reports, profitability reports by product or customer, and
cost variance analysis. These reports provide management with valuable information for
strategic planning, control, and resource allocation.
(viii) Integration with Financial Accounting : Cost accounting integrates with financial accounting
to provide a comprehensive view of an organisation’s financial performance. Cost data is
reconciled with financial statements, ensuring consistency and accuracy in reporting. This
integration allows for a better understanding of the cost structure, profitability, and financial
health of the organisation.
The features of cost accounting revolve around the classification, collection, measurement,
analysis, estimation, control, and reporting of costs. These features enable businesses to make
informed decisions, optimise costs, improve efficiency, and achieve their financial objectives. Cost
accounting provides valuable insights into the cost structure of products, services, activities, and
processes, supporting managerial decision-making and control at various levels within the
organisation.

Scope of Cost Accounting

The scope of cost accounting extends beyond the functions and objectives and encompasses
various areas of business operations where cost-related activities are undertaken. It covers the entire
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cost management process and provides valuable insights into cost behaviour, cost control, and
decision-making. The scope of cost accounting includes :

(i) Cost Identification and Measurement : Cost accounting involves identifying and measuring
costs associated with producing goods or providing services. It encompasses the classification
and categorisation of costs, distinguishing between direct and indirect costs, and assigning
costs to specific cost objects. This process ensures accurate cost determination and provides a
foundation for further analysis and decision-making.
(ii) Cost Analysis and Cost Behaviour : Cost accounting analyses cost data to understand cost
behaviour patterns. It involves studying how costs change in response to changes in activity
levels, production volumes, or other cost drivers. By examining cost behaviour, cost
accountants can identify fixed costs, variable costs, and semi-variable costs, which help in
cost control, budgeting, and forecasting.
(iii) Cost Planning and Budgeting : Cost accounting plays a crucial role in cost planning and
budgeting processes. It assists in setting cost targets, developing cost budgets, and allocating
resources efficiently. Cost accountants collaborate with other departments to establish
realistic cost projections, monitor actual costs against budgeted amounts, and take corrective
actions when necessary.
(iv) Cost Control and Cost Reduction : Cost accounting focuses on cost control measures to
manage and reduce costs. It involves monitoring actual costs, comparing them to standard or
budgeted costs, and analysing cost variances. Cost accountants identify areas of cost
inefficiency, waste, or excessive expenditure and recommend strategies for cost reduction. By
implementing cost control measures, organisations can improve profitability and
competitiveness.
(v) Decision Support : Cost accounting provides critical information for decision-making. It
assists management in evaluating alternative courses of action by considering their cost
implications. Cost accountants perform cost analysis, conduct cost-benefit analysis, and use
techniques such as differential costing and cost-volume-profit analysis to support decision-
making processes. This information aids in determining product pricing, assessing
profitability, evaluating investment opportunities, and optimising resource allocation.
(vi) Performance Evaluation : Cost accounting facilitates performance evaluation by comparing
actual costs with standard costs or budgets. It enables management to assess the efficiency
and effectiveness of departments, products, or projects. Performance evaluation helps in
identifying areas of improvement, rewarding high-performing areas, and aligning
performance with organisational objectives.
(vii) Strategic Cost Management : Cost accounting contributes to strategic cost management by
providing insights into the cost structure of the business. It assists in evaluating the
profitability of different products, services, or business units and supports strategic decision-
making related to market expansion, product development, or cost leadership strategies.
Strategic cost management ensures that cost considerations are integrated into overall
business plans and objectives.
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Objectives of Cost Accounting

The objectives of cost accounting represent the desired outcomes or goals that organisations aim
to achieve through the implementation of cost accounting practices. The objectives of cost accounting
are multi-faceted and serve various purposes within an organisation. The key objectives of cost
accounting are :
(i) Determining Product Cost : One of the primary objectives of cost accounting is to determine
the cost of producing goods or services. By analysing the cost components such as direct
materials, direct labour, and overheads, cost accounting helps in accurately calculating the
cost of individual products or services. This information is crucial for setting appropriate
pricing strategies and making informed decisions regarding product profitability.
(ii) Cost Control and Cost Reduction : Cost accounting aims to control costs and identify
opportunities for cost reduction. It involves monitoring and analysing costs to identify areas
of inefficiency, waste, or excessive expenditure. Through techniques like variance analysis
and budgetary control, cost accounting helps in identifying cost overruns, controlling
expenses, and implementing cost-saving measures to improve overall operational efficiency.
(iii) Facilitating Decision-Making : Cost accounting provides vital information for managerial
decision-making. It aids in evaluating alternative courses of action by assessing their
associated costs and benefits. By providing relevant cost data, such as cost-volume-profit
relationships, break-even analysis, and differential costing, cost accounting assists in making
informed decisions related to pricing, product mix, make or buy decisions, and expansion
strategies.
(iv) Performance Evaluation : Cost accounting plays a significant role in evaluating the
performance of various departments, products, or activities within an organisation. By
comparing actual costs with standard costs or budgets, cost accounting helps in identifying
cost variances and measuring performance. This evaluation enables management to take
corrective actions, reward high-performing areas, and improve overall operational efficiency.
(v) Inventory Valuation : Cost accounting is essential for accurate valuation of inventory. It
provides methods and techniques to assign costs to inventory items, such as First-In, First-
Out (FIFO), Last-In, First-Out (LIFO), or weighted average cost. Proper inventory valuation
assists in financial reporting, determining the cost of goods sold, and assessing the value of
the company’s assets.
(vi) Assisting in Strategic Planning : Cost accounting provides valuable insights for strategic
planning and resource allocation. It helps in assessing the profitability of various products,
services, or business units, which aids in identifying areas of focus or diversification. Cost
accounting data assists in formulating business strategies, setting realistic financial targets,
and determining the optimal allocation of resources.
(vii) Ensuring Regulatory Compliance : Cost accounting helps in ensuring compliance with
regulatory requirements. It provides accurate cost data and cost allocation methods that are
necessary for financial reporting and tax purposes. Cost accounting standards and practices
enable organisations to meet regulatory guidelines and maintain transparency in cost
reporting.
The objectives of cost accounting revolve around determining product costs, controlling costs,
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facilitating decision-making, evaluating performance, inventory valuation, strategic planning, and

regulatory compliance. By fulfilling these objectives, cost accounting supports effective management
decision-making, improves operational efficiency, and contributes to the overall financial success of
the organisation.
Functions of Cost Accounting : The functions of cost accounting refer to the specific activities
and processes involved in managing costs within an organisation. These functions include cost
determination, cost control, cost analysis, budgeting and forecasting, decision support, performance
evaluation, and strategic planning. Each function serves a specific purpose in the overall cost
management process and contributes to achieving the objectives of cost accounting.

Advantages of Cost Accounting

Cost accounting offers several key advantages that contribute to the efficient management of
costs and decision-making in businesses. These advantages can be summarised as follows :
(i) Profitability Analysis : Cost accounting helps identify profitable and unprofitable activities,
enabling businesses to focus on high-yielding areas and eliminate or improve low-
performing ones.
(ii) Efficiency Measurement and Improvement : Cost accounting provides valuable data for
measuring efficiency and identifying areas where improvements can be made, resulting in
enhanced productivity and cost-effectiveness.
(iii) Estimation and Tendering : Cost accounting facilitates accurate cost estimation for contracts
and projects, enabling businesses to submit competitive tenders and win profitable deals.
(iv) Production Planning : Cost accounting guides effective production planning by providing
insights into costs and profitability across different business lines and processes, optimising
resource allocation.
(v) Cost Control and Waste Reduction : Cost accounting helps businesses implement effective
cost controls, reducing waste, identifying inefficiencies, and improving overall cost
management.
(vi) Comparative Cost Analysis : Cost accounting enables businesses to compare costs across
different periods, departments, and processes, identifying cost-saving opportunities and
promoting efficient operations.
(vii) Periodic Profit Determination : Cost accounting allows for regular profit determination
without the need for physical stocktaking, providing timely insights into financial
performance.
(viii) Efficiency and Incentive Systems : Cost accounting facilitates the evaluation of worker
efficiency, enabling businesses to implement suitable incentive systems that reward
productivity and drive performance improvement.
(ix) Financial Strength and Credibility : Cost accounting provides businesses with a clear
understanding of their financial position, enhancing credibility and attracting investors,
creditors, and stakeholders.
(x) Government Compliance and Policy Formulation : Cost accounting assists businesses in
complying with government regulations, such as tax assessment, and provides reliable data
for policy formulation and decision-making at a national level.
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By leveraging cost accounting, businesses can gain a competitive edge, optimise costs, enhance
profitability, and make informed strategic decisions.

Cost Accounting as an Aid to Management

Cost accounting plays a crucial role in aiding management in various aspects of business
operations. It provides valuable information and insights that enable management to make informed
decisions and effectively manage the organisation. Here are some key ways in which cost accounting
aids management :
(i) Cost Control and Reduction : Cost accounting provides detailed information on costs
incurred at various levels of the organisation, including direct costs, indirect costs, and
overheads. This data enables management to identify specific areas of excessive costs,
wastage, or inefficiency. By analysing cost patterns and trends, management can implement
effective cost control measures, such as streamlining processes, reducing unnecessary
expenses, or negotiating better terms with suppliers. Cost accounting helps in identifying cost
drivers and taking proactive steps to reduce costs, ultimately improving overall cost
management and profitability.
(ii) Pricing Decisions : Accurate product costing is crucial for setting appropriate prices that
ensure profitability. Cost accounting helps management determine the true costs associated
with manufacturing or delivering products or services. By considering direct material costs,
labour costs, overheads, and other expenses, management can make informed pricing
decisions.
(iii) Profitability Analysis : Cost accounting helps management analyse the profitability of
different products, services, customers, or market segments. By assessing the costs associated
with each revenue stream, management can allocate resources effectively and focus on high-
profit areas. Cost accounting enables identify areas where pricing adjustments or cost
reductions may be necessary to maximise profitability.
(iv) Budgeting and Planning : Cost accounting plays a crucial role in the budgeting and planning
processes. By providing cost-related data and analysis, it enables management to set realistic
budgets, monitor actual costs, and make adjustments based on changing business conditions.
Cost accounting supports accurate forecasting of future costs, revenues, and profitability by
considering factors such as inflation, cost drivers, or anticipated changes in business
operations. This facilitates effective financial planning, enables proactive management of
resources, and ensures that budgetary targets are aligned with the organisation’s cost
structure and financial goals.
(v) Performance Evaluation and Bench marking : Cost accounting facilitates the evaluation of
departmental or project performance by comparing actual costs against budgets or standards.
It enables management to identify variances, analyse their causes, and take corrective actions
to improve performance. Cost accounting also allows management to benchmark the
performance of the organisation against industry standards or competitors. By comparing
cost structures, productivity levels, and profitability metrics, management can identify areas
for improvement and best practices. Bench marking provides valuable insights for
identifying opportunities to reduce costs, improve efficiency, or enhance product quality. By
adopting best practices and learning from industry leaders, management can drive
continuous improvement, set performance targets, and stay competitive in the market.
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(vi) Decision-Making Support : Cost accounting provides valuable data and insights that
support decision-making at various levels of management. When faced with make or buy
decisions, expansion plans, investment opportunities, or other strategic choices, cost
accounting helps evaluate the financial implications of different options. By analysing
the costs, revenues, and potential risks associated with each alternative, management can
make informed decisions that align with the organisation’s objectives and financial
capabilities.
(vii) Resource Allocation : Cost accounting provides insights into the costs associated with
different activities, processes, or departments within the organisation. This information
assists management in optimising resource allocation. By analysing cost patterns and
resource utilisation, management can identify areas where resources are underutilised or
inefficiently deployed. This allows for reallocating resources to more productive areas,
eliminating redundancies, or making adjustments based on cost-effectiveness. Cost
accounting helps management make informed decisions about resource allocation, ensuring
that resources are utilised efficiently to maximise productivity and minimise waste.
(viii) Strategic Planning : Cost accounting plays a crucial role in strategic planning by
incorporating cost considerations into business plans. It assists management in evaluating the
profitability of various strategic options, assessing risks, and making informed decisions to
achieve long-term objectives. By analysing the costs associated with different strategies,
management can assess the financial implications and feasibility of each option. Cost
accounting helps in determining the potential profitability, return on investment, and
payback period for strategic initiatives, enabling management to allocate resources effectively
and align the organisation’s efforts with its long-term goals.
(ix) Performance Measurement : Cost accounting provides performance metrics that help
management monitor and evaluate the organisation’s performance. By tracking key cost-
related indicators, such as cost per unit, cost variance, or cost-to-sales ratio, management can
assess how efficiently resources are utilised and identify areas requiring improvement. These
metrics enable the comparison of actual performance against predetermined targets or
industry benchmarks, facilitating performance evaluation and the identification of areas for
cost optimisation and process improvement. Cost accounting provides management with the
necessary information to make data-driven decisions and continuously monitor the
organisation’s performance.
(x) Risk Management : Cost accounting aids management in identifying and managing risks
related to costs. By assessing the impact of cost fluctuations, pricing changes, or resource
constraints, management can proactively address potential risks and develop
appropriate risk management strategies. Cost accounting helps in analysing the financial
impact of various risk scenarios, allowing management to evaluate the potential
consequences and devise contingency plans to mitigate those risks. By incorporating cost-
related risk assessments into decision-making processes, management can make informed
choices that balance risk and reward, ensuring the organisation’s financial stability and
sustainability.
Cost accounting equips management with the necessary tools and information to effectively
control costs, allocate resources, make strategic decisions, and drive the organisation towards its
financial and operational objectives.
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Limitations of Cost Accounting

Cost accounting, while a valuable tool for businesses, does have certain limitations. These
limitations include :
(i) Ignores Non-Monetary Factors : Cost accounting primarily focuses on quantitative data and
financial aspects. It does not take into account non-monetary factors such as customer
satisfaction, employee morale, or environmental impact. This limitation can result in
decisions that prioritise cost reduction without considering the broader impact on
stakeholders and long-term sustainability.
(ii) Subjective Allocation of Overheads : Allocating overhead costs to different products or
departments can be subjective and may not accurately reflect the actual cost drivers. This can
lead to distorted cost information and affect the accuracy of decision-making.
(iii) Historical Cost Emphasis : Cost accounting primarily relies on historical cost data, which
may not reflect current market conditions or changes in technology. This can limit the
relevance and accuracy of cost information when making decisions in dynamic and rapidly
changing business environments.
(iv) Focuses on Internal Operations : Cost accounting is primarily focused on internal operations
and may not capture the full cost impact of external factors such as changes in market
demand, competitor actions, or economic fluctuations. This limitation can hinder the
organisation’s ability to respond effectively to external market conditions.
(v) Not Suitable for Small-Scale Operations : Cost accounting systems can be complex and
costly to implement, making them less practical for small-scale businesses with limited
resources. The benefits derived from implementing cost accounting may not outweigh the
associated costs for smaller operations.
(vi) Difficulty in Allocating Joint Costs : Allocating costs for products or services that share
common inputs or processes (joint costs) can be challenging. Different methods of allocation
may result in varying cost allocations, which can affect the accuracy of cost information and
decision-making.
(vii) Focuses on Historical Performance Evaluation : Cost accounting is primarily focused on
evaluating historical performance rather than providing forward-looking insights. While it
helps in assessing past performance, it may not provide sufficient guidance for future
planning and strategic decision-making.
(viii) Difficulty in Measuring Intangible Assets : Cost accounting struggles to capture and
measure intangible assets such as intellectual property, brand value, or customer loyalty.
These assets are increasingly important in today’s knowledge-based economy and can
significantly impact the organisation’s value and performance. Cost accounting fails to
provide a comprehensive view of the organisation’s overall value creation.
(ix) Ethical Considerations : Cost accounting relies on accurate data and the integrity of
individuals involved in the process. Ethical lapses, intentional or unintentional, such as
manipulation of cost data, can lead to misleading information and compromise the
effectiveness of cost accounting.
It is important to recognise these limitations and complement cost accounting with other
management tools and approaches to ensure a comprehensive understanding of the organisation’s
financial and operational performance.
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General Principles of Cost Accounting

Following are the main principles of Cost Accounting :
(1) Cause-effect relationship.
Cause-effect relationship should be established for each item of cost. Each item of cost
should be related to its cause as minutely as possible and the effect of the same on the
various departments should be ascertained. A cost should be shared only by those units
which pass through the departments for which such cost has been incurred.
(2) Charge of cost only after its incurrence.
Unit cost should include only those costs which have been actually incurred. For example
unit cost should not be charged with selling cost while it is still in factory.
(3) Past costs should not form part of future costs.
Past costs (which could not be recovered in past) should not be recovered from future costs
as it will not only affect the true results of future period but will also distort other statements.
(4) Exclusion of abnormal costs from cost accounts.
All costs incurred because of abnormal reasons (like theft, negligence) should not be taken
into consideration while computing the unit cost. If done so, it will distort the cost figures
and mislead management resulting in wrong decisions.
(5) Principles of double entry should be followed preferably.
To lessen the chances of any mistake or error, cost ledgers and cost control accounts, as far
as possible, should be maintained on double entry principles. This will ensure the
correctness of cost sheets and cost statements which are prepared for cost ascertainment and
cost control.

Cost Accounting Information System

Accounting is an information system that aims to develop and communicate information to aid
management in making appropriate decisions. In smaller businesses, where the owner has close
contact with all departments, the need for formal information systems may be less pronounced.
However, in larger organisations, the complexity of operations and the delegation of authority
necessitate the establishment of robust information systems.
This is where the cost accounting information system becomes invaluable. It serves as a scientific
approach to collect, process, store, and communicate cost information pertaining to various activities
within an organisation. Its purpose is to provide timely, accurate, and relevant information to
different levels of management, enabling them to efficiently plan, control, and make informed
decisions.
A cost accounting information system refers to the framework, processes, and technologies used
to collect, analyse, and report cost-related data within an organisation. It is a specialised system that
focuses on generating and managing information related to costs incurred in various activities,
processes, products, or services.
The primary objective of a cost accounting information system is to provide accurate and relevant
cost information to support decision-making, cost control, and performance evaluation within an
organisation. It helps management understand the cost structure, identify cost drivers, and make
informed decisions to optimise resource allocation and improve profitability.
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In today’s computer age, an efficient cost accounting information system has become a necessity.
It ensures that cost-related data is readily available for cost ascertainment, analysis, and control. The
system plays a crucial role in facilitating the functioning of all operational activities at the optimal
level of efficiency and minimum cost.

Design of a Cost Accounting Information System

The design of a cost accounting information system should align with the information needs of
management and be based on a cost-benefit analysis. It should provide integrated and coordinated
information, catering to the requirements of each responsible manager in discharging their functions
effectively. Without an efficient cost accounting information system, cost control needs and profit
opportunities may be missed due to poor communication and delayed information.

Steps in the Designing of Cost Accounting Information System

The development of a cost accounting information system involves several steps. The key steps
involved are :
(i) Identify Information Needs : The first step is to identify the specific information needs of the
organisation and its management. This involves understanding the types of cost information
required, the frequency of reporting, and the level of detail needed to support decision-
making and control.
(ii) Define Objectives : Clearly define the objectives of the cost accounting information system.
These objectives may include cost ascertainment, cost control, performance measurement,
decision support, and strategic planning. The objectives should align with the overall goals
and strategies of the organisation.
(iii) Determine Data Collection Methods : Determine the most suitable methods for collecting
cost data. This may involve identifying the sources of cost information, establishing data
collection procedures, and implementing data capture mechanisms such as manual
recording, automated systems, or integration with other information systems.
(iv) Establish Cost Allocation Methods : Determine the appropriate methods for allocating costs
to different cost objects such as products, services, departments, or projects. This may involve
developing cost allocation bases and formulas that reflect the cost drivers and cost behaviour
within the organisation.
(v) Design Cost Accounting System : Design the cost accounting system by selecting the
appropriate costing techniques and methodologies. This may include job costing, process
costing, activity-based costing, or a combination of methods based on the nature of the
organisation’s operations and cost structure.
(vi) Develop Cost Reporting Formats : Design cost reporting formats that present cost
information in a clear and meaningful way. These reports should provide relevant cost data
to different levels of management, enabling them to make informed decisions and monitor
performance.
(vii) Implement Information System : Implement the cost accounting information system by
integrating the data collection methods, cost allocation methods, and reporting formats. This
may involve configuring software applications, establishing data input and processing
procedures, and training personnel on system usage.
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(viii) Monitor and Evaluate : Continuously monitor and evaluate the effectiveness of the cost
accounting information system. Regularly review the quality, accuracy, and timeliness of the
cost information generated. Make necessary adjustments and improvements to ensure that
the system meets the evolving information needs of the organisation.
By following these steps, organisations can develop a robust cost accounting information system
that provides timely, accurate, and relevant cost information to support decision-making, cost
control, and performance management.

Objectives of a Cost Accounting Information System

The objectives of a cost accounting information system are :
(i) Facilitating Planning and Control : The cost accounting information system plays a crucial
role in supporting the planning and control functions of management. By providing timely
and accurate information, it enables effective decision-making and helps in achieving
organisational goals.
(ii) Cost Control and Reduction : The cost accounting information system assists in controlling
costs by identifying areas of inefficiency, such as idle time, labour turnover, wastage, and
surplus capacity. This information helps management take corrective measures to reduce
costs and improve overall efficiency.
(iii) Variance Analysis and Corrective Action : By comparing actual performance against
standard and budgeted performance, the cost accounting information system highlights
variances. This enables management to identify deviations, analyse their causes, and
implement appropriate corrective actions.
(iv) Leveraging Organisational Strengths : The cost accounting information system brings to the
management’s attention the organisation’s strengths and competitive advantages. This
information enables the management to capitalise on opportunities and make strategic
decisions to enhance profitability.
(v) Monitoring Production Quality : The cost accounting information system provides valuable
insights into production statistics, including information on rejections, defectives, and
spoilage. By monitoring these factors and their impact on costs and product quality,
management can take necessary steps to improve product standards and reduce waste.
(vi) Enhancing Financial Decision-Making : The cost accounting information system provides
valuable financial data and analysis that aids management in making informed financial
decisions. It assists in assessing the profitability of products, services, projects, or divisions,
enabling management to allocate resources effectively and identify areas for improvement.

Characteristics of an Ideal Costing System

An ideal costing system possesses several key characteristics that contribute to its effectiveness
and usefulness in providing accurate and relevant cost information. The characteristics or essentials
of an ideal costing system are :
(i) Accuracy : An ideal costing system ensures the accuracy of cost data through precise data
collection methods, proper allocation of costs, and rigorous verification processes. It strives to
eliminate errors, inconsistencies, and biases to provide reliable cost information.
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(ii) Relevance : The costing system focuses on capturing costs that are relevant to decision-
making. It distinguishes between costs that are controllable and those that are not, ensuring
that management receives information that is directly applicable to planning, control, and
decision-making processes.
(iii) Timeliness : An ideal costing system provides cost information in a timely manner. It
captures and reports costs promptly, enabling management to make informed decisions
based on up-to-date information. Timeliness is crucial to support real-time decision-making
and facilitate proactive cost management.
(iv) Flexibility : The costing system is adaptable to different types of industries, business models,
and cost structures. It can accommodate various costing methods and techniques based on
the specific needs and requirements of the organisation. It allows for customisation and
adjustments as per changing business conditions.
(v) Cost-Effectiveness : The costing system strikes a balance between the cost of implementation
and the benefits derived. It avoids unnecessary complexities and costs associated with data
collection and processing. The system is designed to provide cost information efficiently,
utilising resources effectively without excessive overheads.
(vi) Integration : An ideal costing system integrates with other management information systems
within the organisation. It ensures seamless flow of data and facilitates integration with
financial accounting, production planning, inventory management, and other relevant
systems. Integration enhances the overall effectiveness and efficiency of decision-making
processes.
(vii) Comprehensive Reporting : The costing system generates comprehensive reports that
provide a holistic view of costs and their drivers. It offers both detailed and summarised
information, allowing management to analyse costs at various levels, such as product lines,
departments, or projects. The reports should be clear, understandable, and meaningful to aid
decision-making.
(viii) Forward-Looking : The costing system goes beyond historical cost information and provides
insights into future costs and cost drivers. It assists in forecasting, budgeting, and scenario
analysis, enabling management to anticipate and plan for future cost implications and make
proactive decisions.
(ix) Continuous Improvement : An ideal costing system encourages continuous improvement by
regularly evaluating and refining its processes, methods, and techniques. It strives for on
going enhancements to enhance the accuracy, relevance, and usefulness of cost information.
Feedback from users and stakeholders is sought to drive improvements.
By encompassing these characteristics, an ideal costing system supports effective cost
management, decision-making, and overall organisational performance.

Steps for Installation of a Costing System

The installation of a costing system requires careful planning and implementation to ensure its
effectiveness and smooth integration within the organisation. Here are the steps involved in installing
a costing system :
(i) Needs Assessment : Begin by assessing the specific needs and requirements of the
organisation. Identify the objectives and goals of implementing a costing system, as well as
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the areas where cost information is most critical. This assessment will help determine the
scope and focus of the costing system.
(ii) Existing Routine Analysis : Before implementing the costing system, a thorough analysis of
the existing organisational structure, operations, and routines should be conducted. This
analysis helps identify the specific areas where the costing system needs to be integrated and
adapted.
(iii) System Design : Based on the needs assessment, design the structure and components of the
costing system. Determine the cost elements to be tracked, the allocation methods to be used,
and the level of detail required. Design the reporting formats and determine the frequency of
cost reporting.
(iv) Data Collection : Establish a systematic method for collecting cost data. Identify the sources
of cost data, such as invoices, payroll records, production reports, and purchase orders.
Define the procedures and mechanisms for recording and capturing cost information
accurately and consistently.
(v) Cost Allocation : Determine the appropriate methods for allocating costs to various cost
objects, such as products, services, departments, or projects. Consider different allocation
techniques, such as direct costing, absorption costing, or activity-based costing, based on the
nature of the organisation’s operations.
(vi) Cost Calculation : Develop the necessary formulas and calculations to determine the costs of
different cost objects. This may involve determining direct costs, indirect costs, overhead
allocation, and any applicable cost drivers. Ensure that the calculations align with the
objectives and requirements of the organisation.
(vii) System Implementation : Implement the costing system by integrating it into the
organisation’s existing accounting and information systems. This may involve configuring
software, training personnel, and establishing protocols for data collection, recording, and
reporting. Test the system to ensure its accuracy and functionality before full-scale
implementation. The costing system should be introduced in stages, allowing for a gradual
transition. Existing routines and practices should be utilised unless there are strong reasons
for their replacement. This approach ensures a smoother implementation and minimises
disruptions to on-going operations.
(viii) Monitoring and Evaluation : Continuously monitor and evaluate the costing system’s
performance. Regularly review the accuracy of cost data, assess the relevance of cost
information for decision-making, and solicit feedback from users. Identify areas for
improvement and make necessary adjustments to enhance the system’s effectiveness.
(ix) Clear Authority and Responsibility : Clearly defining authority and responsibility within
the costing system is crucial for its successful implementation. Ambiguity should be avoided,
and roles and responsibilities should be clearly communicated and understood.
(x) Training and Communication : Provide training and guidance to employees involved in
data collection, cost calculation, and cost reporting. Ensure that all stakeholders understand
the purpose and benefits of the costing system. Communicate the importance of accurate cost
information and encourage the use of cost data in decision-making processes.
(xi) Continuous Improvement : Foster a culture of continuous improvement within the
organisation. Encourage feedback, suggestions, and ideas from users and stakeholders to
A/1·22 NATURE AND SCOPE OF COST ACCOUNTING

enhance the costing system’s functionality and relevance. Regularly update and refine the
system to adapt to changing business needs and evolving cost management practices.
Installing a costing system requires careful planning, implementation, and continuous
monitoring to ensure its successful integration and effective utilisation within the organisation. By
following these steps, the organisation can establish a robust costing system that provides accurate
and relevant cost information for decision-making and cost management purposes.

Challenges in Installing a Costing System

Installing a costing system can involve several practical difficulties. Some common challenges
that organisations may face during the installation process are :
(i) Resistance to Change : Implementing a new costing system requires changes in procedures,
routines, and work practices. Resistance to change from employees who are accustomed to
the old system can be a significant hurdle. Overcoming resistance and gaining acceptance for
the new system may require effective communication, training, and support.
(ii) Lack of Data Availability : Costing systems heavily rely on accurate and timely data.
However, organisations may encounter difficulties in gathering the required data, especially
if there are limitations in the existing data collection processes or if data is scattered across
different systems or departments. Ensuring data availability and integrity can be a complex
task.
(iii) Integration with Existing Systems : Costing systems need to integrate with other
information systems, such as financial accounting, inventory management, and production
systems. Ensuring seamless integration and data flow between systems can be challenging,
particularly if there are compatibility issues or if existing systems are outdated.
(iv) Cost Allocation Challenges : Allocating costs accurately to products, services, or cost centers
can be complex, especially in organisations with diverse and interconnected operations.
Determining appropriate cost allocation methods and addressing allocation discrepancies can
be a time-consuming and intricate process.
(v) Resource Constraints : Installing a costing system may require additional resources,
including financial investment, technology infrastructure, and skilled personnel. Limited
resources or budgetary constraints can hinder the implementation process and impact the
system’s effectiveness.
(vi) Training and Skill Development : Employees involved in the costing system may require
training to understand the new processes, methodologies, and tools. Providing adequate
training and skill development opportunities to ensure competence and proficiency can be a
logistical challenge.
(vii) Time and Implementation Complexity : Installing a costing system is a comprehensive and
time-consuming process. It involves various steps, such as system design, data mapping,
process re-engineering, and testing. Balancing the implementation timeline with on-going
business operations and minimising disruptions can be a significant challenge.
(viii) Maintenance and Continuous Improvement : Once the costing system is installed, on-going
maintenance and continuous improvement are essential to keep it relevant and effective.
Organisations need to allocate resources for system updates, data validation, and regular
reviews to address emerging challenges and changing business needs.
NATURE AND SCOPE OF COST ACCOUNTING A/1·23

It is crucial for organisations to anticipate these practical difficulties and develop strategies to
overcome them effectively during the installation of a costing system. Close collaboration between
stakeholders, effective change management practices, and on-going monitoring and support are key
to a successful implementation.

Overcoming Practical Challenges in Installing a Costing System : Steps for

Successful Implementation
To overcome the practical difficulties in installing a costing system, organisations can take the
following steps :
(i) Clear Communication and Change Management : Effective communication is essential to
address resistance to change. Clearly articulate the reasons for implementing the new costing
system and how it will benefit the organisation and employees. Involve key stakeholders in
the decision-making process and ensure their concerns are addressed. Provide training and
support to employees to help them adapt to the new system.
(ii) Data Management and Integration : Ensure data availability and integrity by improving
data collection processes and implementing data governance practices. Identify and resolve
data quality issues, standardise data formats, and establish protocols for data integration
between different systems. Invest in technologies or software tools that facilitate seamless
data flow and integration.
(iii) Cost Allocation Methodologies : Evaluate and select appropriate cost allocation methods
that align with the organisation’s operations and objectives. Consider factors such as activity-
based costing, direct tracing, and cost drivers for accurate cost allocation. Regularly review
and refine the cost allocation methodologies to address any discrepancies or inefficiencies.
(iv) Resource Planning and Allocation : Conduct a thorough assessment of the resources
required for installing and maintaining the costing system. Allocate sufficient budget,
personnel, and technology infrastructure to support the implementation process. Prioritise
resource allocation based on critical needs and potential impact on the success of the system.
(v) Training and Skill Development : Provide comprehensive training programs to employees
involved in the costing system. Ensure that they have a clear understanding of the new
processes, tools, and methodologies. Offer ongoing skill development opportunities to
enhance their competencies and keep them updated on best practices in cost accounting.
(vi) Phased Implementation Approach : Break down the installation process into manageable
phases to minimise disruptions to daily operations. Start with a pilot implementation in a
specific department or cost center to test and refine the system before scaling it up to the
entire organisation. Monitor and address any challenges or issues that arise during each
phase.
(vii) Continuous Improvement and Maintenance : Establish a system of regular reviews and
evaluations to identify areas for improvement. Encourage feedback from users and
stakeholders to identify any system limitations or areas that need adjustment. Allocate
resources for system maintenance, updates, and enhancements to ensure its continued
relevance and effectiveness.
(viii) Seek External Expertise : If internal resources and expertise are limited, consider engaging
external consultants or specialists with experience in implementing costing systems. They can
provide valuable insights, guidance, and support throughout the installation process.
A/1·24 NATURE AND SCOPE OF COST ACCOUNTING

By following these steps, organisations can mitigate the practical difficulties associated with
installing a costing system and increase the chances of a successful implementation that delivers the
desired benefits to the organisation.

Cost Accounting Systems and Techniques

Cost accounting systems and techniques refer to the methods and techniques used by
organisations to gather, analyse, and interpret cost data for decision-making, planning, control, and
performance evaluation purposes. These methods and techniques play a crucial role in helping
businesses manage costs, optimise resource allocation, improve profitability, and make informed
business decisions. The methods and techniques are listed below in brief and shall be discussed in
detail in separate chapters.

Methods of Costing
Methods of costing are used to determine the cost of production based on the nature of the
industry, manufacturing processes, and the measurement of output. The two primary methods of
costing are Specific Order Costing (Job/Terminal Costing) and Operation Costing (Process or Period
Costing). Let’s discuss these methods in brief :
(i) Job Costing : This method involves collecting and accumulating costs for each specific job,
work order, or project separately. It is suitable for industries where work consists of separate
and identifiable jobs. Job costing is commonly used in printing, machine tool manufacturing,
foundries, and general engineering workshops.
(ii) Contract Costing : When a job is extensive and spans a long period, the contract costing
method is employed. Costs are recorded in a separate account for each individual contract.
This method is used by builders, civil engineering contractors, and constructional and
mechanical engineering firms.
(iii) Batch Costing : Batch costing is an extension of job costing and is used when a group of small
orders or units passes through the factory together. Each batch is treated as a unit of cost and
is separately costed. Batch costing is applied in industries such as biscuit manufacturing,
garment manufacturing, and spare parts and component manufacturing.
(iv) Process Costing : Process costing is suitable for industries with continuous production and
distinct, well-defined processes. It involves charging costs to each production process or
department. The costs are then averaged over the units produced during the period. Process
costing is commonly followed in textile industries, chemical industries, tanneries, and paper
manufacturing.
(v) Unit or Output Costing : This method is suitable for industries with continuous
manufacturing processes and identical units. The objective is to determine the cost per unit of
output. Unit costing is used in industries such as mines, quarries, oil drilling, breweries,
cement works, and brickworks.
(vi) Service (or Operating) Costing : Service costing is employed by industries that provide
services rather than manufacturing goods. It is used in transport undertakings, power supply
companies, municipal services, hospitals, and hotels. The method is applied to ascertain the
cost of services rendered, such as cost per tonne-kilometer for transport or cost per kilowatt-
hour for power supply.
NATURE AND SCOPE OF COST ACCOUNTING A/1·25

(vii) Farm Costing : Farm costing is used to calculate the total cost and per unit cost of various
farming activities, including agriculture, horticulture, animal husbandry, poultry farming,
and dairy. It helps improve farming practices, ascertain profits on different farming activities,
and obtain loans based on proper cost accounting records.
(viii) Multiple Operation Costing : This method involves a series of distinct operations or
processes in manufacturing. Each operation incurs conversion costs, and the cost per unit is
calculated based on the final output. Multiple operation costing is applicable to industries
with sequential manufacturing processes.
(ix) Multiple Costing : Multiple costing is the application of more than one method of costing for
the same product. It is used in industries where component parts are separately produced
and then assembled into a final product. Different costing methods, such as process costing
and batch costing, are used to determine the cost of components and the final product. This
method is commonly used in the manufacturing of complex products like automobiles,
engines, and electronics.
It’s important to note that the selection of the appropriate costing method depends on the nature
of the industry, the production processes involved, and the information required for cost control,
decision-making, and performance evaluation. Organisations may even utilise a combination of
costing methods to suit their specific needs and requirements.

Costing Techniques
Costing techniques refer to the various approaches used to calculate and analyse costs in a
systematic manner. These techniques help businesses in determining the cost of their products or
services, controlling costs, and making informed decisions. Some commonly used costing techniques
include :
(i) Uniform Costing : Uniform costing involves the use of the same costing principles and
practices by multiple organisations for the purpose of common control or cost comparison. It
allows for standardised cost reporting and facilitates benchmarking and performance
evaluation across similar businesses.
(ii) Marginal Costing : Marginal costing focuses on differentiating between fixed and variable
costs to ascertain the marginal cost. It helps in analysing the impact of changes in output
volume or product mix on profitability. By separating fixed costs from variable costs,
management can make more informed decisions regarding pricing, product discontinuation,
or resource allocation.
(iii) Standard Costing : Standard costing involves setting predetermined standard costs for
various cost elements and comparing them to actual costs to determine variances. It enables
the identification of cost discrepancies and the analysis of their causes. Management can take
corrective actions based on these variances to improve efficiency and control costs. Latest
developments in standard costing include the use of advanced cost estimation techniques,
such as activity-based standards, to enhance accuracy.
(iv) Historical Costing : Historical costing focuses on ascertaining costs after they have been
incurred. It provides a record of actual costs incurred on past activities. Although it has
limitations, such as not accounting for changes in market conditions or technology, historical
A/1·26 NATURE AND SCOPE OF COST ACCOUNTING

costing facilitates cost comparison over different periods and aids in financial reporting and
decision-making.
(v) Direct Costing : Direct costing involves the practice of charging only direct costs (both
variable and some fixed costs) to operations, processes, or products. Indirect costs are not
allocated to specific cost objects but are treated as period expenses. Direct costing provides
valuable insights into the contribution margin of products or services and helps in pricing
decisions, profitability analysis, and resource allocation.
(vi) Absorption Costing : Absorption costing encompasses the practice of allocating all costs,
both variable and fixed, to operations, processes, or products. Unlike marginal costing, which
excludes fixed costs, absorption costing ensures that all costs are assigned to products. It
helps in determining the full cost of production and supports financial reporting
requirements. Recent developments in absorption costing include activity-based absorption
costing, which allocates costs based on the activities that drive them, providing a more
accurate cost allocation.
In recent years, there have been advancements in costing techniques driven by changes in
technology, globalisation, and business practices. Some notable developments include :
(vii) Activity-Based Costing (ABC) : ABC has gained prominence as a more accurate cost
allocation method, especially in complex and diverse business environments. It assigns costs
based on activities and cost drivers, providing a detailed understanding of cost behavior and
facilitating better decision-making.
(viii) Lean Accounting : Lean accounting has emerged as an approach aligned with lean
manufacturing principles. It focuses on eliminating waste, simplifying the accounting
process, and providing timely and relevant cost information to support lean initiatives and
continuous improvement efforts.
(ix) Target Costing : Target costing has gained significance in industries where competitive
pricing is crucial. It involves setting a target cost based on market conditions and customer
expectations and then designing products and processes to achieve that cost. Target costing
promotes cost-conscious design and helps in meeting customer needs while maintaining
profitability.
(x) Environmental Costing : With increasing environmental concerns, businesses are adopting
environmental costing techniques to measure and manage the costs associated with
environmental impacts. Environmental costing includes the assessment of costs related to
pollution control, waste management, and sustainable practices.
These latest developments reflect the evolving nature of costing techniques to address the
changing business landscape and emerging cost management.

Cost Accountant and His Responsibilities

A cost accountant is a professional who specialises in cost accounting, which involves the
measurement, analysis, and control of costs within an organisation. The role of a cost accountant is
multifaceted and encompasses several key responsibilities. Some of the primary roles and functions
of a cost accountant are :
(i) Cost Estimation and Budgeting : Cost accountants are involved in estimating and budgeting
NATURE AND SCOPE OF COST ACCOUNTING A/1·27

costs for various activities, projects, products, or services. They analyse historical data,
market trends, and other relevant factors to determine the expected costs and prepare
budgets for effective cost management.
(ii) Cost Analysis and Control : Cost accountants analyse actual costs incurred and compare
them with budgeted costs. They identify cost variances, investigate the reasons behind them,
and provide insights to management. Cost accountants play a crucial role in implementing
cost control measures, monitoring expenses, and suggesting improvements to minimise costs
and enhance profitability.
(iii) Product Costing : Cost accountants determine the cost of producing goods or services. They
analyse the cost elements, such as direct materials, direct labor, and overhead, and allocate
them to products or services based on appropriate costing methods. This information helps in
pricing decisions, assessing product profitability, and evaluating the cost-effectiveness of
manufacturing processes.
(iv) Cost Reporting and Financial Analysis : Cost accountants prepare cost reports and financial
statements related to costs, such as cost of goods sold, cost of sales, and cost of operations.
They provide accurate and timely cost information to management for decision-making,
performance evaluation, and financial planning purposes.
(v) Inventory Valuation : Cost accountants are responsible for valuing inventory and ensuring
accurate inventory records. They apply appropriate costing methods, such as FIFO (First-In,
First-Out) or weighted average, to determine the cost of inventory. Accurate inventory
valuation is essential for financial reporting, tax compliance, and assessing the financial
health of the organisation.
(vi) Costing System Design and Implementation : Cost accountants design and implement
costing systems that align with the organisation’s needs and objectives. They establish cost
allocation methods, develop cost codes and cost centres, and implement cost accounting
procedures. Cost accountants also ensure that the costing system integrates with other
financial and operational systems to provide accurate cost information.
(vii) Decision Support : Cost accountants provide valuable insights and analysis to support
decision-making within the organisation. They assist in evaluating investment proposals,
conducting cost-benefit analyses, assessing the financial viability of projects, and identifying
cost-saving opportunities. Cost accountants work closely with management to provide
relevant cost data and financial analysis for informed decision-making.
(viii) Compliance and Regulatory Requirements : Cost accountants ensure compliance with
relevant accounting standards, cost accounting principles, and regulatory requirements. They
stay updated with changes in regulations and industry practices to ensure accurate and
compliant cost accounting practices.
The role of a cost accountant is to contribute to effective cost management, financial performance
analysis, and decision-making within an organisation. They provide critical cost-related information
and insights that enable management to make informed decisions, optimise resources, control costs,
and improve profitability.
A/1·28 NATURE AND SCOPE OF COST ACCOUNTING

Cost Accounting Department and its Relation with Other Departments

Cost accounting department records, classifies and present cost information for manufacturing
and other activities of the organisation. It makes an analysis of cost of manufacturing, marketing and
administration and provides control reports and other decision making data to all levels of
management for the purpose of controlling and reducing costs. It is, therefore, necessary that cost
accounting department should have a proper coordination with other departments of the
organisation. All departments should help each other so that the objective of minimum possible cost
may be achieved without too many bottle-necks.

1. Cost Accounting Department and Production Department.

Cost accounting department and production department are closely related to each other.
Production department is concerned with the conversion of raw materials into finished
products. Cost accounting department helps in estimating the various costs involved in the
manufacturing process like material cost, labour cost and other expenses involved for
manufacturing a product. As per cost estimates, production department makes timely
arrangement of material, labour and other services required for the manufacturing process so
that production may go on smoothly without any interruption. Cost accounting department
is concerned with ascertaining, controlling and reducing cost of the manufacturing process.
The required information regarding costs relating to the manufacturing process both
budgeted and actual is collected by cost accounting department from the production
department and sent to the management for exercising cost control. In a competitive world
for facing competition effectively, reducing cost of production is a very important function.
Both production department and cost accounting department can help each other in
reducing cost of production which is the crying need of the competitive economy.

2. Cost Accounting Department and Purchase Department.

Purchase department is to ensure that right type of material is purchased at a reasonably low
price at a right time from a right supplier and there is no excessive investment in materials.
Continuous availability of material is to be ensured so that production may not be held up
for want of materials. In these respects cost accounting department can help purchase
department by setting various levels of materials like minimum level, maximum level,
reordering level, economic order quantity etc. Various types of material control suggested by
the cost accounting department will be helpful in ensuring minimum possible cost of
materials.

3. Cost Accounting Department and Personnel Department.

Personnel Department concerned with proper recruitment, selection, training labour
turnover, time keeping, time booking, fixing of wage rate, preparation of payroll, idle time
and over time works with close co-ordination of cost accounting department to get effective
results of the personnel policies. Cost accounting department suggest ways and means for
reducing costs relating to employees working in the organisation. Cost accountant can
recommend incentive plans for remunerating employees which will be attractive to the
employees for earning more wages and salaries and at the same time reducing labour cost
NATURE AND SCOPE OF COST ACCOUNTING A/1·29

per unit. In this way both departments personnel and cost accounting can be helpful in
developing a contented labour force which will be willing to work for the organisation.

4. Cost Accounting Department and Finance & Accounts Department.

A close coordination is required between cost accounting department and finance and
accounts department for reducing and controlling costs. Finance department is dependent
upon the cost accounting department for making an estimate of funds required for
production and marketing purposes. Similarly, materials and other supplies cannot be
purchased at the minimum possible prices if the finance department does not provide the
required finance at the time it is required. Cost accounting department helps financial
accounting department in preparing budgets. It also helps financial accounting department
to make the payment of the bills by duly approving them. Past figures are provided to the
cost accountant by financial accounting for making estimates for the future. Cost accounting
department and financial accounting department depend on each other for reconciling profit
as per cost accounts and profit as per financial accounts.

5. Cost Accounting Department and Marketing Department.

Marketing department is mainly concerned with marketing of products at competitive
prices. Marketing department gets cost information from cost accounting department for
fixing reasonable selling prices which may be acceptable to consumers. For considering
alternative methods of marketing, information of various types of costs involved in various
methods is provided by the cost accountant to the marketing manager. Similarly, on the basis
of information provided by the marketing department, cost accounting department will
suggest the cheapest and effective method of marketing a particular product.

COSTACCOUNTINGSTANDARDS

Meaning
Cost Accounting Standards are principles based, deal with the principles of costing, and provide
guidance on the preparation of General Purpose Cost Statements which require attestation by the cost
accounting profession, wherever applicable. Cost Accounting Standards (CAS) are, thus, a set of
standards that provide a structured approach to achieve uniformity and consistency in cost
accounting principles and practices. These provide guidance on the preparation of General Purpose
Cost Statements. To promote uniformity, there was an urgent need to integrate, harmonise, and
standardise the cost accounting principles and practices. Therefore, the Generally Accepted Cost
Accounting Principles have been clearly defined and well documented in the form of the Cost
Accounting Standards. The chart on next page will depict the coverage of Cost Accounting
Standards.
Cost Accounting Standard Board (CASB) has been set up by the Council of the Institute of Cost
Accountants of India (ICAI). The Cost Accounting Standards Board (CASB) also keeps in focus the
Generally Accepted Cost Accounting Principles and formalise them so that with the passage of time,
an accepted framework can be evolved and remain capable of adoption by all users of the standards,
including industries, professionals, and other stakeholders. While formulating the Cost Accounting
Standards, the CASB takes into consideration the applicable laws, usage and business environment
A/1·30 NATURE AND SCOPE OF COST ACCOUNTING

prevailing in India. CASB also gives due consideration to the Cost Accounting Standards, principles
and practices being followed by the other countries.

Constitution of CASB
The CASB will have a Chairman as appointed and nominated by the Council of the Institute and
other members will also be appointed and nominated by the Council. The terms and period of
appointment will also be decided by the Council of the Institute. The Director (Technical) will be the
Secretary of the CASB. The CASB will prepare a report of its work each year and send it to the
Council.

Objectives of CASB
The work of CASB is to develop Cost Accounting Standards on important issues/topics relating
to Cost and Management Accounting with the following objectives :
(i) To equip the profession with better guidelines on standard cost accounting practices
(ii) To assist the Cost Accountants in preparation of uniform cost statements
(iii) To provide guidelines to Cost Accountants to make standard approach towards maintenance
of Cost Accounting Record Rules and Undertaking Cost Audit under the Companies Act and
various other Acts like Income Tax Act, Central Excise Act, Customs Act, Sales Tax Act, etc.
(iv) To assist the management to follow the standard cost accounting practices in the matter of
compliance of statutory obligations.
(v) To help Indian industry and the Government towards better cost management.

Operating Procedure and Policies of CASB

(i) Organising and initiating discussion and deliberation at national level to identify the
areas/topics in respect of which needs for standards are felt.
NATURE AND SCOPE OF COST ACCOUNTING A/1·31

(ii) Generating information on all alternative cost accounting practices in respect of selected
practices.
(iii) Preparation of draft on the standard cost accounting practices in respect of chosen
areas/topic in cost accounting and circulate it to the members of the Institute, national
accounting institute and others and user bodies like industry association, Chambers of
Commerce and Industry, Government bodies etc.
(iv) Allowing sufficient time for consideration and comments on the exposure draft.
(v) Pronouncement of the exposure draft as ‘standard’ after giving due consideration to the
suggestions and modification generated on the circulated exposure drafts from such
individuals and agencies as mentioned in (iii) above.
(vi) To fix a date for the standard to be effective.
(vii) To propagate and generate acceptance and commitment to follow the ‘standards’ prescribed
by CASB.
(viii) To revise the ‘standards’ once issued, if dictated by environment, government, legal authority
and other situation.

Scope and Applicability

The ‘standards’ issued by CASB will be recommendatory in nature and every member of the
institute is expected to honour the same. A standard will always make sure that it complies with the
legal regulations in respect of the matter covered by it. However, a standard by its vary nature will
have to be more definite and specific than its legal requirements. Any limitation in application of a
‘standard’ in specific circumstance must be spelt out in the ‘standard’ itself. Every standard will
broadly have two parts— (a) explanatory part and (b) the operative part. The explanatory section will
set out topic covered, the premises, the need for standardisation and methodology and rationale for
practice recommended. The second part, the operative portion will be the definite direction on the
matter. Every standard will indicate the date from which it will be operative. The standards will be
applicable to preparation of cost statements and other documents where the concepts embedded in
the standard will be applicable. As far as maintenance of cost accounting record rules is concerned,
relevant matter covered under the standards, wherever applicable, will be followed.
Cost Auditors will adopt and encourage the adoption of the standards wherever applicable, in
maintenance of Cost Accounting Record Rules and report the deviations, if any, in the Cost Audit
Reports. The Institute will take up the standards with National Accounting Standard Board to enforce
them and to include in the Companies Act.

Framework of Accounting Standards

The Cost Accounting Standards framework has been adopted by the CASB with the following
structure :
1. Introduction : brief details depict the topic and its role in the cost …
2. Objectives : basic objective that necessitated the standard.
3. Scope : scope of applicability.
4. Definitions : terminology used in the standard.
5. Principles of Measurement : principles behind the ascertainment, measurement,
determination, and categorisation of elements of cost.
A/1·32 NATURE AND SCOPE OF COST ACCOUNTING

6. Assignment of Costs : basis of assignment of costs to the product or service and the generally
accepted cost accounting principles behind such assignment.
7. Presentation : essence of the standard and the prescriptive nature to be followed for any
certification requirement.
8. Disclosure : specific disclosures required in the presentation to provide clarity.

The CASB has identified 39 areas for developing the CASs, which include the 22 standards
released so far. Of these, 21 areas relate to components of cost and the remaining 18 areas are on cost
accounting methodologies. The ICAI has issued 24 Cost Accounting Standards over the period of
time as given in the following table :

CAS No. Title Objective

CAS 1 Classification of Cost For preparation of Cost Statements
CAS 2 Capacity Determination For determination of capacity
CAS 2 (Revised Capacity Determination To bring uniformity and consistency in the principles and
2012) methods of determination of capacity with reasonable
accuracy.
CAS 3 Overheads For Collection, Allocation, Apportionment and Absorption of
overheads
CAS 3 Overheads To bring uniformity and consistency in the principles and
(Revised 2011) methods of determining the Overheads with reasonable
accuracy.
CAS 4 Cost of Production for To determine the assessable value of excisable goods used
Captive Consumption for captive consumption.

CAS 5 Average (equalised) Cost To determine averaged/equalised transportation cost

of Transportation

CAS 6 Material Cost To bring uniformity and consistency in the principles and
methods of determining the material cost with reasonable
accuracy in an economically feasible manner.

CAS 7 Employee Cost To bring uniformity and consistency in the principles and
methods of determining the Employee cost with reasonable
accuracy.

CAS 8 Cost of Utilities To bring uniformity and consistency in the principles and
methods of determining the Cost of Utilities with reasonable
accuracy.

CAS 9 Packing Material Cost To bring uniformity and consistency in the principles and
methods of determining the Packing Material Cost with
reasonable accuracy.

CAS 10 Direct Expenses To bring uniformity and consistency in the principles and
methods of determining the Direct Expenses with reasonable
accuracy.
NATURE AND SCOPE OF COST ACCOUNTING A/1·33

CAS 11 Administrative Overheads To bring uniformity and consistency in the principles and
methods of determining the Administrative Overheads with
reasonable accuracy.

CAS 12 Repairs and Maintenance To bring uniformity and consistency in the principles and
Cost methods of determining the Repairs and Maintenance Cost
with reasonable accuracy.

CAS 13 Cost of Service Cost To bring uniformity and consistency in the principles and
Centre methods of determining the Cost of Service Cost Centre with
reasonable accuracy.

CAS 14 Pollution Control Cost* To bring uniformity and consistency in the principles and
methods of determining the Pollution Control Costs with
reasonable accuracy.

CAS 15 Selling and Distribution To bring uniformity and consistency in the principles and
Overheads methods of determining the Selling and Distribution Overheads
with reasonable accuracy.

CAS 16 Depreciation and To bring uniformity and consistency in the principles and
Amortisation methods of determining the Depreciation and Amortisation
with reasonable accuracy.

CAS 17 Interest and Financing To bring uniformity and consistency in the principles methods
Charges. of determining and assigning the Interest and Financing
Charges with reasonable accuracy.

CAS 18 Research and To bring uniformity and consistency in the principles and
Development Costs methods of determining the Research, and Development
Costs with reasonable accuracy and presentation of the same.

CAS 19 Joint Costs To bring uniformity and consistency in the principles and
methods of determining the Joint Costs.

CAS 20 Royalty and Technical To bring uniformity and consistency in the principles and
Know-how Fee methods of determining the amount of Royalty and Technical
Know-how Fee with reasonable accuracy.

CAS 21 Quality Control To bring uniformity, consistency in the principles, methods of

determining and assigning Quality Control cost with
reasonable accuracy.

CAS 22 Manufacturing Cost To bring uniformity and consistency in the principles and
methods of determining the Manufacturing Cost of excisable
goods.

CAS 23 Overburden Removal To bring uniformity and consistency in the principles, methods
of determining and assigning overburden removal cost with
reasonable accuracy.

CAS 24 Treatment of Revenue in To bring uniformity and consistency in the principles, and
Cost Statements methods for treatment of revenue in cost statements with
reasonable accuracy.
A/1·34 NATURE AND SCOPE OF COST ACCOUNTING

Authority Attaching to the Standard

So long the standards are not enforced by the National Accounting Standard Board or by the
Companies Act, the CASB does not possess the legal authority to impose its views as statutory
regulations but it is by only persuasion the standard can be followed as normal practice by the
members of the profession. ICAI will be duty bound to protect its members who respect and adhere
to the standards prescribed. Disciplinary restriction may be imposed by the Council of the Institute at
appropriate stages as may be felt necessary for not complying with or not honouring the standard.

Mandatory Application of Cost Accounting Standards

The Council of the ICAI issued 22 Cost Accounting Standards, which shall be mandatory with
effect from period commencing on or after 1st April, 2011 for being applied for the preparation and
certification of General Purpose Cost Accounting Statements. In case the cost and management
accountant is of the opinion that if aforesaid standards have not been complied with for the
preparation of the cost statements, it shall be the duty to make a suitable disclosure/qualification in
his audit report/certificate.

Benefits of Cost Accounting Standards

The Cost Accounting Standards—
• provide a structured approach to measurement of costs in manufacturing process or service
industry;
• integrate, harmonise, and standardise cost accounting principles and practices;
• provide guidance to users to achieve uniformity and consistency in classification,
measurement, assignment, and allocation of costs to products and services;
• arrive at the basis of computing the cost of product, activity, or service where required by
legal or regulatory bodies;
• enable practicing members to make use of Cost Accounting Standards in the attestation of
General Purpose Cost Statements; and
• assist in clear and uniform understanding of all the related issues by various user
organisation, government bodies, regulators, research agencies, and academic institutions.
Facilitating and promoting uniformity and consistency not only helps in better understanding
(e.g., clear and in a uniform manner) of all the related issues by companies and/or by the professional
fraternity, but it also helps various user organisations, government bodies, regulators, research
agencies, and academic institutions. Clearly defined and well-documented Generally Accepted Cost
Accounting Principles govern a highly professional job that can only be done by the concerned
professional bodies and individuals in India.

GENERALLYACCEPTEDCOSTACCOUNTINGPRINCIPLES(GACAP)
Introduction
The compilation of Generally Accepted Cost Accounting Principles (GACAP) by the Institute
of Cost Accountants of India is a unique effort to record principles and practices in the discipline
of Cost Accountancy in India, which takes into consideration the global practices as well. There
have been compilations of financial accounting principles such as Paul Grady’s work. (“Inventory
NATURE AND SCOPE OF COST ACCOUNTING A/1·35

of generally accepted accounting principles”, American Institute of Certified Public Accountants,

New York, 1961). While cost data is being used by various stakeholders, the focus has been more
on management use. The absence of institutionalisation of external cost reporting might explain
this lacuna in theory. The Cost Accounting Standards issued by the Cost Accounting Standards
Board in the United States is the nearest to such compilation though this is in the context of
Defence Contract Costing.
The formalisation of Cost Accounting Principles in use in India started acquiring a more
cohesive form in the regime of administered prices ushered in the 1950 through the work of
Tariff Commission mandated to fix tariffs and prices in a variety of industries. The movement
acquired further fillip through the work of other statutory price-fixing authorities including the
Bureau of Industrial Costs and Prices, Cost Accounts Branch of Ministry of Finance. Since the
price enquiries by these bodies covered a wide range of industries, industry specific practices
started unifying into a common body of cost accounting principles.
The introduction of the industry-wise Cost Accounting Record Rules further strengthened the
evolution of a uniform body of cost accounting principles. Even though intended to prescribe the
Cost Accounting records to be maintained by various industries, the Rules carried nuggets of
Cost Accounting principles in the body of the Rules and in footnotes to format of prescribed cost
statements. When some of these got repeated in the Rules prescribed for different industries, it
helped towards the evolution of a generally accepted set of cost accounting principles. Thus the
Rules contained directions on valuation of purchased materials (all direct costs up to the works),
the treatment of major repairs (to be prorated over the period of benefit derived by such repairs),
the costing of transfers of raw materials from own farms (sugar cane at government controlled
price) and the like. It, however, cannot be denied that the Rules framed from time to time did
have certain contradictions - for example, the valuation of sugarcane from own farm to be valued
at market price and valuation of wood from own forest to be valued at cost - but the Cost
Accounting Record Rules did play a major role in unifying cost accounting principles as applied
to various industries.
Similarly the regulatory agencies in charge of individual industries, particularly Fertilizer
Industry Co-ordination Committee, Drug Price Control Authority, Central Electricity Regulatory
Commission and Telecom Regulatory Authority of India, all played a role in evolving a more
consistent set of cost accounting principles.
The Cost Audit Report Rules as amended from time to time did not lay down any cost
accounting principles as such but by requiring disclosure of principles and methods used, it
focused attention on them. The amendment of the Rules in 2001 prescribing a single Proforma
for cost reporting for all industries was a landmark event. It ushered in “General Purpose Cost
Statement”, which is unique in the global practice of cost accounting.
The requirement for determination of cost of production of manufactured goods used for
captive consumption further focussed attention on the subject of GACAP. According to the
Central Excise Valuation (Determination of Price of Excisable Goods) Rules, 2000, the assessable
value of goods used for captive consumption is 110% of cost of production of such goods and as
may be prescribed by the Government from time to time. The cost accounting principles for
determination of cost of production were also well established. Their codification and
standardisation in a single document viz. Cost Accounting Standard 4 (CAS 4) issued on January
A/1·36 NATURE AND SCOPE OF COST ACCOUNTING

3, 2003 became a landmark event. The standard contains a format for reporting the cost of
production of products manufactured for captive consumption. The Certificate for the cost
statement carried a reference to the basis being “Generally Accepted Cost Accounting Principles
and Practices”. Thus was born the phrase forming the title of this document.
The Expert Group constituted by the Ministry of Corporate Affairs under the Chairmanship
of Mr. B.B. Goyal, Advisor (Cost), Ministry of Corporate Affairs, Government of India
acknowledged the existence of an un-codified set of generally accepted cost accounting principles
in use in Indian industries and by the practicing cost accountants for attestation of Cost
Statements. The Expert Group suggested that the principles be codified to provide a formal basis
for the practice of Cost Accounting. The Expert Group also recommended review of alternate
treatment of items in cost accounting thus eliminating needless diversities in practice leading to
the development of cost accounting standards.
The Ministry of Corporate Affairs decided to implement the recommendations of the Expert
Group and notified the Companies (Cost Accounting Records) Rules, 2012 on June 3, 2012. These
Rules introduced a common set of record rules for industries other than regulated industries
specified in the Rules, in place of industry specific rules in vogue earlier. The Rules require every
company to which the rules apply, including all units and branches thereof, to keep cost records
in respect of each of its products and activities on regular basis. The cost records are to be
maintained in accordance with the generally accepted cost accounting principles and cost
accounting standards issued by the Institute of Cost Accountants of India (ICAI) to the extent
these are found to be relevant and applicable. The variations, if any, are to be clearly indicated
and explained.
The present effort of codifying the GACAP and presenting them in a single volume is the
culmination of all the above developments in the practice of cost accounting in India.
Whereas Cost Accounting Standard 4 (CAS 4) issued in 2003 focused attention on GACAP,
the Companies (Cost Accounting Records) Rules, 2011 which require maintenance of cost records
according to GACAP and Cost Accounting Standards gave the mandate for a compilation of
GACAP. Moreover, the supersession of the erstwhile industry-wise detailed Rules providing
guidance on cost accounting principles and practices to be followed by the companies further
necessitated the issuance of this document.

Objectives of GACAP :

(1) to codify the GACAP as applied in the Indian industry;

(2) to narrow down diversities in cost accounting practices facilitating the process of
development of cost accounting standards;
(3) to provide a reference source to industry and practitioners in preparation and
attestation of Cost Statements, where specific cost accounting standards are yet to be
issued;
(4) to provide a reference source to all the stakeholders in the understanding and
interpreting the cost statement; and,
(5) to provide a base for monitoring the evolution of new concepts and practices in
cost accounting and to codify them as and when they become generally accepted.
NATURE AND SCOPE OF COST ACCOUNTING A/1·37

Scope
The scope is to codify the cost accounting principles to be followed by business and other
entities in India in preparing and presenting cost information - more particularly the General
Purpose Cost Statements covered by Cost Audit. This document also encompasses the generally
accepted cost accounting practices presently being followed by such entities.
It draws on the Cost Accounting Record Rules which inter alia also lay down some principles,
the Guidance Notes issued by the ICWAI, the Cost Accounting Standards 1-5 issued by ICWAI
during 2001-2005 which have been applied in practice for some years now, Cost Accounting
Standards 6–12 which have been on the Standards book for a period ranging up to three years
and which have been mandated for application for more than a year now and the observed
practices of Indian Corporate in preparing Cost Statements for audit purposes and by business
entities and others.

Nature of Content and Format

1. This document titled Generally Accepted Cost Accounting Principles (GACAP) contains a
summary of the Cost accounting principles currently followed by business entities in
India in preparing and presenting cost information in the context of general purpose cost
statements for statutory reporting and covered by Cost Audit.
2. It explicitly incorporates the principles already contained in the Cost Accounting
Standards 1–13 issued by the Cost Accounting Standards Board (CASB) in India without
necessarily repeating them.
3. In areas not covered by the standards, it reflects the cost accounting principles found in
the Cost Accounting Record Rules (CARR) prescribed for the 44 industries in the past.
4. Where somewhat conflicting principles have been laid down by the CARR in different
industries, attempt has been made to harmonise the principles so as to evolve a
generally acceptable framework. Where use of alternate principles are sanctioned by the
Rules or where alternate principles are applied in practice in the absence of explicit
guidance in Rules, the alternates have been mentioned with an indication of the
preferred practice.
5. Because the Rules were framed at different points of time spread over many years, it is
likely that the principles contained in the Rules and the practice based on them do not
reflect current concepts. In such cases, the document reflects the current concepts.
6. It also reflects the Cost Accounting Principles contained in the Guidance Notes and other
publications issued by ICWAI from time to time.
7. Cost Accounting principles which are gathering wide spread acceptance in Indian
Companies for management reporting, even though not adopted for statutory cost
reporting (for example, Activity Based Costing), are mentioned with suitable caveats
regarding their lack of applicability for general purpose cost statements for statutory
reporting, where applicable.
8. The document stipulates the main principles in bold letters followed by explanation in
normal type.
A/1·38 NATURE AND SCOPE OF COST ACCOUNTING

Conceptual Frame Work

There is a need for a conceptual frame work that underlies the GACAP detailed in the
succeeding sections. The conceptual frame work, as the name suggests, is a frame work and not a
superset of cost accounting principles. It does not attempt to lay down a principle for any
particular costing issue or to amplify the GACAP. The frame work helps to understand the
GACAP that follow, in the appropriate perspective and guides in modifying them or developing
new principles;
• Focus on drivers of value. Costing is necessary for an informed understanding of the
organisational drivers of cost, revenue, profits and value. Costing has to fulfil this role
both in a historical and in a forward looking context.
• Cost for a purpose. Over a long time it has been recognised that there is a cost concept
relevant for a purpose. Thus external reporting requires historical and full absorption
costing while performance evaluation requires attention directing and diagnostic
information; planning and decision making requires analytical and predictive
information. It is, therefore, not possible for the same set of cost data to fit all purposes,
thereby resulting in a wide range of cost concepts from which preparers and users of cost
information choose a concept relevant to the purpose.
• Reality driven. Cost models must reflect the entity’s business model, its operational
processes, its strategy, its organisational structure and its competitive environment.
Organisational processes and activities drive the costs and these are in turn influenced
by other factors mentioned above.
• Materiality and cost effectiveness. The selection of the methods of implementing the
costing principles should have regard to the issues of materiality and cost effectiveness.
Materiality of cost information is to be judged from the perspective of the user of that
information. The degree of detail and accuracy required are governed by the perspective
of materiality. From the preparers’ viewpoint there is the need to balance the cost of
maintaining a cost accounting system with corresponding benefits. This is the reason
why in a number of places, while dealing with methods of implementing cost accounting
principles, the expression “economically feasible way” has been used in this document.
Hence, for preparation and disclosure of cost information, one is required to judge the
materiality aspect in conjunction with economic feasibility of maintaining such data and
information. For example, maintenance of product/activity-wise cost details for each of
the ancillary product or activity of an entity would neither be material nor economically
feasible.
Any product or activity of an entity which is incidental to its main operations and does
not constitute its main line of business and whose total turnover from the sale/supply of
such product or activity does not exceed 2% of the total turnover of the entity or Rs. 20
crores, whichever is lower, should be treated as an ancillary product or activity.
• Comparability and consistency. Cost information should be prepared and presented
in a way which provides for comparability over time and consistency. The methods used
for preparing and presenting cost information should be changed only where for valid
reasons such as those required by law, compliance with new cost accounting standards or
on the ground that it would result in a more appropriate presentation of cost information.
NATURE AND SCOPE OF COST ACCOUNTING A/1·39

• Transparency and auditability. Since cost information is used generally by various

stakeholders like management, regulators and Government with a business outlook,
there is a need for transparency regarding the definitions used and sources of data. It
should be possible for those who wish to review such cost information to follow an audit
trail. Auditability of cost information is a prerequisite to the effective use of such
information.

Applicability of GACAP
Generally Accepted Cost Accounting Principles (GACAP) applicable to all the elements of Cost
Accounting :
(i) When an element of cost is taken at standard cost, variances due to normal causes are treated as a
part of the element cost but variances due to abnormal causes are not treated as element cost.
(ii) Recovery of any amount from employees/suppliers/other parties towards the costs incurred by the
business for a resource will be netted against such cost.
(iii) Abnormal cost (material and quantifiable) will not form part of the cost.
(iv) Penalties/damages paid to statutory authorities or others will not form part of the total cost.
(v) Cost excludes imputed costs.
(vi) Finance costs related to acquisition of resources such as material, utilities and the like will not
form part of the cost of such resources.
(vii) Any subsidy/grant/incentive etc. received/receivable with respect to the input cost is reduced
from the cost of the cost object to which such amount relates.
(viii) Normally, the measurement of costs for cost accounting purposes follow the some principles as set
out in GACAP applicable to the concerned entity.

QUESTIONS
SHORT ANSWER TYPE

1. State the limitations of financial accounting.

2. State three points of similarities between financial accounting and cost accounting.
3. Give distinction between cost accounting and financial accounting.
OR
Write short note on Financial Vs. Cost Accounting.
4. Define Cost Accounting and distinguish it from costing.
5. What are the main objectives of Cost Accounting ?
6. Give three main headings under which scope of cost accounting is covered.
7. State two advantages of cost accounting to : (i) Management, (ii) Workers, (iii) Creditors,
(iv) Government, (v) General Public.
8. “Costing is a reality and pricing is a policy “Comment.
9. Give five characteristics of an ideal costing system.
10. State the factors which a Cost Accountant should consider while introducing a costing system.
A/1·40 NATURE AND SCOPE OF COST ACCOUNTING

11. Explain the methods of costing.

12. Write a note on Role of Cost Accountants in an organisation.
13. What is Farm Costing ?
14. Give three principles of Cost Accounting.
15. What are the objections against Cost Accounting ?
16. Give six features of Cost Accounting.
17. Discuss the four different methods of costing alongwith their applicability to concerned industry.

18. Discuss the essentials of a good Cost Accounting System.

19. Explain the (a) methods or (b) techniques of costing.
20. Explain the status of Cost Accountant in an organisation.
21. Write a note on Cost Accounting Information System.
22. What is Cost Accounting Standard Board ?

LONG ANSWER TYPE

1. “Financial Accounting procedures are generally designed to ascertain the periodic profit or loss, but
there are important limitations and deficiencies in the system”. Discuss.
OR
“Limitations of financial accounting have made the management to realise the importance of cost
accounting”. Comment.
OR
“Evolution of cost accounting is the outcome of deficiencies in financial accounting system.” Discuss.
2. “While Financial Accounting is external, Cost Accounting is internal to the business.” Explain.
3. How do Cost Accounting procedures and objectives differ from those of Financial Accounting ?
OR
State and explain the main differences between Financial Accounting and Cost Accounting.
OR
Define and distinguish Cost Accounting and Financial Accounting.
4. Discuss the relationship between Cost and Financial Accounting, Explain in brief the advantages of
Cost Accounting. (Punjabi University, 2009, 2013)
5. What is Cost Accounting ? Discuss briefly its important functions (or objective) in a business firm.
6. Enumerate the main objectives (or advantages) of introduction of a Cost Accounting System.
7. What is cost accounting ? What are the advantages of Cost Accounting ?
8. ‘Cost Accounting has come to be an essential tool of the management. Comment.
OR
Explain the importance of Cost Accounting as a managerial tool.
9. How does cost accounting help in the planning and control of operations of a business enterprise ?
10. How does Cost Accounting contribute to the effective and efficient management of an industrial
establishment ?
11. It is contended that competition governs prices and that where production efficiency is good, there is no
need for a proper system of costing. What arguments would you advance to elucidate this opinion ?
NATURE AND SCOPE OF COST ACCOUNTING A/1·41

12. A factory makes only one product in one quality and size. The owner says that his financial accounts
easily give him the material, labour and other cost per unit. Write a brief letter to convince him that he
still needs a costing system.
13. It is said “Cost accounting is a system of foresight and not a post-mortem examination, it turns losses
into profits, speeds up activities and eliminates wastes”. Discuss this statement.
(P.U. B.Com., 2001, 2004)
14. Discuss the role of cost accountant in a manufacturing concern.
15. “A Cost accounting system that simple records costs for the purpose of fixing sale prices has
accomplished only a small part of its mission.” Explain.
16. Discuss briefly the limitations of Cost Accounting.
OR
Explain the complementary role of financial accounting and cost accounting.
17. Discuss the main objections raised against Cost Accounting.
18. “Cost Accounting is an unnecessary expensive luxury for business establishments.” Do you agree with
the statement ? Discuss.
19. Describe briefly the characteristics which an ideal costing system should possess.
20. Discuss briefly some of the matters which a Cost Accountant should investigate before installing a
Costing System in a manufacturing concern.
21. You have been asked to install a costing system in a manufacturing company. What practical difficulties
will you expect and how will you propose to overcome the same ?
22. Describe the two methods of costing giving their scope and characteristics.
23. You are working with a firm of cost consultants. A client having a large manufacturing FMCG Co.
comes to you for advice for installing a cost accounting system in his organisation. What are the basic
considerations you would keep in mind in designing a cost accounting system for your client ? What
are the practical difficulties you perceive on its implementation b y your client and how do you propose
to overcome the same ?
24. (a) What are the essentials features of a good Cost Accounting System ?
(b) Narrate the essential factors to be considered while designing and installing a Cost Accounting
System.
25. “Money spent on installing a costing system is not an expense but an investment”. Comment.
26. “Cost accounting is becoming more and more relevant in the emerging economic scenario in India”.
Comment.
27. In what essential asspects “Cost Accounts’ are key to economy in manufacturing ?
28. Give the need for Cost Accounting Information System. Briefly discuss the objectives and steps for
development of such information system.
29. Write a note on Cost Accounting Standard Board. How many standards have been issued uptill now by
the Institute of Cost Accountants of India.
30. Give the meaning, objects and advantages of Cost Accounting Standards.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·1

CHAPTER

2
Cost—Analysis, Concepts,
Classification and Cost Sheet
In today’s dynamic business environment, mere knowledge of the total cost incurred by an
organisation is no longer sufficient to meet the needs of effective management. To exercise proper
control over costs and make informed managerial decisions, management requires detailed and
accurate data that allows for the analysis and classification of costs. This is where it is important to
understand various elements of cost.

Elements of Cost
Elements of Cost refer to the breakdown of total costs into specific categories based on the nature
of expenses incurred. While the traditional view recognises three primary elements of cost, namely
materials, labour, and other expenses, a more comprehensive analysis reveals that each of these
elements can be further subdivided into various sub-elements. This breakdown provides
management with a deeper understanding of cost components and enables more targeted cost
management strategies.

The chart below illustrates the typical breakdown of cost elements :

Elements of Cost

Materials Labour Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Overheads

Production or Works Overheads Administration Overheads Selling Overheads Distribution Overheads

Analysing costs by their elements helps organisations gain insights into the specific drivers of
expenses within their operations. It allows for a more thorough examination of each cost component
and facilitates the identification of areas where cost reduction efforts can be focused. By dissecting
A/2·2 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

costs into their elemental composition, management can allocate resources more efficiently,
implement cost control measures, and optimise overall profitability.
By analysing costs based on these elements, management gains a clearer understanding of how
different cost components contributes to the overall cost structure of the organisation. This knowledge
is vital for effective decision-making, cost control, and resource allocation.
Now, let’s delve into the detailed discussion of each term, starting with Direct Materials.
(1) Direct Materials : Direct materials refer to the materials that are readily identifiable in the final
product and can be conveniently measured and directly allocated to the product’s cost. These
materials directly enter the production process and become an integral part of the finished product.
For example, in furniture making, timber is a direct material, in dress making, cloth is a direct
material, and in building a house, bricks are direct materials. The following items are typically
classified as Direct Materials :
(i) Raw materials : This includes materials like jute in the manufacturing of gunny bags, pig
iron in foundries, and fruits in the canning industry.
(ii) Materials specifically purchased for a specific job, process, or order : For instance, glue for
bookbinding or starch powder for dressing yarn.
(iii) Parts or components purchased or produced : Examples include batteries for cars or tires for
bicycles.
(iv) Primary packing materials : These are materials such as cartons, wrappings, cardboard boxes,
etc., used to protect finished products from climatic conditions or to facilitate easy
handling within the factory.
It is important to note that indirect materials are those materials that do not fall under the
category of direct materials. Indirect materials include consumables like cotton waste, lubricants,
brooms, rags, cleaning materials, and materials used for repairs and maintenance of fixed assets. They
also encompass items like high-speed diesel used in power generators. Classifying materials into
direct and indirect categories helps facilitate material control. Direct materials are typically high-value
items compared to indirect materials and require strict control and critical analysis to reduce their
cost. In contrast, simple control techniques are usually sufficient for managing indirect materials, as
they are lower in value.
However, there are instances where certain materials are part of the finished product but are not
treated as direct materials. This is often the case when the value of these materials is relatively small,
and it would be impractical to analyse them for the purpose of direct cost allocation. Examples
include sewing thread in dress making or nails in furniture making. These materials are considered
indirect materials. Thus, it can be concluded that the ease and feasibility of tracing a material into the
composition of a finished product determine whether it is classified as a direct material.
(2) Direct Labour : Direct labour encompasses all the labour expended in altering the
construction, composition, confirmation, or condition of a product. In simpler terms, it refers to the
labour that can be easily identified and attributed entirely to a specific job, product, process, or the
conversion of raw materials into finished goods. The wages paid to such labour are known as direct
wages. Direct Labour includes the payment made to the following groups of labour :
Labour engaged in the actual production of the product or carrying out specific operations or
processes.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·3

Labour involved in aiding the manufacturing process through activities such as supervision,
maintenance, tool setting, and material transportation.
Inspectors, analysts, or other specialised personnel required for the production process.
It is important to note that while the wages of supervisors, inspectors, etc., may not typically fall
under the category of direct labour, they can be considered as direct labour if they are directly
engaged in a specific product or process, and the hours they spend on it can be accurately measured
without much effort. However, in cases where the cost incurred is not significant, such as the wages
of trainees or apprentices, their labour, though directly spent on a product, may not be classified as
direct labour. Additionally, it is worth mentioning that direct labour plays a crucial role in the cost
determination of a product. The direct labour cost is directly associated with the production process
and has a direct impact on the overall cost of manufacturing a product. Therefore, accurately tracking
and analysing direct labour costs is essential for effective cost control and decision-making.
By distinguishing direct labour from indirect labour (such as administrative or support staff),
businesses can gain insights into the specific labour costs directly related to the production process.
This information helps management make informed decisions regarding labour utilisation,
productivity, and efficiency.
(3) Direct Expenses : Direct (or Chargeable) Expenses refer to all expenses that can be attributed
and directly charged to a particular cost centre. These expenses are incurred specifically for a
particular product, job, department, or activity. Direct expenses are considered as part of the prime
cost and are directly allocated to the product or cost centre. Direct expenses include various costs that
are directly associated with a specific production or operational activity. Some examples of direct
expenses are :
Royalty based on production : Payments made to the owner of intellectual property rights or
patents based on the production volume.
Goods and Service Tax : Taxes imposed on specific goods produced or sold.
Hire and maintenance charges of specific plant and equipment : Costs incurred for renting or
leasing specialised machinery or equipment exclusively for a particular job or project.
Packing expenses : Costs related to packaging materials and services to make the product ready
for sale or shipment.
Cost of experimental work : Expenses incurred for conducting research, development, or
experimentation specifically for a particular job or project.
Cost of creating patterns, designs, drawings, or making tools : Expenditure associated with the
creation of specific patterns, designs, or tools required for a particular job or product.
Traveling expenses related to a specific contract or job : Costs incurred for travel and
accommodation in connection with a particular contract or job.
Direct expenses play a vital role in determining the total cost of production or the cost associated
with a specific job or product. By directly allocating these expenses to the respective cost centres,
businesses can accurately track the costs incurred for a particular activity. This enables better cost
control, cost analysis, and decision-making. It is important to distinguish direct expenses from
indirect expenses. While direct expenses can be specifically identified and charged to a particular cost
centre, indirect expenses are incurred for general purposes and are not directly attributable to a
specific job, product, or cost centre.
A/2·4 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

EXAMPLE : Compute total direct expenses of product X from the following information,
giving appropriate explanatory notes :
Particulars Figures
Production (Units) 20,000
Sales (Units) 16,000
Labour Hours 10,000
Labour Rate per Hour R 8
Royalty per unit of Sale R 2
Royalty per unit of Production R 1
Design Charges R 12,000
Interest on Loan for Purchase of Machine R 5,000
Hire Charges of Equipment Used for Manufacturing Product Y R 6,000
Penalty for Violating Patent R 4,000

SOLUTION
Computation of Direct Expenses
Particulars Figures
Royalty Paid on Sales 32,000
Royalty paid on Units Produced 20,000
Design Charges 12,000
Hire Charges for Equipment Used for Manufacturing Product X 6,000
Direct Expenses 70,000

(4) Overheads : Overheads can be defined as the cumulative expenses that encompass the costs of
indirect materials, indirect labour, and other expenditures that cannot be directly allocated to specific
cost units. In essence, overheads encompass all expenses other than direct expenses. They include the
costs associated with the overall organisation and operation of the entire undertaking or specific parts
of it, such as the cost of operating supplies, services, and the maintenance of capital assets. The main
groups into which overheads can be further classified are as follows :
(i) Manufacturing or Production or Works Overheads : These represent the indirect expenses
incurred in operating the manufacturing divisions of a company. They encompass all indirect
expenditures incurred from the receipt of an order until its completion and readiness for
dispatch to customers or the finished goods store. Examples of such expenses include
depreciation and insurance charges on fixed assets (such as plant and machinery, buildings,
and electrical equipment), repairs and maintenance costs, electricity and fuel charges, rent,
rates, and taxes, office-related expenses, welfare services, medical services, wages of indirect
workers, indirect materials, and salaries associated with tool rooms, design and drawing
offices, production control, and progress departments.
(ii) Administration Overheads : These refer to the costs associated with general management
and administration of an organisation. They encompass indirect expenses incurred in
formulating policies, directing the organisation, and controlling and managing operations.
Administration overheads are not directly related to research, development, production, or
selling activities. Examples include office rent, utility expenses, salaries and wages of
administrative staff, credit approval and cash collection departments, expenses related to
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·5

general management and executives, legal and accounting services, investigations and
experiments, and other miscellaneous fixed charges.
(iii) Selling Overheads : These represent the expenses incurred in creating and stimulating
demand, securing orders, and promoting sales. Selling overheads encompass the costs
associated with marketing and selling activities, excluding distribution. Examples include
sales office expenses, salespeople’s salaries and commissions, showroom expenses,
advertising charges, attractive packaging for sales promotion, samples and free gifts, after-
sales service expenses, demonstration and technical advice for potential customers, costs
related to marketing information systems, and expenses for catalogues and price lists.
(iv) Distribution Overheads : These include the expenses incurred in handling a product from
the time it is ready for dispatch until it reaches the end consumer. Distribution overheads
encompass the costs incurred in the process that starts with making the packaged product
available for dispatch and ends with the availability of reconditioned or empty packages for
reuse. Examples of distribution overheads include warehouse rent, salaries of warehouse
staff, insurance, expenses for delivery vans and trucks, special packaging for bulk transport,
losses in warehouse stocks, damages to finished goods during transit, and costs associated
with repairing, reconditioning, and wastage of finished goods.
(v) Research and Development Expenses : Research costs involve the expenses associated with
searching for new and improved products, exploring new applications of materials or
products, and developing improved methods. Development costs encompass the expenses
incurred from the implementation of the decision to produce a new product or adopt an
improved method until the formal production of that product or by using that method
commences.
Proper understanding and analysis of overheads are crucial for effective cost management,
budgeting, and decision-making within an organisation. By classifying and analysing overheads into
these distinct categories, businesses can gain insights into the various cost components and make
informed decisions to optimise their operations and enhance overall cost efficiency. By grouping the
above elements of cost, the following divisions of cost are obtained :
1. Prime Cost = Direct Materials + Direct Labour + Direct Expenses
2. Works or Factory Cost = Prime Cost + Works or Factory Overheads
3. Cost of Production = Works Cost + Administration Overheads
4. Total Cost or Cost of Sales = Cost of Production + Selling and Distribution Overheads
The difference between the cost of sales and selling price represents profit or loss.
EXAMPLE. Ascertain the prime cost, works cost, cost of production, total cost and profit
from the undermentioned figures :
Direct Materials R 5,000 ; Direct Labour R 2,500 ; Direct Expenses R 1,000; Factory Expenses
R 1,500 ; Administration Expenses R 800 ; Selling Expenses R 700 and Sales R 15,000.

SOLUTION
Prime Cost = Direct Materials + Direct Labour + Direct Expenses
= 5,000 + 2,500 + 1,000 = 8,500.
R R R R

Works Cost = Prime Cost + Factory Expenses = 8,500 + 1,500 = 10,000.

R R R

Cost of Production = Works Cost + Administration Expenses = 10,000 + 800 = 10,800.

R R R

Total Cost or Cost of Sales = Cost of Production + Selling Expenses = 10,800 + 700 = 11,500.
R R R

Profit = Sales – Total Cost = 15,000 – 11,500 = 3,500.

R R R
A/2·6 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

EXAMPLE. A company manufactures and retails clothing. You are required to group the
costs which are listed below and numbered 1 to 20, into the following classifications (Each cost is
intended to belong to only one classification).
(a) Direct Materials (e) Selling & Distribution Costs
(b) Direct Labour (f) Research & Development Costs
(c) Direct Expenses (g) Finance Costs
(d) Indirect Production Costs. (h) Administration Costs.
(1) Telephone rentals plus metered calls, (2) Wages of security guard for factory, (3) Parcel sent
to customers, (4) Wages of operators in cutting department, (5) Developing a new product in the
laboratory, (6) Wages of fork lift truck drivers who handle raw materials, (7) Wages of storekeepers
in materials store, (8) Chief accountant’s salary, (9) Cost of painting advertising slogans in delivery
vans, (10) Auditor’s fees, (11) Cost of advertising on television, (12) Lubricants for sewing
machines, (13) Floppy disks for general office computer, (14) Maintenance contract for office
photo-copying machines, (15) Interest on bank overdraft, (16) Market Research undertaken prior to
new product launch, (17) Carriage on purchase of raw materials, (18) Royalty paid on number of
units of a particular product produced, (19) Road licences for delivery vehicles, (20) Amount
payable to a company for broadcasting music throughout the factory.
SOLUTION
Numbers Numbers
( a) Direct Materials 17 ( e) Selling & Distribution Costs 3, 9, 11, 16, 19
( b) Direct Labour 4 (f) Research & Development Costs 5
(c) Direct Expenses 18 ( g) Finance Costs 15
( d) Indirect Production Costs 2, 6, 7, 12, 20 ( h) Administration Costs 1, 8, 10, 13, 14.

Overheads can also be classified into three categories : indirect materials, indirect labour, and indirect
expenses.
(i) Indirect Materials : Indirect materials refer to materials that do not typically become a part of
the finished product. They are materials that cannot be directly allocated but can be apportioned or
absorbed by cost centre or cost units. Examples of indirect materials include stores used for
maintenance purposes such as lubricants, cotton waste, bricks, and cement. They also include stores
used by service (non-productive) departments like the power house, boiler house, and canteen.
Additionally, materials of small value that are not considered significant enough to be treated as
direct materials fall into this category. For instance, stores consumed for repair and maintenance
work, sundry stores of small value, small tools for general use, lubricating oil, and losses, deficiencies,
and deterioration of stores are considered indirect materials.
(ii) Indirect Labour : Indirect labour refers to the wages of labour that cannot be directly allocated
but can be apportioned or absorbed by cost centre or cost units. It includes the wages paid to labour
employed in roles other than production. Indirect labour costs encompass employees’ costs that
cannot be directly attributed to a particular cost object. Examples of indirect labour include charge-
hands and supervisors, maintenance workers, departmental coolies, personnel in service
departments, material handling and internal transport staff, apprentices, trainees, instructors, clerical
staff in works, and labour employed in time office and security office. It also includes components
such as holiday pay, leave pay, employer’s contributions to funds, and miscellaneous allowances for
labour.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·7

(iii) Indirect Expenses : Indirect expenses are costs that cannot be directly attributed to a specific
cost object. These expenses cannot be allocated but can be apportioned or absorbed by cost centres or
cost units. Examples of indirect expenses include rent, rates, insurance, municipal taxes, the salary of
the general manager, canteen and welfare expenses, power and fuel costs, expenses related to training
new employees, lighting and heating expenses, telephone expenses, and depreciation. Indirect
expenses comprise two types : (a) expenses for which payments are made for services rendered or
supplies provided, and the amounts can be found from voucher registers on the dates they are
incurred, and (b) items that do not involve any payments and are adjustment transactions, such as
depreciation.

Expenses Excluded from Costs

The total cost of a product should only include items of expenses that are directly attributable to
the production process and have an impact on the profitability of the business. There are certain
expenses that are not included in cost accounts as they are unrelated to the actual production cost.
Certain expenses, such as those related to capital assets, capital losses, profit distributions, and pure
financial matters, should not be included in the cost accounts. Following are the items which are not
included in cost accounts :
(a) Purely Financial Charges. (i) Loss arising from the sale of fixed assets, (ii) Loss on investments,
(iii) Discount on shares and debentures, (iv) Interest on bank loan, mortgages and debentures, (v)
Expenses of the company’s share transfer office, (vi) Damages payable, (vii) Penalties and fines, (viii)
Losses due to scrapping of machinery, (ix) Remuneration paid to the proprietor in excess of a fair
reward for services rendered, (x) Interest on capital, (xi) Expenses of raising capital, (xii) Cost
discount.
(b) Appropriations of Profit. (i) Donations and Charities, (ii) Taxes on income and profits,
(iii) Dividend paid, (iv) Transfers to reserves and sinking funds, (v) Additional provision for
depreciation on fixed assets and for bad debts, (vi) Capital expenditure, specially charged to revenue.
(c) Writing off Intangible and Fictitious Assets. (i) Goodwill, (ii) Patents and Copyrights, (iii)
Advertisement, (iv) Preliminary Expenses, (v) Organisation Expenses, (vi) Underwriting Commission,
(vii) Discount on Issue of Shares/Debentures.
(d) Purely Financial Incomes. (i) Rent receivable, (ii) Profits on the sale of fixed assets, (iii)
Transfer fees received, (iv) Interest received on bank deposits, (v) Dividend received, (vi) Brokerage
received, (vii) Discount, commission received.
(e) Abnormal Gains and Losses. (i) Abnormal wastage of material, (ii) wages of abnormal idle
time, (iii) cost of abnormal idle facilities, (i v) excessive depreciation, (v) abnormal gain on
manufacturing.

Cost Sheet
A Cost Sheet, also known as a Statement of Cost, is a financial statement that provides a detailed
breakdown of costs incurred during a specific accounting period. It serves as a valuable tool for cost
analysis and control, and is prepared using data collected from various cost accounting records.
The cost sheet is typically presented in a columnar form, allowing for easy comparison and
analysis of costs. It discloses the total cost and cost per unit of the units produced during the given
period. This information enables manufacturers to keep a close watch on the cost of production and
make informed decisions regarding resource allocation and production methods.
A/2·8 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Its main advantages include :

(i) Total Cost and Cost per Unit : The cost sheet discloses the total cost and the cost per unit
of the units produced during the given period, providing essential information for financial
analysis.
(ii) Cost Monitoring and Control : It enables manufacturers to closely monitor and control the
cost of production. By analysing the cost data, management can identify areas where costs
can be reduced and take necessary actions to improve efficiency.
(iii) Comparative Analysis : The cost sheet allows for a comparative study of current costs with
past results and standard costs. This analysis helps identify the causes of cost variations,
enabling management to make informed decisions and eliminate adverse factors
contributing to increased costs.
(iv) Production Policy Formulation : By providing insights into cost components, the cost sheet
helps manufacturers formulate effective production policies. It guides decision-making
regarding resource allocation, production methods, and process improvements.
(v) Accurate Pricing : The cost sheet assists in setting accurate selling prices. By considering
the total cost per unit along with desired profit margins and market conditions, businesses
can make informed pricing decisions.
(vi) Cost Minimisation : In competitive markets, the cost sheet helps businesses minimise
production costs. It highlights areas where cost reductions can be achieved, allowing for
streamlined operations and optimised resource utilisation.
(vii) Tender Submissions : The cost sheet is valuable when submitting quotations or
responding to tenders. By providing a breakdown of costs, businesses can prepare accurate
and competitive bids, increasing their chances of winning contracts.
The cost sheet does not form part of the double-entry cost accounting records. However, its
relationship with financial accounts is essential, as it derives its data from financial accounting.
Periodic reconciliation between cost accounting and financial accounting is necessary to ensure
consistency and accuracy. By effectively utilising the information provided by the cost sheet,
businesses can gain better control over their costs, improve decision-making, and enhance overall
financial performance.
SPECIMEN OF COST SHEET OR STATEMENT OF COST Units :
Total Cost Cost per Unit
—————————————————————————————————————————
Direct Materials R R

Direct Labour
Direct or Chargeable Expenses —————————————————————————————————————————
Prime Cost
Add : Works Overheads —————————————————————————————————————————
Works Cost
Add : Administration Overheads —————————————————————————————————————————
Cost of Production
Add : Selling and Distribution Overheads —————————————————————————————————————————
Total Cost or Cost of Sales
Note : If profit is also calculated by deducting cost of sales from sales in the Statement of Cost, then it is
called Statement of Cost and Profit.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·9

ILLUSTRATION 1. Calculate Prime Cost, Factory Cost, Cost of Production, Cost of Sales and
Profit from the following particulars :
R R

Direct materials 1,00,000 Depreciation :

Direct wages 20,000 Factory Plant 500
Direct expenses 10,000 Office Premises 1,250
Wages of foreman 2,500 Consumable stores 2,500
Electric power 500 Manager’s salary 5,000
Lighting : Factory 1,500 Directors’ fees 1,250
Office 500 Office stationery 500
Storekeeper’s wages 1,000 Telephone charges 125
Oil and water 500 Postage and Telegrams 250
Rent : Factory 5,000 Salesmen’s salaries 1,250
Office 2,500 Travelling expenses 500
Repairs and Renewals : Advertising 1,250
Factory Plant 3,500 Warehouse charges 500
Office Premises 500 Sales 1,89,500
Transfer to Reserves 1,000 Carriage outward 375
Discount on shares written off 500 Income-tax 10,000
Dividend 2,000
SOLUTION STATEMENT OF COST AND PROFIT
R R

Direct Materials 1,00,000

Direct Wages 20,000
Direct Expenses 10,000
——————————————————
Prime Cost 1,30,000
Add : Factory Overheads :
Wages of foreman 2,500
Electric power 500
Storekeeper’s wages 1,000
Oil and water 500
Factory rent 5,000
Repairs and renewals—factory plant 3,500
Factory lighting 1,500
Depreciation—factory plant 500
Consumable stores 2,500
——————————
17,500
——————————————————

Factory Cost 1,47,500

Add : Administration Overheads :
Office rent 2,500
Repairs and renewals—office premises 500
Office lighting 500
Depreciation : office premises 1,250
Manager’s salary 5,000
Directors’ fees 1,250
A/2·10 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Office stationery 500

Telephone charges 125
Postage and telegrams 250
————————
11,875
——————————————————
Cost of Production 1,59,375
Add : Selling and Distribution Overheads :
Carriage outward 375
Salesmen’s salaries 1,250
Travelling expenses 500
Advertising 1,250
Warehouse charges 500
———————————
3,875
——————————————————
Cost of Sales 1,63,250
Add : Profit 26,250
——————————————————
Sales 1,89,500
——————————————————

NOTES : (1) Transfer to reserves, income-tax and dividend are excluded from cost accounts being
items of appropriation of profit, so these items have not been included in cost.
(2) Discount on shares written off being an item of non-operating nature is excluded from
cost.

Treatment of Stock
Stock requires special treatment while preparing a cost sheet. Stock may be of raw materials,
work-in-progress and finished goods.

Stock of Raw Materials

If opening stock of raw materials, purchases of raw materials and closing stock of raw materials
are given, then with the help of the following, raw materials consumed can be calculated :
R

Opening Stock of Raw Materials ×××

Add : Purchases of Raw Materials ×××
—————————

×××
Less : Closing Stock of Raw Materials ×××
—————————

Cost of Raw Materials Consumed ×××

—————————

Stock of Work-in-Progress
Work-in-progress means units on which some work has been done but which are not yet
complete. Work-in-progress is valued at prime cost or works cost basis, but the latter is preferred.
Instructions in this respect should be carefully noted from the language of the question. If it is valued
at works or factory cost, then opening and closing stock will be adjusted as follows :
R

Prime Cost ×××

Add : Factory Overheads Incurred ×××
Add : Work-in-Progress (Beginning) ×××
—————————

×××
Less : Work-in-Progress (Closing) ×××
—————————

Factory or Manufacturing or Works Cost ×××

—————————
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·11

Stock of Finished Goods

If opening and closing stocks of finished goods are also given, then these must be adjusted before
calculating cost of goods sold as under :
R

Cost of Production ×××

Add : Opening Stock of Finished Goods ×××
—————————

×××
Less : Closing Stock of Finished Goods ×××
—————————

Cost of Goods Sold ×××

—————————

ILLUSTRATION 2. The accounts of Z Manufacturing Company for the year ended 31st
December, 2023 show the following :
R R

Factory Office Salaries 6,500 Materials Purchased 1,85,000

General Office Salaries 12,600 Travelling Expenses 2,100
Carriage Outward 4,300 Traveller’s Salaries & Commission 7,700
Carriage on Purchases 7,150 Productive Wages 1,26,000

Bad Debts written off 6,500 Depreciation :

Repairs of Plant, Machinery and Tools 4,450 —Plant, Machinery & Tools 6,500
Rent, Rates, Taxes & Insurance —Furniture 300
—Factory 8,500 Directors’ Fees 6,000
—Office 2,000 Gas and Water—Factory 1,200
Sales 4,61,100 —Office 400
Stock of Materials Manager’s Salary (3/4
—31st Dec. 2022 62,800 Factory and 1/4 Office) 10,000
—31st Dec. 2023 48,000 General Expenses 3,400
Income Tax 500 Dividend 1,000
Prepare statement giving the following information :
(a) Materials Consumed; (b) Prime Cost; (c) Factory Cost; (d) Cost of Production; (e) Total Cost;
(f) Net Profit.
SOLUTION
STATEMENT OF COST AND PROFIT
for the period ended 31st December, 2023
R R

Opening Stock of Raw Materials 62,800

Add : Purchases 1,85,000
Add : Carriage on Purchases 7,150
—————————————

2,54,950
Less: Closing Stock of Raw Materials 48,000
—————————————

(a) Value of Materials Consumed 2,06,950

A/2·12 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Productive Wages 1,26,000

—————————————
(b) Prime Cost 3,32,950
Factory Overheads:
Factory Office Salaries 6,500
Repairs of Plant and Machinery 4,450
Factory Rent, Rates, Taxes and Insurance 8,500
Depreciation of Plant, Machinery & Tools 6,500
Factory Gas and Water 1,200
Manager’s Salary (3/4 of 10,000)
R 7,500 34,650
———————————— —————————————
(c) Factory Cost 3,67,600
Administration Overheads :
General Office Salaries 12,600
Office Rent, Rates, Taxes & Insurance 2,000
Depreciation on Furniture 300
Directors' Fees 6,000
Office Gas and Water 400
Manager’s Salary 2,500
General Expenses 3,400 27,200
————————————— —————————————
(d) Cost of Production 3,94,800
Selling and Distribution Overheads:
Carriage Outward 4,300
Bad Debts 6,500
Travelling Expenses 2,100
Traveller’s Salaries & Commission 7,700 20,600
————————————— —————————————
(e) Total Cost 4,15,400
(f) Net Profit 45,700
—————————————
Sales 4,61,100
—————————————
—————————————

Note : Income Tax and Dividend are excluded from cost accounts.

ILLUSTRATION 3. The following extract of costing information relates to commodity ‘A’ for
the half year ending 31st December, 2023.
R R

Purchases of Raw materials 1,20,000 Stock (31st Dec., 2023) :

Works Overheads 48,000 Raw Materials 22,240
Direct Wages 1,00,000 Finished Products (2,000 tons) 32,000
Carriage on Purchases 1,440 Work-in-Progress (1-7-2023) 4,800
Stock (1st July, 2023) :
Raw Materials 20,000 Work-in-Progress (31st Dec., 2023) 16,000
Finished Products (1,000 tons) 16,000 Sales—Finished Products 3,00,000

Selling and distribution overheads are R 1 per ton sold. 16,000 tons of commodity were
produced during the period.
You are to ascertain (i) Cost of raw materials used, (ii) Cost of output for the period, (iii) Cost of
sales, (iv) Net profit for the period, and (v) Net profit per ton of the commodity.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·13

SOLUTION STATEMENT OF COST AND PROFIT

for the half year ending 31st December, 2023
Units (Tons)
———————————————————
R
————————————————
Opening Stock of Raw Materials 20,000
Add : Purchases of Raw Materials 1,20,000
Add : Carriage on Purchases 1,440
————————————————
1,41,440
Less : Closing Stock of Raw Materials 22,240
————————————————
(i) Value of Raw Materials Used 1,19,200
Add : Direct Wages 1,00,000
————————————————
Prime Cost 2,19,200
Add : Works Overheads 48,000
Add : Opening Stock of Work-in-Progress 4,800
————————————————
2,72,000
Less : Closing Stock of Work-in-Progress 16,000
————————————————

(ii) Cost of Output for the period 16,000 2,56,000

Add : Opening Stock of Finished Products 1,000
———————————————————
16,000
————————————————
17,000 2,72,000
Less : Closing Stock of Finished Products 2,000
———————————————————
32,000
————————————————
Cost of Goods Sold 15,000 2,40,000
Selling and Distribution Overheads on 15,000 tons @ R 1 per ton 15,000
————————————————

(iii) Cost of Sales 2,55,000

(iv) Net Profit for the period 45,000
————————————————

Sales 3,00,000
————————————————
45‚000 =
R
3
(v) Net Profit per ton = R
15‚000
Sometimes selling price is to be determined on the basis of cost of production but profit percentage is
generally given on sales. For calculation of profit, the following formula should be used :
Rate Percentage on Sales × Total Cost
Profit =
100 – Rate Percentage on Sales
Suppose if the profit of 25% on sales is to be realised and total cost is R 33,000 ; then profit to be added to
total cost will be calculated as under :
25 × 33‚000
R

Profit = = R 11,000.
100 – 25

ILLUSTRATION 4. From the following particulars of a manufacturing firm prepare a

statement showing (a) Cost of materials used; (b) Works cost; (c) Cost of production (d) Percentage
of works overhead to productive wages; (e) Percentage of general overhead to works cost.
R R

Stock of materials on 1-1-2024 40,000 Works overhead charges 1,50,000

Purchase of raw materials during Office and general expenses 1,00,000
January, 2024 11,00,000 Stock of materials on 31-1-2024 1,40,000
Stock of finished goods on 1-1-2024 50,000 Stock on finished goods
Productive wages 5,00,000 on 31-1-2024 60,000
Finished goods sold 24,00,000
A/2·14 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

SOLUTION STATEMENT OF COST AND PROFIT

for the month of January, 2024

R R

Opening Stock of Raw Material 40,000

Add : Purchase of Raw Materials 11,00,000
———————————————

11,40,000
Less : Closing Stock of Raw Materials 1,40,000
———————————————

(a) Cost of Materials used 10,00,000

Productive Wages 5,00,000
———————————————

Prime Cost 15,00,000

Works Overhead Charges 1,50,000
———————————————

(b) Works Cost 16,50,000

Add : Office and General Expenses 1,00,000
———————————————

(c) Cost of Production 17,50,000

Add : Stock of Finished Goods (opening) 50,000
———————————————

18,00,000
Less : Stock of Finished Goods (closing) 60,000
———————————————

Cost of Goods Sold 17,40,000

Profit 6,60,000
———————————————

Sales 24,00,000
———————————————
———————————————
(d) Percentage of works overhead charges to
1‚50‚000
productive wages = × 100 = 30%
5‚00‚000
(e) Percentage of general overhead to works
1‚00‚000
cost = × 100 = 6.06%
16‚50‚000

ILLUSTRATION 5. Prepare the Cost Sheet to show the total cost of production and cost per
unit of goods manufactured by a company for the month of July, 2023. Also find the cost of sales
and profit.
R R

Stock of Raw Materials, 1-7-2023 3,000 Office Rent 500

Raw Materials purchased 28,000 General Expenses 400
Stock of Raw Materials, 31-7-2023 4,500 Discount on Sales 300
Manufacturing Wages 7,000 Advertisement Expenses to be
Depreciation on Plant 1,500 charged fully 600
Loss on sale of a part of Plant 300 Income Tax Paid 2,000
Factory Rent and Rates 3,000 Sales 50,000

The number of units produced during July, 2023 was 3,000.

The stock of finished goods was 200 and 400 units on 1-7-2023 and 31-7-2023 respectively. The
total cost of the units on hand on 1-7-2023 was R 2,800. All these had been sold during the month.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·15

SOLUTION
STATEMENT OF COST AND PROFIT
for the month of July, 2023
(Units Produced = 3,000)
Units Total
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Opening Stock of Raw Materials 3,000

Add : Raw Materials Purchased 28,000
————————————
31,000
Less : Closing Stock of Raw Materials 4,500
————————————
Value of Materials Consumed 26,500
Manufacturing Wages 7,000
————————————
Prime Cost 33,500
Depreciation on Plant 1,500
Factory Rent and Rates 3,000
————————————
Works Cost 38,000
Office Rent 500
General Expenses 400
————————————

Cost of Production 3,000 38,900

Add : Opening Stock of Finished Goods 200 2,800
———————————— ————————————

3,200 41,700

Less : Closing Stock of Finished Goods ( R 38‚900

3‚000
× 400 ) 400
————————————
5,187
————————————

Cost of Goods Sold 2,800 36,513

Advertisement Expenses 600
————————————

Cost of Sales 37,113

Profit 12,887
————————————

Sales 50,000
————————————
————————————
R 38‚900
Cost of Production per unit = = R 12.97
3‚000
Note. Income tax, loss on sale of a part of plant and discount on sales are excluded from cost accounts.

Cost Concepts
Cost concepts play a crucial role in various aspects of business decision-making, such as product
pricing, budgeting, performance evaluation, financial statement preparation, stock valuation, and
decision-making processes like make-or-buy analysis or lease versus purchase decisions.
Understanding and effectively applying cost concepts enable organisations to make informed
decisions, optimise resource allocation, and achieve their management objectives. Some concepts
which are used in cost accounting are discussed here :
(a) Cost : Cost refers to the amount of resources, expressed in monetary terms that are given up or
sacrificed in exchange for goods or services. It can be defined as the expenditure incurred or
potentially to be incurred in achieving the objectives of management, whether in manufacturing a
product or providing a service. Cost is a generic term that can be qualified to specify its meaning,
such as prime cost, factory cost, or sunk cost. It is important to distinguish cost from value, as cost is
measured in monetary terms, while value is assessed based on the usefulness or utility of an item.
A/2·16 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

The interpretation of cost varies depending on the objective for which it is computed. Total cost is
considered when determining selling prices, while the cost of production is used for stock valuation.
Different conditions and purposes may lead to variations in cost. For example, the cost per unit of a
product changes with fluctuations in the volume of output, as the allocation of fixed expenses per unit
of output decreases or increases.
It is essential to note that there is no such thing as an exact or true cost, as the concept of cost is
not universally applicable in all circumstances and for all purposes. True cost is only applicable up to
the stage of prime cost. Once overheads are included on an estimated basis, the total cost becomes an
estimated cost, providing a reasonable degree of accuracy.
(b) Expense : Expenses are costs that have been allocated against the revenue of a specific
accounting period in accordance with the principle of matching costs to revenue. Examples of
expenses include the cost of goods sold and office salaries incurred during the period.
(c) Loss : Loss represents a decrease in ownership equity that is not compensated by any
corresponding value received. It refers to a diminution in value, such as the destruction of property
by fire, without any offsetting benefit.
The central idea behind cost concepts is the notion of giving up or sacrificing something of value
to acquire something else. Expenses represent the portion of these sacrifices that are allocated to a
specific accounting period, while losses represent sacrifices without corresponding returns. Cost, on
the other hand, implies sacrifices made to obtain and secure some other value.
(d) Cost unit : A cost unit is a measurement or mechanism used to break down costs into smaller,
identifiable segments that can be assigned to specific products or services. It serves as a unit of
quantity for which costs can be determined, such as a tonne for coal production. Cost centre is defined
by CIMA as’ A unit of quantity or product, service or time (or a combination of these) in relation to which cost
may be ascertained or expressed’. Cost units are typically based on physical measurements like number,
weight, area, volume, and so on. It is essential to clearly define and select an appropriate cost unit
before commencing the cost analysis process. The chosen cost unit should neither be too large nor too
small, but rather selected in a manner that allows expenses to be associated with it accurately and
aligns with the operational requirements of the business.
The choice of a cost unit depends on the nature of the business and the type of goods or services
being produced. It can vary widely across industries and businesses. Common examples of cost units
include :
1. Quantity-based units : These are based on physical measures, such as the number of units
produced, weight, volume, length, area, or time. For instance, in manufacturing, the cost unit could be
a single product, a batch of products, or a specific weight of raw material used in production.
2. Composite units : In certain industries or services, a combination of measures is used to represent
the cost unit. For example, in transportation, the cost unit could be expressed as the distance traveled
(e.g., miles or kilometers) multiplied by the weight of goods transported (e.g., tonne-kilometer).
3. Functional units : In some cases, the cost unit is based on the function or activity performed. For
instance, in a consulting firm, the cost unit might be billed hours or the number of client
engagements.
The selection of an appropriate cost unit is crucial for accurate cost calculation, cost control,
pricing decisions, and performance evaluation. It should align with the specific needs and
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·17

characteristics of the business, enabling meaningful analysis and comparison of costs across different
products, services, or activities.

Table Showing Cost Units and Methods of Costing for Different Industries/ Enterprises

Industry/Enterprise Cost Unit Method of Costing

Steel/Cement Tonne Process Costing
Sugar Tonne, Quintal Process Costing
Textiles Metres, Yards Process Costing
Bicycle Manufacturing Number Multiple Costing
Aircraft Number Job Costing
Hospital/Nursing Home Per bed occupied per day/out patient Operating or Service Costing
visit
Timber Cubic Foot Process Costing
Transport Tonne Kilometer, Passenger Kilometer Operating Costing
Chemical Tonne, Kilogram Process Costing
Readymade Garments Number Batch Costing
Building House or Area or Square Foot Job Costing or Contract Costing
Soft Drinks Cases of 24 bottles each or per bottle Process Costing
of different weights
Confectionery Per Kg. Process Costing
Power Kilo-watt hour (kwh) Operating or Service Costing
Automobile Number Process Costing
Brickkiln Per 1,000 Bricks Output Costing
Case Making Per Case Job Costing
Coal Per Tonne Single or One Operation or Output
Costing
Interior Decoration Per Job Job Costing
Pharmaceutical Per 1,000 Tablets, Ampulses Batch Costing
Furniture Per Unit Multiple Costing
Advertising Per Job Job Costing
Oil Refining Per Tonne/Quintal Process Costing

(e) Cost Centre : A cost centre refers to the smallest identifiable segment or area of responsibility
within an organisation where costs are accumulated and monitored. Cost centre is defined by CIMA
as’ A location, person or item of equipment (or group of these) for which cost may be ascertained and used for
the purposes of cost control.’ Typically, cost centres are associated with departments, but in some cases,
a department may contain multiple cost centres. These cost centres serve as the basis for cost
ascertainment and cost control.
A cost centre focuses solely on managing costs and does not generate revenue, while a
department encompasses a wider range of functions and may be responsible for both costs and
revenue generation. Departments are typically structured based on the company’s operational needs,
A/2·18 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

such as sales, marketing, finance, human resources, and operations. Departments may have their own
cost centres within them to monitor and control costs related to their specific activities. Cost centres
are often a part of departments, and they help in tracking and controlling costs associated with the
department’s activities.
A cost centre can be defined as a location, person, or item of equipment (or a group of these) for
which costs can be identified and used for the purpose of cost control. For example, within an
assembly department supervised by a foreman, each assembly line may be considered a separate cost
centre, often with its own assistant foreman. Determining appropriate cost centres is crucial for
accurate cost ascertainment and control. The manager responsible for a cost centre is held accountable
for cost control within their respective area. By consolidating costs within a cost centre, it becomes
feasible to apply a common cost recovery base.

Cost centres can be classified into different types :

(i) Personal Cost and Impersonal Cost Centre : This type of cost centre revolves around a specific
person or group of people, such as a supervisor, foreman, accountant, engineer, or staff members in
various departments like process, mining, or medical staff. An impersonal cost centre is defined by a
particular location or an item of equipment, or a group of these. It could be a branch office, a specific
area within a facility, a machine, a vehicle, or any other identifiable entity. Costs incurred for these
locations or equipment is accumulated separately.
(ii) Operation and Process Cost Centres : An operation cost centre is defined by a specific
operation or task performed within the organisation. It involves individuals or machines engaged in
similar operations. For instance, a cost centre may be established for a specific operation like drilling,
painting, or packaging. Costs related to these operations are accumulated separately for analysis and
control. A process cost centre represents a continuous sequence of operations involved in the
production process. It encompasses multiple operations and departments that are interconnected in
the production flow. Process cost centres are often found in industries with continuous or repetitive
production processes, such as chemical manufacturing or food processing.
(iii) Production and Service Cost Centres : A production cost centre is a department or unit
involved in the manufacturing process. It encompasses activities related to the conversion of raw
materials into finished goods. Examples of production cost centres include assembly lines, machine
shops, welding shops, or any unit directly engaged in the production process. A service cost centre is
a department or unit that provides support services to production cost centres or other areas within
the organisation. They do not directly contribute to the manufacturing process but incur costs
necessary for smooth operations. Maintenance departments, quality control units, tool rooms, and
administrative offices are examples of service cost centres.
The number and nature of cost centres may vary depending on the organisation and industry. In
an engineering industry, cost centres could include machine shops, welding shops, assembly shops,
maintenance departments, and general administrative departments. Production centres are
responsible for actual production, while service cost centres provide support services to facilitate
smooth production operations.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·19

The selection of suitable cost centres or cost units for cost ascertainment depends on factors such
as factory organisation, cost incidence, costing requirements, availability of information, and
management policies.

Difference between Cost Unit and Cost Centre

Basis Cost Unit Cost Centre
Definition and A cost unit refers to the specific unit of A cost centre is a smaller segment or
Scope quantity or measurement of a product, department within an organisation where
service, or activity. It is used to determine costs are accumulated and monitored. It is
the cost per unit and allocate costs to responsible for incurring costs related to a
individual units. specific area of responsibility or activity.

Nature and The primary purpose of a cost unit is to Cost centres are established to collect and
Purpose measure and assign costs to individual control costs related to specific
units of output or activities. It helps in departments, locations, or functions within
calculating the cost per unit and an organisation. They provide a basis for
determining the overall cost of production cost allocation, monitoring, and analysis.
or service.

Relationship Cost units are often associated with the Cost centres may encompass multiple cost
production or delivery of goods or units. They provide a framework for
services. They are the basis for organising and monitoring costs within an
calculating the cost of producing each unit organisation by grouping related activities
or performing each activity. or functions together.

Reporting and Cost units are mainly used for internal Cost centres enable management to track
Analysis reporting purposes, such as calculating and analyse costs related to specific areas
the cost of goods sold, evaluating. or departments. They help in budgeting,
cost control, performance evaluation, and
decision-making.

(f) Profit Centre : A profit centre is a specific segment of a business that is accountable for both
generating revenue and incurring expenses, ultimately revealing the profit or loss associated with that
particular segment. Unlike cost centres, which primarily exist for cost control purposes, profit centres
are established to delegate authority and measure the performance and profitability of individual
segments within an organisation.
Profit centres have the responsibility for generating revenue through sales or service activities
and managing the related expenses within their segment. They are granted a certain level of
autonomy in decision-making, allowing them to make strategic choices and implement policies that
directly impact their financial outcomes. Each profit centre is assigned specific profit targets or
performance goals that it is expected to achieve, and their performance is regularly evaluated through
financial assessments and analyses.
Profit centres can take various forms within an organisation, such as individual departments,
divisions, branches, or subsidiaries. They provide a framework for assessing the financial
performance and accountability of specific segments, enabling decentralised decision-making and a
focus on profit-oriented management. Ultimately, profit centres contribute to effective resource
allocation and maximising overall profitability within the organisation.
A/2·20 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Difference between Cost Centre and Profit Centre

The main differences between a cost centre and a profit centre are as follows :
Basis Cost Centre Profit Centre
Purpose A cost centre is established for the A profit centre is created to measure the
purpose of tracking and controlling revenue, expenses, and profitability of a
costs within a specific segment or particular segment or business unit. Its main
department of an organisation. Its objective is to assess the financial performance
primary focus is on cost management and generate profits.
and efficiency.
Responsibility In a cost centre, the managers are In a profit centre, the managers have the
responsible for controlling costs and additional responsibility of generating revenue
ensuring efficient resource utilisation and managing expenses to achieve a target
within their area of responsibility. They profit. They are empowered to make decisions
are accountable for cost containment that impact both the revenue and cost aspects of
and meeting budgetary targets. their segment.
Performance Cost centres are primarily evaluated Profit centres are assessed based on their ability
Measurement based on their ability to control costs to generate revenue and achieve profit targets.
and operate within budgeted limits. The The performance evaluation includes measures
focus is on cost variance analysis and such as sales revenue, gross profit, net profit,
identifying areas for cost reduction. return on investment, and other profitability
metrics.
Autonomy Cost centres typically have limited Profit centres often have a higher level of
decision-making authority and operate autonomy. They are given more freedom to make
within the broader guidelines set by the strategic decisions, set prices, pursue business
organisation. Their main role is to opportunities, and manage their revenue and
manage costs efficiently. expenses to achieve profitability goals.
Organisational Cost centres are usually departments Profit centres can be individual business units,
Structure or functional units within an divisions, subsidiaries, or branches of an
organisation, such as production organisation. They represent distinct segments
departments, support services, or that have their own revenue streams and
administrative units. They focus on financial performance evaluation.
specific activities or functions.

(g) Cost Object : A cost object refers to a specific item, activity, or unit for which the cost is
measured or desired. It can be a product, service, project, customer, cost centre, or any other entity
that requires a separate evaluation of its cost. Cost objects provide a basis for analysing and allocating
costs. For example, a cost object can be the cost of producing a particular item, providing a service to a
customer, operating a department, or executing a project. By identifying and measuring costs
associated with different cost objects, organisations can better understand the resource utilisation and
cost implications of their activities.
(h) Cost Driver : A cost driver is a factor that influences or determines the cost of a particular cost
object. It is the variable that, when changed, leads to a corresponding change in the total cost of the
cost object. Cost drivers can vary depending on the nature of the activity or cost being analysed.
Examples of cost drivers include the number of units produced, number of setups, volume of items
distributed, number of customers served, advertising expenses, sales personnel count, or number of
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·21

products manufactured. By identifying and monitoring cost drivers, management can assess the
impact of changes in these factors on overall costs. Cost drivers play a crucial role in cost estimation,
cost control, and decision-making processes by providing insights into the relationship between
activities and their associated costs.
(i) Contribution Margin : The contribution margin is the difference between the sales price of a
product or service and its variable costs. It represents the portion of revenue that is available to cover
fixed costs and contribute towards profit. The contribution margin can be expressed as a total amount
or as a ratio or percentage of sales. It is a key measure in determining the profitability of individual
products or services and helps in making decisions regarding pricing, product mix, and cost
management.
(j) Carrying Costs : Carrying costs, also known as holding costs, refer to the expenses incurred in
maintaining inventory. These costs include the cost of financing inventory (such as interest on loans
or opportunity cost of capital), storage costs (rent, utilities), insurance, inventory obsolescence, and
costs associated with handling and managing inventory. Managing carrying costs is important to
optimise inventory levels, minimise storage expenses, and prevent excess inventory or stock outs.
(k) Out-of-Stock Cost : Out-of-stock costs arise when there is a shortage of inventory or when a
product is not available to meet customer demand. These costs can include the loss of sales, potential
damage to customer goodwill and satisfaction, increased customer service efforts to handle
complaints, and negative impact on the company’s reputation. It may also result in employee
dissatisfaction and decreased productivity. Effective inventory management and demand forecasting
are crucial in minimising out-of-stock costs.
(l) Ordering Costs : Ordering costs are the expenses incurred each time an order is placed for the
purchase of materials or goods. These costs include activities such as preparing purchase orders,
processing paperwork, communication, and transportation costs. By optimising ordering processes
and batch sizes, organisations can reduce ordering costs and improve operational efficiency.
(m) Development Cost : Development costs refer to the expenses incurred during the process of
creating and implementing new or improved methods, products, or services. These costs encompass
activities such as research, design, prototyping, testing, and obtaining necessary approvals.
Development costs are incurred before the formal production of the product or implementation of the
new method begins.
(n) Policy Cost : Policy costs are additional costs incurred in line with the policies and guidelines
set by an organisation. These costs go beyond normal requirements and are incurred to align with the
company’s strategic objectives, regulatory compliance, social responsibility, or other specific policies.
Examples of policy costs can include investments in employee training and development,
environmental sustainability initiatives, or safety and security measures.
(o) Idle Facilities Cost : Idle facilities costs arise when fixed assets or available services are not
utilised to their full capacity or remain idle for extended periods. These costs include expenses
associated with the maintenance, depreciation, and other on-going costs of idle facilities. Efficient
utilisation of facilities is important to minimise idle facility costs and maximise resource productivity.
(p) Expired Cost : Expired costs are expenses or losses that are directly related to the current
period and are recognised as an immediate expense on the income statement. These costs include
items such as wages, utilities, rent, and other operating expenses that have been incurred and used up
within the accounting period.
A/2·22 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

(q) Incremental Revenue : Incremental revenue refers to the additional revenue generated by
choosing one alternative over another. When evaluating the profitability of different options,
incremental revenue is compared to incremental costs to determine the net benefit or profitability of
each alternative. Incremental revenue analysis helps in making informed decisions by considering the
additional revenue potential associated with a particular choice.
(r) Added Value : Added value refers to the increase in market value achieved by modifying a
product or service through activities like manufacturing, processing, packaging, or branding. It
excludes the cost of purchased materials or services and includes the element of profit. Added value
measures the additional worth that a product or service acquires as perceived by customers or the
market.
(s) Urgent Costs : Urgent costs are immediate expenses incurred to prevent disruptions in the
production line or operations. These costs are crucial and cannot be delayed without adversely
affecting operational efficiency. Examples include emergency repairs, expedited shipping charges, or
overtime wages to address unexpected issues that could hinder the smooth flow of production.
(t) Postponable Costs : Postponable costs are expenses that can be delayed or deferred to a future
period without significantly impacting current operations’ efficiency. These costs are non-essential
and can be adjusted based on the organisation’s priorities and financial situation. Examples include
non-essential equipment upgrades, certain maintenance activities, or discretionary expenses that can
be postponed during periods of financial constraints.
(u) Pre-production Costs : Pre-production costs are incurred during the phase before formal
production begins. They encompass expenses associated with planning, design, equipment setup,
prototype development, testing, and other activities leading up to full-scale production. These costs
are typically treated as deferred revenue expenditures, except for the portion that is capitalised as
part of the fixed asset value, and are allocated to future production once formal production
commences.
(w) Research Costs : Research costs encompass expenses incurred in the pursuit of new ideas
or processes through experimentation or other methods. They involve activities aimed at
advancing knowledge, exploring new material applications, or developing improved methods,
processes, systems, or services. Examples of research costs include conducting experiments, analysing
data, market studies, hiring research personnel, and obtaining patents. Research costs drive
innovation and can lead to the development of new products, improved efficiency, or competitive
advantages.
(x) Training Costs : Training costs pertain to the expenses associated with providing instruction
and development opportunities to employees, apprentices, or staff members. They include wages,
salaries, and compensation for trainers and trainees, fees for external training programs, and the cost
of materials, tools, and equipment used during training. These costs are allocated to a dedicated
training section and subsequently apportioned to relevant production centers. Training investments
enhance employee skills, knowledge, and productivity, ultimately benefiting the organisation’s
overall performance.

Cost Classification
Cost Classification is the process of categorising costs based on their common characteristics. It
involves grouping similar cost items together to facilitate cost identification, analysis, and decision-
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·23

making. Costs can be classified in various ways depending on the purpose and requirements of a
specific organisation. The important methods of cost classification are as follows :
1. By Nature or Elements 7. By Relationship with Accounting Period
2. By Functions (Capital and Revenue)
3. By Degree of Traceability to the Product 8. By Time
4. By Changes in Activity or Volume 9. According to Planning and Control
5. By Controllability 10. By Association with the Product
6. By Normality 11. For Managerial Decisions
Each method provides a different perspective for grouping costs, allowing organisations to
analyse and manage costs effectively. By employing the appropriate cost classification method,
businesses can gain insights into cost behaviour, allocation, control, and decision-making processes.
Let us discuss each classification in detail.
1. By Nature or Elements (Analytical Classification) : This classification categorises costs into
three main elements : materials, labour, and expenses. Each element can be further subdivided into
more specific categories such as raw materials, spare parts, consumable stores, etc. This classification
helps in understanding the composition of total costs, valuation of work-in-progress, and determining
the overall cost structure.
2. By Functions (Functional Classification) : Costs are classified based on the different functional
areas of a business undertaking, such as production, administration, selling, and distribution.
Manufacturing and production costs encompass all costs involved in the actual manufacturing
process. Commercial costs, on the other hand, include expenses related to the operation of the
business, excluding manufacturing costs. Commercial costs can be further divided into administrative
costs and selling and distribution costs.
3. By Degree of Traceability to the Product (Direct and Indirect) : This classification
distinguishes between direct costs and indirect costs. Direct costs are specifically incurred for and can
be easily identified with a particular cost centre or cost unit. Examples include materials and labour
used in the production of a specific product. Indirect costs, on the other hand, benefit multiple cost
centres or cost units and cannot be directly attributed to a specific entity. Examples of indirect costs
are building rent, management salaries, and machinery depreciation. Differentiating between direct
and indirect costs is important for accurate cost determination and cost allocation purposes.
4. By Changes in Activity or Volume : Costs can be classified based on their behaviour in relation
to changes in the level of activity or volume of production. This classification identifies three types of
costs : fixed costs, variable costs, and semi-variable costs.
(i) Fixed Costs : These costs remain unchanged in total amount regardless of the increase or
decrease in the volume of output or productive activity over a given period of time. However, the
fixed cost per unit decreases as production increases and increases as production declines. Examples
of fixed costs include rent, insurance of factory building, and the salary of the factory manager. Fixed
costs can be further categorised as follows :
(a) Committed Costs : These costs result from commitments made previously or are incurred to
maintain certain facilities and cannot be easily eliminated. The management has little or no
discretion in controlling these costs, such as rent, insurance, and depreciation on purchased
buildings or equipment.
A/2·24 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

(b) Policy and Managed Costs : Policy costs are incurred to implement specific management
policies, such as executive development or housing, and are often discretionary. Managed
costs are incurred to ensure the operational existence of the company, such as staff services.
(c) Discretionary Costs : These costs are not directly related to the operational activities but can
be controlled by management. They arise from policy decisions or new research initiatives
and can be reduced or eliminated at the discretion of management. Examples include
advertising, public relations, and training costs. These costs are not tied to a clear cause-and-
effect relationship between inputs and outputs, and their incurrence is based on periodic
decisions regarding the maximum outlay.
(d) Step Costs : Step costs remain constant for a given level of output and then increase by a
fixed amount at a higher level of output.
(ii) Variable Costs : These costs vary in total in direct proportion to the volume of output.
However, their cost per unit remains relatively constant with changes in production. Examples of
variable costs include direct material costs, direct labour costs, power, and repairs. Variable costs are
referred to as product costs since they depend on the quantity of output rather than on time. For
instance, the expenditure incurred by the Tool Room can be controlled by the foreman in charge of
that section, but the portion of tool-room expenditure apportioned to a machine shop is not under the
control of the machine shop foreman.
(iii) Semi-variable Costs : Semi-variable costs comprise both fixed and variable components. For
example, telephone expenses consist of a fixed annual charge and a variable component based on the
number of calls made. Other examples include depreciation, repairs, and maintenance costs for
buildings and equipment.
5. By Controllability : Costs are classified based on whether or not they can be influenced by a
specified member of the organisation. This classification includes two categories :
(i) Controllable Costs : These costs can be influenced by the actions of a specified member or
manager within the organisation. Lower-level management typically has control over direct costs,
including direct materials, direct labour, and some overhead expenses. An organisation is divided
into responsibility centres, and the managers responsible for each centre can influence the controllable
costs incurred within their respective centres.
(ii) Uncontrollable Costs : These costs cannot be influenced by a specified member of the
organisation and are beyond the control of management. Most fixed costs fall under this category,
such as building rent and managerial salaries. Additionally, overhead costs incurred by one service
section and apportioned to another receiving the service are uncontrollable by the latter.
It is important to note that the distinction between controllable and uncontrollable costs is
subjective and may vary based on individual judgment. Controllability is relative to a particular level
of management or an individual manager. A cost that is controllable from one management
perspective may be uncontrollable from another perspective. Additionally, a cost may be controllable
in the long term but uncontrollable in the short term, as is often the case with fixed costs like
depreciation.
6. By Normality : Costs can be classified based on whether they are normally incurred at a given
level of output and under normal operating conditions. This classification includes two categories :
Normal Cost : Normal costs are the costs that are typically incurred at a given level of output and
under normal operating conditions. They are considered a part of the cost of production.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·25

Abnormal Cost : Abnormal costs are the costs that are not normally incurred at a given level of
output and under normal operating conditions. These costs are exceptional or non-recurring in nature
and are not included in the cost of production. Instead, they are charged to the Costing Profit and
Loss Account.
7. By Relationship with Accounting Period (Capital and Revenue) : Costs can be classified based
on their relationship with the accounting period. This classification distinguishes between capital
costs and revenue costs.
Capital Costs : Capital costs are incurred in purchasing assets that are used to earn income or
increase the earning capacity of the business. These costs are incurred at a specific point in time, but
their benefits are spread over multiple accounting years. Examples include the cost of acquiring a
rolling machine in a steel plant.
Revenue Costs : Revenue costs are expenditures incurred to maintain the earning capacity of the
business. These costs include expenses related to the production process, such as the cost of materials
used, labour charges, depreciation, repairs and maintenance, selling and distribution expenses, and
salaries. Revenue costs are considered as on-going expenses in the day-to-day operations of the
business. In costing, all items of revenue expenditure are taken into consideration, while capital items
are typically excluded.
8. By Time : Costs can be classified as historical costs and predetermined costs.
(i) Historical Costs : Historical costs are costs that are ascertained after they have been incurred.
These costs are available only after the production of a particular item has already been completed.
Historical costs are of historical value and are not directly useful for cost control purposes. They are
based on recorded facts, can be verified through evidence of occurrence, and are mostly objective
since they relate to past events.
(ii) Predetermined Costs : Predetermined costs are estimated costs that are computed in advance of
production, taking into consideration previous periods’ costs and the factors that influence such costs.
When predetermined costs are determined based on a scientific basis, they become standard costs.
Predetermined costs, when compared with actual costs, help identify variances and enable
management to analyse the reasons for deviations and take appropriate remedial actions.
Predetermined costs play a crucial role in cost control and performance evaluation.
Historical costs and predetermined costs are not mutually exclusive but work together in an
organisation’s accounting system. Predetermined costs, such as standard costs, allow for the
establishment of benchmarks for performance evaluation and cost control, while historical costs
provide a reference point for analysing past financial transactions.
9. According to Planning and Control : Costs can be classified as budgeted costs and standard
costs, based on their relationship to planning and control.
Budgeted Costs : Budgeted costs represent estimates of expenditures for different phases of
business operations, such as manufacturing, administration, sales, research and development, etc.
These estimates are coordinated within a well-conceived framework for a future period and serve as
written expressions of managerial targets to be achieved. Various budgets, such as raw material cost
budget, labor cost budget, cost of production budget, manufacturing overhead budget, and office and
administration overhead budget, are prepared. Continuous comparison of actual performance (actual
costs) with budgeted costs helps report variations to management for corrective action.
A/2·26 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Standard Costs : Standard costs translate budgeted costs into actual operations. They are
predetermined costs based on technical estimates for materials, labour, and overheads, considering a
selected period of time and prescribed working conditions. Standard costs provide a benchmark or
norm against which actual costs can be compared. Variances between standard costs and actual costs
help identify deviations and enable management to assess performance, allocate responsibility, and
take corrective measures to avoid recurring discrepancies.
While both budgeted costs and standard costs represent estimates for future costs, they differ in
terms of their basis, emphasis, and level of detail. Budgeted costs rely on past financial accounting
data adjusted for future trends and primarily serve the planning function of management. On the
other hand, standard costs are scientifically determined costs for specific business activities and
emphasise control. Standard costs provide a more intensive analysis at the individual part level, such
as materials, labour, and overheads, whereas budgeted costs provide a macro-level overview of
various business functions.
10. By Association with the Product : Costs can be classified as product costs and period costs
based on their association with the goods or services being produced.
Product Costs : Product costs are directly associated with the purchase and sale of goods or the
production of goods. In a manufacturing context, these costs include the expenses incurred in
acquiring and converting materials and other inputs into finished products ready for sale. Product
costs are considered inventoriable costs and are included in the valuation of inventory. They are
traced to the product and remain in the balance sheet until the products are sold. Product costs are
essential for product pricing and cost-plus contracts. They typically consist of direct materials, direct
labour, and manufacturing overhead in the case of manufacturing businesses. The cost of goods sold
is transferred from inventory to the cost of goods sold account when the products are sold.
Period Costs : Period costs are not directly assigned to specific products but are incurred based
on time periods, such as a month or a year. These costs are necessary to keep the business running
and generate revenue but cannot be directly associated with a particular product. Examples of period
costs include rent, salaries, advertising expenses, and administrative costs. Period costs are expensed
in the period in which they are incurred and are not included in the inventory valuation. They are
charged against revenue in the same period and do not affect the cost of production.
Both product costs and period costs contribute to the net income of a business :
• Product costs are included in the cost of production and are not immediately expensed. They
remain in inventory until the associated products are sold. Only when the products are sold,
the product costs are recognised as an expense in the form of cost of goods sold, reducing the
inventory value.
• Period costs are not related to the production process and are expensed in the period they are
incurred. They directly reduce the revenue generated in that period and are necessary for the
on-going operation of the business.
Understanding the distinction between product costs and period costs is important for proper
financial reporting and analysis, as it allows for accurate calculation of the cost of goods sold and
determination of the profitability of the business.
11. For Managerial Decisions : Costs can be classified into various types based on their relevance
and use in managerial decision-making processes. The following are some classifications of costs :
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·27

(i) Marginal Cost : Marginal cost is calculated by considering only the variable costs, which
include prime costs (direct materials and direct labour) and variable overheads. Fixed costs are
ignored in this calculation. Marginal cost is useful for determining the cost of products, as well as the
value of work-in-progress and finished goods. It helps in analysing the cost implications of producing
additional units.
(ii) Out-of-Pocket Costs : These costs involve cash expenditures made to outsiders, such as
payments to suppliers or contractors. Out-of-pocket costs are relevant for decision-making,
particularly in situations like price fixation during a recession or when making decisions regarding
whether to make or buy a product or service.
(iii) Differential Cost : Differential cost is the difference in total costs between alternative options
considered for a decision. It assists in analysing the cost impact of producing more or fewer units,
changing production methods, adding or eliminating products or territories, or selecting additional
sales channels. If the change increases costs, it is called incremental cost, while a decrease in costs due
to reduced output is termed decremental cost.
(iv) Conversion Cost : Conversion cost represents the sum of direct wages, direct expenses, and
manufacturing overhead costs incurred in converting raw materials from one stage of production to
the next. In other words, it is the total cost of converting raw materials into finished goods, excluding
the cost of direct materials.
(v) Sunk Cost : Sunk costs are irrecoverable costs that have been incurred in the past and are not
relevant for decision-making. They are associated with abandoned assets or projects and are not
affected by changes in volume or future decisions. Sunk costs include the written-down value of
abandoned plants or assets minus their salvage value. For current decision-making processes, sunk
costs are considered irrelevant.
(vi) Imputed or Notional Costs : Imputed costs, also referred to as notional costs, are hypothetical
costs that do not involve any cash outlay. They represent the value of a benefit received or an
opportunity forgone. Although these costs do not involve actual cash expenses, they are considered in
managerial decisions. Examples include notional rent charged on business premises owned by the
proprietor or imputed interest on capital that hasn’t been paid. Imputed or notional costs are
sometimes described as opportunity costs.
(vii) Opportunity Cost : Opportunity cost refers to the cost incurred by selecting one course of
action and forgoing the benefits of other available alternatives. It represents the maximum alternative
earnings that could have been obtained if the resources or assets were used in their next best
alternative. For example, the rent that could have been earned if an owned building were leased out
instead of being used for a project represents the opportunity cost.
(viii) Replacement Cost : Replacement cost is the cost of purchasing an identical asset or material
to replace or revalue an existing one. It represents the cost at current market prices.
(ix) Avoidable and Unavoidable Costs : Avoidable costs are those costs that can be eliminated if
a specific product or department is discontinued. For example, the salaries of clerks employed in a
particular department can be eliminated if the department is discontinued. Unavoidable costs, on the
other hand, cannot be eliminated even if a product or department is discontinued. For instance, the
salary of a factory manager or factory rent remains unchanged.
(x) Explicit Costs : Explicit costs, also known as out-of-pocket costs, involve immediate cash
A/2·28 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

payments to outsiders. These costs are recorded in the books of accounts and include expenses such
as salaries, wages, and interest on capital. Explicit costs are easily measurable and are relevant in
price fixation during trade recessions or when making make-or-buy or-buy decisions.
(xi) Implicit Costs : Implicit costs, also known as economic costs, do not involve immediate cash
outflows. They represent the opportunity cost of using resources for a particular purpose instead of
their next best alternative use. Depreciation is an example of an implicit cost, which is not recorded in
the books of accounts.

Difference between Explicit Costs and Implicit Costs are:

Explicit costs refer to the actual cash outflows incurred by a business and are recorded in
accounting books. They are measurable, tangible, and easily quantifiable in monetary terms. On the
other hand, implicit costs are opportunity costs that represent the value of resources or opportunities
foregone. They do not involve immediate cash payments, are not recorded in accounting books, and
are harder to measure.
Implicit costs reflect the economic impact of choosing one alternative over another and are
relevant for long-term decision-making. While explicit costs are visible and considered in short-term
decisions, implicit costs provide a deeper understanding of the overall value and trade-offs involved
in business choices.

QUESTIONS
SHORT/LONG ANSWER TYPE
1. Tabulate the elements of cost showing the usual items of expenditure pertaining to each.
2. Bring out clearly the significance of each of following cost classifications and explain the meaning of the
terms used therein :
(i) Direct and Indirect ; (ii) Variable and Fixed ; (iii) Controllable and Uncontrollable.
3. (a) “The classification of costs as controllable and non-controllable depends upon a point of reference.”
Explain.
(b) “Direct costs and controllable costs are not necessarily the same”. Comment.
(c) “Product cost is a general term that denotes different costs allocated to products for different
purposes.” Describe three purposes. Explain the composition of Product cost, for the purpose of
external financial reporting along with its rationale.
(d) Direct costs and variable costs are not necessarily the same.” Comment.
4. Write notes on :
(i) Conversion cost ; (ii) Sunk cost ; (iii) Opportunity cost ; (iv) Imputed cost ; (v) Cost centre ; (vi) Cost
unit ; (vii) Differential cost ; (viii) Out of pocket cost ; (ix) Operating costs. (x) Decision making cost
(xi) Relevant Range ; (xii) Product costs.
5. Distinguish between :
(i) Avoidable and unavoidable costs ; (ii) Cost centre and cost unit ; (iii) Product costs and period costs;
(iv) Direct costs and indirect costs ; (v) Capital costs and Revenue costs ; (vi) Opportunity costs and
imputed costs ; (vii) Sunk costs and incremental costs ; (viii) Differential costs and residual costs ; (ix)
Absolute costs and alternative costs ; (x) Urgent and postponable costs ; (xi) Prime cost and conversion
cost ; (xii) Out of pocket cost and opportunity cost ; (xiii) Variable cost and direct cost ; (xiv) Estimated
cost and standard cost ; (xv) Variable cost and cost variance ; (xvi) Conversion cost and added value.
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·29

(xvii) Expired cost and unexpired cost. (xviii) Controllable Costs and Uncontrollable Costs. (xix) Explicit
Costs and Implicit Costs.
6. (a) What is a Cost Centre ? (b) Give the names of five cost centres with name of the industry in which
they normally occur. (c) Differentiate between a cost and profit centre.
7. (a) “Notional costs and imputed costs mean the same thing”. Comment.
(b) What are ‘Imputed Costs’ and ‘Common Costs’ ?
8. Do you agree with the view that cost should be presented in different ways for different purposes ?
Support your view with suitable illustrations.
Or
“The term cost must be qualified according to its context”.
9. (a) Discuss the classification of costs according to time factor of cost determination.
(b) Describe in brief three major elements of cost.
10. Describe the various costs used in decision-making and explain their characteristics.
11. Describe briefly the principal aims of classifying the costs.
12. Distinguish between ‘Period Cost’ and ‘Product Cost’. Why is this distinction considered important?
13. (a) Define : (i) Direct expenditure ; and (ii) Indirect expenditure and of cost in each.
(b) You are required to state why it is important to distinguish between ‘fixed’ and ‘variable’ expenses
in Cost Accounting. Give three examples of each type of expenses.
14. ‘Explain fully the concept of ‘Cost’. Distinguish between ‘Direct Cost’ and ‘Indirect Cost’.
15. “Cost may be classified in a variety of ways according to their nature and the information needs of
management”. Explain and discuss this statement giving examples of classifications required for
different purposes.
16. What is a cost centre and how does it differ from a department of a factory ?
Or
What purposes does cost center serve ? Are cost centres and cost units related to each other ? If yes,
how ?
17. Explain the nature of product and period costs. How do they affect net income of a business enterpris

PRACTICAL PROBLEMS
1. From the following particulars prepare a Cost Sheet showing the total cost per tonne for the period
ended 31st Dec., 2023.
R R

Raw materials 33,000 Rent and taxes (office) 500

Productive wages 38,000 Water supply (works) 1,200
Unproductive wages 10,500 Factory Insurance 1,100
Factory rent and taxes 7,500 Office Insurance 500
Factory lighting 2,200 Legal expenses 400
Factory heating 1,500 Rent of warehouse 300
Motive power 4,400 Depreciation of
Haulage (works) 3,000 —Plant and Machinery 2,000
Directors’ fees (works) 1,000 —Office Building 1,000
Directors’ fees (office) 2,000 —Delivery Vans 200
Factory cleaning 500 Bad debts 100
Sundry office expenses 200 Advertising 300
A/2·30 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Estimating expenses (works) 800 Sales department’s salaries 1,500

Factory stationery 750 Upkeep of delivery vans 700
Office stationery 900 Bank charges 50
Loose tools written off 600 Commission on sales 1,500
The total output for the period has been 14,775 tonnes.
Ans. [Cost per tonne 8] R

[Hints : Prime Cost 71,000; Factory Cost 1,08,050; Cost of Production 1,13,600; Total Cost
R R R R 1,18,200]
2. The following information has been obtained from the records of Left-Centre Corporation for the period
from January 1 to June 30, 2023 :
2023 2023
On January 1 On June 30
R R

Cost of raw materials 30,000 25,000

Cost of work-in-progress 12,000 15,000
Cost of stock of finished goods 60,000 55,000
Transactions during six months are : R R

Purchases of raw materials 4,50,000 Administration overheads 30,000

Wages paid 2,30,000 Selling and Distribution overheads 20,000
Factory overheads 92,000 Sales 9,00,000
Prepare
(i) Cost Sheet showing : (a) Materials consumed ; (b) Prime cost ; (c) Factory cost incurred and factory
cost ; and
(ii) Income statement in traditional form for the six months showing gross profit and net profit
assuming stock of finished goods is valued at works cost.
Ans. [Factory Cost : R 7,74,000; Net Profit : R 71,000]
3. The following data have been extracted from the books of Sunshine Industries Ltd., for the year 2024 :
R R

Opening Stock of Raw Material 25,000 Indirect Consumption of Material 500

Purchase of Raw Material 85,000 Salary—Office 2,500
Closing Stock of Raw Material 40,000 —Salesmen 2,000
Carriage Inward 5,000 Other Factory Expenses 5,700
Wages—Direct 90,000 Other Office Expenses 900
Wages—Indirect 10,000 Manager’s Remuneration 12,000
Rent and Rates—Factory 5,000 Bad Debts written off 1,000
—Office 500 Advertisement Expenses 2,000
Depreciation Travelling Expenses of Salesmen 1,100
—Plant and Machinery 1,500 Carriage and Freight Outward 1,000
—Office Furniture 100 Sales 2,50,000
Cash Discount 5,000 Advance Income-tax paid 15,000
The manager has the overall charge of the company and his remuneration is to be allocated as 4,000 to R

the factory, 2,000 to the office and 6,000 to the selling operations.
R R

From the above particulars prepare a statement showing (a) Prime cost ; (b) Factory cost ; (c) Cost of
production ; (d) Cost of sales ; and (e) Net profit.
Ans. [(a) R 1,65,000 ; (b) R 1,91,700 ; (c) R 1,97,700 ; (d) R 2,10,800 ; (e) R 39,200]
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·31

4. A manufacturing concern requires a statement showing the result of its production operation for
September, 2023. Cost records give the following information.
1st Sep., 2023 30th Sep., 2023
R R

Raw Material 1,00,000 1,23,500

Finished Goods 71,500 42,000
Work-in-Progress 31,000 34,500
Transactions during the month of September 2023 :
R

Purchase of Raw Materials 88,000 Sale of Factory Scrap 2,000

Direct Wages 70,000 Selling and Distribution Expenses 15,000
Works Expenses 39,500 Sales 2,84,000
Administration Expenses 13,000
Ans. [Raw material consumed 64,500 ; Prime cost 1,34,500 ; Factory cost 1,68,500; Cost of production
R R R

R 1,81,500 ; Cost of goods sold 2,11,000 ; Cost of sales 2,26,000 ; Profit 58,000]
R R R

5. The Modern Manufacturing Company submits the following information on 31st March, 2024 :
R R

Sales for the year 2,75,000

Inventories at the beginning of the year :
Finished goods 7,000
Work-in-progress 4,000
Purchase of materials for the year 1,10,000
Materials Inventory :
at the beginning of the year 3,000
at the end of the year 4,000
Direct labour 65,000
Factory overhead @ 60% of the direct labour cost
Inventories at the end of the year :
Work-in-progress 6,000
Finished goods 8,000
Other expenses for the year :
Selling expenses 10% of sales
Administrative expenses 5% of sales
Prepare a statement of cost and profit.
Ans. [Prime Cost 1,74,000 ; Works Cost 2,11,000 ; Cost of Production
R R R 2,24,750 ; Cost of Goods Sold
R 2,23,750 ; Cost of Sales 2,51,250 ; Profit 23,750]
R R

6. Following information has been obtained from the records of a Manufacturing Company :
1-1-2023 31-12-2023
R R

Stock of Raw Materials 40,000 50,000

Stock of Finished Goods 1,00,000 1,50,000
Stock of Work-in-Progress 10,000 14,000
A/2·32 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

R R

Indirect Labour 50,000 Administration Expenses 1,00,000

Lubricants 10,000 Power 30,000
Insurance on Plant 3,000 Direct Labour 3,00,000
Purchase of Raw Materials 4,00,000 Depreciation on Machinery 50,000
Sale Commission 60,000 Factory Rent 60,000
Salaries of Salesmen 1,00,000 Property Tax on Factory Building 11,000
Carriage Outward 20,000 Sales 12,00,000
Prepare a Statement of Cost and Profit showing (a) Cost of Raw Materials Consumed ; (b) Prime Cost; (c)
Total Manufacturing Cost ; (d) Factory Manufacturing Cost ; (e) Cost of Production ; (f) Cost of Goods
Sold ; (g) Cost of Sales ; and (h) Profit.
Ans. [(a) 3,90,000 ; (b)
R R 6,90,000 ; (c) 9,04,000 ; (d) R 9,00,000 ; (e) R 10,00,000 ; (f) R 9,50,000 ; (g) R 11,30,000;
(h) 70,000]
R

7. Following information has been obtained from the records of a manufacturing concern :
1-1-2023 31-12-2023
R R

Stock of Raw Materials 30,000 35,000

Work-in-Progress 15,000 20,000
Stock of Finished Goods 43,700 54,000
R R

Indirect Wages 9,720 Purchase of Raw Materials 1,20,000

Sales 3,25,000 Productive Wages 90,000
Factory Rent & Rates 7,830 Plant Repair 3,420
Office Salaries 15,030 Depreciation on Plant 8,360
General Expenses 13,500 Factory Lighting 7,380
Office Rent 2,000 Salesmen’s Salaries 7,650
Rent of Show Room 1,200
Prepare : (i) Cost Sheet showing cost of raw materials consumed, prime cost, factory cost incurred and
factory cost. (ii) Income statement in traditional form for the year showing gross profit and net profit.
Ans. [(i) R 1,15,000 ; R 2,05,000 ; R 2,41,710 ; R 2,36,710 ; (ii) R 98,590 ; R 59,210]
8. From the following particulars, prepare a Cost Statement showing the components of Total Cost and
Profit for the year ended 31st December, 2023.
1-1-2023 31-12-2023
R R

Stock of finished goods 6,000 15,000

Stock of raw materials 40,000 50,000
Work-in-progress 15,000 10,000
R R

Purchase of raw materials 4,75,000 Sales for the year 8,60,000

Carriage inward 12,500 Income tax 500
Wages 1,75,000 Dividend 1,000
Works Manager’s salary 30,000 Debenture interest 5,000
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·33

Factory employees’ salaries 60,000 Transfer to Sinking Fund for

Factory rent, taxes and insurance 7,250 replacement of machinery 10,000
Power expenses 9,500 Goodwill written off 10,000
Other production expenses 43,000 Payment of sales tax 16,000
General expenses 32,500 Selling expenses 9,250
Ans. [Prime Cost 6,52,500 ; Works Cost 8,07,250 ; Cost of production
R R R 8,39,750 ; Cost of goods sold
R 8,30,750 ; Cost of Sales 8,40,000 ; Profit 20,000]
R R

9. On June 30, 2023 a flash flood damaged the warehouse and factory of ABC Corporation completely
destroying the work-in-progress inventory. There was no damage to either the raw materials or finished
goods inventories. A physical verification taken after the flood revealed the following valuations.
The inventory on Jan. 1, 2023 consisted of the following :
R R

Raw Materials 62,000 Raw Materials 30,000

Work-in-Progress 0 Work-in-Progress 1,00,000
Finished Goods 1,19,000 Finished Goods 1,40,000
A review of the books and records disclosed that the gross profit margin historically approximated 25%
of sales. The sales for the first six months of 2023 were 3,40,000. Raw material purchases were
R

R 1,15,000. Direct labour costs for this period were 80,000 and manufacturing overhead has historically
R

been 50% of direct labour.

Compute the cost of work-in-progress inventory lost at June 30, 2023 by preparing a statement of cost
and profit.
Ans. [Total Cost : R 2,55,000; Profit : R 85,000]
10. Mr. Gopal furnishes the following data relating to the manufacture of a standard product during the
month of April, 2024 :
Raw materials consumed R 15,000
Direct labour charges R 9,000
Machine hours worked 900
Machine hour rate R 5
Administrative overheads 20% on works cost
Selling overheads R 0·50 per unit
Units produced 17,100
Units sold 16,000 at 4 per unit
R

You are required to prepare a Cost Sheet from the above, showing ; (a) the cost of production per unit;
(b) profit per unit sold and profit for the period.
Ans. [(a) R 2 ; (b) R 1.50 and R 24,000]
11. Following information has been obtained from the cost records of Aditya Chemicals Ltd. for 2024 :
R R

Finished Goods on 1-1-2024 50,000 Heat, Light and Power 20,000

Raw Materials on 1-1-2024 10,000 Factory Insurance and Taxes 5,000
Work-in-Progress 1-1-2024 14,000 Repairs to Plant 3,000
Direct Labour 1,60,000 Factory Supplies 5,000
Purchase of Raw Material 98,000 Depreciation—Factory Building 6,000
Indirect Labour 40,000 Depreciation—Plant 10,000
A/2·34 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

Other information made available is —Factory cost of goods produced in 2024 R 2,80,000 ; Raw material
consumed in 2024 95,000 ; Cost of goods sold in 2024 1,60,000
R R

No office and administration expenses were incurred during the year 2024. Prepare a Statement of Cost
and Profit for the year ending 2024 giving maximum possible information and its break-up. What
should be the selling price to obtain a profit of 20% on the selling price ?
Ans. [Total Cost : 1,60,000; Profit : 40,000]
R R

12. In a factory two types of radios are manufactured, viz., Orient and Sujon Models. From the following
particulars prepare a statement showing cost and profit per radio sold. There is no opening or closing
stock.
Orient Sujon
R R

Materials 27,300 1,08,680

Labour 15,600 62,920
Works overhead is charged at 80% on labour and office overhead is taken at 15% on works cost. The
selling price of both radios is 1,000. 78 Orient radios and 286 Sujon radios were sold.
R

⎧⎪ Orient Sujon ⎫⎪
Ans. ⎨⎪ Total cost per unit 816·50 892·40 ⎬⎪
⎩ Profit per unit 183·50 107·60 ⎭
13. Your company is an export-oriented organisation manufacturing Internal-communication equipment of
a standard size. The company is to send quotations to foreign buyers of your product. As the Cost
Accounts Chief, you are required to help the management in the matter of submission of the quotation
by the preparation of a cost estimate based on the following figures relating to the year 2024.
Total Output (in units) 20,000
Expenses incurred R R

Local Raw Materials Consumed 10,00,000 Excise Duty on Production 2,00,000

Imports of Raw Materials Administrative Office Expenses 2,00,000
(actual consumption) 1,00,000 Salary of the Managing Director 60,000
Direct Labour in Works 10,00,000 Salary of the Joint Managing
Indirect Labour in Works 2,00,000 Director 40,000
Storage of Raw Materials and Spares 50,000 Fees of Directors 20,000
Fuel 1,50,000 Expenses on Advertising 1,60,000
Tools Consumed 20,000 Selling Expenses 1,80,000
Depreciation on Plant 1,00,000 Sales Depots 1,20,000
Salaries of Works Personnel 1,00,000 Packaging and Distribution 1,20,000
Note. (i) Local Raw Materials now cost 10% more ; (ii) A profit margin of 20% on Sales is kept ; (iii) The
Government grants subsidy of 100 per unit of export.
R

Prepare a statement of cost.

Ans. [Prime Cost 22,00,000 ; Works Cost 30,20,000 ; Total Cost 39,20,000; Selling Price before Subsidy
R R R

245 ; Quotation 145]

R R

14. The cost of sale of product A is made up as follows :

R R

Materials used in manufacturing 60,000 Administration Expenses 1,250

Materials used in primary packing 10,000 Depreciation on Office
Materials used in selling the product 1,500 Building and Equipment 750
COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET A/2·35

Materials used in the factory 750 Depreciation on Factory Building 1,750

Materials used in the office 1,250 Selling Expenses 3,500
Labour required in producing 10,000 Freight on materials purchased 5,000
Labour required for factory supervision 2,000 Advertising 1,250
Indirect Expenses—Factory 1,000
Assuming that all the products manufactured are sold, what should be the selling price to obtain a
profit of 20% on selling price ?
Ans. [Selling price 1,25,000]
R

[Hints : Prime cost 85,000 ; Works cost

R R 90,500 ; Cost of production R 93,750 ; Cost of sales R 1,00,000 ; Profit
R 25,000]
15. Vindhyachal Industries manufacture a Product X.
On 1st January, 2023, there were 500 units of finished product in stock. Other stocks on 1st January,
2023 were as under :
R

Work-in-Progress 5,740
Raw Materials 11,620
The information available from cost records for the year ended 31st December, 2023 was as follows:
R R

Indirect Labour 12,160 Work-in-Progress on 31-12-2023 7,820

Direct Labour 32,640 Sales—15,000 units 3,60,000
Freight on Raw Material Purchased 5,570 Indirect Materials 21,390
Stock of Raw Materials on 31-12-2023 9,640 Total Manufacturing
Other Factory Expenses 31,730 Cost Incurred 1,94,080
There are 1,500 units of product in finished goods stock on 31st December, 2023. You are required to :
(i) Prepare a statement of cost for 2023 giving all details of cost and their break up, and (ii) Determine
the unit cost at which finished goods stock is to be properly valued at the beginning and at the end of
2023 (assuming the same cost used for both).
Ans. [Prime cost R 1,28,800 ; cost of goods manufactured R 1,92,000 ; R 12 per unit cost of stock, Profit
R 1,80,000]
[Hint : Raw Materials purchased R 88,610].
16. The books of Adarsh Manufacturing Company presents the following data for the month of April, 2024.
Direct labour cost 17,500 being 175% of the works overhead ; cost of goods sold excluding
R

administration expenses 56,000.

R

Inventory accounts showed the following opening and closing balances :

April 1 April 30
R R

Raw materials 8,000 10,600

Work-in-progress 10,500 14,500
Finished goods 17,600 19,000
Other data are :
R

Selling expenses 3,500

General and administration expenses 2,500
Sales for the month 75,000
A/2·36 COST—ANALYSIS, CONCEPTS, CLASSIFICATIONS AND COST SHEET

You are required to : (i) Compute the value of materials purchased. (ii) Prepare a statement of cost
showing the various elements of cost and also the profit.
Ans. [(i) 36,500 ; (ii) Prime Cost 51,400 ; Works Cost 61,400 ; Cost of Goods Manufactured 57,400 ;
R R R R

Cost of Sales 62,000 ; Profit 13,000]

R R

17. The books and records of the Anand Manufacturing Company present the following data for the month
of August, 2023:
Direct labour cost 16,000 (160% of factory overhead)
R

Cost of goods sold 56,000R

August 1 August 31
R R

Raw Materials 8,000 8,600

Work-in-progress 8,000 12,000
Finished goods 14,000 18,000
Other data :
Selling Expenses 3,400
General and Administration Expenses 2,600
Sales for the month 75,000
You are required to prepare a statement showing cost of goods manufactured and sold and profit
earned.
Ans. [Cost of goods manufactured R 60,000 ; Cost of goods sold R 56,000 ; Profit R 15,600]
[Hints : (i) Purchases of Raw Material R 36,000 if closing stock is valued at cost of production.
(ii) Purchases of Raw Material R 38,600, if closing stock is valued at factory cost of goods produced;
Profit 13,000]
R
CONTRACT COSTING B/1·1

SECTION B

CHAPTER

1
Contract Costing
LEARNING OBJECTIVES

To know the features and procedure of Contract costing.

To learn about the recording procedure of contract costs.
To understand the methods of calculating profit on uncompleted contracts.

Contract costing is that form of specific order costing which applies where the work is
undertaken according to customer’s requirements and each order is of long duration as compared to
job costing. The work is generally of constructional and repairs nature. A construction contract is a
contract for the construction of an asset or of a combination of assets which together constitute a
single substantial project. This covers various activities such as construction of plants (including site
preparation), bridges, roads, dams, ships, buildings, complex pieces of equipment, production of
motion pictures etc. That is why this method is used by builders, civil engineering contractors,
constructional and mechanical engineering firms etc. These contracts are negotiated in a number of
ways.

Features of Contract Costing

In contract costing, costs are accumulated and assigned to specific contracts or projects. It is a
method of cost accounting used by companies that take long term, unique projects or contracts such
as construction project, software development or engineering projects.
The key features of contract costing are :
(i) Identification of contracts. Each contract is identified and given a unique contract number.
Each contract is treated as a cost unit.
(ii) Cost Accumulation. Direct costs such as direct materials, direct labour, sub-tractor expenses,
and other directly attributable costs are identified and assigned to specific contracts. Indirect
costs, such as overhead expenses are allocated to contracts based on an appropriate allocation
basis, such as direct labour hours or machine hours.
B/1·2 CONTRACT COSTING

(iii) Contract Budgeting. A budget is prepared for each contract outlining the estimated costs and
revenues associated with the project. The budget serves as a benchmark for monitoring and
controlling projects costs throughout its life cycle.
(iv) Progress Measurement. Contract costing involves measuring the progress of the contract to
determine the percentage of completion. This measurement can be based on physical, cost
incurred, or other measurable milestones depending on the nature of the project.
(v) Retention and Certification. Contract costing considers factors as retention (the withholding
of portion of the contract value as security) and certification (the approval of completed
work) in the calculation of costs and revenue recognisation. These elements play a significant
role in determining the final cost and revenue associated with the contract.
(vi) Revenue Recognisation. Revenue recognisation in contract costing is based on the
percentage of completion method, where revenue is recognised in proportion to the progress
of the contract. This method considers both the costs incurred and the stage of completion to
determine the revenue recognised for a specific period.
Thus, contract costing provides a systematic approach to track, allocate, and control costs for
specific contracts.

Comparison Between Job Costing and Contract Costing

There are certain similarities in job and contract costing. Both the methods belong to the category
of specific order costing in which work is executed according to the specification of customers. Under
both the methods customers come on their own and there is no need of creating demand. Generally
quotation price is asked before giving order and production starts only on receipt of order from the
customer. As every job and contract is dissimilar in nature and is identified by a separate number and
is known by that number until it is completed. Profit is also determined in respect of each job and
contract separately.
Inspite of the above similarities there are certain differences between job and contract costing.
These are given as under :
1. Size. A job is small in size but the contract is big in size.
2. Place of Work. Work under job costing is performed in the workshop of the proprietor but the
contract is executed mostly at site.
3. Time for Completion. A job usually takes less time for completion of work whereas a contract
takes more time to complete the work.
4. Payment of Price. The selling price of a job is paid in full after completing the job but in case of
a contract, the price is paid in various instalments depending upon the progress of the work.
5. Investment. There is heavy investment on assets initially in case of job costing as compared to
contract costing.
6. Nature of Expenses. In job costing, expenses may be direct and indirect but in case of contract
costing, most of the expenses are direct in nature.
7. Transfer of Profit. Profit earned on a job is entirely taken to profit and loss account but in case
of incomplete contract, only proportionate profit is transferred to profit and loss account depending
on the completion stage of the contract.
8. Nature of industry applicable. Job costing is applied in printing, foundry, engineering and
CONTRACT COSTING B/1·3

ship building industries but the contract costing is applied to civil engineering-roads, bridges,
buildings etc.
9. Cost units. Job is the cost unit in job costing but contract is the cost unit in contract costing.
10. Contractual obligation. In job costing a job is undertaken as per specification of the customer
and there is a contractual obligation to complete the job in time. There may be a provision of rejection
of defective job and rectification thereof. In contract costing, in addition to the contractual obligation
as given in case of job costing, there is a provision of retention money and payment to be made
according to the work certified.
11. Cost accumulation and variance analysis. It is more complicated in job costing whereas it is
simple in contract costing.

Types of Contracts
Generally there are three types of contracts :
(i) Fixed price contracts. Under these contracts both parties agree to a fixed contract price.
(ii) Fixed price contracts but in some cases subject to escalation clause (discussed afterwards).
(iii) Cost plus contracts. Under these contracts no fixed price is settled between the two parties.
The contractor is reimbursed for allowable or otherwise defined costs plus a percentage of these costs
or a fixed fee towards profit (discussed in detail afterwards in this chapter).

Recording of Costs of Contract

A Contract Ledger is maintained in which a separate account is opened for each contract
undertaken by a contractor. A Contract Ledger is so ruled out as to give maximum information. A
specimen ruling of the same is given below :

CONTRACT LEDGER
Form No. ........................... Contract Price ............................
Contract No. ....................... Terms of Payment .......................
Site .................................. Retention Money ........................
Completion Date ................. Work Certified ............................
Remarks ............................ Date ........................................ R

Date ........................................ R

Dr. Cr.
Establishment Charges
Establishment Charges
Sub-contract Costs

Sub-contract Costs
Direct Expenses

Direct Expenses
Particulars

Particulars
Materials

Materials
Wages

Wages
Total

Total
Folio

Folio
Plant

Plant
Date

Date
B/1·4 CONTRACT COSTING

Each contract is considered as a separate unit of cost and is allotted a distinguishing number. A
separate account is kept for each individual contract ; usually a greater part of the work is carried out
at the contract site itself, so the whole of the expenditure can be charged direct to the contract.
However, the overhead relating to the office, central stores etc. require apportionment among the
various contracts on some arbitrary basis such as percentage of wages, materials or prime cost.
The recording procedure of the following items may be noted carefully :
1. Materials. Materials purchased directly or supplied from the store or transferred from other
contracts will appear on the debit side. Materials returned to store will appear on the credit side.
Amount received from the sale of surplus materials will appear on the credit side, any profit or loss
arising from the sale will be transferred to the Profit and Loss Account. Materials stolen or destroyed
by fire will be transferred to the Profit and Loss Account. In case any compensation is receivable from
the insurance company for loss of materials, the amount due from insurance company is shown in the
Balance Sheet. The loss which is not compensated is debited to Profit & Loss Account. Materials in
hand at the end of the year will appear on the credit side. Sometimes materials are transferred from
one contract to another contract. Contract receiving the materials is debited and the contract giving
up the materials is credited. Normal wastage incurred in stores and materials should be charged to
contracts by inflating the rates at which materials are priced out. Stores used in the manufacture of
tools should be charged to Works Expenses A/c. Sometimes, it happens that the contractee under the
terms of the contract, supplies some materials which do not affect the contract price. The value of
such material should not be debited to Contract Account but a note will have to be kept to account for
the quantity received and issued on a separate memorandum record.
Treatment of material in contract costing is as follows :
CONTRACT ACCOUNT

R R

To Stock of Materials × × By Material transferred to

To Material Issued from Stores ×× Another Contract ××
To Material Purchases at Site × × By Material Returned to Store ××
To Transfer of Material from By Material Loss ××
Another Contract × × By Material Sold ××
By Stock of Material at Site ××

2. Labour or Wages. All labour employed at the contract site should be regarded as direct labour
and charged direct to the contract concerned. Where possible, separate wages sheets should be
prepared for each contract. If this is not possible, a Wages Analysis Sheet should be prepared
wherein should be entered the particulars of the daily or weekly time sheets. The total of each
column should be posted to be debit of the appropriate contract. Wages accrued or outstanding at
the end of the period should appear on the debit side of the contract account.
3. Site (or Direct) Expenses. All site expenses (other than materials and wages) are charged to
individual contract as and when they are incurred.
4. Indirect Expenses (or Overheads). There are certain expenses (such as salaries of engineers,
surveyors, supervisors etc. engaged on various contracts, stores expenses, administrative and office
expenses) which cannot be directly charged to contracts. Such expenses may be distributed on several
contracts on some suitable basis as a percentage of materials or labour.
CONTRACT COSTING B/1·5

5. Plant and Machinery. Careful records of plant and machinery must be maintained to ensure
that none is lost or improperly disposed of and that the contract is duly charged for the use of plant.
There are two methods in use for charging contracts for the use made of plant and machinery :
(i) Contract Account debited with full value of the plant and credited with depreciated value at
the end. The cost price of the plant or book value of the plant, if the plant is old, is debited to the
contract, the corresponding credit being given to the plant account. When the plant is returned, the
depreciated value is credited to the contract, the corresponding debit being given to the plant
account. This method is used when the plant is required for daily use at the site for a long period or
when the plant is likely to worn out before the contract is completed.
This method requires the revaluation of the plant at the close of each financial year, so that the de-
preciated value may be credited to the contract account. Further, the method does not provide
information to check the economic development of the plant. If the plant is charged to a contract,
there is a possibility of the plant being retained after the work is completed so that it cannot be used
elsewhere.
(ii) Contract account debited with an hourly rate of depreciation. A charge for the use of the
plant may be made to the contract on the basis of the time for which the plant is made use of by the
contract. To determine the charge to be made an “Upkeep Account” should be maintained for each
plant to which should be debited the cost of maintenance, depreciation, fuel, oil etc. A hire rate is
fixed with the help of this account and the contract is charged at this rate. This method is more
scientific as compared to the first. This can be easily applied where a machine is used for a short time.
For costly plants like cranes this method is useful as the cranes may be used for some hours only.
When calculating plant at site or in hand, plant returned to store, plant sold, plant destroyed etc.
should be taken into consideration as shown on next page.
VALUE OF PLANT AT SITE
R

Cost of plant sent to Site ××

Less : Cost of plant returned to Store ××
Cost of plant Sold ××
Cost of Plant destroyed ××
Cost of plant at site ××
××
—————————————

————————————————

××
Less : Depreciation ××
————————————————

Value of plant at site ××

————————————————

6. Sub-contracts. Generally work of a specialised character e.g., the installation of lifts, electrical
fittings, door setting and special flooring, is passed out to any other contractor by the main contractor.
In such cases the work performed by the sub-contractors forms a direct charge to the contracts
concerned. Sub-contract cost will be shown on the debit side of the Contract Account.
7. Extra Work. In most of the contracts additional work or variations of the work originally
contracted for, are required by the contractee. The additional work, being outside the original
B/1·6 CONTRACT COSTING

contract, will be subject to a separate charge. If the additional work is quite substantial, it should be
treated as a separate contract and a separate account should be opened for it. If it is not very
substantial, expenses incurred upon extra work should appear on the debit side of the contract
account as ‘cost of extra work’ and the extra amount which the contractee has agreed to pay should
be added to the contract price.
8. Defective Work. If the work done by the contractor is defective, it will not be paid by the
contractee. Cost of rectification of such defective work is debited to contract account.
9. Penalties. The contractee may impose penalties on the contract when there is a delay in
completion of the contract or there are defects in its execution. In some contracts such penalties are
normally anticipated. Normal penalties are debited to Contract Account but abnormal penalties are
debited to Costing Profit & Loss Account.

Key Terminology
Before we discuss as to how profit on contract is to be calculated, it is important to understand
following terminologies :
(i) Cost of Work Certified or Value of Work Certified—Refers to the approval value of work
completed as on a particular date. It represents the value of work that has been assessed, verified, and
approved by the client or an authorised authority such as an engineer or an architect. This cost or
value of certified portion is calculated and is called “cost of work certified” or “value of work
certified”. This assessment of work certified cost is an important factor in determining the amount
that the contractor is entitled to receive for completed work.
(ii) Cost of Uncertified Work. ‘Cost of uncertified work’ refers to the accumulated costs incurred
for work that has not yet been approved or certified as completed. It represents the expenses
associated with the portion of work that is still in progress or awaiting certification.
(iii) Work-in-Progress. Work in progress (WIP) refers to the value of unfinished or partially
completed work that is still in progress of being worked on as on reporting date. Valuation of WIP
has been discussed further in the chapter.
(iv) Retention Money—is the portion of contract value withheld by the client/contractee in
contract costing. It serves as a security against defects and incomplete work until project completion.
Typically, a percentage (e.g. 5-10%) is retained from each payment and released to the contractor
upon satisfactory completion. Retention acts as a performance guarantee and provides level of
financial protection for the contractee. Retention money is equal to value of work certified minus
payment made to contractor.

EXAMPLE
I. Calculate Work Certified if (a) contract price R 4,00,000 work certified 80%. (b) Cash
received R 8,00,000 being 80% of work certified.
II. Calculate work uncertified if : (a) Total cost incurred to date R 5,00,000, cost of work
certified R 4,00,000. (b) Total cost incurred to date R 6,00,000 to complete 60% of the contract
work. The architect gave certificate for 50% of the contract price.
III. Calculate cash received if : (a ) Work certified R 8,00,000, Payment received from the
Contractee 80%. (b) Contract price R 12,00,000, Work certified 80% , Payment received from
the Contractee 90%.
CONTRACT COSTING B/1·7

SOLUTION
I. (a) Work Certified = Contract Price × Work Certified as a percentage of Contract Price.
=4,00,000 × 80% = 3,20,000
R R

Cash Received 8‚00‚000

R
(b) Work Certified = =
Cash as percentage of Work Certified 80%
= 10,00,000
R

II. (a) Cost of Work Uncertified = 5,00,000 – 4,00,000 = 1,00,000

R R R

10%
(b) Cost of Work Uncertified = 6,00,000 ×
R = 1,00,000
R
60%
III. (a) Cash Received = R 8,00,000 × 80% = 6,40,000
R

(b) Cash Received = R 12,00,000 × 80% × 90% = R 8,64,000

On receipt of certificate, one of the following accounting methods may be adopted :

(a) Credit the appropriate contract account with the value mentioned in the certificate and debit
personal account of the contractee. Cash received is credited to the contractee’s account and
the balance is shown as a debtor representing retention money, or
(b) The contract account is credited with the value of the certificate and the contractee’s account
is debited with the amount payable immediately and a special Retention Money Account is
debited with amount so retained, or
(c) The contract account is credited with the value of the certified work and work-in-progress
account is debited. Whenever any amount is received from the contractee, cash account is
debited and contractee’s account is credited. Until contract is completed, amount received
from contractee shows advance payments and is deducted from work-in-progress in the
Balance Sheet. When contract is completed, contractee’s account is debited with the contract
price and the contract account is credited. This method has been adopted in the worked
illustrations of this chapter.
(v) Notional Profit. Notional profit is the difference between the value of work certified and cost
of work certified. Cost of work not yet certified will also be added to calculate total value of contract.
A contract may take several years in completion, therefore, notional profit is calculated every year
based on the certified work.
EXAMPLES : A contract is proposed with contract price of R 30 lakhs. ABC Pvt. Ltd. is ready
to accept the project with all the prescribed terms and conditions of the contract. At the end of first
year cost of work performed by ABC is R 5 lakh and the value of certified work at the end of first
year is R 10 lakh. ABC has also incurred cost of R 2 lakh which is not yet certified till the end of
first year.
You are required to calculate the Notional Profit of ABC Pvt. Ltd. at the end of first year.
SOLUTION
Particulars Amount ( )
R

Value of Work Certified at the end of 1st year 10,00,000.00

Add : Cost of Work not yet Certified at the end of 1st year 2,00,000.00
Total Value of Contract 12,00,000.00
Less : Cost of Work up-to-date 5,00,000.00
Notional Profit at the end of 1st year 7,00,000.00
B/1·8 CONTRACT COSTING

Estimated Profit
Estimated profit is used to evaluate the overall profitability of the contract based on Contract
Price, Cost incurred till date, and estimated additional cost to be incurred to complete the contract.
Estimated Profit is likely to arise on the completion of contract and it is the excess of contract price
over the estimated total estimated cost of contract (either cost incurred till date or estimated
additional cost or any cost for contingency).

EXAMPLE : ABC Pvt. Ltd. is engaged in a construction contract of R 15 lakh and cost of R 8
lakh is already incurred till date. Additional cost of R 3 lakh is expected to complete the contract.
You are required to compute the Estimated Profit of the contract.

SOLUTION
Particulars Amount ( )
R

Contract Price 15,00,000.00

Less : Total Cost incurred till date 8,00,000.00
Profit till date 7,00,000.00
Less : Estimated Additional Cost 3,00,000.00
Estimated Profit 4,00,000.00

Profit or Loss on Incomplete Contract

Large contracts take a number of years to complete. So their cost can be ascertained only when
they are completed. Even after the contract is completed, a proportion of contract price (the retention
money) may be still outstanding from the contractee. The retention money is payable in full only
when there is no faulty work and the contract is executed in time. So it is not possible to ascertain the
profit or loss till the contract is completed and the period fixed for the payment of retention money
has expired. Theoretically, therefore, profit or loss on contracts should be brought into account only
when the contracts are completed. However, this procedure leads to considerable fluctuations in
annual profits of the contractor. The year in which the contract is completed may show unusually
large profits and other years may even show losses. Such serious fluctuations in profits may affect the
remuneration or dividend payable to owners. So, it is desirable to calculate the notional profit in contract
costing.

Principles to be followed While taking Credit for Profit on Complete Contracts

The portion of profit to be credited to costing profit and loss account depends on the stage of
completion of a contract. The stage of completion of the contract refers to certified work only and
uncertified work is not considered.
The transfer of profit to the costing profit and loss account is done as under :
(i) Contract less than 25% complete : If the contract has just started or it is less than 25%
complete, no profit is taken into account.
(ii) Contract is 25% or more but less than 50% complete : In this case one third of the notional
profit, reduced in the ratio of cash received to work certified, may be transferred to the profit
CONTRACT COSTING B/1·9

and loss account. The amount of profit to be transferred to the profit and loss account may be
determined by using the following formula :
1 Cash Received
× Notional Profit × or % of Cash Received
3 Work Certified

(iii) Contract is 50% or more but less than 90% complete : In this case, two third of the notional
profit, reduced by the portion of cash received to work certified may be transferred to the
profit and loss account. In this case the formula to be used is as under :
2 Cash Received
× Notional Profit × or % of Cash Received
3 Work Certified

(iv) For the contracts which are almost complete. If the work is nearing completion—say the
completion stage is between 90 and 99 per cent, the estimated profit is ascertained deducting
the aggregate of costs to date and additional expenditure to be incurred to complete the
contract from the contract price. A proportion of this estimated total profit is credited to
profit and loss account. This proportion is ascertained by adopting any one of the following
formulae :
Work Certified
(a) Estimated Profit ×
Contract Price
Work Certified Cash Received
(b) Estimated Profit × ×
Contract Price Work Certified
Cash Received
or Estimated Profit ×
Contract Price
Cost of Work to Date
(c) Estimated Profit ×
Estimated Total Cost
Cost of work to date Cash received
(d) Estimated profit × ×
Estimated total cost Work certified

(v) Loss on Incompleted Contracts. In the event of a loss on uncompleted contracts, this should
be transferred in full to the Profit and Loss Account, whatever be the stage of completion of
the contract.

EXAMPLE. A contract expected to be completed in year 4, exhibits the following

information:
End of Year Value of work Cost of work Cost of work not Cash received
certified to date yet certified
(R) ( )
R (R) (R)
1. 0 50,000 50,000 0
2. 3,00,000 2,30,000 10,000 2,75,000
3. 8,00,000 6,60,000 20,000 7,50,000

The contract price is R 10,00,000 and the estimated profit is 20%.

B/1·10 CONTRACT COSTING

You are required to calculate, how much profit should have been credited to the Profit and
Loss A/c by the end of years 1, 2 and 3.

SOLUTION
End. of Value of Work Cost of Work National Amount that should have been
year Certified ( )
R Certified* Profit** credited to Profit and Loss A/c by the
end of year
( )
R ( )
R ( )
R

1 0 0 0 0

1 2‚75‚000
2 3,00,000 2,20,000 80,000 × 80,000 × = 24,444
3 3‚00‚000
2 7‚50‚000
3 8,00,000 6,40,000 1,60,000 × 1,60,000 × = 1,00,000
3 8‚00‚000
Workings :
End of Year Completion of Contract Profit Credited to P & L Account
Year 1 Less than 25 per cent No Profit Credited
Year 2 25 per cent or more than
1 Cash Received
25 per cent but less than Cumulative Profit = × Notional Profit ×
3 Value of Work Certified
50 per cent.
Year 3 50 per cent or more than
2 Cash Received
50 per cent but less than Cumulative Profit = × Notional Profit ×
3 Value of Work Certified
90 per cent.
* Cost of Work Certified = Cost of work to date – Cost of work not yet certified
** Notional Profit = Value of work certified – Cost of work certified)

ILLUSTRATION 1. A company undertook a contract for construction of a large building

complex. The construction work commenced on 1st April, 2023 and the following data are
available for the year ended 31st March, 2024.
R ’000 R ’000
Contract Price 35,000 Plant Hire Charges 1,750
Work Certified 20,000 Wages Related Costs 500
Progress Payments Received 15,000 Site Office Costs 678
Materials Issued to Site 7,500 Head Office Expenses Apportioned 375
Planning & Estimating Costs 1,000 Site Expenses Incurred 902
Direct Wages Paid 4,000 Work Not Certified 149
Materials Returned From Site 250
The contractors own a plant which originally cost R 20 lacs has been continuously in use in
this contract throughout the year. The residual value of the plant after 5 years of life is expected to
be R 5 lacs. Straight line method of depreciation is in use.
As on 31st March, 2024 the direct wages due and payable amounted to R 2,70,000 and the
materials at site were estimated at R 2,00,000.
Prepare Contract Account for the year ended 31st March, 2024 and Show the calculation of
profit to be taken to Profit and Loss Account of the year.
CONTRACT COSTING B/1·11

SOLUTION CONTRACT ACCOUNT

for the year ended 31st March, 2024 ( ’000)
R

To Materials R 7,500 By Materials Returned 250

” Direct Wages 4,000 ” Materials at Site 200
Add : Outstanding 270 ” Work-in-Progress :
————————— 4,270 Work Certified 20,000
To Wages Related Costs 500 Work Uncertified 149
——————————
” Site Expenses 902 20,149
” Plant Hire Charges 1,750
” Planning and Estimating Costs 1,000
” Site Office Costs 678
” H.O. Expenses Apportioned 375
” Depreciation on Plant

( 20‚00‚000 – 5‚00‚000
R

5
R

) 300

” Notional Profit c/d 3,324

————————————— ——————————————
20,599
—————————————
20,599
——————————————
To Profit & Loss A/c By Notional Profit b/d 3,324
2
3 (
× 3,324 ×
15‚000
20‚000 ) 1,662

To Work in Progress A/c (Reserve) 1,662

————————————— ——————————————
3,324 3,324
—————————————
————————————— ——————————————
——————————————

BALANCE SHEET (Extracts)

as on 31st March, 2024 ( ’000)
R

Liabilities R Assets R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Outstanding Wages 270 Plant at Site (2,000 – 300) 1,700

Profit & Loss A/c 1,662 Materials at Site 200
Work in Progress :
Work Certified 20,000
Work Uncertified 149
——————————
20,149
Less : Profit in Reserve 1,662
——————————
18,487
Less : Cash received
from the Contractee 15,000
———————————
3,487
Work-in-Progress Valuation
When the contract is not complete till the end of the accounting year, the engineer/architect is
required to value the work-in-progress. Such work-in-progress is classified into work certified and
work uncertified.
Work Certified : Work certified is that part of work-in-progress which has been approved by the
contractee’s engineer or architect for payment. Work certified is valued at contract price (i.e. selling
price), and includes an element of profit.
B/1·12 CONTRACT COSTING

Work Uncertified : Work uncertified is that part of work-in-progress which is not approved by
engineer or architect. This is valued at cost and thus does not include an element of profit.
Both work certified and uncertified appear on the credit side of the contract account and also on
the asset side of the Balance Sheet.
All cash received on account of such incomplete contracts should be shown in the Balance Sheet
as a deduction from the work-in-progress. The contractee should never be shown as a debtor for the
contract price until the contract is complete. At the same time, he should not be shown as a creditor
for the sums received.
If the expenditure on incomplete contracts includes the value of plant and materials, these items
may be shown separately in the Balance Sheet. Thus, instead of showing the total expenditure under
the heading of work-in-progress, expenditure may be split up and shown under the headings of ‘plant
at sites’, ‘materials at sites’ and ‘work-in-progress’ as given below :
BALANCE SHEET

Fixed Assets
Plant at site ××
Material at Site ××
Current Assets
Work Certified ××
Work Uncertified ××
—————————————

×××
Less : Reserve ××
—————————————

×××
Less : Cash Received from Contractee ××
×××
—————————————

EXAMPLE. A contract is estimated to be 80% complete in its first year of construction as

certified. The contractee pays 75% of value of work certified, as and when certified and makes the
final payment on the completion of contract., Following information is available for the first year.
R

Cost of Work-in-Progress Uncertified 8,000

Profit Transferred to Profit & Loss A/c at the end of year 1 on
Incomplete Contract 60,000
Cost of Work to Date 88,000
Calculate the (a) Value of Work-in-Progress Certified and (b) Amount of Contract Price.
SOLUTION
As the contract is 80% complete, so 2/3rd of the notional profit on cash basis has been transferred to Profit
& Loss A/c in the first year of contract.
2
∴ Amount transferred to Profit & Loss A/c = × National Profit × % of cash received
3
2 75
or 60,000 = × Notional Profit ×
3 100
60‚000 × 3 × 100
or, Notional Profit = = 1,20,000
R

2 × 75
CONTRACT COSTING B/1·13

Computation of Value of Work Certified

Cost of work to date = R 88,000
Add : Notional Profit = R 1,20,000
————————————————

Total Value of Contract = R 2,08,000

Less : Cost of Work Uncertified = 8,000
————————————————

Value of Work Certified = R 2,00,000

————————————————

Since the Value of Work Certified is 80% of the Contract Price, therefore
Value of Work Certified 2‚00‚000 R
Contract Price = = = R 2,50,000
80% 80%

ILLUSTRATION 2. Surya Construction Ltd.with a paid up share capital of R 50 lakhs

undertook a contract to construct MIG apartments. The work commenced on the contract on 1st
April 2023. The contract price was R 60 lakhs. Cash received on account of the contract upto 31st
March, 2024 was R 18 lakhs (being 90% of the work certified). Work completed but not certified
was estimated at R 1,00,000. As on 31st March 2024 material at site was estimated at R 30,000,
machinery at site costing R 2,00,000 was returned to stores and wages outstanding were R 5,000.
Plant and Machinery at site is to be depreciated at 5%.
Following were the ledger balances (Dr.) as per trial balance as on 31st March, 2024 :
R R

Land and Building 23,00,000 Site expenses 5,000

Plant and Machinery (60% at site) 25,00,000 Office expenses 12,000
Furniture 60,000 Rates and taxes 15,000
Materials 14,00,000 Cash at bank 1,33,000
Fuel and Power 1,25,000 Wages 2,50,000
Prepare Contract Account and Balance Sheet.
SOLUTION
CONTRACT ACCOUNT
for the year ended 31-3-2024
R R

To Materials 14,00,000 By Materials at site 30,000

To Wages ( 2,50,000 + 5,000)
R R 2,55,000 By Machine returned ( 2,00,000
R

To Plant and Machinery at site (60%) 15,00,000 – 5% of 2,00,000)

R 1,90,000
To Fuel and Power 1,25,000 By Plant and Machinery at site
To Site Expenses 5,000 ( 13,00,000
R

To Office Expenses 12,000 – 5% of 13,00,000)

R 12,35,000
To Rates & Taxes 15,000 By Work-in-Progress A/c :
To Notional Profit c/d 2,43,000 Work Certified R

( R 18 lakhs ×
100
90 ) 20,00,000

Work Uncertified 1,00,000

——————————————
21,00,000
——————————————— ———————————————

35,55,000 35,55,000
——————————————— ———————————————
B/1·14 CONTRACT COSTING

To Profit & Loss A/c By Notional Profit b/d 2,43,000

( R 2,43,000 ×
1 90
×
3 100 ) 72,900

To Work-in-Progress (Reserve) 1,70,100

——————————————— ———————————————

2,43,000 2,43,000
———————————————
——————————————— ———————————————
———————————————

BALANCE SHEET

Liabilities R Assets R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Share Capital 50,00,000 Land & Building 23,00,000

Profit & Loss A/c 72,900 Plant and Machinery at site 12,35,000
Wages Outstanding 5,000 Plant and Machinery (Store) 11,90,000
Furniture 60,000
Cash at bank 1,33,000
Work-in-Progress :
Certified Work 20,00,000
Uncertified Work 1,00,000
——————————————

21,00,000
Less : Cash received 18,00,000
——————————————

3,00,000
Less : Reserve 1,70,100
——————————————
1,29,900
Material at site 30,000
——————————————— ———————————————

50,77,900 50,77,900
———————————————
——————————————— ———————————————
———————————————

ILLUSTRATION 3. Construction Ltd. is engaged on two contracts A and B during the year.
Following particulars are obtained at the year end (Dec. 31) :
Contract A Contract B
Date of Commencement April 1 September 1
R R

Contract price 6,00,000 5,00,000

Materials issued 1,60,000 60,000
Materials returned 4,000 2,000
Materials at site (Dec. 31) 22,000 8,000
Direct Labour 1,50,000 42,000
Site Expenses 66,000 35,000
Establishment Expenses 25,000 7,000
Plant installed at site 80,000 70,000
Value of Plant (Dec. 31) 65,000 64,000
Cost of contract not yet certified 23,000 10,000
Value of contract certified 4,20,000 1,35,000
Cash received from contractees 3,78,000 1,25,000
Architect’s Fees 2,000 1,000
CONTRACT COSTING B/1·15

During the period materials amounting to R 9,000 have been transferred from contract A to
contract B. You are required to show : (a) Contract accounts, (b) Contractees’ accounts, and (c)
Extract from Balance Sheet as on December 31, clearly showing the calculation of work-in-
progress.
SOLUTION
CONTRACT ACCOUNT
A B A B
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

To Materials Issued 1,60,000 60,000 By Materials returned 4,000 2,000

” Materials from ” Materials at Site
Contract A — 9,000 (Dec. 31) 22,000 8,000
To Direct Labour 1,50,000 42,000 By Materials Transfer-
” Site Expenses 66,000 35,000 red to Contract B 9,000 —
” Establishment ” Work-in-Progress
Expenses 25,000 7,000 A B
Depreciation on : Work Certified
R R

” Plant 15,000 6,000 4,20,000 1,35,000

” Architect’s Fees 2,000 1,000 Work not Certified
” Notional Profit c/d 60,000 23,000 10,000
———————————— ————————————
4,43,000 1,45,000
By Profit and Loss A/c (Loss) 5,000
————————————————————————————— ———————————————————————————
4,78,000 1,60,000 4,78,000 1,60,000
————————————————————————————— ———————————————————————————
To Profit and Loss A/c By Notional Profit b/d 60,000

”
( R

Work-in-Progress
3‚78‚000
60,000 × 2/3 × 4‚20‚000 ) 36,000

(Reserve) 24,000
——————————— ——————————
60,000 60,000
——————————— ——————————

CONTRACTEE’S ACCOUNT
A B A B
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

To Balance c/d 3,78,000 1,25,000 By Cash 3,78,000 1,25,000

BALANCE SHEET
as on 31st December
Liabilities R Assets R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R

Profit and Loss A/c Plant 1,50,000

Profit of A R Less : Depreciation 21,000
———————————
Contract 36,000 1,29,000
Less : Loss of B Contract 5,000 Stock of Materials :
———————————
31,000 Contract A 22,000
Contract B 8,000
———————————
30,000
B/1·16 CONTRACT COSTING

Work-in-Progress : ————————————————————————————
A B
————————————————————————————
R R

Work certified 4,20,000 1,35,000

Work not certified 23,000 10,000
————————————————————————————
4,43,000 1,45,000
Less: Profit in
Reserve 24,000 —
————————————————————————————
4,19,000 1,45,000
Less: Cash
received 3,78,000 1,25,000
————————————————————————————
41,000 20,000 61,000
————————————————————————————-———————————-
————————————————————————————-———————————-

ILLUSTRATION 4. Mr. Bhagwandas undertook a contract for 15,00,000 on an arrangement

R

that 80% of the value of the work done as certified by the architect of the contractee, should be
paid immediately and that the remaining 20% be retained until the contract was completed.
In 2022, the amounts expended were—Materials R 1,80,000 ; Wages R 1,70,000; Carriage R 6,000 ;
Cartage R 1,000 ; Sundry Expenses R 3,000. The work was certified for R 3,75,000 and 80% of this
was paid as agreed.
In 2023 the amounts expended were—Materials R 2,20,000 ; Wages R 2,30,000; Carriage R 23,000;
Cartage R 2,000 ; Sundry Expenses R 4,000. Three-fourth of the contract was certified as done by
31st December and 80% of this was received accordingly. The value of work uncertified was
ascertained at R 20,000.
In 2024 the amounts expended were : Materials R 1,26,000 ; Wages R 1,70,000 ; Carriage R 6,000 ;
Sundry Expenses R 3,000 and on 30th June the whole contract was completed.
Prepare Contract Account, Contractee’s Account and Balance Sheet (only assets side) as would
appear each of these years in the books of the contractor assuming that the balance due to him was
received on completion of the contract.
SOLUTION CONTRACT ACCOUNT

2022 2022
R R

To Materials 1,80,000 By Work-in-Progress A/c c/d 3,60,000

” Wages 1,70,000
” Carriage 6,000
” Cartage 1,000
” Sundry Expenses 3,000
————————————— —————————————

3,60,000 3,60,000
—————————————
————————————— —————————————
—————————————
2023 2023
To Work-in-Progress A/c b/d 3,60,000 By Work-in-Progress A/c :
” Materials 2,20,000 Work certified 11,25,000
” Wages 2,30,000 Work uncertified 20,000
” Carriage 23,000
” Cartage 2,000
” Sundry Expenses 4,000
” Notional Profit c/d 3,06,000
—————————————— ——————————————
11,45,000 11,45,000
——————————————
—————————————— ——————————————
——————————————
CONTRACT COSTING B/1·17

To Profit and Loss A/c By Notional Profit b/d 3,06,000

( 2
3‚06‚000 × × 80%
R
3 ) 1,63,200

” Work-in-Progress A/c (Reserve) 1,42,800

————————————— —————————————

3,06,000 3,06,000
—————————————
————————————— —————————————
—————————————

2024 2024
To Work-in-Progress A/c b/d 11,45,000 By Work-in-Progress A/c b/d 1,42,800
” Materials 1,26,000 By Contractee’s A/c 15,00,000
” Wages 1,70,000
” Carriage 6,000
” Sundry Expenses 3,000
” Profit & Loss A/c 1,92,800
—————————————— ——————————————
16,42,800 16,42,800
——————————————
—————————————— ——————————————
——————————————

CONTRACTEE’S ACCOUNT
2022 2022
R R

To Balance c/d 3,00,000 By Cash 3,00,000

—————————————
————————————— —————————————
—————————————

2023 2023
To Balance c/d 9,00,000 By Balance b/d 3,00,000
” Cash 6,00,000
————————————— —————————————

9,00,000 9,00,000
—————————————
————————————— —————————————
—————————————

2024 2024
To Contract Account 15,00,000 By Balance b/d 9,00,000
” Cash 6,00,000
————————————— —————————————
15,00,000 15,00,000
—————————————
————————————— —————————————
—————————————

BALANCE SHEET

Assets
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

2022 R R

Work-in-Progress 3,60,000
Less : Cash Received 3,00,000
——————————————
60,000
2023
Work-in-Progress :
Work certified 11,25,000
Work uncertified 20,000
——————————————

11,45,000
Less : Reserve 1,42,800
——————————————

10,02,200
Less : Cash received 9,00,000
——————————————
1,02,200
——————————————
B/1·18 CONTRACT COSTING

ILLUSTRATION 5. Following Trial Balance was extracted on 31st December, 2023 from the
books of Swastik Co. Ltd., Contractors :
R R

Share Capital : Shares of R 10 each 3,51,800

Profit and Loss A/c on 1st Jan., 2023 25,000
Provision for Depreciation of Machinery 63,000
Cash received on Account : Contract 7 12,80,000
Creditors 81,200
Land and Buildings (Cost) 74,000
Machinery (Cost) 52,000
Bank 45,000
Contract 7 :
Materials 6,00,000
Direct Labour 8,30,000
Expenses 40,000
Machinery at site (Cost) 1,60,000
—————————————— ——————————————

18,01,000 18,01,000
—————————————— ——————————————

Contract 7 was begun on 1st Jan., 2023. The contract price is R 24,00,000 and the customer has
so far paid R 12,80,000, being 80% of the work certified.
The cost of the work done since certification is estimated at R 16,000.
On 31st Dec., 2023, after the above Trial Balance was extracted, machinery costing R 32,000 was
returned to stores, and materials when at site were valued at R 27,000.
Provision is to be made for direct labour due R 6,000 and for depreciation of all machinery at
1
122 % on cost.
You are required to prepare (a) the Contract Account and (b) the Balance Sheet of Swastik Co.
Ltd. as on 31st December assuming this was the only contract in hand during the period.
SOLUTION
CONTRACT ACCOUNT
R R R

To Materials R 6,00,000 By Work-in-Progress A/c

” Direct Labour 8,30,000 Work certified 16,00,000
Add : Provision for Direct Work uncertified 16,000
————————————
Labour 6,000 16,16,000
————————————
8,36,000 ” Machinery returned
” Expenses 40,000 to stores 32,000
” Machinery 1,60,000 Less : Depreciation 4,000
————————————
” Notional Profit c/d 1,47,000 28,000
” Materials in hand 27,000
” Value of Machinery 1,28,000
” Less : Depreciation 16,000
————————————
1,12,000
—————————————— ——————————————

17,83,000 17,83,000
—————————————— ——————————————
CONTRACT COSTING B/1·19

To Profit and Loss A/c 78,400 ” Notional Profit b/d 1,47,000

( 1,47,000 × 2/3 × 80%)
R

” Work-in-Progress A/c (Reserve) 68,600

—————————————— ——————————————
1,47,000 1,47,000
—————————————— ——————————————

BALANCE SHEET
as on 31st December, 2023
Liabilities R Assets R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Share Capital R 3,51,800 Land & Buildings R 74,000

Profit and Loss A/c 25,000 Machinery 2,12,000
Add : Profit on Contract 78,400 Less : Provision for Depreciation
————————————

1,03,400 ( 63,000 +
R R 20,000 + R 6,500) 89,500
————————————
Less : Depreciation 6,500 1,22,500
————————————
96,900 Work-in-Progress :
Provision for Direct Labour 6,000 Work certified 16,00,000
Creditors 81,200 Work uncertified 16,000
——————————————
16,16,000
Less : Reserve 68,600
——————————————
15,47,400
Less : Cash received 12,80,000
——————————————
2,67,400
Materials in hand 27,000
Bank 45,000
—————————————— ——————————————

5,35,900 5,35,900
—————————————— ——————————————

ILLUSTRATION 6. (Ascertainment of work uncertified) M/s. Kishore & Co. commenced the
work on a particular contract on 1st April, 2023. They close their books of accounts for the year on
31st December each year. Following information is available from their costing records on 31st
December, 2023 :
Material sent to site R 50,000 ; Wages paid R 1,00,000 ; Foreman’s salary R 12,000.
A machine costing R 32,000 remained in use on site for 1/5th of the year. Its working life was
estimated at 5 years and scrap value at R 2,000. A supervisor is paid R 2,000 per month and had
devoted one-half of his time on the contract.
All other expenses were R 15,000. The material at site was R 9,000. The contract price was
R 4,00,000. On 31st December, 2023, 2/3 of the contract was completed ; however, the architect gave

certificate only for R 2,00,000 on which 75% was paid.

Prepare the Contract Account.
SOLUTION CONTRACT ACCOUNT
R R R

To Material 50,000 By Material at Site 9,000

” Wages 1,00,000 ” Work-in-Progress :
” Foreman’s Salary 12,000 Work Certified 2,00,000
” Depreciation Work Uncertified (1) 44,550
—————————————

( )
2,44,550
R 32‚000 – R 2‚000 1
× 1,200
5 5
B/1·20 CONTRACT COSTING

To Supervisor’s Salary

”
(
9 × 2‚000 ×
R

Other Expenses
1
2 ) 9,000
15,000
” Notional Profit c/d 66,350
—————————————— ———————————————

2,53,550 2,53,550
—————————————— ———————————————

To Profit & Loss A/c By Notional Profit b/d

66,350

”
( R
2
66‚350 × × 75%
3 )
Work-in-Progress A/c (Reserve)
33,175
33,175
—————————————— ———————————————

66,350 66,350
——————————————
—————————————— ———————————————
———————————————

Working Note (1) : Calculation of Work Uncertified R

Amount spent on contract 1,87,200

Less : Material at site 9,000
—————————————

Net expenditure on contract 1,78,200

As the contract is 2/3 complete, so far 2/3 contract, the cost is R 1,78,200 for complete contract, the
3
estimated cost is 1,78,200 × = 2,67,300
R R
2

Net expenditure on contract to date 1,78,200

Less : Cost of work certified (1/2 of 2,67,300)
R 1,33,650
[as architect’s certificate is for 2,00,000 & the contract price is
R

R 4,00,000. Work certified represents 1/2 of the contract price]

—————————————

Cost of work uncertified 44,550

—————————————
—————————————

ILLUSTRATION 7. A contractor secured a contract to supply and erect machinery for the
sum of R 7,50,000. He was to receive payments on account from time to time equal to 90% of the
certified value of the work done.
He commenced work on 1st January, 2022 and incurred the following expenditure during the
year—Plant and Tools R 70,000 ; Machinery and Stores R 2,00,000 ; Wages R 1,50,000 ; Sundry
Expenses R 30,000 and Establishment Charges R 40,000.
A part of machinery costing R 20,000 was unsuited to the contract and immediately sold at a
profit of R 5,000.
The value of Plant and Tools on 31st December, 2022 was R 40,000 and the value of Machinery
and Stores then in hand R 30,000.
By 31st January, 2023 he had received payments on account amounting to R 4,38,750 being 90%
of the certified value of work done upto 31st Dec. 2022.
In order to calculate the profit made on the contract upto 31st Dec., 2022 the contractor
estimated the further expenditure that would be incurred in completing the contract and took to
the credit of Profit and Loss A/c for the year that proportion of the estimated net profit to be
CONTRACT COSTING B/1·21

realised on contract which the certified value of the work done bore to the contract price. He
estimated :
(a) that the contract would be completed in a further period of six months;
(b) that Plant and Tools would have a residual value of R 10,000 upon the completion of the
contract;
(c) that the cost of Machinery and Stores required in addition to those in stock on 31st
December, 2022 would be R 1,00,000 and that further Sundry Expenses of R 20,000 would
be incurred;
(d) that the wages on the contract for 6 months to 30th June, 2023 would amount to R 80,000;
(e) that the establishment would cost the same sum per month as in the previous year;
(f) that 221% of the total cost of the contract (excluding this percentage) should be provided for
contingencies.
Prepare Contract Account for the year ended 31st December, 2022 and show your calculations
of Profit and Loss A/c for the year.
SOLUTION
CONTRACT ACCOUNT
for the year ended 31st December, 2022
R R

To Plant and Tools 70,000 By Sale of Plant 25,000

” Machinery & Stores 2,00,000 ” Work-in-Progress :
” Wages 1,50,000 Work certified 4,87,500
” Sundry Expenses 30,000 ” Plant and Tools in hand 40,000
” Establishment Charges 40,000 ” Machinery and stores in hand 30,000
To Profit and Loss A/c
(Profit on sale of plant) 5,000
” Notional Profit c/d 87,500
—————————————— ——————————————
5,82,500 5,82,500
—————————————— ——————————————
To Profit and Loss A/c (1) 34,450 By Notional Profit b/d 87,500
” Work-in-Progress A/c (Reserve) 53,050
—————————————— ——————————————
87,500 87,500
—————————————— ——————————————

Working Note :
(1) Profit to be credited to Profit and Loss Account has been calculated as under : R

Cost to date 4,90,000

Less : Cost of plant sold 20,000
—————————————

4,70,000
Estimated further expenditure : R

Machinery and Stores 1,00,000

Sundry Expenses 20,000
Wages 80,000
Establishment Charges 20,000
————————————

2,20,000
—————————————
B/1·22 CONTRACT COSTING

Less : Residual value of plant 6,90,000

10,000
—————————————
6,80,000
1
Provision for contingencies (2 % on R 6,80,000) 17,000
2
—————————————
Estimated Total Cost 6,97,000
Profit (Estimated) 53,000
—————————————
Contract Price 7,50,000
—————————————

∴ Profit to be credited to Profit and Loss A/c

Work Certified R 4‚87‚500
= Estimated Profit × = R 53,000 × = R 34,450.
Total Contract Price R 7‚50‚000
ILLUSTRATION 8. RST Construction Limited commenced a contract on April 1, 2022. The
total contract was for R 49,21,875. It was decided to estimate the total Profit on the contract and to
take to the credit of Profit and Loss Account that proportion of estimated profit on cash basis,
which work completed bore to total Contract. Actual expenditure for the period April 1, 2022 to
March 31, 2023 and estimated expenditure for April 1, 2023 to September 30, 2023 are given below :

April 1, 2022 to April 1, 2023 to

March 31, 2023 September 30, 2023
(Actuals) (Estimated)
R R

Materials Issued 7,76,250 12,99,375

Labour : Paid 5,17,500 6,18,750
Prepaid 37,500 —
Outstanding 12,500 5,750
Plant Purchased 4,00,000 —
Expenses : Paid 2,25,000 3,75,000
Outstanding 25,000 10,000
Prepaid 15,000 —
Plant returned to Store (historical cost) 1,00,000 3,00,000
(On September 30, 2022) (On September 30, 2023)
Work certified 22,50,000 Full
Work uncertified 25,000 —
Cash received 18,75,000 —
Materials at site 82,500 42,500
The plant is subject to annual depreciation @ 25% on written down value method. The contract
is likely to be completed on September 30, 2023.
Required :
Prepare Contract Account. Determine the profit on the contract for the year 2022-23 on prudent
basis, which has to be credited to Profit and Loss Account.
CONTRACT COSTING B/1·23

SOLUTION CONTRACT ACCOUNT

for the year ending March 31, 2023
R R R R

To Materials Issued 7,76,250 By Plant Returned to Store on

To Labour 5,17,500 30-9-2022 87,500
Add : Outstanding 12,500
————————————
5,30,000 (
1‚00‚000 – R
25
100 × 2
1‚00‚000R
)
Less : Prepaid 37,500
————————————
4,92,500 By Plant at Site 2,25,000
To Plant 4,00,000 ( 3,00,000 – 25% of 3,00,000)
R R

To Expenses 2,25,000 By Materials at Site 82,500

Add : Outstanding 25,000 By Work-in-Progress :
————————————
2,50,000 Certified 22,50,000
Less : Prepaid 15,000 Uncertified 25,000
———————————— ————————————
2,35,000 22,75,000
To Notional Profit c/d 7,66,250
————————————— ——————————————
26,70,000 26,70,000
—————————————
————————————— ——————————————
——————————————

To Profit & Loss A/c 3,89,000 By Notional Profit b/d 7,66,250

( R
22‚50‚000 18‚75‚000
10,21,125 × 49‚21‚875 × 22‚50‚000 )
To Work-in-Progress (Reserve) 3,77,250
————————————— ——————————————
7,66,250 7,66,250
—————————————
————————————— ——————————————
——————————————

Figure of estimated profit of R 10,21,125 has been calculated by preparing Contract Account for the entire
period as given below :
ESTIMATED CONTRACT ACCOUNT
for the entire life period from April 1, 2022 to September 30, 2023
R R

To Materials Issued By Contractee A/c 49,21,875

( 7,76,250 + 12,99,375)
R R 20,75,625 By Material at site 42,500
To Labour By Plant returned on September 30, 87,500
( 5,17,500 + 6,18,750 +
R R R 5,750 11,42,000 2022 ( 1,00,000 – 12,500
R R

1
outstanding labour on 30-9-2023) Depreciation for year)
2
To Plant 4,00,000 By Plant returned on
To Expenses September 30, 2023 :
( 2,25,000 + 3,75,000 +
R R R 10,000) 6,10,000 Cost 3,00,000
To Estimated Profit 10,21,125 Less : 25% Depreciation for
2022-23 75,000
———————————

2,25,000
Less : Depreciation @ 25% p.a.
on 2,25,000 for 6
R

months from 1-4-2023

to 30-9-2023 28,125
——————————
——————————————
1,96,875
——————————————
52,48,750 52,48,750
——————————————
—————————————— ——————————————
——————————————
B/1·24 CONTRACT COSTING

Profit on Incompleted Contracts (Modern Approach)

According to this approach, two methods of calculating the profits on incompleted contracts
are used by the contractors : These are :
(i) Percentage of Completion Method. Under this method the profit is determined at the end of
each accounting period before the completion of the entire contract.
(ii) Completion Contract Method. Under this method, the profit is recognised only when the
contract is completed or substantially completed.
Method (i) may be adopted only if the following conditions are satisfied :
(a) The cost attributable to the different stages of completion of the contract activity can be clearly
identified. For this purpose each stage of the contract should be distinguished as a separate cost
centre or profit centre. This is necessary to match the cost with the revenue till the stage of
completion and to find out the resultant profit attributable to the proportion of work completed.
(b) There must exist adequate estimating process so that both costs to complete the contract and
the percentage of contract performance completed at the end of the accounting period can be reliably
estimated. The stage of completion can be determined by calculating the proportion that costs
incurred to date bear to the estimated total costs of the contract activity.
(c) The costs attributable to the contract generally start with the signing of the contract and end
when the contract is nearing completion. Costs incurred before signing a contract is applicable if
such costs can be directly associated with a specific contract and there is every probability that the
contract will be obtained. The costs may be divided into following classes:
(i) Costs directly related to a specific contract as cost of moving equipment to site, site labour costs
and supervision, material used for construction, expenses incurred at the site ; depreciation of
plant and equipment used etc.
(ii) Costs allocable to contracts as design, technical assistance, insurance, fabrication of materials
elsewhere including overheads etc.
(iii) Costs apportioned to contracts as general administration, finance costs, research and
development cost, depreciation of idle plant and equipment etc.
(iv) Credit is to be given for the materials and other revenue sources, surplus to requirements
transferred to other contracts etc.
(d) Progress payments and advance received from customers cannot generally be treated as
equivalent to revenue earned. The revenue is to be based on the percentage of completion of work.
(e) The amount of loss, if any, estimated on the revised estimate of the incompleted work, is to be
deducted from the present revenue.
EXAMPLE 1. A firm of contractors obtained a contract for construction of bridges across
river Revathi. Following details are available in the records kept for the year ended 31st March,
2024 :
R (in lakhs) R (in lakhs)

Total Contract Price 1,000 Estimated further cost to completion 495

Work Certified 500 Progress Payment Received 400
Work not certified 105 To be Received 140
The firm seeks your advice and assistance in the presentation of accounts keeping in view the
CONTRACT COSTING B/1·25

requirements of “Accounting for Construction Contracts” issued by the Institute of the Chartered
Accountants of India.
SOLUTION
(a) Amount of Foreseeable Loss
( in lakhs)
R

Work Certified 500

Work Uncertified 105
Estimated Further Cost to Completion 495
—————————

Total Cost of Construction 1,100

Less : Total Contract Price 1,000
—————————

Total Forseeable Loss 100

—————————

Note : A forseeable loss on the entire contract should be provided for in the financial statements irrespective of
the amount of work done and the method of accounting followed.
(b) Construction Work-in-Progress i.e. Costs Incurred to Date R (in lakhs)
Work Certified 500
Work Uncertified 105
————————

Construction Work-in-Progress 605

————————

Total Cost of Construction as per (a) 1,100

% of Construction Work-in-Progress
605
1‚100 (
× 100 ) 55%

(c) Proportion of Total Contract Value Recognised as Revenue

55% of R 1,000 lakhs = R 550 lakhs
R in lakhs
Revenue Recognised 550
Less : Cost of Construction Work-in-Progress 605
————————

Loss to be shown in the Profit and Loss for 2023-24 55

————————

(d) Disclosure Requirements R in lakhs

(i) Cost incurred to date on Work-in-Progress 605
Less : Transferred to Profit & Loss A/c as Cost of Sales 605
————————

Nil
————————

(ii) Profit & Loss A/c (Extract)

Revenue 550
Less : Cost of Sales 605
————————

Loss 55
Add : Provision for loss on contract (Bal. Fig.) 45
————————

Net loss including forseeable loss 100

————————

(iii) Balance Sheet (Extract)

Debtors (i.e. revenue recognised) 550
Less : Progress payment received and receivable (400 + 140) 540
————————

10
————————
B/1·26 CONTRACT COSTING

Work-in-Progress
The total expenditure cumulative to the year end is treated as work-in-progress, if no profit is
taken in the accounts. The amount of profit is to be added to the progress cost, if profit is included
for the adoption of the percentage of completion method. For balance sheet purposes, payments
received from the contractee from time to time are normally taken separately as advance and shown
on the liabilities side of the Balance Sheet. Alternatively, the advance may be deducted from the Cost
(and profit) and only one figure kept on the assets side.
ILLUSTRATION 9. A large contract is to be completed in five stages. The completion stage
at the end of an accounting period shows the present position. It is a fixed price contract without
any escalation clause.
Estimate
Phases ————————————————————————————————————— Actual Contract
Original Revised up- Cost Price
todate
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

1. Certified 60,000 64,000 62,000 80,000

2. Completed but not certified 20,000 22,000 21,000 30,000
3. Completed 75% 20,000 22,000 16,600 26,000
4. Completed 25% 40,000 48,000 12,400 60,000
5. Incomplete 24,000 30,000 — 28,000
—————————————————————————————————————————————————————————————————————

1,64,000 1,86,000 1,12,000 2,24,000

—————————————————————————————————————————————————————————————————————

Evaluate the profit to be taken in the accounts of the period if the contractor adopts (a) The
percentage of completion method ; (b) The completed contract method. Also show the work-in-
progress in the Balance Sheet, if R 80,000 is received as final payment for completion of the first
phase.
SOLUTION (a)
Phase Actual Cost % Balance Total Contract Profit
Estimate Price (Loss)
R R R R

1 62,000 — 62,000 80,000 18,000

2 21,000 — 21,000 30,000 9,000

3 16,600 25% 5,500 ( 1

4
of R 22,000 ) 22,100 26,000 *

4 12,400 75% 36,000 ( 3

4
of R 48,000 ) 48,400 60,000 *

5 — 100% 30,000 30,000 28,000 (2,000)

———————————

25,000
———————————
CONTRACT COSTING B/1·27

(b) No profit can be taken into account till all phases are complete.
BALANCE SHEET
Liabilities Under (a) Under (b) Assets Under (a) Under (b)
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Advance* 80,000 80,000 Work-in-Progress 1,37,000

(1,12,000 Cost + 25,000 Profit) 1,12,000
NOTE : * Advance can also be deducted from the work-in-progress on the assets side of the Balance
Sheet.

Cost Plus Contract

Cost plus contract is a contract in which the value of the contract is ascertained by adding a fixed
and mutually pre-decided amount of profit or a certain percentage of profit over the total cost of the
work. It is generally adopted in those cases where the probable cost of the contract cannot be
computed in advance with a reasonable degree of accuracy due to unstable condition of material,
labour etc. or when the work is spread over a large period of time and prices of materials, rates of
labour etc. are liable to fluctuate. The different costs to be included in the execution of the contract are
materially agreed so that no dispute may arise in future in ‘this’ respect. Under such a type of
contract contractee is allowed to check or scrutinise the concerned books, documents and accounts.
Such a contract offers a fair price to the contractee and a reasonable profit to the contractor. Such
contracts are undertaken for production of special articles not usually manufactured e.g., production
of newly designed aircraft components or in case of urgent repairs of ships, vehicles, power house etc.
or in case of construction during war time. Government prefers to give contract on cost plus basis.
Such contracts are advantageous both to the contractor and the contractee. From the Contractor’s
point of view, this method protects him from the risk of fluctuations in market prices of materials, labour
and other services. He knows in advance the profit he can expect on the order when completed.
Moreover, there is no risk of incurring loss on the contract as all agreed costs are recovered. If the
contractor is unscrupulous, he may deliberately inflate cost in order to obtain higher profit. In order
to avoid disputes in future, the contractee must settle the admissible costs such as type of material to
be used, labour rates for different grades, normal wastages to be permitted, the rate or amount of
profit, supervision, fixed overhead and losses such as allowances for wastages, scrap, normal loss etc.
When bills are tendered, the burden of proving each item charged falls on the shoulder of the
contractor. However, this system may put a premium on inefficiency in so far as the contractor
whose costs are highest, obtains highest profit. There is no incentive to find more efficient methods of
production or to reduce costs, as the contractor can obtain no benefit from any saving thereby effected.
He usually reserves the right of cost audit.
From contractee’s point of view, this method ensures that the price paid will depend on cost rather than
on arbitrary commitment to a specific price. Thus, in uncertain market the contractee is suitably
fortified and he pays only reasonable price. This method is suitable when he provides raw materials,
tools etc. to the manufacturer. In general, it is observed that the cost to the contractee tends to be higher
than the cost which could be obtained by other forms of contract.

Target Costing
Under this method the targets of volume of production and targets of various expenditures of
production are fixed before hand and constant efforts are made not to exceed the expenditure targets
B/1·28 CONTRACT COSTING

unless there is a corresponding increase in the volume of production over the target fixed. Thus the
contractor receives an agreed sum of profit over his predetermined costs. If actual costs are below the target
fixed, the contractor is entitled to a bonus which is a proportion of saving thus made.

Escalation Clause

An escalation clause is a provision included in the contract that allows the adjustment of contract
prices or rates based on changes in costs factors over time. These cost factors can include inflation
rates, changes in labour costs, fluctuations in material prices, fuel or energy cost variations or any
other costs components that may impact overall cost of the contract. The escalation clause typically
includes a formula or mechanism that determines how the price adjustments will be calculated. This
may involve a fixed percentage increase, a formula based on index or benchmark etc. The inclusion of
escalation clause in a contract provides a mechanism for addressing cost fluctuations and helps
ensure that both the parties are protected against unforeseen increases in the contract costs.
Just as an escalation clause safeguards the interest of contractor by upward revision of the
contract price, a de-escalation clause may be inserted to look after the interest of the contractee by
providing downward revision of the contract price in the event of cost going down beyond an agreed
level.
ILLUSTRATION 10. Deluxe Limited undertook a contract for R 5,00,000 on 1st July, 2022.
On 30th June, 2023 when the accounts were closed, the following details about the contract were
gathered :
R R

Materials Purchased 1,00,000 Wages Accrued 30-6-2023 5,000

Wages Paid 45,000 Work Certified 2,00,000
General Expenses 10,000 Cash Received 1,50,000
Plant Purchased 50,000 Work Uncertified 15,000
Materials on Hand 30-6-2023 25,000 Depreciation of Plant 5,000
The above contract contained an escalation clause which read as follows :
“In the event prices of materials and rates of wages increase by more than 5%, the contract
price would be increased accordingly by 25% of the raise in the cost of materials and wages
beyond 5% in each case.”
It was found that since the date of signing the agreement the prices of materials and wages
rates increased by 25%. The value of the work does not take into account the effect of the above
clause.
Prepare the contract account. Working should form part of the answer.
SOLUTION
CONTRACT A/c
for the year ending 30th June, 2023
R R

To Materials 1,00,000 By Work-in-Progress :

To Wages ( 45,000 +
R R 5,000) 50,000 Work certified 2,00,000
CONTRACT COSTING B/1·29

To General Expenses 10,000 Work uncertified 15,000

To Depreciation of Plant 5,000 By Material on Hand 25,000
To Notional Profit c/d 80,000 By Contract Escalation (1) 5,000
——————————————— ———————————————
2,45,000 2,45,000
———————————————
——————————————— ———————————————
———————————————

To Profit and Loss A/c By Notional Profit b/d 80,000

( 80‚000 × ×
R
1 1‚50‚000
3 2‚00‚000
R

) 20,000

To Work-in-Progress A/c (Reserve) 60,000

——————————————— ———————————————
80,000 80,000
———————————————
——————————————— ———————————————
———————————————

Working Note :
Materials Total Increase Upto 5% Beyond 5%
—————————————————————————————————————————————————————————————————

R R R

25
( 1‚00‚000 – 25‚000) × 125
R R [in the ratio of 5 : 20] 15,000 3,000 12,000

Wages (
50‚000 ×
R
25
125 ) 10,000 2,000 8,000
————————————————————————————————————————————————————————————————

Total Increase 25,000 5,000 20,000

—————————————————————————————————————————————————————————————————

Increase in contract cost = 25% of increase in material and wages beyond 5%

25
= × 20,000 = 5,000.
R R
100

ILLUSTRATION 11. SB Constructions Limited has entered into a big contract at an agreed
price of R 1,50,00,000 subject to an escalation clause for material and labour as spent out on the
contract and corresponding actuals are as follows :
Standard Actual
Quantity Rate per Tonne Quantity Rate per Tonne
(Tonnes) (Tonnes)
Material : (R) (R)
A 3,000 1,000 3,400 1,100
B 2,400 800 2,300 700
C 500 4,000 600 3,900
D 100 30,000 90 31,500
Labour : Hours Hourly Rate Hours Hourly Rate
(R) (R)
L1 60,000 15 56,000 18
L2 40,000 30 38,000 35
You are required to :
(i) Give your analysis of admissible escalation claim and determine the final contract price
payable.
(ii) Prepare the contract account, if the all expenses other than material and labour related to
the contract are R 13,45,000.
B/1·30 CONTRACT COSTING

SOLUTION
(i) STATEMENT SHOWING ADDITIONAL CLAIM DUE TO ESCALATION CLAUSE
Material Std. Std. Rate Actual Rate Variation in Escalation
Qty./Hours Rate ( )
R Claim ( ) R

(a) (b) (c) (d) = (c – b) (e) = (a × d)

A 3,000 1,000 1,100 +100 +3,00,000
B 2,400 800 700 –100 –2,40,000
C 500 4,000 3,900 –100 –50,000
D 100 30,000 31,500 +1,500 +1,50,000
Material Escalation Claim 1,60,000
Labour :
L1 60,000 15 18 +3 +1,80,000
L2 40,000 30 35 +5 +2,00,000
Labour Escalation Claim 3,80,000

STATEMENT SHOWING FINAL CONTRACT PRICE

Agreed Contract Price 1,50,00,000

Add : Agreed Escalation Claim : R

Material Cost 1,60,000

Labour Cost 3,80,000
——————————————
5,40,000
————————————————

Final Contract Price 1,55,40,000

————————————————
————————————————

(ii) CONTRACT ACCOUNT

Dr. Cr.
R R

To Material : By Contractee’s A/c 1,55,40,000

A—3,400 × R 1,100 = 37,40,000
B—2,300 × R 700 = 16,10,000
C— 600 × R 3,900 = 23,40,000
D— 90 × R 31,500 = 28,35,000
————————————
1,05,25,000
To Labour :
L1— 56,000 × R 18 = 10,08,000
L2 — 38,000 × R 35 = 13,30,000
————————————
23,38,000
To Other Expenses 13,45,000
To Profit and Loss A/c (Profit) 13,32,000
———————————————— ————————————————

1,55,40,000 1,55,40,000
————————————————
———————————————— ————————————————
————————————————
CONTRACT COSTING B/1·31

MISCELLANEOUS ILLUSTRATIONS
PROBLEM 12. Brock Construction Ltd. commenced a contract on November 1, 2022. The
total contract was for R 39,37,500. It was decided to estimate the total profit on the contract and to
take to the credit of P/L A/c that proportion of estimated profit on cash basis, which work
completed bore to the total contract. Actual expenditure for the period November 1, 2022 to
October 31, 2023 and estimated expenditure for November 1, 2023 to March 31, 2024 are given
below :
November 1, 2022 November 1, 2023
to to
October 31, 2023 March 31, 2024
(Actual) (Estimated)
R R

Materials issued 6,75,000 12,37,500

Labour : Paid 4,50,000 5,62,500
Prepaid 25,000 —
Outstanding — 2,500
Plant purchased 3,75,000 —
Expenses : Paid 2,00,000 4,50,000
Outstanding 50,000 25,000
Plant returned to store 75,000 3,00,000
(historical cost) (on March 31, 2023) (on March 31, 2024)
Work Certified 20,00,000 Full
Work Uncertified 75,000
Cash Received 17,50,000
Material at site 75,000 37,500
1
The plant is subject to annual depreciation @ 33 % on written down value method. The
3
contract is likely to be completed on March 31, 2024.
Required :
Prepare the Contract A/c. Determine the profit on the contract for the year November, 2022 to
October, 2023 on prudent basis, which has to be credited to P/L A/c.
SOLUTION Brock Construction Ltd.
CONTRACT ACCOUNT (1-11-2022—31-10-2023)
R R

To Materials issued R 6,75,000 By Plant returned to Store : R

To Labour—Paid 4,50,000 Cost 75,000

Less : Prepaid 25,000 Less : Depreciation

( )
————————————
4,25,000 1
To Plant (Purchased) 3,75,000 for 5 months @ 33 % p.a. 10,417
3 ————————————
To Expenses—paid 2,00,000 64,583
B/1·32 CONTRACT COSTING

Add : Outstanding 50,000 By Work-in-Progress A/c :

————————————
2,50,000 Work Certified 20,00,000
To Notional Profit c/d 6,89,583 Work Uncertified 75,000
————————————
20,75,000
By Plant at site (on 31-10-23)
Cost 3,00,000
Less : Depreciation (1/3) 1,00,000
————————————
2,00,000
By Material at site 75,000
————————————— ——————————————

24,14,583
—————————————
24,14,583
——————————————
————————————— ——————————————
To Profit & Loss A/c By Notional Profit b/d 6,89,583

( R
17‚50‚000 20‚00‚000
2,34,305 × 20‚00‚000 × 39‚37‚500

To Work-in-Progress A/c
) 1,04,135.6

(Profit in Reserve) 5,85,447.4

————————————— ——————————————

6,89,583 6,89,583
—————————————
————————————— ——————————————
——————————————

Working Note CONTRACT ACCOUNT

(from 1-11-23 to 31-3-2024)
for Computations of Estimated Profit
R R

To Materials Issued By Material at site 37,500

( 6,75,000 + 12,37,500)
R R 19,12,500 By Plant returned to Stores on 31-3-22
To Labour paid and Outstanding R

( 4,25,000 + 5,87,500 + 2,500)

R R R 10,15,000 Cost 75,000
To Plant (purchased) 3,75,000 Less : Depreciation
1
To Expenses ( 2,50,000 + 4,25,000)
R R 6,75,000 for 5 months @ 333% p.a. 10,417
———————————
To Estimated Profit 2,34,305 64,583
By Plant at Site
Cost 3,00,000
Less : Dep. (1/3) 1,00,000
———————————

2,00,000
Less : Depreciation for 5 months
@ 1/3 27,778
——————————
1,72,222
By Contractee A/c 39,37,500
————————————— —————————————

42,11,805 42,11,805
—————————————
————————————— —————————————
—————————————

P R O B L E M13. A contractor commenced a contract on 1-7-2023. The costing records

concerning the said contract reveal the following information as on 31-3-2024.

Amount ( ) R

Material sent to site 7,74,300

Labour paid 10,79,000
Labour Outstanding as on 31-3-2024 1,02,500
Salary to Engineer 20,500 per month
CONTRACT COSTING B/1·33

Cost of Plant sent to site (1-7-2023) 7,71,000

Salary to Supervisor (3/4 time devoted to contract) 9,000 per month
Administration and Other Expenses 4,60,600
Prepaid Administration Expenses 10,000
Material in hand at site as on 31-3-2024 75,800

Plant used for the contract has an estimated life of 7 years with residual value at the end of life
R50,000. Some of material costing 13,500 was found unsuitable and sold for 10,000. Contract
R R

price was 45,00,000. On 31-3-2024 two third of the contract was completed. The architect issued
R

certificate covering 50% of the contract price and contractor has been paid 20,00,000 on account. R

Depreciation on plant is charged on straight line basis.

Prepaid Contract Account.
SOLUTION
CONTRACT ACCOUNT
(for the period 1-7-23 to 31-3-24)
R R

To Material Issued R 7,74,300 By Material (Sold) 10,000

To Labour 10,79,000 By Profit & Loss A/c (Loss)
Add : Outstanding 1,02,500 ( 13,500 – 10,000)
R R 3,500
—————————————
11,81,500 By Material in hand 75,800
To Salary to Engineer ( 20,500 × 9)
R 1,84,500 By Work-in-Progress A/c :
To Salary to Supervisor —Work Certified R

( )
50% of 45,00,000 22,50,000
3
R 9,000 × ×9 60,750 —Work Uncertified (2)
4
(26,39,600 –
To Administration and 19,79,700) 6,59,900
—————————————
Other Expenses 4,60,600 29,09,900
Less : Prepaid 10,000
—————————————
4,50,600
To Depreciation on Plant (1) 77,250
To Notional Profit c/d 2,70,300
——————————————— ———————————————

29,99,200 29,99,900
———————————————
——————————————— ———————————————
———————————————
To P & L A/c (3) 1,60,178 By Notional Profit b/d 2,70,300
To Reserve 1,10,122
——————————————— ———————————————

2,70,300 2,70,300
———————————————
——————————————— ———————————————
———————————————

Working Note
1. Calculation of Depreciation on Plant R

Cost of the Plant 7,71,000

Less : Residual Value 50,000
—————————————
7,21,000
—————————————
Estimated Life 7 years
Depreciation Per Annum R 1,03,000
B/1·34 CONTRACT COSTING

R 1‚03‚000
Depreciation for 9 Months = ×9= R 77,250
12
2. Cost of Work Uncertified = Cost incurred to date minus 50% of the total cost of contract
= R 26,39,600 (figure already shown in the contract A/c) – R 19,79,700 = R 6,59,900
3. Calculation of Profit to be Transferred
2 20‚00‚000
R
× 2,70,300 ×
R = 1,60,178R
3 22‚50‚000
R

PROBLEM 14. Batron Ltd., a contractor commences the contract No. HB–128 on 1st July,
2023. The details about the contract for the year ending 31st March, 2024 were following :
Contract Price— 3,00,000; Materials issued— 8,00,000; Material transferred from contract No.
R R

101— 50,000; Wages paid— 6,31,000; Wages outstanding— 35,000; Supervisor;’s Salary—
R R R

R 1,80,000; Establishment Expenses— 41,000; Plant issued— 10,00,000.

R R

Material costing 15,000 was sold for 11,000 and plant costing 80,000 returned to stores on
R R R

31st December, 2023.

A crane costing 20,00,000 has been on the contract site for 73 days. Its working life is
R

estimated at 6 years and its scrap value at 1,10,000. Depreciation on plant is to be charged @ 15%
R

per annum. Up to 31st March, 2024, 3/4 (Three-fourth) of the contract was completed but architect’s
certificate has been issued covering 2/3 of the contract price and 15,00,000 had been received in
cash on account.
Required :
(a) Prepare the Contract No. HB–128 Account for the year ended March 31, 2024.
(b) State as to how much Profit should be credited to Profit and Loss Account for the year
ended March 31, 2024.
SOLUTION Batron Ltd.
CONTRACT NO. HB–128 ACCOUNT
for the year ended March 31, 2024
R R

To Materials Issued 8,00,000 By Bank A/c (Material sold) 11,000

To Material Transferred from By Profit & Loss A/c (Loss on
Contract No. 101 50,000 Sale of Material) 4,000
To Wages Paid 6,31,000 By Plant Returned (ii) 74,000
To Wages Outstanding 35,000 By Plant at Site (iii) 8,16,500

To Supervisor’s Salary 1,80,000 By W.I.P. A/c

To Establishment Exp. 41,000 Value of Work Certified (iv) 20,00,000

To Plant Issued (i) 10,00,000 Cost of Work Uncertified (v) 1,57,875

To Crane Depreciation 63,000
To Notional Profit c/d 2,63,375
——————————————— ———————————————

30,63,375
———————————————
30,63,375
———————————————
——————————————— ———————————————

To Profit & Loss A/c (vi ) 1,31,687 By Notional Profit b/d 2,63,375
To W.I.P. A/c (Reserve) 1,31,688
——————————————— ———————————————

2,63,375
———————————————
2,63,375
———————————————
——————————————— ———————————————
CONTRACT COSTING B/1·35

Working Notes :
(i) Cranes depreciation = [(20,00,000 – 1,10,000)/6] × 73/365 = R 63,000
(ii) Value of the plant returned to store on 31st December, 2023 :
Cost of Plant Returned on 1-7-2023 R 80,000
Less : Depreciation from 1-7-23 to 31-12-23 = (80,000 × 15/100) × 6/12 R 6,000
———————————

R 74,000
(iii) Plant at site on 31-3-2024 = 10,00,000 – 80,000
= 9,20,000 – Depreciation 9,20,000 × 15/100 × 9/12
= R 9,20,000 – 1,03,500 = R 8,16,500
(iv) Value of Work Certified = 30,00,000 × 2/3 = R 20,00,000
(v) Cost of Work Uncertified :
Total cost upto 31-3-2024 = 8,00,000 + 50,000 + 6,31,000 + 35,000 + 1,80,000 + 41,000
+ 10,00,000 + 63,000 – 11,000 – 4,000 – 74,000 – 8,16,500 = 18,94,500 R

Work completed upto 31-3-24 = 3/4 but work certified = 2/3

So, work uncertified = 3/4 – 2/3 = (9 – 8)/12 = 1/12
Hence, cost of work uncertified = 18,94.500 × 1/12 = 1,57,875 R

(vi) Profit transferred to P/L A/c = Notional Profit × 2/3 × (Cash Received/Work Certified)
= R 2,63,375 × 2/3 × (15,00,000/20,00,000) = R 1,31,687

ILLUSTRATION 15. Modern Construction Ltd. obtained a contract No. B-37 for R 40 lakhs.
The following balances and information relate to the contract for the year ended 31st March, 2024 :

1-4-2023 31-3-2024
R R

• Work-in-progress :
• Work certified 9,40,000 30,00,000
• Work uncertified 11,200 32,000
• Materials at site 8,000 20,000
• Accrued wages 5,000 3,000

Additional informations relating to the year 2023-2024 are :

R R

• Materials issued from store 4,00,000 • Share of General Overheads

• Materials directly purchased 1,50,000 for B-37 18,000
• Wages paid 6,00,000 • Materials Returned to Store 25,000
• Architect’s Fees 51,000 • Materials Returned to Supplier 15,000
• Plant Hire Charges 50,000 • Fines and Penalties paid 12,000
• Indirect Expenses 10,000

The contractee pays 80% of work certified in Cash. You are required to prepare : (i) Contract
Account showing clearly the amount of profits transferred to Profit and Loss Account. (ii)
Contractee’s Account. (iii) Balance Sheet.
B/1·36 CONTRACT COSTING

SOLUTION
BOOKS OF MODERN CONSTRUCTION LTD.
Contract No. B-37 Account for the year ended 31st March, 2024

R R

To WIP b/d ( 9,40,000 +

R R 11,200) 9,51,200 By Wages Accrued b/d 5,000
To Stock (Materials) b/d 8,000 By Materials Returned to Store 25,000
To Materials Issued 4,00,000 By Materials Returned to Suppliers 15,000
To Materials Purchased 1,50,000 By WIP c/d— R

To Wages paid 6,00,000 Work Certified 30,00,000

To Wages Accrued c/d 3,000 Uncertified Work 32,000
————————————
To Architect’s Fees 51,000 30,32,000
To Plant Hire Charges 50,000 By Materials Stock C/d 20,000
To Indirect Expenses 10,000
To General Overheads 18,000
To Notional Profit c/d 8,55,800
—————————————— ——————————————

30,97,000 30,97,000
—————————————— ——————————————

To Profit and Loss A/c By Notional Profit b/f 8,55,800

(
2
3
× 8,55,800 ×
R
80
100 ) 4,56,427
To WIP Reserve c/d 3,99,373
—————————————— ——————————————

8,55,800 8,55,800
——————————————
—————————————— ——————————————
——————————————

Note : Fines and penalties being abnormal cost are not shown in contract accounts.
CONTRACTEE’S ACCOUNT
R R

To Balance c/d (80% of R 30,00,000) 24,00,000 By Balance b/d (80% of R 9,40,000) 7,52,000
By Bank (Bal. Figure) 16,48,000
—————————————— ——————————————

24,00,000 24,00,000
——————————————
—————————————— ——————————————
——————————————

BALANCE SHEET (Extract)

as on 31-3-2024
Liabilities R R Assets R

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Profit and Loss A/c 4,56,427 Materials Stock at Site 20,000

Less : Fines 12,000 Materials Stock in Store 25,000
————————————
4,44,427 WIP : R

Outstanding Wages 3,000 Work Certified 30,00,000

Work Uncertified 32,000
—————————————

30,32,000
Less : Advance 24,00,000
—————————————

6,32,000
Less : WIP Reserve 3,99,373
————————————
2,32,627
CONTRACT COSTING B/1·37

ILLUSTRATION 16. The following details are available from the books of accounts of a
contractor with respect to a particular construction work for the year ended 31st March, 2024 :
R R

Contract Price 91,00,000 Material returned to Store 14,840

Cash received from Contractee Head Office Expenses apportioned 2,50,000
(90% of Work Certified) 71,91,000 Cost of Work Uncertified 3,17,000
Material sent to site 35,82,600 On 31st March, 2024 :
Planning and Estimation Cost 3,50,000 Material at site 85,400
Direct Wages paid 32,62,700 Accrued Direct Wages 78,120
Cost of Plant installed at site 7,00,000 Accrued Direct Expenses 9,310
Direct Expenses 1,68,000 Value of Plant (as revalued) 6,16,000
Establishment Expenses 2,03,000
Required : (i) Prepare the Contract Account for the year ended 31st March, 2024. (ii) Show the
relevant Balance Sheet entries.

SOLUTION
CONTRACT ACCOUNT
For the year ended 31st March, 2024
R R

To Material sent to site R 35,82,600 By Materials Returned 14,840

To Direct Wages 32,62,700 By Material at Site 85,400
To Accrued Wages 78,120 By Work-in-Progress :
———————————
33,40,820 Cost of Work Uncertified 3,17,000
To Planning and Estimation Cost 3,50,000 Value of Work Certified
To Direct Expenses 1,68,000 100
R 71‚91‚000 ×
Add : Accrued Expenses 9,310 90 79,90,000
———————————
1,77,310
To Depreciation on Plant
7,00,000 – 6,16,000 84,000
To Establishment Expenses 2,03,000
To Head Office Expenses 2,50,000
To Notional Profit c/d 4,19,510
—————————————— ——————————————

84,07,200 84,07,200
—————————————— ——————————————

To P & L A/c 2,51,706 By Notional Profit b/d 4,19,510

To Reserve 1,67,804
—————————————— ——————————————

4,19,510 4,19,510
——————————————
—————————————— ——————————————
——————————————

Profit Transferred to P & L A/c

2 Cash Received
× Profit ×
3 Work Certified
2 71‚91‚000
× 4,19,510 × R= 2,51,706
3 79‚90‚000
B/1·38 CONTRACT COSTING

BALANCE SHEET (EXTRACT) AS ON 31ST MARCH, 2024

Liabilities Amount Assets Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R

P & L A/c 2,51,706 Work-in-Progress

Accrued Wages 78,120 Value of Work Certified 79,90,000
Accrued Expenses 9,310 Cost of Work Uncertified 3,17,000
——————————————

83,07,000
Less : Reserved Profit 1,67,804
——————————————
81,39,196
Less : Cash Received 71,91,000
——————————————
9,48,196
Material at site 85,400

QUESTIONS
SHORT ANSWER TYPE
1. What is Contract Costing ?
2. What is Notional Profit ?
3. Write a note on “Retention Money”
4. What do you mean by “Cost Plus Contract” ?
5. What is Escalation Clause ?
6. What is estimated Profit ?
7. Write a note on “Work not Certified.”
8. What do you mean by Incomplete Contract ?
9. Write a note on “% Completion method”.
10. How to Calculate Notional Profit ?
11. What is Contract Costing ? Give the main distinguishing features of Contract Costing.
12. What is a Contract Ledger ?
13. What is a cost plus contract ? State its advantages.
14. Enumerate four advantages of cost plus contract to the contractor and the contractee.
15. What is work not certified ? How do you treat it in accounts ?
16. What is Notional Profit ?
17. Explain (or write note on) Escalation clause.
18. Give the four formulae which are used for transferring profit to profit and loss account when the
contract is almost complete.
19. What is Work-in-Progress ? How is it shown in the Contractor’s Balance Sheet ?
20. What is Production Order ? Which Department issues it ?
21. What is Retention Money ? Why is it kept by the contractee (or What is its objective) ?
22. What is Target Costing?
23. Distinguish job costing from contract costing.
CONTRACT COSTING B/1·39

24. “Cost plus contract represents an addition of a percentage of capital employed in the contract”. Do you
agree ?
25. Distinguish between Profit transferred to P/L A/c under % completion method and estimated profit
basis (completed contract) method—in contract costing.
26. Write note on amount to be transferred to Profit & Loss A/c when contract is almost complete, under
different methods.
27. How will you treat profits on incomplete contracts ?
28. State commonly accepted practices for computation of profit on incomplete contracts.
29. From the following particulars relating to Contract No. 55, for the year ended 31st March, 2024,
calculate the cost of uncertified work and the amount of profit to be transferred to Profit & Loss
Account :
Contract Price— 5,00,000; Work Completed—3/5; Cash Received (being 75% of work certified)—
R

R1,50,000.
Net expenditure incurred on contract to date R 1,92,000.
Ans. [Cost of work uncertified R 64,000; Notional Profit R 72,000; Amount transfer to P&L A/c R 18,000]
30. Prepare a Contractor Account, Contractee A/c and Balance Sheet from the following particulars :
Material sent to site— 58,000; Direct wages— 65,000; Chargeable expenses— 35,000; Plant
R R R

installed— 40,000; Indirect expenses— 25,000; Wages accrued— 30,000; Material Returned to store—
R R R

R 8,000; Plant at site at the end— 25,000; Material at site at the end— 10,000; Cash received (being 80%
R R

of work certified— 2,00,000; Work completed—3/4; Contract Price— 4,00,000.

R R

Ans. [Notional Profit 75,000; Amount transferred to Profit & Loss Account;
R R 40,000; Net Amount of WIP
shown in Balance Sheet 50,000[
R

31. The estimated material cost of a job is 5,000 and direct labour cost is likely to be 1,000. In machine
R R

shop it will require machining by Machine No. 1 for 20 hours and by Machine No. 2 for 6 hours.
Machine hour rates for Machine No. 1 and Machine No. 2 are 10 and 15 respectively. Considering
R R

only machine shop cost, the direct wages in all other shops last year amounted to 80,000 as against R

48,000 factory overhead. Last year, factory cost of all jobs amounted to 2,50,000 as against 37,500
R R R

office expenses.
Prepare a quotation which guarantees 20% profit on selling price.
Ans. [ 9,905]
R

32. What is the profit to be recognised as per AS-7 in the current period having regards to the following
data:
Contract price 99,00,000; Cumulative figures : To end of previous period-profit recognised 2,25,000;
R R

To end of current period-total costs 49,50,000; Cost of work certified 36,00,000; Estimated future
R R

costs to completion 27,00,000; Estimated rectification cost 10% of contract price.

R

Ans. [Profit of the current period R 3,00,000]

LONG ANSWER TYPE

1. Explain briefly the distinguishing features of contract accounts.

2. Suggest a system of cost accounts in detail suitable for a public contractor using heavy plant and
carrying out contracts at long distances from his head office.
3. There are two methods of charging a contract cost account for use of plant. Describe the two methods
and state which method is preferable and why ?
B/1·40 CONTRACT COSTING

4. Theoretically it may not be correct to bring into account any profit or loss on uncompleted contracts, but
in practice strict adherence to this principle may have important consequences. Discuss the pros and cons
of the question. How would such profit ordinarily be computed ?
5. Give the broad guidelines for assessment of profit on incomplete contract for incorporation in the P&L
account and balance sheet of a firm.
6. How are profits computed in respect of incomp h laest e n oc to n t r a c t s
advanced reasonably ; (ii) has reasonably advanced ; and (iii) has sufficiently advanced, but is not in the
final stage of completion.
7. Explain the basic principles to be followed in determining the amount of profit on uncompleted
contracts.
8. What is a ‘cost plus’ contract ? Discuss the advantages of cost plus contracts to the manufacturer and
the buyer.
9. Write short notes on : (a) Retention Money, (b) Escalation Clause, (c) Work in Progress, (d) Target
Costing, (e) Economic Batch Quantity, (f) Cost plus Contracts, (g) Job Costing.
10. Discuss the procedure followed in accounting for costs under contract costing.
11. In Contract Costing how will you treat cost of acquiring large heavy duty cranes and other material
moving equipment purchased specifically for the construction of a bridge across a river ?
12. What do you understand by “Cost plus Contracts” and “Escalator Clause” in contract costing ?
13. Explain with the help of an illustration how the cost of work done but not certified may be computed by
a contractor in case of a contract which is still incomplete on the date of the book closure.

PRACTICAL PROBLEMS
1. The following expenditure was incurred on a contract of 12,00,000 for the year ending 31-12-2023.
R

Materials 2,40,000
Wages 3,28,000
Plant 40,000
Overheads 17,200
Cash received on account of the contract to 31st Dec., 2023 was 4,80,000, being 80% of the work
R

certified. The value of materials in hand was 20,000. The plant had undergone 20% depreciation.
R

Prepare Contract Account.

Ans. [Profit & Loss 14,293 (transferred)]
R

2. The following expenses were incurred on an unfinished contract during the year 2024.
Material R 90,000
Wages R 60,000
Other Expenses R 30,000
R 2,00,000 was received by the contractor, being 80% of the work certified. Work done but not certified
was 5,000. Determine the profit to be credited to profit and loss account and profit kept reserve in all
R

the three alternatives given below :

(i) Contract price is R 3,00,000
(ii) Contract price is R 5,50,000
(iii) Contract price is R 12,00,000
Ans. [(a) Amount transfer in P&L—(i) 40,000; (ii) 20,000; (iii) 0; (b) Amount kept in Reserve : (i) 35,000; (ii)
55,000; (iii) 75,000]
CONTRACT COSTING B/1·41

3. How much of profit, if any, you would consider in the following case :
Contract price 20,00,000
R

Cost incurred 11,20,000

R

Cash received 10,80,000

R

Work not certified 1,20,000

R

Deduction from bills by way of security deposit is 10%.

Ans. [Amount transfer in P & L 1,20,000]
R

4. The following were the expenses on a contract which commenced on 1st January 2024.
Materials purchased 1,10,000
Material at the end 1,250
Direct wages 15,000
Plant issued 5,000
Direct expenses 8,000
The contract price was 1,50,000. It was duly received when the contract was completed on 31-3-2024.
R

Charge indirect expenses at 15% on wages and provide 1,000 for depreciation on plant. Prepare the
R

contract account and contractee’s account.

Ans. [(i) Profit on Contract : R 15,000; Payment from Contractee R 1,50,000]

5. Thekedar accepted a contract for the construction of a building for 10,00,000, the contractee agreeing
R

to pay 90% of work certified by the architect. During the first year, the amounts spent were :
Particulars R Particulars R

Material 1,20,000 Machinery 30,000

Labour 1,50,000 Other Expenses 90,000
At the end of the year, the machinery was valued at 20,000 and materials at site were of the value of
R

R 5,000. Work certified during the year totalled 4,00,000. In addition work-in-progress not certified at
R

the end of the year had cost 15,000. Prepare Contract Account in the books of Thekedar. Also show the
R

various figures of profit that can be reasonably transferred to the Profit and Loss Account.
Ans. [Amount transfer to P & L A/c 15,000] R

6. The BBA Construction Company undertakes large contracts. The following particulars relate to contract
No. 125 carried out during the year ended on 31st March, 2024.
Particulars R Particulars R

Work Certified by Architect 1,43,000 Wages accrued on 31st

Cost of Work not Certified 3,400 March 2024 1,800
Plant Installed at Site 11,300 Direct Expenditure 2,400
Value of Plant on 31st Material on Hand on 31st
March 2024 8,200 March 2024 1,400
Materials sent to Site 64,500 Materials Returned to Store 400
Labour 54,800 Direct Expenditure accrued
Establishment Charge 3,250 on 31st March 2024 200
Contract Price 2,00,000
Cash received from Contractee 1,30,000
Prepare a Contract Account for the period ending 31st March 2024 and find out the profit. It was
decided to transfer 2/3 of the profit on cash basis to Profit and Loss Account.
Ans. [Amount transfer to P & L A/c R 11,000]
B/1·42 CONTRACT COSTING

7. S.V. Construction Ltd. has obtained a contract for the construction of a bridge. The value of the contract
is 12 lacs and the work commenced on 1st October, 2022. Following details are shown in their books
R

for the year ended 30th September, 2023 :

Plant purchased 60,000 ; Wages paid 3,40,000 ; Materials issued to site 3,36,000 ; Site expenses
R R R

R 8,000 ; General overhead apportioned 32,000 ; Wages accrued as on 30-9-2023 2,800 ; Materials at
R R

site as on 30-9-2023 4,000 ; Direct expenses accrued as on 30-9-2023 1,200 ; Work not yet certified at
R R

cost 14,000 ; Cash received being 80% of work certified 6,00,000. Life of plant purchased is 5 years
R R

and scrap value is nil.

(1) Prepare Contract Account for the year ended 30th September, 2023, (2) Show the amount of profit
which you consider might be fairly taken on the contract and how you have calculated it.
Ans. [Notional Profit R 36,000, Profit transferred to Profit and Loss Account R 19,200]
8. A railway contractor makes up his accounts to 31st March. Contract No. SER/15 for the construction of
a culvert between Bhilai and Raipur commenced on 1st July, 2023. The costing records yield the
following information at 31st March, 2024.
Materials charged out to site R 31,540 ; Labour R 75,300 ; Foreman’s salaries R 11,700.
A machine costing 25,000 has been on site for 73 days. Its working life is estimated at five years and
R

its final scrap value at 1,000.

R

A supervisor who is paid R 18,000 per annum has spent approximately six months on this contract.
All other expenses and administration amount to R 17,000.
Materials in store at site at the end of the year cost R 2,500.
The contract price is 3,00,000. At the end of the year two-thirds of the contract was completed for
R

which amount, the architect’s certificate has been issued and 1,60,000 has so far been received on
R

account.
It was decided that the profit made on the contract in the year should be arrived at by deducting the
cost of work certified from the total value of the architect’s certificate that 1/3 of the profit so arrived at
should be regarded as a provision against contingencies and that such provision should be increased by
taking to the credit of Profit and Loss Account only such portion of the 2/3 profit as the cash received
bore to the work certified.
Prepare a Contract Account showing profit or loss to be included in respect of this contract in the
financial accounts to 31st March, 2024.
Ans. [Notional Profit R 57,000 ; Profit transferred to Profit and Loss Account R 30,400]
9. Following information relates to a building contract for 10,00,000 and for which 80% of the value of
R

work-in-progress as certified by the architect is being paid by the contractee :

2022 2023 2024
R R R

Materials issued 1,20,000 1,45,000 84,000

Direct wages 1,10,000 1,55,000 1,10,000
Site expenses 5,000 17,000 6,000
Indirect expenses 2,000 2,600 500
Work certified 31st December 2,35,000 7,50,000 10,00,000
Work done but not certified 2,800 8,000 Nil
Materials at site 2,000 5,000 8,000
Value of plant issued 14,000 Nil Nil
CONTRACT COSTING B/1·43

The value of the plant at the end of 2022, 2023 and 2024 was 11,200 7,000 and 3,000 respectively.
R R R

Prepare Contract Account for the three years taking into account such profit as you think proper on
incomplete contract.
Ans. [2022—No profit ; 2023— 1,06,347 ; 2024— 1,33,553]
R R

10. M/s Promising Company undertook a contract for erecting sewerage treatment plant for Prosperous
Municipality for a total value of 24 lakhs. It was estimated that the job would be completed by 31st
R

January, 2024.
You are asked to prepare the Contract Account for the year ending 31st January, 2024 from the
following particulars :
(i)
Materials 3,00,000
R

(ii)
Wages 6,00,000
R

(iii)
Overhead charges 1,20,000
R

(iv)Special Plant 2,00,000

R

(v)Work certified was for 16,00,000 and 80% of the same was received in cash.
R

(vi)Material lying at site as on 31-1-2024 40,000.

R

(vii)Depreciate Plant by 10%.

(viii)5% of the value of material issued and 6% of wages may be taken to have been incurred for the
portion of the work completed, but not yet certified. Overheads are charged as a Percentage of
Direct Wages.
(ix) Ignore depreciation of plant for use on uncertified portion of work.
(x) Ascertain the amount to be transferred to Profit and Loss A/c on the basis of realised profit.
Ans. [Notional Profit 6,58,200 ; Profit transferred to P & L A/c 3,51,040 ; Work Uncertified 58,200]
R R R

11. A contractor makes up his accounts on 31st March each year. The contract was commenced on 1st July
2023. The costing records yield the following informations available as on 31st March, 2024 :
Material charged out of site 21,500 ; Labour 50,110 ; Foreman’s Salary 6,310.
R R R

A machine costing 15,000 has been on the site for 73 days. Its working life is estimated five years
R

and its scrap value is 1,000.

R

A Supervisor, who is paid 1,000 per month has spent approx. one half of his time on the contract.
R

All other expenses and administration amounted to 12,610. Material in store at site on 31st March,
R

2024, cost 2,480.

R

The contract price is 2,00,000 and on 31st March, 2024, 2/3rd of the contract was completed,
R

architect’s certificate had been issued covering 50% of the contract price, 80,000 has so far been paid
R

on contract.
Prepare a contract and state how much profit or loss should be included in the financial A/c on 31st
March, 2024.
Ans. [Notional Profit 30,168; Amount transferred to P&L A/c 16,090]
R R

Hint. [Cost of work uncertified 23,278]

R

12. Modern Constructions (Private) Ltd., Civil Engineering Contractors propose to tender for the
construction of a “Community Hall” in a new township and estimate their direct costs as 1,50,000 :
R

R R

Direct Materials 60,000 Cost of transport of men and materials

Direct Labour (21,000 man-days of to work site 17,000
various categories) 63,000 Other Direct Expenses 10,000
Existing commitments of Modern Construction for the year necessitate an overhead expense of 8,50,500
against execution of works, the direct labour costs of which amount to 5,67,000.
R
B/1·44 CONTRACT COSTING

Assuming that whole of the overhead expense is variable (for the sake of simplicity and tendering),
calculate the estimated value of tendering duly providing for (a) necessary overheads, (b) interest at 5%
on the average of capital outlay, and (c) 10% margin.
Ans. [Price to be quoted R 2,75,674]
13. Modern Contractors have undertaken the following two contracts on 1st January, 2023 :
Contract A Contract B
Materials sent to sites 85,349 73,267
Labour engaged on sites 74,375 68,523
Plant installed at site at cost 15,000 12,500
Direct expenditure 3,167 2,859
Establishment charges 4,126 3,852
Materials returned to store 549 632
Work certified 1,95,000 1,45,000
Cost of work not certified 4,500 3,000
Materials in hand 31st Dec., 2023 1,883 1,736
Wages accrued 31st Dec., 2023 2,400 2,100
Direct expenditure accrued 31st Dec., 2023 240 180
Value on plant 31st Dec., 2023 11,000 9,500
The contract prices have been agreed at 2,50,000 for contract A and 2,00,000 for contract B. Cash has
R R

been received from the contractees as follows : Contract A 1,80,000 and Contract B 1,40,000.
R R

Prepare Contract Accounts, Contractees Account and show how the work-in-progress shall appear in
the Balance Sheet of the contractor.
Ans. [Contract (A) : Amount transfer to P & L A/c R 17,400; Payment from Contractee R 1,80,000; (From
Contractee’s Balance)
Contract (B) : Amount transfer to P & L A/c R 3,413 (loss); Payment from Contractee R 1,40,000
(Contractee’s Balance)
Balance Sheet : Assets Total R 40,744; Liability Total : R 18,907]
14. Following is a summary of the expenditure on Job No. 31 to December 31, 2023 :
R R

Direct Wages 6,900 Stores returned 550

Direct Materials 34,000 Sub-contract Costs 6,300
Stores issued 3,800 Plant 12,000
You obtain the following information :
(1) The job was begun during 2023 and the total contract price is R 60,000.
(2) The architects had certified that four-fifths of the contract had been completed at December 15th.
(3) Depreciation of Plant up to December 15th is R 4,800.
(4) The summary set out above includes items relating to the period since December 15th as follows :
Wages R 700 ; Materials used R 1,620.
(5) Materials at site on December 31st had cost R 5,000 and stores at site had cost R 400.
(6) Establishment charges are 40% on direct wages.
(7) A fine of R 1,000 is likely to be imposed for late completion.
CONTRACT COSTING B/1·45

You are required in respect of Job No. 31 : (a) to prepare a Job Cost Ledger Account ; (b) to show what
profit or loss has arisen on the work certified ; and (c) to suggest what figures should be taken to the
Profit and Loss Account for the year to December 31, 2023.
Ans. [Loss R 2,010]
15. The Hindustan Construction Company Ltd. has undertaken the construction of a bridge over the river
Yamuna for Municipal Corporation. The value of the contract is 12,50,000 subject to a retention of
R

20% until one year after the certified completion of the contract and final approval of the corporation
engineer. Following are the details as shown in the books on 30th June, 2023 :
R R

Labour at site 4,05,000 Materials in hand on June 30, 2023 6,300

Materials direct to site less returns 4,20,000 Wages accrued on June 30, 2023 7,800
Materials from store 81,200 Direct expenses accrued
Hire and use of plant— on June 30, 2023 1,600
plant upkeep account 12,100 Work not yet certified at cost 16,500
Site Expenses 23,000 Work certified by the
General overhead allocated Corporation Engineer 11,00,000
to the contract 37,100 Cash received on account 8,80,000
Prepare (a) Contract Account, (b) Contractee’s Account, and (c) how it would appear in the Balance
Sheet.
Ans. [Notional Profit 1,35,000 ; Profit transferred to Profit & Loss A/c 72,000, WIP 10,53,500]
R R R

16. A firm of building contractors began to trade on 1-1-2023. Following was the expenditure on a contract
for 6,00,000 :
R

R R

Materials issued from stores 1,50,000 Site expenses paid 22,000

Material purchased for the contract 40,000 Establishment expenses 10,000
Plant installed at cost 70,000 Direct expenses accrued
due on 31-12-2023 3,000
Wages paid 2,40,000 Wages accrued due on 31-12-2023 4,000
Out of the plant and materials charged to the contract, plant which cost 5,000 and materials costing
R

R 4,000 were lost. Some part of the materials costing 2,500 were sold at a profit of 500. On 31st
R R

December, 2023 plant which cost 2,000 was returned to stores and plant which cost 3,000 was
R R

transferred to some other contract.

The work certified was 4,80,000 and 80% of the same was received in cash. The cost of work done but
R

uncertified was 3,000. Charge depreciation on plant at 10% p.a. You are required to prepare the
R

contract account for the year ended 31st December, 2023, by transferring to the profit and loss account
the portion of profit, if any, which you consider reasonable.
Also prepare Contractee’s Account, Work-in-Progress Account and Balance Sheet in the books of the
contractor.
Ans. [Notional Profit R 14,000 ; Profit transferred to P & L A/c R 7,467 ; WIP R 4,76,467]
17. Following is the Trial Balance of Premier Construction Company engaged on the execution of Contract
No. 747 for the year ended 31st December 2023 :
R R

Contractee’s Account (amount received against 75% cash certified) 3,00,000

Buildings 1,60,000
Creditors 72,000
B/1·46 CONTRACT COSTING

Bank Balance 35,000

Capital Account 5,00,000
Materials 2,00,000
Wages 1,80,000
Expenses 47,000
Plant 2,50,000
————————————— —————————————

8,72,000 8,72,000
—————————————
————————————— —————————————
—————————————

The work on Contract No. 747 was commenced on 1st January 2023. Materials costing 1,70,000 were R

sent to the site of the contract but those of 6,000 were destroyed in an accident. Wages of 1,80,000
R R

were paid during the year. Plant costing 50,000 was used on the contract all through the year. Plant
R

with a cost of 2 lakhs was used from 1st January, to 30th September and was then returned to the
R

stores. Materials of cost of 4,000 were at site on 31st December, 2023.

R

The contract was for 6,00,000 and the contractee pays 75% of the work certified. Work certified was
R

80% of the total contract work at the end of 2023. Uncertified work was estimated at 15,000 on 31st R

December 2023.
Expenses are charged to the contract at 25% of wages. Plant is to be depreciated at 10% for the entire
year.
Prepare Contract No. 747 Account for the year 2023 and make out the Balance Sheet as on 31st
December, 2023 in the books of Premier Construction Company.
Ans. [Notional Profit R 90,000 ; Profit taken to P & L Account R 37,500 ; Work-in-Progress R 4,42,500; B/S
Total 5,96,500]
R

18. Prepare Contract Account and Contractee’s Account assuming that the amount due from the contractee
was duly received.
R R

Direct Material 20,250 Tractor expenses :

Direct Wages 15,500 Fuel, oil, etc. 2,300
Stores Issued 10,500 Wages of Drivers 3,000
Loose Tools 2,400 Other Direct Charges 2,650
The contract price was 90,000 and the contract took 13 weeks in its completion. The value of Loose
R

Tools and Stores returned at the end of the period were 200 and 3,000 respectively. The plant was
R R

also returned at a value of 16,000 after charging depreciation at 20%. The value of tractor was 20,000
R R

and the depreciation was to be charged to the contract @ 15% per annum. The administrative and office
expenses are to be provided at 10% on works cost.
Ans. [Profit R 26,035]
Hint : Works Cost R 58,150.
19. A contractor undertook a contract for 50,000 on 1st January, 2023 to be completed over a period of two
R

years. His accounting year ends on 31st Dec. State with reasons at what value the work-in-progress on
1st January, 2024 will appear in the contract account in each of the following cases :
(a) Work-in-progress on 1st January, 2024 R 14,000 (including R 800 estimated profit which was taken
to profit and loss account in 2023).
(b) Work-in-progress 14,000 on 1st January, 2024 (including
R R 800 estimated profit which was not
taken to P & L Account in 2023).
(c) Work-in-progress on 1st January, 2024 R 14,000 (excluding R 800 estimated profit which was not
taken to P and L Account in 2023).
CONTRACT COSTING B/1·47

(d) Work-in-progress on 1st January, 2024 R 14,000 (excluding R 800 estimated profit which was taken
to profit and loss account in 2023).
Ans. [(a) R 14,000 (b) R 13,200 (c) R 14,000 (d) R 14,800]
20. Following figures are extracted from the books of Ram Dass, a contractor, for the year ending 31st Dec.,
2023 :
R R R

Work-in-Progress on Materials returned to store 11,000

31st Dec., 2022 17,00,000 Contracts finished 4,50,000
Less : Advances from Work certified 3,00,000
contractees 11,00,000 Profit taken upon contract 2,30,000
——————————————
6,00,000 Administrative expenses (of which
Materials supplied to contracts, R 5,000 is chargeable to
direct 1,20,000 P & L A/c) 25,000
Materials issued from store 2,10,000 Plant issued 50,000
Wages 1,70,000 Materials returned from contracts
Working expenses 30,000 direct to suppliers
9,000
Advances from contractees 8,00,000
Prepare Contract Ledger Control A/c as in General Ledger and Total Contractee’s A/c. Show also how
the work-in-progress would appear in the Balance Sheet as on 31st December, 2023.
Ans. [Work Uncertified 17,60,000 ; Work-in-Progress 6,10,000]
R R

21. Following particulars relate to two houses which a firm of builders had in course of construction under
contract :
House A House B
R R

Work-in-progress on 1st Jan., 2023 excluding

800 estimated profit which was taken
R

to profit and loss account in 2022 14,000

Material purchased 23,000 16,600
Wages 20,000 14,000
Electrical services and fittings 1,400 300
Road making charges 8,000
Contract price (including road making) 60,000 40,000
Cash received to 31st Dec., 2023 60,000 24,000
2
Percentage of cash received to work certified 100% 66 %
3
Value of materials in hand on 31st Dec., 2023 400 540
Completed work not certified 2,500
Value of plant used on sites 12,000 6,000
Period of plant remained on sites during the year 10 months 8 months
The total establishment expenses incurred during the year 2023 amounted to 12,240. These are to be R

charged to the two contracts in proportion to wages. Depreciation of plant is to be taken into account at
the rate of 10% per annum.
Prepare two contracts accounts (in columnar form) showing the profit or loss on each house for the
year 2023 and the sums which you consider appropriately transferable to the profit and loss account.
Ans. [House A : Loss R 15,000 ; House B : Notional Profit R 2,700 ; Profit transferred to Profit & Loss A/c
R 1,200]
B/1·48 CONTRACT COSTING

22. Three contracts commenced on 1st January, 1st July and 1st October, 2023, respectively were
undertaken by a contractor and their accounts on 31st December, 2023 showed the following position :
Contract 1 Contract 2 Contract 3
R R R

Contract Price 4,00,000 2,70,000 3,00,000

Expenditure :
Materials 72,000 58,000 20,000
Wages paid 1,10,000 1,12,400 14,000
General charges 4,000 2,800 1,000
Plant installed 20,000 16,000 12,000
Materials in hand 4,000 4,000 2,000
Wages accrued 4,000 4,000 1,800
Work certified 2,00,000 1,60,000 36,000
Cash received in respect thereof 1,50,000 1,20,000 27,000
Work finished but not certified 6,000 8,000 2,100
The plant was installed on the date of commencement of each contract ; depreciation thereon is to be
taken at 10% per annum.
Prepare Contract Account in tabular form and show how they would appear in the Balance Sheet as on
31st December, 2023.
Ans. [Contract 1—Total Profit 18,000, Profit taken to P/L A/c 9,000, Work-in-progress 1,97,000 ;
R R R

Contract 2—Loss 6,000, Work-in-Progress 1,68,000 ; Contract 3—No profit or loss, Work-in-
R R

Progress 35,100]
R

23. Following particulars are drawn from the costing books of a contract for the month of December, 2023:
R R

(a) Stores Abstract : R R (b) Wages Abstract :

Balance on 30th November, 2023 42,292 Job No. 101 460
Purchases 8,720 Job No. 102 5,752
—————————
Job No. 101 684 6,212
—————————
51,696 Establishment 512
——————————

To Job No. 102 4,224 6,724

—————————— ——————————

Balance on 31st December, 2023 47,472

——————————

On 30th November, 2023, Job Nos. 101 and 102 showed balances of 2,57,264 and 1,13,492, R R

respectively.
A certificate of completion was obtained for Job No. 101 ; of the balance on this account standing on
30th November, 2023, 49,200 was in respect of Plant and Machinery and the remainder considered of
R

wages and materials. A machine costing 4,400 specially bought for this contract was sold for 1,600
R R

during December, 2023. Of the remainder of the balance of Plant and Machinery 32,000 worth had R

been utilised on the job for 8 months and the rest for 6 months. Of the former, half was transferred to
Job No. 102 and the whole of the remaining plant was returned to stores. The contract price for Job No.
101 was fixed at 3,00,000.
R

Prepare contract accounts and work out the profit made on the job certified as completed, allowing
depreciation on Machinery at 15% per annum. Assume 10% for establishment charges on cost of wages
and materials consumed.
Ans. [Profit on Job No. 101 R 64,416 ; Job No. 102 Balance c/d R 1,37,868]
CONTRACT COSTING B/1·49

24. Shiwalik Construction Limited took a contract in 2023 for road construction. The contract price was
5,00,000 and its estimated cost of completion would be 4,60,000. At the end of 2023, the Company
R R

has received 1,80,000 representing 90 per cent of work certified. Work not yet certified had cost
R

5,000.
R

Expenditures incurred on the contract during 2023 were as follows :

Materials R 25,000 ; Labour R 1,50,000 ; Plant R 10,000 .
Materials costing 2,500 were damaged and had to be disposed of for
R R 500. Plant is considered as
having depreciated by 25 per cent.
Prepare Contract Account for 2023 in the books of Shiwalik Construction Limited. Also show all
possible figures that can be reasonably credited to Profit and Loss Account in respect of the contract.
Ans. [Profit R 9,000 ; Other figures of Profit can be R 16,000 and R 14,400]
25. Alcon Construction Company Ltd. commenced its business of construction on 1-4-2023. The trial
balance as on 31-3-2024 showed the following balances :
Dr. ( ) Cr. ( ) R R

Paid up Share Capital 1,00,000

Cash received on account of contract 80% of work certified 1,20,000
Land and Buildings 30,000
Machinery at cost (75% at site) 40,000
Lorries and Vehicles 30,000
Furniture 1,000
Office Equipment 10,000
Bank 4,000
Items relating to Contract :
Materials at site 40,000
Direct Labour 55,000
Expenses at site 2,000
Postage and Telegrams 500
Office Expenses 2,000
Rates and Taxes 3,000
Fuel and Power 2,500
————————————— —————————————

2,20,000 2,20,000
————————————— —————————————

The contract price is 3,00,000 and work certified is 1,50,000. The work completed since certified is
R R

estimated at 1,000 (at cost). Machinery costing 2,000 was returned to stores at the end of the year.
R R

Stock of material at site on 31-3-2024 was of the value of 5,000. Wages outstanding were 200.
R R

Depreciation at 10% only on machinery used for the contract.

You are required to calculate the profit from the contract and show how the work-in-progress will
appear in the Balance Sheet as on 31-3-2024.
Ans. [Notional Profit 47,800 ; Profit transferred to Profit & Loss A/c 25,493 ; B/S Total 1,25,693]
R R R

26. A contractor, who prepares his account on 31st December each year, commenced a contract on 1st April,
2023. The costing records concerning the said contract reveal the following information on 31st
December, 2023 :
Materials charged to site 2,58,100 ; Labour engaged 5,60,500 ; Foremen’s salary 79,300.
Plants costing 2,60,000 had been on site for 146 days. Their working life is estimated at 7 years and
R

their final scrap value at 15,000. A supervisor, who is paid 4,000 p.m., has devoted approximately
R R
B/1·50 CONTRACT COSTING

three-fourths of his time to this contract. The administrative and other expenses amount to 1,40,000. R

Materials in hand at site on 31st December, 2023 cost 25,400. Some of the material costing 4,500 was
R R

found unsuitable and was sold for 4,000 and a part of the plant costing 5,500 (on 31-12-2023)
R R

unsuited to the contract was sold at a profit of 1,000. R

The contract price was 22,00,000 but it was accepted by the contractor, for 20,00,000. On 31st
R R

December, 2023, two-thirds of the contract price agreed to be paid was completed. Architect’s certificate
had been issued covering 50% of the cost of contract and 7,50,000 has so far been paid on account.
R

Prepare contract account and state how much profit or loss should be included in the financial accounts
to 31st December, 2023. Workings should be clearly given. Depreciation is charged on time basis.
Also prepare the Contractee’s account and show how these accounts would appear in the Balance Sheet
as on 31st December, 2023.
Ans. [Notional Profit 2,13,250 ; Profit transferred to P/L A/c 1,06,625 ; WIP 11,55,625 ; Cost of
R R R

Uncertified Work 2,62,250 (i.e., cost of work done 10,49,000 — 7,86,750 i.e., 50% of cost of
R R R

contract)]
27. Compute a conservative estimate of profit on a contract (which has been 80% complete) from the
following particulars. Illustrate all methods of computing the profit.
R R

Total expenditure to date 85,000 Contract price 1,53,000

Estimated further expenditure to Works certified 1,00,000
complete the contract Work not certified 8,500
(including contingencies) 17,000 Cash received 81,600

Ans. [ 33,333 ;
R R 27,200 ; R 42,500 ; R 34,680 ; R 15359; R 12,784]
28. A contractor commenced a building contract on October 1, 2022. The contract price is 4,40,000. R

Following data pertaining to the contract for the year 2023-24 has been compiled from his books and is
as under :

April 1, 2023 R 2023-24 R

Work-in-progress not certified 55,000 Expenses incurred :

Materials at site 2,000 Materials issued 1,12,000
March 31, 2024 Wages paid 1,08,000
Materials at site 4,000 Hire of plant 20,000
Work-in-progress : Not certified 8,000 Other expenses 34,000
Work-in-progress : Certified 4,05,000
The cash received represents 80% of work certified. It has been estimated that further costs to complete
the contract will be 23,000 including the materials at site as on March 31, 2024.
R

Required :
Determine the profit on the contract for the year 2023-24 on prudent basis, which has to be credited to
P/L A/c.
Ans. [Notional Profit R 86,000; Estimated profit R 90,000 ; Profit transferred to Profit & Loss A/c R 66,273]
29. M/s New Century Builders have entered into a contract to build an office building complex for 480 R

lakhs. The work started in April, 2023 and it is estimated that the contract will take 15 months to be
completed. Work has progressed as per schedule and the actual costs charged till March 31, 2024 are as
follows :
CONTRACT COSTING B/1·51

R (in lakhs) Following information is available : R (in lakhs)

Materials 112.20 Materials in hand (March 31, 2024) 6·60
Labour 162.00 Work certified (of which 324 lakhs
R

Hire charges for equipments have been paid) at March 31, 2024 400.00
and other expenses 36.00 Work not yet certified at March 31, 2024,
Establishment charges 32.40 at cost 7.50
——————————

342.60
——————————
——————————

As per management estimates, the following further expenditure will be incurred to complete the
work :
R (in lakhs) R (in lakhs)
Materials 10.50 Equipments hire and other charges 3.00
Labour 16.00 Establishment charges 6.90
Sub-contractors 20.00
You are required to compute the value of work-in-progress as on March 31, 2024 after considering a
reasonable margin of profit and show the appropriate accounts. Make a provision for contingencies
amounting to 5% of total costs.
Ans. [Notional Profit 71·50 lakhs Estimated
R ; Profit 60 lakhs, Profit transferred to Profit & Loss A/c
R

R 50 lakhs ; Profit on Work Certified 53.81579 lakhs, Value of Work in Progress to be shown in the
R

Balance Sheet 65.81579 (i.e., 389.81579 lakhs— 324 lakhs advance]

R R R

30. Modern Construction Ltd., commenced a contract on 1st Jan., 2022. The total contract was for
10,00,000 (estimated by the contractor) and was accepted by Modern Construction Ltd., at 10% less. It
R

was decided to estimate the total profit and to take to the credit of P & L A/c the proportion of
estimated profit on cash basis which the work completed bore to the total contract. Actual expenditure
in 2022 and estimated expenditure in 2023 are given below :

2022 2023
(Actual) (Estimated)
R R

Materials 1,50,000 2,60,000

Labour : Paid 1,00,000 1,20,000
Accrued 10,000 —
Plant purchased 80,000 —
Expenses 40,000 71,000
Plant returned to store on 31st Dec. (cost) 20,000 50,000
(on 30-9-2023)
Materials at site 10,000 —
Work certified 4,00,000 Full
Work uncertified 15,000 —
Cash received 3,00,000 Full
The plant is subject to annual depreciation @ 20% of cost. The contract is likely to be completed on 30th
Sept., 2023. Prepare the Contract Account assuming that the plant costing 10,000 would be exhausted
R

on the contract site during the course of second year and would be a normal loss.
Ans. [Notional Profit R 1,09,000 ; Estimated Profit R 1,27,500 ; Profit transferred to Profit & Loss A/c
R 42,500]
B/1·52 CONTRACT COSTING

31. AB contractors obtained a contract to build houses, the contract price being 4,00,000. Work R

commenced on 1st January, 2022 and the expenditure incurred during the year was—Plant and tools :
20,000 ; Stores and materials : 72,000; Wages : 65,000 ; Sundry expenses : 5,300 ; and
R R R R

Establishment charges : 11,700. R

Certain materials costing 12,000 were unsuited to the contract and were sold for
R R 14,500. A portion
of the plant was scrapped and sold for 2,300. R

The value of the plant and tools on sites on 31st December, 2022 was 6,200 and the value of stores and
R

materials on hand 3,400. Cash received on account was 1,40,000 representing 80% of the work
R R

certified. The cost of the work done but not certified was 21,900, and this was certified later for
R

R 25,000.
AB decided (i) to estimate what further expenditure would be incurred in completing the contract ; (ii)
to compute from this estimate and the expenditure already incurred, the total profit that would be
made on the contract ; and (iii) to take to the credit of profit and loss account for the year 2022 that
proportion of the total profit which correspond to the work certified by 31st December bore to the total
contract price. The estimate was as follows :
(a) That the contract would be completed by 30th September, 2023.
(b) That the wages on the contract in 2023 would amount to R 71,500.
(c) That the cost of stores and materials required in addition to those in stock on 31st December, 2022
would be 68,600 and that further expenses relating to contract would amount to 6,000.
R R

(d) That a further 25,000 would have to be laid out on plant and tools and that residual value of the
R

plant and tools on 30th September, 2023 would be 3,000. R

(e) That the establishment charges would cost the same per month as in 2022.
1
(f) That 2 2% of the total cost (excluding this %) of the contract would be due to defects, temporary
maintenance and contingencies.
Prepare contract account for the year ended 31st December, 2022 and show your calculation of the
amount credited to the profit and loss account for the year.
Ans. [Notional Profit R 46,800 ; Estimated Profit R 55,011 ; Profit transferred to Profit & Loss A/c R 24,067]

PROBLEMS BASED ON MODERN APPROACH

32. Kapur Engineering Company undertakes long-term contract which involves the fabrication of
prestressed concrete blocs and the erection of the same on consumer’s site.
Following information is supplied regarding the contract which is incomplete on 31st March, 2024:
Cost incurred : R

Fabrication cost to date : Cash received on account 6,00,000

Direct Materials 2,80,000 Technical estimate of work completed to date :
Direct Labour 90,000 Fabrication :
Overheads 75,000 Direct Materials 80%
Erection cost to date 15,000 Direct Labour and Overheads 75%
Contract price 8,19,000 Erection 25%
You are required to prepare a statement for submission to the management indicating :
(a) the estimated profit on the completion of the contract.
(b) the estimated profit to date on the contract.
Ans. [(a) R 1,89,000 ; (b) R 1,38,000 or 1,38,462]
CONTRACT COSTING B/1·53

33. Paramount Engineers are engaged in construction and erection of a bridge under a long-term contract.
The cost incurred upto 31-3-2024 was as under :
Fabrication in Lakhs
R in Lakhs R

Direct Materials 280 Overheads 60

Direct Labour 100 Erection costs to date 110
The contract price is 11 crores and the cash received on account till 31-3-2024 was 6 crores.
R R

A technical estimated of the contract indicates the following degree of completion of work :
Fabrication—Direct Material—70%, Direct Labour and Overheads 60%, Erection—40%.
You are required to estimate the profit that could be taken to Profit and Loss Account against this partly
completed contract as at 31-3-2024.
Ans. [Estimated profit 158.33 lakhs; Profit transferred to Profit & Loss A/c 92.476 lakhs or 86.36
R R R

lakhs]
34. Following information is supplied regarding a contract in progress :
R State of Completion
%
Erection cost to date 7,500 25
Fabrication cost to date :
Material 60,000 60
Wages and other expenses 47,500 50
—————————————

1,15,000
—————————————

Contract value 2,00,000

Calculate (i) the estimated profit or loss at the completion of the contract, and (ii) the estimated
profit or loss to date.
Ans. [(i) Estimated Loss 25,000 ; (ii) Loss 12,778]
R

35. A construction company undertaking a number of contracts, furnished the following data relating to its
uncompleted contracts as on 31st March, 2024 :
( in lacs)
R

Contract Numbers
————————————————————————————————————————————————————————————

723 726 729 731

————————————————————————————————————————————————————————————

Total Contract Price 23.20 14.40 10.08 28.80

Estimated Cost on completion of contract 20.50 11.52 12.60 21.60
Expenses for the year ended 31-3-2024 :
Direct Materials 5.22 1.80 1.98 0.80
Direct wages 2.32 4.32 3.90 2.16
Overheads (Excluding Depreciation) 1.06 2.60 2.62 1.05
Profit Reserve as on 1-4-2023 1.50 — — —
Plant issued at Cost 5.00 3.50 2.75 3.00
Materials at Site on 1-4-2023 0.75 — — —
Materials at Site on 31-3-2024 0.45 0.20 0.08 0.05
Work Certified till 31-3-2023 4.65 — — —
Work Certified during the year 2023-24 12.76 13.26 7.56 4.32
Work Uncertified as on 31-3-2024 0.84 0.24 0.14 0.18
Progress payments received during the year 9·57 9.00 5.75 3.60
B/1·54 CONTRACT COSTING

Depreciation @ 20% per annum is to be charged on plant issued. While the Contract No. 723 was carried
over from last year, the remaining contracts were started in the 1st week of April, 2023. Required :
(i) Determine the profit/loss in respect of each contract for the year ended 31st March, 2024.
(ii) State the profit/loss to be carried to Profit & Loss A/c for the year ended 31st March 2024.
723 726 729 731
Ans.
[ (i) Notional Profit (Loss) ( in lakhs)
(ii) Profit to P/L A/c ( in lakhs)
R
R 5.20
2.60
4.28
1.80
(1.27)
(2.52)
(0.06)
(0.06)
]
36. On 1st December, 2023, Vishwakarma Construction Co. Ltd. undertook a contract to construct a
building for 85 lakhs. On 31st March, 2024 the company found that it had already spent 64,99,000 on
R R

the construction. Prudent estimate of additional cost for completion was 32,01,000. What is the
R

additional provision for foreseeable loss, which must be made in the final accounts for the year ended
31st March, 2024 as per provisions of “Accounting for Construction Contracts” ?
Ans. [Additional Provision for foreseeable loss R 3,96,000]

37. An amount of 9,90,000 was incurred on a contract work upto 31-3-2024. Certificates have been
R

received to date to the value of 12,00,000 against which 10,80,000 has been received in cash. The cost
R R

of work done but not certified amounted to 22,500. It is estimated that by spending an additional
R

amount of 60,000 (including provision for contingencies) the work can be completed in all respects in
R

another two months. The agreed contract price of work is 12,50,000. Compute a conservative estimate
R

of the profit to be taken to the Profit and Loss Account as per AS-7.
Ans. [Estimated Profit 1,88,571] R

ADDITIONAL PROBLEMS FOR PRACTICE

38. A construction company undertook a contract at an estimated price of 108 lacs, which includes a
R

budgeted profit of 18 lacs. The relevant data for the year ended 31-3-2024 are as under :
R

( ’000)
R ( ’000)
R

Materials issued to site 5,000 Materials returned from site 100

Direct wages paid 3,800 Direct expenses 500
Plant hired 700 Work certified 10,000
Site office costs 270 Progress payments received 7,200
A special plant was purchased specifically for this contract at 8,00,000 and after use on this contract
R

till the end of 31-3-2024, it was valued at 5,00,000. The cost of materials at site at the end of the year
R

was estimated at 18,00,000. Direct wages accrued as on 31-3-2024 were 1,10,000.

R R

Required :
Prepare the Contract Account for the year ended 31st March, 2024 and compute the profit to be taken to
the Profit and Loss Account.
Ans. [Cost of Contract 87,80,000; Notional Profit
R R 12,20,000 ; Profit transferred to Profit & Loss A/c
12,00,000; Profit in Reserve 20,000]
R

[Hint : Percentage of Contract Completion = 92.59%]

39. Following is the summarised information relating to contract account number 100 :
R R

Contract price 6,00,000 Cash received (80% of certified work) 2,40,000

Wages 1,64,000 Materials at site 10,000
General Expenses 8,600 Plant 20,000
Materials 1,20,000
CONTRACT COSTING B/1·55

Included in the above informations are wages 3,500, materials R R 4,000 and other expenses R 2,500
which were incurred since certification. Depreciate plant at 10%.
Prepare Contract A/c No. 100.
Ans. [Notional Profit R 25,400; Profit transferred to Profit & Loss A/c R 13,547]
40. Compute a conservative estimate of profit on a contract (which has been 90% complete) from the
following particulars. Illustrate 4 methods of computing the profit transferable to Profit & Loss
Account.
R R

Total expenditure to date 4,50,000 Work certified 5,50,800

Estimated further expenditure to complete Work uncertified 34,000
the contract (including contingencies) 25,000 Cash received 4,40,640
Contract price 6,12,000
Ans. [(i) R 1,23,300 ; (ii) R 98,640 ; (iii) R 1,29,789; (iv) R 1,03,832]

41. From the following particulars compute a conservative estimate of profit by 4 methods on a contract
which is 80 per cent complete :
R

Total expenditure to date 8,50,000 Work Certified 10,00,000

Estimate further expenditure Work not certified 85,000
to complete the contract 1,70,000 Cash received 8,16,000
Contract Price 15,30,000
Ans. [On the basis of estimated Profit : 36,800, R R 2,72,000, R 3,33,333, 4,25,000; On the basis of Notional
Profit : 1,27,840, 1,25,333, 1,53,595]
R R R

Note : Least R 1,25,333 should be transferred to Profit & Loss Account.

42. The contract ledger of M/s XYZ showed the following expenditure on account of contract n 31st
December, 2022 :
R R

Materials 2,10,000 Sundry Expenses 15,000

Wages 2,93,000 Establishment Charges 10,000
Plant 70,000
The contract was started on 1st January, 2022 and the contract price was 10,00,000. Cash received on R

account to date was 4,80,000 representing 80% of work certified, remaining 20% being retained until
R

completion. Value of plant on 31st December, 2022 was 20,000 and the value of materials in hand was
R

R 6,000. The cost of work finished but not certified on said date was 50,000. R

Some of the materials costing 20,000 were found unsuitable and were sold for
R R 16,000 and a part of
plant costing 5,000 unsuited for the contract was sold at a profit of 1,000.
R R

The contractor estimated a further expenditure that would be incurred in completing the contract and
took to the credit of P & L A/c for the year 2022 the proportion of estimated net profit on contract which
the value of work certified bears to the contract price. This is to be further reduced by proportion of
cash received that bers to work certified. The estimates of further expenditure were as follows :

(i) That the contract would be completed by 30th June, 2023.

B/1·56 CONTRACT COSTING

(ii) That a further sum of 30,000 would have to be spent on the plant and its residual value on
R

completion of the contract would be 12,000. R

(iii) That materials in addition to those in hand on 31st Dec., 2022 would cost R 1,00,000 and that
further sundry expenses of 7,000 would be incurred.
R

(iv) That the wages for the completion of contract would amount to R 1,69,900.
(v) That the establishment charges would cost the same amount per year as in the previous year.
(vi) That R 18,000 would be sufficient to provide for contingencies.
Prepare Contract Account for the year ended 31st December, 2022 and show the amount to be credited
to P & L A/c for the year. Also show how the relevant figures would appear in the Balance Sheet as on
that date.
Ans. [Notional Profit R 1,03,000; Profit transferred to P/L A/c R 65,460; Estimated Profit R 1,09,100]
43. ABC Ltd. began to trade on 1st January, 2023. During 2023 the company was engaged on only one
contract of which the contract price was 5,00,000. Of the plant and materials charged to the contract,
R

plant which cost 5,000 and materials which cost 4,000 were lost in an accident. On 31st December,
R R

2023 plant which cost 5,000 was returned to the store, the cost of work done but uncertified was
R

2,000 and materials costing 4,000 were in hand on site. Charge 10% depreciation on plant. Compute
R R

Contract A/c and the Balance Sheet from the following :

TRIAL BALANCE
as on 31st December, 2023
R R

Share Capital 1,20,000

Creditors 10,000
Cash recd. (80% of work certified) 2,00,000
Land and Building 43,000
Bank Balance 25,000
Charged to contract :
Materials 90,000
Plant 25,000
Wages 1,40,000
Expenses 7,000
———————————— ————————————

3,30,000 3,30,000
————————————
———————————— ————————————
————————————

Ans. [Notional Profit R 21,000; Profit transferred to P/L A/c R 11,200; B/S Total 1,32,200]
R

44. Prepare Contract Account from the following particulars :

Materials 40,000; Wages 27,000; Plant 18,000; Stores issued 2,000; Loose tools 3,500; Other
R R R R R

indirect expenses 2,700; Running materials of tractor and wages of drivers 6,000.
R R

The contract was completed in 73 days. At the end of this period, plant was returned after charging 15%
depreciation on original cost. The values of loose tools and stores returned were 2,400 and 900 R R

respectively. The value of the tractor was 18,000 and depreciation was to be charged to this contract at
R

the rate of 15% p.a. You are required to provide for administrative expenses at the rate of 10% on total
work cost. The contract price was 1,15,000. R

Ans. [Profit R 25,746; Work Cost R 81,140]

CONTRACT COSTING B/1·57

45. New Construction Ltd. is engaged in a contract during the year. Following information is available at
the year end.
R R

Contract price 6,00,000 Plant installed at cost 80,000

Material delivered direct to site 1,20,000 Value of plant at the end of year 65,000
Material issued from stores 40,000 Accrued wages at the end of year 10,000
Material returned to stores 4,000 Accrued expenses at the end of year 6,000
Materials at site at the end of year 22,000 Cost of contract not certified by
Direct labour payments 1,40,000 architect 23,000
Direct expenses 60,000 Value of contract certified by
Architect’s fees 2,500 architect 4,20,000
Establishment charges 24,500 Cash received from contractor 3,78,000

During the period, materials amounting to R 9,000 have been transferred to another contract to another
place.
You are required to show the Contract Account and Contractee Account.
Ans. [Notional Profit 60,000; Profit transferred to Profit & Loss A/c
R R 36,000]

46. Z Limited obtained a contract No. 999 for 50 lakhs. The following details are available in respect of
R

this contract for the year ended March 31, 2024 :

Materials purchased 1,60,000

Materials issued from stores 5,00,000
Wages and Salaries paid 7,00,000
Drawing and Maps (Expenses for this contract) 60,000
Sundry Expenses 15,000
Electricity charge 25,000
Plant Hire Expenses 60,000
Sub-contract Cost 20,000
Materials Returned to Stores 30,000
Materials returned to Suppliers 20,000

The following balances relating to the contract No. 999 for the year ended on March 31, 2023 and March
31, 2024 are available :
as on 31st march, 2023 as on 31st March, 2024
work certified 12,00,000 35,00,000
Work uncertified 20,000 40,000
Materials at site 15,000 30,000
Wages outstanding 10,000 20,000

The contractor receives 75% of work certified in cash.

Prepare Contract Account and Contractee’s Account.
Ans. [Notional Profit 8,35,000; Profit transferred to Profit & Loss A/c
R R 4,17,500]
B/1·58 CONTRACT COSTING

47. From the following information, prepare contract account in tabular form and show how these figures
appear in the balance sheet as on 31st December, 2023 :
CONTRACT
————————————————————————————————————————————————————————————————————————————————
Particulars A B C
Commencement 1-1-2023 1-7-2023 1-10-2023
R R R

Contract Price 80,000 54,000 60,000

Raw material 14,400 11,600 4,000
Wages 22,000 22,400 2,800
General charges 800 560 200
Plant installed 4,000 3,200 2,400
Materials on hand 800 800 400
Wages accrued 800 800 360
Work certified 40,000 32,000 7,200
Cash received in respect of work certified 30,000 24,000 5,400
Work finished but not certified 1,200 1,600 420
Depreciation is to be charged on the plant @ 10% which was installed on the opening date of the
contract in each case.
Ans. [Notional Profit/Loss—A 3,600 ; B ( 1,120) ; C 600 Amount transferred to Profit & Loss A/c : A –
R R R

R 1,800 ; Work in Progress A— 39,400 ; B — 33,600 ; C — 7,020]

R R R
PROCESS COSTING B/2·1

CHAPTER

2
Process Costing
LEARNING OBJECTIVES
To understand Meaning, Features, Advantage & Disadvantages of Process Costing and
differentiate with Job Costing.
To understand the accounting treatment of normal, abnormal loss and abnormal gain arising in
processes.
To understand the equivalent production method.

Meaning of Process Costing

Process costing is that form of operation costing which is used to ascertain the cost of the
product at each process or stage of manufacture, where processes are carried. According to ICMA,
“It is that form of operation costing where standardised goods are produced to ascertain the cost of
product at each stage of manufacture and where material is passed through various operations to
obtain a final product.

Features of Process Costing

Following are the main features of Process Costing :
(i) Production is done having a continuous flow of identical products except where plant and
machinery is shut down for repairs etc.
(ii) There are clearly defined process cost centres and the accumulation of all costs (material,
labour and overheads) by the cost centre is possible.
(iii) There is maintenance of accurate records of the units and part units produced and cost
incurred by each process.
(iv) The finished product of one process becomes the raw material of the next process or
operation and so on until the final product is obtained.
(v) Avoidable and unavoidable losses usually arise at different stages of manufacture for various
reasons. Treatment of normal and abnormal losses or gains is to be studied in this method of costing.
B/2·2 PROCESS COSTING

(vi) Sometimes goods are transferred from one process to another process not at cost price but at
transfer price just to compare this with the market price and to have a check on the inefficiency and
losses occurring in a particular process.
(vii) In order to obtain accurate average costs, it is necessary to measure the production at
various stages of manufacture as all the input units may not be converted into finished goods ; some
may be in progress. Calculation of effective units is to be learnt in this method of costing.
(viii) Different products with or without by-products are simultaneously produced at one or more
stages or processes of manufacture. The valuation of by-products and apportionment of joint cost
before point of separation is an important aspect of this method of costing.
(ix) Output is uniform and all units are exactly identical during one or more processes. Therefore,
the cost per unit of production can be ascertained only by averaging the expenditure incurred during
a particular period.
(x) It is not possible to trace the identity of any particular lot of output to any lot of input
materials. For example, in the sugar industry, it is not possible to trace any lot of sugar bags to a
particular lot of sugarcane fed or vice versa.

Application of Process Costing

The industries in which process costs may be used are many. In fact a process costing system can
usually be devised in all industries except where job, batch or unit operation costing is necessary. In
particular, the following are examples of industries where process costing is applied.
Chemical works Biscuit works Coke works
Soap making Oil refining Paint, ink and varnishing etc.
Box making Textile, weaving, spinning etc. Meat products factory
Distillation process Food products Milk dairy
Paper mills Canning factory
Distinction Between Job Costing and Process Costing
The main points of difference between job costing and process costing are given as under :
Basis of distinction Job Costing Process Costing
1. Production Production is against specific orders. Production is in continuous flow; the
products being homogeneous.
2. Cost Costs are determined for each job Costs are compiled for each process on
Determination separately. time basis i.e., for production of a given
accounting period.
3. Entity Each job is separate and independent of Products lose their individual entity as
others. they are manufactured in a continuous
flow.
4. Unit Cost Total cost of a job is divided by the number The total cost of each process is divided
of units produced in the job in order to by the total production for the process to
calculate unit cost of a job. calculate the average cost per unit for the
period.
5. Cost Costs are compiled when a job is Costs are calculated at the end of the
Calculation completed. cost period.
PROCESS COSTING B/2·3

6. Transfer There are usually no transfers from one job Transfer of costs from one process to
to another unless there is a surplus work or another is made, as the product moves
excess production. from one process to another.
7. Work-in- There may or may not be work-in-progress There is always some work-in-process at
progress at the beginning or end of the accounting the beginning as well as at the end of the
period. accounting period.
8. Control Proper control is comparatively difficult as Proper control is comparatively easier as
each product unit is different and the the production is standardised and is
production is not continuous. more stable.
9. F o r m s a n d It requires more forms and details regarding It requires few forms and less details but
Details materials and labour due to the need for the a closer analysis of operations is needed.
allocation of labour to so many orders and
material is issued in bulk to departments.
10. Suitability It is suitable where the goods are made to It is suitably employed where goods are
customer’s order, production is intermittent made for stock and production is
and customers’ orders can be identified in continuous or goods although made to
the value of production. customer’s order are, owing to the
continuous nature of the production, lost
sight in the volume of production.
11. Cost Centre The cost centre is a job. The cost centre is a job.
12. Collection and Costs are collected and ascertained for Costs are collected and ascertained for
Ascertainment each job separately. each process separately.
of cost

Advantages of Process Costing

Following are the main advantages of process costing :
1. It is possible to determine process costs periodically at short intervals. Unit cost can be
computed weekly or even daily if overhead rates are used on predetermined basis.
2. It is simple and less expensive to find out the process cost.
3. It is possible to have managerial control by evaluating the performance of each process.
4. It is easy to allocate the expenses to processes in order to have accurate costs.
5. It is easy to quote the prices with standardisation of process. Standard costing can be
established easily in process type of manufacture.

Disadvantages of Process Costing

Following are the main disadvantages of process costing :
1. Costs obtained at the end of the accounting period are only of historical value and are not
very useful for effective control.
2. Work in progress is required to be ascertained at the end of an accounting period for
calculating the cost of continuous process. Valuation of work in progress is generally done on
estimated basis which introduces further inaccuracies in total cost.
3. Where different products arise in the same process and common costs are prorated to various
cost units. Such individual products’ costs may be taken as only approximation and hence
not reliable but may be taken as the best.
B/2·4 PROCESS COSTING

4. There is a wide scope of errors while calculating average costs. An error in one average cost
will be carried through all processes to the valuation of work in process and finished goods.
5. The computation of average cost is more difficult in those cases where more than one type of
products are manufactured and a division of the cost elements is necessary.

Fundamental Principles of Process Costing

Following are the fundamental principles of process costing :
1. Cost of materials, wages and overhead expenses are collected for each process or operation in
a period.
2. Adequate records in respect of output and scrap of each process or operation during the
period are kept.
3. The cost per finished output of each process is obtained by dividing the total cost incurred
during a period by the number of units produced during the period after taking into
consideration the losses and amount realised from sale of scrap.
4. The finished product alongwith its cost is transferred from one process to the next process
just like raw materials of that process.

Elements of Production Cost

Following are the main elements of production cost in process costing.
(i) Materials. Generally in process costing, all the material required for production is issued to
the first process, where after processing it is passed to the next process and so on. Some operation on
the material is performed in each process which has been passed from the first process. In some other
cases, material may pass from the first process to the second process, where extra or new materials
are added, then more material is added in the next processes, this may continue until completion.
Sufficient supplies of raw materials must be available to meet the production needs. Material may be
requisitioned in prescribed way or bulk requisitions may be issued. When bulk requisitions are used,
materials are issued from the stores to the departments in large quantities, where they are held in
departmental stock until such time as they are needed.
(ii) Labour. Generally, the cost of direct labour is very small part of the cost of production in
industries adopting process costing. The direct labour element becomes smaller and smaller while the
overhead element increases with the introduction of more and more automatic machinery. The
recording and allocating of time spent on production is relatively easy as compared with job costing.
Generally employees are engaged continuously on one process and time spent by them is posted to
the debit of the Process Account. But, if employees are engaged on more than one processes, it will be
necessary to record the time spent on each one or an approximate apportionment of the total time will
be allocated to each process concerned.
(iii) Production Overhead. The overhead element of total cost is generally very high in process
industries. Great care is required to ensure that each process is charged with a reasonable share of
production overhead. The actual overheads are debited to each Process Account.
For the purpose of cost accounting, process industries are divided into departments, each
department representing a particular process. A process may consist of a separate operation or series
of operations. A foreman or supervisor is appointed for each department. He is responsible for the
efficient functioning of his department.
PROCESS COSTING B/2·5

Process Accounts
In process costing, a separate account is kept for each process. The account is debited with the
value of materials, labour, direct expenses and overheads relating to the process. The value of by-
products and scrap, if any, is credited to this account. The balance of this account, representing the
cost of partially worked out product, is passed on to the next process and so on until the product is
completed. Thus the finished product of one process becomes the raw material of the next process.
In some industries, depending upon the plant arrangement, the partially worked out product of a
process may be transferred to a Process Stock Account from which it may be issued to the next
process as and when required.
ILLUSTRATION 1. (Simple) A product passes through three processes. During March 2024,
1,000 finished units were produced with the following expenditure :
Process A Process B Process C
R R R

Direct Materials 1,500 2,600 2,000

Direct Wages 5,000 4,000 3,000

Overhead expenses amounted in all to R 6,000. They are to be apportioned on the basis of
direct wages. Main raw materials issued to Process A (besides above) were worth R 6,000. Ignoring
the question of stock, prepare the Process Accounts concerned.
SOLUTION PROCESS A ACCOUNT (1,000 Units)
Cost per Total Cost per Total
unit unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

To Input Material issued 6.00 6,000 By Process B A/c 15.00 15,000

” Direct Materials 1.50 1,500
” Direct Labour 5.00 5,000
” Overhead Expenses 2.50 2,500
———————————————————————————— ——————————————————————————

15.00 15,000
————————————————————————————
15.00 15,000
——————————————————————————
———————————————————————————— ——————————————————————————

PROCESS B ACCOUNT (1,000 Units)

R R R R

To Process A A/c 15.00 15,000 By Process C A/c 23.60 23,600

” Materials 2.60 2,600
To Direct Wages 4.00 4,000
” Overhead Expenses 2.00 2,000
———————————————————————————— ——————————————————————————

23.60 23,600
————————————————————————————
23.60 23,600
——————————————————————————
———————————————————————————— ——————————————————————————

PROCESS C ACCOUNT (1,000 Units)

R R R R

To Process B A/c 23.60 23,600 By Finished Goods

” Materials 2.00 2,000 A/c 30.10 30,100
” Direct Wages 3.00 3,000
” Overhead Expenses 1.50 1,500
———————————————————————————— ——————————————————————————
30.10 30,100
————————————————————————————
30.10 30,100
——————————————————————————
———————————————————————————— ——————————————————————————
B/2·6 PROCESS COSTING

ILLUSTRATION 2. Neo Pharma processes a product through three distinct stages the
product of one process being passed on to the next process and so on to the finished product intact.
Details of the cost incurred in each process are given below :
Process A Process B Process C
R R R

Raw Materials 1,150 1,050 700

Direct Wages 500 600 700
The overhead expenses for the period amounted to R 3,600 and is to be distributed to the
processes on the basis of direct wages.
There were no stocks in any of the processes either at the beginning or at the close of the
period.
Assuming the output was 1,000 kilos show the process cost of A, B and C indicating also the
cost per kilo of each element of cost and the output in each process.
(b) If 10 per cent of the output is lost in storage and giving samples, what should the selling
1
price per unit be to make a gross profit 33 3 % on the selling price.
SOLUTION PROCESS A ACCOUNT (output = 1,000 kg)
Per kg. R Per kg. R

R R

To Raw Materials 1.15 1,150 By Process B A/c 2.65 2,650

” Direct Wages 0.50 500

” Overheads ( 500
1‚800
× R 3‚600 ) 1.00
—————————
2.65
1,000
——————————
2,650
——————————
2.65
———————————
2,650
—————————
————————— ——————————
—————————— ——————————
—————————— ———————————
———————————

PROCESS B ACCOUNT
Per kg. R Per kg. R

R R

To Process A A/c 2.65 2,650 By Process C A/c 5.50 5,500

” Raw Materials 1.05 1,050
” Direct Wages .60 600

” Overheads ( 600
1‚800
× R 3‚600 ) 1.20
—————————
1,200
—————————— —————————— ———————————
5.50 5,500 5.50 5,500
—————————
————————— ——————————
—————————— ——————————
—————————— ———————————
———————————

PROCESS C ACCOUNT
Per kg. R Per kg. R

R R

To Process B A/c 5.50 5,500 By Finished Stock A/c 8.30 8,300

” Raw Materials .70 700
To Direct Wages .70 700

” Overheads ( 700
1‚800
× R 3‚600 ) 1.40
—————————
1,400
—————————— —————————— ———————————

8.30 8,300 8.30 8,300

—————————
————————— ——————————
—————————— ——————————
—————————— ———————————
———————————
PROCESS COSTING B/2·7

(b) If 10% is lost

Total output = 900 kgs. Selling price to earn 3331 % on
Total cost = R 8,300 Selling price (or 12 of cost) = R 9.22 + R 4.61 = R 13.83.
R 8‚300
Cost per kg = = R 9.22
900

Main Aspects of Process Costing

In process costing, the four main aspects which are to be discussed in detail are : (1) Process
losses, (2) Inter process profits, (3) Work-in-progress and effective or equivalent production, (4)
Joint and by-products. First three are discussed in this chapter, the fourth is discussed in the next
chapter.

Process Losses
In many processes, some loss is inevitable. It is essential that accurate records are maintained to
enable control of the items to be affected. The cost department must be kept well informed through
the medium of scrap tickets, material credit notes and loss reports etc. It should be pointed out to the
supervisors and foremen that any loss as scrap should be measured and recorded, otherwise
production costs will increase. Materials which have been processed and are then found to be
defective and scrapped have incurred their share of labour and variable overheads upto the point of
rejection, so obviously the loss to the firm increases with each stage of production. It is desirable that
scrap should be disposed of immediately as it is usually valued higher than the loose scrap and needs
less storage space. The loss may arise on account of (a) evaporation, residuals, ash, swarf, (b)
unavoidable handling, breakage and spoilage losses and (c) withdrawal for testing and inspection. It
may be normal or abnormal.

Normal Process Loss

It is a part of the process loss caused under normal circumstances. It is an inevitable loss which
cannot be avoided and does occur under normal circumstances. It is non-controllable loss and may
occur due to evaporation or pilferage. Thus it is the loss which is unavoidable on account of inherent
nature of production process. Such loss can be estimated in advance on the basis of scientific study of
the manufacturing process and the nature of raw material. It is calculated at a certain percentage of
the input in units introduced in the respective process. Such loss (in case of wastage) is recorded only
in items of quantity and the cost per unit of usable production is increased accordingly. Where scrap
loss possesses some value as a waste product or as raw material for an earlier process, the value
thereof is credited to process account. This reduces the cost of normal output. In this way process loss
is shared by usable units. A separate normal loss account is opened in the cost records. Following
journal entries are passed in respect of normal loss :

Debit Credit
——————————————————————————————————————————————————————————————————————

(i) For scrap value of normal loss Normal Loss A/c Process A/c
(ii) For adjustment of the short fall in the sale of
normal loss Normal Gain A/c Normal Loss A/c
(iii) For realisation of scrap value of normal loss Cash A/c Normal Loss A/c.
B/2·8 PROCESS COSTING

ILLUSTRATION 3. Bengal Chemical Co. Ltd. produced three chemicals during the month of
July, 2024 by three consecutive processes. In each process 2% of the total weight put in is lost and
10% is scrap which from processes (1) and (2) realises R 100 a ton and from process (3) R 20 a ton.
The products of three processes are dealt with as follows :
Process 1 Process 2 Process 3
Passed on to the next process 75% 50% —
Sent to warehouse for sale 25% 50% 100%
Expenses incurred :
Process 1 Process 2 Process 3
————————————————————————————————————————————————————————————————————————————————————————————————————
R Tons R Tons R Tons
Raw materials 1,20,000 1,000 28,000 140 1,07,840 1,348
Manufacturing wages 20,500 — 18,520 — 15,000 —
General expenses 10,300 — 7,240 — 3,100 —
Prepare Process Cost Accounts showing the cost per ton of each product.
SOLUTION
PROCESS 1 ACCOUNT
Tons R Tons R
——————————————————————————— ——————————————————————————

To Raw Materials 1,000 1,20,000 By Loss of Weight

” Mfg. Wages 20,500 (2% of 1,000 tons) 20 —
To General Expenses 10,300 By Sale of Scrap
(10% of 1,000 tons) 100 10,000
” Transfer to Warehouse 220 35,200
” Transfer to Process 2
(cost per ton 160) R 660 1,05,600
——————————————————————————— ——————————————————————————

1,000 1,50,800
———————————————————————————
1,000 1,50,800
——————————————————————————
——————————————————————————— ——————————————————————————

PROCESS 2 ACCOUNT
Tons R Tons R
——————————————————————————— ——————————————————————————

To Transfer from Process 1 660 1,05,600 By Loss of Weight

” Raw Materials 140 28,000 (2% of 800 tons) 16 —
” Mfg. Wages 18,520 ” Sale of Scrap
” General Expenses 7,240 (10% of 800 tons) 80 8,000
” Transfer to Warehouse 352 75,680
” Transfer to Process 3 (cost
per ton 215)
R 352 75,680

———————————————————————————— ——————————————————————————

800 1,59,360 800 1,59,360

————————————————————————————
———————————————————————————— \——————————————————————————
——————————————————————————

PROCESS 3 ACCOUNT
Tons R Tons R
——————————————————————————— ——————————————————————————

To Transfer from Process 2 352 75,680 By Loss of Weight

” Raw Material 1,348 1,07,840 (2% of 1,700 tons) 34 —
PROCESS COSTING B/2·9

To Mfg. Wages 15,000 By Sale of Scrap

” General Expenses 3,100 (10% of 1,700 tons) 170 3,400
” Transfer to Warehouse
(cost per ton 132.50)
R 1,496 1,98,220
———————————————————————————— ————————————————————————

1,700 2,01,620 1,700 2,01,620

————————————————————————————
———————————————————————————— ————————————————————————
————————————————————————

Abnormal Process Loss

Any loss caused by unexpected or abnormal conditions such as plant break down, sub-standard
materials, carelessness, accident etc. or loss in excess of the margin anticipated for normal process loss
should be regarded as abnormal process loss. The cost of an abnormal process loss unit is equal to the
cost of a good unit. The units of abnormal loss are calculated as under :
Abnormal Loss = Actual Loss – Normal Loss or Abnormal Loss = Expected Output (i.e. Input –
Normal Loss) – Actual Output.
The valuation of abnormal process loss should be done with the help of the following formula :
Value of Abnormal Loss
Normal Cost of Normal Output (i.e. Cost of the Process – Scrap Value of Normal Loss)
= × Units of Abnormal Loss
Normal Output (i.e. Input Units – Normal Loss in Units)

All cases of abnormal process loss should be thoroughly investigated and steps taken to prevent
their recurrence in future. Abnormal process loss should not be allowed to affect the normal cost of
production as it is caused by abnormal or unexpected conditions. Such loss representing the cost of
materials, labour and overhead incurred on the wastage should be transferred to an Abnormal Loss
Account. If this abnormal loss has got any scrap value, it should be credited to Abnormal Loss
Account and the balance is ultimately transferred to Costing Profit and Loss Account.
A separate abnormal loss account is opened in the cost records. Following journal entries are
passed in respect of abnormal loss :
Debit Credit

(i) For value of abnormal loss Abnormal Loss A/c Process A/c

(ii) For scrap value realised Cash A/c Abnormal Loss A/c

(iii) For transfer of the balance to Costing Costing Profit and Loss A/c Abnormal Loss A/c
Profit and Loss Account

EXAMPLE 1. In process A 100 units of raw materials were introduced at a cost of R 1,000.
The other expenditure incurred by the process was R 602. Of the units introduced 10% are
normally lost in the course of manufacture and they possess a scrap value of R 3 each. The output
of Process A was only 75 units. Prepare Process A Account and Abnormal Loss Account.

SOLUTION
PROCESS A ACCOUNT
Units R Units R
———————————————————————— ————————————————————————

To Raw Material 100 1,000 By Normal Loss

” Other Expenses 602 10% of 100 units @ R 3 each 10 30
B/2·10 PROCESS COSTING

By Abnormal Loss 15 *262

” Process B (output) 75 1,310
—————————— —————————— —————————— ———————————

100 1,602 100 1,602

—————————— ——————————
—————————— —————————— ——————————
—————————— ———————————
———————————

*Units entered 100

Less : Normal Loss 10
—————————

Normal Output 90 units

Actual Output 75 ”
—————————

Units of Abnormal Loss 15 units

—————————

Value of Abnormal Loss

Normal Cost of Normal Output 1‚572 R
= × Units of Abnormal Loss = × 15 = 262. R
Normal Output 90
ABNORMAL LOSS ACCOUNT
Units R Units R
——————————————————————— ——————————————————————

To Process A 15 262 By Cash (scrap value

of loss @ 3)R 15 45
” Costing Profit and Loss A/c 217
—————————— —————————— —————————— ———————————

15 262 15 262
——————————
—————————— ——————————
—————————— ——————————
—————————— ———————————
———————————

ILLUSTRATION 4. Following data are available pertaining to a product after passing

through two processes A and B :
Output transferred to process C from process B 9,120 units for R 49,263.
Expenses incurred in Process C :
Sundry materials R 1,480 ; Direct labour R 6,500 ; Direct expenses R 1,605.
The wastage of process C is sold at R 1.00 per unit. The overhead charges were 168% of direct
labour. The final product was sold at R 10.00 per unit fetching a profit of 20% on sales.
Find the percentage of wastage in process C and prepare Process C Account.
SOLUTION
PROCESS C ACCOUNT
Units R Units R

To Process B A/c 9,120 49,263 By Normal Loss A/c 456 456

To Sundry Materials 1,480 By Finished Goods A/c
To Direct Labour 6,500 (See note) 8,664 69,312
To Direct Expenses 1,605
To Overhead Charges
(168% Labour) 10,920
——————————- ———————————— —————————— ————————————

9,120 69,768 9,120 69,768

——————————-
——————————- ————————————
———————————— ——————————
—————————— ————————————
————————————

456 Units
Percentage of Normal Loss in Process C = × 100 = 5%
9‚120 Units
Suppose units of normal loss =x
No. of units of finished product = 9,120 – x
PROCESS COSTING B/2·11

Value of normal loss @ 1 per unit

R =x
Cost of finished goods per unit = 10 – 20% of 10 = 8.
R R R

Cost of finished goods = (9,120 – x) × 8 R

Thus x + ( 72,960 – 8x )
R R R = 69,768
R

or 72,960 – 7x
R R = 69,768
R

R 7x = 72,960 – 69,768 = 3,192

R R R

or x = 456 Units.
∴ Normal loss units = 456 units
Finished goods units = 9,120 – 456 = 8,664 Units
Cost of finished units = 8,664 × 8 = 69,312
R R

Abnormal Gain (or Effectives)

We know that margin allowed for normal loss is an estimate (i.e. on the basis of expectation in
process industries in normal conditions) and slight differences are bound to occur between the actual
output of a process and that anticipated. These differences will not always represent increased loss,
on occasions the actual loss will be less than that expected. Thus, when actual loss in a process is
smaller than was expected, an abnormal gain results. The value of the gain will be calculated in
similar manner to an abnormal loss, then posted to an Abnormal Gain Account.
Abnormal gain being the result of actual loss being less than the normal, the scrap realisation
shown against normal loss gets reduced by the scrap value of abnormal gain. Consequently, there is
an apparent loss by way of reduction in the scrap realisation attributable to abnormal gain. This loss
is set off against abnormal gain by debiting this account. The balance of this account becomes
abnormal gain and is transferred to Costing Profit & Loss Account.
Accounting Entries
Debit Credit
(i) For value of abnormal gain Process A/c Abnormal Gain A/c
(ii) For adjustment of the scrap value of Abnormal Gain A/c Normal Loss A/c
abnormal gain
(iii) For transfer of balance to Costing Profit Abnormal Gain A/c Costing Profit and Loss
and Loss Account A/c
EXAMPLE 2. In process B, 75 units of a commodity were transferred from process A at a cost
of R 1,310. The additional expenses incurred by the process were R 190. 20% of the units entered are
normally lost and sold @ R 4 per unit. The output of the Process was 70 units. Prepare Process B
Account and Abnormal Gain Account.
SOLUTION PROCESS B ACCOUNT
Units R Units R
——————————————————————— ———————————————————————

To Process A A/c 75 1,310 By Normal Loss A/c (20% i.e.,

” Additional Expenses 190 15 units sold @ 4/-)
R 15 60
” Abnormal Gain A/c 10 *240 By Process C A/c (Output) 70 1,680
—————————— —————————— —————————— ———————————

85 1,740 85 1,740
—————————— ——————————
—————————— —————————— ——————————
—————————— ———————————
———————————

*Normal Output. Units entered – Normal Loss

= (75 – 15) = 60 units
Actual Output = ———————————
70 units
Abnormal Gain 10 units
B/2·12 PROCESS COSTING

Value of Abnormal Gain

Normal Cost of Normal Output R 1‚440
= × Units of Abnormal Gain = × 10 = 240
R
Normal Output 60
ABNORMAL GAIN ACCOUNT
Units R Units R
———————————————————————— ————————————————————————

To Normal Loss A/c (Loss of income) 10 40 By Process B A/c 10 240

To Costing Profit and Loss A/c — 200
—————————— —————————— —————————— ———————————

10
——————————
240
——————————
10
——————————
240
———————————
—————————— —————————— —————————— ———————————

EXAMPLE 3. In a production process, normal loss is 10% of input and abnormal gain
amounted to 600 units. If final output of the process is 16,800 units, find out the quantity of actual
loss, if any.
SOLUTION
Let Input be X
Output = Input – Normal Loss + Abnormal Gain
Output – Abnormal Gain = Input – Normal Loss; or, 16,800 – 600 = 90% of Input
Input = 16200/0.9 = 18,000; Actual Loss = Input – Output = 18,000 – 16,800 = 1,200 units.
[Or Normal Loss = 1,800; Actual Loss = Normal Loss – Abnormal Gain = 1,800 – 600 = 1,200]
ILLUSTRATION 5. The product of a manufacturing company passes through two processes
X and Y and then to finished stock account. It is ascertained that in each process normally 5% of
the weight of the output is lost and 10% is scrap, which from Process X realises R 80 per tonne and
from Process Y R 200 per tonne. The following data is available relating to both the processes for
the month of December 2023 :
Process X Process Y
Materials in tonnes 1,000 70
Cost of materials per tonne ( )
R 125 200
Wages (R) 30,000 10,250
Manufacturing expenses (R) 6,000 5,000
Output in tonnes 830 780
There was no stock or work in progress in any process.
Prepare :
(i) Process accounts showing cost per tonne of each process.
(ii) Abnormal Loss/Gain Account.
SOLUTION
(i) Dr. PROCESS X ACCOUNT Cr.
Particulars Tonnes ( )
R Particulars Tonnes ( )
R

To Materials @ 125 R 1,000 1,25,000 By Normal Loss (5% of 830) 41.5 —

To Wages 30,000 By Scrap (10% of 1,000 @ 80) R 100 8,000
To Mfg. Expenses 6,000 By Abnormal Loss @ 178.2* R 28.5 5,079
By Process Y (transferred)
(@ 178.20)* R 830 1,47,921
1,000 1,61,000 1,000 1,61,000

R 1‚61‚000 – 8‚000
R R 1‚53‚000
* Cost per unit = = = R 178.2
1‚000 – (41.5 + 100) 858.5
PROCESS COSTING B/2·13

Dr. PROCESS Y ACCOUNT Cr.

Particulars Tonnes ( )
R Particulars Tonnes ( )
R

To Process X 830 1,47,921 By Normal Loss (5% of 780) 39 —

To Materials @ R 200 70 14,000 By Scrap [10% of 900
To Wages 10,250 (i.e. 830 + 70) @ R 200] 90 18,000
To Mfg. Expenses 5,000 By Finished Stock
To Abnormal Gain (@ R 206.45)* 780 1,61,031
(@ R 206.45)* 9 1,860
909 1,79,031 909 1,79,031

R 1‚77‚171 – 18‚000 1‚59‚171

R
*Cost per unit = = = R 206.45
900 – (39 + 90) 771
(ii) Dr. ABNORMAL LOSS ACCOUNT Cr.
Particulars Tonnes ( )
R Particulars Tonnes ( )
R

To Process X 28.5 5,079 By Cash ( 80 × 28.5) R 2,280

By Costing P & L A/c 2,799
5,079 5,079

Dr. ABNORMAL GAIN ACCOUNT Cr.

Particulars Units ( )
R Particulars Units ( )
R

To Normal Loss ( 200 × 9)

R 9 1,800 By Process Y 9 1,860
To Costing P & L A/c 60
1,860 1,860

ILLUSTRATION 6. RST Limited processes product Z through two distinct processes, Process
I and Process II. On completion, it is transferred to finished stock. From the following information
for the year 2023-24, prepare Process I, Process II and Finished Stock A/c.
Particulars Process I Process II
Raw Materials used 7,500 units —
Raw Materials Cost per unit R 60 —
Transfer to next process/finished stock 7,050 units 6,525 units
Normal Loss (on inputs) 5% 10%
Direct Wages R 1,35,750 R 1,29,250
Direct Expenses 60% of direct wages 65% of direct wages
Manufacturing Overheads 20% of direct wages 15% of direct wages
Realisable value of scrap per unit R 12.50 R 37.50
6,000 units of finished goods were sold at a profit of 15% on cost. Assume that there was no
opening or closing stock of work-in-progress.
B/2·14 PROCESS COSTING

SOLUTION
PROCESS I ACCOUNT
Qty. Rate Amount Qty. Rate Amount
R R R R

To Raw Material 7,500 60 4,50,000 By Normal Loss

To Direct Wages 1,35,750 (5% × 7,500) 375 12.50 4,688
To Direct Expenses By Abnormal Loss 75 96.79 7,260
(60% of Direct Wages)
To Manufacturing
81,450
(
6‚94‚350 – 4‚688
R

7‚125
R

)
Overheads (20% of = 96.79 R

Direct Wages) 27,150 By Process II Account 7,050 96.79 6,82,402

7,500 6,94,350 7,500 6,94,350

PROCESS II ACCOUNT
Qty. Rate Amount Qty. Rate Amount
R R R R

To Process I 7,050 96.79 6,82,402 By Normal Loss (10%) 705 37.50 26,438
To Direct Wages 1,29,250 By Finished Stock A/c 6,525 140.05 9,13,823
To Direct Expenses (65%
of Direct Wages) 84,013
To Manufacturing
Overheads (15% of
Direct Wages) 19,387
9,15,052
To Abnormal Gain

( R 9‚15‚052 –R 26‚438
6‚345 ) 180 140.05 25,209
7,230 9,40,261 7,230 9,40,261

FINISHED STOCK ACCOUNT

Qty. Rate Amount Qty. Rate Amount
R R R R

To Process II 6,525 140.05 9,13,823 By Sales A/c 6,000 161.06 9,66,341

To Profit and By Balance c/d 525 140.05 73,526
Loss Account 1,26,044
6,525 10,39,867 6,525 10,39,867

ILLUSTRATION 7. A product passes through three processes—P, Q and R.

The details of expenses incurred on the three processes during the year 2024 were as under :
P Q R
Units Issued 10,000
R R R

Cost per Unit 100

Sundry Materials 16,000 33,150 32,200
PROCESS COSTING B/2·15

Labour 30,000 80,000 65,000

Sale Price of Output (per unit) 120 165 250
Management expenses during the year were R 80,000 and selling expenses were R 50,000. These
are not allocable to the processes.
Actual output of the three processes was : Process P—9,300 units ; Process Q—5,400 units ;
Process R—2,100 units.
Two-thirds of the output of Process P and one-half of the output of Process Q was passed on to
the next process and the balance was sold. The entire output of Process R was sold.
The normal loss of the three processes, calculated on the input of every process, was: Process
P—5%; Process Q—15% ; and Process R—20%.
The loss of Process P was sold at R 2 per unit, that of Process Q at R 5 per unit and that of
Process R at R 10 per unit.
Prepare the three Process Accounts and the Profit & Loss A/c
SOLUTION PROCESS P ACCOUNT
Units Amount Units Amount
——————————————————————————— ————————————————————————————

R R

To Cost of Input Units 10,000 10,00,000 By Normal Loss A/c 500 1,000
” Sundry Materials 16,000 ” Abnormal Loss
” Labour 30,000 @ 110 per unit
R 200 22,000
” Process Q A/c 6,200 6,82,000
” Profit and Loss A/c 3,100 3,41,000
——————————————————————————— ———————————————————————————

10,000 10,46,000
———————————————————————————
10,000 10,46,000
———————————————————————————
——————————————————————————— ———————————————————————————

PROCESS Q ACCOUNT
Units R Units R
————————————————————————--- ————————————————————————----

To Process P A/c 6,200 6,82,000 By Normal Loss A/c 930 4,650

” Sundry Materials 33,150 ” Process R A/c 2,700 4,05,000
” Labour 80,000 ” Profit and Loss A/c 2,700 4,05,000
” Abnormal Gain A/c
@ 150 each 130 19,500
——————————————————————————— ———————————————————————————

6,330 8,14,650 6,330 8,14,650

———————————————————————————
——————————————————————————— ———————————————————————————
———————————————————————————

PROCESS R ACCOUNT
Units R Units R
————————————————————————--- ——————————————————————----

To Process Q A/c 2,700 4,05,000 By Normal Loss A/c 540 5,400

” Sundry Materials 32,200 ” Abnormal Loss A/c @ R 230 60 13,800
” Labour 65,000 ” Profit and Loss A/c 2,100 4,83,000
——————————————————————————— ——————————————————————————

2,700 5,02,200 2,700 5,02,200

———————————————————————————
——————————————————————————— ——————————————————————————
——————————————————————————

PROFIT AND LOSS ACCOUNT

Units R
———————————————————————----
Units R
——————————————————————-----
To Process P @ 110
R 3,100 3,41,000 By Sales
” Process Q @ 150 R 2,700 4,05,000 P @ 120R 3,100 3,72,000
B/2·16 PROCESS COSTING

To Process R @ 230R 2,100 4,83,000 Q @ 165 R 2,700 4,45,500

” Management Expenses 80,000 R @ 250 R 2,100 5,25,000
” Selling Expenses 50,000 ” Net Loss 16,500
——————————————————————————— ———————————————————————————

7,900 13,59,000 7,900 13,59,000

———————————————————————————
——————————————————————————— ———————————————————————————
———————————————————————————

ILLUSTRATION 8. The product manufactured by the Standard Chemicals Ltd. passes

through three processes I, II and III. Following costs have been incurred for the month of
September 2023 :
Process I Process II Process III
Details
(R) (R) (R)
1. Materials Consumed 40,000 7,500 5,000
2. Direct Wages 22,500 10,000 10,000
3. Direct Expenses 20,500 2,250 2,505
Total (R) 83,000 19,750 17,505
(units) (units) (units)
4. Output 3,900 3,850 3,200
5. Finished Process Stock :
(i) 1-9-2023 600 550 800
(ii) 30-9-2023 500 800 NIL
6. Stock Valuation on 01-9-2023 ( per unit)
R 24.50 31.00 37.00
7. Percentage of Loss 2 5 10
8. Net Realisable Value of Loss per unit (R) 13.50 16.25 21.00

Four thousand units of raw materials were introduced in Process No. I at a cost of rupees
twenty thousand.
Stocks are valued and transferred to subsequent processes at weighted average cost. The
percentage of loss is computed on the number of units entering the process concerned.
Prepare (i) Process A/cs ; (ii) Process Stock A/cs ; (iii) Normal Loss A/c ; (iv) Abnormal
Loss/Gain or /Effective A/c.
SOLUTION
PROCESS I ACCOUNT
Units R Units R
——————————————————————————- —————————————————————————-

To Units Introduced 4,000 20,000 By Normal Loss 80 1,080

To Materials 40,000 By Abnormal Loss 20 520
To Direct Wages
To Direct Expenses
22,500
20,500 ( 1‚01‚920
R

3‚920
× 20)
By Process I Stock A/c
@ 26 per unit
R 3,900 1,01,400
——————————- —————————————- ——————————-—————————————-

4,000
——————————-
1,03,000 4,000 1,03,000
——————————- —————————————-
—————————————- ——————————-—————————————-
——————————-—————————————-
PROCESS COSTING B/2·17

PROCESS I STOCK A/C

Units R Units R
——————————————————————————- —————————————————————————

To Opening Balance By Transfer to Process II A/c

@ 24.50 per unit
R 600 14,700 @ 25.80 R 4,000 1,03,200
To Process I A/c 3,900 1,01,400 By Closing Balance
@ 25.80 per unit
R 500 12,900
——————————- —————————————- ——————————- ————————————-

4,500 1,16,100
——————————- —————————————-
—————————————-
4,500
——————————-
1,16,100
————————————-
——————————- ——————————- ————————————-

PROCESS II A/C
Units R Units R
————————————————————————-- ——————————————————————————

To Process I Stock A/c 4,000 1,03,200 By Normal Loss A/c 200 3,250
To Material Consumed 7,500 By Process II Stock A/c 3,850 1,21,275
To Direct Wages 10,000 @ 31.50 per unit
R

To Direct Expenses 2,250

To Abnormal Gain A/c

( 1‚19‚700
R

3‚800
× 50 ) 50 1,575
——————————- —————————————- ——————————-—————————————-

4,050
——————————-
1,24,525 4,050 1,24,525
——————————- —————————————-
—————————————- ——————————-—————————————-
——————————-—————————————-

PROCESS II STOCK A/C

Units R Units R
——————————————————————————- —————————————————————————-

To Opening Balance By Process III A/c

@ 31 per unit
R 550 17,050 @ 31.44 per unit
R 3,600 1,13,175
To Process II A/c 3,850 1,21,275 By Closing Balance 800 25,150
——————————- —————————————- ——————————- —————————————-

4,400
——————————-
1,38,325
—————————————-
4,400 1,38,325
——————————- —————————————-
—————————————-
——————————- —————————————- ——————————-

PROCESS III A/C

Units R Units R
———————————————————————---- —————————————————————————-

To Process II Stock A/c 3,600 1,13,175 By Normal Loss

To Materials Consumed 5,000 @ 21 per unit R 360 7,560
To Direct Wages 10,000 By Abnormal Loss A/c 40 1,520
To Direct Expenses 2,505
(
1‚23‚120
3‚240
R
× 40 )
By Process III Stock A/c 3,200 1,21,600
@ 38 per unit
R
——————————- —————————————- ——————————- —————————————-

3,600
——————————-
1,30,680 3,600 1,30,680
——————————- —————————————-
—————————————- ——————————-
——————————- —————————————-
—————————————-

PROCESS III STOCK A/C

Units R Units R
————————————————————————-- ——————————————————————————
To Opening Balance By Cost of Goods Sold A/c 4,000 1,51,200
@ 37 per unit
R 800 29,600
To Process III A/c 3,200 1,21,600
——————————- —————————————- ——————————- —————————————-

4,000
——————————-
1,51,200
—————————————-
4,000 1,51,200
——————————- —————————————-
—————————————-
——————————- —————————————- ——————————-
B/2·18 PROCESS COSTING

ABNORMAL GAIN A/C

Units R Units R
————————————————————————-- —————————————————————————-
To Normal Loss A/c 50 812.50 By Process II A/c 50 1,575
To Costing P/L A/c 762.50
——————————- —————————————- ——————————- —————————————-
50 1,575
——————————- —————————————-
—————————————-
50 1,575
——————————- —————————————-
—————————————-
——————————- ——————————-

NORMAL LOSS A/C

Units R Units R
————————————————————————- ————————————————————————--
To Process I A/c 80 1,080 By Abnormal Gain A/c 50 812.50
To Process II A/c 200 3,250 By Cash/Debtors 590 11,077.50
To Process III A/c 360 7,560
——————————- —————————————- —————————- —————————————-
640 11,890
——————————- —————————————-
—————————————-
640 11,890.00
——————————- —————————————-
—————————————-
——————————- ——————————-

ABNORMAL LOSS A/C

Units R Units R
————————————————————————- —————————————————————————-

To Process I A/c 20 520 By Cash 60 1,110

To Process III A/c 40 1,520 By Costing P/L A/c — 930
——————————- ———————————— —————————— ————————————

60 2,040 60 2,040
——————————-
——————————- ————————————
———————————— ——————————
—————————— ————————————
————————————

Inter Process Profits

Sometimes the output of one process is transferred to a subsequent process, not at cost, but at a
price showing a profit to the transferer process. Transfer price may be made at a price corresponding
to current wholesale market price or at cost plus an agreed percentage. The difference between cost
and the transfer price is known an inter process profits. This is done when each process is treated as
a profit centre. The objects are :
(i) to show whether the cost of production competes with the market price,
(ii) to make each process stand on its own efficiency and economies i.e. the transferee processes
are not given the benefits of economies affected in the earlier process.
This system involves a rather unnecessary complication of the accounts, as the desired
comparisons could be prepared on separate cost reports for each process or by adopting a standard
costing system, when standards could be set for each process. The complexity brought into the
accounts arises from the fact that the inter process profits introduced remain included in the prices of
process stocks, finished stocks and work-in-progress. In such cases, the difference between the debit
and credit side of the process account represents profit or loss and is transferred to the Profit and Loss
Account. The stocks at the end and at the beginning contain an element of unrealized profits, which
have to be written back in this method. If the profit element contained in the closing inventory is
more than the profit element in the opening inventory, profit will be overstated and vice versa. Profit
is realised only on the goods sold, thus to obtain the actual profit the main task would be to calculate
the profit element contained in the inventories. For balance sheet purposes, inter-process profit
cannot be included in stock, as a firm cannot make a profit by trading itself. To avoid these
complications a provision must be created to reduce the stock to actual cost price. This problem arises
only in respect of stock on hand at the end of the period, because goods sold will have realised the
internal profits.
PROCESS COSTING B/2·19

Advantages of Inter Process Profits

(i) It helps in comparison between the cost of output and its market price at the stage of
completion.
(ii) Each process is made to stand by itself as to profitability.
Disadvantages of Inter Process Profits
(i) The use of inter process profits involves complications.
(ii) The system shows profits which are not realised because of stock not sold out.
In order to compute the profit element in closing inventories and to obtain the net realised profit
for a period, three columns have been shown on each side of process accounts and closing stocks
have been deducted from the debit side of the process accounts instead of showing it on the credit
side. Cost of closing stock can be easily obtained if we compare the accumulated cost and total in any
process. The cost of stock can be obtained by the formula :
Cost
× Closing Stock
Total
The profit on closing stock can then be easily obtained by deducting the cost of stock thus arrived
at from the value of stock. The procedure has been made clear in the following illustration :
ILLUSTRATION 9. A certain product passes through three processes before it is completed.
The output of each process is charged to the next process at a price calculated to give a profit of
20% on transfer price (i.e. 25% on cost price). The output of Process III is charged to finished stock
account on a similar basis. There was no work-in-progress at the beginning of the year and
overheads have been ignored. Stock in each process has been valued at prime cost of the process.
Following data are obtained at the end of 31st March, 2024.
Process I Process II Process III Finished Stock
R R R R

Direct material 4,000 6,000 2,000 —

Direct wages 6,000 4,000 8,000 —
Stock on 31st March 2,000 4,000 6,000 3,000
Sale during the year — — — 36,000
From the above information prepare
(a) process cost accounts showing the profit element at each stage ; (b) actual realised profits ;
and (c) stock valuation as would appear in the balance sheet.
SOLUTION
(a) The process cost accounts showing the profit at each stage are as follows :
PROCESS I ACCOUNT
Total Cost Profit Total Cost Profit
——————————————————————————————————— ——————————————————————————————————

R R R R R R

To Materials 4,000 4,000 — By Process II A/c (transfer) 10,000 8,000 2,000

” Wages 6,000 6,000 —
——————————— —————————— ———————————

Total 10,000 10,000 —

B/2·20 PROCESS COSTING

Less Closing Stock c/d 2,000 2,000 —

——————————— —————————— ———————————
Prime cost 8,000 8,000 —
To Gross Profit
(25% on Cost) 2,000 — 2,000
——————————— —————————— ——————————— —————————— —————————— —————————

10,000 8,000 2,000 10,000 8,000 2,000

——————————— —————————— ——————————— —————————— —————————— —————————
To Stock b/d 2,000 2,000 —

PROCESS II ACCOUNT
Total Cost Profit Total Cost Profit
——————————————————————————————————— ——————————————————————————————————

R R R R R R

To Process I A/c By Process III A/c

(transfer) 10,000 8,000 2,000 (transfer) 20,000 14,400 5,600
To Materials 6,000 6,000 —
To Wages 4,000 4,000 —
—————————— —————————— ——————————
Total 20,000 18,000 2,000
Less : Closing
Stock c/d 4,000 3,600 400
—————————— —————————— ——————————

Prime Cost 16,000 14,400 1,600

To Gross Profit
(25% on Cost) 4,000 — 4,000
——————————— —————————— —————————— —————————— —————————— —————————

20,000 14,400 5,600 20,000 14,400 5,600

——————————— —————————— —————————— —————————— —————————— —————————

To Stock b/d 4,000 3,600 400

PROCESS III ACCOUNT

Total Cost Profit Total Cost Profit
——————————————————————————————————- —————————————————————————————————-

R R R R R R

To Process II A/c By Finished Stock A/c

(transfer) 20,000 14,400 5,600 (transfer) 30,000 19,520 10,480
To Material 2,000 2,000 —
To Wages 8,000 8,000 —
—————————— —————————— —————————

Total 30,000 24,400 5,600

Less : Closing
Stock c/d 6,000 4,880 1,120
—————————— —————————— —————————

Prime cost 24,000 19,520 4,480

To Gross Profit
(25% on Cost) 6,000 — 6,000
—————————— ————————— ————————— —————————— ————————— —————————

30,000 19,520 10,480 30,000 19,520 10,480

—————————— ————————— ————————— —————————— ————————— —————————

To Stock b/d 6,000 4,880 1,120

FINISHED STOCK ACCOUNT

Total Cost Profit Total Cost Profit
——————————————————————————————————— —————————————————————————————————-

R R R R R R

To Process III A/c 30,000 19,520 10,480 By Sales 36,000 17,568 18,432
PROCESS COSTING B/2·21

Less : Stock A/c 3,000 1,952 1,048

—————————— ————————— —————————

27,000 17,568 9,432

Gross profit 9,000 — 9,000
—————————— ————————— ————————— —————————— ————————— —————————

36,000 17,568 18,432 36,000 17,568 18,432

—————————— ————————— ————————— —————————— ————————— —————————

To Stock b/d 30,000 1,952 1,048

Note. Calculation of profit on closing stock :

This can be easily done looking the line above the closing stock line in each process and applying the
following formula :
Cost Column R 24‚400
Cost of Stock = × Stock Process III : × R 6,000 = R 4,880
Total Column R 30‚000

Process I : No profit ∴ Profit = R 6,000 – R 4,880 = R 1,120

R 18‚000 R 19‚520
Process II : × 4,000 = R 3,600 Finished Stock = × R 3,000 = R 1,952
R 20‚000 R 30‚000

∴ Profit = R 4,000 – R 3,600 = R 400 ∴ Profit = R 3,000 – R 1,952 = R 1,048.

(b) Actual realised profit can be shown as under :

Apparent profit Unrealised profit Actual profit
from process in closing stock (gross)
—————————————————————————————————————————————————————————————————————————————————————————————————————

R R R

Process I 2,000 — 2,000

Process II 4,000 400 3,600
Process III 6,000 1,120 4,880
Finished stock 9,000 1,048 7,952
—————————————————————————————————————————————————————————————————————————————————————————————————————

21,000 2,568 18,432*

(*Compare this figure with that of profit column of sales side of finished stock account.)
(c) Stock Valuation for balance sheet purpose : From the stock column of respective closing stocks, we
observe :
Cost of closing stock
R

Process I 2,000
Process II 3,600
Process III 4,880
Finished stock 1,952
————————————

Total 12,432
————————————

Check : Total cost incurred in all processes 30,000

Less : Cost of goods sold 17,568
————————————

Cost of closing stock 12,432

————————————

Sometimes, opening stock and production overheads are given. If stock is to be valued at prime cost, then
we should add the opening stock at the beginning along with transfer cost of materials and wages. From the total
of these, closing stock should be deducted to calculate prime cost. Then production overheads are added. This
becomes the total cost of the process to which is added the desired percentage of profit.
B/2·22 PROCESS COSTING

ILLUSTRATION 10. A certain product passes through two processes desired before it is
transferred to finished stock. Following information is obtained for the month of March 2024.
Items Process I Process II Finished Stock
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R

Opening stock 7,500 9,000 22,500

Direct material 15,000 15,750
Direct wages 11,200 11,250
Production overheads 10,500 4,500
Closing stock 3,700 4,500 11,250
Profit % on transfer price to the next process 25% 20%
Inter-process profits for opening stock — 1,500 8,250
Stocks in processes are valued at prime cost and finished stock has been valued at the price at
which it was received from Process II. Sales during the period were R 1,40,000.
Prepare and compute—
(a) process cost accounts showing profit element at each stage ; (b) actual realised profit ; and
(c) stock valuation for balance sheet purposes.
SOLUTION
(a) The process cost accounts for Process I, Process II and Finished Stock Account showing profit element
at each stage of production are as follows :
PROCESS I ACCOUNT
Total Cost Profit Total Cost Profit
—————————————————————————————————— ————————————————————————————————

R R R R R R

To Opening Stock b/d 7,500 7,500 — By Process II A/c

To Materials 15,000 15,000 — (Transfer) 54,000 40,500 13,500
To Wages 11,200 11,200 —
—————————— ————————— —————————

33,700 33,700 —
Less : Closing Stock c/d 3,700 3,700 —
—————————— ————————— —————————

Prime Cost 30,000 30,000 —

To Production Overheads 10,500 10,500 —
—————————— ————————— —————————

Total Cost 40,500 40,500 —

To Gross Profit
1
(333 % on Cost) 13,500 — 13,500
—————————— ————————— ————————— —————————— ————————— —————————
54,000 40,500 13,500 54,000 40,500 13,500
—————————— ————————— ————————— —————————— ————————— —————————
To Stock b/d 3,700 3,700 —

PROCESS II ACCOUNT
Total Cost Profit Total Cost Profit
———————————————————————————————————- ————————————————————————————————————
R R R R R R

To Opening Stock b/d 9,000 7,500 1,500 By Finished Stock A/c 1,12,500 75,750 36,750
” Process I A/c
(transfer) 54,000 40,500 13,500
PROCESS COSTING B/2·23

To Material 15,750 15,750 —

” Wages 11,250 11,250 —
————————————— ————————— —————————
Total 90,000 75,000 15,000
Less Closing
Stock c/d 4,500 3,750 750
————————————— ————————— —————————
Prime Cost 85,500 71,250 14,250
” Overheads 4,500 4,500 —
————————————— ————————— —————————

90,000 75,750 14,250

Gross Profit c/d
1
( of Cost) 22,500 — 22,500
4
———————————— —————————— —————————— ———————————— —————————— ——————————

1,12,500 75,750 36,750 1,12,500 75,750 36,750

———————————— —————————— —————————— ———————————— —————————— ——————————

To Stock b/d 4,500 3,750 750

FINISHED STOCK ACCOUNT

Total Cost Profit Total Cost Profit
———————————————————————————————————— —————————————————————————————————————

R R R R R R

To Opening Stock b/d 22,500 14,250 8,250 By Sales 1,40,000 82,500 57,500
” Process II A/c 1,12,500 75,750 36,750
———————————— —————————— ——————————

1,35,000 90,000 45,000

Less : Closing
Stock c/d 11,250 7,500 3,750
———————————— —————————— ——————————

1,23,750 82,500 41,250

To Gross Profit 16,250 — 16,250
———————————— —————————— —————————— ———————————— ————————— —————————

1,40,000 82,500 57,500 1,40,000 82,500 57,500

———————————— —————————— —————————— ———————————— ————————— —————————

To Stock b/d 11,250 7,500 3,750

Note. Calculation of unrealised profit in closing stock :
Process I : Nil.
Cost 75‚000 R
Process II : × Closing Stock = × 4,500 = R R 3,750
Total 90‚000 R

∴ Profit = 4,500 – 3,750 = 750

R R R

90‚000
R
Finished Stock : × 11,250 = 7,500
R R
1‚35‚000
R

∴ Profit = 11,250 – 7,500 = 3,750.

R R R

( b)
Unrealised Profit
——————————————————————————————————————————————————————————————————
Apparent Profit Opening Stock Closing Stock Transferred Actual Profit
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R R

Process I 13,500 — — — 13,500

Process II 22,500 1,500 750 (+) 750 23,250
Finished Stock 16,250 8,250 3,750 (+) 4,500 20,750
—————————————————— —————————————————— —————————————————— ——————————————————— ——————————————

Total 52,250 9,750 4,500 (+) 5,250 57,500

[ Check. Actual Profit of R 57,500 is the same as given in the Profit column of sales side of finished stock
account.]
B/2·24 PROCESS COSTING

(c) Cost of Stock R Check

Process I 3,700 Total Cost incurred : R

Process II 3,750 Process I 36,700

Finished Stock 7,500
—————————
Process II 31,500
—————————
14,950 Total 68,200
—————————
Add : Cost of Total Opening Stock
[ 7,500 + 7,500 + 14,250]
R R R 29,250
—————————
97,450
Less : Cost of Goods Sold 82,500
—————————
Cost of Stock 14,950
—————————

ILLUSTRATION 11. XYZ Ltd. divides its output in processes A and B. After leaving Process
B the product is passed into Finished Stock. The output of Process A is transferred to Process B at a
price which gives Process A a profit of 25% thereon and the output of Process B is transferred to
finished stock at a price which gives Process B a profit of 20% thereon.
The following information is provided in respect of Process A and B for the year 31st March,
2024 :
Process A Process B
( )
R (R)
Stock on 1st April, 2023 3,200 2,000
Material used 6,400 2,700
Direct Labour 12,500 8,500
Overhead 2,500 1,700
Stock on 31st March, 2024 2,100 900
Finished goods were in stock on 1st April, 2023 of the value of 10,200 and on 31st March, 2024
R

of value of R 6,200. Sales amounting to R 68,400 were affected during the year.
The reserves on 1st April, 2023 for unrealised profits included in Stock valuations were :
Process B R 350; Finished goods R 3,430.
Process stocks are valued at Prime Cost.
Prepare Process Accounts, Finished Stock Account and Trading and Profit & Loss Account as
on 31st March, 2024.
SOLUTION PROCESS A ACCOUNT
Particulars Total Cost Profit Particulars Total Cost Profit
R R R R R R

To Opening Stock 3,200 3,200 — By Cost Transfer to

To Material Used 6,400 6,400 — Process B 30,000 22,500 7,500
To Direct Labour 12,500 12,500 —
22,100 22,100 —
Less : Closing Stock 2,100 2,100 —
Prime Cost 20,000 20,000 —
Add : Overhead 2,500 2,500 —
22,500 22,500 —
Add : Profit
(25% on Transfer
Price) 7,500 — 7,500
30,000 22,500 7,500 30,000 22,500 7,500
PROCESS COSTING B/2·25

PROCESS B ACCOUNT
Particulars Total Cost Profit Particulars Total Cost Profit
R R R R R R

To Opening Stock 2,000 1,650 350 By Cost Transfer to

To Cost Transfer from Finished Stock 55,000 36,314 18,686
Process A 30,000 22,500 7,500
To Material 2,700 2,700 —
To Direct Labour 8,500 8,500 —
43,200 35,350 7,850
Less : Closing Stock 900 736 164
Prime Cost 42,300 34,614 7,686
To Overhead 1,700 1,700 —
44,000 36,314 7,686
Add : Profit 20% on
Transfer Price 11,000 — 11,000
55,000 36,314 18,686 55,000 36,314 18,686

FINISHED STOCK
Particulars Total Cost Profit Particulars Total Cost Profit
R R R R R R

Opening Stock 10,200 6,770 3,430 By Sales 68,400 38,987 29,413

To Cost Transfer from
Process B 55,000 36,314 18,686
65,200 43,084 22,116
Less : Closing Stock 6,200 4,097 2,103
59,000 38,987 20,013
Profit 9,400 — 9,400
68,400 38,987 29,413 68,400 38,987 29,413

TRADING AND PROFIT & LOSS ACCOUNT OF XYZ LTD.

for year ended 31st March, 2024
Particulars Amount Particulars Amount
( )
R ( )
R

To Opening Stock By Sale 68,400

Process A 3,200 By Closing Stock
Process B 2,000 Process A 2,100
Finished Goods 10,200 15,400 Process B 900
——————————

To Material Used Finished Stock 6,200

—————————
9,200
Process A 6,400
Process B 2,700
—————————— 9,100
To Direct Labour
Process A 12,500
Process B 8,500 21,000
—————————
B/2·26 PROCESS COSTING

To Overhead
Process A 2,500
Process B 1,700 4,200
—————————

To Gross Profit 27,900

77,600 77,600
To Stock Reserve By Gross Profit 27,900
Process B 164 By Stock Reserve
Finished Stock 2,103 2,267 Process B 350
——————————

To Net Profit 29,413 Finished Stock 3,430 3,780

—————————

31,680 31,680

Working Note :
Total of cost column
Calculation of cost price of closing stock = × Invoice Price of Closing Stock
Total of total column
35‚350
Process B = × 900 = 736
R
43‚200
43‚084
Finished Stock = × 6,200 = R 4,097
65‚200
Note : Overheads are assumed to be direct.

Work-in-Progress
The problem of work-in-progress or unfinished units in process industries is a very important
problem and frequently a difficult one. In most of the firms manufacturing is on a continuous basis
and the problem of work-in-progress is quite common. The work-in-progress consists of direct
materials, direct wages and production overhead. Direct material is put into the process at the
beginning of the period and then added to in the course of the period. Some of this material is thus
worked on, completed and transferred to stock. At the end of the period the closing work-in-progress
consists of material which has only partially been processed but the full cost was incurred
immediately on transfer from stores to the process. Thus it is necessary to assume the closing work-
in-progress to be 100 per cent complete as regards materials. In some cases where additions are made
in the second or any subsequent process of other kinds of materials, further considerations would
apply according to the circumstances of each case. Direct labour and production overheads are not
incurred in the same way. The costs accrue during the period and attach to the units as and when
they are completed. Hence the closing work-in-progress only shows these costs to the extent to which
the units being processed have been completed.

Meaning of Equivalent Production

This represents the production of a process in terms of completed units. In other words, it means
converting the uncompleted production into its equivalent of completed units. The term equivalent
unit means a notional quantity of completed units substituted for an actual quantity of incomplete
physical units in progress, when the aggregate work content of the incomplete units is deemed to be
equivalent to that of the substituted quantity. (e.g. 100 units of 60% completed = 60 completed units).
The principle applies when operation costs are being apportioned between work-in-progress and
PROCESS COSTING B/2·27

completed output. Thus in each process an estimate is made of the percentage completion of any
work-in-progress. A production schedule and a cost schedule will then be prepared. The work-in-
progress is inspected and an estimate is made of the degree of completion, usually on a percentage
basis. It is most important that this estimate is as accurate as possible because a mistake at this stage
would affect the stock valuation used in the preparation of final accounts. The formula of equivalent
production is :
Equivalent units of work-in-progress
= Actual no. of units in progress of manufacture × Percentage of work completed
For example, if 70% work has been done on the average on 200 units still in process, then 200
such units will be equal to 140 completed units. The cost of work-in-progress will be equal to 140
completed units.

Calculation of Equivalent Production

Following steps are worth noting in its calculation under different methods:
Method I. Under this method opening work-in-progress is stated in equivalent completed units
by applying the percentage of work needed to complete the unfinished work of the previous period.
Then number of units started and completed (i.e. units started less closing stock) are added. Further
equivalent completed units of closing work-in-progress are also added to get the equivalent
production.
Method II. Under this method units completed during the period (i.e. units started + opening
stock units—closing stock units) are added to the units of closing stock completed during the period
and out of the total units, opening stock units completed in previous year are deducted to get the
units of equivalent production.
Method III. Under this method units of uncompleted input are added to the units of incomplete
work in opening stock and out of the total units, incomplete work in closing stock are deducted to
have units of equivalent production.
Suppose in January, 2024, the following is available relating to process A :
Opening Stock (work-in-progress)—10,000 units—40% complete. Units brought in the process—
50,000. Transferred to Process B—40,000 complete units (entire complete production). Closing Stock
(work-in-progress)—20,000 units, 75% complete. Calculation of effective production will be done as
below under different methods :
Effective units
Method (I) Opening Stock—work required to be completed (10,000 × 60%) 6,000
Add units completed during the period i.e. units
started less closing stock (50,000 – 20,000) 30,000
Add Closing Stock – work done (20,000 × 75%) 15,000
———————————
Completed equivalent production 51,000
———————————
———————————

Method (II) Units completed during the year 40,000

Add Closing Stock work done (20,000 × 75%) 15,000
———————————
55,000
Less Opening Stock (work already completed in previous period) (10,000 × 40%) 4,000
———————————
Completed equivalent production 51,000
———————————
———————————
B/2·28 PROCESS COSTING

Method (III) Opening Stock : Work incomplete (10,000 × 60%) 6,000

Add Input—incomplete 50,000
———————————
56,000
Less Closing Stock : Work incomplete (20,000 × 25%) 5,000
———————————

Completed equivalent production 51,000

———————————
———————————

Procedure for Evaluation

The procedure to be adopted under such case is as under :
(1) Find out equivalent production after taking into consideration the process losses, degree of
completion of opening and/or closing stock.
(2) Find out net process cost according to elements of costs i.e., materials, labour and overheads.
(3) Ascertain cost per unit of equivalent production of each element of cost separately by
dividing each element of costs by respective equivalent production units.
(4) Evaluate output finished and transferred and work-in-progress.
The total cost per unit of equivalent production will be equal to the total cost divided by effective
production and cost of work-in-progress will be equal to the equivalent units of work-in-progress
multiplied by the cost per unit of effective production.
In short, the following three statements are to be prepared :
(i) Statement of Equivalent Production. (ii) Statement of Cost. (iii) Statement of Evaluation (i.e.
apportionment of process costs).
The problems on equivalent production may be divided into four groups :
I. When there is only closing work-in-progress but with no process losses.
II. When there is only closing work-in-progress but with process losses.
III. When there is opening as well as closing work-in-progress with no process losses.
IV. When there is opening as well as closing work-in-progress with process losses.
These are now discussed one by one.

I. When there is only closing work-in-progress but with no process losses

Under this case, the existence of process losses is ignored. Closing work-in-progress is converted
into equivalent units on the basis of estimates as regards degree of completion of materials, labour
and production overhead. After calculating the equivalent units, it is not difficult to evaluate closing
work-in-progress.
ILLUSTRATION 12. Input 3,800 units ; output 3,000 units; closing work-in-progress 800
units.
Degree of Completion Process Costs
R

Materials 80% 7,280

Labour 70% 10,680
Overheads 70% 7,120
Find out (a) Equivalent Production, (b) Cost per unit of Equivalent production and (c) prepare
the Process A Account assuming that there is no opening work-in-progress and process loss.
PROCESS COSTING B/2·29

SOLUTION
( a) STATEMENT OF EQUIVALENT PRODUCTION

Input Output Equivalent Production Units

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Items Units Items Units Materials Labour and Overheads
——————————————————————————————————————————————————————————————————————————

Units % Units %
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Units Units completed

Intro- and transferred 3,000 3,000 100 3,000 100
duced 3,800 Work-in-progress 800 640 80 560 70
——————————— ———————————— ————————————————— ——————————— ————————————— ————————

3,800 3,800 3,640 3,560

———————————
——————————— ————————————
———————————— —————————————————
————————————————— ———————————
——————————— —————————————
————————————— ————————
————————

(b) STATEMENT OF COST

Elements of Cost Cost Equivalent Production Cost per Completed

(Units) Unit
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R

Materials 7,280 3,640 2.00

Labour 10,680 3,560 3.00
Overheads 7,120 3,560 2.00
—————————————————————————— —————————————————————————————

25,080 7.00
——————————————————————————
—————————————————————————— —————————————————————————————
—————————————————————————————

STATEMENT OF EVALUATION

R R

Finished Goods 3,000 × 7 = R 21,000

Work-in-Progress
Materials 640 × 2 = R 1,280
Labour 560 × R 3= 1,680
Overheads 560 × R 2= 1,120
———————————————— ———————————

4,080
(c) PROCESS A ACCOUNT

Units Amount Units Amount

———————————————— —————————————————— —————————————— ————————————
R R

To Materials 3,800 7,280 By Finished Stock A/c 3,000 21,000

To Labour 10,680 By Work-in-progress A/c 800 4,080
” Overheads 7,120
———————————————— —————————————————— —————————————— ————————————

3,800 25,080 3,800 25,080

———————————————— ——————————————————
———————————————— —————————————————— ——————————————
—————————————— ————————————
————————————

II. When there is only closing work-in-progress but with process losses
Losses are inherent in process operation. If there are process losses, the treatment is the same as
already discussed in this chapter. In case of normal loss, nothing should be added as equivalent
production. Abnormal loss should, however, be considered as production of good units completed
B/2·30 PROCESS COSTING

during the period. If units scrapped (normal) have any realisable value, the amount should be
deducted from the cost of materials in the cost statement before dividing by equvalent production
units. Abnormal gain will be deducted to obtain equivalent production. Special attention should be
given while valuing abnormal losses or gains.
ILLUSTRATION 13. During January 2024 units were introduced into Process I. The normal
loss was estimated at 5% on input. At the end of the month, 1,400 units had been produced and
transferred to the next process, 460 units were uncompleted and 140 units had been scrapped. It
was estimated that uncompleted units had reached a stage in production as follows :
Material 75% completed ; Labour 50% completed ; Overheads 50% completed.
The cost of 2,000 units was R 5,800.
Direct material introduced during the process amounted to R 1,440.
Direct wages amounted to R 3,340.
Production overheads incurred were R 1,670.
Units scrapped realised R 1 each.
Units scrapped passed through the process, so were 100% completed as regards material,
labour and overhead.
Find out (a) Equivalent Production, (b) Cost per unit ; and (c) Show the necessary accounts.
SOLUTION
( a) STATEMENT OF EQUIVALENT PRODUCTION

Input Equivalent Production

———————————————————————————————————————————————————————————————————————
(Units) Output Units Material Labour and Overheads
———————————————————————————————————————————————————————————————————————

Qty. % Qty. %
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

2,000 Normal Loss 100 — — — —

Abnormal Loss 40 40 100 40 100
Finished Production 1,400 1,400 100 1,400 100
Work-in-Progress 460 345 75 230 50
——————————————— ————————————————————————————————————————————————————————————————————————————————————

2,000 Total 2,000 1,785 1,670

———————————————
——————————————— ————————————————————————————————————————————————————————————————————
———————————————————————————————————————————————————————————————— ————————————————
————————————————— ———

(b) STATEMENT OF COST

Elements of Cost Cost Equivalent Cost per
( )
R Production Unit
(Units) ( )R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Materials
Cost of units introduced 5,800
Direct Materials 1,440
—————————————

7,240
Less : Scrap value of normal loss 100
—————————————

7,140 1,785 4
Direct Wages 3,340 1,670 2
Overheads 1,670 1,670 1
——————————— ———————————— —————————————

Total 12,150
———————————— ————————————
7
—————————————
———————————— ———————————— —————————————
PROCESS COSTING B/2·31

STATEMENT OF EVALUATION

Elements Equivalent Cost per Cost Total

Production of Production Unit Cost
Cost (Units) R R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Abnormal Loss Material 40 4 160

Labour 40 2 80
Overheads 40 1 40 280
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Finished Production Material 1,400 4 5,600

Labour 1,400 2 2,800
Overheads 1,400 1 1,400 9,800
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Work-in-Progress Material 345 4 1,380

Labour 230 2 460
Overheads 230 1 230 2,070
————————————————————————————————————

12,150
———————————————
———————————————

(c) PROCESS I ACCOUNT

Units Amount Units Amount

R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Units introduced 2,000 5,800 By Normal Loss 100 100

To Direct Material 1,440 By Abnormal Loss 40 280
To Direct Wages 3,340 By Process I Finished
To Production Overheads 1,670 Production 1,400 9,800
By Balance c/d
(Work-in-Progress) 460 2,070
—————————— —————————— —————————— ————————————

2,000 12,250 2,000 12,250

——————————
—————————— ——————————
—————————— ——————————
—————————— ————————————
————————————

PROCESS II ACCOUNT

Units R

To Process I A/c 1,400 9,800

ABNORMAL LOSS ACCOUNT
Units R Units R

To Process I A/c 40 280 By Cash/Dr. 40 40

(Sale @ 1 per unit)
R

By Costing P. & L. A/c (Loss) 240

—————————— —————————— —————————— —————————

40 280 40 280
——————————
—————————— ——————————
—————————— ——————————
—————————— —————————
—————————

III. When there is opening as well as closing work-in-progress but with no

process losses
Often in a continuous process there will be opening as well as closing work-in-progress which are
to be converted into equivalent of completed units for apportionment of process costs. The procedure
of conversion of opening work-in-progress will vary depending upon which method of valuation of
work-in-progress is used.
B/2·32 PROCESS COSTING

The valuation of work-in-progress can be made in the following ways depending upon the
assumptions made regarding the flow of costs :
(a) Average Cost Method, (b) FIFO, (c) LIFO and (d) Weighted Average Method. These are
discussed one by one in the following pages :
(a) Average Cost Method. According to this method opening inventory of work-in-progress and
its costs are merged with production and cost of the current period respectively. An average cost per
unit is determined by dividing the total cost by the total equivalent units, to ascertain the value of the
units completed and units in process. This method is useful when prices fluctuate from period to
period. The closing valuation of work-in-progress in the old period is added to the cost of the new
period and an average rate obtained which tends to even out price fluctuations. In calculating the
equivalent production opening units will not be shown separately as units of opening work-in-
progress are taken to be included in the units completed and transferred.

ILLUSTRATION 14. From the following details prepare statement of equivalent production,
statement of cost, statement of evaluation and Process Account by following average cost method :
Opening work-in-progress : (2,000 units)
Materials (100% complete) R 7,500

Labour (60% complete) R 3,000

Overhead (60% complete) R 1,500

Units introduced into the process 8,000

There are 2,000 units in process, and the stage of completion is estimated to be :
Material 100% ; Labour 50% ; Overheads 50%.
8,000 units are transferred to the next process.
The process costs for the period are :
Material 1,00,000 ; Labour 78,000 ; Overheads 39,000.
SOLUTION STATEMENT OF EQUIVALENT PRODUCTION
Production Units Materials Labour and Overheads
————————————————————————————————————————————————————————————————————————————————————
% Completion Eq. Units % Completion Eq. Production
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Finished and Transferred 8,000 100 8,000 100 8,000

Closing Work-in-progress 2,000 100 2,000 50 1,000
———————————— —————————— —————————

Total 10,000 10,000 9,000

————————————
———————————— ——————————
—————————— —————————
—————————

STATEMENT OF COST

Material Labour Overheads

R R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Cost of opening work-in-progress 7,500 3,000 1,500

Cost incurred during the process 1,00,000 78,000 39,000
—————————————————————————————————————————————————————————————————————————————————

1. Total cost 1,07,500 81,000 40,500

—————————————————————————————————————————————————————————————————————————————————

2. Equivalent units 10,000 9,000 9,000

—————————————————————————————————————————————————————————————————————————————————

3. Cost per unit (1 ÷ 2) 10.75 9.00 4.50

= R 24.25
PROCESS COSTING B/2·33

STATEMENT OF EVALUATION

(a) Value of output transferred : R

8,000 units @ 24.25

R 1,94,000
(b) Value of closing WIP : R

Materials 2,000 @ R 10.75 = 21,500

Labour 1,000 @ R 9.00 = 9,000
Overhead 1,000 @ R 4.50 = 4,500
—————————

35,000
——————————————
2,29,000
——————————————

PROCESS ACCOUNT

Units R Units R

To Opening WIP 2,000 12,000 By Finished Stock transferred

To Materials 8,000 1,00,000 to Next Process 8,000 1,94,000
To Labour 78,000 By Work-in-Progress A/c 2,000 35,000
To Overheads 39,000
——————————— ———————————— —————————— ————————————

10,000 2,29,000 10,000 2,29,000

——————————— ———————————— —————————— ————————————

(b) FIFO Method. According to this method, the units first entering the process are completed
first after taking into consideration the percentage of work to be done and shown separately in the
statement of equivalent production. Thus the units completed during a period would consist partly of
units which were incomplete at the beginning of the period and partly of the units introduced during
the period. The cost of completed units is affected by the value of opening inventory which is based
on the cost of previous period. This method is satisfactory when prices of raw materials and rates of
direct labour and overheads are relatively stable. Work-in-progress at the end of the period becomes
the opening work-in-progress for the next period ; the closing work-in-progress will be valued at
costs ruling during the new period, while the opening work-in-progress will be valued at costs ruling
during the old period. Thus, where costs are more or less the same in each period, this system is
adequate.
ILLUSTRATION 15. From the following details, prepare statement of equivalent production,
statement of cost, statement of evaluation ad Process Account by following FIFO Method.
Opening work-in-progress (2,000 units) R R

Materials (100% complete) 5,000

Labour (60% complete) 3,000
Overheads (60% complete) 1,500 9,500
—————————

Units introduced into the process 8,000

There are 2,000 units in progress and the stage of completion is estimated to be :
Materials 100% ; Labour 50% ; Overheads 50%.
8,000 units are transferred to the next process :
The process costs for the period are :
Materials R 96,000 ; Labour R 54,600 ; Overheads R 31,200.
B/2·34 PROCESS COSTING

SOLUTION STATEMENT OF EQUIVALENT PRODUCTION

Production Units Materials Labour and Overheads
———————————————————————————————————————————————————————————————————————
% Equivalent % Equivalent
Completion Production Completion Production
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
—

Opening WIP 2,000 — — 40 800

Completely processed during
the period (8,000 – 2,000) 6,000 100 6,000 100 6,000
Closing WIP 2,000
————————————
100 2,000
——————————
50 1,000
—————————

Total 10,000
————————————
8,000
——————————
7,800
—————————
———————————— —————————— —————————

STATEMENT OF COST

Cost Equivalent Cost per unit

Element of Cost (incurred during production
the year) (Units)
R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Materials 96,000 8,000 12

Labour 54,600 7,800 7
Overheads 31,200 7,800 4
———————————————————————————————————————————————————————————————————————————

Total 1,81,800 23
———————————————————————————————————————————————————————————————————————————

STATEMENT OF EVALUATION

Opening work-in-progress : (current cost) R R

Materials —
Labour : 800 units @ 7 = R 5,600
Overheads : 800 units @ 4 = R 3,200
——————————
8,800
Closing WIP
Materials : 2,000 @ R 12 = 24,000
Labour : 1,000 @ R 7= 7,000
Overheads : 1,000 @ R 4= 4,000
——————————
35,000
Units completely processed during the period : 6,000 @ R 23 1,38,000 (approx.)
——————————————

1,81,800
——————————————
——————————————

PROCESS ACCOUNT

Units R Units R

To Opening WIP 2,000 9,500 By Finished Stock

To Material 8,000 96,000 transferred to next process
To Labour 54,600 ( 9,500 + 8,800 +
R R

To Overheads 31,200 1,38,000)

R 8,000 1,56,300
By Closing WIP 2,000 35,000
——————————— ———————————— —————————— ————————————

10,000 1,91,300 10,000 1,91,300

——————————— ———————————— —————————— ————————————
PROCESS COSTING B/2·35

(C) Last in First-out (LIFO) Method. According to this method, units lastly entering in the
process are first to be completed. This assumption will definitely have a different impact on the cost
of completed units and closing inventory of work in progress. The completed units will be shown at
their current cost and the closing inventory of work-in-progress will continue to appear at the cost of
opening inventory of work-in-progress alongwith current cost of work in progress, if any.
ILLUSTRATION 16. From the following information relating to the month of January, 2024,
calculate the equivalent production units and the value of finished production and work-in-
progress using LIFO method.
Opening work-in-progress on 1st January Units introduced in the
15,000 units ; 50% complete. process : 30,000 units
Cost R Cost R

Materials 18,000 Materials 90,000

Labour 24,000 Labour 1,57,500
Overheads 24,000 Overheads 2,10,000
——————————— —————————————

66,000 4,57,500
——————————— —————————————

During the period 22,500 units were completed and transferred to the next process. Closing
work-in-progress on 31st January : 22,500 units ; 50% complete.
SOLUTION
CALCULATION OF EQUIVALENT UNITS

Equivalent Production
Units in Particulars —————————————————————————————————————————————————————

Units % of Equivalent
out completion units
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

15,000 Opening Work-in-Progress

30,000 Units introduced into the process
Units completed and transfer of
the units introduced during the year 22,500 100 22,500
Closing Work-in-Progress :
Of the units introduced during the period 7,500 50 3,750
Of the opening Work-in-Progress 15,000 — —
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

45,000 26,250

As the units in the opening work-in-progress were already 50% complete ; no work has been done on these
units during the period.
(ii) Cost per unit of equivalent production
R 4‚57‚500
= = R 17.43.
26‚250

Valuation of Finished Production and WIP

1. Finished production = 22,500 × 17.43 = R R 3,92,175
2. Closing work-in-progress = R 66,000 + (3,750 × 17.43) = R 1,31,362.50
(D) Weighted Average Method. When two or more dissimilar products are manufactured in the
same process, a simple average process cost may give misleading results. In such a case, a close study
B/2·36 PROCESS COSTING

of production and costs of each type of product is required to be made and the relative importance
of one as compared to others should be indicated in terms of points to be used as a common
denominator. In order to find out the cost of production under weighted average method, statements
of weighted average production in terms of points and cost for each type of product should be
prepared. The computation of weighted average process cost sheet will be easy, if due consideration
to weights or points are given. It will be more clear from the following illustration :
ILLUSTRATION 17. X Co. Ltd. produces three types of products A, B and C and keeps
accounts for Process I, Process II and Process III. Following statements show the relative
importance of each type of product in each process :
Process I Points Process II Points Process III Points
Product A 2 4 2
Product B 4 2 1
Product C 8 3 2
Costs for each process for March, 2024 are as follows :
Process I Process II Process III Total
R R R R

Materials 12,000 9,000 9,000 30,000

Labour 4,200 3,000 1,800 9,000
Overheads 3,000 5,100 2,400 10,500
—————————————————————————————————————————————————————————————————————————————————————————————————

19,200 17,100 13,200 49,500

—————————————————————————————————————————————————————————————————————————————————————————————————

Production during the period :

Product A 600 units ; Product B 300 units ; Product C 900 units.
You are required to—
(a) prepare a statement showing weighted average production for each process and
(b) compute the cost for each type of product.
SOLUTION STATEMENT OF WEIGHTED AVERAGE PRODUCTION
Weighted Production (Units) (i.e., Units × Points)
————————————————————————————————————————————————————————————————————————————————————————————————
Items Production Units Process I Process II Process III
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Product A 600 1,200 2,400 1,200
Product B 300 1,200 600 300
Product C 900 7,200 2,700 1,800
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(A) Total points 1,800 9,600 5,700 3,300
(B) Total cost in each process ( ) R 19,200 17,100 13,200
Cost per unit
((B) ÷ (A) 2 3 4

STATEMENT OF COST OF EACH TYPE OF PRODUCT

Process I Process II Process III Total Units Production Units Total

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R

Cost per Unit 2 3 4

Product A
Weighted Average of One Unit 2 4 2
PROCESS COSTING B/2·37

Unit Cost 4 12 8 24 600 14,400

Product B
Weighted Average of One Unit 4 2 1
Unit Cost 8 6 4 18 300 5,400
Product C
Weighted Average of One Unit 8 3 2
Unit Cost 16 9 8 33 900 29,700
—————————————
49,500
—————————————
—————————————

IV. When there is opening as well as closing work-in-progress but with losses
Under this method equivalent production units regarding opening and closing work-in-progress
are to be calculated with due adjustment for process losses as already discussed in the previous
pages. Sometimes, particulars relating to inbetween process (say process B) are given. In that case
effective units will be calculated with reference to Materials-I (entering from Process A) and
Materials-II (introduced in Process B). Material I will be taken as 100% complete in respect of
abnormal loss/gain, finished goods and work-in-progress. This will be more clear from the following
illustrations :
ILLUSTRATION 18. From the following information for March, 2024, prepare process cost
accounts for Process II (Apply FIFO Method).
Opening stock : 600 units R 1,050.
Degree of completion : Materials 80%, Labour 60%, Overhead 60%.
Transfer from Process I : 11,000 units at R 5,500.
Transfer to Process III : 8,800 units.
Direct Materials added in Process II : R 2,410.
Direct Labour amounted to R 7,155.
Production overhead incurred R 9,540.
Units scrapped : 1,200.
Degree of completion : Materials 100%, Labour 70%, Overhead 70%.
Closing Stock : 1,600 units.
Degree of completion : Materials 70%, Labour 60%, Overhead 60%.
There was a normal loss in the process of 10% of production. Units scrapped realised at 50
paise per unit.
SOLUTION
For Statement of Equivalent Production, please see the next page.
STATEMENT OF COST
Elements of Cost Cost Equivalent Cost per
Production Unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Material I : R R Units R P.
Transferred from previous process 5,500
Less : Scrap value 1,000 units at 50 paise 500
————————————
5,000 10,000 0.50
Material II (Added in Process) 2,410 9,640 0.25
Direct Labour 7,155 9,540 0.75
Overhead 9,540
—————————————
9,540 —————————————1.00
24,105
—————————————
2.50
—————————————
B/2·38 PROCESS COSTING
PROCESS COSTING B/2·39

STATEMENT OF EVALUATION
Particulars Elements of Cost Equivalent Cost per unit Cost Total Cost
Production
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
—
Units R P. R P. R

Opening Material I — — — —
Stock Material II 120 0.25 30.00
Labour 240 0.75 180.00
Overhead 240 1.00 240.00
————————————————
450
Abnormal Material I 200 0.50 100.00
Loss Material II 200 0.25 50.00
Labour 140 0.75 105.00
Overhead 140 1.00 140.00
————————————————
395
Finished Material I 8,200 2.50 20,500
Production

Closing Material I 1,600 0.50 800.00

Stock Material II 1,120 0.25 280.00
Labour 960 0.75 720.00
Overhead 960 1.00 960.00
————————————————
2,760
———————————

• 24,105

PROCESS II ACCOUNT
Units Amount Units Amount
R R
———————————————————————— ————————————————————————
To Balance b/d 600 1,050 By Normal Loss 1,000 500
To Process I 11,000 5,500 By Abnormal Loss 200 395
To Materials 2,410 By Process III
To Direct Labour 7,155 8,200 units @ 2.50 = 20,500
R R

To Overhead 9,540 600 units opening stock

= 1,500 ( 1,050 + 450)
R R 8,800
R 22,000
By Balance c/d
——————————— ———————————
(Work-in-progress) 1,600
———————————
2,760
———————————
11,600 25,655 11,600 25,655
———————————
——————————— ———————————
——————————— ———————————
——————————— ———————————
———————————

ILLUSTRATION 19. Following data pertains to Process I for March, 2024 of Bata Ltd.
R

Opening Work-in-Progress (1,500 units for) 15,000

Degree of completion :
Materials 100%, Labour and Overheads 33 1/3%
Input of Materials 18,500 units at 52,000
Direct Labour 14,000
Overheads 28,000
Closing Work-in-Progress 5,000 units
B/2·40 PROCESS COSTING

Degree of completion : Materials 90% and Labour and Overheads 30%

Normal Process Loss is 10% of total Input (opening work in progress units + units put in)
Scrap value R 2.00 per unit
Units transferred to the next process 15,000 units.
You are required to :
(a) Compute equivalent units of production.
(b) Compute cost per equivalent unit for each cost element i.e. materials, labour and overheads.
(c) Compute the cost of finished output and closing work-in-process.
(d) Prepare the process and other accounts.
Assume : (i) FIFO Method is used by the company.
(ii) The cost of opening work-in-progress is fully transferred to the next process.
SOLUTION
STATEMENT OF EQUIVALENT PRODUCTION AND COST

Materials Labour Overheads

Input Output Units ——————————————————————————————————————————————————————————————————————

units % Units % Units % Units

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

1,500 Opening WIP transferred 1,500 — — 662/ 3 1,000 662/ 3 1,000

18,500 Normal Loss 2,000 — — — — — —
Finished Goods 13,500 100 13,500 100 13,500 100 13,500
Closing WIP 5,000 90 4,500 30 1,500 30 1,500
—————————— ————————————— ——————————— ——————————— ———————————————————————

20,000 22,000 18,000 16,000 16,000

——————————
Less : Abnormal Gain 2,000 100 2,000 100 2,000 100 2,000
————————————— ——————————— ———————————— ————————————————————————

20,000 16,000 14,000 14,000

————————————

Materials 52,000
Less : Scrap Value (2,000 × 2) 4,000 R 48,000 R 14,000 R 28,000
—————————————

Cost per Equivalent Unit R 3 R 1 R 2

STATEMENT OF EVALUATION
Opening Material— R R

WIP Labour 1,000 @ R 1= 1,000

Overheads 1,000 @ R 2= 2,000 3,000
———————————

Finished Goods 13,500 × 6 R 81,000

Abnormal Gain 2,000 × 6 R 12,000
Closing Material 4,500 × R 3 =13,500
WIP Labour 1,500 × R 1 = 1,500
Overheads 1,500 × R 2 = 3,000 18,000
—————————

PROCESS I ACCOUNT

Units R Units R
———————————————————————————— ———————————————————————————

To Opening WIP 1,500 15,000 By Normal Loss A/c 2,000 4,000

” Materials 18,500 52,000 By Finished Goods 15,000
PROCESS COSTING B/2·41

To Direct Labour 14,000 Units R

” Overheads 28,000 1,500 18,000

” To Abnormal Gain 2,000 12,000 13,500 81,000 99,000
————————— —————————

By Closing WIP 5,000 18,000

———————————————————————————— ———————————————————————————

22,000 1,21,000
————————————————————————————
22,000 1,21,000
——————————————————————————
———————————————————————————— ——————————————————————————

NORMAL LOSS ACCOUNT

Units R Units R
———————————————————————————— ———————————————————————————

To Process I A/c 2,000 4,000 By Abnormal Gain A/c 2,000 4,000

————————————————————————————
———————————————————————————— ———————————————————————————
———————————————————————————

ABNORMAL GAIN ACCOUNT

Units R Units R
———————————————————————————— ———————————————————————————

To Normal Loss A/c 2,000 4,000 By Process I A/c 2,000 12,000

(Loss of Income)
” Costing P/L A/c 8,000
———————————————————————————— ———————————————————————————

2,000 12,000
————————————————————————————
2,000 12,000
———————————————————————————
———————————————————————————— ———————————————————————————

MISCELLANEOUS ILLUSTRATIONS
ILLUSTRATION 20. A company manufactures its sole product by passing the raw material
through three distinct process in its factory. During the months of April 2024, the company
purchased 96,000 kg of raw material at 5 per kg and introduced the same in process I. Further
R

particulars of manufacture for the month are given below :

Process Process Process
I II III
Material Consumed 33,472 27,483 R 47,166 R R

Direct Labour 80,000 72,000 56,000

Overheads 1,20,000 1,08,000 84,000
Normal Waste in process as % of input 3% 1% 1%
Sale Value of Waste ( /kg.) R 2 3 5
Actual Output during the month (kg.) 93,000 92,200 91,500
Prepare the three process accounts and accounts relating to abnormal loss/gain, if any.
SOLUTION PROCESS I ACCOUNT
kgs. ( )
R kgs. ( )
R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Input of R.M. 96,000 4,80,000 By Normal Loss A/c 2,880 5,760

To Other Material 33,472 (3% of 96,000)
To Direct Labour 86,000 By Abnormal Loss A/c
To Overheads 1,20,000 @ 7.60 per kg.) R

( i.e.
( 7‚13‚472 –
R R 5‚760)

96‚000 – 2‚880 × 120 ) 120 912

By Process A/c (Bal. Fig.) 93,000 7,06,800

———————————— ——————————————— ———————————— ———————————————

96,000 7,13,472 96,000 7,13,472

————————————
———————————— ———————————————
——————————————— ———————————— ———————————————
———————————— ———————————————
B/2·42 PROCESS COSTING

PROCESS II ACCOUNT
kgs. ( )
R kgs. ( )
R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Process II A/c 93,000 7,06,800 By Normal Loss A/c 930 2,790

To Materials 27,483 By Process III (Bal. Fig.) 92,200 9,12,780
To Direct Labour 72,000
To Overheads 1,08,000
To Abnormal Gain A/c @ R 9.90

( i.e.
R 9‚14‚283 – 2‚790
R

93‚000 – 930 × 130 ) 130

————————————
1,287
——————————————— ———————————— ———————————————
93,130 9,15,570 93,130 9,15,570
————————————
———————————— ———————————————
——————————————— ————————————
———————————— ———————————————
———————————————

PROCESS III ACCOUNT

kgs. ( )
R kgs. ( )
R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Process II A/c 92,200 9,12,780 By Normal Loss A/c 922 4,610

To Materials 47,166 By Finished Stock (Bal. Fig.) 91,500 10,98,000
To Direct Labour 56,000
To Overheads 84,000
To Abnormal Gain A/c
@ 12 per kg. 222 2,664

( )
R

10‚99‚946 – 4‚610
R R
i.e. × 222
92‚200 – 922 —————————— ——————————————— ———————————— ———————————————
92,422
——————————
11,02,610
———————————————
92,422 11,02,610
———————————— ———————————————
———————————————
—————————— ——————————————— ————————————

ABNORMAL LOSS ACCOUNT

kgs. ( )
R kgs. ( )
R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Process I A/c 120 912 By Cash @ 2 R 120 240

By Costing Profit & Loss A/c 672
———————————— ——————————————— ———————————— ———————————————
120 912 120 912
————————————
———————————— ———————————————
——————————————— ———————————— ———————————————
———————————— ———————————————

ABNORMAL GAIN ACCOUNT

kgs. ( )
R kgs. ( )
R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Process II A/c @ 3 R 130 390 By Process II A/c 130 1,287

To Process III A/c @ 5 R 222 1,110 By Process III A/c 222 2,664
To Costing Profit & Loss A/c
(Bal. Fig.) — 2,451
———————————— ——————————————— ———————————— ———————————————

352 3,951 352 3,951

————————————
———————————— ———————————————
——————————————— ———————————— ———————————————
———————————— ———————————————

ILLUSTRATION 21. AB Ltd. gives the following particulars relating to process A in its plant
for the month of December 2023 :
Units introduced during the month 19,500
Output : Units transferred to process B 18,200
Units scrapped (completely processed) 1,400
WIP (Closing Balance) 400 units
[Degree of completion : Materials 100%, Labour and Overhead 50%]
PROCESS COSTING B/2·43

Cost R

WIP (Opening balance) as on 1-12-2023 500 units Materials 4,800

Labour 3,200
Overhead 6,400
———————————

14,400
———————————
———————————

Process costs incurred during the month : R

Materials 1,86,200
Labour 72,000
Overhead 1,06,400
——————————————

3,64,600
——————————————
——————————————

Normal loss in processing is 5% of total input and normal scapped units fetch R 1 each, prepare
:
(i) Statement of equivalent production
(ii) Statement showing cost of each element
(iii) Statement of apportionment of cost
(iv) Process ‘A’ account.
SOLUTION
(i) STATEMENT OF EQUIVALENT PRODUCTION
Input Unit Output Units Material Labour Overhead
Units % Units % Units %
Opening WIP 500 Complete 18,200 18,200 100 18,200 100 18,200 100
Introduced 19,500 Normal Loss @ 5% 1,000 — — — — — —
Abnormal Loss 400 400 100 400 100 400 100
Closing WIP 400 400 100 200 50 200 50
Total 20,000 Total 20,000 19,000 18,800 18,800

(ii) STATEMENT OF COST

Particulars Material ( )
R Labour ( )
R Overhead ( ) R

Opening WIP Costs 4,800 3,200 6,400

Add : Process Costs incurred during month 1,86,200 72,000 1,06,400
Total Costs 1,91,000 75,200 1,12,800
Less : Sale of Scrapped units @ R 1 each 1,000 — —
Total (A) 1,90,000 75,200 1,12,800
Equivalent units (B) 19,000 18,800 18,800
Cost per unit (A + B) 10 4 6

(iii) STATEMENT OF APPORTIONMENT OF COST

Particulars ( )R

Unit Completed [18,200 × (10 + 4 + 6)]

R 3,64,000
Abnormal Loss [400 × (10 + 4 + 6)]
R 8,000
Closing WIP : Material (400 × 10) R 4,000
Labour (200 × 4) R 800
Overhead (200 × R 6) 1,200 6,000
——————————
B/2·44 PROCESS COSTING

(iv) Dr. PROCESS ‘A’ ACCOUNT Cr.

Particulars Units ( )
R Particulars Units ( )
R

To Opening WIP 500 14,400 By Normal Loss @ 1 each

R 1,000 1,000
To Material 19,500 1,86,200 By Abnormal Loss 400 8,000
To Labour 72,000 By Transfer to Process B
To Overhead 1,06,400 (Balancing figure) 18,200 3,64,000
By Closing WIP 400 6,400
20,000 3,79,000 20,000 3,79,000

ILLUSTRATION 22. The following details are available in respect of Process I for the month
of January 2024 :
Opening work in process (800 units) R 4,000

Units ‘transferred in’ from previous process (9200 units) R 36,800

Labour cost R 16,740

Overheads R 8,370

Units completed and transferred out to next process 7,900 units

Units scrapped 1,200 units
Closing WIP 900 units
Degree of Completion :
Opening WIP Units Scrapped Closing WIP
Materials 100% 100% 100%
Labour & Overheads 60% 80% 70%
Normal loss is 8% of the total input including opening work in process. Scrap value is R 4 per
unit to be adjusted in direct materials cost. Assuming that FIFO method of inventory valuation is
used, you are required to prepare :
(i) Statement of equivalent production
(ii) Statement showing cost per equivalent units.
(iii) Statement of valuation.
(iv) Process X account for the month of March 2024.
SOLUTION
(i) STATEMENT OF EQUIVALENT PRODUCTION
Input Output Materials Labour Overheads
Units Units % Units % Units % Units
800 Opening WIP 800 — — 40 320 40 320
9,200 Introduced completed 7,100 100 7,100 100 7,100 100 7,100
Normal Loss 800 — — — — — —
Abnormal Loss 400 100 400 80 320 80 320
Closing WIP 900 100 900 70 630 70 630
10,000 Total 10,000
Equivalent Units 8,400 8,370 8,370

(ii) STATEMENT OF PER UNIT COST

( ) (A)
R Equivalent Cost per unit
units (B) (A ÷ B)
Materials 36,800
PROCESS COSTING B/2·45

Less : Scrap 3,200

33,600 8,400 4
Labour 16,740 8,370 2
Overheads 8,370 8,370 1
Total 58,710 7

(iii) STATEMENT OF VALUATION

Eq. Units Cost per Cost ( ) R Total
unit ( ) R

Opening WIP : Material — 4 —

Labour 320 2 640
Overheads 320 1 320
960
Introduced & Completed : Material 7,100 4 28,400
Labour 7,100 2 14,200
Overheads 7,100 1 7,100
49,700
Abnormal Loss : Material 400 4 1,600
Labour 320 2 640
Overheads 320 1 320
2,560
Closing WIP : Material 900 4 3,600
Labour 630 2 1,260
Overheads 630 1 630
5,490

(iv) PROCESS ACCOUNT

Units Amt. ( )R Units Amt. ( )
R

To Opening WIP 800 4,000 By Normal Loss 800 3,200

To Materials 9,200 36,800 By Abnormal Loss 400 2,560
To Direct Wages 16,740 By Next Process A/c 7,900 54,660
To Overheads 8,370 By Closing WIP 900 5,490
( 4,000 +
R R 960
+ R 49,700)
10,000 65,910 10,000 65,910

ILLUSTRATION 23. The following details relate to an intermediary process in a factory:

% Degree No. of Costs
of completion units (R)
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

WIP (Opening balance) : 300 12,300

Materials 50
B/2·46 PROCESS COSTING

Labour 80
Overheads 80
Transfer from previous process 100 3,800 1,36,800
Process materials added 7,900
Direct wages 37,400
Overheads 14,960
Transfer to next process (finished) 100 3,500
WIP (closing balance) : 600
Materials 100
Labour 80
Overheads 80
Prepare :
(i) Statement of equivalent production (on FIFO basis)
(ii) Statement showing cost of each element
(iii) Statement of apportionment of cost
(iv) Process cost accounts.
SOLUTION
(i) STATEMENT OF EQUIVALENT PRODUCTION
Labour &
Input Output Material I Material II
Overheads
Item units Item unit % units % units % units
Opening WIP 300 Opening WIP 300 — — 50 150 20 60
Transfer from Introduced
Previous and completed 3,200 100 3,200 100 3,200 100 3,200
Process 3,800 Closing WIP 600 100 600 100 600 80 480
4,100 4,100 3,800 3,950 3,740
(ii) STATEMENT OF COST OF EACH ELEMENT
Cost ( )
R Equivalent units Cost per unit ( )
R

(A) (B) (A ÷ B)
Material I 1,36,800 3,800 36
Material II 7,900 3,950 2
Labour 37,400 3,740 10
Overheads 14,960 3,740 4
(iii) STATEMENT OF APPORTIONMENT OF COST
Cost Element Equivalent Cost per Total Cost
units unit ( )
R

( ) R

Opening WIP Material I — 36 —

Material II 150 2 300
Labour 60 10 600
Overheads 60 4 240
Total 1,140
PROCESS COSTING B/2·47

Introduced and Material I 3,200 36 1,15,200

completed Material II 3,200 2 6,400
Labour 3,200 10 32,000
Overheads 3,200 4 12,800
Total 1,66,400

Closing WIP Material I 600 36 21,600

Material II 600 2 1,200
Labour 480 10 4,800
Overheads 480 4 1,920
Total 29,520

(iv) PROCESS ACCOUNT

Units R Units R

To Opening WIP 300 12,300 By Transferred to

To Transfer from Next Process (1) 3,500 1,79,840
Previous Process 3,800 1,36,800 By Closing WIP 600 29,520
To Materials 7,900
To Labour 37,400
To Overheads 14,960
4,100 2,09,360 4,100 2,09,360

(1) Cost of output transferred to next process is : R 12,300 + R 1,140 + R 1,66,400 = R 1,79,840

QUESTIONS
SHORT ANSWER TYPE
1. (a) What is Process Costing ?
(b) Distinguish between Job Costing and Process Costing.
2. Name five industries in which process costing is used.
3. Name the four important aspects of process costing.
4. What is normal loss ? How is it treated in cost accounts ?
5. Why does abnormal loss/gain arises ? How will you treat these in cost accounts ?
OR
Explain the term “effectives” with reference to process costing.
6. Define normal and abnormal process losses, explaining the possible causes.
OR
Distinguish between normal process loss and abnormal process loss.
7. Give the main objects of inter-process profit.
OR
What is inter-process profits ? Explain it clearly. State its advantages and disadvantages.
8. Why is adjustment of stocks necessary in case of inter process profits ?
9. What do you understand by equivalent production/output ?
B/2·48 PROCESS COSTING

10. What is impact of equivalent on the preparation of production statement if FIFO or Average is
used ?
11. Give two points of advantages and disadvantages of inter process profit.

12. 2,400 units are introduced into a process at a cost of 36,000. The total additional expenditure
R

incurred in the process is 21,600. Of the units introduced 10% are normal loss in the course of
R

manufacture. The sale price of lost units is 15 each. Due to abnormal causes only 1,920 units
R

could be produced. How would you write the process account showing the abnormal loss ?
Ans. [Abnormal loss 240 units R 6,000; Transferred to Finished Stock 1,920 units at R 48,000]
13. A product passes from Process I and Process II. Materials issued to Process I amounted to 40,000, R

Labour 30,000 and manufacturing overheads were 27,000. Normal loss was 3% of input as
R R

estimated. But 500 more units of output of Process I were lost due to the carelessness of workers.
Only 4,350 units of output were transferred to Process II. There were no opening socks. Input raw
materials issued to Process I were 5,000 units. You are required to show Process I Account.
Ans. [Abnormal Loss 500 units at R 10,000; Transferred to Process II 4,350 units at R 87,000]
14. Fifty units are introduced into a process at a cost of 50. The total additional expenditure incurred
R

by the process is 32. Of the units introduced 10 per cent are normally spoil in the course of
R

manufacture ; these possess a scrap value of 0.20 each. Owing to an accident only 40 units are
R

produced.
You are required to—(i) prepare a process account, and (ii) give journal entries to show how the
loss arising out of spoiled units should be treated.
Ans. [Process Total Cost 72 ; Abnormal Loss (5 units) 9]
R R

15. A batch of 600 units was introduced in a process at 20 per unit. 500 units were completed and
R

transferred to the finished goods stores. The normal process loss was 20% of the input, and the
scrap is normally sold to a contractor at 3 each. The labour and overhead expenditure, incurred
R

in the process amounted to 600. You are required to show the Process and Abnormal Gain
R

Accounts.
Ans. [Abnormal Gain (20 units), 510. Cost of Actual Production 500 units 12,750]
R R

16. At the end of process A, carried on in a factory during the week ending July 31st, 2024 the number
of units produced was 850 excluding 50 units damaged at the very end of the process. The
damaged units realised 3 per unit as scrap. A normal loss of 10 per cent occurs during the
R

process, the wastage realised was 2 per unit. R

A unit of raw materials costs 4. The other expenses for the week were :
R

Wages 500 ; Power 200 ; General Expenses 450 .

R R R

2
Forty per cent of the output is sold so as to show a profit of 16 3 per cent on the selling price; the
rest of the output is transferred to process B.
Prepare Process A Account.
Ans. [Profit on Sales 384; Sales 340 units at
R R 2,304; Transfer to Process B A/c 510 units @
R 5.65 per unit, i.e., at 2,880].
R

17. In process A, 10,000 units were introduced during January. 2000 units 40% complete in all respects
remained as closing work-in-progress at the end of the month. Compute the equivalent production
and obtain the cost of closing work-in-progress if total process costs during the period be 26,400. R

Ans. [Equivalent units 8,800, Value of closing WIP R 2,400].

18. In process A, opening work-in-progress in February was 2,000 units 40% complete. 10,500 units
were introduced during the period and 11,000 completed units were transferred to Process B and
PROCESS COSTING B/2·49

1,500 units remain as closing work in progress 70% complete. Calculate equivalent production and
apportion the total process costs of 33,750 to production and work in progress inventories under
R

FIFO method.
Ans. [Equivalent Production 11,250 units; Value of Opening WIP R 3,600; Value of Finished
Goods 27,000; Closing WIP 3,150]
R R

19. In process A there was opening work in progress of 1,000 units 40% complete and closing work-in-
progress 11,000 units 70% complete. Units introduced during the month of January were 1,10,000
units and completed units transferred to Process B were 86,000 units. Compute equivalent
production, and apportion the total costs of 3,89,200 to production, abnormal loss and work-in-
progress inventories.
Ans. [Equivalent production 97,300 units Units R

Value of opening work-in-progress 600 2,400

Value of Finished Goods 85,000 3,40,000
Value of Abnormal Loss 4,000 16,000
Value of Closing work-in-progress 7,700 30,800
20. 10,000 Units of raw materials are introduced into a process at a cost of 20,000. Wages and
R

overheads for the process are 5,100 and 3,400 respectively. 7,500 Units were completed, of the
R R

remaining 2,500 units, on an average 40% work has been done. Ascertain the cost of one complete
unit.
Ans. [Equivalent units 8,500. Cost of one completed unit R 3.00.]
21. Following particulars are extracted from the books of Y Ltd. for the month of August 2024:
Opening Stock of W.I.P. 200 units
Degree of Completion :
Materials 100% ; Labour 40% ; Overhead 40%
Units introduced in August, 2024 1,050
Completed units in August, 2024 1,100
Closing W.I.P. (units) 150
Degree of Completion :
Materials 100% ; Labour 70% ; Overhead 70%
Prepare a statement of equivalent production.
Ans. [Equivalent Units; Materials 1,050; Labour and Overhead 1,125]
22. Find out the equivalent production for the following data under the FIFO method :
Opening work-in-progress 2,000 units
Degree of completion : Materials 80%
Labour 60%
Overheads 60%
Units introduced 8,000
Closing work-in-progress 3,000 units
Degree of completion : Materials 80%
Labour 60%
Overheads 60%
Assume there are no process losses.
Ans. [Effective units ; Material 7,800 ; Labour and Overheads 7,600 units each]
B/2·50 PROCESS COSTING

LONG ANSWER TYPE

1. Describe briefly the main features of process costing. Name the industries where process costing
can be applied. Also compare process costing with job costing.
2. Explain normal loss, abnormal loss and abnormal gain and explain their effect in ascertainment of
cost of an article. How they should be dealt with in Process Cost Accounts.
3. What is inter-process profit ? What are the objectives and the disadvantages of this concept ?
Suggest alternative method by which the objectives can be achieved without corresponding
disadvantages ?
4. What is meant by ‘equivalent production’ ? Discuss its importance in valuing work-in-progress.
Or
What are equivalent units of production ? State the two methods of calculating equivalent units.
5. Discuss the merits and demerits of Average Cost method and FIFO method for valuation of work-
in-progress.
6. Explain fully the principles you would adopt for the valuation of work-in-progress at the end of an
accounting period.
Or
Explain briefly the procedure for valuation of work-in-progress.

7. Explain normal loss and abnormal gain and state how they should be dealt with in process cost
accounts. (B.Com. (Prof.) G.N.D.U, April 2011)

PRACTICAL PROBLEMS
1. (Simple) Department I of Coromandel Chemicals conducts a process which requires mixing of
materials and cooking of the mixture in batches of 1,000 lbs each. Cooking results in 10 per cent
loss of weight of the mixture. Also, past experience shows that two batches out of every ten started
in the process are spoiled.
The production records for March, 2024 show the following :
(i) Production started in the Process : 50 batches of 1,000 lbs each.
(ii) Production completed and transferred to finished goods : 34,200 lbs.
(iii) There is no inventory of work-in-progress at the beginning or at the end of the month.
Costs recorded during the month totalled 45,000.
R

Prepare the Account of the Process conducted by Department I.

Ans. [Abnormal Loss (800 lbs) 1,029, Transferred to Finished Stock 43,971]
R R

2. (Simple) The product of a manufacturing concern passes through two processes, A and B and then
to finished stock. It is ascertained that in each process, normally 5% of the total weight is lost and
10% is scrap from which processes A and B realize 80 per tonne and 200 per tonne respectively.
R R

The following are the figures relating to the processes :

Particulars Process A Process B
Materials (tones) 1,000 70
Cost of Materials tone
R 125 200
Wages ( )
R 28,000 10,000
Manufacturing Expenses ( ) R 8,000 5,250
Output (tones) 830 780
There was no stock or WIP in any process.
PROCESS COSTING B/2·51

Prepare the Process Cost Account of Process B assuming no inter-process profit mark-up on
transfers to Process B.
Ans. [Abnormal Gain 3,150 (i.e. 15 unit @ 210); Transfer to Finished Stock 780 units;
R R

Valued at 1,63,800]
R

3. (Where wastage is given) Following information is extracted from the cost accounts of a factory
producing a commodity in the manufacture of which three processes are involved. Prepare Process
Accounts, showing the cost of the output and the cost per unit at each stage of manufacture.
You may presume that
(a) The operations in each separate process are completed daily ; and
(b) The value at which units are to be charged to Process two and Process three are the cost
per unit of Process one and one plus two respectively.
Process 1 2 3
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R

Direct Wages 2,500 5,000 6,500

Machine Expenses 1,400 1,200 1,200
Factory Overheads 1,100 1,550 900
Raw Materials Consumed 8,000 — —
units units units
Production (Gross) 2,750 — —
Wastage 150 210 200
Opening Stock of Raw Materials — 250 500
Closing Stock of Raw Materials — 440 100
Cost of Output Cost per Unit
R R

⎡⎢ Process 1 13‚000 5 ⎤
Ans. ⎢⎣ Process 2 19‚800 9 ⎥ ⎥
Process 3 32‚000 13.33 ⎦
4. In a factory the product passes through two processes A and B. A loss of 5% is allowed in Process A
and 2% in Process B, nothing being realised by disposal of wastage.
During April, 2024, 10,000 units of material costing 6 per unit were introduced in Process A. The
R

other costs are :

Process A Process B
R R

Materials — 6,140
Labour 10,000 6,000
Overheads 6,000 4,600
The output was 9,300 units from Process A. 9,200 units were produced by Process B, which were
transferred to the warehouse.
8,000 units of the finished product was sold @ 15 per unit. The selling and distribution expenses
R

were 2 per unit.

R

Prepare (i ) Process Accounts ; and (ii) A statement of profit or loss of the firm for April 2024,
assuming there were no opening stocks of any type.
Ans. [Process A : Abnormal Loss (200 units) 1,600 ; 9,300 units transferred to Process B at
R

74,400 ; Process B : Abnormal Gain (86 units) 860 ; 9,200 units transferred to Finished
R R
B/2·52 PROCESS COSTING

Stock at 92,000. Net Profit before adjustment of Abnormal Gain and Abnormal Loss
R

was 24,000 and after adjustment 23,260]

R R

5. A product passes through two processes A and B. During the year 2024, the input to process A of
basic raw material was 8,000 units @ 9 per unit. Other information for the year is as follows :
R

Process A Process B
Output units 7,500 4,800
Normal Loss (% to input) 5% 10%
Scrap Value per unit ( ) R 2 10
Direct Wages ( ) R 12,000 24,000
Direct Expenses ( ) R 6,000 5,000
Selling Price per unit ( ) R 15 25
Total overheads 17,400 were recovered as percentage of direct wages. Selling expenses were
R

R5,000. There are not allocate to the processes. 2/3 of the output of Process A was passed on to the
next process and the balance was sold. The entire output of Process B was sold.
Prepare Process A and B Accounts and Profit & Loss Account.
Ans. [Process A : Abnormal Loss (100 units) @ R 12.50 per unit = R 1,250; Transfer to Process B
(5,000 units) at 62,500. R

Process B : Abnormal Gain (300 units) valued @ R 2,180 per unit R 6,540; Transfer to
Finished stock 4,800 units at 1,04,640.
R

Net Profit R 19,100]

6. JK Ltd. produces a product “AZE”, which passes through two processes, viz., process I and process
II. The output of each process is treated as the raw material of the next process to which it is
transferred and output of the second process is transferred to finished stock. The following data
related to December, 2023 :
Process I Process II
25,000 units introduced at a cost of R 2,00,000 —
Material consumed R 1,92,000 96,020
Direct labour R 2,24,000 1,28,000
Manufacturing expenses R 1,40,000 60,000
Normal wastage of input 10% 10%
Scrap value of normal wastage (per unit) R 9.90 8.60
Output in Units 22,000 20,000
Required :
(i) Prepare Process I and Process II account.
(ii) Prepare Abnormal effective/wastage account as the case may be each process.
Ans. [Process I : Abnormal Loss (500 units) at 16,250; Transferred to Process II (22,000 units)
R

at 7,15,000.
R

Process II : Abnormal Loss (200 units) at 9,900; Transferred to Finished Stock (20,000
R

units) at 9,90,000.
R

7. A company manufactures a chemical product by a series of operations in three processes. Raw

material is fed into Process I and the finished chemical that comes out of Process III is transferred
to finished goods store. The following particulars relating to operations for April 2024 are given
below :
PROCESS COSTING B/2·53

Process I Process II Process III

Raw materials issued 80,000 kgs. R 9,60,000 — —
Direct wages R 1,25,600 R 1,72,000 R 1,42,500
Overhead costs R 1,68,000 R 1,77,280 R 1,24,690
Normal processing loss (% of input) 3% 2% 1%
Output transferred to next process 74,000 kgs. 69,400 kgs. 69,000 kgs.
Work-in-process (cb) 3,000 2,400 —
(Processed material awaiting transfer to next process)
Prepare the accounts of Processes I, II, and III and also abnormal loss and abnormal gain accounts,
if any.
8. Product ‘Z’ is obtained after it passes through three distinct processes. Following information is
obtained from the accounts for the month ending March 31, 2024 :
Process
————————————————————————————————————————————————————————————

Items Total I II III

R R R R

Direct Material 7,542 2,600 1,980 2,962

Direct Wages 9,000 2,000 3,000 4,000
Production Overheads 9,000 — — —
% of Normal Loss to input 5% 10% 15%
Output (in units) during the month 950 840 750
Value of scrap per unit ( )
R 2 4 5
1,000 units at 3 each were introduced to process I. There was no stock of material or work-in-
R

progress at the beginning or end of the period. The output of each process passes direct to the next
process and finally to finished stores. Production overhead is recovered on 100 per cent of direct
wages.
Prepare process cost accounts and other related accounts.
Ans. [Process I—Transferred to II 9,500 ; Process II—Abnormal Loss (15 units) 300;
R R

Transferred to Process III 16,800 ; Process III—Abnormal Gain (36 units) 1,368,
R R

Transferred to Finished Goods 28,500] R

9. (Process Losses). Following particulars related to two processes—X and Y for the month of Jan.
2024 :
Process X Process Y
————————————————————————————————————————————————

Total input (units) 50,000 1,000

@ 1.50 p.u.
R

Normal Loss (% of input) 10% 5%

Additional costs incurred :
Materials — 3,600
Direct Labour 35,000 45,000
Overheads 27,500 39,500
Realisable Value of Scrap p.u. 0.50
R 2R

Output (units) 43,000 43,000

B/2·54 PROCESS COSTING

The entire output of process X was transferred to process Y. The entire output of process Y was sold
at 6 per unit. Assume, there was no opening or closing stock of any type in process X or Y.
R

You are required to prepare the necessary accounts for the period.
Ans. [Process X : Abnormal Loss (2,000 units) R 6,000; Transferred to Process Y (43,000 units)
R 1,29,000.
Process Y :Abnormal Gain (1,200 units) 6,106; Transferred to Finished Stock (43,000
R

units) 2,18,806]
R

10. In a manufacturing unit, raw material passes through four processes I, II, III and IV and the
output of each process is the input of the subsequent process. The loss in the four processes I, II, III
2
and IV are respectively 25%, 20%, 20% and 16 3 % of the input. If the end product at the end of
process IV is 40,000 kgs. what is the quantity of raw material required to be fed at the beginning of
process I and the cost of the same at 5 per kg.
R

Find out also the effect of increase or decrease in the material cost of the end product for variation
of every rupee in the cost of the raw material.
Ans. [Raw Material required in the beginning of Process I : 1,00,000 Kgs. Or 2.50 Kgs. @ 5 per R

Kg.; End product will increase or decrease by 2.50] R

11. The product of a manufacturing concern passes through two processes—A and B. The normal losses
and abnormal losses are defective units having a scrap value of 2 and 5 per unit in processes A
R R

and B respectively. The following information relates to the month ending 31-3-2024 :
Process A Process B
Raw materials issued @ 5 R 3,000 units —
Normal loss 10% of input 5% of input
Output 2,800 units 2,600 units
Additional components 1,000
R 780 R

Direct Wages 4,000

R 3,000 R

Direct Expenses 10,000

R 14,000 R

Production Overhead 75% 125%

(as a percentage of direct wages)
There was no opening or closing work in progress but opening and closing stocks of finished goods
were 20,000 and 23,000 respectively.
R R

Prepare Process Accounts, Finished Stock A/c, Normal Loss A/c, Abnormal Loss A/c and Abnormal
Gain A/c.
Ans. [Process A—Abnormal Gain 100 units @ 12 = 1,200; Transfer to Process B—2,800 units
R R

at 33,600.
R

Process B—Abnormal Loss 60 units @ R 20.46 = 1,228. Transfer to Finished Stock 2,600
units at 53,202.
R

Finished Stock—Balance 23,000.]R

12. A product passes through three processes— A,B and C.

The details of expenses incurred on the three processes during the year 2024 were as under :
A B C
Units Issued 1,000
R R R

Cost per unit 50

Sundry Materials 1,600 3,315 3,220
Labour 2,600 8,000 6,392
Sale Price of Output (per unit) 70 100 200
PROCESS COSTING B/2·55

Actual output of the three proceses was : Process A—930 units ; Process B—540 units; Process C—
210 units.
Two-thirds of the output of Process A and one-half of the output of Process B was passed on to the
next process and the balance was sold. The entire output of Process C was sold.
The normal loss of the three processes, calculated on the input of every process, was : Process A—
5%; Process B—15%; and Process C—20%.
The loss of Process A was sold at R 1 per unit, that of Process B at R 3 per unit and that of Process
C at 6 per unit.
R

Selling expenses were R 9,000. These are not allocable to the processes.
Prepare the three process accounts and the Profit & Loss A/c
Ans. [Process A : Abnormal Loss (20 units) R 1,140; Transferred to B Process 620 units at
R 35,340.
Process B: Abnormal Gain (13 units) R 1,144 ; Transferred to Process C 270 units at
R23,760.
Process C : Abnormal Gain (6 units) R 918, Transferred to Income Statement (210 units)
at 32,130. Net Profit 8,140]
R R

13. (Process Losses) The production in a manufacturing company passes through three distinct
processes, I II and III. The output of each process is transferred to the next process and the output
of process III is transferred to finished goods stock. The normal loss in each process and the
realisable value of the same are given below :
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Process Percentage of normal Realisable value

waste related to input per unit
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

I 5 R 0.70
II 7 R 0.80
III 10 R 1.00
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

The details of cost data and output for a month are as shown below :
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Processes
————————————————————————————————————————————————————————————————————————

I II III
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Materials Consumed ( ) R 1,20,000 40,000 40,000

Direct Labour Cost ( ) R 80,000 60,000 60,000
Production Expenses ( ) R 40,000 40,000 28,000
Output (Units) 38,000 34,600 32,000
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Process I was fed with 40,000 units of input costing 3,20,000. There were no opening or closing
R

work-in-progress.
Prepare the process accounts for the month.
Ans. [Process I : Transfer to Process II 38,000 units at 5,58,600. R

Process II : Transfer to Process III 34,600 units at 6,81,888. Abnormal Loss 740 units
R

valued at 14,584.R

Process III : Transfer to Finished Stock 32,000 units at 8,28,699. Abnormal Gain 860 R

units at 22,271].
R

14. (Process Losses) A product passes through two processes. The output of Process I becomes the
input of Process II and the output of Process II is transferred to warehouse. The quantity of raw
B/2·56 PROCESS COSTING

materials introduced into Process I is 20,000 kgs. at R 10 per kg. The cost and output data for the
month under review are as under :
Process I Process II
Direct Materials R60,000 40,000
R

Direct Labour R40,000 30,000

R

Production Overheads R39,000 40,250

R

Normal Loss 8% 5%
Output 18,000 17,400
Loss Realisation of /Unit
R 2.00 3.00
The company’s policy is to fix the selling price of the end product in such a way as to yield a profit
of 20% on selling price.
Required : (i) Prepare the Process Accounts. (ii) Determine the Selling Price per unit of the end
product.
Ans. [(i) Process I : Transfer to Process II 18,000 kgs. at 3,28,500. Value of Abnormal Loss
R

(400 kgs.) at 7,300. Process II : Transfer to Warehouse 17,400 kgs at 4,43,700. Value of
R R

Abnormal Gain (300 kgs.) at 7,650. (ii) 31.875.]

R R

INTER-PROCESS PROFIT
15. A product passes through two processes A and B. Output of Process A is transferred to Process B at
cost plus 25% profit and the output of process B is similarly transferred to Finished Stock Account
at cost plus 25% profit. There was no Work-in-Progress in either process on 31st March, 2024. On
this date, the following further information was available:
Process A Process B
R R

Material Consumed 8,000 24,000

Wages 12,000 16,000
Closing Stock (Value at Prime Cost) 4,000 12,000
Out of the finished stock, a portion remained at hand valued at 18,000 and the balance sold for
R

58,000. Prepare the Process and Finished Stock Accounts. Question of oncost should be ignored.
R

Also calculate the amount of reserve that should be made in respect of unrealised profit.
Ans. [Profit : Process A— 4,000 ; Process B— 12,000 ; Finished Stock— 16,000 ; Actual
R R R

Profit— 26,640]
R

16. The product of a manufacturing concern passes through three processes A, B and C. The output of
process A and B is charged to the next process to give a profit of 25% on cost, while the output of
process C is charged to Finished Stock Account which gives process C, a profit of 25% on cost.
From the following particulars prepare the Process Accounts and Finished Stock Account and
calculate the amount of unrealised profit included in the closing stock and the amount of actual
profit made by the concern. There was no opening stock and closing stock in each process has been
valued at prime cost.
Processes
—————————————————————————————————————————————————————————————————

A B C
R R R

Materials Used 14,000 21,000 7,000

Labour 21,000 14,000 28,000
Closing Stock 7,000 14,000 21,000
Sales R 1,26,000
PROCESS COSTING B/2·57

Closing Stock of Finished Goods amounted to 14,000. R

Ans. [Profit : Process A— 7,000 ; Process B— 14,000 ; Process C— 21,000 ; Finished Stock—
R R R

35,000 ; Actual Profit— 66,790]

R R

17. A certain product passes through three processes before it is transferred to finished stock. These
processes are known as A, B and C. The following information is obtained for the month of
January, 2024 :
Process A Process B Process C Finished Stock
R R R R

Opening Stock (at Prime Cost) 1,000 1,200 800 3,000

Direct Materials 2,000 2,100 3,000 —
Wages 1,500 1,500 1,600 —
Overheads 1,400 600 4,000 —
Closing Stock (at Prime Cost) 500 600 400 1,500
Inter-Process Profit for Opening Stock — 200 200 1,100
Profit (% on transfer price to next process) 25% 20% 20% —
Sales of finished stock during January, 2024 amounted to R 35,000. You are required to—
(a) Prepare Process Cost Accounts; and
(b) Calculate Actual Realised Profit.
Ans. [(a) Profit : Process A— 1,800 ; Process B— 3,000 ; Process C— 6,000 ; Finished Stock—
R R R

3,500 ; (b) Actual Realised Profit— 15,050]

R R

18. Product A passes through three processes before it is completed. The output of each process is
charged to the next process at price calculated to give a profit of 20% on transfer price (i.e., 25% on
cost price). The output of process III is charged to finished stock account on a similar basis. There
was no work-in-progress at the beginning of the year and overheads have been ignored. Stocks in
each process have been valued at prime cost of the process. Following data are obtained at the end
of 31st March, 2024 :
Details Process I Process II Process III Finished
Stock
R R R R

Direct Materials 20,000 5,000 4,000 —

Direct Wages 15,000 10,000 20,000 —
Stock on 31st December 5,000 6,500 9,500 5,000
Sales during the year — — — 1,10,000
From the above information prepare :
(a) process cost accounts showing the profit element at each stage ;
(b) actual realised profit ; and
(c) stock valuation as would appear in the Balance Sheet.
Ans. [(a) Profit : Process I— 7,500 ; Process II— 11,500 ; Process III— 18,000 and Finished
R R R

Stock 25,000,
R

(b) R 57,078,
(c) R 21,078]
19. Product B passes through three processes before it is transferred to finished stock. Following
information is obtained for the month of March :
B/2·58 PROCESS COSTING

Details Process Finished

——————————————————————————————————————————————————————

I II III Stock
R R R R

Opening Stock 5,000 8,000 10,000 20,000

Direct Material 40,000 12,000 15,000 —
Direct Wages 35,000 40,000 35,000 —
Production Overheads 20,000 24,000 20,000 —
Closing Stock 10,000 4,000 15,000 30,000
Profit % on Transfer
Price (to next process) 25% 20% 10% —
Inter-process Profit for
Opening Stock — 1,395 2,690 6,534
Stocks in processes are valued at prime cost and finished stock has been valued at the price at
which it is received from Process III. Sales during the period were 4,00,000. R

Prepare and compute :

(a) process cost accounts showing profit element at each stage ;
(b) actual realised profit ; and
(c) stock valuation for Balance Sheet purpose.
Ans. [(a) Process I— 30,000, Process II— 50,000; Process III— 35,000 and Finished Stock—
R R R

60,000 ; (b) 1,71,084 ; (c) 44,465]

R R R

20. A product passes through three processes ‘X’, ‘Y’ and ‘Z’. The output of process ‘X’ and ‘Y’ is
transferred to next process at cost plus 20 per cent each on transfer price and the output of process
‘Z’ is transferred to finished stock at a profit of 25 per cent on transfer price. The following
informations are available in respect of the year ending 31st March, 2024 :
Process Process Process Finished
X Y Z Stock
R R R R

Opening Stock 15,000 27,000 40,000 45,000

Material 80,000 65,000 50,000
Wages 1,25,000 1,08,000 92,000
Manufacturing Overheads 96,000 72,000 66,500
Closing Stock 20,000 32,000 39,000 50,000
Inter Process Profit included
in Opening Stock NIL 4,000 10,000 20,000
Stock in processes is valued at prime cost. The finished stock is valued at the price at which it is
received from process ‘Z’. Sale of the finished stock during the period was 14,00,000. R

You are required to prepare :

(i) Process accounts and Finished Stock Account showing profit element at each stage.
(ii) Profit and Loss Account.
(iii) Show the relevant items in the Balance Sheet.
Ans. [Profit : Process X : 74,000; Process Y :
R R 1,52,000; Process Z R 3,24,000; Transferred to
Finished Stock at Total Cost 12,96,000]R
PROCESS COSTING B/2·59

EQUIVALENT PRODUCTION
21. (Simple) 10,000 units of raw materials are introduced into a process at a cost of 20,000. Wages
R

and overheads for the process are 5,100 and 3,400 respectively, 7,500 units were completed ; of
R R

the remaining 2,500 units on the average 40% work has been done in respect of labour and
overheads.
Prepare (i) Statement of Equivalent Production, (ii) Statement of Cost, (iii) Statement of
Evaluation, and (iv) Process Account.
Ans. [Effective units : Materials 10,000 ; Labour and Overheads 8,500 units ; Cost per unit :
Material 2; Wages 0.60 and Overheads 0.40 ; Value of : Finished Goods 22,500 ;
R R R R

Work-in-Progress 6,000] R

22. During the month of April 2024, 4,000 units were introduced into Process ‘A’ at the cost of
R 23,200. At the end of the month 3,000 units were completed and transferred to Process ‘B’ A/c.
720 units were still in process and 280 units were scrapped. A normal loss of 5% was expected. It
was estimated that the incomplete units have reached a stage in production as follows :
Materials 75% ; Labour and Overheads 50%.
The additional costs incurred were :
Materials R 6,160 ; Wages R 13,760 ; Overheads R 6,880.
Units scrapped realised at R 2 per unit.
Prepare :
(1) A statement showing equivalent production; and
(2) Statement showing cost per unit.
Ans. [Equivalent Units : Materials 3,620, Labour and Overheads 3,440; Cost per equivalent
unit : Material 8, Labour 4 and Overheads 2]
R R R

23. (Equivalent Production FIFO). From the following details prepare Statement of Equivalent
Production and Statement of Cost by using FIFO :
Opening work-in-process 2,000 units ; Materials (100% complete) 7,500 ; Labour (60% complete)
R

R3,000 ; Overheads (60% complete) 1,500 ; Introduced into the process 8,000 units
R

There are 2,000 units in closing work-in-progress and the stage of completion is estimated to be :
Materials 100%, labour 50%, overheads 50%, 8,000 units are transferred to next process.
The process cost for the period are :
Materials R 1,00,000 ; Labour R 78,000 ; Overheads R 39,000
Ans. [Equivalent units : Material 8,000 units; Labour and overhead 7,800 units; Cost per unit :
Material 12.50; Labour 10 and Overhead 5]
R R R

24. A manufacturing concern produces standardised electric meters in one of its departments. From
the following particulars relating to a job of 50 meters you are required to determine the values of
the work-in progress and the finished goods.
(a) Cost incurred as per job card :
Direct materials 7,500 ; Direct labour 2,000 ; Overheads 6,000.
R R R

(b) Selling price per meter 450 R

(c) Selling and distribution expenses 30% of the sale value

(d) 25 meters are completed and transferred to the stock of finished goods.
(e) Completion stage of work-in-progress :
Direct material 100% ; Direct labour 60% ; Overheads 60%
Ans. [Effective units : Material 50, Direct Labour and Overheads 40 ; Cost per Equivalent
B/2·60 PROCESS COSTING

unit: Material 150; Labour and Overheads 200 ; Value of WIP 6,750 ; Finished Stock
R R R

R7,875 at market price 315 (i.e. 450 – 135 Selling and Distribution Expenses)].
R R R

25. From the following data of Kiran Processing Industry Ltd., calculate (a) Equivalent Production,
(b) Cost per unit of Equivalent Production, and (c) Cost of units completed and awaiting
completion.
R

Number of units introduced in the process 4,000

Number of units completed and transferred to next process 3,500
Number of units in process at the end of the period 400
Stage of Completion :
Materials 80% ; Labour 50% ; Overheads 50%.
Normal process loss at the end of the process 100 units ; Value of scrap 1 per unit ; Value of raw
R

materials 7,740 ; Wages 11,100 ; Overheads 7,400

R R R

Ans. [Effective units : Materials 3,820 ; Labour and Overheads 3,700 ; Cost per unit Materials
2: Labour 3 ; Overheads 2 : Value of Finished Goods 24,500; Work-in-progress
R R R R

1,640]
R

26. (Average Cost Method) SBL LTD. furnishes you the following information relating to process-B for
the month of April, 2024:
(i) Opening Work-in-progress : NIL.
(ii) Units introduced—10,000 units @ R 5 per unit.
(iii) Expenses debited to the process-B :
Processing Materials— 24,600; Direct Labour— 10,400; Overheads— 5,000.
R R R

(iv) 8,000 units of finished output were transferred to the next process during the month.
(v) Normal Loss in Process—10% of input.
(vi) Closing Work-in-progress—800 units.
Degree of Completion : Material—100%; Labour & Overheads—50%.
(vii) Degree of Completion of Abnormal Loss : Material—100%; Labour & Overheads—80%.
(viii) Scrap realisation : Normal Loss—@ R 2 per unit; Abnormal Loss—@ R 4 per unit.
You are required to prepare :
(1) Statement of Equivalent Production. (2) Statement of Cost of Each Element. (3) Statement of
Evaluation. (4) Process-B Account. (5) Abnormal Loss Account.
Ans. [ (a) Material 9,000 units, Labour & Overhead 8,560 units
(b) Cost per unit : Material 8.067; Labour 1.215, Overheads 0.584 = Total
R R R R 9.866.
(c) Finished Output 78,926; Abnormal Loss 1,900, Closing WIP 7,174.
R R R

(d) Total of Process B A/c (10,000 units)— 90,000.R

(e) R1,100 transferred to Costing P/L A/c]

27. (Average Cost Method) Following details are related to the work done in Process ‘A’ of XYZ
Company during the month of March, 2024:
R

Opening Work-in-progress (2,000 units)

Materials 80,000
Labour 15,000
Overheads 45,000
Materials introduced in Process ‘A’ (38,000 units) 14,80,000
PROCESS COSTING B/2·61

Direct Labour 3,59,000

Overheads 10,77,000
Units scrapped : 3,000 units
Degree of completion :
Materials 100%
Labour and Overheads 80%
Units finished and transferred to Process ‘B’ : 35,000
Normal Loss:
5% of total input including opening work-in-progress
Scrapped units fetch R 20 per piece
You are required to prepare by using Average Cost Method :
(i) Statement of Equivalent Production; (ii) Statement of Cost; (iii) Statement of Distribution
Cost; and (iv) Process ‘A’ Account, Normal and Abnormal Loss Accounts.
Ans.
(i) Equivalent units : Materials 38,000, Labour and Overhead 37,400.
(ii) Cost per unit : Material 40, Labour 10 and Overheads 30.
R R R

(iii) Completed and transferred to Process B = 35,000 units @ 80 = 28,00,000. Abnormal

R R

Loss : 1,000 units, Total Cost 72,000; Closing WIP 2,000 units— 1,44,000.
R R

(iv) Process A/c Total 30,56,000.]

R

28. (Average Cost Method) A company produces a component, which passes through two processes.
During the month of April, 2024, materials for 40,000 components were put into Process I of which
30,000 were completed and transferred to Process II. Those not transferred to Process II were 100%
complete as to materials cost and 50% complete as to labour and overheads cost. The Process I
costs incurred were as follows:
Direct Materials R 15,000 ; Direct Wages R 18,000 ; Factory Overheads R 12,000.
Of those transferred to Process II, 28,000 units were completed and transferred to finished goods
stores. There was a normal loss with no salvage value of 200 units in Process II. There were 1,800
units, remained unfinished in the process with 100% complete as to materials and 25% complete as
regard to wages and overheads.
No further process material costs occur after introduction at the first process until the end of the
second process, when protective packing is applied to the completed components. The process and
packing costs incurred at the end of the Process II were:
Packing Materials R 4,000 ; Direct Wages R 3,500 ; Factory Overheads R 4,500.
Required to prepare by using Average Cost Method :
(i) Statement of Equivalent Production, Cost per unit and Process I A/c.
(ii) Statement of Equivalent Production. Cost per unit and Process II A/c.
Ans. [ (i) Equivalent Production (Units) : Materials 40,000; Labour and Overheads 35,000;
Cost per unit : Material 0.375, Labour & Overhead 0.8571, Transfer to Process
R R

II—(30,000 units) at 36,964. R

(ii) Effective Production (Units) : Material 29,800, Labour and Overheads 28,450; Cost
per unit—Material 1.24, Labour and Overhead— 0.2812; Closing Inventory (1,800
R R

units) 2,359, Transfer to Finished Goods Stores A/c (28,000 units) at 46,605]
R R
B/2·62 PROCESS COSTING

29. (FIFO) X Ltd., a manufacturer of a specialised product, is having a process costing system. The
stock of work-in-progress at the end of each month is valued on FIFO basis. At the beginning of a
month, the stock of work-in-progress was 400 units (40 per cent complete) which was valued as
follows :
Materials R 3,600 ; Labour R 3,400 ; Overheads R 1,000 .
During the month, actual issue of materials for production purpose was 68,500. Wages and R

overheads in the month amounted to 79,800 and 21,280 respectively. Finished production taken
R R

into the stock in the month was 2,500 units. There was no loss in the process. At the end of the
month, the stock of work-in-progress was 500 units (60 per cent complete as to labour and
overheads and 80 per cent complete as to materials).
Prepare (i) Statement of equivalent production (ii) Statementof Evaluation and (iii) Process
Account.
Ans. [Effective units : Materials 2,740 ; Labour and Overheads 2,640 each ; Cost per equivalent
unit. Material 25, Labour 30.227, Overheads 8.061 ; Cost of production (2,500 units)
R R R

1,56,094 ; Closing WIP 21,486]

R R

30. (FIFO) The finished products of a factory pass through two processes, the entire material being
placed in process at the beginning of the first process. From the following production and cost data
relating to the first process work out the value of the closing inventory and of the value of materials
transferred to the second process (use FIFO Method).
R Kgs.
Opening inventory 10,000 Opening inventory (25 per cent complete) 4,000
Material 27,500 Put into process 12,000
Labour 50,000 Transferred to II Process 10,000
Manufacturing Overhead 40,000 Closing inventory (20 per cent complete) 5,000
Normal Spoilage during process 1,000
Ans. [Effective units : For Material, Labour and Overheads 10,000 kgs. ; Cost per unit :
Material 2.75, Labour 5.00, Overheads 4.00; Value of closing inventory 11,750 ;
R R R R

Value of stock transferred 1,15,750] R

31. (Average Cost Method) Process II receives units from Process I and after carrying out work on
the units transfers them to Process III. For one accounting period the relevant data were as
follows:
Opening WIP 200 Units (25% complete) valued at R 5,000.
800 units received from Process I valued at R 8,600, 840 units were transfered to Process III.
Closing WIP 160 units (50% complete)
The costs of the period were R 33,160 and no units were scrapped.
Required :
Prepare the Process Account for Process II using the Average Cost Method of Valuation.
Ans. [Effective units. Material, Labour and Overhead 920 units. Cost per Equivalent Unit
R 50.826. Transfer to Process III 42,694, Work-in-Progress 4,066]
R R

32. (Average Cost Method) Following details are given in respect of a manufacturing unit for the
month of April 2024.
(i) Opening work-in-progress 5,000 units
(a) Materials (100% complete) 18,750 ; R (b) Labour (60% complete) R 7,500 ; (c)
Overheads (60% complete) 3,750 R
PROCESS COSTING B/2·63

(ii) Units introduced into the process 17,500 units.

(iii) 17,500 units are transferred to the next process.
(iv) Process costs for the period are
Material 2,50,000 ; Labour 1,95,000 ; Overheads
R R R 97,500.
(v) The stage of completion of units in closing WIP are estimated to be : Material 100%,
Labour 50% and Overheads 50%.
You are required to prepare a statement of equivalent units of production and a statement of cost.
Also find the value of
(a) output transferred,
(b) closing work-in-progress, using average cost method. Apply Average Method.
Ans. [Effective Units : Materials 22,500, Labour and Overheads 20,000 units. Value of Output
transferred 4,74,810, Value of Closing WIP 97,690.]
R R

33. (Average Cost Method) A company manufactures a single product in two successive processes.
Following information is obtained for the month of January :
Process I :
(i) No opening work-in-process on 1st January.
(ii) During the month, 1,630 units costing 4,740 were put into process.
R

(iii) Labour and overhead incurred amounted to 3,475.

R

(iv) During the month, 1,200 units were finished and passed to Process II.
(v) On 31st January, 380 units remained in process the operations on which were half
completed but the materials for the whole process have been charged to the process.
Process II
(i) No opening work-in-process on 1st January.
(ii) Labour and overhead incurred amounted to 1600. Materials added at the end of operations
R

amounted to 750.R

(iii) On January 31, 800 units had been transferred to finished stock.
(iv) At that date, 360 units remained in process and it was estimated that one half of the
operations had been completed.
Show the Process Accounts, treating any process loss as a normal loss. Use average method.
Ans. [Process I. Effective units : Materials 1,580 ; Labour and Overhead 1,390 ; Cost per unit—
Material 3 ; Labour and Overhead 2.50 ; Valuation of finished goods 6,600 ; Work-in-
R R R

Progress 1,615.
R

Process II. Effective units : Material I 1,160 ; Materials II, Labour and Overhead 980;
Cost per unit; Material I— 5.6897, Material-II— 0.7653 ; Labour and Overhead 1.6327 ;
R R R

Valuation of finished goods 6,470; Work-in-progress 2,480]

R R

34. (Simple) Following information is available regarding Process A for the month of February, 2024 :
Production Record
Units in process as on 1-2-2024 4,000
(All materials used, 25% complete for labour and overhead)
Units completed 14,000
New units introduced 16,000
Units in process as on 28-2-2024 6,000
1
(All materials used, 333 % complete for labour and overhead)
B/2·64 PROCESS COSTING

Cost Records
Work in progress as on 1-2-2024 R Cost during the month R

Materials 6,000 Materials 25,600

Labour 1,000 Labour 15,000
Overhead 1,000 Overhead 15,000
Presuming that average method of inventory is used, prepare :
(i) Statement of equivalent production ; (ii) Statement showing cost for each element ; (iii)
Statement of apportionment of cost ; (iv) Process cost account for process A.
Ans. [Effective Units : Materials 20,000, Labour and Overhead 16,000; Cost per Equivalent
Unit : Material 1.58, Labour and Overhead 1 each, Value of Finished Stock 50,120
R R R

Closing WIP 13,480, Total of Process A account 63,600].

R R

35. (Average Cost Method) From the following information relating to Process I of a factory for the
month of April 2024, prepare the statement of equivalent production, statement of cost, statement
of evaluation and Process Account, using average cost method :
(i) Opening Work-in-Progress : 500 units Materials R 27,000
Labour R 8,000
Overheads R 12,500
———————————

47,500
———————————

(ii) Cost incurred during April 2024.

Input of materials : 14,000 units R 5,74,750
Labour R 1,19,300
Overheads R 1,78,450
(iii) Process loss :
Normal loss : 10%
Value of scrapped unit : 10 each.
R

Actual loss during April 2024 : 1,500 units

Degree of completion : Materials 100%, Labour and Overheads 60%
(iv) Closing work in progress : 1,000 units
Degree of completion : Materials 100%, Labour and Overheads 70%
(v) Processed units transferred to Process II : 12,000 units during April 2024.
Ans. [Effective units : Materials 13,050 units; Labour and Overhead 12,730 units. Value of
Finished Goods 8,40,000; Value of Abnormal Loss 3,000; Closing WIP 62,500.]
R R R

36. ABX Company Ltd. provides the following information relating to Process B :
(i) Opening Work-in-progress — NIL
(ii) Units introduced — 45,000 units @ 10 per unit
R

(iii) Expenses debited to the process :

Direct material— 65,500; Labour— 90,800; Overhead— 1,80,700.
R R R

(iv) Normal loss in the process—2% of input

(v) Work-in-Progress—1,800 units
Degree of completion
Materials—100%; Labour—50%; Overhead—40%.
(vi) Finished output—42,000 units
(vii) Degree of completion of abnormal loss :
Materials—100%; Labour—80%; Overhead—60%.
PROCESS COSTING B/2·65

(vii) Units scrapped as normal loss were sold at 5 per unit.

R

(x) All the units of abnormal loss were sold at 2 per unit.
R

You are required to prepare :

(a) Statement of equivalent production.
(b) Statement showing the cost of finished goods, abnormal loss and closing balance of work-in-
progress.
(c) Process-B account and abnormal loss account.
Ans. [(a) Equivalent units : Material 44,100-; Labour 43,140, overhead 42,900.
Cost per unit : Material 11.5873; Labour 2.1048; Overhead 4.2121.
R R R

(b) Cost of Finished Goods 7,51,976.40. Value of Abnormal Loss 4,739.52; Closing WIP
R R

R 25,784.17;
(c) Process B A/c Total 7,87,000.
R

37. (Average Cost Method) Data relating to work done in Process ‘A’ of a company during the month
of April, 2024 is given below :
Opening Work-in-Progress (1000 units) :
R

Materials 40,000
Labour 7,500
Overheads 22,500
R

Materials introduced in Process ‘A’ (19,000 units) 7,40,000

Direct labour 1,79,500
Overheads 5,38,500
Units scrapped : 1500 units
Degree of completion : materials : 100%
Labour and overheads : 80%
Closing Work-in-Progress : 1000 units
Degree of completion : Materials : 100%
Labour and overheads : 80%
Units finished and transferred to process ‘B’ = 17,500 units
Normal loss : 5% of total input including opening W.I.P.
Scrapped units fetch 20 per piece.
R

Required : (a) Statement of Equivalent Production. (b) Statement of Cost. (c) Statement of
Distribution of Cost. (d) Process ‘A’ Account and Other Accounts. Use Average Cost Method.
Ans. [Effective Units : Materials 19,000 ; Labours and Overheads 18,700; Cost per Equivalent
Unit — Materials R 40, Labour R 10, Overheads R 30 ; Valuation of Finished Stock
14,00,000, Abnormal Loss 36,000, Closing WIP 72,000; Total of Process A Account
R R R

15,28,000]
R

38. (Average Cost Method) Roy & Johnson (P) Ltd. gives the following particulars relating to process
A in its plant for the month of December 2023 :
Cost R

Work-in-progress (opening balance) on 1-12-2023—500 units : Material 4,800

Labour 3,200
Overheads 6,400
——————————

14,400
——————————
——————————
B/2·66 PROCESS COSTING

Units introduced during the month —19,500

Processing costs incurred during the month :
Materials R1,86,200
Labour 72,000
Overheads 1,06,400 R 3,64,600
—————————————

Output : Units transferred to process B 18,200

Units scrapped (completely processed) 1,400
Work-in-process (closing balance) 400
[Degree of completion : Materials—100%
Labour
and Overheads—50%].
Normal loss in processing is 5% of total input and normal scrapped units fetch 1 each.
R

Prepare the following statements for process A for December, 2023 using Average Method.
(a) Statement of equivalent production ; (b) Statement of cost ; (c) Statement of evaluation; (d)
Process ‘A’ Account.
Ans. [Effective Units : Materials 19,000 ; Labour and Overheads 18,800, Cost per Equivalent
Unit: Material 10, Labour 4 and Overheads 6 ; Value of Finished Goods Transferred
R R R

R 3,64,000 ; Value of Abnormal Loss (400 units) 8,000 ; Value of Closing WIP 6,000]
R R

39. (FIFO) Following data are available in respect of Process I for February, 2024 :
Opening stock of work-in-progress : 800 units at total cost of 4,000.
(i) R

(ii)
Degree of completion of opening work in progress :
Material 100% ; Labour 60% ; Overheads 60%
(iii) Input of materials at a total cost of 36,800 for 9,200 units.
R

(iv) Direct wages incurred 16,740.

R

(v) Production overheads 8,370.

R

(vi) Units scrapped 1,200 units. The stage of completion of these units was :
Materials 100% ; Labour 80% ; Overheads 80%
(vii) Closing work in progress : 900 units. The stage of completion of these units was :
Materials 100% ; Labour 70% ; Overheads 70%
(viii) 7,900 units were completed and transferred to the next process.
(ix) Normal loss is 8% of the total input (opening stock plus units put in).
(x) Scrap value is 4 per unit.
R

You are required to :

(a) Compute equivalent production.
(b) Calculate the cost per equivalent unit for each element.
(c) Calculate the cost of abnormal loss (or gain), closing work-in-progress and the units
transferred to the next process using the FIFO method.
(d) Show the Process Account for February, 2024.
Ans. [(a) Materials : 8,400 units, labour and overheads: 8,370 units.
(b) Material cost per unit 4 R

Labour cost per unit 2 R

Overhead cost per unit 1 R

————————————

R 7
————————————
————————————
PROCESS COSTING B/2·67

(c) Abnormal Loss (400 units) R 2,560

Closing WIP (900 units) R 5,490
Finished Goods (7,900 units) R 54,660 [4,960 + 49,700]
40. (Average Cost Method) A company within the food industry mixes powdered ingredients in two
different processes to produce one product. The output of Process I becomes the output of Process 2
and the output of Process II is transferred to the packing department.
From the information given below, you are required to open accounts for Process I, Process II,
abnormal loss and packing department and to record the transactions for the week ended 11th
May, 2024 :
Process I
Input :
Material A 6,000 kilograms at 50 paise per kilogram
Material B 4,000 kilograms at Rupee 1 per kilogram
Mixing Labour 430 hours at R 2 per hour
Normal Loss 5% of weight input, disposed of at 16 paise per kilogram
Output 9,200 kilograms
No work-in-progress at the beginning or end of the week.
Process II
Input :
Material C 6,600 kilograms at R 1.25 per kilogram
Material D 4,200 kilograms at R 0.75 per kilogram
Flavouring
Essence R 300
Mixing Labour 370 hours at R 2 per hour
Normal Waste 5% of weight input with no disposal value
Output 18,000 kilograms.
No work-in-progress at the beginning of the week but 1,000 kilograms in process at the end of the
week and estimated to be only 50% complete so far as labour and overheads were concerned.
Overheads of 3,200 incurred by the two processes to be absorbed on the basis of mixing labour
R

hours.
Ans. [Process I—Transfer to Process II 9,200 kgs. at 9,200. Abnormal Loss 300 kgs. at 300.
R R

Process II—Transfer to Packing Deptt. 18,000 kgs at 21,960. Work-in-Progress 1,000 kgs
R

at 1,160.]
R

SALES AFTERFURTHERPROCESSING ORAT THE SPLIT OFF POINT

41. A Company’s plant processes 1,50,000 kgs. of raw material in a month to produce two products,
viz., ‘P’ and ‘Q’. The cost of raw material is 12 per kg. The process costs per month are :
R

Direct Materials 90,000

Direct Wages 1,20,000
Variable Overheads 1,00,000
Fixed Overheads 1,00,000
The loss in process is 5% of input and the output ratio of P and Q which emerge simultaneously is
1 : 2. The selling prices of the two products at the point of split off are : P 12 per kg. and Q 20
R R
B/2·68 PROCESS COSTING

per kg. A proposal is available to process P further by mixing it with other purchased materials.
The entire current output of the plant can be so processed further to obtain a new product ‘S’. The
price per kg. of S is 15 and each kg. of output of S will require one kilogram of input P. The cost
R

of processing of P into S (including other materials) is 1,85,000 per month.

R

You are required to prepare a statement showing the monthly profitability based on both the
existing manufacturing operations and on further processing.
Will you recommend further processing ?
Ans. [ P Q S
R R R

Existing Mfg. Operations 60,000 2,00,000

On Further Processing 2,00,000 17,500]
42. A Chemical Processing Company produces four different products A, B, C and D from a single raw
material. All the four products are produced simultaneously at a single split-off point. Product C
does not require further processing. The other three products require further processing before
being sold. The company adopts the suitable sales value method of allocating joint costs to
products.
The cost of the material used for the year just ended was 18,000 and the initial processing costs
R

amounted to a further 30,000. The Output, Sales and additional processing cost for the relevant
R

year were as follows :

Product Output Sales Additional
in Units Processing Costs
R R

A 4,000 36,000 5,000

B 3,500 14,000 1,750
C 2,500 20,000 —
D 1,200 12,000 3,250
(a ) Prepare a comparative Profit and Loss statement showing the profit or loss made on each
product separately.
(b) A proposal has been made by the management to sell at split-off directly to other processors. If
that alternative had been selected, sales price per unit would have been A 7.0, B 3.50, C 8.0,
R R R

D 9.0. What would be the overall net profit of the company under this alternative ?
R

(c) Give your recommendations as to the future course of action to be followed by management in
regard to its processing of products from the viewpoint of profit improvement.
Ans. A B C D
⎡ (a) Profit ( )
R 10,333 4,083 6,667 2,917 ⎤
⎢ ⎥
⎢ (b)
R 23,050 i.e. decreased byR 950. ⎥
⎢⎣ (c) A be processed further and D should be sold at split-off point. ⎥⎦
STATEMENT OF EQUIVALENT PRODUCTION

Equivalent Production
——————————————————————————————————————————————————————————————————————————————————————————————————————————————

Input Units Output Units Material I Material II Labour Overhead

———————————————————————————————————————————————————————————————————————————————————————————————————————————————

Qty. % Qty. % Qty. % Qty. %

———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Opening Stock 600 Opening Stock 600 — — 120 20% 240 40% 240 40%

Process I 11,000 Normal Loss 1,000 — — — — — — — —

Abnormal Loss 200 200 100% 200 100% 140 70% 140 70%

Finished Production 8,200 8,200 100% 8,200 100% 8,200 100% 8,200 100%

Closing WIP 1,600 1,600 100% 1,120 70% 960 60% 960 60%
——————————— ———————————

11,600 Total 11,600

——————————— ———————————

—————————— ————————— ————————— ————————

Equivalent Production 10,000 9,640 9,540 9,540

—————————— ————————— ————————— ————————

NOTE : 1. Material I refers to materials of Process I. It will be always 100% complete as it is finished product of the previous
process.
2. Material II refers to material added in Process II.
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·1

SECTION C

CHAPTER

1
Reconciliation of Cost and
Financial Accounts
LEARNING OBJECTIVES

To state the meaning and need of Reconciliation.

To understand the reasons for differences in profits from Cost and Financial accounts.
To know the Procedure for Preparation of Reconciliation Account.

Need for Reconciliation

Non-integrated Accounting System is a system of accounting under which separate ledgers are
maintained for cost and financial accounts by accountants. Under such a system the cost accounts
restricts itself to recording only those transactions which relate to the product or service being
provided. In addition to this the enterprise will have to operate its financial books separately. This
will eventually lead to recording certain items with different amounts. Similarly certain items may be
omitted from recording either from cost books or financial books. Hence it can be stated that under
non-integrated accounting system reconciliation of the separate books becomes a necessity.
From the above it is clear that in those concerns where there are no separate cost and financial
accounts, the problem of reconciliation does not arise. But where cost and financial accounts are
maintained independent of each other, it is imperative that periodically two accounts are reconciled.
Though both sets of books are concerned with the same basic transactions but the figure of profit
disclosed by the former does not agree with that disclosed by the latter. Thus, reconciliation between
the results of the two sets of books is necessary due to the following reasons:
● To find out the reasons for the difference in the profit or loss in cost and financial accounts and to
indicate the position clearly and to be sure that no mistakes pertaining to accounts have been
committed.
● To ensure the mathematical accuracy and reliability of cost accounts in order to have cost
ascertainment, cost control and to have a check on the financial accounts.
C/1·2 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

● To contribute to the standardisation of policies regarding stock valuation, depreciation and

overheads.
● To facilitate coordination and promote better cooperation between the activities of financial and cost
sections of the accounting department.
● To place management in better position to acquaint itself with the reasons for the variation in
profits paving the way to more effective internal control.

Reasons for Disagreement in Profit

The disagreement between the costing and financial profit is caused by the following :
1. Items Shown only in Financial Accounts. There are a number of items which are included in
financial accounts but find no place in cost accounts. These may be items of expenditure or
appropriation of profit or items of income. The former reduce the profit while the latter have the
reverse effect. The items may be classified as under :
(a) Purely Financial Charges. (i) Loss arising from the sale of fixed assets, (ii) Loss on
investments, (iii) Discount on debentures, (iv) Interest on bank loan, mortgages and debentures, (v)
Expenses of the company’s share transfer office, (vi) Damages payable, (vii) Penalties and fines, (viii)
Losses due to scrapping of machinery, (ix) Remuneration paid to the proprietor in excess of a fair
reward for services rendered.
(b) Appropriations of Profit. (i) Donations and Charities, (ii) Taxes on income and profits, (iii)
Dividend paid, (iv) Transfers to reserves and sinking funds, (v) Additional provision for depreciation
on fixed assets and for bad debts, (vi) Capital expenditure specially charged to revenue.
(c) Writing Off Intangible and Fictitious Assets. Goodwill, Patents and Copyrights,
Advertisement, Preliminary Expenses, Organisation Expenses, Underwriting Commission, Discount
on Issue of Shares/Debentures etc.
(d) Purely Financial Incomes. (i) Rent receivable, (ii) Profits on the sale of fixed assets, (iii)
Transfer fees received, (iv) Interest received on bank deposits, (v) Dividend received, (vi) Brokerage
received, (vii) Discount, commission received etc.
2. Items Shown only in Cost Accounts. There are certain items which are included in cost
accounts but not in financial accounts. These items are very few and usually are notional charges. For
example, interest may be calculated on capital employed in production to show the nominal cost of
employing the capital though, in fact, no interest has been paid. Similarly production may be charged
with a nominal rent for premises owned to enable the concern to compare its cost of production with
that of a rented factory. Depreciation on assets is charged even when the book value is reduced to
negligible figure. Salary of the proprietor where he works but salary is not charged to Profit and Loss
A/c.
3. Over or Under-absorption of Overheads. Overheads absorbed in cost accounts on the basis of
estimation like percentage on direct materials, percentage on direct wages, etc. may be more or less
than the actual amount incurred. If overheads are not fully absorbed i.e. the amount in cost accounts
is less than the actual amount, the shortfall is called under-absorption. On the other hand, if overhead
expenses in cost accounts are more than the actual, it is called over-absorption. Thus, under or over-
absorption of overheads leads to difference in two accounts. Sometimes selling and distribution
expenses are ignored in cost accounts and as such costing profit will be higher and thus requires
reconciliation. Treatment of under/overabsorption of overheads has already been discussed in a
previous chapter.
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·3

4. Different Bases of Stock Valuation. The valuation of all stocks in financial accounts is done on
the basic principle of cost or realisable value whichever is less. The valuation of stock in cost accounts
is dependent on this fact whether it is raw material, work-in-progress and finished goods. In case of
raw material, value of stock will depend on whether FIFO or LIFO or Average method is adopted.
Work-in-progress inventory may be valued at prime cost or works cost or cost of production basis.
Finished goods are generally valued at total cost of production basis. Thus different bases adopted for
valuation of raw materials, work-in-progress and finished goods may differ and cause disagreement
in the results.
5. Different Methods of Charging Depreciation. The methods of charging depreciation may
differ in financial accounts and cost accounts and may cause disagreement in profits of the two books
of accounts. For example, Straight Line or Diminishing Balance Method (as per provisions of the
Companies Act or Income Tax Act) is adopted in financial accounts whereas in cost accounts machine
hour rate or production hour or unit method may have been adopted.
6. Abnormal Gains and Losses. Abnormal items as abnormal wastage of material by theft, wages
of abnormal idle time, cost of abnormal idle facilities, exceptional bad debts, abnormal gain on
manufacturing may be shown in financial accounts but are excluded from the cost accounts and are
taken directly to the costing and profit and loss account. This causes difference in profits as per two
books of accounts.

Methods of Reconciliation
Reconciliation of costing and financial profits can be attempted either
(a) by preparing a Reconciliation Statement or
(b) by preparation a Memorandum Reconciliation Account.

Reconciliation Statement
When reconciliation is attempted by preparing a reconciliation statement, profit shown by one set
of accounts is taken as base profit and items of difference are either added to it or deducted from it to
arrive at the figure of profit shown by other set of accounts.

Procedure of Reconciliation
When there is a difference between the profits disclosed by cost accounts and financial accounts,
the following steps shall be taken to prepare a Reconciliation Statement :
(I) Ascertain the various reasons of disagreement (as discussed above) between the profits
disclosed by two sets of books of accounts.
(II) If profit as per cost accounts (or loss as per financial accounts) is taken as the base :
Add: (i) Items of income included in financial accounts but not in cost accounts.
(ii) Items of expenditure (as interest on capital, rent on owned premises etc.) included in cost
accounts but not in financial accounts.
(iii) Amounts by which items of expenditure have been shown in excess in cost accounts as
compared to the corresponding entries in financial accounts.
(iv) Amounts by which items of income have been shown in excess in financial accounts as
compared to the corresponding entries in cost accounts.
C/1·4 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

(v) Over-absorption of overheads in cost accounts.

(vi) The amount by which closing stock of inventory is undervalued in cost accounts.
(vii) The amount by which the opening stock of inventory is overvalued in cost accounts.
(viii) Over charge of depreciation in cost accounts.
Deduct :
(i) Items of income included in cost accounts but not in financial accounts.
(ii) Items of expenditure included in financial accounts but not in cost accounts.
(iii) Amounts by which items of income have been shown in excess in cost accounts over the
corresponding entries in financial accounts.
(iv) Amounts by which items of expenditure have been shown in excess in financial accounts
over the corresponding entries in cost accounts.
(v) Under-absorption of overheads in cost accounts.
(vi) The amount by which closing stock of inventory is overvalued in cost accounts.
(vii) The amount by which the opening stock of inventory is undervalued in cost accounts.
(viii) Under charge of depreciation in cost accounts.
(III) After making all the above additions and deductions, the resulting figure will be profit as per
financial accounts (or loss as per cash accounts).
NOTE : If profit as per financial accounts (or loss as per cost accounts) is taken as the base, then items
added shall be deducted and items to be deducted shall be added i.e. the procedure shall be
reversed.

Memorandum Reconciliation Account

Reconciliation can also be done by preparing a Memorandum Reconciliation Account. This
account is a memorandum account only and does not form part of the double entry. When
reconciliation is attempted through Memorandum Reconciliation Account, profit to be taken as “base
profit” is shown like opening balance of this Account. All items of differences required to be
deducted are debited and those to be added are credited to this Account, the balancing figure of this
Account is the profit shown by other set of Accounts. The specimen form of Memorandum
Reconciliation Account is given as follows :

MEMORANDUM RECONCILIATION ACCOUNT

To Financial expenses : By Profit as per Cost Accounts
Discount ” Financial income :
Fines and penalties Rent
Bank interest Interest
Underwriter’s commission Dividend
Donations Profit on sales of assets
Goodwill written off ” Items charged in cost accounts :
” Under-absorption of overheads Interest on own capital
” Under-valuation of opening stock in cost Rent on own building
accounts ” Over-absorption of overheads
” Over-valuation of closing stock in cost accounts ” Over-valuation of opening stock in cost accounts
” Under charge of depreciation in cost accounts ” Under-valuation of closing stock in cost accounts
” Profit as per Financial Accounts ” Over charge of depreciation in cost accounts.
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·5

EXAMPLE. A manufacturing company has disclosed net loss of R 48,700 as per their cost
accounting records for the year ended 31st March, 2024. However their financial accounting
records disclosed net profit of R 35,400 for the same period. A scrutiny of data of both the sets of
books of accounts revealed the following informations :
R

(i)
Factory Overheads Under Absorbed 30,500
(ii)
Administrative Overheads Over Absorbed 65,000
(iii)
Depreciation Charged in Financial Accounts 2,25,000
(iv)Depreciation Charged in Cost Accounts 2,70,000
(v)
Income-tax Provision 52,400
(vi)Transfer Fee (Credited in Financial Accounts) 10,200
(vii)Obsolescence Loss Charged in Financial Accounts 20,700
(viii)Notional Rent of Own Premises charged in Cost Accounts 54,000
(ix)
Value of Opening Stock :
(a) in Cost Accounts 1,38,000
(b) in Financial Accounts 1,15,000
(x) Value of Closing Stock :
(a) In Cost Accounts 1,22,000
(b) In Financial Accounts 1,12,500
Prepare a Memorandum Reconciliation Account by taking costing loss as base.
SOLUTION
MEMORANDUM RECONCILIATION ACCOUNT

R R

To Net Loss as per Cost Accounts 48,700 By Administration Overheads Over

To Factory Overheads under Absorbed Recovered in Cost Accounts 65,000
in Cost Accounts 30,500 By Depreciation Overcharged in Cost
To Provision for Income Tax 52,400 Accounts ( 2,70,000 –
R R 2,25,000) 45,000
To Obsolescence Loss 20,700 By Transfer Fees in Financial Accounts 10,200
To Overvaluation of Closing Stock in By Notional Rent of Own Premises 54,000
Cost Accounts ( ii) 9,500 By Overvaluation of Opening Stock
To Net Profit (as per Financial Accounts) 35,400 in Cost Accounts (i) 23,000
————————————— —————————————

1,97,200 1,97,200
—————————————
————————————— —————————————
—————————————

Working Notes :
(i) Overvaluation of Opening Stock as per Cost Accounts
= Value in Cost Accounts – Value in Financial Accounts
= R 1,38,000 – R 1,15,000 = R 23,000.
(ii) Overvaluation of Closing Stock as per Cost Accounts
= Value in Cost Accounts – Value in Financial Accounts
= R 1,22,000 – R 1,12,500 = R 9,500.
C/1·6 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Can Computer Accounting Obviate the Need of Reconciliation?

Computer accounting has not at all obviated the need to reconcile cost accounts and financial
accounts as the basic approach in the preparation of the two sets of accounts is different. Many items
like notional expenses and appropriation of profit may be recorded in one set of accounts but not in
the other. Likewise, different amounts in respect of the same items like depreciation, overheads etc.
may be recorded in the two sets. As such difference in profit as revealed by the two sets is bound to
arise. Hence the need to reconcile the two sets of books arises to identify the causes of difference and
establish their accuracy.

Circumstances in which reconciliation can be avoided

The reconciliation of cost and financial books can be avoided if the maintenance of two sets of
books for cost accounting and financial accounting is dispensed with. This can be done by adopting
integral or integrated accounts in the organisation wherein only one set of books is operated
recording both financial and cost accounts.
ILLUSTRATION 1. (When profits as per financial and cost accounts are given). The profit
shown in the financial accounts was R 1,12,870 and for the same period the cost accounts showed a
profit of R 27,040.
Examination of the accounts showed the following differences :
Cost Accounts Financial Accounts
R R

Depreciation 98,260 1,05,200

Stock valuations :
Opening stocks 2,75,100 2,55,000
Closing stocks 1,82,180 1,87,500
Profit on sale of asset — 8,500
Dividend received — 26,350
Imputed rent charge 32,500
Reconcile the profit figures
SOLUTION
RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 27,040

Add : Profit on sale of asset 8,500
Dividend received 26,350
Imputed rent charge 32,500
Overvaluation of opening stock in Cost A/cs 20,100
Undervaluation of closing stock in Cost A/cs 5,320
————————————————————
92,770
—————————————————

1,19,810
Less : Under charge of depreciation in Cost A/cs 6,940
—————————————————

Profit as per Financial Accounts 1,12,870

—————————————————
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·7

ILLUSTRATION 2. (When profits as per financial & cost accounts are given). From the
following summary of Trading and Profit and Loss Account which appears in the financial
accounts of X. Ltd., and the additional information given, you are required to prepare detailed
statement reconciling the profit of R 60,570 as disclosed by the Financial Accounts with the figure
of profit i.e. R 54,650 as disclosed in Cost Accounts.
SUMMARY OF TRADING AND PROFIT AND LOSS ACCOUNT
R R

To Opening Stock 5,000 By Sales 3,15,000

” Purchases 1,35,000 ” Closing Stock 8,500
” Direct Wages 42,500
” Works Expenses 10,500
” Depreciation 12,200
” Gross Profit c/d 1,18,300
——————————————— ———————————————

3,23,500 3,23,500
——————————————— ———————————————

To Selling Expenses 34,220 By Gross Profit b/d 1,18,300

” Administration Expenses 21,790 ” Profit on Sale of Land 3,650
” Financial Expenses 5,470 ” Investment Income 100
” Net Profit 60,570
——————————————— ———————————————

1,22,050 1,22,050
——————————————— ———————————————

Note. (a) In the Cost Accounts (i) works expenses are charged at a rate of 5 paise per product
produced, (ii) selling expenses are charged at a rate of 12 per cent on sales, (iii) administration
expenses are charged at a fixed sum of R 25,000 per annum, which include financial expenses
R 13,000.

(b) Items of non-revenue value are not included in the Cost Accounts.
(c) In the Cost Accounts, stock is valued at direct cost (Materials and Labour) but in financial
accounts, it includes an allowance for overheads.
(d) Opening Stock Closing Stock
(5,000 units) (8,000 units)
R R

Valued : Materials 3,100 5,300

Labour 1,100 1,700
Overheads 800 1,500
———————————— ————————————

5,000 8,500
———————————— ————————————

Sales were 2,10,000 units at R 1.50 per unit.

SOLUTION RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 54,650

Less : Administration expenses undercharged in Cost Accounts ( 21,790 – 12,000)
R R 9,790
Less : Under-valuation of opening stock in Cost Accounts ( 5,000 – 4,200)
R R 800 10,590
—————————————————————————————
44,060
C/1·8 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Add : Works expenses overcharged in Cost A/cs ( 10,650 (1) – 10,500)

R R 150
Selling expenses overcharged in Cost A/cs ( 37,800 – 34,220)
R R 3,580
Financial expenses overcharged in Cost A/cs ( 13,000 – 5,470)
R R 7,530
Under-valuation of closing stock in Cost A/cs ( 8,500 – 7,000)
R R 1,500
Profit on sale of land and investment not
included in Cost Accounts ( 3,650 + 100)
R R 3,750 16,510
—————————————————————————————
Profit as shown in Financial Accounts 60,570
—————————————

Working Note : (1) Units

Sales for the period 2,10,000
Add : Closing Stock 8,000
—————————————

2,18,000
Less : Opening Stock 5,000
—————————————

Production during the period 2,13,000

5
Works Expenses @ 5 paise per product = 2,13,000 × = R 10,650
100

ILLUSTRATION 3. (When profit as per financial accounts is given). A company maintained

separate cost and financial accounts, and the costing profit for the year 2024 differed to that
revealed in financial accounts, which was shown as R 50,000.
Following information is available.
(i) Cost Accounts Financial Accounts
R R

Opening Stock of Raw Materials 5,000 5,500

Closing Stock of Raw Materials 4,000 5,300
Opening Stock of Finished Goods 12,000 15,000
Closing Stock of Finished Goods 14,000 16,000
(ii) Dividends of R 1,000 were received by the company.
(iii) A machine with net book value of R 10,000 was sold during the year for R 8,000.
(iv) The company charged 10% interest on its opening capital employed of R 80,000 to its
process costs. You are required to determine the profit figure which was shown in the cost
accounts.

SOLUTION
CALCULATION OF PROFIT AS PER COST ACCOUNTS
R R

Profit as per Financial Accounts 50,000

Add : (i) Overvaluation of opening stock of raw materials in Financial A/cs 500
(ii) Overvaluation of opening stock of finished goods in Financial A/cs 3,000
(iii) Loss on sale of machinery 2,000
—————————————
5,500
—————————————

55,500
Less : (i) Overvaluation of closing stock of raw materials in Financial A/cs 1,300
(ii) Overvaluation of closing stock of finished goods in Financial A/cs 2,000
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·9

(iii) Dividend received by the company 1,000

(iv) Interest on capital employed 8,000
—————————————
12,300
—————————————

Profit as per Cost Accounts 43,200

—————————————

ILLUSTRATION 4. The audited accounts of a company showed the profits of R 59,660. From
the following information provided, you are required to prepare a reconciliation statement, clearly
bringing out the reasons for the difference between the two figures and arrive at the profit as per
Cost Accounts using the additional information given below :
PROFIT AND LOSS ACCOUNT
for the year ended March 31, 2024
Particulars Amount Particulars Amount
(R) (R)
Opening R.M. 24,70,000 Sales 34,65,000
Purchases 8,20,000
——————————————

32,90,000
Closing R.M. 7,50,000 25,40,000
—————————————

Direct Wages 2,30,000

Factory Overheads 4,05,000
Gross Profit c/d 2,89,500
34,65,000 34,65,000
Administrative Overheads 98,000 Gross Profit b/d 2,89,500
Selling Overheads 1,34,340 Dividends 3,500
Net Profit 59,660
2,92,000 2,92,000

The Cost records show the following :

(i) Closing stock balance of R 7,95,400
(ii) Direct wages absorbed during the year R 2,18,800
(iii) Factory overheads absorbed R 4,65,000
(iv) Administrative overheads absorbed @ 2.5% on sales
(v) Selling overheads charged @ 5% of the value of sales.
SOLUTION RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 26,725

Add : 1. Overabsorption of Factory Overheads ( 4,65,000 – 4,05,500)
R R 59,500
2. Overabsorption of Selling Overheads ( 1,73,250 – 1,34,340)
R R 38,910
3. Dividend Received 2,500
1,00,910
1,27,635
C/1·10 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Less : 1. Underabsorption of Wages ( 2,30,000 – 2,18,800)

R R 11,200
2. Underabsorption of Administrative Overheads
( 98,000 – 86,825)
R R 11,375
3. Over-valuation of Closing Stock in Cost A/cs
( 7,95,400 – 7,50,000)
R R 45,400
67,975
Profit as per Financial Accounts 59,660
ILLUSTRATION 5. (Where profit as per cost accounts is given). From the following data
prepare a reconciliation statement :
R R

Profit as per cost accounts 1,45,500 Overvaluation of closing stock in

Works overheads under-recovered 9,500 cost accounts 7,500
Administrative overheads Interest earned during the year 3,750
under-recovered 22,750 Rent received during the year 27,000
Selling overheads over-recovered 19,500 Bad debts written off during the year 9,000
Overvaluation of opening stock Preliminary expenses written off
in cost accounts 15,000 during the year 18,000
SOLUTION RECONCILIATION STATEMENT
R R R

Profit as per Cost Accounts 1,45,500

Add : Over-recovery of selling overheads 19,500
Overvaluation of opening stock 15,000
Income excluded from cost accounts
Interest earned 3,750
Rent Received 27,000
———————————
30,750
———————————
65,250
——————————————
2,10,750
Less : Under-recovery of works overheads 9,500
Under-recovery of administration overheads 22,750
Overvaluation of closing stock 7,500
Expenses excluded from cost accounts :
Bad debts 9,000
Preliminary expenses 18,000
———————————
27,000
———————————
66,750
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Profit as per Financial Accounts 1,44,000

ILLUSTRATION 6. (When profits as per financial and cost accounts are given). The net profit
of A. Co. Ltd. appeared at R 41,800 as per financial records for the year ending 31st March, 2024.
The cost books, however, showed a net profit of R 1,11,900 for the same period. A scrutiny of the
figures from both the sets of accounts revealed the following facts :
R

Works overhead under-recovered in costs 1,500

Administrative overheads over-recovered in costs 850
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·11

Depreciation charged in financial accounts 5,600

Depreciation recovered in costs 6,250
Interest on investments not included in costs 3,000
Loss due to obsolescence charged in financial accounts 2,850
Income-tax reserve made in financial accounts 20,150
Bank interest and transfer fee credited in financial books 370
Stores adjustment (credit) in financial books 230
Value of opening stock in : Cost accounts 24,800
: Financial accounts 26,300
Value of closing stock in : Cost accounts 25,000
: Financial accounts 23,000
Interest charged in cost accounts 2,000
Imputed rent charged in cost accounts 1,000
Goodwill written off 5,000
Loss on the sale of furniture 600
Selling and distribution expenses not charged in cost accounts 10,000
Donations to Prime Minister’s Relief Fund 5,100
Transfer to Debenture Redemption Fund 9,000
Transfer to Dividend Equalisation Fund 20,500
Prepare (i) a statement showing the reconciliation of net profit as per cost accounts and net
profit as shown in the financial books; (ii) Memorandum Reconciliation Account.
SOLUTION
(i) RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 1,11,900

Add : (a) Administration overheads over-recovered in cost accounts 850
(b) Depreciation overcharged in cost books : R

Cost books 6,250

Financial books 5,600
————————— 650
(c) Receipts and gains credited in financial books
but not shown in cost books :
(i) Interest on investments 3,000
(ii) Bank interest and transfer fees 370
(iii) Stores adjustments 230
(d) Imputed rent charged in cost accounts 1,000
(e) Interest charged in cost accounts 2,000 8,100
———————————————————————————————————

1,20,000
Less : (a) Works overhead under-recovered in cost books 1,500
(b) Expenses and losses debited in financial books
but excluded from cost books :
(i) Income Tax 20,150
(ii) Loss due to obsolescence 2,850
(iii) Goodwill written off 5,000
(iv) Loss on the sale of furniture 600
C/1·12 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

(v) Selling and distribution expenses not

charged in cost accounts 10,000
(vi) Donation to Prime Minister’s Relief Fund 5,100
(vii) Transfer to Debenture Redemption Fund 9,000
(viii) Transfer to Dividend Equalisation Fund 20,500
(c) Under-valuation of opening stock in cost accounts 1,500
(d) Over-valuation of closing stock in cost accounts 2,000
—————————————————
78,200
—————————————————

Profit as per Financial Accounts 41,800

—————————————————

(ii) MEMORANDUM RECONCILIATION STATEMENT

R R

To Work overhead under-recovered By Profit as per Cost Accounts 1,11,900

in cost books 1,500 By Administration overheads
To Expenses and losses debited in over recovered in cost accounts 850
financial books but excluded from By Depreciation overcharged in cost
cost books : R accounts ( 6,250 – 5,600)
R R 650
Income-tax 20,150 By Receipts and gains credited in F.A.
Loss due to Obsolescence 2,850 but not in C.A. R

Goodwill Written off 5,000 Interest on Investment 3,000

Loss on Sale of Furniture 600 Bank Interest & Transfer Fees 370
Selling & Distribution Exp. 10,000 Stores Adjustments 230
———————
Donation to P.M.’s Relief 3,600
Fund 5,100 By Imputed rent charged in cost accounts 1,000
Debenture Redemption Fund 9,000 By Interest charged in cost accounts 2,000
Dividend Equalisation Fund 20,500
————————————
73,200
To Under-valuation of opening stock
in cost accounts 1,500
To Over-valuation of closing stock in
cost accounts 2,000
To Profit as per Financial Accounts 41,800
————————————— ————————————

1,20,000 1,20,000
—————————————
————————————— ————————————
————————————

ILLUSTRATION 7. (When both profits are not given). Following figures are available in
respect of Ashok Engineering Company for the year ended 31st March, 2024:
Financial Cost
Accounts Accounts
Opening Stock :
Raw Material 6,000 5,000
Work-in-Progress 7,000 6,500
Finished Stock 5,000 4,500
Closing Stock :
Raw Material 4,000 4,300
Work-in-Progress 3,000 3,700
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·13

Finished Stock 5,900 6,200

Purchases 40,000
Direct Wages 20,000
Factory Expenses 20,000 21,000 absorbed
Sales 1,10,000
Administration Expenses 3,000 2,300 absorbed
Selling Expenses 4,000 4,500 absorbed
Financial Expenses 1,000
Interest and Dividends Received 1,600
Compute profit in Financial Accounts as well as in Cost Accounts and prepare a Reconciliation
Statement. Show clearly the reasons for the variation of the two profit figures.
SOLUTION
STATEMENT OF COST AND PROFIT

Opening Stock of Raw Materials 5,000

Add : Purchase of Raw Materials 40,000
————————————————
45,000
Less : Closing Stock of Raw Materials 4,300
————————————————
Materials Consumed 40,700
Direct Wages 20,000
————————————————
Prime Cost 60,700
Factory Overheads 21,000
Add : Beginning Work-in-Progress 6,500
————————————————
88,200
Less : Closing Work-in-Progress 3,700
————————————————
Works Cost 84,500
Administration Expenses 2,300
————————————————
Cost of Production 86,800
Add : Finished Goods (Beginning) 4,500
————————————————
91,300
Less : Finished Goods (Closing) 6,200
————————————————
Cost of Goods Sold 85,100
Selling Expenses 4,500
————————————————
Cost of Sales 89,600
Profit as per Cost Accounts 20,400
————————————————
Sales 1,10,000
————————————————

PROFIT AND LOSS A/c (Financial Books)

R R

To Opening Stock : By Sales 1,10,000

Raw Materials 6,000 By Closing Stock :
Work-in-Progress 7,000 Raw Materials 4,000
Finished Stock 5,000 Work-in-Progress 3,000
To Purchases 40,000 Finished Stock 5,900
C/1·14 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

To Direct Wages 20,000 By Interest and Dividend 1,600

To Factory Expenses 20,000
To Admn. Expenses 3,000
To Selling Expenses 4,000
To Financial Expenses 1,000
To Net Profit as per Financial Accounts 18,500
——————————————— ———————————————

1,24,500 1,24,500
———————————————— ———————————————

RECONCILIATION STATEMENT

R R

Profit as per Cost Accounts 20,400

Add : Over-absorption of Factory Overheads ( 21,000 –
R R 20,000) 1,000
Over-absorption of Selling Expenses ( 4,500 – 4,000)
R R 500
Interest and Dividend received 1,600
——————————
3,100
————————————————
23,500
Less : Over-valuation of Opening Stock in Financial Accounts 2,000
Under-valuation of Closing Stock in Financial Accounts 1,300
Financial Expenses Charged in Financial A/cs 1,000
Under-absorption of Administration Overheads 700
——————————
5,000
————————————————
Profit as per Financial Accounts 18,500
————————————————

ILLUSTRATION 8. (When both profits are not given). Ashoka Engineering Co. manufactures
two sizes of a machine component, Size A and Size B. Following data refer to the year ended 31st
March, 2024 :
Size A Size B
Production 125 units 400 units
Sales 120 units 360 units
Wages cost per unit R 40 R 30
Material cost per unit R 15 R 12
Sale price per unit R 125 R 90
All expenses other than wages and materials are analysed under ‘works overheads’ which
during the year amounted to R 9,000 and ‘office overheads’ which amounted to R 10,000.
In fixing the selling price it was estimated that works overheads should be taken at 50% on
1
wages and office overhead expenses at 333 % on works cost.
You are required to compute the following :
(a) The total cost of each unit on the basis of the above overhead percentages ;
(b) The net profit for the year shown by the financial accounts, valuing unsold stocks at actual
material and wages cost plus works overheads at 50% on wages ; and
(c) The reconciliation of net profit in (b) above with estimated total net profit based on cost
figures.
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·15

SOLUTION STATEMENT OF COST AND PROFIT

Size ‘A’ Size ‘B’
(125 Units) (400 Units) Total
————————————————————————————————————————————————
of
Per Total Per Total ‘A’ + ‘B’
Unit Cost Unit Cost
——————————————————————————————————————————————————————————————

R R R R R

Materials 15 1,875 12 4,800 6,675

Wages 40 5,000 30 12,000 17,000
——————————————————————————————————————————————————————————————

Prime Cost 55 6,875 42 16,800 23,675

Works Overheads (50% on wages) 20 2,500 15 6,000 8,500
——————————————————————————————————————————————————————————————

Works Cost 75 9,375 57 22,800 32,175

1
Office Overheads (33 3% on works cost) 25 3,125 19 7,600 10,725
——————————————————————————————————————————————————————————————

Cost of Production 100 12,500 76 30,400 42,900

Less : Closing Stock on Current Cost Basis — 500 — 3,040 3,540
——————————————————————————————————————————————————————————————

Cost of Goods Sold 100 12,000 76 27,360 39,360

Profit 25 3,000 14 5,040 8,040
——————————————————————————————————————————————————————————————
Sales 125 15,000 90 32,400 47,400
Profit as per Cost Books = R 8,040.
PROFIT AND LOSS ACCOUNT
R R R R

To Materials : By Sales :
A 1,875 A 15,000
B 4,800 B 32,400
—————————— 6,675 —————————— 47,400
To Wages : By Closing Stock :
A 5,000 A (5 unit 1 @ 75)R 375
B 12,000 B (40 units @ 57)R 2,280
—————————— ——————————
17,000 2,655
To Works Expenses 9,000
To Office Expenses 10,000
To Net Profit 7,380
———————————————— ———————————————
50,055 50,055
———————————————— ———————————————

RECONCILIATION STATEMENT
R Amount
R

Profit as per Cost Accounts 8,040

Add : Office overheads over-recovered in cost books
Cost books 10,725
Financial books 10,000 725
————————————— ————————————————

8,765
Less : Under recovery of works overheads in cost books
Cost books 8,500
Financial books 9,000 500
————————————— ————————————————

Less : Over-valuation of closing stock in cost books 8,265

C/1·16 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Cost books 3,540

Financial books 2,655 885
————————————— ————————————————

Profit as per Financial Accounts 7,380

————————————————

ILLUSTRATION 9. From the information given below, prepare (a) a statement showing
profit or loss, and (b) another statement reconciling the costing profit with that shown by financial
accounts :
TRADING AND PROFIT AND LOSS ACCOUNT
For the year ended 31st March, 2024
R R

Materials Consumed 1,50,000 Sales (1,50,000 units) 3,20,000

Direct Wages 75,000
Factory Expenses 45,000
Office Expenses 13,500
Selling & Distribution Expenses 9,000
Net Profit 27,500
——————————————— ———————————————

3,20,000 3,20,000
———————————————
——————————————— ———————————————
———————————————

The normal output of the factory is 1,25,000 units. Factory expenses of a fixed nature are
R 25,000. Office expenses are for all practical purposes constant. Selling and distribution expenses
are constant to the extent of R 3,000 and the balance varies with sales assuming that indirect
expenses are absorbed on the basis of normal production capacity in cost accounts.
SOLUTION STATEMENT OF COST AND PROFIT
R R

Materials consumed 1,50,000

Direct wages 75,000
———————————————
Prime Cost 2,25,000
Factory Expenses :
6
6/5 of Fixed Expenses ( 5 × R 25,000) 30,000
Variable Overheads ( 45,000 –
R R 25,000) 20,000 50,000
—————————————————————————————————
Works Cost 2,75,000
Office Expenses :
(6/5 of 13,500)
R 16,200
———————————————
Cost of Production 2,91,200
Selling and Distribution Expenses :
6/5 of 3,000 Fixed
R 3,600
Variable ( 9,000 – 3,000)
R R 6,000
—————————————————

9,600
———————————————
Cost of Sales 3,00,800
Profit 19,200
———————————————
Sales 3,20,000
———————————————
———————————————

Note : Actual output of 1,50,000 units is 6/5 i.e.‚ ( 1‚50‚000

1‚25‚000 )
of normal output, so absorption of fixed overheads

in cost accounts will be done accordingly.

RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·17

RECONCILIATION STATEMENT

R R

Profit as per Cost Accounts 19,200

Add : Over-absorbed Works Expenses 5,000
Over-absorbed Office Expenses 2,700
Over-absorbed Selling and Distribution Expenses 600
—————————————

8,300
———————————————
Profit as per Financial Accounts 27,500
———————————————
———————————————

ILLUSTRATION 10. (When both profits are not given) The financial records by Modern
Manufacturers Ltd. reveal the following data for the year ended March 31, 2024 :
(R in thousands) (R in thousands)
Sales (20,000 units) 4,000 Work-in-progress : (Closing)
Materials 1,600 Materials 48
Wages 800 Labour 32
Factory Overheads 720 Overheads (Factory) 32
Office and Administrative Overheads 416 Goodwill written off 320
Selling and Distribution Overheads 288 Interest on Capital 32
Closing Stock of Finished Goods Dividend received 10
(1,230 units) 240 Interest received 5
In the costing records, factory overhead is charged at 100% of wages, administration overhead
at 10% of works cost and selling and distribution overhead at R 16 per unit sold.
Prepare a statement reconciling the profit as per cost records with the profit as per financial
records of the company. All workings should form part of your answer.
SOLUTION
STATEMENT OF COST AND PROFIT
R

Materials 16,00,000
Wages 8,00,000
————————————————
Prime Cost 24,00,000
Add : Factory Overheads (100% of Wages) 8,00,000
————————————————

32,00,000
Less : Closing Work-in-Progress 1,12,000
————————————————

Works Cost 30,88,000

Add : Administration Overheads (10% of Works Cost) 3,08,800
————————————————

Cost of Production 33,96,800

Less : Closing Stock of Finished Goods

( Closing Stock
Production (Sales + Closing Stock)
× Cost of Production
Cost of Goods Sold
)( 1‚230
21‚230
× R 33‚96‚800 ) 1,96,800
————————————————
32,00,000
C/1·18 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Selling and Distribution Overheads ( 16 × 20,000)

R 3,20,000
————————————————

Cost of Sales 35,20,000

Profit 4,80,000
————————————————

Sales 40,00,000
————————————————

PROFIT AND LOSS ACCOUNT

R R

To Materials 16,00,000 By Sales 40,00,000

” Wages 8,00,000 ” Finished Stock 2,40,000
” Factory Overheads 7,20,000 ” Work-in-Progress 1,12,000
” Admn. Overheads 4,16,000 ” Dividend Received 10,000
” Selling and Distribution Overheads 2,88,000 ” Interest Received 5,000
” Goodwill 3,20,000
” Interest on Capital 32,000
” Net Profit 1,91,000
——————————————— ———————————————

43,67,000 43,67,000
——————————————— ———————————————

RECONCILIATION STATEMENT
R R

Profits as per Cost Accounts 4,80,000

Add : Over-recovery of Factory Overheads 80,000
Over-recovery of Selling and Distribution Overheads 32,000
Under Valuation of Finished Goods in Cost A/cs 43,200
Interest and Dividend Received ( 10,000 + 5,000)
R R 15,000 1,70,200
——————————————— —————————————————

6,50,200
Less : Under-recovery of Administration Overheads 1,07,200
Goodwill written off 3,20,000
Interest on Capital 32,000 4,59,200
——————————————— —————————————————

Profit as per Financial Accounts 1,91,000

—————————————————

Sometimes both normal output and actual output are given in the question and fixed expenses are charged
on the basis of normal output in the profit and loss account. But while preparing statement of cost and profit
these are charged on the basis of actual output i.e. by reducing or increasing the fixed expenses in that
proportion which actual output bears to that of normal output.
Suppose
Normal output = 1,50,000 units
Actual output = 1,00,000 units
Fixed factory overheads = 18,000.
R

Then fixed factory overheads must have been recovered in cost accounts R 12,000 ( i.e. 18,000 ×
R

1‚00‚000
1‚50‚000 )
· This will be more clear from the following illustration :

ILLUSTRATION 11. (When actual and normal output are given). Following information is
available from the financial books of a company having a normal production capacity of 60,000
units for the year ended 31st March, 2024 :
(i) Sales R 10,00,000 (50,000 units).
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·19

(ii) There was no opening and closing stock of finished units.

(iii) Direct material and direct wages cost were R 5,00,000 and R 2,50,000 respectively.
(iv) Actual factory expenses were R 1,50,000 of which 60% are fixed.
(v) Actual administrative expenses were R 45,000 which are completely fixed.
(vi) Actual selling and distribution expenses were R 30,000 of which 40% are fixed.
(vii) Interest and dividends received R 15,000.
You are required to :
(a) Find out profit as per financial books for the year ended 31st March, 2024 ;
(b) Prepare a statement of cost and profit to ascertain the profit as per cost accounts for the
year ended 31st March, 2024 assuming that the indirect expenses are absorbed on the basis
of normal production capacity ; and
(c) Prepare a statement reconciling profits shown by financial and cost books.
[B.Com. Panjab Sept., 2011 Modified]
SOLUTION PROFIT AND LOSS ACCOUNT
for the year ended 31-3-2024
R R

To Direct Materials 5,00,000 By Sales 10,00,000

To Direct Wages 2,50,000 By Interest & Dividends 15,000
To Factory Expenses 1,50,000
To Administrative Expenses 45,000
To Selling & Distribution Expenses 30,000
To Net Profit 40,000
——————————————— ———————————————
10,15,000 10,15,000
——————————————— ———————————————

STATEMENT OF COST AND PROFIT

(Normal output 60,000 units)
R R

Direct Materials 5,00,000

Direct Wages 2,50,000
———————————————
Prime Cost 7,50,000
Factory Expenses :
Variable (40% of R1,50,000) 60,000

Fixed ( 90,000 ×
R
5
6 )i.e. on the basis of normal output 75‚000
—————————————
1‚35‚000
————————————————

Works Cost 8,85,000

Administration Expenses (
45,000 ×
R
5
6
Cost of Production
) 37,500
———————————————
9,22,500
Selling and Distribution Expenses : R

Variable 18,000

Fixed
Cost of Sales
(
12,000 ×
R
5
6 ) 10‚000
————————————
28‚000
————————————————

9,50,500
Profit 49,500
———————————————
Sales 10,00,000
———————————————
C/1·20 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 49,500

Add : Interest and dividend not recorded in Cost Accounts 15,000
———————————————
64,500
Less : Expenses underabsorbed in Cost Accounts :
Factory Expenses 15,000
Administration Expenses 7,500
Selling and Distribution Expenses 2,000 24,500
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Profit as per Financial Accounts 40,000

MISCELLANEOUS ILLUSTRATIONS
ILLUSTRATION 12. The net profit of Dhura Ltd. shown by cost accounts for the year ended
31st March 2024 was R 10,35,000 and by financial accounts for the same period was R 5,00,200.
A scrutiny of the figures of the financial accounts and the cost accounts revealed the following
facts :
Particulars (R)
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

(i) Administrative overhead under recovered in cost accounts 14,800

(ii) Factory overhead-over-recovered in cost accounts 20,000
(iii) Depreciation-over charged in financial accounts 40,000
(iv) Interest on Investment 20,000
(v) Loss due to obsolescence charged in financial accounts 24,000
(vi) Abnormal Labour wastage charged in financial accounts 2,00,000
(vii) Income Tax provided in financial accounts 2,80,000
(viii) Bank Interest credited in financial accounts 4,000
(ix) Stocks adjustment credited in financial accounts 28,000
(x) Loss due to depreciation in stock values charged in financial accounts 48,000

Prepare as on 31-3-2024 (i) Memorandum Reconciliation Account, (ii) Reconciliation

Statement.
SOLUTION
(i) Memorandum Reconciliation Account
as on 31st March, 2024
R R

To Administrative Overhead under By Profit as per Cost Accounts 10,35,000

Recovered in Cost Accounts 14,800 By Factory Overheads Over-
To Depreciation Over-charge in recovered in Cost Accounts 20,000
Financial Accounts 40,000 By Interest on Investment 20,000
To Loss due to Obsolescence 24,000 By Bank Interest Credited in Financial
To Abnormal Labour Wastage Account 4,000
Charged in Financial Accounts 2,00,000 By Stores Adjust Credit in Financial
To Income Tax Provided in Financial Account 28,000
Accounts 2,80,000
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·21

To Loss Due to Depreciation in Stock

Values in Financial Accounts 48,000
To Profit as per Financial Accounts 5,00,200
——————————————— ———————————————

11,07,000 11,07,000
———————————————
——————————————— ———————————————
———————————————

(ii) Reconciliation Statement

as on 31-3-2024
Particulars R R

Profit as per Financial Accounts 5,00,200

Add :
( i) Administration Overhead under Recovered 14,800
(ii) Over Recovery of Depreciation 40,000
(iii) Loss due to Obsolescence Considered 24,000
(iv) Abnormal Labour Wastage 2,00,000
(v) Income Tax 2,80,000
(vi) Loss due to Depreciation in Stock 48,000 6,06,800
11,07,000
Less :
( i) Factory Overhead Over-recovery 20,000
(ii) Interest on Investment 20,000
(iii) Bank Interest 4,000
(iv) Stock Adjustment 28,000 72,000
Profit as per Cost Accounts 10,35,000

ILLUSTRATION 13. In a factory, works overheads are absorbed at 60% of Labour Cost and
office overheads at 20% of Works Cost. Prepare (i) Cost Sheet, (ii) Profit & Loss Account and (iii)
Reconciliation Statement if Total Expenditure consists of Material R 2,00,000; Wages R 1,50,000;
Factory Expenses R 1,00,000 and Office Expenses R 85,000.
10% of the Output is Stock at the end and Sales are R 5,20,000.
[B.Com. Panjab Sept. 2008 & Dec. 2016]
SOLUTION
STATEMENT OF COST & PROFIT
R

Materials 2,00,000
Wages 1,50,000
——————————————
Prime Cost 3,50,000
Works Overheads (60% of Wages) 90,000
——————————————
Works Cost 4,40,000
Office Overheads (20% of Works Cost) 88,000
——————————————
Total Cost 5,28,000
Less : Closing Stock of Finished Goods (10%) 52,800
——————————————
Cost of Goods Sold 4,75,200
Profit 44,800
——————————————
Sales 5,20,000
——————————————
——————————————
C/1·22 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

PROFIT & LOSS A/C

R R

To Materials 2,00,000 By Sales 5,20,000

To Wages 1,50,000
To Factory Expenses 1,00,000
To Office Expenses 85,000
—————————————

5,35,000
Less : Closing Stock (10%) 53,500
—————————————

Cost of Goods Sold 4,81,500

To Profit 38,500
————————————— —————————————-

5,20,000 5,20,000
—————————————
————————————— —————————————-
—————————————-

RECONCILIATION STATEMENT

R R

Profit as per Cost Accounts 44,800

Add : Over-absorption of Office Overheads 3,000
Under valuation of Closing Stock in Cost Accounts 700
——————————
3,700
———————————-

48,500
Less : Under-absorption of Factory Overheads 10,000
———————————-

Profit as per Financial Accounts 38,500

———————————-
———————————-

ILLUSTRATION 14. The Profit and Loss Account of Oil India (Pvt.) Ltd. for the year ended
31st March, 2024 is as follows :
R R

To Materials 4,80,000 By Sales 9,60,000

To Wages 3,60,000 By Work-in-Progress : R

To Direct Expenses 2,40,000 Materials 30,000

To Gross Profit 1,20,000 Wages 18,000
Direct Expenses 12,000
———————————
60,000
By Closing Stock 1,80,000
—————————————— ——————————————

12,00,000 12,00,000
—————————————— ——————————————

To Administration Expenses 60,000 By Gross Profit 1,20,000

Net Profit 66,000 By Dividends Received 6,000
—————————————— ——————————————

1,26,000 1,26,000
——————————————
—————————————— ——————————————
——————————————

As per the cost records the direct expenses have been estimated at a cost of R 30 per kg. and
administration expenses at R 15 per kg. During the year production was 6,000 kgs. and sales were
4,800 kgs.
Prepare a statement of Costing Profit and Loss Account and reconcile the costing profit with
financial profit.
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·23

SOLUTION
STATEMENT OF COST AND PROFIT
R R

Materials 4,80,000
Wages 3,60,000
Direct Expenses : On Production (6,000 kgs. × R 30) 1,80,000
On Work-in-Progress 12,000
—————————————
1,92,000
————————————————
Prime Cost 10,32,000
Less : Closing Work In Progress 60,000
————————————————
Works Cost 9,72,000
Administration Expenses (6,000 × R 15) 90,000
————————————————
Cost of Production 10,62,000

Less: Closing Stock ( R 10‚62‚000

6‚000
× 1,200 ) 2,12,400
————————————————

Cost of Goods Sold 8,49,600

Profit 1,10,400
————————————————

Sales 9,60,000
————————————————
————————————————

RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 1,10,400

Add : Overabsorption of Administration Expenses 30,000
Dividend Received 6,000
—————————————-
36,000
—————————————
1,46,400
Less : Under Recovery of Direct Expenses 48,000
Overvaluation of Closing Stock in Cost Accounts 32,400
—————————————-
80,400
—————————————
Profit as per Financial Accounts 66,000
—————————————
—————————————

ILLUSTRATION 15. (When Cost Ledger Accounts are to be prepared before reconciliation).
Following figures have been extracted from the Cost Records of a manufacturing unit :
R R

Stores : Work-in-Progress :
Opening Balance 30,000 Opening Balance 60,000
Purchases 1,60,000 Direct Wages Applied 60,000
Transfers from Work-in-Progress 80,000 Overheads Applied 2,40,000
Issues to Work-in-Progress 1,60,000 Closing Balance 40,000
Issues to Repairs and Maintenance 20,000
Deficiencies found in Stock Taking 6,000
Finished products : Entire output is sold at a profit of 10% on actual cost from Work-in-
Progress.
Direct wages incurred R70,000 ; Overheads incurred R 2,50,000.
C/1·24 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Items not included in Cost Records : Income from investments R 10,000 ; Loss on sale of capital
assets R 20,000.
Draw up Stores Control Account, Work-in-Progress Control Account, Costing Profit and Loss
Account, Profit and Loss Account and Reconciliation Statement.
SOLUTION
Costing Books
STORES CONTROL ACCOUNT
R R

To Balance b/d 30,000 By Work-in-Progress Control A/c 1,60,000

To General Ledger Adjustment A/c 1,60,000 By Production Overhead Control A/c
To Work-in-Progress Control A/c 80,000 (Repairs and Maintenance) 20,000
By Costing Profit and Loss A/c
(Shortage in stock taking) 6,000
By Balance c/d (1) 84,000
——————————————— ———————————————

2,70,000 2,70,000
——————————————— ———————————————

WORK-IN-PROGRESS CONTROL ACCOUNT

R R

To Balance b/d 60,000 By Stores Control A/c 80,000

To Stores Control A/c 1,60,000 By Costing Profit and Loss A/c
To Wages Control A/c 60,000 —Cost of Sales (Bal. figure) 4,00,000
(Direct wages applied) By Balance c/d 40,000
To Production Overhead Control A/c 2,40,000
——————————————— ———————————————

5,20,000 5,20,000
——————————————— ———————————————

COSTING PROFIT AND LOSS ACCOUNT

R R

To Work-in-Progress Control A/c By General Ledger Adjustment A/c

—Cost of Sales 4,00,000 (Sales = Cost + 10% Profit)
To Stores Control A/c (Shortage) 6,000 ( 4,00,000 + 40,000)
R R 4,40,000
To General Ledger Adj. A/c (Profit) 34,000
——————————————— ———————————————

4,40,000 4,40,000
——————————————— ———————————————

Working Notes :
PRODUCTION OVERHEAD CONTROL ACCOUNT
R R

To General Ledger Adjustment A/c 2,50,000 By Work-in-Progress Control A/c 2,40,000

To Stores Control A/c 20,000 By Balance c/d 30,000
——————————————— ———————————————

2,70,000 2,70,000
——————————————— ———————————————

WAGES CONTROL ACCOUNT

R R

To General Ledger Adjustment A/c 70,000 By Work-in-Progress Control A/c 60,000

By Balance c/d 10,000
——————————————— ———————————————

70,000 70,000
——————————————— ———————————————
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·25

Financial Books
PROFIT AND LOSS ACCOUNT
R R R R

To Opening Stock : By Sales 4,40,000

Stores 30,000 By Closing Stock :
Work-in-Progress 60,000 Stores (1) 84,000
————————————
90,000 Work-in-Progress 40,000
————————————
To Purchases 1,60,000 1,24,000
To Wages 70,000 By Income from Investments 10,000
To Overhead Expenses 2,50,000 By Net Loss 16,000
To Loss on Sale of Capital Assets 20,000
——————————————— ———————————————

5,90,000 5,90,000
——————————————— ———————————————

RECONCILIATION STATEMENT
R R

Profit as per Cost Accounts 34,000

Add : Income from Investments included in Financial Accounts
but not in Cost Accounts 10,000
———————————————
Less : Underabsorption of Wages 10,000 44,000
Underabsorption of Production Overheads 30,000
Loss on Sale of Capital Assets shown in Financial Accounts
but not in Cost Accounts 20,000 60,000
————————————————————————————————
Loss as per Financial Accounts 16,000
———————————————

Working Note (1) : Closing Stock of Stores

Opening Balance + Purchases + Transfers from Work-in-Progress – Issues to Work-in-Progress – Issues to
Repairs and Maintenance – Deficiencies Found in Stock Taking = 30,000 + 1,60,000 + 80,000 – 1,60,000
R R R R

– 20,000 – 6,000 = 84,000.

R R R

ILLUSTRATION 16. ABC Pvt. Ltd. has furnished its Profit and Loss Account for the year
ended 31st March, 2024 and also given a statement showing reconciliation between the profit as
per financial records and cost records. Profit and Loss Account is given below :
PROFIT AND LOSS ACCOUNT
for the year ended 31st March, 2024
Particulars Amount Particulars Amount
R R
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Opening Stock By Sales 17,80,000

Raw Materials 95,500 By Closing Stock :
W.I.P. 45,000 Raw Materials 99,000
Finished Goods 78,000 W.I.P. 58,000
To Purchases 6,42,000 Finished Goods 80,000
To Direct Wages 2,22,000 By Dividend received on
To Factory Overheads 2,45,000 Shares 1,65,000
To Administrative Expenses 1,98,500
To Selling Expenses 3,42,000
To Goodwill written off 80,000
C/1·26 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

To Interest on Loans 50,000

To Legal Charges 42,000
To Net Profit 1,42,000
——————————————— ———————————————

21,82,000 21,82,000
———————————————
——————————————— ———————————————
———————————————

Reconciliation Statement as at 31st March, 2024 is given below :

Amount Amount
R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Profits as per Financial Records 1,42,000

Add :
Raw Material—Closing Stock 1,500
W.I.P.—Opening Stock 2,000
Finished Goods—Opening Stock 3,000
Finished Goods—Closing Stock 1,000
Goodwill Written off 80,000
Interest on Loans 50,000
Legal Charges 42,000 1,79,500
———————————— —————————————

3,21,500
Less :
Raw Materials—Opening Stock 2,500
W.I.P.—Closing Stock 3,500
Dividend received on Shares 1,65,000 1,71,000
———————————— —————————————

Profit as per Cost Records 1,50,500

You are required to draw up the following accounts in the Cost Ledger of ABC Pvt. Ltd.:
(i) Material Control Account, (ii) W.I.P. Control Account, (iii) Finished Goods Control Account,
(iv) Cost of Sales Account, (v) Costing Profit and Loss Account.
SOLUTION
(i) MATERIAL CONTROL ACCOUNT
Particulars Amount Particulars Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Balance b/d ( 95,500 +

R R 2,500) 98,000 By WIP Control A/c 6,39,500
To General Ledger Adj. 6,42,000 By Balance c/d ( 99,000 + R R 1,500) 1,00,500
———————————— ————————————
7,40,000
————————————
7,40,000
————————————

(ii) WIP CONTROL A/C

Particulars Amount Particulars Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Balance b/d ( 45,000 – 2,000)

R R 43,000 By Finished Goods A/c 10,95,000
To Material Control 6,39,500 By Balance c/d ( 58,000 – R R 3,500) 54,500
To Wages Control A/c 2,22,000
To Factory Overhead Control A/c 2,45,000
————————————— —————————————
11,49,500 11,49,500
————————————— —————————————
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·27

(iii) FINISHED GOODS CONTROL ACCOUNT

Particulars Amount Particulars Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Balance b/d ( 78,000 –

R R 3,000) 75,000 By Cost of Sales A/c 12,87,500
To WIP Control A/c 10,95,000 By Balance c/d ( 80,000 + R R 1,000) 81,000
To Admn. Exp. Control A/c 1,98,500
————————————— —————————————

13,68,500 13,68,500
————————————— —————————————

(iv) COST OF SALES ACCOUNT

Particulars Amount Particulars Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Finished Goods Control 12,87,500 By Closing P/L A/c 16,29,500

To Selling Exp. A/c 3,42,000
————————————— —————————————
16,29,500 16,29,500
————————————— —————————————

( v) COSTING PROFIT & LOSS ACCOUNT

Particulars Amount Particulars Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Cost of Sales A/c 16,29,500 By General Ledger Adj. 17,80,000

To Profit 1,50,500
————————————— —————————————
17,80,000
—————————————
17,80,000
—————————————

QUESTIONS
SHORT ANSWER TYPE
1. Discuss the need (or importance) of reconciliation of cost and financial accounts.
OR
Why is it necessary to reconcile the profits between cost accounts and financial accounts ?
OR
Write short note on reasons for the difference in profit as shown by cost and financial accounts.
2. State three items of (i) expenses or losses (ii) incomes or gains which are shown in Financial Profit and
Loss Account but not in Costing Profit and Loss Account.
3. Give examples of two items of expenses which are included in cost accounts as notional charges but not
in financial accounts.
4. State briefly the treatment of under or over-absorption of overheads while reconciling costing profits
with financial profits.
5. How will you deal with under or overvaluation of stocks in cost accounts while preparing reconciliation
statement ?
“Under or overcharge of depreciation in cost accounts as compared to financial accounts affects the
6.
reconciliation statement.” Discuss.
7. Find out the profit as per financial records, from the following data :
(i) Profit as per cost records 70,500 ; (ii) Under valuation of closing stock in cost records 10,500 ; (iii)
R R

Administration overheads under recovered in cost records 5,200 ; (iv) Bad Debts and preliminary
R

expenses written off in Financial Accounts only 7,345 ; (v) Depreciation over-charged in Cost records
R

3,445
R

Ans. [Profit as per Financial Accounts 71,900] R

C/1·28 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

8. Prepare Reconciliation Statement from the following particulars to find out profit as per Financial
Accounts :
Profit as per Cost Accounts 92,250 ; Sundry Income shown in Financial Accounts 1,270;
R R

Overvaluation of Closing Stock in Cost Accounts 12,310 ; Over Recovery of Direct Wages in Cost
R

Accounts 6,930 ; Under Absorption of Factory Overheads in Cost A/cs 4,450 ; Over Absorption of
R R

Administration Expenses in Cost Accounts 2,200 ; Under Absorption of Selling Expenses in Cost A/cs
R

19,400.
R

Ans. [Profit as per Financial A/cs 66,490]

R

9. Prepare a reconciliation statement from the following figures and ascertain the profits as per financial
books :
Loss as per cost accounts 50,000; Under-valuation of closing stock in cost accounts 25,000;
R R

Preliminary expenses written-off in financial books 10,000; Profit on sale of furniture recorded in
R

financial books only 6,000; Interest on bank loan 6,075; Factory overheads over-absorbed 11,075.
R R R

Ans. [Loss as per Financial Books 24,000]

R

10. In the reconciliation between Cost and Financial Accounts, one of the areas of differences is different
methods of stock valuation. State with reasons, in each of the following circumstances whether Costing
Profit will be higher or lower than the Financial Profit.
Items of Stock Cost Valuation Financial Valuation
R R

(i) Raw Material (Opening) 50,000 60,000

(ii) Work-in-Progress (Closing) 60,000 50,000
(iii) Finished Stock (Closing) 50,000 60,000
(iv) Finished Stock (Opening) 60,000 50,000
Ans. [(i) and (ii) will increase the profit each by R 10,000 and item (iii) and (iv) will decrease the profit
each by 10,000]
R

11. A manufacturing company has disclosed a net loss of 2,13,000 as per their cost accounting records for
R

the year ended March 31, 2024. However, their financial accounting records disclosed a net loss of
2,58,000 for the same period. A scrutiny of data of both the sets of books of accounts revealed the
R

following information :
(i) Factory overheads underabsorbed 5,000 ; (ii) Administration overheads overabsorbed 3,000 ; (iii)
R R

Depreciation charged in financial accounts 70,000 ; (iv) Depreciation charged in cost accounts 80,000;
R R

(v) Interest on investments not included in cost accounts 20,000 ; (vi) Income-tax provided in financial
R

accounts 65,000 ; (vii) Transfer fees (credit in financial accounts) 2,000 ; (viii) Preliminary expenses
R R

written off 3,000 ; (ix) Over-valuation of closing sock of finished goods in cost accounts 7,000
R R

Prepare a Memorandum Reconciliation Account.

Ans. [Total of Memorandum Reconciliation Account R 2,93,000]
12. A manufacturing company disclosed a Net Loss of 5,72,000 as per their Cost Accounts for the year
R

ended March 31, 2024. Following information was revealed as a result of scrutiny of the figures of both
the sets of books :
(i) Factory overheads over-absorbed 16,000 ; (ii) Administration overheads under-absorbed 24,000 ;
R R

(iii) Depreciation charged in Financial Accounts 2,20,000 ; (iv) Depreciation charged in Cost Accounts
R

R 2,45,000 ; (v) Interest on Investments not included in Cost Accounts 64,000 ; (vi) Income-tax
R

provided 1,54,000 ; (vii) Interest on loan funds in Financial Accounts 2,63,000 ; (viii) Transfer fees
R R

(Credit in financial books) 16,000 ; (ix) Stores adjustment (Credit in financial books) 8,000
R R

Prepare a Memorandum Reconciliation Account.

Ans. [Net Loss as per Financial Books R 8,84,000]

RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·29

13. R Limited showed a net loss of 35,400 as per their Cost Accounts for the year ended 31st March, 2024.
R

However the Financial Accounts disclosed a net profit of 67,800 for the same period. The following
R

information were revealed as a result of scrutiny of the figures of cost accounts and financial accounts :
R R

(i) Administrative Overhead (viii) Value of Opening Stock :

Under Recovered 25,500 In Cost Accounts 1,65,000
(ii) Factory Overhead Over In Financial Accounts 1,45,000
Recovered 1,35,000 (ix) Value of Closing Stock :
(iii) Depreciation Under In Cost Accounts 1,25,500
Charged in Cost Accounts 26,000 In Financial Accounts 1,32,000
(iv) Dividend Received 20,000 (x) Goodwill Written-off
(v) Loss due to Obsolescence in Financial Accounts 25,000
Charged in Financial Accounts 16,800 (xi) Notional Rent of Own Premises
(vi) Income Tax Provided 43,600 Charged in Cost Accounts 60,000
(vii) Bank Interest Credited in (xii) Provision for Doubtful
Financial Accounts 13,600 Debts in Financial Accounts 15,000
Prepare a reconciliation statement by taking costing net loss as base.

LONG ANSWER TYPE

1. What is the purpose of Reconciling Cost and Financial Accounts ? Indicate the possible sources of
difference between them. How will you prepare Reconciliation Statement to reconcile the cost and
financial accounts ?
2. It has been stated that an efficient costing system will not necessarily produce accounts which in their
result will agree with the financial accounts. Comment upon this statement.
3. (a) State the need for reconciliation of cost and financial accounts necessary ? Under what
circumstances can a reconciliation statement be avoided ?
(b) List out ten items either debit or credit which appear in the financial accounts but do not appear in
the cost accounts.
(c) Enumerate the items which are generally excluded from Cost Accounts.
4. Why is it necessary to reconcile the profit shown by the cost accounts and financial accounts ? Explain
the main sources of differences which would enter into such a reconciliation.
OR
What is the need of Reconciliation of Cost and Financial Accounts ? Why do they disagree ?
(B.Com. Panjab, Dec. 2017)
5. What do you understand by Reconciliation of Cost and Financial Accounts ? Enumerate the reasons as
to why such Reconciliation is necessary. Under what circumstances such Reconciliation be avoided.
6. The Chief Cost Accountant of Omega Ltd. found to his surprise that the profit was the same as per cost
accounts as well as the financial accounts. He asked his deputy to find out the reasons for the same. You
are required to analyse and suggest whether a Reconciliation Statement is necessary or not.
7. What is a Reconciliation Statement ? State the reasons for the difference between the profits shown in
the cost accounts and those shown in the financial accounts of an industrial organisation.
8. “There is generally a divergence between financial profits and cost profits”. Explain this statement and
give reasons for such divergence.
OR
Explain the reasons for the disagreement of profit between cost books and financial books. Prepare an
imaginary Reconciliation Statement. [B.Com. Panjab 2016 & 2017]
9. “Reconciliation of cost and financial accounts in the modern computer age is redundant.”
C/1·30 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

PRACTICAL PROBLEMS
WHEN PROFITS AS PERFINANCIAL AND COST ACCOUNTS ARE GIVEN
1. The financial Profit and Loss Account of a Manufacturing Company for the year ended 31st March, 2024
is as follows :
R R

To Material Consumed 50,000 By Sales 1,24,000

To Carriage Inwards 34,000
To Works Expenses 12,000
To Direct Wages 1,000
To Administration Expenses 4,500
To Selling and Distribution Expenses 6,500
To Debenture Interest 1,000
To Net Profit 15,000
————————————— —————————————

1,24,000 1,24,000
————————————— —————————————

The Net Profit shown by the cost accounts for the year is R 16,270. Upon detailed comparison of the two
sets of accounts it is found that :
(a) The amounts charged in the cost accounts in respect of overhead charges are as follows : Works
overhead charges 11,500 ; Office overhead charges 4,590 ; Selling and distribution expenses
R R

6,640.
R

(b) No charge has been made in the cost accounts in respect of debenture interest.
You are required to reconcile the profits shown by the two sets of accounts.
Hints. [Add : Over-absorption of Administration Overheads 90 and S & D Overheads R R 140.
Less : Under recovery of Works Expenses 500 and Debenture Interest 1,000]
R R

2. Profit disclosed by a company’s Cost Accounts for the year was 50,000, whereas the net profit as
R

disclosed by the Financial Accounts was 29,750. Following information is available.

R

(a) Overheads as per cost accounts were estimated at R 8,500. The charge for the year shown by the
financial accounts was 7,000.
R

(b) Directors’ fees shown in the financial accounts only for R 2,000.
(c) The company allowed R 5,000 as provision for doubtful debts.
(d) Work was commenced during the year on a new factory and expenditure of 30,000 was made. R

Depreciation at 5 per cent p.a. was provided for in the financial accounts for 6 months.
(e) Share-transfer fees received during the year were R 1,000.
(f) Provision for income-tax was R 15,000.
From the above, prepare a statement reconciling the figures shown by the cost and financial accounts.
Hints : [Add : Over-recovery of Overheads 1,500, Share Transfer Fees 1,000. Less : Directors’ Fees
R R

2,000, Provision for D/D 5,000, Depreciation 750, Provision for I.T. 15,000]
R R R R

3. A Company’s Trading and Profit and Loss Account was as follows :

R R

Purchases 25,210 Sales : 50,000 units at 1.50 each

R 75,000
Direct Wages 10,500 Discount received 260
Works Expenses 12,130 Profit on Sale of Land 2,340
Selling Expenses 7,100 Closing Stock 4,080
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·31

Administration Expenses 5,340

Depreciation 1,100
Net Profit 20,300
———————————— ————————————

81,680 81,680
———————————— ————————————

The profit as per Cost Accounts was only 19,770. Reconcile the financial and cost profits using the
R

following information :
(a) Cost accounts value of closing stock : 4,280.
R

(b) The works expenses in the cost accounts were taken as 100 per cent of direct wages.
(c) Selling and administration expenses were charged in the cost accounts at 10 per cent of sales and
0.10 per unit respectively.
R

(d) Depreciation in the cost accounts was 800.

R

Hint. [Add : Profit on sale of land 2,340, overabsorption of selling expenses 400, discount
R R

received 260. Less : Over-valuation of closing stock in Cost Accounts 200, under-
R R

absorption of works expenses 1,630 & administration expenses 340, undercharge of

R R

depreciation in Cost Accounts 300]

R

4. Prepare a Reconciliation Account from the following details :

Profit as per financial accounts were of 60,000, while the profits as per cost accounts were of 59,700.
R R

The values of opening and closing stock as shown in cost accounts and financial accounts were as
under:
Financial A/cs Cost A/cs
Raw materials : R R

Opening 25,000 25,300

Closing 30,000 29,600
W.I.P. :
Opening 16,000 15,500
Closing 20,000 19,900
[Hint : Starting with Profit as per Cost Accounts. Add (Cr. side)—Over Valuation of Opening Stock
of Raw Materials in Cost Accounts 300; Under valuation of Closing Stock of RM in Cost Accounts
R

R 400. Under Valuation of Closing Stock of WIP in Cost Accounts 100. Less (Dr. side)—Under
R

Valuation of Opening Stock of WIP in Cost Accounts 500] R

WHEN PROFITS AS PERFINANCIAL ACCOUNTS ARE GIVEN

5. A company maintains separate Cost and Financial Accounts, and the costing profit for 2024 differed to
that revealed in the Financial Accounts, which was shown as 50,000.
R

Following information is available :

(i) Cost Accounts Financial Accounts
R R

Opening stock of raw material 5,000 5,500

Closing stock of raw material 4,000 5,300
Opening stock of finished goods 12,000 15,000
Closing stock of finished goods 14,000 16,000
(ii) Dividend of 1,000 was received by the company.
R

(iii) A machine with net book value of 10,000 was sold during the year for 8,000.
R R

(iv) The company charged 10% interest on its opening capital employed of 80,000 to its process
R

costs.
C/1·32 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

You are required to determine the profit figure which was shown in the Cost Accounts.
Ans. [Profit as per Cost A/cs 43,200]
R

6. During the financial year ending 31-3-2024, the profits of a firm as per Profit and Loss Account are
R 30,400. You are required to prepare a Reconciliation Statement and arrive at the profit as per Cost
Accounts using the additional information given here :
PROFIT AND LOSS ACCOUNT
for the year ending 31-3-2024
R R

Opening Stock 2,50,000 Sales 3,70,000

Purchases 85,000 Closing Stock 77,500
Direct Wages 24,200 Sundry Incomes 800
Factory Overheads 23,800
Administrative Overheads 10,900
Selling Expenses 24,000
Net Profit 30,400
4,48,300 4,48,300

The costing records show : (i) Closing balance of Stock 82,000. (ii) Direct Wages 26,300. (iii) Factory
R R

Overheads 18,500. (iv) Administrative Overheads 4% of Sales. (v) Selling Overheads 5% of Sales.
R

(B.Com. Panjab 2015 Modified)

Ans. [Profit as per Cost Accounts : 38,900]
R

7. From the following information (i) determine the profit as it would be shown by Cost Accounts; and
(ii) prepare a statement reconciling it with profit shown by Financial Accounts assuming that indirect
expenses are absorbed on the basis of normal production capacity in Cost Accounts.
TRADING AND PROFIT AND LOSS ACCOUNT
For the year ended 31st March, 2024
R R

Materials Consumed 1,00,000 Sales (1,00,000 units) 2,00,000

Direct Wages 50,000
Works Expenses 30,000
Office Expenses 9,000
Selling and Distribution
Expenses 6,000
Net Profit 5,000
——————————————— ———————————————

2,00,000 2,00,000
——————————————— ———————————————

The normal output of the factory is 1,50,000 units. Works expenses of a fixed nature are 18,000. Office
R

expenses are for all practical purposes constant. Selling and distribution expenses are constant to the
extent of Rs 3,000 and the balance varies directly with sales. (B.Com. Panjab April, 2012 Modified)
Ans. [Profit as per Cost Accounts 15,000].
R

8. (When profits as per financial accounts is given). Following is a summary of the Trading and Profit and
Loss Account of Messrs Alpha Manufacturing Co. Ltd. for the year ended 31st March, 2024 :

R R R

To Material Consumed 27,40,000 By Sales (1,20,000 units) 60,00,000

” Wages 15,10,000 ” Finished Stock (4,000 units) 1,60,000
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·33

To Factory Expenses 8,30,000 By Work-in-Progress :

” Administration Expenses 3,82,400 Materials 64,000
” Selling and Distribution Wages 36,000
Expenses 4,50,000 Factory Expenses 20,000 1,20,000
————————————

To Preliminary Expenses By Dividend Received 18,000

(written off) 40,000
” Goodwill (written off) 20,000
” Net Profit 3,25,600
——————————————— ———————————————

62,98,000 62,98,000
———————————————
——————————————— ———————————————
———————————————

The company manufactures a standard unit. In the Cost Accounts :

(i) Factory expenses have been recovered from production at 20 per cent on Prime Cost ;
(ii) Administration expenses at 3 per unit on units produced ;
R

(iii) Selling and distribution expenses at 4 per unit on units sold.

R

You are required to prepare a statement of cost and profit in cost books of the company and to reconcile
the profit disclosed with that shown in the Financial Accounts. (B.Com. Panjab Sept., 2012 Modified)
Ans. [Profit as per Cost Accounts : 3,40,645; Total Cost : 56,59,355]
R R

9. Following information is made available to you from the financial books of S.V. Ltd. for the year ended
March 31, 2024 :
R R

To Direct Materials used 3,00,000 By Sales (2,00,000 units) 7,50,000

To Direct Wages 2,00,000
To Factory Expenses 1,20,000
To Office Expenses 40,000
To Selling & Distribution
Expenses 80,000
To Net Profit 10,000
—————————————— ——————————————

7,50,000 7,50,000
——————————————
—————————————— ——————————————
——————————————

Normal output of the factory is 2,50,000 units. Factory overheads are fixed upto 60,000 and officeR

expenses are fixed for all practical purposes. Selling and distribution expenses are fixed to the extent of
R 50,000; the rest are variable.
Prepare a statement reconciling the profits as per Cost and Financial Accounts assuming that
indirect expenses are absorbed on the basis of Normal production capacity in cost accounts.
Ans. [Profit as per Cost Accounts R 40,000]
10. Following is the Trading and Profit and Loss Account of a manufacturer for the year ended 31st Dec.,
2023 :
R R

To Opening Stock : By Closing Stock :

Raw Materials 59,000 Raw Materials 64,000
To Purchases of Raw Materials 3,73,000 Work in Progress 25,600
To Wages Paid 5,96,000 By Cost of Goods Manufactured 13,19,900
To Factory Exp. 3,81,500
——————————————— ———————————————

14,09,500
———————————————
14,09,500
———————————————
C/1·34 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

To Cost of Goods Manufactured 13,19,900 By Sales (15,200 units) 18,24,000

To Administration Expenses 2,45,000 By Finished Stock (2,800 units) 2,35,200
To Selling and Distribution Exp. 3,28,000 By Interest on Investments 2,600
To Preliminary Exp. Written-off 20,000 By Dividend Recd. 11,000
To Loss on Sale of Fixed Assets 15,000
To Net Profit 1,44,900
——————————————— ———————————————

20,72,800 20,72,800
———————————————
——————————————— ———————————————
———————————————

In cost accounts, factory overheads are allocated to production at 60% of direct labour cost;
administration overheads are applied at 12 per unit over the units produced; and selling and
R

distribution overheads are charged so as to work out 20% of selling price.

You are required to :
(i) prepare a Statement of Cost and ascertain the Profit as per Cost Accounts; and
(ii) prepare a Statement Reconciling the Profit or Loss as per the two Accounts.
Ans. [Profit as per Cost Accounts R 1,82,400]
[Hint : Valuation of Closing Stock of Finished Goods in Cost Accounts R 2,35,200]
11. ABC Ltd. has furnished the following information from the financial books for the year ended 31st
March, 2024:
PROFIT & LOSS ACCOUNT

R R

To Opening Stock By Sales (10,250 units) 28,70,000

(500 units at 140 each)
R 70,000 ” Closing Stock
” Material consumed 10,40,000 (250 units at 200 each)
R 50,000
” Wages 6,00,000
” Gross Profit c/d 12,10,000
—————————————— ——————————————

29,20,000 29,20,000
—————————————— ——————————————

To Factory Overheads 3,79,000 By Gross Profit b/d 12,10,000

” Administration Overheads 4,24,000 ” Interest 1,000
” Selling Expenses 2,20,000 ” Rent received 40,000
” Bad Debts 16,000
” Preliminary Expenses 20,000
” Net Profit 1,92,000
—————————————— ——————————————

12,51,000 12,51,000
——————————————
—————————————— ——————————————
——————————————

The cost sheet shows the cost of materials at 104 per unit and the labour cost at 60 per unit. The
R R

factory overheads are absorbed at 60% of labour cost and administration overheads at 20% of factory
cost. Selling expenses are charged at 24 per unit. The opening stock of finished goods is valued at
R

R 180 per unit.

You are required to prepare:
(i) A statement showing profit as per Cost Accounts for the year ended 31st March, 2024; and
(ii) A statement showing the reconciliation of profit as disclosed in Cost Accounts with the profit
shown in Financial Accounts.
Ans. [ (i) Profit as per Cost Accounts 1,94,000.
R
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·35

Hint :
Add : (a) Over Recovery of Selling Overheads 26,000; R

(b) Overvaluation of Opening Stock in Cost Accounts 20,000; R

(c) Income excluded in Cost Accounts (Interest 1,000 + Rent 40,000) = 41,000
R R R

Less :
(i) Underrecovery of Factory Overheads ( 19,000) and Administrative Overheads ( 24,000) =
R R

43,000.
R

(ii) Overvaluation of Closing Stock in Cost Accounts 10,000 R

(iii) Expenses excluded from Cost Accounts (Bad Debts 16,000 + Preliminary Expenses 20,000)
R R

= 36,000]
R

12. Following is the Trading and Profit & Loss Account of Omega Ltd.
Particulars R Particulars R
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

To Materials Consumed 23,01,000 By Sales (30,000 units) 48,75,000

To Direct Wages 12,05,750 By Finished Goods Stock
To Production Overheads 6,92,250 (1,000 units) 1,30,000
To Administration Overheads 3,10,375 By Work-in-Progress :
To Selling and Distribution Materials 55,250
Overheads 3,68,875 Wages 26,000
To Bad Debts Written Off 22,750 Production Overheads 16,250
—————————
To Goodwill Written Off 45,500 97,500
To Fines 3,250 By Dividends Received 3,90,000
To Interest on Mortgage 13,000 By Interest on Bank Deposits65,000
To Loss on Sale of Machine 16,250
To Taxation 1,95,000
To Net Profit 3,83,500
—————————————— ——————————————

55,57,500 55,57,500
——————————————
—————————————— ——————————————
——————————————

The Cost Accounting records of Omega Ltd. which manufactures a standard unit show the following :
(i) Production overheads have been charged at 20% of Prime Cost.
(ii) Administration overheads have been recorded at 9.75 per finished unit.
R

(iii) Selling and distribution overheads have been recorded at 13 per unit sold. R

Required :
(a) Prepare a Costing Profit and Loss Account, indicating net profit.
(b) Prepare a statement reconciling the profit disclosed by cost records with that shown in financial
accounts.
Ans. [(a) 2,14,500]
R

WHEN PROFITS AS PERCOST ACCOUNTS ARE GIVEN

13. The profit as per Cost Accounts is R 1,65,300. Following details are ascertained on comparison of Cost
and Financial Accounts :
Cost Accounts Financial Accounts
R R

(a) Opening Stocks :

Materials 32,600 33,000
Work-in-Progress 20,000 21,000
C/1·36 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

(b) Closing Stocks :

Materials 36,000 34,400
Work-in-Progress 16,000 15,200
(c) Interest remitted but ignored in Cost Accounts— 800. R

(d) Interest charged but not considered in financial accounts— 6,000. R

(e) Preliminary expenses written off— 13,000.

R

(f) Overhead expenses charged in financial accounts are 1,21,200 but overheads recovered in cost
R

accounts are 1,26,000.

R

Find out the Profit as per Financial Accounts by drawing up a Reconciliation Statement.
Ans. [ 1,58,500].
R

Hints. [Add : Interest charged in Cost Accounts 6,000. Indirect expenses overcharged in Cost
R

Accounts 4,800.
R

Less : Undervaluation of stock of material and WIP in Cost Accounts 1,400, overvaluation
R

of closing stock of materials and WIP 2,400, Interest remitted but ignored in Cost Accounts
R

R 800, Preliminary expenses 13,000]

R

14. From the following figures prepare a Reconciliation Statement :

R

Net Loss as per costing records 1,72,400

Works overhead under-recovered in costing 3,120
Administrative overhead recovered in excess 1,700
Depreciation charged in financial records 11,200
Depreciation recovered in costing 12,500
Interest received not included in costing 8,000
Obsolescence loss charged in financial records 5,700
Income-tax provided in financial books 40,300
Bank interest credited in financial books 750
Stores adjustments (credit) in financial books 475
Value of opening stock in : Cost Accounts 52,600
Financial Accounts 54,000
Value of closing stock in : Cost Accounts 52,000
Financial Accounts 49,600
Interest charged in Cost Accounts but not in Financial Accounts 6,000
Preliminary expenses written off in Financial Accounts 800
Provision for doubtful debts in Financial Accounts 150
Ans. [Net Loss as per Financial Records R 2,08,045]
15. The cost accountant of a company has arrived at a profit of 73,24,150 based on cost accounting records
R

for the year ended 31-3-2024. As cost auditor, you find the following differences between financial
accounts and cost accounts.
(a) Value of WIP and Finished Goods as per F/A 1,28,21,995 ; Value of WIP and Finished Goods as per
R

Cost Accounts 1,31,04,220 ; (b) Profit on Sale of Fixed Assets 61,500 ; (c) Loss on Sale of Investments
R R

R 11,200 ; (d) Voluntary Retirement Compensation included in Salaries and Wages in F/A 16,75,000 ;
R

(e) Donation paid 25,000 ; (f) Major Repairs and Maintenance Written off in F/A 13,26,000 ; Amount
R R

in Cost Accounts 6,08,420 ; (g) Insurance Claim relating to previous year received during the year
R

R 14,29,000 ; (h) Profit from Retail Trading Activity 7,12,300.

R
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·37

You are required to prepare a reconciliation statement between the profit figures as per costing and
financial accounts. Calculate the profit as per financial books.
Ans. [Profit as per Financial A/cs 68,15,945]
R

16. Following is the summarized version of Trading and Profit and Loss Account of Continental
Enterprises Limited for the year ended 31st March, 2024 :
R R

To Materials 48,000 By Sales 96,000

” Wages 36,000 ” Closing Stock of Finished
” Works Expenses 24,000 Goods 18,000
” Gross Profit c/d 12,000 ” Work-in-Progress : R

Materials 3,000
Wages 1,800
Work Expenses 1,200
—————————
———————————
6,000
———————————

1,20,000
———————————
1,20,000
———————————

To Administration Expenses 6,000 By Gross Profit b/d 12,000

To Net Profit 6,000
——————————— ———————————

12,000 12,000
——————————— ———————————

During the year, 6,000 units were manufactured and 4,800 of these were sold.
The costing records show that works overheads have been estimated at 3 per unit produced and
R

administration overheads at 1.50 per unit produced. The costing books show a profit of 11,040.
R R

Prepare a statement of cost and profit and reconcile the profit as per Cost Accounts and financial
books.
Ans. [Over-recovery of Administration Overheads, 3,000; Under-recovery of Factory Overheads 4,800 ;
R R

Over-valuation of Closing Stock in Cost Accounts 3,240] R

17. A manufacturing company disclosed a net loss of 3,47,000 as per their Cost Accounts for the year
R

ended March 31, 2024. The Financial Accounts however disclosed a net loss of 5,10,000 for the same
R

period. Following information was revealed as a result of scrutiny of the figures of both the sets of
accounts :
(i) Factory Overheads Under-absorbed 40,000 ; (ii) Administration Overheads Overabsorbed 60,000 ;
R R

(iii) Depreciation charged in Financial Accounts 3,25,000 ; (iv) Depreciation charged in Cost Accounts
R

R 2,75,000 ; (v) Interest on Investments not included in cost Accounts 96,000 ; (vi) Income-tax Provided
R

R 54,000 ; (vii) Interest on Loan Funds in Financial Accounts 2,45,000 ; (viii) Transfer Fees (Credit in
R

Financial Books) 24,000 ; (ix) Stores Adjustment (Credit in Financial Books) 14,000 ; (x) Dividend
R R

Received 32,000.
R

Prepare a Memorandum Reconciliation Account.

WHEN BOTH THE PROFITS ARE NOT GIVEN

18. From the following particulars, prepare :
(a) P & L A/c.
(b) a statement showing the cost of manufacture, calculating factory expenses at 25% on prime cost
and office overheads at 75% on factory expenses.
(c) a statement reconciling the profits shown by the Cost Accounts with that shown by P & L A/c. The
selling price was fixed at cost plus 25%.
C/1·38 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Stock on 1st April, 2023

Finished articles 8,000 Raw materials 4,000
Stock on 31st March, 2024
Raw materials 6,000 Sales 65,000
Finished articles 2,000 Works expenses 7,750
Purchases of raw materials 24,000 Office expenses 6,100
Wages 10,000
Ans. [Profit as per Cost Accounts 13,000, Profit as per Financial Accounts
R R 13,150]
19. Following information has been obtained from the records of Freezer Ltd., a manufacturer of one ton
air-conditioners :
(a) Materials per machine 1,500 ; Wages per machine 900 ; Number of machines manufactured and
R R

sold 80 ; Sale price per machine 4,250 .

R R

(b) Works expenses to be charged at 60% of the wages.

(c) Office expenses to be charged at 20% of works cost.
(d) There were no stocks of machines or work-in-progress at the beginning or at the end of the period.
Prepare a statement showing the profit per machine sold. Also prepare a statement showing the actual
profit. Works expenses were 43,000 and office expenses were 48,000 as per the financial records.
R R

You are also required to reconcile the profit as shown by the costing records with that shown by the
financial records.
Ans. [Profit as per Cost Accounts 57,760, Profit as per Financial Accounts 57,000]
R R

20. From the following details of Small Tools Ltd. compute profit in Financial Accounts as well as in Cost
Accounts and reconcile profit between Cost and Financial Accounts showing clearly the reasons for the
variation of the two profit figures :
R R

Sales 20,000 Bad Debts 100

Purchase of Materials 3,000 Interest on Overdraft 50
Closing Stock of Materials 500 Profit on Sale of Assets 1,000
Direct Wages 1,000 Selling Expenses 2,000
Indirect Wages 500 Distribution Expenses 1,000
Indirect Expenses 2,000
In Cost Accounts :
Manufacturing overhead recovered @ 300% on direct wages.
Selling overhead recovered 1,500. R

Distribution overhead recovered 700. R

Ans. [Profit as per Financial Accounts 11,850 ; Profit per Cost Accounts 11,300]
R R

21. A factory turns out two products A and B. The cost of materials and labour is as follows :
A B
R R

Materials (per unit) 12.50 7.50

Wages Direct 10.00 6.00
Works overhead is charged at 100% of wages and Office overhead at 25% of works cost. 200 units of A
and 500 units of B were produced and sold at 50 and 30 per unit respectively, there being no
R R

opening and closing stocks.

If actually the works expenses amounted to 4,800 and office expenses to 4,200 reconcile the results
R R

shown by Cost Accounts and Financial Accounts.

Ans. [Profit as per Cost Accounts 4,687.50 ; Profit as per Financial Accounts 4,750.00]
R
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·39

22. The Modern Radio Co., which commenced business on 1st April, 2023, sets before you the following
information, and asks you to prepare a statement showing profit per radio sold (charging labour and
material at actual cost : works overheads at 100% on labour and office overheads at 25% on works cost)
and a statement showing the reconciliation between the profit as shown by the Cost Accounts and the
Profit as shown by the Profit and Loss Account for the year ending 31st March, 2024.
Two grades of radios are manufactured and are known as ‘Janta’ and ‘Deluxe’. There were no radios in
stock or in the course of manufacture on 31st March, 2024 and the number of radios sold during the
year was : ‘Janta’ 160 units and ‘Deluxe’ 95 units. The particulars given are as under :
Janta Deluxe
R R

Average cost of materials per radio 28 32

Average cost of labour per radio 48 58
Selling price per radio 180 240
The works expenses were R 16,800 and the office expenses were R 6,220.
Ans. [Profit as per Cost Accounts : Janta R 4,000, Deluxe R 5,225, Profit as per Financial Accounts 7,870]
R

23. Summarised information extracted from the books of a company relating to the year 31st March, 2024:
(i) Factory overhead (actual) 60,000 of which 60% are fixed.
R

(ii) Selling and distribution overheads (actual) 12,000 of which 50% are fixed.
R

(iii) Administration overheads (actual) 18,000 are constant for all practical purposes.
R

(iv) Material and wages cost are 2,00,000 and 1,00,000 respectively.
R R

(v) Sales (20,000 units) 4 lakhs.

R

(vi) Normal output during the period was expected to be 16,000 units.
(vii) There is no opening and closing stock of finished product.
On the basis of information given above you are required to :
(a) Ascertain the actual amount of profit.
(b) Prepare a cost sheet and find out estimated profit assuming that overheads are absorbed in cost on
the basis of normal production.
(c) Reconcile the above profits by preparing a statement of reconciliation.
Ans. [(a) Net Profit 10,000; (b) Loss 5,000; (c) [Overabsorption of Factory Overheads ( 9,000),
R R R

Administrative Overheads ( 4,500) and Selling & Distribution Overheads ( 1,500)]]

R R

24. Following figures are available from financial accounts for the year ended 31st March, 2024 :
R R

Direct Material Consumption 2,50,000 Legal Charges 5,000

Direct Wages 1,00,000 Dividend Received 50,000
Factory Overheads 3,80,000 Interest on Deposit Received 10,000
Administration Overheads 2,50,000 Sales (1,20,000 units) 7,00,000
Selling and Distribution Overheads 4,80,000 Closing Stock
Bad Debts 20,000 Finished Stock (40,000 units) 1,20,000
Preliminary Expenses (written off) 10,000 Work-in-Progress 80,000
The Cost Accounts reveal—
Direct Material Consumption— 2,80,000. R

Factory Overheads recovered at 20% on Prime Cost.

Administration Overheads at 3 per unit of production.
R

Selling and Distribution Overheads at 4 per unit sold.

R
C/1·40 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

Prepare (1) Statement of Cost and Profit. (2) Financial Profit and Loss Account. (3) Statement
reconciling the profits disclosed by the Costing Profit and Loss Account and Financial Profit and Loss
Account. (B.Com. Panjab April, 2009 Modified)
Ans. [(1) Net Loss 4,22,000; (2) Net Loss 5,35,000; (3) Deduct Overcharging of Materials 30,000,
R R R

Overcharge of Administrative Expenses 2,30,000. Dividend and Interest 60,000.

R R

Add : Under-absorption of Factory Overheads 3,04,000 ; Bad Debts 20,000 ; Preliminary and
R R

Legal Expenses 15,000 ; Under Valuation of Closing Stock in Financial Books 94,000]
R R

25. Following figures are extracted from the Financial Accounts of Selwel Ltd. for the year ending 31-3-
2024 :
in Thousands
R in Thousands R

Sales (20,000 units) 5,000 Work-in-Progress :

Materials 2,000 Materials 60
Wages 1,000 Labour 40
Factory Overheads 900 Factory Overheads 40
Administration Overheads 520 Goodwill written off 400
Selling and Distribution Overheads 360 Interest paid on Capital 40
Finished Goods (1,230 units) 300
In the costing records, Factory Overheads are charged at 100% of Wages, Administration Overheads at
10% of Factory Cost and Selling and Distribution Overheads at the rate of 20 per unit sold.
R

Prepare a statement reconciling the profit as per Cost Records with the profit as per Financial Records.
Ans. [Profit as per Financial Accounts R 2,20,000, Profit as per Cost Accounts R 6,00,000]
Hint. [Add : Over-recovery of Factory Overheads 1,00,000 ; Over-recovery of Selling and
R

Distribution Overheads 40,000; Under-valuation of Finished Goods in Cost Accounts

R

Rs 54,000.
Less : Under-recovery of Administration Overheads 1,34,000, Goodwill written off
R

4,00,000; Interest on Capital 40,000].

R R

26. Following are the figures extracted from the Cost Ledger of a firm :
R

(a) Inventory : (c) Finished Products :

(i) Opening Balance 10,000 (i) Opening Balance 20,000
(ii) Net Debits 90,000 (ii) Debits 1,75,000
(iii) Net Credits 80,000 (iii) Credits from cost of sales 1,86,000
(iv) Drawals for maintenance Further data from financial books :
included in net credits above 10,000 Sales 2,10,000
(b) Work-in-progress : Wages 25,000
(i) Opening Balance 15,000 Other Expenses 85,000
(ii) Debits for Material as per
Inventory A/c
Debits for Labour 20,000
Debits for Overheads 80,000
(iii) Credits—Finished Goods 1,75,000
You are required to prepare a Costing Profit and Loss Account leading up to the Profit as per Financial
Accounts.
Ans. [Profit as per Cost Accounts R 24,000; Profit as per Financial Accounts R 4,000]
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·41

27. The following figures have been extracted from the cost records of a manufacturing company :
Stores R Work-in-Progress : R

Opening Balance 63,000 Opening Balance 1,26,000

Purchases 3,36,000 Direct Wages Applied 1,26,000
Transfer from Work-in-Progress 1,68,000 Overhead Applied 5,04,000
Issues to Work-in-Progress 3,36,000 Closing Balance 84,000
Issues to Repairs and Maintenance 42,000
Normal Deficiencies Found in
Stock Taking 12,600
Finished Products :
Entire output is sold at a Profit of 10% on actual cost from work-in-progress :
Others : Wages incurred R 1,47,000; Overhead incurred R 5,25,000.
Income from investment R 21,000; Loss on sale of Fixed Assets R 42,000l.
Draw the Stores Control Account, Work-in-progress Control Account, Costing Profit and Loss Account,
Profit and Loss Account and Reconciliation Statement.
Ans. [SL Control A/c 1,76,400; WIP Control A/c 84,000; Profit as per Costing P/L A/c 84,000; Loss as
R R R

per Financial A/cs 33,600; Reconciliation Statement : Add Income from Investments 21,000;
R R

Deduct—Underabsorption of Overheads 96,600; Loss on Sale of Fixed Assets 42,000 in Profit as

R R

per Cost A/cs]

28. You are given the following information of the cost department of a manufacturing company :
R R

Stores : Work-in-progress :
Opening Balance 12,60,000 Opening Balance 25,20,000
Purchases 67,20,000 Direct Wages Applied 25,20,000
Transfer from Work-in-progress 33,60,000 Overhead Applied 90,08,000
Issue to Work-in-progress 67,20,000 Closing Balance 15,20,000
Issue to Repairs and Maintenance 8,40,000
Shortage Found in Stock taking 2,52,000
Finished Products :
Entire output is sold at a profit of 12% on actual cost from work-in-progress.
Other information :
Wages incurred 29,40,000; Overhead incurred
R R 95,50,000; Income from investment R 4,00,000; Loss on
sale of fixed assets 8,40,000.
R

Shortage in stock taking is treated as normal loss.

You are required to prepare : (i) Stores control account; (ii) Overhead Control Account; (iii) Work-in-
progress Control Account; (iv) Costing Profit and Loss Account; (v) Profit and Loss Account and (vi)
Reconciliation Statement.
Ans. [(iv) Profit R 19,06,560; (v) Loss R 5,87,440]
29. Profit and Loss Account as shown in the financial books of a company for the year ended 30-9-2023
together with a statement of reconciliation between the Profit as per Financial and Cost Accounts is
given below :
C/1·42 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

PROFIT AND LOSS ACCOUNT

for the year ended 30-9-2023
R R R R

Opening Stock : Sales 15,00,000

Raw Materials 90,000 Closing Stock :
Work in Progress 50,000 Raw Materials 98,000
Finished Goods 70,000
———————————
2,10,000 Work in Progress 53,000
Raw Material Purchases 5,00,000 Finished Goods 72,000
———————————
2,23,000
Direct Wages 2,00,000 Miscellaneous Receipts 45,000
Factory Overheads 2,00,000
Administration Expenses 1,70,000
Selling and Distribution Expenses 2,20,000
Preliminary Expenses written off 75,000
Debenture Interest 30,000
Net Profit 1,63,000
—————————————— ——————————————

17,68,000 17,68,000
—————————————— ——————————————

Statement of reconciliation of profit as per financial and cost accounts :

R R

Profit as per Financial Accounts 1,63,000

(a) Difference in valuation of stock :
Add : Raw Materials—closing stock 1,200
Work-in-progress—opening stock 1,300
Finished goods—opening stock 2,000
—closing stock 1,000
——————————

Total (A) 5,500

Less : Raw Materials—opening stock 1,650
Work-in-progress—closing stock 750 2,400
—————————— ——————————

Total (B)
A–B 3,100
(b) Other items
Add : Preliminary expenses written off 75,000
Debenture interest 30,000
—————————————

1,05,000
Less : Miscellaneous receipts 45,000 60,000
————————————— —————————————

Profit as per Cost Accounts 2,26,100

—————————————

You are required to prepare the following accounts as they would appear in the Costing Ledger :
(i) Raw Material Control A/c ; (ii) Work-in-progress Control A/c ; (iii) Finished Goods Control A/c ;
(iv) Cost of Sales A/c and ; (v) Costing Profit and Loss A/c
Ans. [(a) Direct Material charged to WIP Control A/c 4,92,450 ; (b) Work completed transferred to
R

Finished Goods Control A/c 8,88,900 ; (c) Cost of Goods Sold transferred to Cost of Sales A/c
R

10,53,900 : (d) Cost of Sales transferred to Costing Profit and Loss A/c 12,73,900 (e) Profit
R R

2,26,100]
R
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS C/1·43

30. Following represents the Trading and Profit and Loss Account of a manufacturer of a standard fire
extinguisher :

R R

To Material 29,150.00 By Sales 75,000.00

To Wages 18,610.00 By Stock of Finished Goods 1,812.50
To Factory Expenses 14,055.00 By Work-in-Progress : R

To Gross Profit c/d 20,527.50 Materials 2,800

Wages 1,560
Factory 1,170 5,530.00
——————————————— ————————— ———————————————

82,342.50 82,342.50
———————————————
——————————————— ———————————————
———————————————

To Administration Expenses 13,650.00 By Gross Profit b/d 20,527.50

To Net Profit 6,877.50
——————————————— ———————————————

20,527.50 20,527.50
———————————————
——————————————— ———————————————
———————————————

1,550 Extinguishers were manufactured during the year and 1,500 were sold during the same period.
The cost records show that Factory Expenses work out at 8.25 and Administrative Expenses at
R

R 9.0625 per article produced : the cost accounts showing an estimated total profit of 7,031.25 for the
R

year.
From the information given, you are required to prepare
(a) Factory Overheads Account
(b) Administrative Overheads Account
(c) Reconciliation Account showing the total net profit as per the Cost Accounts and the net profits
shown in the financial books. (B.Com. Panjab Sept. 2010)
Ans. [Under absorption of factory overheads R 97.50; Over absorption of Administration overheads
R 396.88]
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·1

CHAPTER

2
Marginal Costing and Break-even
Analysis
LEARNING OBJECTIVES
To understand the systems of Cost accounting-
(i ) Absorption Costing,
(ii) Marginal Costing
To understand the meaning of marginal costing, its features, advantages and disadvantages.
To understand the computation method of Break-even-Point.
To know the meaning and effects of price reduction on margin of safety.
To learn the relationship between Cost-Volume-Profit and Break-even point.

It is desirable to understand the technique of absorption costing before understanding marginal

costing and cost volume profit analysis.

ABSORPTIONCOSTING

Absorption costing also known as ‘full costing’ is a conventional technique of ascertaining cost. It
is the practice of charging all costs both variable and fixed to operations, processes and products. It is
the oldest and widely used technique of ascertaining cost. Under this technique of costing, cost is
made up of direct costs plus factory overhead costs absorbed on some suitable basis. Under this
technique, cost per unit remains same only when the level of output remains same. But when the level
of output changes the cost per unit also changes because of the presence of fixed cost which remains
constant. The change in cost per unit with a change in the level of output in absorption costing
technique poses a problem to the management in taking managerial decisions. Absorption costing is
useful if there is only one product and there is no inventory. Overhead recovery rate is based on
normal capacity instead of actual level of activity. Two distinguishing features of absorption costing
are that fixed factory expenses are included in unit cost and inventory value.
C/2·2 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Ascertainment of Profit Under Absorption Costing

Under this technique of costing the following proforma is used for the ascertainment of profit:
INCOME STATEMENT
R R

Sales ×××
Less : Cost of Goods Manufactured
Direct Material ×××
Direct Labour ×××
Factory Overheads :
Variable ×××
Fixed (at actual production basis) ×××
———————————

×××
Add : Value of Opening Stock ×××
———————————

×××
Less : Value of Closing Stock at Current Cost ×××
———————————

×××
Add : Underabsorption or Less Overabsorption of Fixed
Factory Overheads ××× ×××
——————————— ———————————

Gross Profit ×××

Less : Administration, Selling & Distribution Expenses :
Fixed ×××
Variable ×××
———————————

×××
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Net Income or Profit ×××

ILLUSTRATION 1. Following data relate to XYZ company :

Normal capacity 40,000 units per month Actual production 44,000 units.
Variable cost per unit R 6. Sales 40,000 units @ R 15 per unit.
Fixed manufacturing overheads R 1,00,000 per month or R 2.50 per unit at normal capacity.
Other fixed expenses R 2,40,000 per month.
Prepare Income Statement under absorption costing.
SOLUTION INCOME STATEMENT
R R

Sales (40,000 × 15) R 6,00,000

Less : Cost of Goods Manufactured :
Variable cost @ 6 per unit for 44,000 units
R 2,64,000
Fixed manufacturing overheads @ 2.50 for 44,000 units.
R 1,10,000
———————————————
3,74,000

Less : Closing inventory ( 4‚000

44‚000
× R 3,74,000 ) 34,000
———————————————

3,40,000
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·3

Less : Overabsorption of fixed manufacturing overheads

( 1,10,000 – 1,00,000)
R R 10,000
———————————————
3,30,000
——————————————
Gross Profit 2,70,000
Less : Other fixed expenses 2,40,000
——————————————
Net Income 30,000
——————————————
——————————————

Advantages of Absorption Costing

Following are the main advantages of absorption costing :
(i) It recognises the importance of including fixed manufacturing costs in product cost
determination and framing a suitable pricing policy. In fact all costs (fixed and variable) related
to production should be charged to units manufactured. Price based on absorption costing
ensures that all costs are covered. Prices are well regulated where full cost is the basis.
(ii) It will show correct profit calculation in case where production is done to have sales in future
(e.g., seasonal sales) as compared to variable costing.
(iii) It helps to conform with accrual and matching concepts which require matching cost with revenue
for a particular period.
(iv) It has been recognised by various bodies as FASB (USA), ASC (UK), ASB (India) for the purpose
of preparing external reports and for valuation of inventory.
(v) It avoids the separation of costs into fixed and variable elements which cannot be done easily
and accurately.
(vi) It discloses inefficient or efficient utilisation of production resources by indicating
underabsorption or overabsorption of factory overheads.
(vii) It helps to make the managers more responsible for the costs and services provided to their
centres/departments due to correct allocation and apportionment of fixed factory overheads.
(viii) It helps to calculate the gross profit and net profit separately in income statement.

Limitations of Absorption Costing

Following are the main limitations of absorption costing :
1. Difficulty in comparison and control of cost. Absorption costing is dependent on level of
output ; so different unit costs are obtained for different levels of output. An increase in the volume
of output normally results in reduced unit cost and a reduction in output results in an increased cost
per unit due to the existence of fixed expenses. This makes comparison and control of cost difficult.
2. Not helpful in managerial decisions. Absorption costing is not very helpful in taking
managerial decisions such as selection of suitable product mix, whether to buy or manufacture,
whether to accept the export order or not, choice of alternatives, the minimum price to be fixed
during the depression, number of units to be sold to earn a desired profit etc.
3. Cost vitiated because of fixed cost included in inventory valuation. In absorption costing, a
portion of fixed cost is carried forward to the next period because closing stock is valued at cost of
production which is inclusive of fixed cost.
4. Fixed cost inclusion in cost not justified. Many accountants argue that fixed manufacturing,
C/2·4 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

administration and selling and distribution overheads are period costs and do not produce future
benefits and, therefore, should not be included in the cost of product.
5. Apportionment of fixed overheads by arbitrary methods. The validity of product costs under
this technique depends on correct apportionment of overhead costs. But in practice many overhead
costs are apportioned by using arbitrary methods which ultimately make the product costs inaccurate
and unreliable.
6. Not helpful for preparation of flexible budget. In absorption costing no distinction is made
between the fixed and variable costs. It is not possible to prepare flexible budget without making this
distinction.

MARGINALCOSTING

Need for Marginal Costing

Fixed expenses remain constant in aggregate amount and do not vary with the increase or
decrease in production upto a particular level of output. Just contrary to this variable expenses
increase or decrease in proportion to increase or decrease in output and remain constant per unit of
output. Fixed expenses per unit continue to vary with the increase or decrease in production because
these expenses remain constant upto a certain level of production. Thus, fixed overheads lead to
different costs per unit at different levels of production. On account of this, a special technique
known as marginal costing has been developed which excludes fixed overheads entirely from the cost
of production and gives us the same cost per unit upto a particular level of output. Thus, under this
technique fixed expenses are not allocated to cost units but are charged against “fund” which arises
out of excess of selling price over total variable costs.

Meaning of Marginal Cost

The Chartered Institute of Management Accountants, London, defines the term “marginal
cost” as follows :
Marginal Cost is the amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit. In this context a unit may
be a single article, a batch of articles, an order, a stage of production capacity or a department. It
relates to the change in output in the particular circumstances under consideration.
For example, if variable costs per unit are R 10 and fixed expenses are R 1,50,000 per annum, an
output of 30,000 units per annum results in the following expenditure :
R

Variable cost of 30,000 units @ R 10 = 3,00,000

Fixed cost = 1,50,000
—————————————

Total cost = 4,50,000

—————————————

If output is increased by one unit, the following expenditure will be incurred : R

Variable cost of 30,001 units @ 10R = 3,00,010

Fixed cost = 1,50,000
—————————————

Total cost 4,50,010

Less : Total cost for output of 30,000 units 4,50,000
—————————————

Marginal cost of 1 unit 10

—————————————
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·5

It means marginal cost is the variable cost. It is also known as direct cost, volume cost or activity
cost.

Meaning of Marginal Costing

According to CIMA Terminology Marginal Costing is the ascertainment of marginal costs and of
the effect on profit of changes in volume or type of output by differentiating between fixed costs and
variable costs. In this technique of costing which presents management the required information
enabling it to measure profitability of an undertaking by considering behaviour of costs. It is not a
distinct method of acertainment of costs such as process or job costing but a technique in which only
variable costs are charged to operations, processes or products, leaving all indirect costs to be written
off against profits in the period in which they arise. It is clear from the above that only variable costs
form part of product cost in the technique of marginal costing because only variable costs are changed
if output is increased or decreased and fixed costs remain the same.
Marginal costing is different from direct costing. Direct costing is the practice of charging all
direct costs to operations, processes or products, leaving all indirect costs to be written off against
profit in the period in which they arise. Thus, in direct costing some fixed costs could be
considered to be direct costs in appropriate circumstances but fixed cost is never taken in marginal
cost.

Features of Marginal Costing

Following are the main features of Marginal Costing :
(i) It is a technique of costing which is used to ascertain the marginal cost and to know the
impact of variable cost on the volume of output.
(ii) All costs are classified into fixed and variable cost on the basis of variability. Even semi
fixed is segregated into fixed and variable cost.
(iii) Variable cost alone are charged to production. Fixed costs are recovered from contribution.
(iv) Fixed costs are written off and charged to Statement of Profit & Loss for the period during
which they are incurred.
(v) Valuation of stock of work in progress and finished goods is done on the basis of marginal
cost.
(vi) Selling price is based on marginal cost plus the contribution.
(vii) Profit is calculated by deducting marginal cost and fixed cost from sales.
(viii) Cost Volume Profit (or Break Even) Analysis, is one of the integral part of marginal
costing.
(ix) The profitability of product/department is based on contribution made available by each
product/department.
(x) It involves the techniques of both cost recording and cost reporting.
From the above, it is to be noted carefully that there are two aspects which require detailed
treatment. These are :
1. Ascertainment of Marginal Cost. 2. Break Even and Cost Volume Profit Analysis.
These will be discussed in detail one by one.
C/2·6 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Ascertainment of Profit under Marginal Cost

Ascertainment of marginal cost is different from absorption cost. In marginal cost it is assumed
that the difference between the aggregate sales value and the aggregate marginal cost of the output
sold is contribution and provides a fund to meet the fixed cost and profit of the firm. In respect of
each product, the difference between its sales value and the marginal cost is known as “contribution”
made by the product to this fund. This contribution is also the aggregate of fixed expenses and profit
(or minus loss).
Product A Product B Product C
Total sales value Total sales value Total sales value
( 2,00,000)
R ( 1,00,000)
R ( 3,00,000)
R

minus minus minus

Marginal (or variable) Marginal (or variable) Marginal (or variable
cost of goods sold cost of goods sold cost of goods sold
( 1,50,000)
R ( 80,000)
R ( 2,20,000)
R

Yields Contribution Yields Contribution Yields Contribution

( 50,000)
R ( 20,000)
R ( 80,000)
R

Fund
( 1,50,000)
R

minus
Fixed Expenses
( 1,00,000)
R

leaves
Profit
( 50,000)
R

If more than one products are produced, contribution of all products are merged into the fund out
of which fixed expenses are deducted to get the figure of the profit. Diagram represents a firm
manufacturing three products and shows how individual product contributions are merged into the
fund, the total amount of which should be sufficient to meet the fixed expenses and provide the
desired profit.

Advantages of Marginal Costing

Following are the main advantages of marginal costing :
(i) It is simple to understand and easy to operate as it does not involve allocation,
apportionment and absorption of fixed costs.
(ii) The valuation of closing stock under marginal costing is done at marginal cost and thus
prevents the illogical carry forward of fixed costs of one period to the next period as part
of value of closing stock.
(iii) There is no problem of computing fixed overhead recovery rates and their under o r over
recovery as fixed overheads are charged against the contribution.
(iv) In marginal costing, it is established that profit is a function of sale and not of production as
profit depends on sales volume and not on production volume. This can be verified by
preparing a profit statement under marginal costing.
(v) It facilitates control over variable costs by avoiding arbitrary apportionment or allocation of
fixed costs.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·7

(vi) It is a very useful tool of profit planning. It guides the management about the profitability at
various levels of production and sales.
(vii) It is very valuable technique in decision-making. It provides information to the management
in making decisions like make or buy, selling price fixation, export decision etc. which are
based on contribution.
(viii) It provides the management with useful techniques like break even or cost-volume
analysis, P/V ratio etc.
(ix) It helps in cost control by concentrating on variable cost as the fixed cost is non-controllable
in the short period.
(x) It helps in evaluation of performance of different departments, divisions, products, salesmen
etc.
(xi) It is a valuable adjunct to standard costing and budgetary costing.
(xii) It furnishes a better and more logical basis for fixation of selling price and tendering for
contract particularly when business is dull.
(xiii) Changes in per unit variable cost reflect changes in efficiency in a far better way than
changes in per unit total cost which are affected by capacity utilisation in a big way.
(xiv) The system of variable costing is best suited for internal reporting at different levels of
management as it reflects performance in a better way.
(xv) Under variable costing, contribution is determined by sales and variable costs and profit
figure is not influenced by fluctuations in production and inventory build up.

Limitations (or Disadvantages) of Marginal Costing

Marginal costing technique has certain limitations which must be kept in mind while making
use of this technique.
1. The separation of expenses into fixed and variable presents certain technical difficulties whereas
marginal costing technique assumes that all expenses can be divided into fixed and variable. In fact,
no variable cost is completely variable and no fixed cost is completely fixed. Actually, most of the
expenses are semi-veriable and it is difficult to segregate them into fixed and variable.
2. Time taken for the completion of jobs is not given due attention because marginal cost excludes fixed
expenses which are connected with time. Fixed expenses should be considered if the suitable
comparison of two jobs is to be made.
3. With the development of technology, fixed expenses have increased and their impact on
production is much more than that of variable expenses. Therefore, a system of costing which ignores
fixed expenses is less effective because a significant portion of the cost representing fixed expenses is not
taken care of.
4. It is possible that a concern using marginal costing technique may value work-in-progress and
finished stocks at marginal cost. The arguments against valuing these items at marginal costs are as
follows :
(a) Balance Sheet will not exhibit a true and fair view because work-in-progress and finished stock
will be shown at marginal costs which do not include fixed expenses. Thus, finished stocks
and work-in-progress will be understated in the Balance Sheet.
C/2·8 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

(b) In case of loss by fire, full loss on account of stock destroyed by fire cannot be recovered from the
insurance company because marginal costing technique of valuation of stock will not take
fixed expenses into consideration.
5. Marginal costing technique does away with the difficulties involved in the apportionment of overheads
because fixed expenses are deducted from total contribution. But the problem of apportionment of
variable costs still arises.
6. Marginal costing technique is difficult to apply in contract or shipbuilding industry where the value
of work-in-progress is high in relation to turnover. If fixed expenses are not included in the valuation
of work-in-progress, losses may occur every year till the contract is completed, while on the
completion of the contract there may be huge profits.
7. Cost control can be better achieved with the help of other techniques such as budgetary control and
standard costing as marginal costing technique does not provide any standard for the evaluation of
performance which is provided by standard costing and budgetary control.
8. Marginal costing technique cannot be successfully applied in cost plus contracts unless a high
percentage over the marginal cost is charged from the contractee to cover the fixed costs and profits.
9. Sometimes, an order from a new customer is accepted at a very low price on the argument that
if marginal cost is little less than the price of the order, it will give some contribution. This may
sometimes lead to a general reduction in selling price and thus to losses.
10. The technique is not suitable for external reporting, viz., for tax authorities where marginal
income is not considered as taxable profit.
11. This techniques wrongly assumes that fixed costs cannot be controlled. Fixed costs can also be
controlled with the help of effective system of budgetary control and standard costing.

Income Determination Under Marginal Costing and Absorption Costing

As we have seen that there are different formats for calculating the income under marginal
costing and absorption costing. Following can be possible cases:
1. When there is production but no sales. Under this case, the income under absorption costing
may reflect profit though no sales has been made. This is due to the fact that fixed manufacturing
overheads have been over absorbed above normal capacity production than its actual fixed
manufacturing overheads. But variable income statement will show loss as there are no sales. Though
no sales has been made but income statement will show gross profit equal to the amount of over
absorption of fixed manufacturing overheads. Thus profit under absorption costing is influenced by
various factors as quantity of production units, units sold, selling price, cost of production etc.

ILLUSTRATION 2. Following data relate to XYZ company :

Normal capacity 40,000 units per month Actual production 44,000 units.
Variable cost @ R 10 per unit Sales— Nil.
Fixed manufacturing overheads R 1,00,000 per month or R 2.50 per unit at normal capacity.
Other fixed expenses R 8,000.
You are required to prepare income statement under (a) absorption costing and (b) marginal
costing.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·9

SOLUTION
INCOME STATEMENT (Absorption Costing)
R R

Sales —
Less : Variable Cost @ 10 per unit
R 4,40,000
Fixed manufacturing overheads for 44,000 units @ R 2.50 1,10,000
——————————————

Cost of goods manufactured 5,50,000

Less : Closing inventory 5,50,000
——————————————
Cost of goods sold Nil
Less : Overabsorption of overheads (4,000 × R 2.50) – 10,000
——————————————

Gross Profit 10,000

Less : Other fixed expenses 8,000
——————————————
Net Income 2,000
——————————————
——————————————

Note. The above income statement will not show the profit if other fixed expenses are more than the gross
profit.

(b) INCOME STATEMENT (Marginal Costing)

R R

Sales Nil
Less : Variable Cost :
Cost of goods manufactured for 44,000 units @ R 10 per unit 4,40,000
Less : Closing inventory 4,40,000
————————————————

Cost of goods sold Nil

————————————————

Contribution Nil
Less : Fixed manufacturing overhead 1,00,000
Other fixed expenses 8,000 1,08,000
———————————————— ————————————————

Net Loss 1,08,000

————————————————
————————————————

2. When production is equal to sales. When production and sales are equal i.e., there is no
opening or closing stock or when the inventory of finished goods does not fluctuate from period to
period, net income will be the same under absorption costing and marginal costing techniques.
3. When sales are less than production. When closing stock is more than the opening stock i.e.,
production exceeds sales, profit will be higher in absorption costing as compared to marginal costing.
4. When sales exceeds production. When closing stock is less than the opening stock i.e., sales
exceeds production, profit in marginal costing will be higher as compared to absorption costing.

Reasons for Difference in Profit under Absorption Costing and Marginal Costing
Net profit ascertained under the absorption costing will not be the same as under the marginal
costing because of :
1. Difference in Stock Valuation. Stocks of work-in-progress and finished goods are valued at
marginal cost not including fixed costs under the marginal costing method whereas in the absorption
costing they are valued at cost of production which includes fixed costs. In other words, the
C/2·10 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

valuation of stocks will be done at lower figure in the marginal costing as compared to the absorption
costing therefore, profits under these two techniques of costing will differ.
2. Over- or Under-absorption of Overheads. In absorption costing method, there can never be
hundred per cent absorption of fixed overheads because of the difficulty in forecasting costs and
volume of output. There will be either over-absorption or under-absorption, whereas in the marginal
costing method, the actual amount of fixed overheads is wholly charged to Statement of Profit and
Loss. Hence, profits under the two techniques will differ.
ILLUSTRATION 3. Your company has a production capacity of 2,00,000 units per year.
Normal capacity utilisation is reckoned as 90%. Standard variable production costs are R 11 per
unit. The fixed factory costs are R 3,60,000 per year. Variable selling costs are R 3 per unit and fixed
selling costs are R 2,70,000 per year. The unit selling price is R 20. In the year just ended on 30th
June, 2023, the production was 1,60,000 units and sales were 1,50,000 units. The closing inventory
on 30-6-2023 was 20,000 units. The actual variable production costs for the year were R 35,000
higher than the standard.
(i) Calculate the profit for the year : (a) by the absorption costing method, and (b) by the
marginal costing method.
(ii) Explain the difference in the profits.
SOLUTION
(i) (a) PROFIT STATEMENT
for the year ended 30th June, 2023
(Under Absorption Costing Method)
R R

Sales : 1,50,000 units @ R 20 per unit 30,00,000

Less : Cost of Production :
Variable production costs
For 1,60,000 units @ R 11 per unit 17,60,000
Increase in variable cost 35,000
Fixed costs for 1,60,000 units @ R 2 3,20,000
———————————————

21,15,000
Add : Opening Stock : 10,000 units
(i.e., sales 1,50,000 units + closing stock
20,000 units—production 1,60,000 units)
@ 13 (i.e., variable cost 11 + 2
R R R

fixed cost at normal capacity utilisation

i.e.
R 3‚60‚000
90% of 2‚00‚000 units ) 1,30,000
———————————————
22,45,000
Less : Closing Stock : 20,000 units valued at

current cost ( R 21‚15‚000

1‚60‚000
× 20‚000 ) 2,64,375
———————————————

19,80,625
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·11

Add : Underabsorption of fixed costs ( 3,60,000 – R R 3,20,000) 40,000

——————————————
20,20,625
———————————————

Gross Profit 9,79,375

Less : Selling Expenses :
Variable 4,50,000
Fixed 2,70,000
——————————————
7,20,000
———————————————

Net Profit 2,59,375

———————————————
———————————————

(i) (b) PROFIT STATEMENT

for the year ended 30th June, 2023
(Under Marginal Costing)
R R

Sales : 1,50,000 units @ 20 per unit

R 30,00,000
Less : Marginal Cost :
Variable production cost
For 1,60,000 units @ 11 per unit R 17,60,000
Additional variable production cost 35,000
———————————————
17,95,000
Variable cost of opening stock of finished
goods (10,000 units @ 11) R 1,10,000
———————————————

19,05,000
Less : Closing Stock of finished goods : 20,000
units valued at current variable production

(
cost i.e.‚
R 17‚95‚000
1‚60‚000
× 20‚000 ) 2,24,375
———————————————

Variable production cost of 1,50,000 units 16,80,625

Add : Variable selling cost of 1,50,000 units sold
(1,50,000 × R 3) 4,50,000
———————————————
21,30,625
———————————————

Contribution 8,69,375
Less : Fixed Cost :
Fixed production cost 3,60,000
Fixed selling cost 2,70,000
———————————————
6,30,000
———————————————

Net Profit 2,39,375

———————————————
———————————————

(ii) The difference in profits, 20,000 (i.e., 2,59,375 – 2,39,375), as arrived at under absorption costing
R R R

and marginal costing is due to the element of fixed cost included in the valuation of opening stock and closing
stock as shown below :
Difference in Closing Stock R 40,000
Less : Difference in Opening Stock R 20,000
————————————

Net Difference R 20,000

————————————
C/2·12 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Difference Between Absorption Costing and Marginal Costing

Following are the various points of difference between absorption costing and marginal
costing.
Absorption Costing Marginal Costing
1. All costs fixed and variable are included for Only variable costs are included. Fixed costs are
ascertaining the cost. recovered from contribution.

2. Different unit costs are obtained at different Marginal cost per unit will remain same at different
levels of output because of fixed expenses levels of output because variable expenses vary in the
remaining same. same proportion in which output varies.

3. Difference between sales and total cost is profit. Difference between sales and marginal cost is
contribution and difference between contribution and
fixed cost is profit or loss.
4. A portion of fixed cost is carried forward to the Stock of work-in-progress and finished goods are valued
next period because closing stock of work-in- at marginal cost which does not include fixed cost. Fixed
progress and finished goods is valued at cost of cost of a particular period is charged to that very period
production which is inclusive of fixed cost. In and is not carried over to the next period by including it
this way costs of a particular period are vitiated in closing stock. Being so, costs of a particular period
because fixed cost being period cost should be are not vitiated.
charged to the period concerned and should not
be carried over to the next period.
5. If stocks of working-in-progress and finished If stocks of work-in-progress and finished goods
goods increase during a period, absorption increase during a period, marginal costing reports less
costing will reveal more profits as compared to income than absorption costing. But when such stocks
marginal costing. When such stocks decrease, decrease, the technique of marginal costing reveals
less profits are shown by more information than absorption
absorption costing than marginal costing costing. The difference in profits as arrived at under
because under this technique of costing, closing absorption costing and marginal costing is due to
stocks are valued at higher figures as explained difference in accounting for fixed overheads. The
above in point (4), i.e., closing stocks are valued technique of marginal costing values closing stocks at
at total cost which is inclusive of variable cost their variable costs and does not include element of
and fixed cost. fixed costs.
6. The apportionment of fixed expenses on an Only variable costs are charged to products, marginal
arbitrary basis gives rise to over or under cost technique does not lead to over or under absorption
absorption of overheads which ultimately makes of fixed overheads.
the product cost inaccurate and unreliable.
7. Absorption costing is not very helpful in taking The technique of marginal costing is very helpful in
managerial decisions such as whether to accept taking managerial decisions because it takes into
the export order or not, whether to buy or consideration the additional cost involved only assuming
manufacture, the minimum price to be charged fixed expenses remaining constant.
during the depression etc.
8. Costs are classified according to functional basis Costs are classified according to the behaviour of costs
such as production cost, office and i.e., fixed costs and variable costs.
administrative cost and selling and distribution
cost.
9. Absorption costing fails to establish relationship Cost, Volume and Profit (i.e., CVP) relationship is an
of cost, volume and profit as costs are seldom integral part of marginal cost studies as costs are
classified into fixed and variable. classified into fixed and variable costs.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·13

Break Even Analysis

Break even analysis is a logical extension of marginal costing. It is based on the same principles
of classifying the operating expenses into fixed and variable. Now-a-days it has become a powerful
instrument in the hands of policy makers to maximise profits.
There may be change in the level of production due to many reasons, such as competition, introduction
of a new product, trade depression or boom, increased demand for the products, scarce resources,
change in the selling prices of products, etc. In such cases management must study the effect on
profit on account of the changing levels of production. A number of techniques can be used as an aid
to management in this respect. One such technique is the break even analysis.
The term ‘break even analysis’ is interpreted in the narrower as well as broader sense. Used in its
narrower sense, it is concerned with finding out the break even point, i.e., level of activity where the
total cost equals total selling price. Used in its broader sense, it means that system of analysis which
determines the probable profit at any level of production. The break even analysis establishes the
relationship of costs, volume and profit ; so this analysis is also known as ‘Cost-Volume-Profit
Analysis’.

Assumptions underlying Break-even Analysis

Following are the main assumptions underlying Break-even Analysis :
(i) Fixed costs remain unchanged at all levels of activity.
(ii) Variable cost change in direct proportionate to the volume of output.
(iii) Costs can be classified into fixed and variable elements.
(iv) Selling Price remains constant irrespective of volume or production or sales changes.
(v) Price of raw materials, labour rate, etc. remain constant.

Uses of Break-even Analysis

Important uses of Break-even Analysis are :
(i) It helps in determining the selling price which will give desired result.
(ii) It helps in forecasting costs and profit as a result of change in volume.
(iii) It helps in fixing sales volume to cover a given return on capital employed.
(iv) It helps in determination of costs and revenues at different levels of output.
(v) It studies the impact of increase or decrease in fixed and variable costs on profit.
(vi) Inter-firm comparison of profit is made possible.

COST-VOLUME-PROFITANALYSIS

Cost-Volume-Profit (CVP) analysis studies the variations in cost and profit in relation to change
in the volume of output and sales through a large number of internal and external factors which
influence the amount of profit, the volume of output and sales. The three factors CVP analysis are
interlinked and interdependent. As we know that profit depends upon sales, selling price to a great
extent depends upon cost, volume of sales depends upon volume of production which in relation to
cost. In CVP analysis an attempt is made to measure variation in cost and profit with variation in
volume.
C/2·14 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

There exists close relationship between the cost, volume and profit. If volume is increased, the
cost per unit will decrease and profit per unit will increase. Thus there is direct relation between
volume and profit but inverse relation between volume and cost. Analysis of this relationship has
become interesting and useful for the cost and management accountants. This analysis may be
applied for profit-planning, cost control, evaluation of performance and decision making.
The main objectives of such analysis are given below :
(i) This analysis helps to forecast profit fairly accurately as it is essential to know the relationship
between profits and costs on one hand and volume on the other.
(ii) This analysis is useful in setting up flexible budgets which indicates costs at various levels of
activity. We know that sales and variable costs tend to vary with the volume of output. It is necessary
to budget the volume first for establishing budgets for sales and variable costs.
(iii) This analysis assists in evaluation of performance for the purpose of control. In order to review
profits achieved and costs incurred, it is necessary to evaluate the effects on costs of changes in
volume.
(iv) This analysis also assists in formulating price policies by showing the effect of different price
structures on costs and profits. We are aware that pricing plays an important part in stabilizing and
fixing up volumes especially in depression period.
(v) This analysis helps to know the amount of overhead costs to be charged to the products cost at
various levels of operation as we know that pre-determined overhead rates are related to a selected
volume of production.
(vi) This analysis makes possible to attain target profit by locating the volume of sales required for
such profit and finally achieving such sales volume.
(vii) This analysis helps management in taking number of decisions like make or buy, suitable sales
mix, dropping of a product etc.

Assumptions underlying Cost-Volume-Profit Analysis

Following are the main assumptions underlying cost-volume-profit analysis :
(i) Fixed and variable cost patterns can be established with reasonable accuracy and that fixed
costs remain static and marginal costs are completely variable at all levels of output.
(ii) Selling prices are constant at all sales volumes.
(iii) Factor prices (e.g. material prices, wage rates) are constant at all sales volumes.
(iv) Efficiency and productivity remain unchanged.
(v) In a multi product situation, there is constant sales mix at all levels of sales.
(vi) Turnover level (volume) is the only relevant factor affecting costs and revenue.
(vii) The volume of production equals the volume of sales.

Elements of Cost-Volume-Profit Analysis

Cost-Volume-Profit analysis establishes the relationship between costs, volume of output and
profits. It studies the effect on profit of changes in volume of output and cost. In order to understand
mathematical relationship between cost, volume and profit, it is required to understand the following
concepts which can be treated as elements of Cost-Volume-Profit analysis.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·15

(i) Marginal Cost Equation ; (ii) Contribution Margin ; (iii) Profit/Volume (P/V) Ratio ; (iv)
Break Even Point ; (v) Margin of Safety.

( i) Marginal Cost Equation

For the sake of convenience, elements of costs can be written in the form of an equation as
follows :
Sales = Variable Cost + Fixed Expenses ± Profit/Loss
Or Sales – Variable Costs = Fixed Expenses ± Profit/Loss
Or S – V = F ± P where ‘S’ stands for sales, V for variable costs, F for fixed expenses, + P for
profit and – P for loss.
Or S – V = C because F + P, i.e., Fixed Expenses + Profit/Loss = Contribution.
In order to make profit, contribution must be more than the fixed expenses and to avoid any loss,
contribution must be equal to the fixed expenses.
Marginal cost equation of S – V = F ± P is very useful to find any of the four factors, i.e., S, V, F or
P if three of these factors are known.
EXAMPLE. Determine the amount of fixed expenses from the following particulars:
Sales R 2,40,000 : Direct Materials R 80,000 ; Direct Labour R 50,000 ; Variable Overheads
R 20,000 and Profit R 50,000.

SOLUTION
The Marginal Cost Equation is
S–V=F+P
S or Sales = 2,40,000
R

V or Variable Costs = 80,000 + 50,000 + 20,000 =

R R R R 1,50,000
(Direct Materials + Direct Labour + Variable Overheads)
P or Profit = 50,000
R

F or Fixed Expenses = ? (not given)

Applying the figures in the equation, we get
R 2,40,000 – 1,50,000 = F + 50,000
R R

Or 2,40,000 – 1,50,000 – 50,000 = F

R R R

Or R 40,000 = F
∴ Fixed Expenses = R 40,000.

( ii) Contribution Margin

Contribution is the difference between the sales and the marginal cost of sales and it contributes
towards fixed expenses and profit. Suppose selling price per unit is R 15, variable cost per unit R 10,
fixed cost R 1,50,000, then contribution per unit will be R 5 (selling price – marginal cost i.e., R 15 –
R 10). Contribution for 30,000 units @ R 5 is R 1,50,000 which is sufficient only to meet the fixed costs

of R 1,50,000 and no amount is left for profit. If output is 20,000 units, contribution is R 1,00,000 (i.e.,
20,000 × R 5) which is not sufficient to meet fixed expenses of R 1,50,000 and the result is a loss of
R 50,000. An output of 40,000 units will give a contribution of R 2,00,000 (i.e., 40,000 × R 5) which will

be sufficient to meet fixed costs of R 1,50,000 and leave a profit of R 50,000. Thus, contribution will
first go to meet fixed expenses and then to earn profit. Contribution can be represented as :
Contribution = Selling Price – Marginal Cost or Fixed Expenses ± Profit/Loss or Sales × P/V Ratio
C/2·16 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

In marginal costing, contribution is very important as it helps to find out the profitability of a
product, department or division, to have better product mix, for profit planning and to maximise the
profits of a concern. Contribution is different from profit. Contribution is helpful in taking decision to
accept or reject, fixing the selling price, determine the product mix especially in case of key factor.

Profit
Profit is the net gain in activity or the surplus that remains after deducting fixed expenses from
the total contribution. Profit can be calculated as under :
Profit = Sales – Total Cost
or = Sales – ( Variable Cost + Fixed Cost)
or = Contribution – Fixed Cost
or = Margin of Safety (in Values) × P/V Ratio

Difference Between Contribution and Profit

Following are the main differences between Contribution and Profit :
Contribution Profit
(i) Includes fixed cost and profit. (i) Does not include fixed cost.
(ii) Based on Marginal Cost Concept. (ii) Based on common man concept.
(iii) Contribution above break even contributes (iii) Profit is expected only after covering variable
to profit. and fixed costs.
(iv) Contribution analysis requires a (iv) Profit does not require any such concept.
knowledge of break even concept.

( iii)Contribution/Sales (C/S)or Profit/Volume (P/V)Ratio

The profit/volume ratio is one of the most important ratios for studying the profitability of
operations of a business and establishes the relationship between contribution and sales usually
expressed as a percentage. This ratio is calculated as under :

P/V Ratio =
Contribution
Sales (
i.e.‚
C
S )
or =
Fixed Expenses + Profit
Sales (
i.e.‚
F+P
S )
or =
Sales – Variable Costs
Sales (
i.e.‚
S–V
S )
Change in Profits or Contributions
or =
Change in Sales
This ratio can also be shown in the form of a percentage if the formula is multiplied by 100.
Thus, if selling price is R 15 and the marginal cost is R 10, then P/V ratio
R 15 – R 10 5 1 1 × 100 1
= = = or = 333 %.
R 15 15 3 3
1
In the above example, for every R 100 of sales, contribution is 33 3 %. A sale of every R 100 will
1
bring a profit of R 33 after fixed expenses are met. Comparison of P/V ratios for different products
3
can be made to find out which product is more profitable. Higher the P/V ratio, more will be the
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·17

profit and lower the P/V ratio, lesser will be the profit. Hence, it should be the goal of every concern
to increase or improve the P/V ratio. It can be done by :
(a) Increasing the selling price per unit.
(b) Reducing direct and variable costs by effectively utilising men, machines and materials.
(c) Switching the production to more profitable products or increasing the proportion of sales of
products showing a higher P/V ratio.
(d) Reducing the share of low margin products in the total sales and increasing the share of high
margin products.
The P/V ratio is very useful and is used for the calculation of :
Fixed Costs (i.e. FC)
(i) Break Even Point =
P/V Ratio
(ii) Value of sales to earn a desired amount of profit :
Fixed Costs + Desired Profit
Sales =
P/V Ratio
(iii) Variable Costs = Sales (1 – P/V Ratio)
(iv) Profit = (Sales × P/V Ratio) – Fixed Cost
(v) Fixed Cost = (Sales × P/V Ratio) – Profit
Profit
(vi) Margin of Safety =
P/V Ratio
EXAMPLE. Calculate P/V Ratio from the following information :
(i) Given : Selling price R 10 per unit, Variable cost per unit R 6.
(ii) Given the profits and sales of two periods as under :
Sales Profits
R R

2023 1,50,000 20,000

2024 1,70,000 25,000
SOLUTION
Contribution R 4
(i) P/V Ratio = × 100 = × 100 = 40%
Sales R 10
[Contribution = S.P. – V.C. i.e., 10 – 6 = 4]
R R R

Change in Profit R 5‚000

(ii) P/V Ratio = × 100 = × 100 = 25%.
Change in Sales R20‚000

( iv)Break Even Point

A business is said to break even when its total sales are equal to its total costs. It is a point of no
profit no loss. At this point, contribution is equal to fixed cost. A concern which attains break even
point at less number of units will definitely be better from another concern where break even point is
achieved at more units of production.

Uses of Break-Even Point

(i) Knowledge about no profit no loss point.
(ii) Knowledge about margin of safety.
C/2·18 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

(iii) Total profit can be computed.

(iv) Input for decision-making.
Break even point can be calculated by the following formula :
Break Even Point (in units)
Total Fixed Expenses
=
Selling Price per Unit – Marginal Cost per Unit
Total Fixed Expenses .
or =
Contribution per Unit

Cash Break Even Point = Cash Fixed Cost

Contribution per unit

Break Even Point Based on Total Sales

The marginal cost equation is :
S–V=F±P
or S – V = F + Nil (at break even point profit is nil)
∴ For BEP, the equation is :
S–V =F
S–V F
or = (dividing both sides by S – V, where S – V > 0)
S–V S–V
F
or 1 =
S–V
F×S
or S×1 = (multiplying both sides by S)
S–V
∴ The formula for the calculation of break even sales is :
F×S
S–V
or
Fixed Cost
P/V Ratio
as [
S
=
1
S–V P/V Ratio ]
Distinction Between P/V Ratio and Break Even Point
Following are the main distinctions between P/V Ratio and Break-even Point :
Points of Distinction P/V Ratio Break-even Point
1. Meaning The ratio of percentage of contribution Break-even Point is a point-where
to sales is known as P/V ratio or total revenue equals to total cost
Marginal Income Ratio or Contribution (variable and fixed). At Break-even
to Sales Ratio or Variable Profit Ratio Point, contribution is equal to fixed
and indicates the profitability of the cost.
concern.
2. Use and Significance The P/V ratio is used to analyse the The method for determining Break-
effect of changes in volume, price on even Point includes algebraic
the profits of an organisation and is methods including equation as well
significant in planning and analysing of as graphic methods. It is used to
profits. know the point where there is no
profit or loss.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·19

3. Study and Expression The P/V ratio is an extension of Break-even Point can be
marginal costing and is the study of expressed in break-even quantity
inter-relationships of costs behaviour or break-even sales or cash break-
patterns, level of activities and the even points. It tells at what point
profit that results from each alternative the concern starts earning profit.
combination.

ILLUSTRATION 4. From the following particulars calculate (i) Contribution (ii) P/V Ratio
(iii) Break even point in units and in rupees. (iv) What will be the selling price per unit if the
break even point is brought down to 25,000 units ? (v) How many units are to be sold to earn a net
income of 20% on sales.
Fixed Expenses R 1,50,000 ; Variable Cost per unit R 10 ; Selling Price per unit R 15.

SOLUTION
( i) Contribution= Selling Price per unit – Variable Cost per unit = 15 – R R 10 = R 5.
Contribution 5R 1
(ii) P/V Ratio = × 100 = × 100 = 33 %.
Sales 15
R 3
(iii) Break Even Point (in units)
Fixed Expenses 1‚50‚000
R
= = = 30,000 units.
Contribution per unit 5
R

Fixed Expenses 1‚50‚000

R
Break Even Point (in rupees) = = 1 = 4,50,000.
R
P/V Ratio 33 % 3
Fixed Expenses
(iv) Break Even Point (in units) =
Contribution per unit
Fixed Expenses 1‚50‚000
R
Or Contribution per unit = = = 6. R
Break Even Point (in units) 25‚000
Selling Price per unit = Variable Cost + Contribution per unit = 10 + 6 =
R R R 16.
(v) Suppose the number of units to be sold = N
20
FC + (N × S.P.)
100
∴ N =
Contribution per unit
R 1‚50‚000 + 0.20 (N × 15)
R

N = R( 15 – 10)
R

5N = R 1,50,000 + 3N
R 1‚50‚000
or 2N = or N = 75,000 units
2

Calculation of Output or Sales Value at which a Desired Profit is Earned

The formula for the calculation of output to earn a certain amount of profit is as follows :
Fixed Expenses + Desired Profit
Selling Price per Unit – Marginal Cost per Unit
Fixed Expenses + Desired Profit
or
Contribution per Unit
(F + P)S
The formula for the calculation of sales value to earn a certain amount of profit is . It is
S–V
derived as follows :
The marginal cost equation is :
S–V=F+P
C/2·20 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Multiplying both sides by S, we get

(F + P)S
(S – V) S = (F + P)S or S =
S–V
(F + P)S F+P
or Sales to Earn a Profit = or
S–V P/V Ratio
ILLUSTRATION 5. From the following data, calculate :
(i) Break even point expressed in amount of sales in rupees.
(ii) Number of units that must be sold to earn a profit of R 1,20,000 per year.
(iii) How many units are to be sold to earn a net income of 15% of sales ?
(iv) Number of units to be sold to earn a target profit of R 1,05,000 after income tax. (Assume
Income Tax Rate to be 50%)
Selling Price per unit R 40 ; Variable Manufacturing Cost per unit R 22 ; Variable Selling
Cost per unit R 3 ; Fixed Factory Overheads R 1,60,000 ; Fixed Selling Cost R 20,000.
SOLUTION
( i) Break Even Point (in units)
Fixed Expenses
=
Selling Price per unit – Marginal Cost per unit
R 1‚60‚000 + 20‚000 R R 1‚80‚000
= = = 12,000 units.
R 40 – 25 R R 15
(Marginal Cost = Variable Manufacturing Cost + Variable Selling Cost)
Break Even Point (In Sales value) = Break even units × Selling price per unit
= 12,000 × R 40 = R 4,80,000.
(ii) Output to earn a profit of R 1,20,000 :
Fixed Expenses + Profit
Selling Price per unit – Marginal Cost per unit
R 1‚80‚000 + R 1‚20‚000 R 3‚00‚000
= = = 20,000 units
R40 – R 25 R 15
(iii) Suppose Number of units to be sold = N.
Fixed Co st + Desired Profit
∴ N=
Co ntribution per unit
15
R 1‚80‚000 + (N × R 40)
100
N= R 15
15 N = 1,80,000 + 6N
or 9 N = 1,80,000
N = 20,000 units.
Target Profit
Fixed Cost +
Income Tax Rate
(iv) Sales in units =
Contribution per unit
R 1‚05‚000
R 1‚80‚000 +
1 – .5 R 3‚90‚000
= = = 26,000 units
R 15 15
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·21

Composite B.E.P.
A business undertaking may have different manufacturing establishments each having its own
production capacity and fixed cost but producing the same product. At the same time, the concern as
a whole is a unit having different establishments under the same management. Hence, the combined
fixed costs have to be met by the combined BEP sales. In this analysis, there are two approaches
namely :
(i) Constant product mix approach ; (ii) Variable product mix approach.
Under the first approach, the ratio in which the products of the various establishments are mixed is
constant. The mix will be maintained at BEP sales also. Under the second approach, that product of the
establishment would be preferred where the contribution ratio is bigger.
EXAMPLE. ‘A’ Limited has two factories X and Y producing the same article whose selling
price is 150 per unit. Following are the other particulars :
R

Factory X Factory Y Total

Capacity (units) 10,000 15,000 = 25,000
Variable cost per unit R100 R 120
Fixed expenses R 3,00,000 R2,10,000 = R 5,10,000
Determine the B.E.P. for the two factories and for the company as a whole assuming
(a) constant sales mix and (b) variable sales mix.
SOLUTION
Factory X Factory Y
Contribution per unit : S.P. – V.C. 50 R R30
Fixed expenses 3,00,000
R R 2,10,000
B.E.P. (units) 6,000 units 7,000 units
( 3,00,000 ÷ 50)
R R ( 2,10,000 ÷ 30)
R R

Composite B.E.P.
(a) Constant Sales Mix

Combined P/V Ratio =

( 2
5
× R 50 +) ( 3
5
× R 30 ) =
R 20 + 18 R
× 100 =
76
or 25.33%
Sales Price R 150 3
Combine Fixed Expenses = 5,10,000 R

3
B.E.P. = R 5,10,000 ×
× 100 = 20,13,158. R
76
As the sale price is uniform, the mix in the capacity ratio itself is 10,000 units : 15,000 units i.e. 2 : 3
2
X = 20,13,158 ×
R = 8,05,263 or 5,368 units
R
5
3
Y = 20,13,158 × = 12,07,895 or 8,053 units.
R R
5
Note : Constant sales mix is in proportion to the capacities of two factories i.e., 10,000 units : 15,000 units or 2 : 3
(b) Variable Sales Mix
As factory X is giving a higher contribution, it shall be used in full i.e. 10,000 units should be produced here
before production is commenced at Y. This will give a contribution of 5,00,000. (i.e. 10,000 units @ 50)
R R

Total fixed expenses for the two factories are R 5,10,000.

Additional contribution required to meet the fixed expenses fully R 10,000.
C/2·22 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

No. of units to be produced at factory Y to produce the

10‚000
R
Contribution of 10,000 =
R = 334 units
30
R

Total number of units X 10,000

Y 334
————————————

10,334
————————————

The above discussion could be applied to an undertaking selling different products each having its own
contribution and sales potentials. The composite break even point for the business could be worked out keeping
the product mix constant. This would involve working out a composite P/V ratio as in the above case.
EXAMPLE. A company is producing an identical product in two factories. Following are the
details in respect of both the factories :
Factory X Factory Y
R R

Selling Price per unit 50 50

Variable Cost per unit 40 35
Fixed Cost 2,00,000 3,00,000
Depreciation included in the above 40,000 30,000
Sales (units) 30,000 20,000
Production Capacity (units) 40,000 30,000
You are required to determine : (a) Break-Even Point (BEP) for each factory individually. (b)
Which factory is more profitable ? (c) Cash BEP for each factory individually. (d) BEP for company
as a whole assuming the present product mix is 3 : 2.
Note : Indicate BEP in units
SOLUTION
(a) Computation of Break-even Point for each factory individually
Factory X Factory Y
Fixed Cost R 2,00,000 R 3,00,000
Contribution per unit R 10 R 15
Fixed Cost
BEP = 20,000 units 20,000 units
Contribution per unit
(b) Which factory is more profitable will depend on the level of production. If the production is 20,000 units
only at each factory both are equally ‘profitable’ since both have their break-even points at this level. If
the output is less than 20,000 units, factory X will give lower loss @ 10 per unit of the shortfall below
R

the break-even point, whereas the loss will be 15 per unit in case of factory Y. Production in excess of
R

20,000 units will make factory Y more profitable since each extra unit produces a profit of 15 per unit
R

as compared to 10 per unit in case of factory X.

R

However, in case, choice is to be made as to whose capacity is to be utilised first, choice should be for
Y since it give s a higher contribution per unit.
(c) Computation of Cash Break-even Point for each factory individually.
Factory X Factory Y
Cash Fixed Cost (i.e. Fixed Cost – Depreciation) R1,60,000 R2,70,000
Contribution per unit 10 R 15
R

Cash Fixed Cost

BEP = 16,000 units 18,000 units
Contribution per unit
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·23

(d) Computation of Break-even Point for the company as a whole, as the present mix, is 3 : 2
Combined Contribution = (3/5 × R 10) + (2/5 × R 15) = R 12
Fixed Cost =5,00,000
R

5‚00‚000
R
Combined BEP = = 41,667 units
12 R

ILLUSTRATION 6. M Ltd. manufactures three products P, Q and R. The unit selling prices
of these products are R 100, R 80 and R 50 respectively. The corresponding unit variable costs are
R 50, R 40 and R 20. The proportions (quantity-wise) in which these products are manufactured and

sold are 20%, 30% and 50% respectively. The total fixed costs are R 14,80,000.
Given the above information, you are required to work out the overall break-even quantity
and the product-wise break up of such quantity.
SOLUTION
CALCULATION OF BREAK EVEN QUANTITY

Products Overall
——————————————————————————————————————————————————————————————————

P Q R
——————————————————————————————————————————————————————————————————
R R R

Selling price per unit 100 80 50

Less : Variable cost per unit 50 40 20
——————————————————————————————————————————————————————————————————

Contribution per unit 50 40 30

——————————————————————————————————————————————————————————————————
Quantity-wise proportion of the
products manufactured and sold 20% 30% 50%
Weighted Contribution Margin R 10 12
R 15
R R 37
(Contribution × Proportion of Quantity) (50 × 20%) (40 × 30%) (30 × 50%)
Total Fixed Costs 14,80,000
R

Overall Break Even Quantity 40,000 units

( Total Fixed Cost

Overall Contribution Margin ) ( R 14‚80‚000
R 37 )
Production-wise Break Even Quantity 8,000 12,000 20,000 40,000
units units units units
(Total Break Even Quantity × Proportion) (40,000 × 20%) (40,000 × 30%) (40,000 × 50%)

ILLUSTRATION 7. An analysis of costs of Sullivan Manufacturing Company led to the

following information :
Cost Elements Variable Costs
(Percentage of Sales)
Direct Materials 32.8
Direct Labour 28.4
Factory Overheads 12.6
Distribution Expenses 4.1
General and Administrative Expenses 1.1
——————————

79.0
——————————
C/2·24 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Fixed Costs R 3,15,000

Budgeted sales for the next year are R 18,50,000.
You are required to determine— (i) the break-even sales volume, (ii) the profit at the budgeted
sales volume, (iii) the profit, if actual sales—(a) drop by 10 per cent. (b) increase by 5 per cent
from budgeted sales.
SOLUTION
Percentage of variable cost to sales is 79% :
∴ Percentage of Contribution to Sales = 100 – 79 = 21.
(Contribution = Sales – Variable Cost)
Contribution 21
P/V Ratio (Profit/Volume Ratio) = = or 21%
Sales 100
(i) Break Even Sales Volume
Fixed Costs 100
= = 3,15,000 ×
R = 15,00,000 R
P/V Ratio 21
(ii) Profit at the budgeted sales of 18,50,000
R

Percentage of Contribution to Sales = 21

∴ Contribution at the budgeted sales of 18,50,000
R

21
= 18,50,000 ×
R = 3,88,500
R
100
Profit = Contribution – Fixed Expenses
= 3,88,500 – 3,15,000 = 73,500.
R R R

(iii) (a) Profit if actual sales drop by 10% R

Budgeted Sales 18,50,000

Less : 10% Decline 1,85,000
———————————————

Actual Sales 16,65,000

———————————————
———————————————
21
Contribution @ 21% of sales = R 16‚65‚000 × = 3,49,650
100
Less : Fixed Expenses 3,15,000
———————————————

Profit 34,650
———————————————
———————————————

(b) Profit if actual sales increase by 5% from budgeted sales

Budgeted Sales 18,50,000
Add : 5% increase 92,500
———————————————

Actual Sales 19,42,500

———————————————
———————————————
R 19‚42‚500 × 21
Contribution @ 21% on Sales = 4,07,925
100
Less : Fixed Expenses 3,15,000
———————————————

Profit 92,925
———————————————
———————————————

Margin of Safety
Margin of safety is the difference between the actual sales and the sales at break even point. It
represents the shock absorbing capacity of the business. The larger the difference, the better it is.
Larger difference means that the business is more sound and has a greater capacity to bear loss due to
price reduction and vice versa. One of the assumptions of marginal costing is that output will coincide
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·25

sales, so margin of safety is also the excess production over the break even point’s output. Sales or
output beyond break even point is known as margin of safety because it gives some profit, at break
even point only fixed expenses are recovered. Margin of safety can also be expressed in percentage.
For example, if present sales are 4,00,000 and break even sales are
R 3,00,000, margin of safety is R

R 1,00,000 i.e., 4,00,000 – 3,00,000 or 25% i.e.

R R
1‚00‚000
4‚00‚000 ( R

R )
× 100 . Thus, formula for the calculation

of margin of safety is :
Margin of Safety (M/S) = Present Sales – Break Even Sales
Margin of Safety can also be calculated with the help of the following formula :
Profit
Margin of Safety (M/S) =
P/V Ratio
EXAMPLE. MENZ Ltd. earned a profit of R 3,00,000 during the year 2023-24. If the marginal
cost and selling price of a product are R 80 and R 100 per unit respectively, find out the amount of
‘Margin of Safety’.
SOLUTION
Margin of Safety = Profit/(P/V Ratio)
But P/V Ratio = Contribution/Sales = 20/100 = 20%
Hence, Margin of Safety = 3,00,000/0.20 = 1,50,000
R R

ILLUSTRATION 8. Assuming that the cost structure and selling prices remain the same in
Periods I and II, find out :
(a) Profit Volume Ratio ; (b) Fixed Cost ; (c) Break Even Point for Sales ; (d) Profit when Sales
are of R 1,00,000 ; (e) Sales required to earn a Profit of R 20,000 ; and (f) Margin of Safety at a profit
of R 15,000 ; (g) Variable cost in Period II.
Period Sales Profit
R R

I 1,20,000 9,000
II 1,40,000 13,000
SOLUTION
Change in Pofits R 4‚000
(a) P/V Ratio = × 100 = × 100 = 20%
Change in Sales R 20‚000

(b) Fixed Cost = (Sales × P/V Ratio) – Profit = R

( 1,20,000 × 5
1
) – R 9,000

= R 24,000 –
9,000 = 15,000.
R R

Fixed Cost R 15‚000

(c) Break Even Point (in rupees) = = = R 75,000.
P/V Ratio 20%

(d) Profit = (Sales × P/V Ratio) – Fixed Cost = ( 1,00,000 × 5

1
) – R 15,000 = R 5,000.

Fixed Cost + Desired Profit 15‚000 + 20‚000

R R
(e) Sales = = = R 1,75,000.
P/V Ratio 20%
Profit 15‚000
R
(f) Margin of Safety = = = 75,000. R
P/V Ratio 20%
(g) Variable Cost in Period II = (1 – P/V Ratio) × Sale
80
= × 1,40,000 = 1,12,000.
R R
100
C/2·26 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Margin of safety is that sales or output which is above break even point. All fixed expenses are
recovered at break even point ; so fixed expenses have been excluded from the formula of margin of
safety given above. Margin of safety is that sales which gives us profit after meeting fixed costs ; so
formula of its calculation takes only profit.
If the margin of safety is large, it is an indicator of the strength of a business because with a
substantial reduction in sales or production, profit shall be made. On the other hand, if the margin is
small, a small reduction in sales or production will be a serious matter and lead to loss. The margin of
safety at break even point is nil because actual sales volume is just equal to the break even sales.
Margin of safety has a positive co-relation with price variation. It increases with increase in price
and falls with reduction in price.
Efforts should be made by the management to increase (or improve) the margin of safety so
that more profit may be earned. This margin can be increased by taking the following steps :
(i) Increase the level of production. (Sales volume) provided the capacity is available. (ii) Increase
the selling price. (iii) Reduce the fixed or the variable costs or both. (iv) Substitute the existing
products by more profitable products. (v) Modernisation of production facilities and the introduction
of the most cost effective technology.
In inter-firm comparison margin of safety may be used to indicate the relative position of firms.
ILLUSTRATION 9. A company has fixed expenses of R 90,000 with sales at R 3,00,000 and a
profit of R 60,000 during the first half year. If in the next half year, the company suffered a loss of
R 30,000, Calculate :

(a) The P/V ratio, break even point and margin of safety for the first half year.
(b) Expected sales volume for next half year assuming that selling price and fixed expenses
remain unchanged.
(c) The break even point and margin of safety for the whole year.
SOLUTION
Contribution R1‚50‚000
(a) P/V Ratio = × 100 = × 100 = 50%
Sales R3‚00‚000
Fixed Cost 90‚000
R
Break Even Point = = = 1,80,000.
R
P/V Ratio 50%
Margin of Safety = Actual Sales – Break Even Sales = 3,00,000 –
R R 1,80,000
= 1,20,000.
R

Fixed Cost – Loss R 90‚000 – 30‚000

R
(b) Expected Sales Volume = = = 1,20,000.
R
P/V Ratio 50%
Fixed cost for the whole year
(c) Break Even Point (for the whole year) =
P/V Ratio
R 1‚80‚000
= = 3,60,000.
R
50%
Margin of Safety = Actual Sales – Break Even Sales = 4,20,000 – 3,60,000 = 60,000.
R R R

ILLUSTRATION 10. (a) Given the following, calculate P/V ratio and profit when sales are
R 20,000 :
(i) Fixed cost R 4,000 ; (ii) Break-even-point R 10,000.
(b) Given the following, find the margin of safety sales :
(i) Profit earned R 24,000 ; (ii) Selling price per unit R 10 ; (iii) Marginal cost per unit R 7.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·27

(c) From the following data, find out (i) sales ; and (ii) new break-even sales, if selling price is
reduced by 10% :
Fixed cost R 4,000 ; Break-even sales R 20,000 ; Profit R 1,000 and Selling price per unit R 20.
(d) Attempt the following (working notes should form part of the answer):
(i) Total fixed cost R 12,000; Contribution R 20,000; Number of units sold 10,000; Variable cost
is 60% of sales. Determine selling price per unit and also the total profits/loss.
(ii) Total fixed cost R 12,000. Actual sales R 48,000; Margin of safety R 8,000. Determine P/V
ratio.
(iii) A company which has a margin of safety of R 4 lakhs makes a profit of R 80,000. Its fixed
cost is R 5 lakhs. Find the break-even sales volume.
(e) A company has a fixed cost of 2,00,000. It sells two products—X and Y in the ratio of 2 : 1.
R

If contribution of X is 10 per unit and of Y is 20 per unit, how many units of each X and Y would
R R

be sold at break-even point ?

(f) The ratio of variable cost to sales is 60%. The break-even-point occurs at 80% of sales. Fixed
costs are 2,00,000. Find the sales capacity and the sales at break-even-point. Also determine profit
R

at 90% and 100% sales capacity.

SOLUTION
Fixed Cost 4‚000 R
(a) P/V Ratio = = × 100 = 40%
Break Even Sales 10‚000
R

Profit = (Sales × P/V Ratio) – Fixed Cost = ( 20,000 × 40%) –

R R 4,000
= 8,000 – 4,000 = 4,000
R R R

Per unit
R

(b) Sales 10
Less : Marginal cost 7
———————

Contribution 3
———————

Margin of Safety Profit R 24‚000

(Sales units) = = = 8,000 units
Contribution per unit R 3
Margin of Safety (value) = 8,000 × 10 = 80,000 R R

Profit 24‚000 R
or Margin of Safety = = = 80,000 R
P/V Ratio 30%
(c) (i) Fixed Cost = R4,000 i.e., Contribution at B.E.P. Sales
Contribution 4‚000 R
P/V Ratio = × 100 = × 100 = 20%
B.E Sales 20‚000 R

Fixed Cost + Profit 5‚000 R

Sales = = = 25,000 R
P/V Ratio 20%
(ii) New selling price = 20 – 10% = 20 – 2 = 18 per unit
R R R R

Variable cost = 80% of 20 = 16 per unit

R R

New Contribution = 18 – 16 = 2 per unit

R R R

2 R 1
New P/V Ratio = × 100 = 11 %
18 R 9
Fixed Cost 4‚000 R
∴ New Break Even Sales = = = 36,000 R
P/V Ratio 1
11 %
9
C/2·28 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

( d)
(i) Given. Contribution = 20,000; R Total Fixed Cost = 12,000; R

Variable cost is 60% of Sales

As we know, Profit = Contribution – Total Fixed Cost = 20,000 – 12,000 = R R R 8,000
Since Variable Cost is 60%
∴ P/V Ratio = 100 – Variable Cost Ratio = 100 – 60 = 40%
Contribution 20‚000 R
Total Sales = = = 50,000 R
P/V Ratio 40%
50‚000 R
Now, Selling price per unit = = 5 R
10‚000
(ii) Given. Total Fixed Cost = 12,000; R Actual Sales = 48,000 R

Margin of Safety = 8,000 R

As we know, Break-Even Sales = Actual Sales – Margin of Safety

= 48,000 – 8,000 = 40,000
R R R

Fixed Cost 12‚000

Also, Break-even Point = ⇒ 40,000 =
P/V Ratio P/V Ratio
12‚000
∴ P/V Ratio = × 100 = 30%
40‚000
(iii) Given. Margin of Safety = R 4,00,000; Profit = R 80,000
Fixed Cost = 5,00,000
R

Profit
Margin of Safety =
P/V Ratio
80‚000 R
⇒ R 4,00,000 =
P/V Ratio
80‚000
∴ P/V Ratio = × 100 = 20%
4‚00‚000
Fixed Cost
Now, Break-even Sales =
P/V Ratio
5‚00‚000
R
= = R 25,00,000
20%
(e) Ratio of sales = X : 2, Y : 1
Contribution per unit X = 10 × 2 = 20
R

Contribution per unit Y = R 20 × 1 = 20

————

40
————

Fixed Cost
Break Even Point=
Contribution per composite unit
2‚00‚000
R
= = 5,000 units
40 R

∴ Units of X = 5,000 × 2 =10,000 units

Units of Y = 5,000 × 1 = 5,000 units
(f) P/V Ratio = 100% – 60% = 40%
Sales of BEP = Fixed Cost ÷ P/V Ratio
= R 2,00,000 ÷ 40%
= R R 5,00,000
Sales at 100% capacity = R 5,00,000 ÷ 80%
= R 6,25,000
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·29

Determination of Profits at :
90% Capacity 100% Capacity
Sales 5,62,500
R 6,25,000
R

P/V Ratio 40% 40%

Fixed Cost 2,00,000
R 2,00,000
R
——————————————— ———————————————

Contribution = (S × P/V Ratio) R 2,25,000 R 2,50,000

Less : Fixed Cost R 2,00,000 R 2,00,000
——————————————— ———————————————

Profit R 25,000 R 50,000

——————————————— ———————————————

ILLUSTRATION 11. (a ) X Ltd. has earned contribution of R 2,00,000 and net profit of
R 1,50,000 on sales of R 8,00,000. What is its margin of safety ?
(b) If margin of safety is R 2,40,000 (40% of sales) and P/V Ratio is 30% of AB Ltd., calculate its
(i) Break even sales and (ii) Amount of profit on sales of R 9,00,000.
(c) A company sells its product at R 15 per unit. In a period, if it produces and sells 8,000 units,
it incurs a loss of R 5 per unit. If the volume is raised to 20,000 units, it earns a profit of R 4 per unit.
Calculate break-even point both in terms of rupees as well as in units.
(d) A company earned a profit of R 30,000 during the year 2023-24. If the marginal cost and
selling price of a product are R 8 and R 10 per unit respectively, find out the amount of ‘Margin of
Safety’.
(e) The profit volume (P/V) ratio of B B & Co. dealing in precision instruments is 50% and the
margin of safety is 40%.
You are required to work out the break-even point and the net profit if the sale volume is R 50
lakhs.
(f) Comment on the economic soundness of the following firms :
Firm A Firm B
R R

Current Sales Volume 3,00,000 3,00,000

Break Even Sales Volume 2,00,000 2,00,000
Margin of Safety 1,00,000 1,00,000
Fixed Cost 1,00,000 60,000
(g) A company has a P/V Ratio of 40 per cent. By what percentage must sales be increased to
offset :
(i) 10 per cent reduction in selling price and (ii) 20 per cent reduction in selling price.

SOLUTION
Contribution 2‚00‚000
R
(a) P/V Ratio = × 100 = × 100 = 25%
Sales 8‚00‚000
R

Profit R 1‚50‚000
Margin of Safety = = = 6,00,000
R
P/V Ratio 25%
Profit
(b) Margin of Safety =
P/V Ratio
or Profit = Margin of Safety × P/V Ratio = R 2,40,000 × 30% = R 72,000
Margin of Safety R 2‚40‚000
Total Sales = = = R 6,00,000
40% 40%
C/2·30 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Contribution = Sales × P/V Ratio = 6,00‚000 × 30% = 1,80,000

R R

Fixed Cost = Contribution – Profit = 1,80,000 – 72,000 = 1,08,000

R R R

Fixed Cost 1‚08‚000 R

(i) Break Even Sales = = = 3,60,000 R

P/V Ratio 30%
(ii) Profit = (Sales × P/V Ratio) – Fixed Cost = ( 9,00,000 × 30%) – 1,08,000
R R

= 2,70,000 – 1,08,000 = 1,62,000

R R R

(c) Average cost at 8,000 units volume

= Selling price per unit + loss component per unit
= 15 + 5 = 20
R R R

Average cost at 20,000 units volume = 15 – 4 = 11 R R R

Total cost at 8,000 units volume = 8,000 × 20 = 1,60,000

R R R

Total cost at 20,000 units volume = 11 × 20,000 = 2,20,000

R R

Change in total cost 60‚000 R

Variable cost per unit = = = 5 R
Change in volume of production 12‚000
Fixed cost = Total cost – Variable cost = 1,60,000 – 40,000 = 1,20,000R R R

Contribution 10 2 R

P/V Ratio = × 100 = × 100 = 66 %

Sales 15 3 R

Fixed cost 1‚20‚000 R

Break Even Point (Rupees) = = = R 1,80,000
P/V Ratio 2
66 %
3
Fixed Cost 1‚20‚000 R

Break Even Point (in units) = = = 12,000 units

Contribution per unit 10 R

Alternative Solution :
We know the following relationship :
Sales = TC + P/L : Sales = TC + P/L
R15 = x + (5) R : R15 =x+ 4 R

R20 =x R11 =x
TC = 8,000 × R 20 per unit = 1,60,000;
TC = 20,000 × 11 per unit = 2,20,000.
R R

Difference in Cost 60‚000 R

Variable Cost per unit = = = R 5 per unit
Difference in Activity 12‚000 units
TC = Fixed Cost + VC per unit × Activity
R 1,60,000 = x + R 5 × 8,000
R 1,20,000 = x
Fixed Cost 1‚20‚000 R
B.E.P. (unit) =
Contribution per unit
=
( 15 – 5)
= 12,000 units
R R

S 15
B.E.P (Sales ) = Fixed Cost × = 1,20,000 ×
R R = 1,80,000. R
C 10
Per unit
R

(d) Selling price 10

Less : Marginal cost 8
——————

Contribution 2
——————

2R
P/V Ratio = × 100 = 20%
10
R

Profit 30‚000 R
Margin of Safety = = = R 1,50,000
P/V Ratio 20%
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·31

(e) Calculation of Sales at Break-even Point

Sales 50,00,000

(
Less : Margin of Safety 40% i.e. 50‚00‚000 ×
40
100 ) 20,00,000
——————————————————

Sales at Break Even Point 30,00,000

——————————————————

P/V Ratio 50%

Therefore, Contribution or Fixed Expenses at B.E.P. (50% of R 30,00,000) R 15,00,000
Calculation of Net Profit at Sales Volume of R 50,00,000
R

Contribution on R 50,000,000 Sales

( Sales × P/V Ratio i.e.‚ R 50‚00‚000 ×

50
100 ) 25,00,000

Less : Fixed Expenses 15,00,000

——————————————————

Profit 10,00,000
——————————————————
——————————————————

(f) Firm A Firm B

R R

Break Even Sales 2,00,000 2,00,000

Fixed Cost or Contribution 1,00,000 60,000
(At B.E.P. Contribution is equal to Fixed Cost) 50% 30%

P/V Ratio i.e. (

Contribution
Sales
× 100 ) 1‚00‚000
2‚00‚000 (
× 100 ) ( 60‚000
2‚00‚000
× 100 )
R R

Current Sales Volume 3,00,000 3,00,000

————————————— ———————————

Contribution on Current Sales Volume 1,50,000 90,000

(i.e., Sales × P/V Ratio) (3,00,000 × 50%) (3,00,000 × 30%)
Less : Fixed Cost 1,00,000 60,000
————————————— ———————————

Profit 50,000 30,000

————————————— ———————————

Comment : Firm A is more sound as compared to Firm B because it gives excess profit of 20,000 (i.e., R

R 50,000 – 30,000). It is because of higher P/V ratio of 50%. Higher the P/V ratio, better it is. Firm A will start
R

earning profit @ 50% on sales after B.E.P. whereas firm B will earn profit @ 30% on sales in excess of break
even sales.
(g) Suppose selling price per unit is R 1 and units sold are 100.

After reduction After reduction

Present of 10% in of 20% in
position selling price selling price

R R R

Sales 100 90 80
Less : Variable cost 60 60 60
—————————————————————————————————————————————————————————————————————

Contribution 40 30 20
—————————————————————————————————————————————————————————————————————
C/2·32 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Total sales in order to offset

decrease in selling price
Sales × Present Contribution 90 80
= × 40 × 40
New Contribution 30 20
∴ % Increase in Sales = 120
R = 160
R

20% 60%

Effect of Price Reduction on P/V Ratio, B.E. Point and Margin of Safety
In order to see the effect of certain changes on P/V ratio, breakeven point and margin of
safety, the following data is assumed :
Original After 10% increase
No. of Units Produced & Sold 8,000 8,800
Unit Selling Price 20
R 22 R

Unit Variable Cost 10

R 11 R

Total Fixed Costs 40,000

R 44,000
R

I
Contribution R 10 ( 20 –
R R 10) R 22 – 10 = 12
R R

II
R 20 – 11 = 9
R R

Present Solution Increase in per Increase in per Increase in total Increase in no. of
unit selling price unit variable fixed costs units sold
cost
P/V ratio = R 10 R 12 9 No effect No. effect
× 100 × 100 = × 100
Contribution R 20 22 20
Sales = 50% 54.55% = 45%
Break Even R40‚000 R40‚000 40‚000
R 44‚000
R
No effect
Point 50% 6 45% 50%
Fixed Costs = 80,000
R 11 = 88,889
R = 88,000
R
=
P/V Ratio = 73,333
R

Margin of R 1,60‚000 R1,76,000 – R 1,60,000 – R 1,60,000 – (8,800 × 20) – R

Safety = Total – R 80‚000 R73,333 88,889

R R 88,000 80,000 =
R

Sales – BEP = R 80,000 = 1,02,667

R = 71,111
R = 72,000
R
R1,76,000 –
Sales 80,000
R

= 96,000
R

From the above it is clear that if

(i) there is increase in selling price per unit it will increase the P/V ratio reduce the break even
point and increase the margin of safety. If there is reduction in price per unit, it will decrease
the P/V ratio, increase the break even point and shorten the margin of safety.
(ii) there is increase in variable cost per unit, it will decrease the P/V ratio, increase the break even
point and shorten the margin of safety.
(iii) there is increase in total fixed costs, there will no effect on P/V ratio, increase the break even
point and shorten the margin of safety.
(iv) there is increase in no. of units sold, it will have no effect on P/V ratio and break even point
but will increase the margin of safety.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·33

ILLUSTRATION 12. The following information is given by Tushar Ltd. for the year 2022-
2023 :
Profits R 12,000. Fixed Cost R 24,000; Margin of Safety R 30,000.
For the year 2023-24 it is anticipated that the variable cost and fixed cost will decrease by 25%
and selling price will fall by 10%.
You are required to calculate for the year 2023-24 : (i) Sales to earn profit @ 10% on sales and
margin of safety, (ii) Profit if the sales are anticipated at 10% above the present break-even point.
(iii) Profit if margin of safety is anticipated 50% above the present percentage of margin of safety.
SOLUTION
Profit R12‚000
P/V Ratio = × 100 = × 100 = 40%
Margin of Safety R30‚000
R

Let the Selling Price (SP) 100

Less : Contribution 40
———————

Variable Cost 60
———————

Present Fixed Cost 24,000

Less : Reduced by 25% 6,000
——————————

New Fixed Cost 18,000

——————————

Present S.P. 100

Less : Reduced by 10% 10
—————

90
—————

Variable Cost 60
Less : 25% of R 60 15
—————

45
—————

New Contribution = Sales – Variable Cost

= 90 – 45 = 45
R R R

R45
New P/V Ratio = × 100 = 50%
R90
Fixed Cost + Desired Profit
Sales for Desired Profit =
P/V Ratio
Let Sales for Desired Profit = x
x R 18‚000 + x/10
Profit 10% on Sales = =
10 50%
1‚80‚000 + x
x = ×2
10
5x = 1,80,000 + x
4x = 1,80,000
1‚80‚000
x = = 45,000 (Sales)
R
4
Fixed Cost 18‚000
R
BEP = = = 36,000
R
P/V Ratio 50%
Margin of Safety = Sales – Break-even Sales
= 45,000 – 36,000 = 9,000
R R R

Fixed Cost 24‚000

R
Present BEP = = = 60,000
R
P/V Ratio 40%
C/2·34 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

New Sales = 60,000 + 10% of 60,000 = 66,000

R R R

Contribution
P/V Ratio =
Sales
Contribution = 33,000
R

Contribution = Fixed Cost + Profit

33,000 = 18,000 + Profit
R

Profit = 15,000
R

Present Sales = 60,000 (Sales at BEP) + 30,000 (Margin of Safety)

R R

= 90,000
R

30‚000
R 1
% of Margin of Safety = × 100 = 333%
90‚000
R

1 1
Anticipated Margin of Safety = 333% + 50% of 333% = 50%
Anticipated BEP = 36,000
R

Margin of Safety = 50% of Total Sales

Actual Sales = Margin of Safety of B.E. Point
x (let) = 50% of x + 36,000 R

1
x– x =
2 R 36,000
x =
72,000 R

Contribution
P/V Ratio =
Sales
Contribution
50% =
72‚000 R

Contribution = 36,000 R

Contribution = Fixed Cost + Profit

36,000 = 24,000 + Profit
R R

Profit = 12,000. R

ILLUSTRATION 13. A company manufacturing a single product sells it at a price of R 120

per unit. The variable cost per unit is R 72 and the amount of fixed overhead cost amount to R 27
lakhs. Based on these data, you are required to work out the following :
(i) Present P/V Ratio and Break-Even Sales.
(ii) Increase in volume of sales required if the profit is sought to be increased by R 5.40 lakhs.
(iii) Percentage increase/decrease in sales volume :
(a) to offset an increase of R 6 per unit in variable cost;
(b) an increase in selling price by 10% without affecting the quantum of existing profits.
SOLUTION
Sales – Variable Cost 120 – 72 R R
(i) P/V Ratio = × 100 = × 100 = 40%
Sales 120 R

Fixed Cost 27 lakhs

R
BEP Sales = = = 67.50 lakhs or 56,250 units.
R
P/V Ratio 40%
(ii) Increase in Volumes of Sales
Additional Profit R5.40 lakhs
= = = 11,250 units.
R
(S.P – V.C.) 48 R

(iii) (A) Revised Variable Cost = 72 + 6 = 78R R R

∴ Revised Contribution = 120 – 78 = 42R R R

27 lakhs
R
Revised BEP = = 64,285 units
42 R
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·35

Increase in Output = 8,035 units

8‚035
∴ Percentage increase in Output = × 100 = 14.3%
56‚250
(B) Revised Selling Price (10% increase) = 132 R

∴ Revised Contribution = 132 – 72 = 60 R R R

27 lakhs
R
Revised BEP = = 45,000 units
60 R

Decrease in Output = 11,250 units

11‚250
∴ Percentage decrease in Output = × 100 = 20%
56‚250
ILLUSTRATION 14. The following figures are related to LM Limited for the year ending
31st March, 2024 :
Sales—24,000 units @ 200 per unit;
R

P/V Ratio 25% and Break-even Point 50% of sales.

You are required to calculate :
(i) Fixed cost for the year
(ii) Profit earned for the year
(iii) Units to be sold to earn a target net profit of 11,00,000 for a year. R

(iv) Number of units to be sold to earn a net income of 25% on cost.

(v) Selling price per unit [assuming (a) P/V ratio remains the same or (b) variable cost
proportion is constant if Break-even Point is to be brought down by 4,000 units.
SOLUTION
Break-even point (in units) is 50% of sales = 24,000 × 50% = 12,000 units
Hence, Break-even point (in sales value) is 12,000 units × 200 = 24,00,000 R R

Fixed Cost
(i) We know that Break-even sales =
P/V Ratio
Fixed Cost
or R 24,00,000 =
25%
or Fixed Cost = 24,00,000 × 25% = 6,00,000
R R

So Fixed Cost for the year is 6,00,000 R

(ii) Profit for the year = Contribution – Fixed Cost = [(24,000 units × 200) × 25% – 6,00,000] R R

= 12,00,000 – 6,00,000 = 6,00,000

R R R

(iii) Target net profit is 11,00,000

R

Hence, Target contribution = Target Profit + Fixed Cost

= 11,00,000 + 6,00,000 = 17,00,000
R R R

Contribution per unit = 25% of 200 = 50 per unit

R R

R 17‚00‚000
No. of units = = 34,000 units
R 50 per unit
So, 34,000 units to be sold to earn a target net profit of 11,00,000 for a year.R

(iv) Net desired total Sales (Number of units × Selling price) be X, then desired profit is 25% on Cost or 20%
on Sales i.e. 0.2 X
Fixed Cost + Desired Profit
Desired Sales =
P/V Ratio
R 6‚00‚000 + 0.2X
X= or, 0.25 X = R 6,00,000 + 0.2X or, 0.05 X = R 6,00,000 or, X = R 1,20,00,000
25%
C/2·36 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

R 1‚20‚00‚000
No. of units to be sold = = 60,000 units
R 200
(iv) If Break even point is to be brought down by 4,000 units then Break-even point will be 12,000 units
– 4,000 units = 8,000 units
Fixed Cost = R 6,00,000
R 6‚00‚000
Required Contribution per unit = = R 75
8‚000 units
Contribution per unit 75 R
(a) Selling Price = = R 300 per unit
P./V ratio 25%
(assuming PV ratio will remain as 25%)
Hence, selling price per unit shall be R 300 if Break-even point is to be brought down by 4,000 units.
(b) When variable cost proportion is constant. In that case, Selling p[rice will be : Existing variable cost
( 150) + New contribution per unit ( 75) i.e. 225 per unit.]
R R R

ILLUSTRATION 15. (a) Sales of X Co. were R 30,000 producing a profit of R 800 in a week.
In the next week sales amounted to R 38,000 producing profit of R 2,400. Find out the break even
point.
(b) What would be the volume of sales to derive a profit of R 20,000 if the P/V ratio is 68% and
Fixed overheads for the period R 40,000.
(c) A company has two projects to choose from. Project A breaks-even at R 3,20,000 and Project
B breaks-even at R 5,00,000. Which project is better to choose ? What could the difference be due
to ?
SOLUTION
( a) Sales Profit
R R

In a week 30,000 800

Next week 38,000 2,400
Contribution Changes in contribution in two periods
P/V Ratio = × 100 = × 100
Sales Changes in sales in two periods
Changes in Profit in two periods 2‚400 – 800 R R
= × 100 = × 100 = 20%
Changes in sales in two periods 38‚000 – 30‚000 R R

(Since fixed expenses remain constant)

To calculate break-even point, it is necessary to find out fixed expenses.
1
Contribution in first week when sales are R 30,000 and P/V ratio is 20% = R 30,000 × = R 6,000.
5
Fixed Expenses = Contribution – Profit = 6,000 – 800 = 5,200
R R R

Fixed Expenses 5‚200

R
Break Even Point = = = 26,000 R
P/V Ratio 20%
Fixed Overheads + Profit 40‚000 + 20‚000
R R
(b) Sales = =
P/V Ratio 68%
100
= 60,000 ×
R = 88,235.
R
68
(c) Project A is better to choose because it has lower break even point. It is likely to earn more profit because
it will start earning profit at lower level of sales.
Project A will start earning profit when its sales reach the level of 3,20,000 whereas project B will start
R

earning profit when its sales reach the level of 5,00,000. The difference could be due to high fixed cost of
R

project B and lower fixed cost of project A.

MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·37

BREAKEVENCHART
A break-even chart is a graphical representation of marginal costing. It is considered to be one of
the most useful graphic presentation of accounting data. It is a readable reporting device that would
otherwise require voluminous reports and tables to make the accounting data meaningful to the
management. This chart shows the inter-relationship between cost, volume and profit. It shows the
break-even point and also indicates the estimated cost and estimated profit or loss at various volumes
of activity. There are three methods of drawing a break-even chart. These have been explained with
the help of the following Illustration :
ILLUSTRATION 16. From the following data, calculate the break even point and profit if
output is 50,000 units by drawing a break even chart.
Production Fixed Variable Selling Total Total
Expenses Cost per unit Price per unit Cost Sales
(Units) (R) (R) (R) (R) (R)
0 1,50,000 10 15 1,50,000 0
10,000 1,50,000 10 15 2,50,000 1,50,000
20,000 1,50,000 10 15 3,50,000 3,00,000
30,000 1,50,000 10 15 4,50,000 4,50,000
40,000 1,50,000 10 15 5,50,000 6,00,000
50,000 1,50,000 10 15 6,50,000 7,50,000
60,000 1,50,000 10 15 7,50,000 9,00,000
SOLUTION
FIRST METHOD. On the X-axis of the graph is plotted the number of units produced, sold and on the Y-axis
are shown costs and sales revenues.
The fixed cost line is drawn parallel to X-axis. This line indicates that fixed expenses remain the same with
any volume of production. The variable costs for different levels of activity are plotted over the fixed cost line. The
variable cost line is joined to fixed cost line at zero volume of production. This line can also be regarded as the
total cost line because it starts from the point where fixed cost has been incurred and variable cost is zero. Sales
values at various levels of output are plotted, joined and the resultant line is the sales line. The sales line will
cut the total cost line at a point where the total costs are equal to total revenues and this point of intersection of
C/2·38 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

two lines is known as break even point—the point of no profit no loss. The number of units to be produced at the
break even point is determined by drawing a perpendicular to the X-axis from the point of intersection and
measuring the horizontal distance from the zero point to the point at which the perpendicular is drawn. The sales
value at break even point is determined by drawing a perpendicular to the Y-axis from the point of intersection
and measuring the vertical distance from the zero point to the point at which the perpendicular is drawn. Loss
and profit are as have been shown in the chart which show that if production is less than the break even point,
the business shall be running at a loss and if the production is more than the break even level, profit shall result.
SECOND METHOD. A variation of the first method is that variable cost line is plotted first and then fixed cost
line over the variable cost line. The latter line is the total cost line because it is drawn over the variable cost
line and represents the total cost (variable and fixed) at various levels of output. This method is more helpful to
the management for decision making because it shows the recovery of fixed costs at various levels of production
before profits are realised. Contributions at various levels of production are automatically disclosed in the chart.

THIRD METHOD. Under this method, the fixed cost line is drawn parallel to the X-axis. The contribution line
is drawn from the origin and this line goes up with the increase in output. The sales line is plotted as usual. The
question of interaction of sales line with cost line does not arise because the total cost line is not drawn in this
method. In this method, break even point is that point where the contribution line cuts the fixed cost line. At this
point, contribution is equal to fixed expenses and there is no profit no loss.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·39

If the contribution is more than the fixed expenses, profit shall arise and if the contribution is less than the
fixed expenses, loss shall arise. In this example there is a profit of 1,00,000 when the output is 50,000 units.
R

At this level of output, contribution is 2,50,000 (i.e., 50,000 units @ 5), and fixed cost is 1,50,000, resulting
R R R

in a profit of 1,00,000, i.e., contribution minus fixed cost.

R

Arithmetical Verification
Fixed Expenses R 1‚50‚000
Break Even Point = = = 30,000 units of output
Contribution per unit R 5
or 30,000 units × Selling price
= 30,000 × R 15 = R 4,50,000 sales
Profit when the output is 50,000 units
Contribution for 50,000 units @ 5 R = R 2,50,000
Less : Fixed Expenses = R 1,50,000
———————————————

Profit = R 1,00,000
———————————————

Angle of Incidence
This is the angle formed at the break even point at which the sales line cuts the total cost line.
This angle indicates rate at which profits are being made. Large angle of incidence is an indication that
profits are being made at a high rate. On the other hand, a small angle indicates a low rate of profit
and suggests that variable costs form the major part of cost of production. A large angle of incidence
with a high margin of safety indicates the most favourable position of a business and even the
existence of monopoly conditions.

Relationship Between Angle of Incidence, Break even Sales and Margin of Safety
When break even sales are very low, with large angle of incidence, it indicates that the firm is
enjoying business stability and in that case margin of safety sales will also be high.
When break even sales are low, but not very low with moderate angle of incidence, in that case,
though the business is stable, the profit earning rate is not very high as in earlier case.
Contrary to above, when break even sales are high, angle of incidence will be narrow with much
low margin of safety sales.

Assumptions Underlying Break Even Chart

1. All costs can be separated into fixed and variable costs.
2. Fixed costs will remain constant and will not change with the change in level of output.
3. Variable costs will fluctuate in the same proportion in which the volume of output varies. In
other words, prices of variable cost factors i.e., wage rates, price of material etc. will remain
unchanged.
4. Selling price will remain constant even though there may be competition or change in volume
of production.
5. The number of units produced and sold will be the same so that there is no opening or closing
stock.
6. There will be no change in operating efficiency.
7. There is only one product or in the case of many products, product mix will remain
unchanged.
8. Product specifications and methods of manufacturing and selling will not change.
C/2·40 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Advantages of Break Even Charts

1. Information provided by the break even chart can be understood by the management more
easily than contained in the Profit and Loss Account and the Cost Statements because a break even
chart is the simple presentation of cost, volume and profit structure of the company. It summarises a
great mass of detailed information in a graph in such a way that its significance may be grasped even
with a cursory glance.
2. A break even chart is useful for studying the relationship of cost, volume and profit. The chart
is very useful for taking managerial decisions because it shows the effect on profits of changes in fixed
costs, variable costs, selling price and volume of sales.
3. The chart is very useful for forecasting costs and profits at various volumes of sales.
4. A break even chart is a tool for cost control because it shows the relative importance of the fixed
costs and the variable costs.
5. Profitability of various products can be studied with the help of these charts and a most
profitable product mix can be adopted. Profits at different levels of activity can also be ascertained.
6. The profit potentialities can be best judged from a study of the position of the break even point
and the angle of incidence in the break even chart. Low break even point and large angle of incidence
in the break even chart indicate that fixed costs are low and margin of safety is high. It is a sign of
financial stability. In such a case, some monopolistic conditions prevail and high profits are earned
over a large range of production activity. Low break even point and small angle of incidence show
that fixed costs are low and margin of safety is high, but rate of profit is not high because of absence
of monopolistic conditions. High break even point and large angle of incidence show that fixed costs
are high and margin of safety is low. A small fall in volume may put the business into losses and a
small increase in volume may give a high profit because of large angle of incidence. Last, high break
even point and small angle of incidence is the worst position because it indicates a low margin of
safety and a low rate of profit.
7. It is helpful in the determination of sale price which would give desired profits or a B.E.P.
8. It is helpful in knowing the effect of increase or reduction in selling price.

Limitations
1. A break even chart is based on a number of assumptions (discussed earlier) which may not
hold good. Fixed costs vary beyond a certain level of output. Variable costs do not vary
proportionately if the law of diminishing or increasing returns is applicable in the business. Sales
revenues do not vary proportionately with changes in volume of sales due to reduction in selling
price as a result of competition or increased production.
In the break even chart, we have seen that the total cost line and the sales line look straight lines.
This is possible only with a number of assumptions. But, in practice, the total cost line and the sales
line are not straight lines because the assumptions do not hold good. Thus, there might be several
break even points at different levels of activity.
2. A limited amount of information can be shown, in a break even chart. A number of charts will
have to be drawn up to study the effects of changes in fixed costs, variable costs and selling prices.
3. The effect of various product mixes on profits cannot be studied from a single break even
chart.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·41

4. A break even chart does not take into consideration capital employed which is a very important
factor in taking managerial decisions. Therefore, managerial decisions on the basis of break even
chart may not be reliable.
In spite of the above limitations, the break even chart is a useful management device for analysing
the problems, if it is constructed and used by those who fully understand its limitations.

Profit-Volume Graph
Profit-volume graph is a simplified form of break even chart and is an improvement over the
break even chart as it clearly shows the relationship of profit to volume or sales. This graph suffers
from the same limitations with which break even chart suffers. It is possible to construct a P/V graph
for any data relating to a business from which a break even chart can be drawn. Construction of this
graph is relatively simple and the procedure of construction is as follows :
(1) A scale for sales on horizontal axis is selected and other scale for profits and fixed cost or loss
on the vertical axis is selected. The area below the horizontal axis is the ‘loss area’ and that above it is
the ‘profit area’.
(2) Points of profits of corresponding sales are plotted and joined. The resultant line is the
profit/loss line.

Uses of P/V Graph

(i) To determine break even point.
(ii) To show impact on profits of selling profit at different prices for a product.
(iii) To forecast costs and profits resulting from changes in sales volume.
(iv) To show the deviations of actual profit from anticipated profit relative profitability under
conditions of high or low demand.

Limitations of P/V Graph

(i) It assumes that cost can be predicted at any level of activity and can be categorised into fixed
and variable and their written behaviour at all levels, i.e., fixed costs always remain fixed and
variable cost strictly vary with production.
(ii) Assume constant selling price and the same pattern of sales amount of different products.
(iii) Changes in inventory levels at the beginning and end will be insignificant.
(iv) It assumes the same level of technology and the same level of efficiency.
All these mean our simplification of actual state of affairs and to that extent the conclusions
drawn are affected.

Cash Break Even Chart

While preparing cash break-even chart, only cash fixed costs are taken. Non-cash items like
depreciation etc., are excluded from the fixed costs for computation of break-even point. Cash break-
even chart depicts the level of output or sales at which the sales revenue will be equal to total cash
outflow. It is computed as under :
Cash Fixed Costs
Cash BEP =
Contribution per unit
C/2·42 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Following is the diagrammatic representation of cash break-even chart :

Sales

.C.
Sales & ashF Total Costs
NonC
Costs
Rs. lacs

Cash Fixed Costs

0 Output x

Hence for example suppose insurance has been paid on 1st January, 2021 till 31st December, 2023,
then this fixed cost will not be considered as a cash fixed cost for the period 1st January, 2022 to 31st
December, 2023.
ILLUSTRATION 17. Prepare a P/V graph from the following data :
Units produced 60,000 ; Selling price per unit R 15 ; Variable cost per unit R 10 ; Fixed costs
R 1,50,000.

Show the expected sales on the graph when the profit to be earned is R 87,500.
SOLUTION

Arithmetical Verification
Fixed Expenses + Profit R 1‚50‚000 + R 87‚500 R 2‚37‚500
Sales (in units) = = = = 47,500 units
Contribution per unit 5 R R5
∴ Sales = 47,500 units @ 15 = 7,12,500.
R R

ILLUSTRATION 18. Following figures relate to one year’s working at 100 per cent capacity
level in a manufacturing business :
R R

Fixed overhead 1,20,000 Direct materials 4,10,000

Variable overhead 2,00,000 Sales 10,00,000
Direct wages 1,50,000
Represent the above figures on a break-even chart and determine from the chart the break-
even point. Verify your result by calculations.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·43

SOLUTION COST AND SALES AT VARIOUS CAPACITY LEVELS

Per cent Fixed Variable Total Sales
Capacity Overheads Costs Costs
R R R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
— 1,20,000 — 1,20,000 —
20 1,20,000 1,52,000 2,72,000 2,00,000

40 1,20,000
( 7‚60‚000 ×
3,04,000
20
100 ) 4,24,000
( 10‚00‚000 ×
4,00,000
20
100 )
60 1,20,000
( 7‚60‚000 ×
4,56,000
40
100 ) 5,76,000
( 10‚00‚000 ×
6,00,000
40
100 )
80 1,20,000
( 7‚60‚000 ×
6,08,000
60
100 ) 7,28,000
( 10‚00‚000 ×
8,00,000
60
100 )
100 1,20,000
( 7‚60‚000 ×
7,60,000
80
100 ) 8,80,000
( 10‚00‚000 ×
10,00,000
80
100 )
(Given) (Given)
Arithmetical Verification
Total Variable Costs : R

Direct Materials 4,10,000

Direct Wages 1,50,000
Variable Overhead 2,00,000
——————————————
Marginal Cost 7,60,000
——————————————
Contribution = Sales – Marginal Cost = 10,00,000 – 7,60,000 = 2,40,000
R R R

Contribution 2‚40‚000 R 24
P/V Ratio = = = or 24%
Sales 10‚00‚000 R 100
Fixed Expenses 1‚20‚000 R 100
Break Even Point = = = 1,20,000 × = 5,00,000
R R
P/V Ratio 24 24
100
At 10,00,000 sales, 100% capacity is reached. ∴ At 5,00,000 sales, 50% capacity is reached.
R R

Hence, break even point is reached at a 50% capacity utilisation.

C/2·44 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

ILLUSTRATION 19. You are given the following data for the year 2024 for a factory :
Output 40,000 units Variable Expenses per unit R 10
Fixed Expenses R 2,00,000 Selling Price per unit R 20
Draw a break even chart showing the break even point.
How many units must be produced and sold if the selling price is reduced by 10% in order to
give the same profit ? Show by break even chart what will be the new break even point ?
SOLUTION
COST AND SALES AT VARIOUS LEVELS OF OUTPUT
Output Fixed Variable Total Sales Proposed Sales
(Units) Expenses Expenses Cost @ 20
R @ 18
R

0
R

2,00,000 —
R R

2,00,000
R

—
(20 –
10
100
—
× 20 )
10,000 2,00,000 1,00,000 3,00,000 2,00,000 1,80,000
20,000 2,00,000 2,00,000 4,00,000 4,00,000 3,60,000
30,000 2,00,000 3,00,000 5,00,000 6,00,000 5,40,000
40,000 2,00,000 4,00,000 6,00,000 8,00,000 7,20,000
50,000 2,00,000 5,00,000 7,00,000 10,00,000 9,00,000
60,000 2,00,000 6,00,000 8,00,000 12,00,000 10,80,000

Arithmetical Verification
Contribution = Selling Price – Variable Cost = R 20 – R 10 = R 10 per unit
Fixed Expenses R 2‚00‚000
Present Break Even Point = = = 20,000 units
Contribution per unit R 10
Present Profit = Total Contribution – Fixed Expenses
= R 40,000 × R 10 – R 2,00,000 = R 2,00,000.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·45

10
Selling Price with 10% reduction = R 20 – × R 20 = R 18.
100
Contribution = R 18 – R 10 = R 8.
Fixed Expenses 2‚00‚000 R
Net Break Even Point = = = 25,000 units.
Contribution per unit 8 R

Fixed Expenses + Profit 2‚00‚000 + 2‚00‚000

Desired Production or Sales = = R
Contribution per unit 8
= 50,000 units.

MISCELLANEOUS ILLUSTRATIONS
ILLUSTRATION 20. The profit volume ratio of Ulysis Manufacturers Ltd. is 40% and the
margin of safety is also 40%. Work out the following, if the sales volume is R 1.50 crore :
(i) Break-even point; (ii) Net profit; (iii) Fixed cost; and (iv) Sales required to earn a profit of
R 30 lakhs.
SOLUTION
(i) Calculation of Break Even Point
Margin of Safety = Actual Sales – Break Even Point
40% of Actual Sales = 1,50,00,000 – Break Even Point
R

Break Even Point = 1,50,00,000 – 60,00,000 = 90,00,000

R R R

(ii) Calculation of Profit

Profit
Margin of Safety =
P/V Ratio
Profit
R 40% of 1,50,00,000 (Sales) =
R
40%
40
R 60,00,000 × = Profit
100
Profit = 24,00,000
R

(iii) Calculation of Fixed Cost

Fixed Cost
Break Even Point =
P/V Ratio
Fixed Cost
R 90,00,000 =
40%
40
Fixed Cost = 90,00,000 ×
R = 36,00,000 R
100
(iv) Calculation of Sales Required to Earn Profit of 30,00,000 R

Fixed Cost + Profit

Sales =
P/V Ratio
R 36‚00‚000 + 30‚00‚000R
Sales =
40%
100
Sales = 66‚00‚000 ×
R = 1,65,00,000 R
40
ILLUSTRATION 21. ABC manufacturing company provides you the following financial
information about their spectacles frames business which they started two years ago :
Financial Year 2022-23 (R) Financial Year 2023-24 (R)
Total Sales 40,000 60,000
Total Cost 35,500 43,200
C/2·46 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

You are required to compute :

(i) P/V Ratio (ii) Break-even sales level
(iii) Margin of Safety
SOLUTION
2022-23 ( ) R 2023-24 ( ) R Difference ( )R

Total Sales 40,000 60,000 20,000

Less : Total Cost (35,500) (43,200) (7,700)
Profit 4,500 16,800 12,300
Difference profit
(i) P/V Ratio = × 100
Difference in sales
12‚300
= × 100 = 61.5%
20‚000
(ii) Total Cost = Fixed Cost + Variable Cost
⇒ Fixed Cost = R 43,200 – (38.5% of R 60,000) …[Variable Cost Ratio = 100 – 61.50 = 38.5%
= R 43,200 –
23,100 = 20,100
R R

Fixed Cost 20‚100 R

∴ Break-even Sales Level = =
P/V Ratio 61.5%
= 32,683 (Approx.)
R

(iii) Margin of Safety = Actual Sales – Break-even Sales

For year 2022-23 = 40,000 – 32,683 = 7,317
R R R

For year 2023-24 = 60,000 – 32,683 = 27,317

R R R

ILLUSTRATION 22. A retail dealer in garments is currently selling 24,000 shirts annually.
He supplies the following details for the year ended 31st Dec., 2023 :
Selling price per shirt R 500

Variable cost per shirt R 350

Fixed cost p.a.

Staff salaries R 12,00,000

General office costs R 8,00,000

Advertising costs R 4,00,000

As a Cost Advisor of the firm you are required by the Management to answer the following,
considering each part independently :
(a) Calculate break-even point and margin of safety in sales revenue and number of shirts
sold.
(b) Assume 20,000 shirts are sold in a year, find out profits.
(c) If it is decided to introduce a commission of R 20 per shirt, how many shirts would require
to be sold in a year to earn a net income of R 15,000 after tax, tax rate being 50%.
SOLUTION
Total Fixed Cost = 12,00,000 + 8,00,000 + 4,00,000 = 24,00,000
R R R R

Contribution (C) = Selling Price – Variable Cost = 500 – 350 = 150R R R

Fixed Cost 24‚00‚000 R

(a) Break even-point = = = 16,000 shirts
Contribution per unit 150 R

Margin of Safety = Actual Sales – B.E. Sales = 24,000 – 16,000 = 8,000 shirts
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·47

(b) When 20,000 shirts are sold, then

Contribution (C) = 20,000 × 150 = R R 30,00,000
∴ Profit (P) = C – F = R 30,00,000 – R 24,00,000 = R 6,00,000
(c) When commission of R 20 is payable, then
Variable Cost per shirt = R 350 + R 20 = R 370
Contribution = S – V = R 500 – R 370 = R 130
Net income after tax is 15,000, then
R

100
Net income before tax = 15,000 × = 30,000 R
50
Required Net Income = 30,000
R

Fixed Cost + Required Profit

∴ Required Sales =
Contribution per unit
24‚00‚000 + 30‚000
R R
= = 18,692 shirts (approx.)
130 R

ILLUSTRATION 23. A company producing a single product sells it at R 50 per unit. Unit
variable cost is R 35 and fixed cost amount to R 12 lakhs per annum. With this data, you are
required to calculate the following treating each independent of the other.
(a) P/V Ratio and Break-even sales
(b) New break-even sales if variable cost increases by R 3 per unit, without increase in selling
price.
(c) Increase in sales required if profits are to be increased by R 2.4 lakhs.
(d) Percentage increase/decrease in sales volume units to off-set.
(i) An increase of R 3 in the variable cost per unit.
(ii) 10% increase in selling price without affecting existing profits quantum.
(e) Quantum of advertisement expenditure permissible to increase sales by R 1.2 lakhs
without affecting existing profits quantum.
SOLUTION
Contribution per unit 15
(a) P/V Ratio = × 100 = × 100 = 30%
Selling Price per unit 50
Fixed Cost 12 lakhs R
Break-even Sales = = = 40 lakhs R
P/V Ratio 30%
12
( b) New P/V Ratio = × 100 = 24%
50
12 lakhs
R
New Break-even Sales = = 50 lakhs R
24%
Increase in Contribution
(c) Increase in Sales required =
P/V Ratio
2.4 lakhs
R
= = 8 lakhs R
30%
Reduction in Contribution 3
( d) (i) % Increase in Sales Volume (units) = = × 100 = 25%
New Contribution per unit 12
Increase in Contribution per unit
(ii) % Decrease in Sales Volume =
New Contribution per unit
5
= × 100 = 25%
20
( e) 30% of 1.2 lakhs i.e. 36,000 should be maximum permissible advertisement expenditure for
R R

incurrence to get an increase of sales of 1.2 lakhs without affecting existing profits.
R
C/2·48 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

ILLUSTRATION 24. A company has three factories situated in Punjab, Haryana and
Himachal Pradesh with its head office in Delhi. The management has received the following
summary report on the operations of each factory for a period :
(R in ’000)
Sales Profit
Actual Over (under) Actual Over (under)
Budget Budget
Punjab (Pb) 2,200 (800) 270 (360)
Haryana (H) 2,900 300 420 180
Himachal Pradesh (H.P.) 2,400 (400) 660 (220)
Calculate for each factory and for the company as a whole for the period : (i) Fixed cost; (ii)
Break even sales.
SOLUTION
Working Note :
CALCULATION OF P/V RATIO ( in ’000)
R

Punjab Haryana Himachal Pradesh

(Pb) (H) (H.P.)
Sales Profit Sales Profit Sales Profit
Actual 2,200 270 2,900 420 2,400 660
Add : Under
(Over Budgeted) + 800 360 – 300 180 + 400 220
Budgeted 3,000 630 2,600 240 2,800 880
P/V Ratio =
Difference in Profits 630 – 270 420 – 240 880 – 660
= =
Difference in Sales 3‚000 – 2‚200 2‚900 – 2‚600 2‚800 – 2‚400
360 180 220
× 100 = 45% × 100 = 60% × 100 = 55%
800 300 400
(i) Fixed Costs = 2,200 × .45 – 270 2,900 × .6 – 420 2,400 × .55 – 660
Actual Sales × P/V Ratio – Profit
= 990 – 270 = 1,740 – 420 = 1,320 – 660
= 720 = 1,320 = 660

Total Fixed Cost = 2,700

(ii) Break-even Sales =
Fixed Cost 720 1‚320 660
= = 1,600 = 2,200 = 1,200
P/V Ratio 45% 60% 55%

Total BES = 5,000

ILLUSTRATION 25. (Treatment of commission in calculating sale price and calculation of

BEP) A foreign soft-drink company is planning to establish a subsidiary company in India to
produce mineral water. Based on the estimated annual sales of 40,000 bottles of the mineral water,
cost studies produced the following estimates for the Indian industry.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·49

Total Annual Costs % of Total Annual Cost

which is variable
R

Materials 6,30,000 100%

Labour 4,50,000 80%
Factory Overheads 2,76,000 60%
Administration Overheads 1,20,000 35%

The Indian production will be sold by manufacturer’s representatives who will receive a
commission of 8% on the sale price. No portion of the foreign office expenses is to be allocated to
the Indian industry. You are required to
(i) Compute the sale price per bottle to enable the management to release an estimated profit
on sales proceeds in India.
(ii) Calculate break-even point in Rupees sales as also in number of bottles for the Indian
subsidiary on the assumption that the sale price is R 42 per bottle.
SOLUTION
SEGREGATION OF COST
Total Variable Fixed
R R R

Material 6,30,000 6,30,000 —

Labour 4,50,000 3,60,000 90,000
Factory Overheads 2,76,000 1,65,600 1,10,400
Administration Overheads 1,20,000 42,000 78,000
Total 14,76,000 11,97,690 2,78,400

(i) Computation of Sale price per bottle

Commission 8% of sales
Profit 10% of sales
——————————————————

Commission and Profit 18% of sales

——————————————————

Hence total cost is 82% (100% – 18%) of sales

100
So Sales = 14,76,000 ×
R = 18,00,000 R
82
18‚00‚000 R

Therefore sale price per bottle = = 45 per bottle R

40‚000
11‚97‚600
R

(ii) Variable Cost = = 29.94

40‚000
Add : Commission 8% of R 42 = 3.36
————————

Variable Cost 33.30

————————

Contribution = 42 – 33.30 = 8.70

R R R

2‚78‚400
Break Even Point = = 32,000 Bottles
8.70 R

Break Even Point ( ) = 32,000 × 42 =

R R 13,44,000
C/2·50 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

ILLUSTRATION 26. The profit for the year of Push On Ltd. works out to 12.5% of the
Capital employed and the relevant figures are as under :
Sales R 5,00,000 ; Direct Materials R 2,50,000 ; Direct Labour R 1,00,000 ; Variable Overheads R
40,000 ; Capital Employed R 4,00,000.
The new Sales Manager who has joined the company recently estimates for next year a profit
of about 23% on capital employed, provided the volume of sales is increased by 10% and
simultaneously there is an increase in Selling Price of 4% and an overall cost reduction in all the
elements of cost of 2%.
Find out by computing in detail the cost and profit for next year, whether the proposal of Sales
Manager can be adopted.
SOLUTION
STATEMENT SHOWING THE COST AND PROFIT FOR THE NEXT YEAR
Estimated
sales, cost &
Existing profit after
Volume increase in
selling price
and overall
cost reduc-
tion

[ ]
R R

110 104
(A) Sales 5,00,000 5,72,000 i.e. R 5‚00‚000 × ×
100 100
—————————————————————————————————————
—————————————————————————————————————

Direct Materials 2,50,000 2,69,500 [ i.e. R 2,50,000 × 1.10 × .98]

Direct Labour 1,00,000 1,07,800 [ i.e. R 1,00,000 × 1.10 × .98]
Variable Overheads 40,000 43,120 [ i.e. R 40,000 × 1.10 × .98]
—————————————————————————————————————

(B) Marginal Cost 3,90,000 4,20,420

—————————————————————————————————————
—————————————————————————————————————
(C) Contribution [(A) – (B)] 1,10,000 1,51,580
Fixed Cost 60,000 58,800 [ i.e. R 60,000 × .98]
(Balancing Figure)
—————————————————————————————————————

Profit (12.5% on R 4,00,000) 50,000 92,780

—————————————————————————————————————
—————————————————————————————————————
Percentage of Profit on Capital
Profit
Employed = 12.5% 23.195%
Capital Employed

As the profit is more than 23% of capital employed, the proposal of Sales Manager can be adopted.
ILLUSTRATION 27. Two plants manufacturing the same product decide to merge.
Particulars of operation of the two plants before the merger were as follows :
Plant A Plant B
Capacity utilized 80% 60%
Sales R 4.80 crores R 2.40 crores

Variable cost 3.52 crores 1.80 crores

Fixed cost 0.80 crore 0.40 crore
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·51

You are required to work out : (i) Break even capacity of the merged plant. (ii) Profit earned at
75% capacity of the merged plant. (iii) Sales required to earn a profit of R one crore.
SOLUTION
COMPUTATION OF THE BREAK EVEN CAPACITY OF THE MERGED PLANT
Plant A Plant B Merged Plant
————————————————————————————————————————————————————————————————————
Existing Capacity Utilised 80% 60%
———————————————————————————————————————————————
R in Crores R in Crores
Sales 4.80 2.40
Less : Variable Cost 3.52 1.80
———————————————————————————————————————————————
Contribution 1.28 0.60
Less : Fixed Cost 0.80 0.40
———————————————————————————————————————————————
Profit 0.48 0.20
———————————————————————————————————————————————
Capacity Utilisation 100% 100% 100%
(After Merger of Plants) R in Crores R in Crores R in Crores
Sales 6.00 4.00 10.00

( 4.80
80%
× 100% ) ( 2.40
60
× 100 ) 10.00

Less : Variable Cost 4.40 3.00 7.40

( 3.52
80%
× 100% )( 1.80
60%
× 100% )
————————————————————————————————————————————————————————————————————

Contribution 1.60 1.00 2.60

Less : Fixed Cost 0.80 0.40 1.20
————————————————————————————————————————————————————————————————————

Profit 0.80 0.60 1.40

———————————————————————————————————————————————
26%

P/V Ratio :
Contribution
Sales
× 100 ( 2.60
10.00
× 100 )
Fixed Expenses 1.20 CroresR
Break Even Sales of the Merged Plant= = = R 4.6154 Crores
P/V Ratio 26%
4.6154 Crores
R

(i) Break Even Capacity % = × 100 = 46.15%

10 Crores R

(Sales at 100% Capacity)

(ii) Profit Earned at 75% Capacity of the Merged Plant
R in Crores

Sales at 75% Capacity ( R 10 Crores

100% × 75% ) 7.50
———————

Contribution @ 26% i.e. ( R 7.50 crores ×

26
100 ) 1.95

Less : Fixed Expenses 1.20

———————

0.75
———————
C/2·52 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

(iii) Required Sales to Earn Profit of R 1 Crores

Fixed Expenses + Profit
Sales =
P/V Ratio
R 1.20 Crores + R 1 Crore
= = R 8.4615 Crores
26%

QUESTIONS
SHORT ANSWER TYPE
1. What is absorption costing ?
2. Give two distinguishing features of absorption costing.
3. Give a proforma for ascertainment of profit under absorption costing.
4. Enumerate three advantages of absorption costing.
5. Enumerate four limitations of absorption costing.
6. Why is there need for marginal costing ?
7. Define Marginal Cost.
8. Define Marginal Costing. Point out the limitations of marginal costing.
9. Distinguish between marginal cost and direct cost.
OR
“An item of cost is direct for one business may be indirect for another.” Explain with suitable examples.
10. State the advantages of Marginal Costing.
11. Give a proforma for ascertainment of profit under marginal cost.
12. Briefly explain the significance of ‘break-even analysis’.
13. What are the assumptions underlying Break Even Analysis ?
14. What are uses of Break Even Analysis ?
15. What is Cost Volume Profit Analysis ?
16. Give Marginal Costing Equation.
17. Give the various uses of P/V Ratio.
18. What is Contribution ?
19. What is P/V Ratio ? Enumerate the practical applications of this ratio. Give three ways by which P/V
Ratio can be improved.
20. What is break even point ?
21. Why are P/V Ratio and Margin of Safety calculated ?
22. What is Margin of Safety ? How can it be improved ? Illustrate the impact of price variation thereon.
23. What is the formula of calculating break even point in units and in value?
24. Do you find any mistake in the following statements ?
(a) Contribution is equal to fixed expenses. (b) Total cost is marginal cost. (c) Profit-Volume ratio is
improved by reducing variable cost per unit. (d) Profit-Volume Ratio is improved by reducing fixed
expenses.
25. Point out mistake (if any) in the following statements :
(a) Break even point occurs where total cost line and sales line intersect each other.
(b) Margin of safety is before the break even point.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·53

26. A company making and selling toys has made the following estimates :
Selling price 20 a unit ; Fixed costs 15,00,000 a year ; Variable cost
R R R 16 per unit ; Sales volume 5
lakh units.
Suppose a selling price decrease of 10% results in a 15% increase in sales volume, what will be the
profit ?
Ans. [Loss R 3,50,000].
27. “While variable costs are controllable, fixed costs are not”. Comment.
28. “Absorption costing obscures the total amount of fixed cost whereas variable costing highlights it”.
Comment.
29. Distinguish between.
(i) Contribution and Profit ; (ii) Break even analysis and profit planning (from the point of view of
control and decision making) ; (iii) Marginal Costing and Differential Costing.
30. “Marginal cost reveals the lowest price at which a product can be sold”. Comment. Also state the
exceptions, if any.
31. State the main assumptions of Break Even Charts.
32. Mention some possible courses of action to improve profit volume ratio.
33. Selling price per unit is R 10, variable cost per unit is R 6 and fixed cost is R 8,000. Calculate break-even
point in units.
Ans. [2,000 units]
34. A company making and selling toys has made the following estimates :
Selling price R 20 a unit ; Fixed costs R 15,00,000 a year ; Variable cost R 16 per unit ; Sales volume 5
lakh units.
Suppose a selling price decrease of 10% results in a 15% increase in sales volume, what will be the
profit ?
Ans. [Loss R 3,50,000]
35. Calculate BEP when fixed cost R 3,00,000; Sales R 8,00,000; Variable Cost R 2,00,000.
Ans. [ 4,0,000].
R

36. Excellent Ltd. has supplied you the following information in respect of one of its products.
Total Fixed Cost 18,000 ; Total Variable Cost 30,000 ; Total Sales 60,000 ; Units sold 20,000 (units)
R R R

Find out : (a) Contribution per unit (b) BEP, (c) Margin of safety ; (d) Volume of sales to earn a profit of
R 24,000.
Ans. [(a) R 1.50; (b) R 36,000 or 12,000 units; (c) R 24,000; (d) R 84,000].
37. Sunrise Ltd. sold goods for 3,00,000 in a year. In that year, the variable cost was 60% of sales and
R

profit was 80,000. Selling price per unit was 100.

R R

Find out for the year—(i) P/V Ratio; (ii) Fixed Cost; (iii) Break-even Sales in Rupee Terms; and (iv)
Break-even sales if selling price was reduced by 10% and fixed costs were increased by 10,000. R

Ans. [(i) 40%; (ii) R 40,000; (iii) R 1,00,000; (iv) R 1,50,000]

38. A company makes 1,500 units of a product for which the profitability statement is given below :
R R

Sales 1,20,000
Direct Material 30,000
Direct Labour 36,000
C/2·54 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

Variable Overheads 15,000

——————————

Total Variable Overheads 81,000

Fixed Cost 16,800
——————————
Total Cost 97,800
—————————

Profit 22,200
—————————
—————————

After the first 500 units of production, the company has to pay a premium of 6 per unit towardsR

overtime labour. The premium so paid has been included in the direct labour cost of 36,000 given R

above. You are required to compute the break-even point.

Ans. [575 units]

LONG ANSWER TYPE

1. Define ‘marginal cost’ and ‘marginal costing’. How are variable costs and fixed costs treated in marginal
costing ?
2. Explain clearly what do you understand by “contribution” in a cost accounting sense. How is it related
to profit ? List three benefits management can obtain from knowing the contribution from its cost units.
OR
Discuss the role of contribution in marginal costing.
3. “The effect of a price reduction is always to reduce the P/V ratio, to raise the break even point and
shorten the margin of safety.” Explain and illustrate by a numerical example.
4. (a) What is P/V (Profit-Volume) ratio and to what uses is it put ? Write a note on contribution Vs. P/V
Ratio.
(b) How do the following reflect on break-even point and P/V ratio :
(i) Increase in total fixed costs; (ii) increase in total physical sales; (iii) decrease in variable cost per unit.
5. Give a comparative description of absorption costing and marginal costing.
OR
What is marginal cost ? How it differs from Absorption Cost ? (B.Com. Panjab April 2014)
6. Describe how the following factors will have an impact on the break even point and profit-volume ratio
:
(i) Increase in fixed expenses. (ii) Increase in direct labour cost. (iii) Increase in sales quantity. (iv)
Increase in sales price per unit.
OR
What happens to contribution/sales ratio, break even point and marginal of safety when : (i) Unit
selling price of the product increases; (ii) unit variable cost increases; (iii) Total fixed cost increases; (iv)
Number of units sold increases. You answer must be supported by simple numerical illustration.
(B.Com. Pb, Sept. 2014)
7. Discuss the importance of Break even point, Margin of safety, Contribution, and Profit-volume ratio in
relation to marginal costing.
8. What do you understand by the term ‘Break even point’? Why should it be calculated ?
9. Mention the basic assumptions and limitations of ‘Break-even Analysis.
10. What is Cost-Volume Profit Analysis ? Give its objectives.
11. Explain the uses and limitations of Break Even Charts.
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·55

12. What is profit-volume graph ? Explain how it is drawn ? What are its important limitations ?
13. What is Marginal Costing ? Discuss its managerial applications or uses of marginal costing.
(B.Com. Pb,
April 2011)
OR
What do you understand by Marginal Costing ? State its usefulness as a tool for corporate decisions.
Bring out some limitations of Marginal Costing. (B.Com. Pb, April 2010)
14. A factory is manufacturing three products A, B and C. The company maintains costing records of these
three products on variable costing basis as also on absorption costing basis. The financial accountant
suggested the chief of the factory to close the production of item C, as it was running at loss and only A
and B products were making profit.
Now, do you think that the financial accountant, is right ? If you disagree, give your views, as a cost
accountant, in support of your arguments.

PRACTICAL PROBLEMS
1. Fixed overhead 2,40,000 ; Variable cost per unit 15 ; Selling price per unit 30.
R R R

Find out : (a) Break even sales units, and (b) if the selling price is reduced by 10%. What will be the new
break even point ?
Ans. [(a) 16,000 units ; (b) 20,000 units]
R

2. Profit 200 ; Sales 2,000 ; Variable cost 75% of sales.

R R

(a) Find out Break even sales ; (b) what would be the sales volume to earn a profit of R 500?
Ans. [(a) 1,200 ; (b) 3,200]
R R

3. You are required to calculate break even volume using the following data :
Profit 5,000 (20% of sales) ; P/V Ratio 50%.
R

Ans. [ 15,000]
R

4. From the following figures, you are required to calculate (i) P/V Ratio, (ii) Break Even Sales Volume
(iii) Margin of Safety and (iv) Profit.
Sales 4,000; Variable cost 2,000 ; Fixed cost 1,600.
R R R

Ans. [(i) 50% ; (ii) 3,200 ; (iii) 800 ; (iv) 400]

R R R

5. Given :
Break even volume R 8,000 ; Fixed costs R 3,200 ; Find out profit when sales are R 10,000.
Ans. [ 800]
R

6. Calculate the break-even point from the following figures.

Sales 3,00,000 ; Fixed expenses
R R 75,000 ; Direct Materials R 1,00,000 ; Direct Labour R 60,000 ; Direct
expenses 40,000
R

Ans. [ 2,25,000]
R

7. From the following data, calculate the break-even point :

Selling price per unit 20 ; Direct Materials cost per unit
R R 8 ; Direct Labour cost per unit R 2 ; Variable
overhead per unit 3 ; Fixed overheads (total) 28,000.
R R

If sales are 20% above the break-even point, determine the net profit.
Ans. [ 4,000 units ; Profit will be more by
R R 5,600]
8. From the following figures, calculate the sales required to earn a profit of R 1,20,000.
Sales R 6,00,000 ; Variable costs R 3,75,000 ; Fixed costs R 1,80,000.
Ans. [ 8,00,000]
R
C/2·56 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

9. From the following data calculate :

(a) Break-even point expressed in sales rupees.
(b) Number of units to be sold to earn a profit of 60,000 a year. R

Selling price 20 per unit ; Variable manufacturing cost 11 per unit ; Variable selling cost
R R R 3 per unit;
Fixed costs 2,52,000 per year.
R

Ans. [(i) 8,40,000 (ii) 52,000 units]

R

10. Selling price per unit 150 ; Variable cost per unit 90 ; Fixed Cost 6,00,000
R R R

(a) What will be the selling price per unit if the break even point is 8,000 units?
(b) Compute the sales required to earn a profit of 2,20,000. R

Ans. [(a) R 165 (b) R 20,50,000]

11. From the following information, you are required to find out (i) margin of safety ; and (ii) volume of
sales required to earn profit of 10% on sales :
Total Fixed Cost ( ) 4,500 ; Total Variable Cost ( ) 7,500 ; Total Sales ( ) 15,000 ; Sales (Units) 5,000
R R R

Ans. [(i) 6,000 (ii) 3,750 Units or 11,250]

R R

12. Following figures relate to one year’s working at 100 per cent capacity level in a manufacturing
business. Calculate break-even point.
Fixed Overhead 1,20,000 ; Variable Overhead 2,00,000 ; Direct Wages 1,50,000 ; Direct Materials
R R R

4,10,000 ; Sales 10,00,000

R R

Ans. [ 5,00,000]
R

13. From the following information, calculate margin of safety.

Sales (4,000 units @ 25 each) 1,00,000 ; Variable Cost 72,000 ; Fixed Expenses
R R R R 16,800
Ans. [ 40,000]
R

14. Given :
Fixed costs 8,000 ; Break even units 4,000 ; Sales 6,000 units
R

Selling price per unit R 10.

You are required to work out : (i) variable cost per unit, (ii) profit.
Ans. [(i) R 8, (ii) R 4,000]
15. You are required to calculate : (a) Margin of safety, (b) Sales, (c) Variable cost from the following figures:
Fixed costs R 12,000 ; Profit R 1,000 ; Break even sales R 60,000
Ans. [(a) R 5,000 ; (b) R 65,000 ; (c) R 52,000]
16. Selling price per unit R 12 ; Variable cost per unit R 8 ; Fixed cost R 40,000.
Find out : (i) Break even sales units and value, (ii) Profit when sales would be R 3,00,000, (iii) Margin of
Safety when sales are as in (ii).
Ans. [(i) 10,000 units, R 1,20,000 ; (ii) R 60,000 ; (iii) R 1,80,000]
17. Given : Sales 10,000 units ; Variable cost R 1,00,000 ; Sales value R 2,00,000 ; Fixed cost R 40,000 ; Selling
price per unit 20. R

You are required to find out (a) Break even volume, and (b) Break even sales units.
Ans. [(a) R 80,000 ; (b) 4,000 units]
18. The cost, volume and profit relationship of a company is described by equation Y = 3,00,000 + 0.7 X in R

which X represents sales revenue and Y represents the total cost. Find out the following :
(i) C/S ratio ; (ii) BE point ; (iii) Sales volume required to earn a profit of R 90,000 ; (iv) Sales volume
when there is a loss of 30,000. R

Ans. [(i) 30% (ii) 10,00,000 ; (iii) 13,00,000 (iv) 9,00,000]

R R R
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·57

19. (a) From the following particulars calculate the P/V ratio, Break-even sales and fixed costs.
Profit R 2,000 which represents 10% of sales. Margin of safety = R 10,000.
Ans. [P/V Ratio = 1/5 ; Break-even Sales R 10,000 ; Fixed Cost R 2,000]
(b) A company produces single product which sells for R 20 per unit. Variable cost is R 15 per unit and
Fixed overhead for the year is 6,30,000. R

Required :
(a) Calculate sales value needed to earn a profit of 10% on sales.
(b) Calculate sales price per unit to bring BEP down to 1,20,000 units.
(c) Calculate margin of safety sales if profit is R 60,000.
Ans. [(i) R 42,00,000; (ii) R 20.25; (iii) R 2,40,000]
20. Find P/V Ratio, and Margin of Safety when Sales, Variable Cost and Fixed Costs are R ten lakhs, four
lakhs, four lakhs respectively ?
Ans. [(i) 60% ; R 3,33,333]
21. A company has annual fixed cost of 1,40,000. In the year 2022-23 sales amounted to 6,00,00,000 as
R R

compared with 4,50,00,000 in the preceding year 2021-22. A profit in 2022-23 42,00,000 more than
R R

that in 2021-22. On the basis of the above information; answer the following :
(i) At what level of sales the company break-even ?
(ii) Determine profit/loss on a forecast on a sales volume of R 8,00,00,000.
(iii) If there is a reduction in selling price by 10% in the financial year 2023-24 and company desires to
earn the same amount of profit as in 2022-23. What would be the required sales volume ?
Ans. [(i) PV Ratio : 28%; Break Even Sales : R 5,00,00,000; (ii) Profit : R 84,00,000; (iii) New PV Ratio : 20%;
Required Sales : 8,40,00,000]
R

22. (a) A small-scale industrial unit sold all its output in 2024 for 11,50,000 at the rate of 11.50 per unit.
R R

The total fixed charges of the establishment amounted to 2,00,000 per annum and the variable R

cost per unit of production was 7.50. The management desires to reduce the selling price to
R

11.00 per unit, and maintain the same amount of profit as before. However, the variable costs are
R

estimated to have gone up by 10 per cent. How many units should be produced and sold to give
effect to this decision ?
(b) A plant produces a product in the quantity of 10,000 units at a cost of 3.00 per unit. If 20,000 units R

are produced, the cost per unit will be 2.50. What are the total fixed costs ? What is the variable
R

cost per unit ?

Ans. [(a) 1,45,455 units; (b) Fixed cost = R 10,000 ; Variable Cost per unit = R 2]
23. By noting “P/V will increase or decrease or not change”, as the case may be, state how the following
independent situations will affect the P/V ratio :
(i) An increase in physical sales volume ;
(ii) An increase in the fixed cost ;
(iii) A decrease in the variable cost per unit ;
(iv) A decrease in the contribution margin ;
(v) An increase in selling price per unit ;
(vi) A decrease in the fixed cost ;
(vii) A 10% increase in both selling price and variable cost per unit ;
(viii) A 10% increase in selling price per unit and 10% decrease in the physical sales volume ;
C/2·58 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

(ix) A 50% increase in the variable cost per unit and 50% decrease in fixed cost; and
(x) An increase in the angle of incidence.
Ans. [(i) No change ; (ii) No Change ; (iii) Increase ; (iv) Decrease ; (v) Increase ; (vi) No change ; (vii) No
change ; (viii) Increase ; (ix) Decrease ; (x) Increase]
24. The National Company has just been formed. They have a patented process which will make them the
sole suppliers of Product A. During the first year the capacity of their plant will be 9,000 units and this
is the amount they will be able to sell. Their costs are :
Direct labour R 15 per unit ; Raw materials R 5 per unit ; Other variable costs R 10 per unit ; Fixed costs
R2,40,000
(a) If the company wishes to make a profit of 2,10,000 during the first year, what should the selling
R

price be ? What is the contribution margin at this price ?

(b) If at the end of the first year, they wish to increase their volume and an increase of 1,00,000 in the R

annual fixed costs will increase their capacity to 50,000 units, how many units will they have to sell
to realise a profit of 7,60,000, if their new selling price is 70 per unit and no other costs change,
R R

except that they invest 5,00,000 in advertising with a view to achieve this end ?
R

Ans. [(a) Selling Price R 80 per unit ; contribution per unit R 50 ; (b) 40,000 units]
25. Following are the present cost and output data of a manufacturer :
Product Price Variable cost % of sales
per unit
R R

Tables 120 80 40
Chairs 60 40 35
Book cases 80 60 25
Total fixed cost R 40,000
Last year’s sales was R 2,00,000.
The manufacturer is considering to drop the line of book cases and replace with cabinets. His estimates
for the new scheme are as follows :
Product Price Variable cost % of sales
per unit
R R

Tables 120 80 40
Chairs 60 40 40
Cabinets 150 100 20
Total fixed cost per annum R 40,000.
Sales 2,50,000.
R

Is the change worth undertaking ?

Ans. [The change is worth undertaking as it will increase present profit of R 22,500 to R 43,333].
26. From the following details calculate BEP and Margin of Safety :
Sales 4,20,000 ; Fixed Cost 90,000 ; Variable cost ratio 55% of sales
R R

Ans. [B.E.P. 2,00,000, Margin of Safety = 2,20,000]

R R

27. From the following particulars calculate the P/V ratio, break even sales and margin of safety :
Budgeted output(Units) 50,000 ; Selling price per unit 20 ; Fixed expenses 3,00,000 ; Variable costs
R R R

per unit 10 R

Ans. [P/V Ratio 50% B.E.P. 6,00,000 ; Margin of Safety 4,00,000]

R R
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·59

28. A manufacturer has planned his level of operation at 50% of his plant capacity of 30,000 units. His
expenses are estimated as follows, if 50% of the plant capacity is utilised.
(i) Direct materials 8,280 ; (ii) Direct wages 11,160 ; (iii) Variable and other manufacturing expenses
R R

R 3,960 ; (iv) Total fixed expenses irrespective of capacity utilisation 6,000 R

The expected selling price in the domestic market is 2 per unit. Recently, the manufacturer has
R

received a trade enquiry from an overseas organisation interested in purchasing 6,000 units at a price of
R 1.45 per unit.
As a professional management accountant what would be your suggestion regarding acceptance or
rejection of the offer ? Suppose your suggestion with suitable quantitative information.
Ans. [Offer should be rejected as acceptance of the offer will give negative contribution of R 660]
29. Given :
Margin of Safety = R 8,000 which represents 40% of sales, P/V Ratio = 50%.
You are required to find : (i) Break even sales, (ii) Fixed cost, (iii) Total Profit.
Ans. [(i) R 12,000 ; (ii) R 6,000 ; (iii) R 4,000]
30. From the following particulars calculate (a) Contribution per unit (b) P/V Ratio (c) Break even point in
units (d) What will be selling price per unit, if the break even point is brought down to 10,000 units :
Selling price per unit R 20 ; Variable cost per unit R 16 ; Fixed expenses R 60,000.
Ans. [(a) R 4 ; (b) 20% ; (c) 15,000 units (d) R 22]
31. Following information is provided to you :
Selling price per unit R 40·00 ; Variable cost per unit R 24·00 ; Fixed costs per unit R 6·00 ; Profit per unit
R 10·00
Present sales volume is 2,000 units
You are required to calculate :
(a) P.V. Ratio and Break even point ; (b) Margin of safety ; (c) Sales required to earn a profit of R 26,000 ;
(d) Profit at Sales volume of 2,500 units
Ans. [(a) P/V Ratio 40% ; B.E.P. 750 units or R 30,000 Sales ; (b) Margin of safety R 50,000 ; (c) Sales required
R 95,000 ; (d) Profit 28,000] R

32. Following are obtained from the records of a factory :

Sales (4,000 units @ R 25 each) R 1,00,000 ; Variable Cost R 72,000 ; Fixed Expenses R 16,800
Calculate (i) P/V Ratio, (ii) Break even points in rupees, (iii) Margin of Safety, (iv) It is proposed to
reduce the selling price by 20%. What extra units should be sold to obtain the same amount of profit?
Ans. [(i) 28% ; (ii) R 60,000 ; (iii) R 40,000 ; (iv) 10,000 units]
33. Three firms X, Y and Z manufacture the same product. The selling price is 8 per unit of the product— R

equal for all the firms. The fixed cost for the firms X, Y and Z respectively are 80,000, 2,00,000 and R R

3,30,000 while the variable costs per unit are R. 6, 4 and 3.

R R R

(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 ?
Ans. [ X Y Z
(a) Units 40,000 50,000 66,000
(b) ( ) R 80,000 1,20,000 70,000]
C/2·60 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

34. A firm has purchased a plant to manufacture a new product, the cost data for which is given below :
Estimated annual sales 24,000 units ; Estimated costs : Material 4.00 per unit ; Direct Labour 0.60 per
R R

unit ; Factory Overhead (Fixed) 24,000 per year ; Administration Expenses (Fixed) 28,800 per year ;
R R

Selling Expenses (Fixed) 15% on sales

(i) Calculate the volume of sales, if profit per unit is R 1.02 ; and
(ii) Find out break-even point in terms of units of output.
Ans. [(i) R 2,20,800 ; (ii) 18,678 units]
35. The sales turnover and profit during two years were as follows :
Year Sales Profit
R R

2023 1,50,000 20,000

2024 1,70,000 25,000
You are required to calculate : (i) P/V Ratio and Fixed Cost, (ii) Break Even Point, (iii) The sales
required to earn a profit of 40,000, (iv) The profit made when sales are 2,50,000, (v) Margin of safety
R R

at a profit of 50,000, (vi) Variable costs of the two periods.

R

Ans. [(i) 25%, 17,500 ; (ii) 70,000 ; (iii) 2,30,000 ; (iv) 45,000 ; (v) 2,00,000 ; (vi) 2023— 1,12,500 and
R R R R R R

2024— 1,27,500]R

36. The sales of Forma Ltd. in the first half of 2024 amounted to 2,70,000 and profit earned was 7,200.
R R

The sales in the second half year registered an increase and amounted to 3,42,000. The profit earned R

was 20,700 in that half year. Assuming no change in fixed costs, calculate (i) the profit/volume ratio,
R

(ii) the amount of profit when sales are 2,16,000 and (iii) the amount of sales required to earn a profit
R

of 36,000.
R

3
Ans. [(i) 184 % ; (ii) Loss R 2,925 ; (iii) Rs 4,23,600]

37. The sales and profits during two periods are as under :
Period I Sales 20 Lakhs—Profit 2 Lakhs.
R R

Period II Sales 30 Lakhs—Profit 4 Lakhs.

R R

Calculate (i) P/V ratio (ii) The sales required to earn a profit of R 5 Lakhs.
Ans. [(i) 20% ; R 35,00,000]
38. From the following data relating to a company, calculate ; (i) Break-even sales ; and (ii) sales required to
earn a profit of 6,000 per period.
R

Period Total Sales Total Costs

R R

1 42,500 38,700
2 39,200 36,852
Ans. [(i) R 33,864 (ii) R 47,500]
39. The sales and profit during the two years were as follows :
Sales R Profit R

2023 1,00,000 10,000

2024 1,50,000 20,000
(i) Find out the break even point. (ii) What amount of sales will generate a profit of R 40,000 ? (iii) What
will be the profit if the sales are 1,20,000 ? R

Ans. [ 50,000 (ii)

R R 2,50,000 (iii) R 14,000]
MARGINAL COSTING AND BREAK-EVEN ANALYSIS C/2·61

40. The ratio of variable costs to sales is given to be 70%. The break even point occurs at 60% of capacity
sales. Find the capacity sales when fixed costs are 1,50,000. Determine profit at 80% and 100% sales.
R

Ans. [Break even point = 5,00,000 ; Capacity sales = 8,33,333 ; Profit at 80% capacity sales = 50,000 ;
R R R

Profit at 100%; Sales = 1,00,000] R

41. A plant is operating at 60 per cent capacity.

The fixed costs for operating the plant amount to 20,000 and the variable cost to 80,000. The sale
R R

proceeds of the product realise 1,25,000. The Managing Director asks the Management Accountant to
R

find out for him the percentage of capacity at which the plant should work so that a profit of 30,000 is R

realised. Show the calculation to be made by the Management Accountant.

Ans. [ ]2
663

42. Your company manufacturing a single product sells it at a price of 80 per unit. The variable cost per R

unit is 48 and the annual fixed cost amounts to 18 lakh. Based on these data, you are required to
R R

work out the following :

(i) Present P/V ratio and break-even sales.
(ii) Increase in the volume of sales required if the profit is sought to be increased by 3.6 lakh. R

(iii) Percentage increase/decrease in sales volume :

— to off set an increase of 4 per unit in variable cost ; and
R

— an increase in selling price by 10% without affecting the quantum of existing profit.
Ans. [(i) 40%, R 45 lakhs (ii) R 9 lakhs (iii) 14.28% (Increase), 20% (Decrease)].
43. From the following data, calculate :
(i) Break-even point expressed in amount of Sales in rupees ?
(ii) No. of Units that must be sold to earn a profit of 60,000 per year. R

(iii) How many Units must be sold to earn a net income of 10% of Sales ?
Sales Price R 20 per unit ; Variable Cost 14 per unit ; Fixed Cost
R R 7,92,000 per year.
Ans. [(i) R 26,40,000 ; (ii) 1,42,000 units ; (iii) 1,98,000 units].
44. (a) From the following data, find out (i) sales; and (ii) new break-even sales, if selling price is reduced
by 10%.
Fixed Cost 4,000 ; Break-even Sales 20,000 ; Profit 1,000 ; Selling Price per Unit 20
R R R

(b) From the following data, compute break-even sales and margin of safety :
Sales 10,00,000 ; Fixed Cost 3,00,000 ; Profit 2,00,000
(c) From the following data, calculate break-even point (BEP) :
Selling Price per Unit 20 ; Variable Cost per Unit 15 ; Fixed Overheads 20,000
If sales are 20% above BEP, determine the net profit.
Ans. [(a) (i) Sales 25,000 ; (ii) New Break-even Sales 36,000;
R R

(b) B.E.P. (Sales) 6,00,000, Margin of Safety 4,00,000;

R R

(c) B.E.P. (Sales) 96,000, Profit 4,000.]

R R

45. Sales Profit

R R

Period 1 10,000 2,000

Period 2 15,000 4,000
You are required to calculate : (i) P/V Ratio ; (ii) Fixed Costs ; (iii) Break-even sales volume ; (iv) Sales
to earn a profit of 3,000 ; and (v) Profit when sales are 8,000.
R R

Ans. [(i) 40% ; (ii) R 2,000 ; (iii) R 5,000 ; (iv) R 12,500 ; (v) R 1,200.]
C/2·62 MARGINAL COSTING AND BREAK-EVEN ANALYSIS

46. There are two factories under the same management. It is desired to merge these two factories. The
following information is available :
Factory A Factory B
Capacity Operation 100% 60%
Sales R 300 lakhs R 120 lakhs
Variable Cost R 220 lakhs R 90 lakhs
Fixed Cost R 40 lakhs R 20 lakhs

Calculate :
(i) The capacity of the merged plant for the purpose of breaking-even and
(ii) The profit on working at 75% of the merged capacity.
Ans. [(i) 46.15% ; (ii) R 37.5 lakhs]
Hint. [P/V Ratio = 26%]

BREAK EVEN/P/V CHARTS

47. From the following particulars, draw a break even chart and find out the break even point:
Variable cost per unit 10 ; Selling price per unit 15 ; Fixed expenses 40,000.
R R R

What will be the selling price per unit if break even point is brought down to 5,000 units.
Ans. [Break even point 8,000 units ; Selling price 18] R

48. You are given the following data for a costing year for factory :
Budgeted Output 1,00,000 units Variable Expenses per unit R 10
Fixed Expenses 5,00,000 R Selling Price per unit R 20
Draw a break even-chart showing the break even point. If the selling price is reduced to R 18 per unit,
what will be the new break even point ?
Ans. [Break Even Point : (i) 50,000 units, (ii) 62,500 units]
49. Following is the data taken from the records of a concern manufacturing a special part ZED.
Selling price per unit R 20 Budgeted level of output and sales 80,000 units
Direct material cost per unit R 5 Budgeted recovery rate of fixed
Direct labour cost per unit R 3 overhead cost per unit R 5
Variable overhead cost per unit R 2
You are required to :
(a) Draw a break even chart showing the break even point.
(b) In the same chart show the impact of break even point.
(1) If the selling price per unit is increased by 30% and
(2) If the selling price per unit is decreased by 10%.
Note : Assume a scale of 1″ = 20,000 units for ‘X’ axis and 1″ = 4,00,000 for ‘Y’ axis. Workings should form
R

part of the answer.

Ans. [(a) B.E.P. = 40,000 units ; (b) (1) B.E.P. = 25,000 units ; (b) (2) B.E.P. = 50,000 units]
50. (a) From the data given below you are required to present on graph paper a profit volume
(P/V) graph to show the expected company performance based on the budget for one year.
Sales 6,00,000 ; Marginal Cost 3,50,000 Fixed Cost 1.50,000.
R R R

Determine the Break-Even Point and the Margin of Safety.

(b) Discuss briefly the limitations of a profit volume graph.
Ans. [Break-Even Point 3,60,000 ; Margin of Safety 2,40,000]
R R
APPLICATIONS OF MARGINAL COSTING C/3·1

CHAPTER

3
Applications of Marginal Costing
LEARNING OBJECTIVES
To understand about Application of Marginal Costing.
To learn Cost Control
To understand about Profit Planning
To understand about Evaluation of Performance
To understand about Decision Making

The present Indian economic scenario which is poised for a great surge forward with series of
reform process, liberation and globalisation. In this background, the application of marginal costing
techniques assumes a special significance as it helps to ensure globally competitive prices by way of
differentiation between fixed and variable cost. Managerial decisions demand that in the short run
the selling price should cover at least the variable cost of production and any surplus left over should
cover the fixed expenses to the extent possible. The elements like gross contribution, profit-volume
ratio, etc. are extremely helpful in capacity planning, make or buy decisions, quotations for export
markets, break-even analysis, etc. and thereby help in containing the costs to the barest minimum by
elimination of inefficiencies. Marginal costing is a very useful tool for management because of its
following applications and merits :

1. Cost Control
Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled
by the top management and that to a limited extent. Variable costs can be controlled by the lower
level of management. Marginal costing by concentrating all efforts on the variable costs can control
and thus provides a tool to the management for control of total cost.
There may be situations where the profits of the concern are decreasing inspite of increase in
sales. If the data is presented on the basis of absorption costing basis, the management may not be
able to comprehend the results. Marginal costing analysis will correctly bring out the reasons as to
why the profits are decreasing inspite of increase in sales.
C/3·2 APPLICATIONS OF MARGINAL COSTING

Moreover, it should be noted that in marginal costing fixed costs are not eliminated at all. These
are shown separately as a deduction from the contribution instead of merging with cost of sales and
inventories. This helps the management to have control on fixed costs also in the long period as these
costs are programmed in advance.

2. Profit Planning
Marginal costing helps the profit planning i.e., planning for future operations in such a way as to
maximise the profits or to maintain a specified level of profit. Absorption costing fails to bring out
the correct effect of change in sale price, variable cost or product mix on the profits of the concern but
that is possible with the help of marginal costing. Profits are increased or decreased as a consequence
of fluctuations in selling prices, variable costs and sales quantities in case there is fixed capacity to
produce and sell.

ILLUSTRATION 1. Two businesses, Y Ltd. and Z Ltd., sell the same type of product in the
same type of market.
Their budgeted profit and loss accounts for the coming year are as follows :
Y Ltd. Z Ltd.
R R

Sales 1,50,000 1,50,000

Less : Variable Cost 1,20,000 1,00,000
————————————— —————————————

Contribution 30,000 50,000

Less : Fixed Cost 15,000 35,000
————————————— —————————————

Budgeted Net Profit 15,000 15,000

—————————————
————————————— —————————————
—————————————

You are required to : (a) calculate the break even point of each business ; (b) calculate the sales
volume at which each of business will earn R 5,000 profit ; (c) calculate at which sales volume both
the firms will earn equal profits. (d) state which business is likely to earn greater profit in
conditions of : (i) heavy demand for the product ; (ii) low demand for the product and briefly give
your reasons.
SOLUTION
Y Ltd. Z Ltd.
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Contribution R30‚000 1 R50‚000 1 1
(a) P/V Ratio = = or 20% = or 33 %
Sales R1‚50‚000 5 R1‚50‚000 3 3
Fixed Cost R15‚000 R35‚000
Break Even Point = = 75,000R = 1,05,000
R
P/V Ratio 1 1
5 3
Fixed Cost + Desired Profit R15‚000 + 5‚000 R R35‚000 + 5‚000R
(b) Sales Volume =
P/V Ratio 1 1
5 3
= 1,00,000
R = 1,20,000
R

(c) Sales Volume (for both the firms to earn equal profit)
Difference in Fixed Costs 20‚000 R 3
= = = R 20,000 × × 100 = R 1,50,000
Difference in P/V Ratio 1 40
13 %
3
APPLICATIONS OF MARGINAL COSTING C/3·3

Alternative Solution for (c)

Sales volume at which both the firms will earn equal profit can also be calculated by another method as
given below :
F+P F+P
=
P/V P/V
R15‚000 + P 35‚000 + P R
=
20% 1
33 %
3
R15‚000 + P 35‚000 + P R
=
20 100
100 3 × 100
1 1
( 15,000 + P)
R = ( 35,000 + P)
R
3 5
1 1
R 5,000 + P = 7,000 + P
R
3 5
1 1
P– P = R 7,000 – R 5,000
3 5
2
P = R 2,000
15
15
P = R 2,000 × = R 15,000
2
Profit for both the firms = R 15,000
F+P R 15‚000 + 15‚000
R
Y Ltd. : Sales = = = R 1,50,000
P/V 20%
F+P R 35‚000 + 15‚000
R

Z Ltd. : Sales = = = R 1,50,000

P/V 1
33 %
3
Thus, at sales volume of R 1,50,000 profit will be equal.
(d) (i) In conditions of heavy demand, a concern with larger P/V ratio can earn greater profits
because of greater contribution. Thus, Z Ltd. is likely to earn greater profit.
(ii) In conditions of low demand, a concern with lower break even point is likely to earn more
profit because it will start earning profits at lower level of sales. In this case Y Ltd. will start earning
profits when its sales reach the level of 75,000, whereas Z Ltd. will start earning profits when its
R

sales reach the level of 1,05,000. Therefore, in case of low demand break even point should be
R

reached as earlier as possible so that the concern may start earing profits.

3. Evaluation of Performance
The different products, departments, markets and sales divisions have different profit earning
potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector of a
concern. Performance evaluation is better done if distinction is made between fixed and variable
expenses. A product, department, market or sales division giving higher contribution should be
preferred if fixed expenses remain same.

ILLUSTRATION 2. (Elimination of a product). A company manufactures 3 products A, B and

C. There are no common processes and the sale of one product does not affect prices or volume of
sales of any other.
C/3·4 APPLICATIONS OF MARGINAL COSTING

The Company’s budgeted profit/loss for 2024 has been abstracted thus :
Total A B C
R R R R

Sales 3,00,000 45,000 2,25,000 30,000

—————————————————————————————————————————————————————————————————————————

Production Cost :
Variable 1,80,000 24,000 1,44,000 12,000
Fixed 60,000 3,000 48,000 9,000
—————————————————————————————————————————————————————————————————————————

Factory Cost 2,40,000 27,000 1,92,000 21,000

Selling and Administrative Cost :
Variable 24,000 8,100 8,100 7,800
Fixed 6,000 2,100 1,800 2,100
—————————————————————————————————————————————————————————————————————————

Total Cost 2,70,000 37,200 2,01,900 30,900

—————————————————————————————————————————————————————————————————————————

Profit 30,000 7,800 23,100 (–) 900

—————————————————————————————————————————————————————————————————————————

On the basis of the above the Board had almost decided to eliminate product C, on which a
loss was budgeted. Meanwhile they have sought your opinion. As the company’s Cost and
Management Accountant what would you advice ? Give reasons for your answer.
SOLUTION
Products Total
————————————————————————————————————————————————————————————————————————————————

A B C
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

Sales 45,000 2,25,000 30,000 3,00,000

Less : Marginal Cost : R R R

Product Cost 24,000 1,44,000 12,000

S & Adm. Cost 8,100 8,100 7,800
————————— ————————————— ——————————

32,100 1,52,100 19,800 2,04,000

————————— ————————————— —————————— ————————————

Contribution per unit 12,900 72,900 10,200 96,000

Less : Fixed Cost
( 60,000 + 6,000)
R R 66,000
————————————

Profit 30,000
————————————
————————————

P/V Ratio (
Contribution
Sales
× 100 ) 28.67% 32.4% 34%

From the above it is clear that product C is contributing 10,200 towards the fixed expenses of the
R

company. If product C is eliminated the profit of the company will be reduced to 19,800 (i.e., 30,000 – R R

R 10,200). Moreover, the P/V Ratio of product C is the highest as compared to other products. Hence it is not
advisable to eliminate product C.

ILLUSTRATION 3. (Profitability of a product). The Novelties Ltd. is not keen on making

special efforts to push the sales of product B, one of three main products it deals in, since the
APPLICATIONS OF MARGINAL COSTING C/3·5

product B is not considered to be as profitable as the other two. The selling prices and cost of the
three products are :
Product Selling Direct Direct Labour
————————————————————————————————————————————————————————————

Price Material Dept. X Dept. Y Dept. Z

R R R R R

A 340 50 40 10 10
B 290 30 10 40 10
C 320 40 10 10 40
Overhead rates for each department per rupee of direct labour are as follows :
Dept. X Dept. Y Dept. Z
R R R

Variable Overheads 1.20 0.40 1.00

Fixed Overheads 1.20 2.00 1.40
—————— ——————— ———————

Total 2.40 2.40 2.40

——————
—————— ———————
——————— ———————
———————

What will be your advice about the profitability of product B ? Give reasons.
SOLUTION STATEMENT SHOWING THE COMPARATIVE PROFITABILITY
Products
————————————————————————————————————————————
Products A B C
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R

(A) Selling Price 340 290 320

————————————————————————————————————————
(B) Marginal Cost :
Direct Material 50 30 40
Direct Labour 60 60 60
Variable Overheads (1) 62 38 56
————————————————————————————————————————
172 128 156
————————————————————————————————————————
————————————————————————————————————————
(C) Contribution (A) – (B) 168 162 164
Fixed Overheads (2) 82 106 88
————————————————————————————————————————
Profit 86 56 76
————————————————————————————————————————
————————————————————————————————————————
Contribution
P/V Ratio = × 100 49.4% 55.9% 51.3%
Sales
The attitude of Novelties Ltd. towards product B is based on wrong considerations. Though product B is
giving a little less contribution as compared to other products but it has the maximum profit volume ratio. The
wrong attitude of company towards this product may be due to the inequitable apportionment of fixed overhead
cost and that is why the profit of product B is less as compared to A and C. But this is not the right attitude of the
company. Product B sales must be pushed up as long as it gives good contribution. Moreover, it has the
maximum profit volume ratio as compared to other products.
Working Notes :
Dept. X Dept. Y Dept. Z Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(1) Variable Overheads R

A 40 × R 1.20 = R 48 10 × R 0.40 = R 4 10 × R 1= R 10 62
B 10 × R 1.20 = R 12 40 × R 0.40 = R 16 10 × R 1= R 10 38
C 10 × R 1.20 = R 12 10 × R 0.40 = R 4 40 × R 1= R 40 56
C/3·6 APPLICATIONS OF MARGINAL COSTING

(2) Fixed Overheads :

A 40 × R 1.20 = R 48 10 × 2 = R 20 10 × R 1.40 = R 14 82
B 10 × R 1.20 = R 12 40 × 2 = R 80 10 × R 1.40 = R 14 106
C 10 × R 1.20 = R 12 10 × 2 = R 20 40 × R 1.40 = R 56 88
ILLUSTRATION 4. (Profitability for discontinuation of sales). A company which sells four
products, some of them unprofitable, proposes discontinuing the sale of one of them. Following
information is available regarding its income, costs and activities for a year :
Products
——————————————————————————————————————————————————————————————————————————————————————

A B C D
R R R R

Sales 3,00,000 5,00,000 2,50,000 4,50,000

Cost of sales at purchase price 2,00,000 4,50,000 2,10,000 2,25,000
————————————— ————————————— ————————————— —————————————

Area of storage (sq. ft.) 50,000 40,000 80,000 30,000

No. of parcels sent 1,00,000 1,50,000 75,000 1,75,000
No. of invoices sent 80,000 1,40,000 60,000 1,20,000
Its overhead costs and basis of allocation are :
R Basis of allocation to production
Fixed costs :
Rent and insurance 30,000 sq. ft.
Depreciation 10,000 parcel
Salesman’s salaries & expenses 60,000 sales value
Administrative wages and salaries 50,000 no. of invoices
Variable costs :
Packing, wages and materials 20 p. per parcel
Commission 4% of sales
Stationery 10 p. per invoice
You are required to :
(a) prepare a profit and loss statement showing percentage profit or loss to sales for each
product.
(b) compare the profit if the company discontinues sales of product B with the profit if it
discontinues product C.
SOLUTION (For Statement of Profit & Loss see next page)
(b)
Contribution If product ‘B’ If product ‘C’
from is discontinued is discontinued
R R

Product A (+) 60,000 (+) 60,000

Product B — (–) 14,000
Product C + 9,000 —
Product D + 1,60,000
——————————————————
(+) 1,60,000
——————————————————
Total Contribution 2,29,000 (+) 2,06,000
Less : Fixed Cost 1,50,000
——————————————————
1,50,000
——————————————————
Profit 79,000
——————————————————
56,000
——————————————————
—————————————————— ——————————————————
Conclusion
Since contribution in case of product B is negative, it is better to discontinue ‘B’ ; only thereby the profit will
be maximum, i.e., 79,000 as compared to the existing profit of 65,000.
R R
APPLICATIONS OF MARGINAL COSTING C/3·7
C/3·8 APPLICATIONS OF MARGINAL COSTING

ILLUSTRATION 5. (Utilisation of resources for improvement of profitability). A Ltd.

Manufactures three products and the cost particulars for a year are as follows :
Product
—————————————————————————————————————————————————————————————————————————————————

X Y Z
(R) (R) (R)
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Sales 2,00,000 4,00,000 2,50,000

Material cost 1,00,000 1,50,000 1,25,000
Labour cost 30,000 50,000 40,000
Variable overheads 10,000 20,000 25,000
Fixed overheads 35,000 50,000 25,000

The company imports one of the raw material which is used in manufacture of all products,
the consumption of material is as follows :
X 2,000 kgs. ; Y 5,000 kgs. and Z 3,000 kgs.
There is restriction in import of the material. The management is planning to close down one
of the lines of product, and utilise the materials for other two lines to improve the profitability. As
the cost and management accountant of the company, prepare a report for the closure of one line
for improving the profitability.

SOLUTION
STATEMENT SHOWING THE PROFITABILITY OF THREE PRODUCTS
X Y Z
——————————————————————————————————————————————————————————

R R R

(A) Sales 2,00,000 4,00,000 2,50,000

——————————————————————————————————————————————————————————

Less : Marginal Cost :

Material cost 1,00,000 1,50,000 1,25,000
Labour cost 30,000 50,000 40,000
Variable overheads 10,000 20,000 25,000
——————————————————————————————————————————————————————————

(B) Total Marginal Cost 1,40,000 2,20,000 1,90,000

——————————————————————————————————————————————————————————

(C) Contribution (A) – (B) 60,000 1,80,000 60,000

Less : Fixed Cost 35,000 50,000 25,000
——————————————————————————————————————————————————————————

Profit 25,000 1,30,000 35,000

——————————————————————————————————————————————————————————

Imported materials in kgs. 2,000 5,000 3,000

Contribution per kg. of
imported material R 30 R 36 R 20
Ranking II I III

Product Z gives the lowest contribution per kg. of imported materials. Hence it may be discontinued and raw
material rendered surplus i.e. 3,000 kgs. should be utilised for production of Y which gives the highest
contribution per kg of raw material. If it is done, the contribution will increase by 48,000 i.e., 16 (i.e., 36 –
R R R

R 20) × 3,000 kgs. Hence the total profit will increase to 2,38,000 (i.e., 190,000 + 48,000). In case the full
R R R

quantity 3,000 kgs. cannot be utilised on Y due to market constraints, the balance can be used for production of
X (second priority).
APPLICATIONS OF MARGINAL COSTING C/3·9

4. Decision Making
The information provided by the total cost method is not sufficient in solving the management
problems. Marginal costing technique is used for providing assistance to the management in vital
decision-making, especially in dealing with the problems requiring short-term decisions where fixed
costs are excluded. Following are important areas where managerial problems are simplified by use
of the marginal costing :
(i) Fixation of selling price. (vii) Alternative methods of production.
(ii) Key or limiting factor. (viii) Cost indifferent point.
(iii) Make or buy decisions. (ix) Diversification of products.
(iv) Selection of a suitable product mix. (x) Closing down or suspending activities.
(v) Effect of change in price. (xi) Alternative course of action.
(vi) Maintaining a desired level of profit.

I. Fixation of Selling Prices

Although prices are more controlled by market conditions and other economic factors than by
decisions of management yet fixation of selling prices is one of the most important functions of
management. This function is to be performed :
(a) Under normal circumstances. (b) In times of competition. (c) In times of trade depression. (d) In
accepting additional orders for utilising idle capacity. (e) In exporting and exploring new markets.
In Normal Circumstances the price fixed must cover total cost as otherwise profits cannot be
earned. It can also be fixed on the basis of marginal cost by adding a high margin to marginal cost
which may be sufficient to contribute towards fixed expenses and profits. Thus, in the long run the
selling price should cover all costs variable and fixed and bring the desired margin of profit.
In times of competition, products may have to be sold at a price below total cost, if such a step is
necessary to meet the situation arising due to competition, trade depression, additional orders for
utilising spare capacity, exploring new markets, liquidation of excess stock etc. Thus, in special
circumstances, price may be below the total cost and it should be equal to marginal cost plus a certain
amount (if possible). This is only a short term step taken with the hope that better times will come
when prices will be increased. Pricing decisions are thus affected by long term and short term
objectives.
EXAMPLE. XYZ Company produced and sold 1,000 toys. The cost structure for each toy is as
follows :
Sale Price R 500, Materials R 100, Labour R 50, Variable Overheads R 25, Fixed Overheads R 200.
Due to heavy competition, the price has to be reduced to R 425 for the next year. Assuming
there is no change in costs, find out how many toys shall be sold to ensure same amount of total
profit as last year.
SOLUTION STATEMENT OF LAST YEAR PROFIT

Sales (1,000 × R 500) 5,00,000

Less : Total Cost ( 100 +
R R 50 + R 25 + R 200) or R 375 × 1,000 3,75,000
—————————————————
Profit 1,25,000
—————————————————
—————————————————
C/3·10 APPLICATIONS OF MARGINAL COSTING

New Selling price R 425

Now contribution per unit = , 425 –R R 175 = 250 R

Fixed Cost + Desired Profit

Sales for Desired Profit (in units) =
Contribution per unit
R2‚00‚000 + 1‚25‚000
R 3‚25‚000
R
= = = R 1,300 units
250 R 250R

ILLUSTRATION 6. ABC limited has been working below normal capacity due to recession.
The directors of this company have been approached by a customer with an enquiry for a special
purpose job. The costing department estimated the following in respect of the job :
Direct materials R 60,000,
Direct Labour Hours 800 @ R 25 pr hour;
Overhead costs (normal rates of recovery variable R 10 per hour and fixed R 15 per hour)
The directors of the company seek your advice on the minimum price to be charged. Assume
that there are no production difficulties regarding the job.

SOLUTION
R

Direct Material 60,000

Direct Labour (800 × R 25) 20,000
Variable Overhead Cost (800 × R 10) 8,000
—————————

88,000
—————————
—————————

The absolute minimum price is 88,000 i.e. total of variable cost. As this price will not make any
R

contribution, a proportion of fixed cost of 12,000 (i.e. 800 × 15) may be added to make the job worthwhile.
R R

The amount to be added will depend upon the circumstances of that case.

ILLUSTRATION 7. (Determination of Selling Price under both monopoly and competitive

conditions). In a purely competitive market 10,000 units of a product can be manufactured and
sold and a certain amount of profit is generated. It is estimated that 2,000 units of that product
need to be manufactured and sold in a monopoly market to earn the same amount of profit. Profit
under both the market conditions is targeted at R 2,00,000. The variable cost per unit is R 100 and
the total fixed cost is R 60,000. You are required to determine the selling prices under both
monopoly and competitive conditions.

SOLUTION
Suppose Selling Price per unit = x
In monopoly market :
Total Sales = 2,000x R

Variable Cost = 2,000 × R 100 = 2,00,000

Fixed Cost = 60,000
———————————

Total Cost = 2,60,000

Desired Profit = 2,00,000
F+P R 2‚60‚000 + 2‚00‚000R
Selling Price = = = R 230
No. of units 2‚000 units
APPLICATIONS OF MARGINAL COSTING C/3·11

In competitive conditions :
Total Sales = 10,000 x R

Variable Cost = 10,000 × 100 = 10,00,000

Fixed Cost = 60,000
——————————————
Total Cost = 10,60,000
Profit = 2,00,000
R 10‚60‚000 + 2‚00‚000
R
Selling Price = = 126 R
10‚000 units
Hence in monopoly price is R 230 per unit
and in competition, price is R 126 per unit

Pricing in Depression. Prices fall during depression and the product may be sold below the total
cost. In case there is a serious but temporary fall in the demand on account of depression leading to
the need for a drastic reduction in prices temporarily, the minimum selling price should be equal to
the marginal cost. If the selling price at which the goods can be sold is equal to marginal cost or more
than marginal cost the product should be continued. Fixed expenses will be incurred even if the
product is discontinued during depression for a short period. If the product can be sold at a price
which is a little more than marginal cost, loss on account of fixed expenses will reduce because price
will recover fixed expenses to some extent. This can be made clear by giving the following example :
Suppose, marginal cost per unit is R 10 and fixed expenses amount to R 1,50,000. Selling price per
unit is R 11 and 40,000 units can be sold at this price.
R

Marginal cost : 40,000 units @ R 10 4,00,000

Fixed Expenses 1,50,000
——————————————

Total Cost 5,50,000

——————————————
R 5‚50‚000
Cost per unit = R 13.75
40‚000
Even though the selling price of R 11 is below the total cost, yet it is advantageous to sell the
product at the selling price of R 11 which is more than the marginal cost of R 10. This will reduce the
loss on account of fixed expenses (if the product is discontinued) by R 40,000 as shown below :
R

Selling price of 40,000 units @ R 11 4,40,000

Less : Total cost (Calculated earlier) 5,50,000
——————————————

Loss 1,10,000
——————————————

Loss if the product is discontinued (Fixed Expenses) 1,50,000

Loss reduced if the product is continued (R 1,50,000 – R 1,10,000) 40,000
EXAMPLE. ABC limited has been working below normal capacity due to recession. The
directors of this company have been approached by a customer with an enquiry for a special
purpose job. The costing department estimated the following in respect of the jobs:
Direct materials R 60,000
Direct Labour Hours 800 @ 25 per hour
Overhead costs (normal rates of recovery variable R 10 per hour and fixed R 15 per hour)
C/3·12 APPLICATIONS OF MARGINAL COSTING

The directors of the company seek your advice on the minimum price to be charged. Assume
that there are no production difficulties regarding the job.

SOLUTION
Computation of the Minimum Price R

Direct Material 60,000

Direct Labour (800 hrs. × 25) R 20,000
Variable Overheads (800 hrs. × R 10) 8,000
——————————

Variable Cost 88,000

——————————
——————————

As the variable cost is 88,000, any price above this will make a contribution. A price at 88,000 will be a
R R

no profit no loss stage. Depending upon the bargaining strength of the company and market conditions, the
company should fix the price above 88,000 so that it earns some contribution.
R

Selling Price Below the Marginal Cost

If the selling price is below the marginal cost, loss will be more than the fixed costs because
variable expenses will not be recovered fully. Hence, efforts should be made to sell the product at a
price which is equal to the marginal cost or more than the marginal cost. Production should be
discontinued if the price obtained is below the marginal cost so that loss may not be more than the
fixed costs. But, in the following circumstances, production may be continued even if the selling
price is below the marginal cost.
1. When a new product is introduced in the market. The new product is sold at a very low price
to make it popular. This is done with the hope that sales will increase with the passage of time and
cost of production will come down as a result of increase in sales. Ultimately cost of production will
be in line with the selling price and the concern will start earning profit from the new line of
production.
2. When foreign market is to be explored to earn foreign exchange. Government sometimes
allows import quotas against foreign exchange earned and profits from import quotas may be much
more than the loss on exporting the product at a price below the marginal cost.
3. When the concern has already purchased large quantities of materials. It is better to convert
the material into finished goods and sell these at a price below the marginal cost if the sale of
materials will give rise to loss which is more than the loss incurred if the production is done.
4. When closure of business may mean breaking of business connections and connections may
be re-established by a heavy expenditure on advertisement and sales promotion. In such a case, it is
better to continue the production and sell the product at a price below the marginal cost.
5. When the sales of one product at a price below the marginal cost will push up the sales of
other profitable products. The loss in one product will be made up by profits in other products.
6. When employees cannot be retrenched. In such a case, it is better to maintain the production
even if the price is below the marginal cost.
7. When weak competitors are to be eliminated from the market.
8. When facing severe competition from a new entrant into the firm’s line of business.
9. For publicity and advertisement. Price below marginal cost is only for a limited quantity.
10. When the goods are of perishable nature. It is better to sell the perishable goods at a price
which they can realise ; otherwise these goods will perish and nothing will be realised.
APPLICATIONS OF MARGINAL COSTING C/3·13

Accepting Additional Orders, Exploring Additional Markets and Exporting

When additional orders are accepted or additional markets explored at a price below normal
price to utilise idle capacity, it should be very carefully seen that they will not affect the normal
market and goodwill of the company. The order from a local merchant should not be accepted at a
price below normal price because it will affect relationship of the concern with the other customers
purchasing the goods at normal price. In case of foreign markets, goods may be sold at a price below
normal price keeping in view the direct and indirect benefits of exporting such as import quotas,
subsidies of Government, prestige of exporting etc.

Factors to be Considered Before Launching a Product in the New Market

Following are the main factors to be considered before launching a product in the new market
(whether Indian or Foreign).
(i) Whether the firm has Surplus Capacity to meet the new demand.
(ii) What price is being offered by the new market ? In any case, it should be higher than the
variable cost of the product plus any additional expenditure to be incurred to meet the
specific requirements of the new market.
(iii) Whether the sale of goods in the new market will affect the present market for the goods. It is
particularly true in case of sale of goods in a foreign market at a price lower than the
domestic market price. Before accepting such an order from a foreign buyer, it must be seen
that the goods sold are not dumped in the domestic market itself.

Factors in Accepting Export Orders

The decision making by management requires the consideration of two types of factors, i.e., (i)
Cost Factors and (ii) Non-Cost Factors.
(i) Cost Factors. The most important cost factor in deciding about export sales is that export
price should be more than the variable cost of the product. In such cases, the export sales will
make a contribution and since there generally is no fixed cost involved the contribution is
equal to profit. If the company has to incur an additional fixed cost for export production,
then such fixed cost should also be covered to make the export order profitable.
(ii) Non-Cost Factors. These are qualitative factors such as ;
(a) Export house status ; (b) Earning of foreign exchange ; (c) Goodwill enhancement of
the company ; (d) Creating employment opportunities.

EXAMPLE. A machine shop in a factory is working to its full capacity and earning a
contribution of R 50 per hour. The management receives a high priority order which it wants to
execute immediately. Material will be supplied by the customer and the special order will take a
minimum of 10 hours. Wages payable will be R 15 per hour and variable overhead will be 150% of
wages. If the customer is prepared to pay R 800 for the order, should the order be accepted ?
SOLUTION
R

Opportunity Cost of R 10 Machine Hours (10 × R 50) 500

Wages Payable for 10 Machine Hours (10 × R 15) 150
C/3·14 APPLICATIONS OF MARGINAL COSTING

Variable Overheads (150% of Wages) ( R 150 ×

150
100 ) 225
——————

Total Cost 875

——————
——————
Price offered by the Customer 800
R

Loss = 875 – 800 = 75

R R R

So, the offer should not be accepted as there is no idle capacity.

Special Order Acceptance

Special order refer to any additional large order received which is at a price lower than normal
selling price at which a company is selling its products. Such special order may be for (i) Export-
order, (ii) Bulk order from a domestic buyer.
(i) Export order. When a company is working at below 100% capacity and an export-order is
received at a price which is below normal domestic price, such a order should be accepted as long as
it is above the variable cost and makes a contribution. In such a case, the entire amount of
contribution is profit because the fixed cost is already covered in domestic sales.
(ii) Bulk order. This is similar to export order situation. when a company is not fully utilising its
production capacity and a bulk order is received for unutilised capacity at below normal selling price,
the management should consider accepting an order provided the price offered is above variable cost
and price discrimination is possible i.e. the bulk buyer will not undercut i.e. sell the product at price
lower than your normal price or will not compete with you.

ILLUSTRATION 8. (Acceptance or rejection of a special order). The Cost Sheet of a product

is given as under :
R

Direct Materials 5.00

Direct Wages 3.00
Factory Overheads :
Fixed R 0.50
Variable R 0.50
————————————
1.00
Administrative Expenses 0.75
Selling and Distribution Overheads :
Fixed R 0.25
Variable R 0.50
————————————
0.75
————————

10.50
————————

The selling price per unit is R 12.

The above figures are for an output of 50,000 units, the capacity for the firm is 65,000 units. A
foreign customer is desirous of buying 15,000 units at a price of R 10 per unit. Advise the
manufacturer whether the order should be accepted. What will be your advice if the order were
from a local merchant ?
APPLICATIONS OF MARGINAL COSTING C/3·15

SOLUTION
MARGINAL COST OR ADDITIONAL COST FOR ADDITIONAL 15,000 UNITS
Per unit For 15,000 units
R R

Direct Materials 5.00 75,000

Direct Wages 3.00
——————————
45,000
—————————————
Prime Cost 8.00 1,20,000
Variable Overheads :
Factory 0.50 7,500
Selling and Distribution 0.50
——————————
7,500
—————————————
Marginal Cost 9.00 1,35,000
Sales 10.00
——————————
1,50,000
—————————————
Contribution 1.00 15,000
—————————— —————————————

The order from the foreign customer will give an additional contribution of 15,000. Hence, the order should
R

be accepted because additional contribution of 15,000 will increase the profit by this amount because fixed
R

expenses have already been met from the internal market.

The order from the local merchant should not be accepted at a price of 10 which is less than normal price
R

of 12. This price will affect relationship with other customers and there will be a general tendency of reduction
R

in the price.
ILLUSTRATION 9. (Acceptance or rejection of foreign offer). The Everest Snow Company
manufactures and sells direct to customers 10,000 jars of ‘Everest Snow’ per month at R 1.25 per jar.
The company’s normal production capacity is 20,000 jars of snow per month. An analysis of cost
for 10,000 jars show :
R R

Direct material 1,000 Jars 600

Direct labour 2,475 Fixed expenses of manufacturing,
Power 140 selling and administration 7,955
Misc. supplies 430
The company has received an offer for the export under a different brand name of 1,20,000 jars
of snow at 10,000 jars per month at 75 paise a jar.
Give your view on acceptance or non-acceptance of the offer.
SOLUTION
Present Position Position after export
Order Receipt
———————————————————————————————————————————————————————————————————————
R R R R

Sales Price 12,500 (12,500 +

Less : Variable Cost 7,500) 20,000
Direct Material 1,000 2,000
Direct Labour 2,475 4,950
Power 140 280
Misc. Supplies 430 860
Jars 600 1,200
————————— ———————————

4,645
—————————
9,290
———————————
Contribution 7,855 10,710
Less : Fixed Cost 7,955 7,955
————————— ———————————
Profit (Loss) (100) 2,755
—————————
————————— ———————————
———————————
C/3·16 APPLICATIONS OF MARGINAL COSTING

From the above statement it is clear that the offer for export should be accepted as it converts the loss of
R 100 into a net profit of 2,755.
R

ILLUSTRATION 10. (Acceptance or rejection of an offer). Chair Manufacturers Ltd. present

the following information for the past year :
Material cost R 1,20,000 Variable overheads R 60,000
Labour cost R 2,40,000 Units produced 12,000
Fixed overheads R 1,20,000 Selling price R 50 per unit
The available capacity is a production of 20,000 units per year. The firm has an offer for the
purchase of 5,000 chairs at a price of R 40 per unit. It is expected that by accepting this offer there
will be saving of R 1 per unit in material costs on all units manufactured, the fixed overheads will
increase by R 35,000 and the overall efficiency will drop by 2 per cent on all production. Draft a
report to the management giving your recommendations as to whether or not the offer should be
accepted.
SOLUTION
Dear Sir,
The offer to accept the order of 5,000 chairs has been evaluated with the help of the following statement :
Present Position Position after Acceptance
Sale 12,000 units of Order : Sale 17,000 units
————————————————————————————————————————————————————————————————————————————————————
Per unit Total Per unit Total
——————————————————————————————————————————————————————————————————————————————————————

R R R R

Sales (A) 50 6,00,000 [12,000 × R 50 8,00,000

——————————

+ 5,000 × R 40)
Less : Variable Cost :
Material 10 9

Labour ( R 2‚40‚000 100

×
12‚000 units 98 ) 20 20.41

Variable Overheads 5 5.00

———————— ———————————
Total Variable Cost (B) 35 4,20,000 34.41 5,84,970
————————
———————— ————————————
———————————— ————————————
———————————— —————————————

Contribution (A) – (B) 15 1,80,000 2,15,030

Less : Fixed Cost 1,20,000 1,55,000
————————————— —————————————
Profit 60,000 60,030
Though there is a marginal increase of 30 in profits by accepting the offer, but it is desirable to accept
R

taking into consideration the possibilities of getting orders in future. But at the same time, it has to be ensured
that there will not be general reduction in price because of the acceptance of this order.

ILLUSTRATION 11. (Acceptance of foreign offer and quotation under the same management).
A company manufacturing electric motors at a price of R 6,900 each, made up as under :
R

Direct materials 3,200

Direct labour 400
Variable overheads 1,000
Fixed overheads 200
APPLICATIONS OF MARGINAL COSTING C/3·17

Depreciation 200
Variable selling overheads 100
Royalty on production 200
Profit 1,000
—————————

6,300
Central exercise duty 600
—————————

6,900
—————————

(i) A foreign buyer has offered to buy 200 such motors at R 5,000 each. As a cost and
management accountant of the company would you advise acceptance of the offer ?
(ii) What should the company quote for a motor to be purchased by a company under the
same management if it should be at cost ?
SOLUTION
R

Sale price offered 5,000

Less : Variable costs : R

Direct materials 3,200

Direct labour 400
Variable overheads 1,000
Variable selling overheads 100
Royalty 200 4,900
————————— —————————
Contribution 100
—————————

From the above, it is clear that the offer gives 100 as contribution towards the recovery of fixed cost
R

besides covering marginal cost. As it is an export order so there will be no incidence of central excise. Moreover,
there will also be government incentive for export order, which will help the company to recover further the fixed
cost and balance, if any, the depreciation. If the order is not accepted, the capacity remains unutilized. Other
non-monetary aspects may also be viewed.
(ii) If the motor is sold at cost price, the price to be quoted will be the total price less selling overheads and
profit i.e., 6,300 – 1,100 = 5,200. Central excise duty may be added where payable.
R R R

II. Key Factor

Key factor is that factor which is most important about profitability of a product. These factors
are equally important for arriving at managerial decisions because these factors limit the volume of
output at a particular point of time or over a period. These are called key factors, scarce factors,
limiting factors, principal budget factors or governing factors. The limiting factors may be sale, raw
material, labour, plant capacity and availability of capital. Example : for a concern established in a
relatively new town, labour may be a key factor or the concern may find it difficult to acquire an
unlimited quantity of raw material because of scarcity or the quota system, etc. In the later case,
material will be the key factor. The extent of influence of these factors should be carefully examined
before arriving at a particular decision. Contribution per unit of key factor should be considered and
that course of action should be adopted which gives the highest contribution per unit of key factor.
Usually the limiting factor is sales. A concern may not be able to sell as much as it can produce.
But sometimes a concern can sell all it produces but production is limited due to the shortage of
materials, labour, plant capacity, or capital. In such a case, a decision has to be taken regarding the
choice of the product whose production is to be increased, reduced or stopped. Ordinarily, when
C/3·18 APPLICATIONS OF MARGINAL COSTING

there is no limiting factor, the choice of the product will be on the basis of the highest P/V ratio. But
when there are scarce or limited resources, selection of the product will be on the basis of contribution
per unit of scarce factor of production. In short, scarce resources should be utilised in those directions
where contribution per unit of limited resources is the maximum. For example, materials are limited
in supply and products X and Y use the same materials. Three units of materials are used for
producing product X and five units for Y. Suppose further contribution per unit is R 12 in case of
product X and R 15 in case of product Y.
In this case, contribution per unit of materials is R 4 (i.e. R 12 ÷ 3)in case of product X and R 3
(i.e. R 15 ÷ 5) in case of product Y. Hence the available material should first be used for
manufacturing product X upto limit of demand for it and the balance of materials (if any) should be
used for Y because product X yields more contribution per unit of scarce resource i.e., materials.
As mentioned earlier, usually limiting factor is sales. Therefore, in addition to limiting factor
from the production side, limiting factor may also be difficulty in selling the items produced. In such
a case ranking of items produced will be based on relatives contribution per unit of limiting factor of
production but the number of units of a product to be produced getting rank one will be restricted to
the number of units as per demand for that product and then the production of the other product
getting second rank will be done but restricted to sales demand if balance of limiting factor is
available and so on.
ILLUSTRATION 12. (When priorities are to be fixed for different products with reference to
the key factor). A company manufactures and markets three products X, Y and Z. All the three
products are made from the same set of machines. Production is limited by machine capacity. From
the data given below, indicate priorities for products X, Y and Z with a view to maximising profits:
Products
———————————————————————————————————————————————————————

X Y Z
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Raw material cost per unit (R) 11.25 16.25 21.25

Direct labour cost per unit (R) 2.50 2.50 2.50
Other variable cost per unit (R) 1.50 2.25 3.55
Selling price per unit (R) 25.00 30.00 35.00
Standard machine time required per unit in minutes 39 20 28

SOLUTION
STATEMENT INDICATING PRIORITIES OF DIFFERENT PRODUCTS TO MAXIMISE PROFITS

Products
——————————————————————————————————————————————————————————————————
X Y Z
——————————————————————————————————————————————————————————————————
R R R R R R

Selling Price per unit 25 30 35

Less : Variable Cost per unit :
Raw Material Cost per unit 11.25 16.25 21.25
Direct Labour Cost per unit 2.50 2.50 2.50
Other Variable Cost per unit 1.50 2.25 3.55
————————— —————————— —————————

15.25 21 27.30
—————————— —————————— ——————————

Contribution per unit (A) 9.75 9 7.70

APPLICATIONS OF MARGINAL COSTING C/3·19

Standard machine time required per

unit in minutes (B) 39 20 28
Contribution per minute (A) ÷ (B) 0.25 0.45 0.275
Priorities for products III I II

ILLUSTRATION 13. (When different key factors are involved). Following particulars are
extracted from the records of a company.
Per unit
—————————————————————————————————————————————————————————————————————

Product A Product B
Sale Price ( R) 100 110
Consumption of Materials (kgs.) 5 4
Material cost (R) 24 14
Direct wages (R) 2 3
Machine hours used 2 3
Variable overheads 4 6
Comment on the profitability of each product (both use the same raw material) when :
(i) Total sales potential in units is limited. (ii) Total sales potential in value is limited. (iii)
Raw Material is in short supply. (iv) Production capacity (in terms of machine hour) is the
limiting factor.
SOLUTION
Per unit
———————————————————————————————————————————————

Product A Product B
R R

Sale Price 100 110

Less : Variable cost 30 23
——————— ——————
Contribution 70 87
——————— ——————

Contribution per rupee of Sales (P/V Ratio) 70 paise 79 paise

Contribution per kg. of Material R14 R 21.75
Contribution per Machine Hour 35R 29 R

(i) When total sales potential in units is limited, product B will be better as compared to A as its contribution
per unit is more by 17 (i.e. 87 – 70).
R R R

(ii) When sales potential in value is limited, product B is better as compared to A as its contribution per
rupee of sales is more by 9 paise (i.e. 79 paise – 70 paise).
(iii) When raw material is in short supply, product B is better as compared to A as its contribution per kg. of
material is more by 7.75 (i.e. 21.75 – 14).
R R R

(iv) When production capacity (in terms of machine hours) is the limiting factor, product A is better as
compared to B as its contribution per machine hour is more by 6 (i.e. 35 – 29).
R R R

III. Make or Buy Decision

A concern can utilise its idle capacity by making component parts instead of buying them from
market. In arriving at such a make or buy decision, the price asked by the outside suppliers should
be compared with the marginal cost of producing the component parts. If the marginal cost is lower
than the price demanded by the outside suppliers, the component parts should be manufactured in
the factory itself to utilise unused capacity. Fixed expenses are not taken in the cost of manufacturing
C/3·20 APPLICATIONS OF MARGINAL COSTING

component parts on the assumption that they have been already incurred, the additional cost
involved is only variable cost. For example, the total cost of making a component part comes to R 8
consisting of R 6 as variable cost and R 2 as fixed cost. Suppose further an outside supplier is ready to
supply the same component part at R 7. On the basis of total cost method, it appears that it is cheaper
to buy the component. But on the basis of marginal cost, the offer of the outside supplier should be
rejected because the acceptance will mean that the total cost of the purchased part from the outside
supplier will come to R 9 i.e., R 7 (supplier’s price) plus R 2 (fixed cost which cannot be saved even if
the component is purchased from outside source).

Factors that Influence Make or Buy Decision

In a make or buy decision the following cost and non-cost factors must be considered
specifically.

Cost Factors
1. Availability of plant facility.
2. Quality and type of item —which affects the production schedule.
3. The space required for the production of item.
4. Any special machinery or equipment required.
5. Any transportation involved due to the location of production i.e. the ‘Feeder Point’
6. Cost of acquiring special know how required for the item.
7. As to purchase of raw material the factors like market price, price trend, availability and
other must be kept in view.
8. As to labour factors like availability of the required labour.
9. As to overhead expenses, adoption of lease for apportioning them must be taken into
consideration including other factors.
10. As to application of the techniques of costing it must be viewed for marginal costing,
differential costing or otherwise alike one.
11. In view of above and generally the production of an item will mean an outlay on machines
and other facilities including employment of staff which may be permanent and of fixed
nature. Thus fixed expenses burden may tend to increase. So our production is kept at the
estimated minimum requirement keeping in view the possible fluctuations in demand and
the excess quantity required to be purchased from outside. The effect is that, should demand
fall orders from outsiders can be cut down; the cost to be incurred will then be in proportion
to the effective demand.
12. Having decided to purchase, it is also to be seen whether the released capacity can be put to
more profitable use or not.

Non-Cost Factors
Among the non-cost factors specifically.
1. In favour of making, the factors like
(i) Secrecy of company production ; (ii) Idle facility available ; (iii) Quality and stability of
market supply ; (iv) Tax considerations ; (v) Desirability of maintaining certain facilities.
APPLICATIONS OF MARGINAL COSTING C/3·21

2. In favour of buying factors like

(i) Lack of capital required ; (ii) Passing the know how to suppliers or not ; (iii) Uneven
production of end product ; (iv) Wide selection.
3. Generally the following as
(i) If quality can not be ensured in our production, the article concerned should be
purchased from outside; if outside supplier can not be relied upon in this respect the
article should be produced by the firm itself, whatever be the cost.
(ii) In case there are large fluctuations in demand, it is better to purchase from outside, but
if the demand is likely to increase substantially, own production may lead to lower costs
latter.
(iii) Ensure the capability and reliability of the outside suppliers to supply without any
interruption. In this regard the following factors are to be considered :
(a) the general reputation enjoyed by supplier for reliability ; (b) financial position and
reputation ; (c) technical know how and production facilities ; (d) his relation with his
workmen etc.
(iv) If the business secrecy is to be maintained the manufacturing know how should not be
passed on to the supplier, then it is better to produce,
(v) The outside supplier should not be a competitor.
In fact, it is a very crucial decision and both cost and non-cost factors must be weighted well.
ILLUSTRATION 14. A manufacturing company finds that while the cost of making a
component part is R 10, the same is available in the market at R 9 with an assurance of continuous
supply. Give your suggestion whether to make or buy this part. Give also your views in case the
supplier reduces the price from R 9 to R 8. The cost information is as follows :
Materials R 3.50 Other Variable Expenses R 1.00
Direct Labour R 4.00 Fixed Expenses R 1.50
SOLUTION
To take a decision on whether to make or buy the component part, fixed expenses being irrelevant cost
should not be added to the cost because these will be incurred even if the part is not produced. Thus, additional
cost of the part will be as follows :
R

Materials 3.50
Direct Labour 4.00
Other Variable Expenses 1.00
————————
Total 8.50
————————
————————
The company should produce the part if the part is available in the market at 9.00 because the production
R

of every part will give to the company a contribution of 50 paise ( i.e., 9.00 – 8.50).
R R

The company should not manufacture the part if it is available in the market at 8 because additional cost of
R

producing the part is 50 paise ( i.e., 8.50 – 8) more than the price at which it is available in the market.
R R

In some cases inspite of lower variable cost of production, there may be an increase in the fixed costs. In
such a case increase in fixed cost becomes the relevant cost and should be considered for make or buy
decision. It becomes essential to find out the minimum requirement of volume in order to justify the making
instead of buying. This volume can be calculated by the following formula :
Increase in Fixed Costs
Contribution per Unit (i.e.Purchase Price – Variable Cost of Production)
C/3·22 APPLICATIONS OF MARGINAL COSTING

ILLUSTRATION 15. A firm can purchase a separate part from an outside source @ R 11 per
unit. There is a proposal that the spare part be produced in the factory itself. For this purpose a
machine costing R 1,00,000 with annual capacity of 20,000 units and a life of 10 years will be
required. A foreman with a monthly salary of R 500 will have to be engaged. Materials required
will be R 4.00 per unit and wages R 2.00 per unit. Variable overheads are 150% of direct labour.
The firm can easily raise funds @ 10% p.a. Advice the firm whether the proposal should be
accepted.
SOLUTION
Increase in Fixed Costs R

Depreciation of Machine 10,000

Salary of Foreman 6,000
Interest on Capital 10,000
———————————

26,000
———————————
Contribution per unit R

Purchase Price 11
Less : Variable Cost :
R

Materials 4.00
Wages 2.00
Variable Overheads 3.00
—————————
9
—————————
Contribution per unit 2
—————————
—————————
R 26‚000
Minimum Volume = = 13,000 units.
R2
In order to accept the proposal it is essential that the volume should be at least 13,000 units.
If there is no idle capacity and making of the spare part in the factory involves the loss of other work,
the loss of contribution arising from displacement of work should also be considered alongwith variable
cost of production. The loss of contribution is found with reference to key or limiting factor. If the
purchase price is higher than the total variable cost of production plus traceable fixed costs plus the
loss of contribution of production, it will be more profitable to manufacture.
ILLUSTRATION 16. K Ltd. produces a variety of products, each having a number of
component parts. B takes 5 hours to process on a machine working to full capacity. B has a selling
price of R 100 and a marginal cost of R 60 per unit. ‘A–10’ component part used for product A,
could be made on the same machine (M–23) in 2 hours for a marginal cost of R 10 per unit. The
supplier’s price is R 24. Assume that machine hour is the limiting factor. Advise whether the
company should buy or make component part A–10 from the market under both the situations.
(i) When machine M–23 is working at full capacity.
(ii) When machine M–23 has idle capacity. Give reasons.
SOLUTION
Contribution per unit of B = R 100 –60 = 40
R R

40
R
Contribution per machine hour = = 8 R
5
If one unit of ‘A–10’ takes 2 hours, then 16 (i.e.,
R R 8 × 2) contribution is lost.
∴ Full cost to make one unit of ‘A–10’ = R 10 + R 16 = R 26.
APPLICATIONS OF MARGINAL COSTING C/3·23

This is more than the supplier’s price of R 24. Hence it would be more profitable to buy ‘A–10’ than to make.
Situation (i). Full Capacity Utilisation (Existing)
R

Cost of making A–13 Component 10

Loss of Contribution ( 8 × 2) (Opportunity Cost)
R 16
——————

26
——————

This manufacturing cost exceeds the supplier’s price of 24, so the decision is to buy the component
R

assuming assured supply of same quality of the component.

Situation (ii). Idle Capacity (Existing)
The existing idle capacity must be utilised by manufacturing the required component A–10. The company
saves 14 ( i.e. 24 – 10) per unit of the component if it decides to manufacture the same.
R R R

ILLUSTRATION 17. Ridewell Cogcle Ltd. purchases 20,000 bells per annum from an
outside supplier at R 5 each. The management feels that these be manufactured and not
purchased. A machine costing R 50,000 will be required to manufacture the item within the factory.
The machine has an annual capacity of 30,000 units and life of 5 years. Following additional
information is available :
Material cost per bell will be R 2.00 ; Labour cost per bell will be R 1.00 ; Variable overheads
100% of labour cost.
You are required to advise whether—
(i) the company should continue to purchase the bells from the outside supplier or should
make them in the factory ; and
(ii) the company should accept an order to supply 5,000 bells to the market at a selling price
of R 4.50 per unit ?
SOLUTION
(i) Statement showing the cost of manufacture of one unit (bell)
Per Unit
R

Material 2.00
Labour 1.00
Variable Overheads 1.00
————————
Marginal Cost 4.00

Depreciation (
10‚000
R

20‚000 ) Total Cost

0.50
————————
4.50
————————
————————
Purchase Cost 5.00
Saving per bell 0.50
Therefore, the company should manufacture the bells resulting in a saving of R 10,000 annually for 20,000
bells.
(ii) Marginal cost per bell is 4.00 as shown above. As depreciation of the machine is recovered on 20,000
R

bells, there will be no additional depreciation on the extra 5,000 bells to be sold in the market. Further the
machine has additional capacity too. Therefore, the company is advised to supply 5,000 bells to the market at
R 4.50 per unit and make a profit of 0.50 per unit i.e., total profit 2,500.
R R

IV. Selection of a Suitable Product Mix

When a factory manufactures more than one product, a problem is faced by the management as
to which product mix will give the maximum profits. The best product mix is that which yields the
C/3·24 APPLICATIONS OF MARGINAL COSTING

maximum contribution. The products which give the maximum contribution are to be retained and
their production should be increased. The products which give comparatively less contribution
should be reduced or closed down altogether. The effect of sales mix can also be seen by comparing
the P/V ratio and break even point. The new sales mix will be favourable if it increases the P/V ratio
and reduces the break even point.
ILLUSTRATION 18. Present the following information to show to the management:
(i) The marginal product cost and the contribution per unit.
(ii) The total contribution and profits resulting from each of the following sales mixtures.
(iii) The proposed sales mixes to earn a profit of R 250 and R 300 with total sales of A and B
being 300 units.
Product A Product B
R R

Direct materials (per unit) 10 9

Direct wages (per unit) 3 2
Sales price (per unit) 20 15
Fixed expenses R 800
(Variable expenses are allocated to
products as 100% of direct wages)
Sales mixtures : (a) 100 units of Product A and 200 of B ; (b) 150 units of product A and 150 of B
; (c) 200 units of product A and 100 of B
Recommend which of the sales mixtures should be adopted.
SOLUTION
(i ) STATEMENT OF MARGINAL COST AND UNIT CONTRIBUTION
Product A Product B
————————————————————————————————————————————————————————————————
Per unit Per unit Per unit Per unit
————————————————————————————————————————————————————————————————
R R R R

Sale Price 20 15
Less : Variable Cost :
Direct Materials 10 9
Direct Wages 3 2
Variable Overheads 3 16 2 13
————————————————————————————————————————————————————————————————
Contribution 4 2
————————————————————————————————————————————————————————————————

(ii)
Mix (a) Mix (b) Mix (c)
——————————————————————————————————————————————————————————————————————————————————————————
A B Total A B Total A B Total
——————————————————————————————————————————————————————————————————————————————————————————
Sales (units) 100 200 300 150 150 300 200 100 300
Contribution per unit ( )R 4 2 4 2 4 2
——————————————————————————————————————————————————————————————————————————————————————————

Total Contribution ( )
R 400 400 800 600 300 900 800 200 1,000
Less : Fixed Cost 800 800 800
———————— ——————— ———————
Profit ( ) R — 100 200
APPLICATIONS OF MARGINAL COSTING C/3·25

Mix (c) should be adopted as it gives the maximum contribution and profit.
(iii) Proposed Mixes.
Case I Case II
R R

Required profit 250 300

Fixed cost 800 800
———————— ————————
Contribution 1,050 1,100
————————
———————— ————————
————————

Case I
Let p nos. of A be sold.
Then (300 – p) nos. of B are to be sold.
Equating 4p + 2 (300 – p) = 1,050
4p + 600 – 2p = 1,050
2p = 450
∴ p = 225
Proposed Mix A = 225 units
B = 75 units (i.e. 300 – 225)
Case II
Say ‘x ’ nos. of A to be sold then (300 – x) nos. of B are to be sold.
Equating, 4 x + 2 (300 – x) = 1,100
4x + 600 – 2x = 1,100.
2x = 500
x = 250.
Proposed Mix A = 250
B = 50 units.
ILLUSTRATION 19. Small Tools Factory has a plant capacity adequate to provide 19,800
hours of machine use. The plant can produce all A type tools or all B type tools or a mixture of the
two types. Following information is relevant.
Per type A B
Selling Price ( ) R 10 15
Variable Cost ( ) R 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 tools can be
sold in a year. Annual fixed costs are R 9,900.
Compute the product-mix that will maximise the net income to the company and find that
maximum net income.
SOLUTION
STATEMENT SHOWING THE CONTRIBUTION PER MACHINE HOUR
Tools
————————————————————————————————————————————
Type A Type B
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R

Selling Price per type 10.00 15.00

C/3·26 APPLICATIONS OF MARGINAL COSTING

Less : Variable Cost per type 8.00 12.00

———————— ————————
Contribution per type 2.00 3.00
———————— ————————
Hours required to produce 3 4
2.00 3.00
Contribution per machine hour = 0.67 = 0.75
3 4
Ranking II I
From the above, it is clear that type B should be produced to the maximum extent and the balance machine
hours should be utilised for production of A type tools.
STATEMENT SHOWING THE MAXIMUM NET INCOME
Type No. of Machine Contribution Total
Tools Hours per unit Contribution
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R

B 3,000 12,000 3.00 9,000

A 2,600 7,800 2.00 5,200
———————————————————————— ————————————————————————
19,800 14,200
————————————————————————
————————————————————————
Less : Annual Fixed Cost 9,900
————————————————————————
Net Income 4,300
————————————————————————
————————————————————————

ILLUSTRATION 20. (a) Alcos Ltd. manufacture and sell four types of products under the
1 2 2 1
brand names A, B, C and D. The mix in the value comprises of 33 3%, 413%, 163%, and 83% of A, B,
C and D respectively. The total budgeted sales (100%) are R 60,000 per month. Operating costs
are :
Variable Costs :
Product A 60% of selling price ; Product B 68% of selling price ; Product C 80% of selling
price; Product D 40% of selling price ; Fixed Cost—R 14,700 per month.
Calculate the break even point for the products on an overall basis.
(b) It has been proposed to change the sales mix as follows, the total sales per month
remaining R 60,000 :
Product A 25% ; Product B 40% ; Product C 30% ; Product D 5%.
Assume that the proposal is implemented, calculate the break even point.
SOLUTION (a)
Product A Product B Product C Product D Total
2 2 1
Sales Mix 3331% 413% 163% 83% 100%
R R R R R

Sales 20,000 25,000 10,000 5,000 60,000

Variable Cost 12,000 17,000 8,000 2,000 39,000
(60% of (68% of (80% of (40% of (65% of
Sales) Sales) Sales) Sales) Sales)
————————————
Overall Contribution 21,000
Less : Fixed Cost 14,700
————————————
Net Profit 6,300
————————————
————————————

Fixed Cost R14‚700

Break Even Point = × Sales = × R 60,000 = R 42,000 of sales.
Sales – Variable Cost R 60‚000 – 39‚000
R
APPLICATIONS OF MARGINAL COSTING C/3·27

(b) Revised contribution on change of sales mix is as follows :

Product A Product B Product C Product D Total
Revised Sales Mix 25% 40% 30% 5% 100%
R R R R R

Sales 15,000 24,000 18,000 3,000 60,000

Variable Cost 9,000 16,320 14,400 1,200 40,920
(60% of (68% of (80% of (40% of (68.2%
Sales) Sales) Sales) Sales) Sales)
Overall Contribution 19,080
Break Even Point for Revised Sales Mix
Fixed Cost
= × Revised Sales
Revised Sales – Revised Variable Cost
14‚700R
= × 60,000 = 46,226 of Sales.
R R
60‚000 – 40‚920
R R

ILLUSTRATION 21. M/s Sangyog Industries currently manufacture three products : P, Q

and R. The projected figures as per budget are as under :
Product Sales Value (R) P/V Ratio (%)
P 6,00,000 40
Q 10,00,000 30
R 24,00,000 50
The fixed overheads for the corresponding period are estimated at R 19,14,000.
You are required to prepare a statement showing projected loss, if any, on the basis of the
above information, and suggest to the management the change in the volume of sales for each
product assuming the same sales mix as considered in the budget in order to eliminate the loss.
SOLUTION
STATEMENT SHOWING PROJECTED PROFITABILITY
Products Sales Value ( ) R Product Mix P/V Ratio Contribution
(%) ( )R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

P 6,00,000 15 40 2,40,000
Q 10,00,000 25 30 3,00,000
R 24,00,000 60 50 12,00,000
————————————————————————————————————————————————————————————— ———————————————————

40,00,000 100 17,40,000

Less : Fixed Expenses (–) 19,14,000
——————————————————

Loss (–) 1,74,000

——————————————————
——————————————————

STATEMENT SHOWING ADDITIONAL SALES VOLUME TO ELIMINATE LOSS

Products Product Mix (%) Additional P/V Ratio (%) Additional Sales
Contribution Volume ( ) R

Required ( ) R

P 15 26,100 40 65,250
Q 25 43,500 30 1,45,000
R 60 1,04,400 50 2,08,800
100 1,74,000 4,19,050

Additional Sales Volume required to eliminate loss is R 4,19,050.

C/3·28 APPLICATIONS OF MARGINAL COSTING

ILLUSTRATION 22. A multi product Company has the following costs and output data for
the last year
Product
—————————————————————————————————————————————————————————————————————————

X Y Z
Sales Mix 40% 35% 25%
R R R

Selling Price 20 25 30
Variable Cost per unit 10 15 18
Total Fixed Costs 1,50,000
Total Sales 5,00,000
The company proposes to replace product Z by Products S. Estimated cost and output data are :
X Y S
Sales Mix 50% 30% 20%
R R R

Selling Price 20 25 28
Variable Cost/unit 10 15 14
Total Fixed Cost 1,50,000
Total Sales 5,00,000
Analyse the proposed change and suggest what decision the Company should take.
SOLUTION
I. Present
X Y Z Total
R R R

Selling Price 20 25 30
Less : Variable Cost 10 15 18
——————— ——————— ———————
Contribution 10 10 12
——————— ——————— ———————
P/V Ratio 50% 40% 40%
Sales Mix 40% 35% 25% 100%
Contribution per Rupee of
Sales (P/V Ratio × Sales Mix) 20% 14% 10% 44%
Sales R 5,00,000
——————————————
Total Contribution: 44% of R 5,00,000 R 2,20,000
Less : Fixed Cost R 1,50,000
——————————————
Profit R 70,000
1,50,000 ÷ 44%
——————————————
B/E Point = R 3,40,909
II. Proposed
X Y S Total
Selling Price 20 25 28
Variable Cost 10 15 14
——————— ——————— ———————
Contribution per of Sales
R

(P/V Ratio × Sales Mix) 10 10 14

P/V Ratio 50% 40% 50%
Sales Mix 50% 30% 20% 100%
APPLICATIONS OF MARGINAL COSTING C/3·29

Contribution per R of Sales

(P/V Ratio × Sales Mix) 25% 12% 10% 47%
Sales R 5,00,000
——————————————

Total Contribution : 47% of R 5,00,000 R 2,35,000

Less : Fixed Cost R 1,50,000
——————————————

Profit R 85,000
——————————————

B/E Point (1,50,000 ÷ 47%) 3,19,149

A comparison of the old situation and proposed change shows that if product Z is replaced by product S it
would increase the profit by 15,000 and break even point will reduce by 21,760. The change is beneficial
R R

and, therefore, product Z may be dropped.

ILLUSTRATION 23. SR Steel Company produces three grades of steel namely—Super,
Good and Normal. Each of these three grades of steel are high in demand and the company is able
to sell whatever is produced.
The processing hours is a bottle-neck. The company is operating at 100% capacity. The
variable conversion cost per unit is at R 100 per process hour. The fixed cost is R 24,00,000. In
addition, the Cost Accountant was able to extract the following information about the three grades
of steel.
Product Super Good Normal
Budgeted Production (units) 3,000 3,000 3,000
Selling Price per unit (R) 4,500 3,600 3,000
Direct Materials Cost per unit (R) 1,200 1,500 1,400
Process hours per unit 20 12 10

Required :
(i) Determine the contribution margin per unit and statement of profitability at budgeted
operations.
(ii) Present an analysis to management showing the relative profitability of three grades of
steel assuming processing hours is a bottle-neck.
(iii) Management wishes to improve profitability by changing the product mix. Assuming as
per management policy the production of any product cannot exceed 4,000 units and a
minimum of 1,000 units of each grade of steel has to be produced. Find the most profitable
mix as per management policy and profit thereon.
SOLUTION
(I) PROFITABILITY STATEMENT
Grades of Steel Total
Particulars
Super Good Normal ( )
R

Budgeted Production (in units) 3,000 3,000 3,000

(A) Selling Price per unit ( ) R 4,500 3,600 3,000
Variable Cost per unit :
Direct Material 1,200 1,500 1,400
Conversion Cost (Hours × R 100) 2,000 1,200 1,000
C/3·30 APPLICATIONS OF MARGINAL COSTING

(B) Variable Cost (Total 3,200 2,700 2,400

(C) Contribution 1,300 900 600
Total Contribution (C × No. of Units) 39,00,000 27,00,000 18,00,000 84,00,000
Less : Fixed Cost (24,00,000)
Profit 60,00,000
(ii)
Super Good Normal
(A) Contribution per unit ( ) R 1,300 900 600
(B) Processing hours 20 12 10
Contribution per hour (A ÷ B) 65 75 60
Ranking II I III
(iii) Based on the above analysis Product-mix should be :
Good = 4,000 units (Maximum)
Super = 1,000 units (Minimum)
Normal = 1,000 units (Minimum)
However budged processing hours are (Given) :
Super = 3,000 units × 20 hrs. = 60,000
Good : 3,000 units × 12 hrs. = 36,000
Normal = 3,000 units × 10 hrs. = 30,000
——————————————

Total 1,26,000
——————————————
——————————————

Product-mix given above will consume :

Good (4,000 units × 12 hrs.) = 48,000 hrs.
Super (1,000 units × 20 hrs.) = 20,000 hrs.
Normal (1,000 units × 10 hrs.) = 10,000 hrs.
————————————————

Total 78,000 hrs.

————————————————
————————————————

∴ Hours remaining = 1,26,000 hrs. – 78,000 hrs. = 48,000 hrs.

These remaining hours should be used to produce Rank II Product.
Super = 48,000 hrs. ÷ 20 hrs. = 2,400 units.
Thus, the final product-mix is as follows so as to utilise all the budgeted processing hrs.
Good = 4,000 units
Super = 1,000 + 2,400 = 3,400 units
Normal = 1,000 units.
ILLUSTRATION 24. A company running an orchard, with an adequate supply of labour,
presents the following data and requests your advice about the area to be allotted for the
cultivation of various types of fruits, which would result in the maximization of profits. The
Company contemplates growing Apples, Lemons, Oranges and Peaches.
Apples Lemons Oranges Peaches
Selling price per box ( R) 15 15 30 45
Season’s yield in boxes per acre 500 150 100 200
Cost : R R R R

Material per acre 270 105 90 150

APPLICATIONS OF MARGINAL COSTING C/3·31

Labour :
Growing per acre 300 225 150 195
Picking and packing per box 1.50 1.50 3 4.50
Transport per box 3 3 1.50 4.50
The fixed costs in each season would be :
Cultivation and Growing R 56,000 ; Picking R 42,000 ; Transport R 10,000 ; Administration
R 84,000 ; Land Revenue R 18,000.

Following limitations are also placed before you :

(a) The area available is 450 acres, but out of this, 300 acres are suitable for growing only
Oranges and Lemons. The balance of 150 acres is suitable for growing any of the four fruits viz.,
Apples, Lemons, Oranges and Peaches.
(b) As the produce may be hypothecated to banks, area allotted for any fruit should be
demarcated in complete acres and not in fractions of an acre.
(c) The marketing strategy of the Company requires the compulsory production of all the four
types of fruits in a season and the minimum quantity of any one type to be 18,000 boxes.
Calculate the total profit that would accrue if your advice is accepted.

SOLUTION
STATEMENT SHOWING THE COMPARATIVE PROFITABILITY AND MAXIMUM PROFIT
Apples Lemons Oranges Peaches
Selling Price per box ( )R 15 15 30 45
Season’s yield in boxes per acre 500 150 100 200
Sales value per acre (A) ( ) R 7,500 2,250 3,000 9,000
—————————————————————————————————————————————————————————————————————————
Variable cost per acre (B) :
Material per acre ( )
R 270 105 90 150
Labour :
Growing per acre ( ) R 300 225 150 195
Picking, packing and transport per box
500 × 4.50
R 2,250
150 × 4.50
R 675
100 × 4.50
R 450
200 × 9.00
R 1,800
—————————————————————————————————————————————————————————————————————————
2,820 1,005 690 2,145
—————————————————————————————————————————————————————————————————————————
Contribution per acre (A) – (B) 4,680 1,245 2,310 6,855
Ranking II IV III I
18‚000 18‚000 18‚000 18‚000
Minimum acreage to be Total
500 150 100 200
allocated to each fruit = 36 acres = 120 acres = 180 acres = 90 acres 426 acres
Acrege to be allotted out of total 450 acres 36 acres 120 acres 180 acres 90 + 24
= 114 acres 450 acres
Contribution per acre ( )R 4,680 1,245 2,310 6,855 R

Total Contribution ( )
R 1,68,480 1,49,400 4,15,800 7,81,470 15,15,150
—————————————————————————————————————————————————————————————————————————
Less : Fixed Costs 2,10,000
——————————————
Net Profit 13,05,150
——————————————
——————————————
C/3·32 APPLICATIONS OF MARGINAL COSTING

V. Effect of Change in Sales Price

Management is confronted with the problem of cut in prices of products from time to time on
account of competition, expansion programme or government regulations. It is, therefore, necessary
to know the effect of a cut in prices of the products. The effect of a cut in selling price per unit will be
that contribution per unit will reduce.
ILLUSTRATION 25. Hansa Ltd. manufacturing a single product is facing severe
competition in selling it at R 50 per unit. The company is operating at 60% level of activity, at
which level sales are R 12,00,000. Variable costs are R 30 per unit. Semi-variable costs may be
considered as fixed at R 90,000 when output is nil and the variable element is R 250 for each
additional 1% level of activity. Fixed costs are R 1,50,000 at the present level of activity, but if a
level of activity of 80% or above is reached, these costs are expected to increase by R 50,000.
To cope with the competition, the management of the company is considering a proposal to
reduce the selling price by 5%. You are required to prepare a statement showing the operating
profit at levels of activity of 60%, 70%, 80% and assuming that : (a) the selling price remains at
R 50; and (b) the selling price is reduced by 5%.

Show also the number of units which will be required to be sold to maintain the present
profits if the company decided to reduce the selling price of the product by 5%.
SOLUTION
STATEMENT SHOWING OPERATING PROFIT
(a) When Selling Price is R 50 per unit
Production Capacity
—————————————————————————————————————————————————————————
60% 70% 80%
—————————————————————————————————————————————————————————

Output in units 24,000 28,000 32,000

—————————————————————————————————————————————————————————

R R R

Sales @ 50 per unit

R 12,00,000 14,00,000 16,00,000

] ]
Less : Variable Cost @ 30 per unit + Variable
R 7,20,000 8,40,000 9,60,000
part of semi-variable expenditure
@ 250 for each 1% of activity
R 15,000 17,500 20,000
—————————————————————————————————————————————————————————
Contribution 4,65,000 5,42,500 6,20,000
Less : Fixed Overheads
+ Fixed part of semi-variable expenditure
1,50,000
90,000 ] 1,50,000
90,000
2,00,000
90,000
—————————————————————————————————————————————————————————
]
Profit 2,25,000 3,02,500 3,30,000
—————————————————————————————————————————————————————————
—————————————————————————————————————————————————————————

(b) When Selling Price is R 47.50 i.e. 5% less than R 50

Production Capacity
——————————————————————————————————————————————————————
60% 70% 80%
——————————————————————————————————————————————————————
Output in units 24,000 28,000 32,000
——————————————————————————————————————————————————————
R R R

Sales @ 47.50 per unit

R 11,40,000 13,30,000 15,20,000
Less : Variable Cost @ 30 per unit + Variable 7,20,000 8,40,000 9,60,000

] ]
R

part of semi-variable expenditure @

R 250 for each 1% of activity 15,000 17,500 20,000
——————————————————————————————————————————————————————
Contribution 4,05,000 4,72,500 5,40,000
APPLICATIONS OF MARGINAL COSTING C/3·33

Less : Fixed Overheads

+ Fixed part of semi-variable expenditure
1,50,000
90,000 ] 1,50,000
90,000
2,00,000
90,000 ]
——————————————————————————————————————————————————————
Profit 1,65,000 2,32,500 2,50,000
——————————————————————————————————————————————————————
——————————————————————————————————————————————————————

The sales volume required at selling price of 47.50 to maintain existing profit of
R R 2,25,000 (earned at 60%
capacity when selling price is 50) is calculated as follows :
R

Fixed Cost + Profit 2‚40‚000 + 2‚25‚000

R R
= = 13,08,889. R
P/V Ratio 27
76
Sales 13‚08‚889 R

Number of units required to be sold = = = 27,556 units.

Selling price per unit 47.50 R

P/V Ratio is calculated as follows :

Contribution
P/V Ratio =
Sales
Contribution at 60% capacity when selling price is R 47.50 = R 4,05,000
Sales at 60% capacity when selling price is 47.50 =
R R 11,40,000
4‚05‚000 27
R
P/V Ratio = = ·
11‚40‚000 76
R

ILLUSTRATION 26. The revenue account of Goodwill Co. Ltd. has been summarised as
shown below :
R R

Sales 60,00,000
Direct Materials 18,00,000
Direct Wages 12,00,000
Variable Overheads 4,80,000
Fixed Overheads 17,20,000
———————————————— 52,00,000
————————————————

Profit 8,00,000
————————————————

The licensed capacity of the company is R 80,00,000 but the key factor is sales demand. It is
proposed by the management that in order to utilise the existing capacity, the selling price of the
product should be reduced by 5%.
You are required to prepare a forecast statement showing the effect of the proposed reduction
in selling price after taking into account the following changes in costs :
(i) Sales forecast R 76,00,000 (at reduced prices)
(ii) Direct wages rates and variable overheads are expected to increase by 5%.
(iii) Direct material prices are expected to increase by 2%.
(iv) Fixed overheads will increase by R 80,000.

SOLUTION GOODWILL CO. LTD.

Forecast Statement Showing the Effect of Change in Selling Price and Costs
R R

Sales at full licensed capacity 80,00,000

5
Less : 5% Reduction in Selling Price R 80,00,000 × 4,00,000
100
———————————————

Sales Forecast 76,00,000

C/3·34 APPLICATIONS OF MARGINAL COSTING

Less : Direct Materials R 24,48,000 (2)

Direct Wages R 16,80,000 (3)
Variable Overheads R 6,72,000 (4)
——————————————————

Marginal Cost 48,00,000

———————————————

Contribution 28,00,000
Less : Fixed Overheads (5) 18,00,000
———————————————

Estimated Profit 10,00,000

———————————————

Working Notes :
1
(1) The sales volume has increased by 333%. It is calculated as follows : R

Sales forecast at old prices 80,00,000

Less : Last year’s sales 60,00,000
————————————————

Increase in sales volume as compared to last year 20,00,000

————————————————
R 20‚00‚000 1
% increase in sales volume = × 100 = 33 .
R 60‚00‚000 3
1
Thus production is expected to increase by 33 3% because sale volume is increased by this percentage.
1
Consequently, variable expenses will also increase by 33 3% if there is no change in prices.
(2) Direct Material Costs : R

Last year 18,00,000

1
Add : 33 3 % increase in production 6,00,000
———————————————

24,00,000
Add : 2% of R 24,00,000 for increase in price of materials 48,000
———————————————

24,48,000
———————————————

(3) Direct Wages : R

Last year 12,00,000

1
Add : 33 3 % increase due to increase in production 4,00,000
———————————————

16,00,000
Add : 5% of R 16,00,000 due to increase in labour rates 80,000
———————————————

16,80,000
———————————————

(4) Variable Overheads R

Last year 4,80,000

1
Add : 33 3% increase in production 1,60,000
———————————————

6,40,000
Add : 5% increase in rates 32,000
———————————————

6,72,000
———————————————

(5) Fixed Overheads : R

Last year 17,20,000

Add : Increase 80,000
———————————————

18,00,000
———————————————
APPLICATIONS OF MARGINAL COSTING C/3·35

MISCELLANEOUS ILLUSTRATIONS
ILLUSTRATION 27. (Profit planning) PH Gems Ltd. is manufacturing readymade suits. It
has annual production capacity of 2,000 pieces. The Cost Accountant has presented following
information for the year to the management :

Particulars Amount ( )R Amount ( ) R

Sales 1,500 pieces @ 1,800 per piece

R 24,00,000
Direct Material 5,94,200
Direct Labour 4,42,600
Overheads (40% Fixed) 11,97,000 22,33,800
Net Profit 4,66,200
Evaluate following options :
(i) If selling price is increased by 200, the sales will come down to 60% of the total annual
R

capacity. Should the company increase its selling price ?

(ii) The company can earn a profit of 20% on sales if the company provide TIEPIN with
readymade suit. The cost of each TIEPIN is 18. Calculate the sales to earn a profit of 20%
R

on sales.
[C.A. Inter, May, 2018]
SOLTUTION
(i) PROFITABILITY STATEMENT (IF SELLING PRICE IS INCREASED BY R 200)
Particulars ( )
R ( )
R

Sales @ 60% Capacity = 1,200 pieces @ 2,000 per piece 24,00,000

(
Direct Material = 5,94,200 ×
1‚200
1‚500 ) 4,75,360

(
Direct Labour = 4,42,600 ×
1‚200
1‚500 ) 3,54,080

Overheads : Fixed (11,97,000 × 40%) 4,78,800

(
Variable 7,18,200 ×
1‚200
1‚500 ) 5,74,560 18,82,800

Net Profit 5,17,200

Yes, the Company should increase its Selling Price. As at Sales of 1,500 pieces it can earn profit of
R

R 310.8 per unit and at Sales of 1,200 pieces it can earn profit of 431 per unit.
R

(ii) Evaluation of Option (ii)

( )R

Sales 1,800.00

Less : Direct Material ( R 5‚94‚200

1‚500 ) 396.13

Cost of Tie PIN 18.00

Direct Labour ( R 4‚42‚600

1‚500 ) 295.07
C/3·36 APPLICATIONS OF MARGINAL COSTING

Variable Overheads ( R 11‚97‚000 × 60%

1‚500 ) 478.80
—————————————
1,188.00

Contribution 612.00
P/V Ratio ( 612/1800 × 100)
R 34.0%

4‚78‚800 + 0.20 of Sales

R
Sales to required earn a profit of 20% of Sales =
34.00%
Sales = 34,20,000 or 1,900 units ( 34,20,000/1800)
R R

To earn profit 20% on sales of readymade suit (along with TIE PIN) company has to sell 1,900 units i.e. 95%
of the full capacity. This sales level of 1,900 units is justified only if variable cost is constant. Any upside in
variable cost would impact profitability, to achieve the desired profitability. Production has to be increased but the
scope is limited to 5% only.
ILLUSTRATION 28. PJ Ltd. manufactures hockey sticks. It sells the products at 500 each R

and makes a profit of 125 on each stick. The company is producing 5,000 sticks annually by using
R

50% of its machinery capacity. The cost of each stick is as under :

Direct Material R150
Direct Wages R50
Works Overhead R 125 (50% fixed)
Selling Expenses R 50 (25% variable)
The anticipation for the next year is that cost will go up as under :
Fixed Charges 10%
Direct Wages 20%
Direct Material 5%
There will not be any change in selling price.
There is an additional order for 2000 sticks in the next year.
Calculate the lowest price that can be quoted so that the company can earn the same profit as it
earned in the current year ?
SOLTUTION
Selling Price = R 500
Profit = R 125
No. of Stock = R 5,000
Particulars Current Year Next Year
( )
R ( )
R

Direct Material 150 157.50

(150 + 5%)
Direct Wages 50 60
(50 + 20%)
Works Overheads 62.50 62.50
(125 × 50%)
Selling Expenses 12.50 12.5
(50 × 25%)
Total Variable Cost 275 292.50
Fixed Cost = 3,12,500 (62.5 × 5,000) +
R R 1,87,500 (37.5 × 5,000) 5,00,000 5,50,000
Let Lowest Price Quoted = x
Now, Sales = Target Profit (5,000 units × R 125) + Variable Cost + Fixed Cost
APPLICATIONS OF MARGINAL COSTING C/3·37

Or, (5,000 × 500) + (2,000 × x) = 6,25,000 + 20,47,500 + 5,50,000

Or, x = 361.25
R

So, Lowest Price that can be quoted to earn the profit of 6,25,000 (same as current year) is
R R 361.25
ILLUSTRATION 29. Top-tech a manufacturing company is presently evaluating two
possible machines for the manufacture of superior Pen-drives. The following information is
available :
Particulars Machine A Machine B
Selling Price per unit R 400.00 R 400.00
Variable Cost per unit R 240.00 R 260.00
Total Fixed Costs per year R 350 lakhs R 200 lakhs
Capacity (in units) 8,00,000 10,00,000
Required :
(i) Recommend which machine should be chosen ?
(ii) Would you change your answer, if you were informed that in near future demand will be
unlimited and the capacities of the two machines are as follows ?
Machine A—12,00,000 units
Machine B—12,00,000 units
Why ?
SOLUTION
(i) Computation of Profit
Particulars Machine A ( ) R Machine B ( ) R

Selling Price per unit 400 400

Less : Variable Cost per unit (240) (260)
Contribution per unit × Units (capacity) 160 140
8,00,000 units 10,00,000 units
Total Contribution 12,80,00,000 14,00,00,000
Less : Fixed Costs (3,50,00,000) (2,00,00,000)
Profit 9,30,00,000 12,00,00,000
Recommendation :
Machine B should be chosen as it yields higher profit
(ii) Computation of Profit :
Particulars Machine A ( ) R Machine B ( ) R

Total Contribution
A = 12,00,000 × / 160
R 19,20,00,000
B = 12,00,000 × R 140 16,80,00,000
Less : Fixed Costs (3,50,00,000) (2,00,00,000)
Profit 15,70,00,000 14,80,00,000
In this case, the answers should be changed, as Machine A should be chosen as it yields higher profit.
ILLUSTRATION 30. (Fixation of Sale Price/Alternative Proposal) XYZ Ltd. is engaged in the
manufacturing of toys. It can produce 4,20,000 toys at its 70% capacity on per annum basis.
C/3·38 APPLICATIONS OF MARGINAL COSTING

Company is in the process of determining sales price for the financial year 2023-24. It has provided
the following information :
Direct Material R 60 per unit

Direct Labour R 30 per unit

Indirect Overheads :
Fixed R 65,50,000 per annum

Variable R 15 per unit

Semi-variable 5,00,000 per annum up to 60% capacity and R 50,000 for every 5%
R

increase in capacity or part thereof up to 80% capacity and thereafter

R 75,000 for every 10% increase in capacity or part thereof.

Company desires to earn a profit of R 25,00,000 for the year. Company has planned that the
factory will operate at 50% of capacity for first six months of the year and at 75% of capacity for
further three months and for the balance three months, factory will operate at full capacity.
You are required to :
1. Determine the average selling price at which each of the toy should be sold to earn the
desired profit.
2. Given the above scenario, advise whether company should accept an offer to sell each Toy
at :
(a) R 130 per Toy (b) R 129 per Toy
SOLUTION
1. Statement of Cost:
For first 6 For further For Total
months 3 months remaining
3 months
6,00,000 6,00,000 6,00,000 4,12,500
× 6/12 × × 3/12 × × 3/12 = units
50% = 75% = 1,50,000
1,50,000 1,12,500 units
units units
Direct Materials 90,00,000 67,50,000 90,00,000 2.47,50,000
Direct Labour 45,00,000 33,75,.000 45,00,000 1,23,75,000
Indirect—Variable Expenses 22,50,000 16,87,500 22,50,000 61,87,500
Indirect—Fixed Expenses 32,75,000 16,37,500 16,37,500 65,50,000
Indirect Semi-variable Expenses
• For first six months @ 5,00,000 per annum 2,50,000
• For further three months @ 6,50,000* per annum 1,62,500
• For further three months @ 8,50,000** per annum 2,12,500 6,25,000
Total Cost 1,92,75,000 1,36,12,500 1,76,00,000 5,04,87,500
Desired Profit 25,00,000
Sales Value 5,29,87,500
Average Sales Price per Toy 128.45
* R 5,00,000 + [3 times (from 60% to 75%) × 50,000] = R 6,50,000
** R 6,50,000 + [1 time (from 75% to 80%) × 50,000] + [2 times (from 80% to 100%) × 75,000] = R 8,50,000
APPLICATIONS OF MARGINAL COSTING C/3·39

2. (a) Company should accept the offer as it is above its targeted sales price of R 128.45 per toy.
(b) Company should accept the offer as it is above its targeted sales price of R 128.45 per toy.
ILLUSTRATION 31. (Make or Buy). K.K. Industries Ltd. purchases 12,000 units p.a. of a
spare part from another manufacture @ 4 per unit. The production manager has put forward a
proposal that the production of this spare part may be undertaken by the company in order to have
full control over the supply of the spare part. He has submitted the following information along
with the proposal:
(i)Material and Labour would cost 0.60 and 0.50 respectively per unit.
R R

(ii)Variable overhead will be 100% of labour.

(iii)A foreman will be employed at 1,000 p.m.
R

(iv) Machine needed would cost 50,000. It will have a production capacity of 15,000 units and
R

its economic life will be 5 years.

(v) Funds need for the above (iv) can be obtained at an interest rate of 10% p.a.
You are required to advise the management about the proposal.
SOLTUTION
STATEMENT OF MARGINAL COST AND SAVINGS
R

Materials @ R 0.60 per unit 7,200

Wages @ R 0.50 per unit 6,000
Variable Overhead @ (100% of Labour) 6,000
Marginal Cost of making 19,200
Market price for 12,000 units 48,000
(A) Savings 28,800
Additional Fixed Costs :
1. Depreciation on Machine 10,000
2. Foreman’s Salary 12,000
3. Interest on Investments 5,000
(B) Total 27,000
Profit (A – B) 1,800

On the basis of above computation, we can agree to accept the proposal of Production Manager that
production of the spare part may be undertaken by the company because it will provide not only full control over
the supply of the spare part but will also provide an additional profit of 1,800.
R

ILLUSTRATION 32. (Whether or not to explore the foreign market). A company annually
manufactures 10,000 units of a product at a cost of R 4 per unit and there is home market for
consuming the entire volume of production at the sale price of R 4.25 per unit. In the year 2024,
there is a fall in the demand for home market which can consume 10,000 units only at a sale price
of R 3.72 per unit. The analysis of the cost per 10,000 units is :
R R

Material 15,000 Fixed overheads 8,000

Wages 11,000 Variable overheads 6,000
The foreign market is explored and it is found that this market can consume 20,000 units of the
product if offered at a sale price of R 3.55 per unit. It is also discovered that for additional 10,000
C/3·40 APPLICATIONS OF MARGINAL COSTING

units of the product (over initial 10,000 units) the fixed overheads will increase by 10%. Is it
worthwhile to try to capture the foreign market ?
SOLUTION
ANALYSIS OF COST DATA FOR 10,000 UNITS
Total Cost per unit
R R

Material 15,000 1.50

Wages 11,000 1.10
Variable Overheads 6,000 0.60
—————————— ———————
Marginal Cost 32,000 3.20
Fixed Overheads 8,000 0.80
—————————— ———————
Total Cost 40,000 4.00
—————————— ———————

In 2024, selling price in the domestic market is 3.72 per unit which is more than the marginal cost of 3.20
R R

per unit. Therefore, it is desirable to continue the sales in the domestic market because every unit of sale will be
contributing 0.52 per unit towards fixed expenses. Similarly, sales in the foreign market at a selling price of
R

R 3.55 per unit is advisable because selling price is more than the marginal cost. Sale of 20,000 units in the
foreign market will convert loss of 2,800 if sale is made only in the domestic market to a profit of 2,600 if sale
R R

of 20,000 units is made in the foreign market alongwith sale of 10,000 units in the domestic market as is evident
from the table given below :
STATEMENT SHOWING ADVISABILITY OF SELLING IN THE FOREIGN MARKET
Sale in Home Sale in Foreign Total
Market Market
10,000 units 20,000 units
—————————————————————————————————————————————————————————————————

(1) Sale : 10,000 units @ R 3.72 R R R

20,000 units @ R 3.55 37,200 71,000 1,08,200

—————————————————————————————————————————————————————————————————
Material 15,000 30,000 45,000
Wages 11,000 22,000 33,000
Variable Overheads 6,000 12,000 18,000
—————————————————————————————————————————————————————————————————

(2) Marginal Cost 32,000 64,000 96,000

—————————————————————————————————————————————————————————————————

(3) Contribution (1) – (2) 5,200 7,000 12,200

—————————————————————————————————————————————————————————————————

(4) Fixed Overheads 8,000 (a) 1,600 9,600

—————————————————————————————————————————————————————————————————

(5) Profit (3) – (4) 2,800 5,400 2,600

(Loss)

(a) Increase in fixed overheads for 10,000 units additional = 10%.

20
∴ Increase in fixed overheads for 20,000 units additional = 20% i.e., × R 8,000
100
= R 1,600.
ILLUSTRATION 33. (Make or Buy) Kaustubh Ltd. company manufactures component Q,
one unit of which is required for each unit of Product K. The budgeted output of K is 1,20,000
units. The cost details for 10,000 units of component Q are as under :
Direct Materials R 72,000

Direct Labour @ R 15 per hour R 90,000

Variable Overheads R 54,000

Fixed Overheads R 54,000

APPLICATIONS OF MARGINAL COSTING C/3·41

The component Q’s unit price is R 24 in the market. If the company decides to purchase the
component Q from the market, it has the following two options for the capacity so released :
(i) Rent out the released capacity at R 3 per hour.
(ii) Manufacture another component, Alpha, which can be sold at R 24 per unit in the market.
The cost details of this component for 10,000 units are as follows :
Direct Materials R 90,000

Direct Labour @ 15 per hour

R R 45,000

Variable Overheads R 90,000

Required :
(a) Evaluate the two options available for the use of spare capacity and recommend whether
the company should manufacture or buy the component Q. If your recommendation is in
favour of buying the component Q from the market, which of the two options you will
prefer ?
(b) In case, no alternative use of the spare capacity is there, whether the company should
make the component Q in the factory or purchase it from the market ?
Give proper workings to justify your recommendation.
SOLUTION Cost of Producing 1,20,000 units of Component Q
R for 10,000 units
Direct Materials 72,000
Direct Labour 90,000
Variable Overheads 54,000
Total Variable Cost 2,16,000
2‚16‚000
R
Cost of 1,20,000 units of Q = × 1,20,000 = 25,92,000 R
10‚000
Purchase Cost of Component Q = 1,20,000 × 24 = 28,80,000
R R

∴ Difference (Loss in buying) = 28,80,000 – 25,92,000 = 2,88,000

R R R

Option (i) : Rent of the released Capacity @ 3 per hour

R

Hours per unit =

6‚000
10‚000
= 0.6 hour. [ Q
R 90‚000
R 15
= 6,000 hrs.

Time Taken for 1,20,000 units = 1,20,000 × 0.6 = 72,000 hrs.

Hours released = 72,000
Rent = 72,000 × 3 = 2,16,000
R R

Option (ii) : To make component Alpha

Variable Cost of 10,000 units = 90,000 + 45,000 + 90,000
R R R

= 2,25,000
R

Variable Cost per unit = 2,25,000/10,000 units = 22.50

R R

45‚000
R

Time spent on one unit = = 0.3 hr.

15 × 10‚000
Hours released 72‚000 hrs.
Maximum production of Alpha = =
Hour per unit 0.3 hr.
= 2,40,000 units
Sales of Alpha = 2,40,000 × 24 R R 57,60,000
Less : Variable Cost = 2,40,000 × R 22.50 ( 54,00,000)
R
—————————————————————

Contribution R 3,60,000
—————————————————————
—————————————————————
C/3·42 APPLICATIONS OF MARGINAL COSTING

Comments :
1. If component Q is produced the cost = R 25,92,000
2. If component Q is purchased and capacity released is rented out, then the net cost of purchasing will be
:
R 28,80,000 – Rent received ( 2,16,000) =
R R 26,64,000
3. If released capacity is used to produce Alpha then cost of buying will be (net) = R 28,80,000
– 3,60,000 = 25,20,000
R R

Conclusion: It is better to buy component Q from outside and produce Alpha. This is because here net cost
of buying Q is the lowest. So this option is better than renting out spare capacity. But if spare capacity released
by the non-manufacture of Q cannot be put to some alternative use, then it is better to self produce component Q
because if purchased from outside it will result in a loss of 24 – 21.60 = 2.40 per unit i.e., 1,20,000 units ×
R R R R

2.40 = 2,88,000.
R

ILLUSTRATION 34. (Key Factor) The sales, cost, selling price and processing time of three
different herbal drinks produced by a company for the year just concluded are given below :
Product
Particulars
Strong Normal Mild
Annual Sales (No. of Packs 250 gms) 6,000 5,000 1,000
Selling Price (R/Pack) 50 40 30
Unit Cost (R/Pack) 42 36 21
Processing Time/per pack (hrs.) 1.5 1 2
The total processing hours available to the company is 16,000 hours which is fully utilised.
Fixed manufacturing overheads are fully absorbed in unit cost at a rate of 200% of variable cost.
For the coming year the demand for the three products has been estimated as under :
Strong 6,000 packs: Normal 6,000 packs; Mild 2,000 packs.
Considering that the selling prices are fixed and the processing time can be switched from one
product line to another, calculate the best production programme for next operating year
indicating the increase in net profit that will result.
SOLUTION
PROFITABILITY STATEMENT
Particulars Strong Normal Mild
Selling Price (per unit) ( )R 50 40 30

Less : Variable Cost* ( ) R

[ Unit cost
3 ] (14) (12) (7)

Contribution (per unit) ( ) R 36 28 23

Hours (per unit) 1.5 1 2
Contribution (per hour) 24 28 11.5
Ranking II I III
Maximum Sales (packs) 6,000 6,000 2,000
Processing Time (hrs)
= (No. of packs × Processing hrs.) 9,000 6,000 1,000 (Bal.)**
APPLICATIONS OF MARGINAL COSTING C/3·43

Product Mix ( )
R 6,000 6,000 500**
Contribution [Product Mix × Contribution (per unit)] 2,16,000 1,68,000 11,500
R

Total Contribution R (2,16,000 + 1,68,000 + 11,500) 3,95,500

Less : Fixed Cost*** 3,02,000
Profit for the Next Year 93,500
Less : Current Year Profit**** 77,000
∴ Increase in Profit 16,500

Capacity is in short supply or limiting factor i.e., capacity requirement according to demand is more than its
supply. Therefore, more than one limiting factor.

Working Notes:
* Let Variable cost be x
Total Cost = Fixed Cost + Variable Cost = x (2) + x = 3x
1
∴ Variable Cost (x) = Total Cost × 3
** Total Processing hrs. available to the company = 16,000 hrs.
For Strong packs : maximum hrs. (6,000 units × 1.5 hrs.) = 9,000 hrs.
For Normal packs : maximum hrs. (6,000 units × 1 hrs.) = 6,000 hrs.
Therefore, For Mild packs : maximum hrs. (16,000 – 9,000 – 6,000) = 1,000 hrs.
1‚000 hrs.
∴ Mild (Units) = = 5,000 units
2 hrs.

*** Calculation of Fixed Cost :

Strong Pack :
Fixed Cost (per unit) = Unit Cost – Variable Cost = R (42 – 14) = R 28
Fixed Cost ( ) = Annual Sales × Fixed Cost (per unit) = 6,000 ×
R R 28 = R 1,68,000
Normal Pack :
Fixed Cost (per unit) = R (36 – 12) = R 24; Fixed Cost ( ) = 5,000 ×
R R 24 = R 1,20,000
Mild Pack:
Fixed Cost (per unit) = R (21 – 7) = R 14; Fixed Cost ( ) = 1,000 ×
R R 14 = R 14,000
∴ Total Fixed Cost = R 1,68,000 + R 1,20,000 + R 14,000 = R 3,02,000
**** Current Year Profit :
Particulars Annual Sales Contribution Total Contribution
(Units) (per unit) (Sales × Contribution)
Strong 6,000 36 2,16,000
Normal 5,000 28 1,40,000
Mild 1,000 23 23,000
Total Contribution 3,79,000
Less : Total Fixed Cost*** (3,02,000)
Current Year’s Profit 77,000
C/3·44 APPLICATIONS OF MARGINAL COSTING

QUESTIONS
SHORT ANSWER TYPE

1. (a) Explain the relevance of ‘key factor’ in decision making.

(b) Write short note on determination of cost of indifferent point.
2. (Make or Buy Decision) The Vinayak Limited Company manufactures a range of products and has just
received a proposal from Shankar Limited. Company that one of its products ‘T’, could be supplied to
them advantageously at a price of 28 per unit. The cost of manufacturing in the Vinayak Limited.
R

Company is as under :

Details T costs per unit ( )

R

Material 15
Process 1 15
Process 2 5
Total 35

From further enquiries the following facts emerge :

(i) Process 1 cost included an element of fixed overhead of approximately 40%.
(ii) Process 2 is a joint process producing three products in addition to ‘T’. The process costs would
still be incurred if ‘T’ were not produced by the Company.
Advise the management of the Vinayak Ltd. Company whether the proposal to purchase should be
accepted or to continue manufacturing.
Ans. [As the supplier’s price is 28 which is higher than over own variable cost i.e.
R R 24, Vinayak Ltd.
should continue to manufacture product T]

LONG ANSWER TYPE

1. State the importance of the technique of marginal costing in decision making.
2. What are the factors (cost and non-cost) taken into consideration while deciding whether to make or
buy ?
3. What is a key factor ? How does this factor affect the decision about the profitability of a product ?
4. Discuss the importance and application of marginal costing in the present economic scenario of India.
OR
Write more note on Applications of Marginal Costing.

PRACTICAL PROBLEMS
PROFIT PLANNING
1. Quality Products Ltd. manufacture and market a single product. Following data are available :
R per unit R per unit
Materials 16 Selling Price 40
Conversion Costs (Variable) 12 Fixed Costs : R 5 lakhs
Dealer’s margin 4 Present Sales : 90,000 units
Capacity utilisation : 60 per cent.
APPLICATIONS OF MARGINAL COSTING C/3·45

There is acute competition. Extra efforts are necessary to sell. Suggestions have been made for
increasing sales—
(a) by reducing sales price by 5 per cent ;
(b) by increasing dealers margin by 25 per cent over the existing rate.
Which of these two suggestions would you recommend, if the company desires to maintain the present
profit ? Give reasons.
Ans. [Suggestion (b)]

2. 50,000 units of an item are produced and sold in the home market at 50 per unit. The home market
R

cannot absorb more than 50,000 units in a year but there is an export market for this item at 30 per R

unit. It is proposed to increase the production and sell the additional quantities in the foreign market at
R 30 per unit. The variable cost works out to 25 per unit and the fixed charges amount to 8,00,000 in
R R

a year. Calculate the number of additional units to be made and sold abroad to achieve a total profit of
R 6,00,000 in a year both on domestic and foreign sales together.
Ans. [30,000 units]
3. A company has two plants at Location I and II. Operating at 100% and 75% of their capacities
respectively. The company is considering a proposal to merge the two plants at one location to optimise
available capacity. The following details are available in respect of the two plants, regarding their
present performance/operation :
Particulars Location I Location II
Sales ( in lakhs)
R 200 75
Variable cost ( in lakhs)
R 140 54
Fixed Cost ( in lakhs)
R 30 14

For decision-making purposes you are required to work out the following information ;
(i) The capacity at which the merged plant will break-even.
(ii) The profit of the merged plant working at 80% capacity.
(iii) Sales required if the merged plant is required to earn an overall profit of R 22 lakhs.
Ans. [(i) 50%; (ii) R 26.40 lakhs; (iii) R 225 lakhs]
[Hint. P/V Ratio of Merged Plant = 29.33%; Break-even Point of Merged Plant = R 150 lakhs]

4. Two manufacturing companies which have the following operating details decided to merge :
Company No. 1 Company No. 2
Capacity utilisation (%) 90 60
Sales ( lakhs)
R 540 300
Variable costs ( lakhs)
R 396 225
Fixed Costs ( lakhs)
R 80 50
Assuming that the proposal is implemented, calculate :
(i) Break even sales of the merged plant and the capacity at that stage.
(ii) Profitability of the merged plant at 80% capacity utilisation.
(iii) Sales turnover of the merged plant to earn a profit of R 75 lakhs.
(iv) When the merged plant is working at a capacity to earn a profit of 75 lakhs what percentage
R

increase in selling price is required to sustain an increase of 5% in fixed overheads.

Ans. [(i) 45.61%; (ii) 11.14%; (iii) R 791.23 lakhs ; (iv) 0.8215%]
C/3·46 APPLICATIONS OF MARGINAL COSTING

DROPPING OF A PRODUCT
5. Following are the present cost and output data of a manufacturer :
Product Price Variable cost % of sales
per unit
R R

Tables 120 80 40
Chairs 60 40 35
Book cases 80 60 25
Total fixed cost 40,000
R

Last year’s sales was 2,00,000.

R

The manufacturer is considering to drop the line of book cases and replace with cabinets. His estimates
for the new scheme are as follows :
Product Price Variable cost % of sales
per unit
R R

Tables 120 80 40
Chairs 60 40 40
Cabinets 150 100 20
Total fixed cost per annum 40,000.
R

Sales 2,50,000.
R

Is the change worth undertaking ?

Ans. [The change is worth undertaking as it will increase present profit of R 22,500 to R 43,333]
6. The Skyrock Ltd. produces and sells three types of products P, Q and R. The management committee
has decided to discontinue the production of ‘Q’ since there is not much profit in it. From the following
set of information find out the profitability of the products and give your short comments on the
decision of the management.
Selling Direct Direct Wages per unit
Products price material ———————————————————————————————————————————————————————————

per unit per unit Dept. A Dept. B Dept. C

R R R R R

P 300 60 20 15 10
Q 275 30 20 20 10
R 305 70 12 10 20
The absorption rates of overhead on the Direct Wages are :
Dept. A Dept. B Dept. C
Variable overhead 150% 120% 200%
Fixed overhead 200% 240% 150%
Ans. [Q is the most profitable product, so efforts should be made to increase its sales rather than
discontinuing it]

ACCEPTANCE OF AN OFFERORORDER
7. A manufacturer has planned his level of operation at 50% of his plant capacity of 30,000 units (at 100%
capacity). His expenses are estimated as follows, if 50% of the plant capacity is utilised.
APPLICATIONS OF MARGINAL COSTING C/3·47

R R

(i) Direct materials 8,280

(iii) Variable and other manufacturing expenses 3,960
(ii) Direct wages 11,160
(iv) Total fixed expenses irrespective of
capacity utilisation 6,000
The expected selling price in the domestic market is 2 per unit. Recently, the manufacturer has
R

received a trade enquiry from an overseas organisation interested in purchasing 6,000 units at a price of
R 1.45 per unit.
As a professional management accountant what would be your suggestion regarding acceptance or
rejection of the offer ? Suppose your suggestion with suitable quantitative information.
Ans. [Offer should be rejected as acceptance of the offer will give negative contribution of 660] R

8. A mechanical toy factory presents the following information for the year 2024 :
R R

Material cost 1,20,000 Variable overheads 60,000

Labour cost 2,40,000 Units produced 15,000
Fixed overheads 1,20,000 Selling price per unit 40
The available capacity is a production of 20,000 units per year. The firm has an offer for the purchase of
5,000 additional units at a price of 30 per unit. It is expected that by accepting this offer, there will be a
R

saving of 1 per unit in material cost on all units manufactured ; the fixed overheads will increase by
R

R 20,000 and the overall efficiency will drop by 3% on all production.

Prepare a statement showing the variation of net profits resulting from the acceptance of the order.
Ans. [Profit will increase by R 103]
9. A manufacturing business sells its product at R 20 per unit. It has a normal capacity of 50,000 units per
annum, and budgeted costs at this level are :
R R

Direct materials 3,00,000 Expenses :

Direct labour 2,00,000 Fixed 2,50,000
Variable 1,00,000
A sales budget has been prepared for the local market and orders are expected for 35,000 units. The
sales manager has established that an export order for an additional 10,000 units could be negotiated at
a special price of 14 per unit. He has also established that a second order of 4,000 modified units could
R

be obtained at a special price of 13 per unit. The modifications would reduce the cost of direct
R

materials by 1 per unit but would increase the direct labour cost by 25%.
R

Examine the problem and submit your recommendations, with facts and figures, as to whether the
special orders should be accepted or not.
Ans. [Additional Contribution on 10,000 units @ 2 per unit = 20,000 ; Additional Contribution on 4,000
R R

units @ 1 per unit = 4,000 ; Special order should be accepted]

R R

KEY FACTOR
10. (Priorities when machine capacity or shortage of raw material is the key factor). A company manufactures and
markets three products A, B and C. All the three products are made from the same set of machines.
Production is limited by machine capacity. From data given below indicate priorities for products A, B
and C with a view to maximising profits.
Product A Product B Product C
Raw Material Cost per Unit 2.25 R 3.25 R 4.25 R

Direct Labour Cost per Unit 0.50 R 0.50 R 0.50 R

C/3·48 APPLICATIONS OF MARGINAL COSTING

Other Variable Cost per Unit 0.30

R R 0.45 0.71
R

Selling Price per Unit 5.00

R R 6.00 7.00
R

Standard machine time required per unit 39 minutes 20 minutes 28 minutes

In the following year the company faces extreme shortage of raw materials. It is noted that 3 kg., 4 kg.
and 5 kg. of raw materials are required to produce one unit of A, B and C respectively. How would
products priorities change ?
Ans. [Priorities for Products : A, B and C]
11. Two products are manufactured in a factory. The prime costs, variable overhead costs and the selling
price per unit are given below :
Product A Product B
R R

(a) Direct Materials 100 150

(b) Direct Wages 200 300
(c) Direct Labour Hours 60 hrs. 120 hrs.
(d) Variable Overheads 2,000 2,500
(e) Selling Price 10,000 12,000
The budgeted fixed charges for the year amounted to 50 lakhs. Budgeted direct labour hours are
R

50,000 hours.
Calculate the profit per unit of A and B if fixed charges are absorbed on direct labour hour method.
Also state on which product the company should concentrate to get maximum profit, assuming there is
restricted supply of labour and unlimited sales potential. Support your recommendation by
calculations.
Ans. [Profit per unit on product A 1,700; Loss per unit on product B 2,950 ; Concentration on product A
R R

because P/V ratio and contribution per labour hour is more in this product as compared to product B]
12. In a factory producing two different kinds of articles, the limiting factor is the availability of labour.
From the following information from the factory for the year 2024 show which product is more
profitable :
Product A Product B
Cost per unit Cost per unit
R R

Materials 5.00 5.00

Labour :
6 hrs. @ 0.50
R 3.00
3 hrs. @ 0.50
R 1.50
Overheads :
Fixed 50% of labour 1.50 0.75
Variable 1.50 1.50
———————— ————————

Total cost 11.00 8.75

Selling price 14.00 11.00
———————— ————————

Profit 3.00 2.25

———————— ————————

Total production for the month (units) 500 600

Maximum capacity per month—4,800 hours.
Suppose (i) 1,000 units of B are manufactured instead of 600 units or (ii) 700 units of A are
manufactured instead of 500 units.
APPLICATIONS OF MARGINAL COSTING C/3·49

Give proof in support of your answer by assuming the above output.

Ans. [Product B is more profitable]
13. In a factory producing two different products, the limiting factor is the availability of materials. From
the following particulars, decide the product you would recommend for priority :
Product X Product Y
Cost per unit Cost per unit
R R

Materials 25 40
Labour 10 15
Variable Expenses 5 6
Fixed Expenses 4 4
—————— ——————

Total Cost 44 65
Selling Price 55 80
—————— ——————

Profit 11 15
—————— ——————

Ans. [Product X is recommended]

14. Comment on the relative profitability of the following two products if (i) there is no key factor and
(ii) output is the key factor.
Production cost per unit
—————————————————————————————————————————————————

Product A Product B
R R

Materials 200 150

Wages 100 200
Fixed Overhead 350 100
Variable Overhead 150 200
Profit 200 350
————————— —————————
1,000 1,000
————————— —————————

Output per week 200 100

Ans. [(i) Product A (ii) Product B]
15. A company produces two products A and B using similar inputs and facilities.
The availability of Labour hours in a year is 2,35,000 hours and this is considered as the limiting factor.
The following details are available for the two products :
Product A Product B
Selling Price per unit ( )
R 100 50
Direct Material per unit ( ) R 50 11
Direct Labour ( 5 per hour)
R 25 20
Estimated Sale Demand (Nos.) 10,000 50,000
Other variable costs common to both products are :
(i) Variable production overhead R 2 per hour of direct labour.
(ii) Variable selling overhead 10% of sale price.
In the context of the above limiting factor, you are required to calculate a production plant that will
maximise contribution to the company and also workout total contribution at the level.
Ans. [Product A : 7,000 units (Total Contribution 35,000; Product B : 50,000 units (Total Contribution
R

R3,00,000]
C/3·50 APPLICATIONS OF MARGINAL COSTING

MAKE ORBUY DECISION

16. A company finds that while its costs 625 per unit to manufacture a component the same is available in
R

the market at 575 each with an assurance of continuous supply. The break-down of the cost per unit is
R

as follows :
Material 275 + Labour 175 + Other variable cost 50 + Depreciation and other fixed cost 125 =
R R R R

Total Cost 625.R

(i) Should it buy or make the component ? Give reason for your answer.
(ii) What would be your decision, if the supplier offers the same component at 480 each ?
R

Ans. [ (i) Company should make the component ; (ii) Company should purchase the component from the
market]

SALE MIX/PRODUCT MIX

17. Allied Manufacturing Company gives you the following information :
Product A Product B
R R

Fixed Overheads 10,000 p.a.

R

Direct Materials per unit 20 25

Direct Labour per unit 10 15
Variable Overheads (100% of Direct Labour)
Selling Price per unit 60 100
You are required to present a statement showing the marginal cost of each product and recommend
which of the following sales mixes should be adopted :
(a) 900 units of A and 600 units of B;
(b) 1,800 units of A only;π
(c) 1,200 units of B only;
(d) 1,200 units of A and 400 units of B.
Ans. [ Contribution per unit : Product A 20; Product B 45.
R R

Profit of Mix. (a) 35,000; (b) 26,000; (c) 44,000; (d) 32,000.
R R R R

Sales Mix (c) is recommended as it fetches maximum profit]

18. A confectioner markets three products, all of which require sugar. His average monthly sales, cost of
sales and sugar consumption are as follows :
Product Product Product Total
X Y Z
Sales ( )
R 10,000 12,000 8,000 30,000
Cost of Sales ( )
R 6,000 8,000 5,600 19,600
Sugar Requirement (kgs.) 500 800 240 1,540
Due to Government restrictions his sugar quota has been reduced to 1,405 kgs. per month. Suggest a
suitable sales mix which would give the company maximum profit under the given circumstances.
Ans. [500 kgs. of X ; 240 kgs. of Z and 665 kgs. of Y]
19. You are furnished undernoted data :
Product A Product B
Sales 10,000 units @ R 1 7,500 units @ 1.33
R

Costs :
Fixed R 2,000 R 5,500
Variable @ R 0.60 per unit @ R 0.40 per unit
APPLICATIONS OF MARGINAL COSTING C/3·51

Determine the effect on profits, if sales of A or B are increased in the mixture of total sales. Assume that
idle capacity exists and production of A or B in units can be increased by 50%.
Ans. [Profit is the maximum when sales of B are increased in the mixture of total sales]
20. Calculate the effect of sales mix from the following data by comparing the P/V ratio and break even
point :
P Q R S
R R R R

Sales 40,000 50,000 20,000 10,000

Variable Costs 24,000 34,000 16,000 4,000
New Sales Mix 30,000 44,000 40,000 6,000
Fixed Cost R 29,400.
Ans. [Existing Sales Mix P Q R S Total
P/V Ratio 40% 32% 20% 60% 35%
Break Even Point R 84,000
New Sales Mix 40% 32% 20% 60% 31.4%
Break Even Point R 93,630
Conclusion. New mix is not favourable]

21. On the basis of the following information in respect of an engineering company, what is the product
mix which will give the highest profit attainable ? Do you recommend overtime working upto a
maximum of 15,000 hours at twice the normal wages? (Overheads are ignored for the purpose of this
question)
Products manufactured A B C
Raw material per unit 10 kgs. 6 kgs. 5 kgs.
Labour hours per unit @ 1 per hourR 15 25 20
Selling price per unit 125 R 100 200R R

Maximum production possible 6,000 units 4,000 units 3,000 units

1,00,000 kgs. raw materials are available @ 10 per kg. Maximum production hours are 1,84,000 with
R

facility for a further 15,000 hours on overtime basis at twice the normal wage rate.
Ans. [Labour is the key factor. A product mix of 6,000 units of A, 1,360 units of B and 3,000 units of C will
give maximum contribution of 4,70,400 ; R

Overtime is not recommended as it reduces contribution by 6,000] R

22. (Key Factor) An agriculture based company having 210 hectares of land is engaged in growing three
different cereals namely, wheat rice and maize annually. The yield of the different crops and their
selling prices are given below :
Wheat Rice Maize
Yield (in kgs per hectare) 2,000 500 100
Selling Price ( per kg.)
R 20 40 250

The variable cost data on different crops are given below : (All figures in R per kg.)
Crop Labour Charges Packing Materials Other Variable Expenses
Wheat 8 2 4
Rice 10 2 1
Maize 120 10 20
C/3·52 APPLICATIONS OF MARGINAL COSTING

The company has a policy to produce and sell al the three kinds of crops. The maximum and minimum
area to be cultivated for each crop is as follows :

Crop Maximum Area Minimum Area

(in hectares) (in hectares)
Wheat 160 100
Rice 50 40
Maize 60 10

You are required to :

(i) Rank the crops on the basis of contribution per hectare.
(ii) Determine the optimum product mix considering that all the three cereals are to be produced.
(iii) Calculate the maximum profit which can be achieved if the total fixed cost per annum is
R 21,45,000.
Assume that there are no other constraints applicable to this company.
Ans. [(i) Wheat—II ; Rice—I ; Maize—III (ii) Optimum mix (in hectares) Wheat—150 ; Rice—50 ; Maize—
10 (iii) 4,30,000]
R

23. Small Tools Factory has a plant capacity adequate to provide 19,800 hours of machine use. The plant
can produce all A type tools or all B type tools or mixture of the two types. Following information is
relevant :
Per type A B
Selling price R 10 R 15
Variable cost R 8 R 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 tools can be sold in a
year. Annual fixed costs are 9,000.
R

Compute the product mix that will maximise the net income of the company and find the maximum net
income.
Ans. [A—2,600 ; B—3,000 ; R 5,200]
24. Vinak Ltd. which produces three products furnishes you the following data for 2023-24 :
Products
——————————————————————————————————————————

A B C
Selling price per unit ( )R 100 75 50
Profit volume ratio (%) 10 20 40
Maximum sales potential (units) 40,000 25,000 10,000
Raw material content as percentage of variable costs (%) 50 50 50
The fixed expenses are estimated at 6,80,000. The company uses a single raw material in all the three
R

products. Raw material is in short supply and the company has a quota for the supply of raw material
of the value of 18,00,000 for the year 2023-24 for the manufacture of its products to meet its sales
R

demand.
(i) Set a product mix which will give a maximum overall profit keeping the short supply of raw
materials in view ; (ii) Compute that maximum profit.
Ans. [(i) A—20,000 units, B—25,000 units, C—10,000 units ; (ii) R 95,000]
APPLICATIONS OF MARGINAL COSTING C/3·53

25. Following particulars are taken from the records of a company engaged in manufacturing two products,
A and B, from a certain material :
Product A Product B
(per unit) (per unit)
R R

Sales 2,500 5,000

Material cost ( 50 per kg)
R 500 1,250
Direct labour ( 30 per hour)
R 750 1,500
Variable overheads 250 500
Total fixed overheads : R 10,00,000

Comment on the profitability of each product when :

(i) Total sales in value is limited.
(ii) Raw material is in short supply.
(iii) Production capacity is the limiting factor.
(iv) Total availability of raw materials is 20,000 kgs. and maximum sales potential of each product is
1,000 units, find the product mix to yield maximum profits.
Ans. [(i) Product A (ii) Product A (iii) Product A (iv) 1,000 units of A and 400 units of B. Maximum Profit
R 7,00,000]

EFFECT OF CHANGE IN SELLING PRICE

26. The Profitability Statement of Gourmet Co. Ltd. has been summarized as given below :

Amount ( )
R Amount ( )
R

Sales 15,00,000
Direct Materials 4,50,000
Direct Wages 3,00,000
Variable Overheads 1,20,000
Fixed Overheads 4,40,000 (13,10,000)
Profit 1,90,000

The budgeted capacity of the company is 20,00,000 but the key factor is sales demand. It is proposed
R

that in order to utilize the existing capacity the selling price of the only product manufactured by the
company should be reduced by 5%. You are required to prepare a forecast statement which should
show the effect of the proposed reduction in selling price and include any changes in costs expected
during the coming year. The following additional information is given :
(i) Sales forecast 19,00,000 (after reduction).
R

(ii) Direct Materials prices are expected to increase by 2%.

(iii) Direct wage rates are expected to increase by 5%.
(iv) Variable overheads are expected to increase by 5%.
(v) Fixed overheads will increase by 20,000.
R

Ans. [Profit R 2,40,000]

1

SOLUTION
(a ) STATEMENT OF PROFIT AND LOSS
Products
Basis of ———————————————————————————————————————————————————————————————————————————————————————————————————

Apportionment A B C D Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R R
Sales (A) Actual 3,00,000 5,00,000 2,50,000 4,50,000 15,00,000
—————————————————————————————————————————————————————————————————————————————————————————————————————

Variable Costs : Actual 2,00,000 4,50,000 2,10,000 2,25,000 10,85,000

Packing, wages and materials @ 20 paise No. of parcels sent 20,000 30,000 15,000 35,000 1,00,000
Commission 4% of sales Sales 12,000 20,000 10,000 18,000 60,000
Stationery @ 10 paise No. of invoices sent 8,000 14,000 6,000 12,000 40,000
—————————————————————————————————————————————————————————————————————————————————————————————————————

Total Variable Cost (B) 2,40,000 5,14,000 2,41,000 2,90,000 12,85,000

—————————————————————————————————————————————————————————————————————————————————————————————————————

Contribution (Sales—Total Variable

Cost (A) – (B) 60,000 (–) 14,000 9,000 1,60,000 2,15,000
—————————————————————————————————————————————————————————————————————————————————————————————————————

Less : Fixed Costs :

Rent and Insurance Area of storage (sq. ft.) 7,500 6,000 12,000 4,500 30,000
Depreciation No. of parcels 2,000 3,000 1,500 3,500 10,000
Salesman’s salaries and expenses Sales value 12,000 20,000 10,000 18,000 60,000
Administration wages and salaries No. of invoices 10,000 17,500 7,500 15,000 50,000
—————————————————————————————————————————————————————————————————————————————————————————————————————

Total Fixed Cost 31,500 46,500 31,000 41,000 1,50,000

—————————————————————————————————————————————————————————————————————————————————————————————————————
—————————————————————————————————————————————————————————————————————————————————————————————————————
Profit/Loss 28,500 (–) 60,500 (–) 22,000 1,19,000 65,000
Percentage of Profit And Loss to Sales 9·5% (–) 12·1% (–) 8·8% 26·44% 4·33%
STANDARD COSTING AND VARIANCE ANALYSIS D/1·1

SECTION D

CHAPTER

1
Standard Costing and Variance
Analysis
LEARNING OBJECTIVES
To know how standard costing is different from standard cost, budgetary control and marginal
costing.
To learn about the analysis of variances and its importance.
To understand the Computation of Material, Labour, Overhead, Sales Variances and Profit &
Loss Variances.
To know about the importance and causes of Variance analysis.
To understand the advantages and disadvantages of Standard Costing.

Basically there are two systems of costing i.e. Historical Cost System and Standard Cost System.
Historical Cost System is based on actual cost. During the early stages in the development of Cost
Accounting, historical costing was the only method available for ascertaining cost. But historical
costing is not an effective method of exercising cost control because it does not provide yardsticks
with which actual performance may be compared. Historical costing is not preceded by planned
costs which are a must for effective cost control. The limitations and disadvantages of historical or
actual costing system have led to the development of standard costing system. Historical cost is valid
only for one accounting period for which it has been ascertained ; so it is not very helpful in price
quotations and production planning. Historical cost is just postmortem of the expenditure which has
been incurred ; so it is not an effective device of cost control.
On the other hand, standard costing is a very important system of cost control. It is important to
determine what a product should cost, and if the actual cost is more than the determined cost, then
why it is so. Standard costing aims at eliminating the wastes and increasing efficiency in
performances through setting up standards for production expenses and production performance. A
standard cost system can provide many useful informations which cannot be given by an actual or
D/1·2 STANDARD COSTING AND VARIANCE ANALYSIS

absorbing cost system. Under an actual costing system, it will be necessary to revise the absorption
rates for fixed overheads at regular intervals according to the variations in the volume of output and
cost of a particular job may be different in two periods depending upon the volume of the output. A
standard cost system eliminates the effect on job costs of fluctuations in volume of output by
separating the cost of idle facilities because standard costs have been defined as the normal costs for
normal production efficiency at a normal level of output.

Standard Cost
The word standard means a criterion or yardstick. Hence, standard cost is a predetermined cost.
It is a determination in advance of production, of what should be the cost. When standard costs are
used for the purposes of cost-control, the technique is known as the standard costing. The costing
terminology of Chartered Institute of Management Accountants, London defines standard cost as
follows :
“A predetermined calculation of how much costs should be under specified working conditions.
It is built up from an assessment of the value of cost elements and correlates technical specifications
and the quantification of materials, labour and other costs to the prices and/or wages rates expected
to apply during the period in which the standard cost is intended to be used. Its main purposes are to
provide bases for control through variance accounting for the valuation of stock and work in
progress and in some cases, for fixing selling prices.”
Eric L. Kohler has defined standard cost as follows :
“Standard cost is a forecast or pre-determination of what actual cost should be under projected
conditions, serving as a cost control and as a measure of production efficiency or standard of
comparison when ultimately aligned against actual cost. It furnishes a medium by which the
effectiveness of current results can be measured and the responsibility for deviations can be
placed.”
The main points in the above definitions are :
(i) It is pre-determined calculation of what cost ought to be under specific working conditions.
(ii) It is built up by correlating standard quantity (of machine time, labour time and
material) and forecast of future market trend for price standards (i.e., prices for material,
wage rates and machine cost per hour etc.)
(iii) It provides bases for control through variance accounting.
(iv) It provides bases for valuation of stock and work-in-progress and in some cases for fixing
selling price.

Standard Costing
It is the preparation of standard costs and applying them to measure the variations from actual
costs and analysing the causes of variations with a view to maintain maximum efficiency in
production. It is a technique which uses standards for costs and revenues for the purpose of control
through variance analysis.
From the definition given above, it is clear that the technique of standard costing may
comprise :
(i) Ascertainment of standard costs under each element of cost i.e., material, labour and
overhead.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·3

(ii) Measurement of actual costs.

(iii) Comparison of the actual costs with the standard costs to find out the variances.
(iv) Analysis of variances for the purpose of ascertainment of reasons of variances for taking
the appropriate action where necessary so that maximum efficiency may be achieved.
Standard costing is a technique which is complimentary to the actual costing or historical costing
system. Standard costs serve as yardsticks against which actual costs are compared to know the
reasons of inefficiencies. Therefore, actual costing system cannot be ignored even if standard costing
system is adopted.
The system of standard costing can be useful in all types of industries, but it is more commonly
used in industries producing standardised products which are repetitive in nature. Thus, standard
costing is more widely applied in process and engineering industries and is not suitable for job order
industries. Even in jobbing industries where jobs differ from each other, there is a considerable scope
for the use of this system of costing. Though the product in such industries might not be of a
repetitive and standard nature, still the operations performed for the completion of the jobs, would be
of a repetitive nature and standard can be laid down for the operations performed. Standard cost of
the job can be ascertained by adding up the standard cost of the operations involved in the job.
Comparison of the actual cost and the standard cost of the operations will be helpful in controlling
the cost of the operations and therefore, of job cost too.

Distinction Between Historical Costing and Standard Costing

Historical Costing Standard Costing
1. Ascertain-ment of Costs are ascertained after their Cost are predetermined.
Cost incurrence i.e. based on actual cost.
2. Yardstick It does not provide any yardstick It provides predetermined cost as a
against which efficiency of performance yardstick to measure actual performance.
can be measured
3. Availability of These costs are available too late to In it reports efficiency of variance helps in
Reports correct inefficiencies taking immediate action to correct the
position.
4. Data for Price Under it, costing data is obtained too In it, price can be quoted on the basis of
Quotation late for the purpose of price quotations, predetermined costs.
etc.
5. Cost Control It cannot be used for cost control It is used for cost control.
6. Expensive System It is comparatively an expensive system It is not so expensive system.

Standard Costing and Budgetary Control

Both standard costing and budgetary control achieve the same objective of maximum efficiency
and cost reduction by establishing predetermined standards, comparing actual performance with the
predetermined standards and taking corrective measures, where necessary. Thus, although both are
useful tools to the management in controlling costs, they differ in the following respects :
1. To be able to establish standard costs, some form of budgeting is essential as there is the need to
forecast the level of output and prescribed set of working conditions in the periods in which the
D/1·4 STANDARD COSTING AND VARIANCE ANALYSIS

standard costs are to be used. On the other hand, budgetary control can be prepared on the basis of
past figures adjusted to future trends. But to get the best out of budgetary control, linking of
budgetary control with standard costing is recommended.
2. Budgetary control is a management technique in planning and control whereas standard
costing is an engineering exercise and based on engineering data.
3. Budgetary control is a financial measure of target and achievement whereas standard costing
system a costing techniques.
4. In Budgetary Control analysis is made for each department or section level in standard costing
analysis is made for each product.
5. Standards are based on technical assessments whereas budgets are based on past actual adjusted
to future trends.
6. Budgetary control deals with the operations of a department of business as a whole while
standard costing is applied to manufacturing of a product, process or processes or providing a
service. Thus, budgetary control is extensive whereas standard costing is intensive in its application. For
example, budgets are prepared for different functions of the business i.e., production, sales,
purchases, cash etc. Standard costs, on the other hand, are compiled for various elements of cost.
7. Standards are set mainly for production and production expenses whereas budgets are
compiled for all items of income and expenditure. Therefore, budgeting is a much broader function than
standard costing.
8. Budgets set up maximum limits of expenses above which the actual expenditure should not
normally exceed. Standards set up targets which are to be attained by actual performance. Thus,
budgetary control lays emphasis on costs not exceeding the budgets and standard costing gives importance to
costs approaching the standard costs.
9. Budgets are projection of financial accounts ; standard costs are projection of cost accounts because
budgetary control adopts a more general approach of giving service to the management than does
standard costing. Financial accounting, as we know, is concerned with the overall efficiency of the
business whereas cost accounting deals with individual products, ascertaining and controlling their
costs. Standard costs aim at efficiency at every point ; so they are projection of cost accounts. On the
other hand, budgetary control aims at overall efficiency (i.e., efficiency of a particular function such
as sales function, purchase function, production function etc.) ; so it is a projection of financial
accounts.
10. In budgetary control, variances are not revealed through the accounts but are revealed in total. But
in standard costing, variances are analysed in detail according to their originating causes. Thus,
standard costing reveals variances through different accounts.
11. Budgets are anticipated or expected costs meant to be used for forecasting requirements of
material, labour, cash etc. Standard costs, on the other hand, do not tell what the costs are expected to
be, but rather what the costs should be under specific conditions of production performance and as such
cannot be used for the purpose of forecasting.
Both standard costing and budgetary control are complimentary to each other and for maximum
efficiency both should be used simultaneously. Both may prove more effective if they are used in
conjunction with each other.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·5

Standard Costs and Estimated Costs

Standard costs and estimated costs are predetermined costs, but their objectives are different.
Important points of differences between the two are as follows :
1. The object of estimated cost is to have a reasonable assessment of what a cost ‘will be’ whereas
standard cost aims at what a cost ‘should be’.
2. Estimated costs are calculated on the basis of past performance adjusted in the light of
anticipated changes in the future. Standard costs, on the other hand, are determined on a scientific
basis keeping in view certain factors and conditions of efficiency.
3. Estimated costs are for fixing selling prices of products, for taking a decision to manufacture or
to buy, for quoting the selling price of a job etc. They do not serve the purpose of cost control.
Standard costs, on the other hand, lay emphasis on cost control, set the targets against which actual
performance is measured and corrective measures are taken, where necessary.
4. Estimated costs are used by the concerns which adopt historical costing system of ascertaining cost
whereas standard costs are used by the concerns which follow standard costing system.
5. Standard costs are used as a regular system of accounts from which variances are found out
whereas use of estimated costs is as statistical data only.
6. Standard costs are to be fixed for each element of cost whereas estimated cost can be for a part of
the business and also for a particular purpose.

Standard Costing and Marginal Costing

Standard costing is a system of accounting in which all expenses (fixed and variable) are
considered for the determination of standard cost for a prescribed set of working conditions. On the
other hand, marginal costing is a technique in which only variable expenses are taken to ascertain the
marginal cost. Both standard costing and marginal costing are completely independent of each other and may
be installed jointly. This system of joint installation may be named as Marginal Standard Costing or
Standard Marginal Costing System. Variances are calculated in the same way as in standard costing
system with the only difference that volume variances are absent because fixed expenses are charged
in totals in each period.

Standard Costing and Standardised Costing

The term ’standardised costing’ is synonymous to uniform costing. Uniform costing is a system of
costing under which several undertakings use the same costing principles and practices. With the
help of uniform costing, several common processes of various industrial units can be standardised
which will be helpful in improving the performance of inefficient units. Both standard costing and
standardised costing (i.e., uniform costing) can be used for better management of industrial units.

Preliminaries to the Establishment of Standard Costs

Following preliminaries should be gone through before a standard costing system is established :
(1) Establishment of cost centres ; (2) Types of standard ; and (3) Setting the standards.
1. Establishment of Cost Centres. As defined earlier in this book, a cost centre is a location,
person or item of equipment for which costs may be ascertained and used for the purpose of cost
D/1·6 STANDARD COSTING AND VARIANCE ANALYSIS

control. Establishment of c o s t centres is necessary for fixing responsibilities for unfavourable

variances.
2. Types of Standards. There are three types of standards :
(a) Current Standard. A standard which is related to current conditions and is established for use over
a short period of time. This standard may be fixed on the basis of ideal standard or expected standard.
Ideal Standard. This is the standard which can be attained under the most favourable conditions possibly.
In other words, this standard is based upon a very high degree of efficiency which is rather
impossible to achieve. In this standard, it is assumed that there will be the most desirable conditions
of performance and that there will be no wastage of materials or time and no inefficiencies in the
manufacturing processes. This standard is not likely to be achieved because ideal conditions of
performance will not prevail. It is, therefore, a theoretical standard.
The utility of this standard is that it sets a target which, though not attainable in practice, is always
aimed at. The criticism of the standard is that when actual costs are compared with such standard
costs, large unfavourable variances are shown and these variances become a permanent feature of the
concern. The ideal standard will breed frustration among employees because such standard is never to
be attained. Nobody will pay serious attention to such standard and setting up of this standard will
become a farce.
Expected or Attainable Standard. This is the standard which is anticipated during a future specified
budget period. In fixing this type of standard present conditions and circumstances prevailing within a
particular industry are taken into consideration. Besides, due weightage is given to the expected
changes in the present circumstances and conditions. In setting up this standard, a reasonable allowance
is also made for unavoidable (normal) wastages. This standard is, therefore, considered to be more
realistic than the ideal standard because this standard is based on realities rather than on the most
ideal conditions. Hence, this type of standard is best suited from control point of view because this
standard reveals real variances from the attainable performance.
(b) Basic Standard. It is a standard which is established for use unaltered over a long period of time.
This standard is fixed for long periods so as to help forward planning. Basic standard is established
for some base year and is not changed for a long period of time as material prices, labour rates and
other expenses change. Deviations of actual costs from basic standards will not serve any practical
purpose because basic standards remain unaltered over a long period of time and are not adjusted to
current market conditions. Thus, this type of standard is not suitable from cost control point of view.
However, variances calculated on the basis of basic standards will help in studying the trends in
manufacturing costs over a long period of time.
Comparison of Current Standard and Basic Standard. Current standards relate to current
conditions and operate only for a short period before they are revised when conditions change. On
the other hand, basic standards are set for a long period and there is no need for constant revision for
such standards. Deviation of actual costs from basic standard costs will not serve any practical
purpose because standards are not adjusted to current market conditions. However, such standards
will be helpful in studying the trends of variances over a long period of time which is not possible in
case of current standards which go on changing. Current standards will take care of inflationary
tendencies because they are adjusted to current market conditions. On the other hand, basic
standards are static and do not take care of inflationary tendencies.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·7

(c) Normal Standard. This standard is defined as “the average standard which it is anticipated can be
attained over a future period of time, preferably long enough to cover one trade cycle”. Such standards are
established on the basis of average estimated performance over a future period of time (say 5
years) covering one trade cycle. It is difficult to follow normal standards in practice as it is not
possible to forecast performances with a reasonable degree of accuracy for a long period of time.
Such standards are attainable under anticipated normal conditions and are not attainable if
anticipated conditions do not prevail over a future period of time. That is why, normal standards
may not be a useful device for the purpose of cost control.
3. Developing (or Setting or Establishment of) Standard Cost. Just like a Budget Committee,
there should be a Standard Committee which should be entrusted with the work of setting standard
costs. This Committee will include General Manager, Purchase Officer, Production Engineer,
Production Manager, Sales Manager, Cost and Management Accountant, and other functional heads,
if any.
Of all the persons, the cost accountant plays a very important role in setting the standards
because he is to supply the necessary costs figures and coordinate the activities of the committee so
that standards set are as accurate as possible.
It may be noted that standards set should neither be too high nor too low. Nobody will take interest in
the standards if these are too high because such standards are not capable of being achieved and
employees will always have an opportunity to excuse the failure to reach such standards. Such
standards are not realistic and, therefore, cannot be used in inventory valuation, product costing and
pricing, planning and control, and capital investment decisions. Low standards, on the other hand,
will not induce employees and management to put more efforts because they can be achieved very
easily. They defeat the objectives of standard costing and fail to disclose inefficiencies because they
can be attained by poor performance. As a general rule, currently attainable standards should be set
which can be attained if employees and management become more efficient or put some more efforts.
Such standards motivate employees and are most appropriate for performance appraisal, cost control
and decision making. According to the National Association of Accountants (U.S.A.), “Such
standards provide definite goals which employees can usually be expected to reach and also appear
to be fair bases from which to measure deviations for which the employees are held responsible. A
standard set at a level which is high yet still attainable with reasonable diligent effort and attentive to
the correct methods of doing the job may also be effective for stimulating efficiency.”
The success of standard costing depends upon the establishment of correct standards. Thus,
every possible care should be taken in the establishment of standards and standards should be
established for each element of cost as follows :

(a) Direct Material Cost. Standard material cost for each product should be predetermined. This
will include :
(i) Determination of standard quantity of materials needed for the production.
(ii) Determination of standard price per unit of material.
In ascertaining standard quantity of materials, the standard specification of materials should be
planned by the engineering department after consulting the past records. While setting standards an
allowance should be made for the normal wastage of materials. The purpose of determining
standard quantities of materials should be to achieve maximum economies in material usage. A
D/1·8 STANDARD COSTING AND VARIANCE ANALYSIS

detailed listing of all materials required for a product is made on a Standard Material specification,
the specimen of which may be as follows :

STANDARD MATERIAL SPECIFICATION

No. ........... Date ...............
Description of the Product ....................

Description of Quantity of the Material

Code No. the Material per Product Remarks
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Prepared by ............
Checked by ............

The standard prices of materials should be determined for the various types of material needed
for the production. This is done by the cost and management accountant in collaboration with the
purchase officer. Standard price for each item of material is established after carefully studying the
market conditions and forecasting the trend of prices for a future period. While setting standard
material price, the cost of purchasing and storekeeping should also be included in the price of
materials. The object of fixing standard prices of materials is to increase efficiency in the purchasing
so that prices of materials may be kept down. Any difference between standard price and actual
price is to be referred to the Purchasing Department for explanation, so before setting standards for
material prices, it is advisable to see that purchasing functions are efficiently managed. Setting up of
standard prices of materials required is a difficult task because it depends on so many factors beyond
anybody’s control. Generally standard prices are based on current prices adjusted to expected
changes in future.

(b) Direct Labour Cost. Determination of standard direct labour cost will include determination
of :
(i) Standard time. (ii) Standard rate.
It becomes necessary to standardise the time to be taken for each category of labour and for each
operation involved. Time and motion study will determine how much time is to be allowed for each
operation involved. While fixing the standard time, due allowance should be made for fatigue, tool
setting, receiving instructions and normal idle time. Standard time can also be determined on the
basis of the average of the past performance. Though this method is simple, it is not scientific. Thus,
standard time is established on the basis of time and motion study and this is done in conjunction
with the work study engineers. Standard times established according to time and motion study are
independent of previous performances. It is good for the development of objective standards.
Standard time can also be set by taking trial runs for new products. This method is not satisfactory as
real conditions are not available in such runs.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·9

The fixation of standard labour rates is not so difficult as the fixation of standard prices of materials
is because labour rates are usually pre-established. Standard rates of pay should be established for
every category of labour. Labour rates in the past may not be reliable basis for determination of rates if
the labour rates are subject to fluctuating demand and supply of the labour force. Any expected
increase in rates should be considered in the determination of standard rates. Establishment of
standard rates of pay do not present ay problem in those industries where wage rates have been fixed
by contracts, Law, Wages Tribunals and Wages Boards. Fixation of standard rates will depend upon the
method of wage payment. Standard rates per hour or per day will be fixed if wages are paid according
to time wages system and when the method of wage payment is piece rate, standard wages per piece
will be fixed. Personnel department will help the cost and management accountant in determining
standard rates of pay.
Overheads. Broadly speaking overheads are segregated into fixed and variable and standard
overhead rate should be determined for fixed as well as variable overhead. Standard fixed overhead
rate and standard variable overhead rate should also be determined according to the function-wise
classification of overheads—manufacturing, administrative and selling and distribution so that exact
place of overhead variance may be located and corrective action may be taken. Standard overhead
rate is determined keeping in view past experience, present conditions and future trends. Fixation of
standard overhead rate involves determination of standard overhead costs, estimation of standard
level of production reduced to a common base such as units of production, direct labour hours,
machine hours, etc. and finally determination of standard overhead rate by dividing standard
overhead costs by standard level of production. The formula for the calculation of standard rate is :
Standard variable overhead rate :
Standard variable overheads for the budget period
Budgeted production in units or budgeted hours for the budget period
Standard fixed overhead rate :
Standard fixed overheads for the budget period
Budgeted production in units or budgeted hours for the budget period

Standard Hours
Production is generally expressed in physical units such as kilos, tons, gallons, units, dozens etc.
But it is difficult to express all the products in one common unit when different types of products
which are measured in different units are manufactured in a factory. In such a case, it is essential to
have a common unit in which all the products can be measured. Time factor is common to all the
products, and, therefore, production can be expressed in standard hours. A standard hour can be
defined as an hour which measures the amount of work that should be performed in one hour under standard
conditions. For example, if 100 units of product A can be produced in 10 hours and 200 units of

product B can be produced in 25 hours, a standard hour represents 10 units of product A [

100 units
10 hours ]
and 8 units of product B [ 200 units
25 hours ]. By using the standard hour, it is easy to calculate the volume of

output for a period. Thus, if budgeted hours for product A and product B are 8,000 and 4,000
respectively, budgeted output will be 80,000 (i.e., 8,000 × 10) units of product A and 32,000 (i.e., 4,000
D/1·10 STANDARD COSTING AND VARIANCE ANALYSIS

× 8) units of product B. Similarly, actual output can be expressed in terms of standard hours as
shown below :
Product Actual Output Standard Production in standard
(In units) units per hour hours or standard
hours produced
A 75,000 10 7,500
B 38,000 8 4,750
———————————

12,250
———————————

Standard Costing and Inventory Valuation

Usually inventory is valued in cost accounts on the basis of cost and in case of financial accounts
it is valued on the basis of cost or market price whichever is lower. If inventory is valued at cost,
efficiency or inefficiency of one period will be transferred to the next period and will distort the unit
cost of the next period. A good principle is that efficiency or inefficiency of a period should not be
passed on to the next period. Therefore, it is desirable that inventory should not be valued at cost
rather it should be valued at normal cost known as standard cost. Hence, a concern following
standard costing should value inventory at standard costs. However, standard costs should be
suitably amended in the light of variances not connected with efficiency or inefficiency, otherwise,
costs will be lower or above than the normal level of cost calculated on the basis of normal
performance.

Standard Cost Card or Standard Cost Sheet

It is an important part of the system of standard cost accounting. The standards established for
each element of cost (i.e., materials, labour and overheads) for a product are recorded in a standard
cost card or standard cost sheet. Such a card shows for a specified unit of production, the quantity
and price of each type of material required, the time and rate of each category of labour, the overhead
rate, total standard cost and cost per unit. A standard cost card should be maintained for each
product showing total standard cost of output dividing into various elements of cost.
A specimen of Standard Cost Card is given below :
STANDARD COST CARD
No. ...........
Product. .............. Date of Setting Standard .........................
Element of Cost Quantity or Hour Rate Standard Cost or Sales
R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
1. Direct Material
Material A 40 units 20 800
Material B 20 units 30 600
——————————————— ————————

60 units 1,400
Less : Normal Loss (10%) 6 units Scrap Value 120
——————————————— ————————

Normal Output 54 units 1,280

———————————————

2. Direct Labour 50 Hrs. 15 750

STANDARD COSTING AND VARIANCE ANALYSIS D/1·11

3. Overheads :
Variable 10 Hrs. 20 200
Fixed 10 Hrs. 10 100
————————

Total Cost 2,330

Profit 20% on Cost 466
————————

Selling Price 2796

————————

Total Cost R 2‚330

Standard Cost per unit = = = R 43.31
Output 54 units
Standard Selling Price per unit 43.31 + 20% of
R R 43.31 = R 51.76

ANALYSISOFVARIANCES
Control is a very important function of management. Through control management ensures that
performance of the organisation conforms to its plans and objectives. Analysis of variances or
variance analysis is the procedure of analysing the variances according to their causes. It is helpful in
controlling the performance and achieving the profits that have been planned.
The deviation of the actual cost or profit or sales from the standard cost or profit or sales is
known as “variance”. When actual cost is less than standard cost or actual profit is better than
standard profit, it is known as favourable variance and such a variance is usually a sign of efficiency of
the organisation. On the other hand, when actual cost is more than standard cost or actual profit or
turnover is less than standard profit or turnover, it is called unfavourable or adverse variance and is
usually an indicator of inefficiency of the organisation. The favourable and unfavourable variances
are also known as credit and debit variances respectively. Variances of different items of cost provide
the key to cost control because they disclose whether and to what extent standards set have been
achieved.
Another way of classifying the variances may be controllable and uncontrollable variances. If a
variance is due to inefficiency of a cost centre (i.e., individual or department), it is said to be
controllable variance. Such a variance can be corrected by taking a suitable action. For example, if
actual quantity of material used is more than the standard quantity, the foreman concerned would be
responsible for it. But if excessive use is due to defective supply of materials or wrong setting of
standards, the purchasing department or cost accounting department would be responsible for it. On
the other hand, an uncontrollable variance does not relate to an individual or department but it arises
due to external reasons like increase in prices of materials. This type of variance is not controllable
and no particular individual can be held responsible for it. In case of uncontrollable variances, future
standards should be revised.

Importance of Variance Analysis

The importance of variance analysis in controlling costs can be stated as under :
(i) Variances are analysed to find out the reasons or circumstances causing these so that management
can excise proper control.
(ii) Variances would serve as a useful tool in the implementation of the concept of management by
exception and in that variances keep the management informed about the erratic and out of line
behaviour of business. This helps the management to concentrate only on operations and segments of
an enterprise where deviations are there from target performance.
D/1·12 STANDARD COSTING AND VARIANCE ANALYSIS

(iii) Variances as a control device are calculated to assign/fix responsibility for deviations from the
standard cost and thus to control cost. For the purposes of control variances are classified as
controllable and uncontrollable variances. If a variance can be identified as the primary responsibility
of a specified person, it is said to be a controllable variance. The size of controllable variance reflects
the degree of efficiency of the person concerned. If the variance is due to the factors beyond the
control of an individual, then variance is said to be uncontrollable. The division of variance into
controllable and uncontrollable is extremely important because the attention of the management is
drawn particularly towards controllable variance. Controllable variances are carefully analysed and
reported to the management to enable it to pursue corrective action and thus facilitate the
implementation of the principle of management by exception.
There are a number of reasons which give rise to variances and the analysis of variances will
help to locate the reason and person or department responsible for a particular variance. The
management need not pay attention to items or departments proceeding according to standards
laid down. It is only in case of unfavourable items that the management has to exercise control. This
type of management technique is known as ‘management by exception’ and is considered as an
efficient way of exercising control because management cannot devote their limited time to every
item.
However, before reaching a conclusion, one has to understand that a variance may be due to
controllable causes or uncontrollable causes. A variance which is beyond the control of the manager
is uncontrollable and for this a manager cannot be held responsible.
For example, if market price of material has gone up, it is uncontrollable or if electricity or power
rates are increased by the government, a business manager cannot be responsible for the adverse
variance that will result from such a situation. Similarly, if price of a material comes down in the
market, it will be creating a favourable material price variance but a manager cannot be rewarded for
such a variance because it is not because of his actions.
Therefore before interpreting the variance, one has to see the exact cause of such a variance and
whether it is controllable or uncontrollable. Managers can be held responsible only for controllable
variances, i.e., those variances which show their performance and efficiency.
However, all companies do not utilise variance analysis in their managerial process. There are
many reasons for this. Instead of variance analysis, many companies perform horizontal or vertical
analysis.
The deviation of total actual cost from total standard cost is known as total cost variance. It is a net
variance which is the aggregate of all variances relating to various elements of cost, both favourable
and unfavourable.
Analysis of variances may be done in respect of each element of cost and sales, viz.,
1. Direct Material Variances ; 2. Direct Labour Variances ; 3. Overhead Variances ; 4. Sales
Variances.

Material Variances
In case of materials, the following may be the variances : (a) Material Cost Variance ; (b) Material
Price Variance ; (c) Material Usage or Quantity Variance ; (d) Material Mix Variance ; (e) Material
Yield Variance.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·13

Following chart shows the division and sub-division of material variances :

Material Cost Variance

Material Price Variance Material Usage

Material Usage or
(orQuantity
Quantity)Variance
Variance

Material Mix Material Yield

Variance Variance

Now, we proceed to define these variances one by one.

(a) Material Cost Variance (MCV). It is the difference between the standard cost of materials
allowed (as per standards laid down) for the output achieved and the actual cost of materials used.
Thus, it may be expressed as :
Material Cost Variance = Standard Cost of Materials for Actual Output
– Actual Cost of Materials Used
Or Material Cost Variance = Material Price Variance + Material Usage or Quantity Variance
Or Material Cost Variance = Material Price Variance + Material Mix Variance
+ Material Yield Variance.

In order to calculate material cost variance, it is necessary to know :

1. Standard quantity of materials which should have been required (as per standards set) to
produce actual output. Thus, standard quantity of materials is :
Actual Output × Standard Quantity of Materials per unit.
Note. In order to find out standard quantity of materials specified, actual output (and not standard
output) is to be multiplied by standard quantity of materials per unit.

2. Standard price per unit of materials.

3. Actual quantity of materials used.
4. Actual price per unit of materials.
(b) Material Price Variance (MPV). It is that portion of the material cost variance which is due
to the difference between the standard price of materials used for the output achieved and the
actual price of materials used. In other words, it can be expressed as :
Material Price Variance :
Actual Usage (Standard Unit Price – Actual Unit Price).
Here, Actual Usage = Actual quantity of material (in units) used
Standard Unit Price = Standard price of material per unit
Actual Unit Price = Actual price of material per unit.
(c) Material Usage (or Quantity) Variance (MQV). It is that portion of the material cost variance
which is due to the difference between the standard quantity of materials specified for the actual
output and the actual quantity of materials used. It may be expressed as :
D/1·14 STANDARD COSTING AND VARIANCE ANALYSIS

Material Usage Variance :

Standard Price per unit (Standard Quantity – Actual Quantity).
Note. Standard quantity means quantity of material which should have been used (as per standard determined) for
the actual output achieved.

ILLUSTRATION 1. The standard material required to manufacture one unit of product X is

10 kgs. and the standard price per kg. of material is R 25. The cost accounts records, however,
reveal that 11,500 kgs. of materials costing R 2,76,000 were used for manufacturing 1,000 units of
product X. Calculate material variances.

SOLUTION
Standard price of material per kg. = R 25
Standard usage per unit of product X = 10 kgs.
∴ Standard usage for an actual output of 1,000 units of product X = 1,000 × 10 kgs. = 10,000 kgs.
Actual usage of material = 11,500 kgs.
Actual cost of materials = R 2,76,000
R 2‚76‚000
Actual price of material per kg. = = R 24
11‚500

(a) Material Cost Variance

Standard Cost of Material – Actual Cost of Material
or Standard Usage × Standard Rate – Actual Usage × Actual Rate
10,000 kgs. × R 25 – 11,500 kgs. × R 24
R 2,50,000 – R 2,76,000 = R 26,000 Adverse.
(b) Material Price Variance
Actual Usage (Standard Unit Price – Actual Unit Price)
11,500 kgs. ( 25 –
R R 24) = R 11,500 Favourable

(c) Material Usage Variance

Standard Unit Price (Standard Usage – Actual Usage)
R 25 (10,000 kgs. – 11,500 kgs.) = R 37,500 Adverse.

Verification
Material Cost Variance = Material Price Variance + Material Usage Variance
R 26,000 Adverse = R 11,500 Fav. + 37,500 Adverse
R 26,000 Adverse = R 26,000 Adverse.
ILLUSTRATION 2. From the following particulars calculate : (i) Total Material Cost
Variance; (ii) Material Price Variance ; and (iii) Material Usage Variance.

Standard Actual
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Materials Units Price ( R) Units Price ( R)

A 1,010 1.0 1,080 1.2
B 410 1.5 380 1.8
C 350 2.0 380 1.9
STANDARD COSTING AND VARIANCE ANALYSIS D/1·15

SOLUTION
Workings :
Material Standard Cost Actual Cost
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Units Price ( ) R Total ( ) R Units Price ( )R Total ( )R

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

A 1,010 1.0 1,010 1,080 1.2 1,296

B 410 1.5 615 380 1.8 684
C 350 2 700 380 1.9 722
—————————— ——————————

2,325 2,702
——————————
—————————— ——————————
——————————

(i) Material Cost Variance

Standard Cost of Materials – Actual Cost of Materials
or St. Quantity × St. Unit Cost – Actual Quantity × Actual Unit Cost.
∴ Materials Cost Variance = R 2,325 – R 2,702 = R 377 Adverse.
(ii) Material Price Variance
Actual Quantity (St. Unit Price – Actual Unit Price)
Materials A : 1,080 Units ( 1 – R R 1.20) = R 216 Adverse
Materials B : 380 Units ( 1.5 –R R 1.80) = R 114 Adverse
Materials C : 380 Units ( 2.0 –R R 1.90) = R 38 Favourable
—————————————

Total Material Price Variance = R 292 Adverse

—————————————
(iii) Material Usage Variance
St. Price Per Unit (St. Quantity – Actual Quantity)
Materials A : R 1 (1,010 Units – 1,080 Units) = R 70 Adverse
Materials B : R 1.5 (410 Units – 380 Units) = R 45 Favourable
Materials C : R 2 (350 Units – 380 Units) = R 60 Adverse
——————————

Total Material Usage Variance = R 85 Adverse

——————————
Verification
Materials Cost Variance = Material Price Variance + Material Usage Variance
R377 Adverse = – 292 – 85 = 377 Adverse.
R R R

(d) Material Mix Variance (MMV). It is that portion of the material usage variance which is due
to the difference between standard and the actual composition of a mixture. In other words, this
variance arises because the ratio of materials being changed from the standard ratio set. It is
calculated as the difference between the standard price of standard mix and standard price of
actual mix.
In case of material mix variance, two situations may arise :
(i) When actual weight of mix and the standard weight of mix do not differ. In such a case,
material mix variance is calculated with the help of the following formula:
Standard Unit Cost (Standard Quantity – Actual Quantity)
or Standard Cost of Standard Mix – Standard Cost of Actual Mix.
If the standard is revised due to shortage of a particular type of material, the material mix
variance is calculated as follows :
Standard Unit Cost (Revised Standard Quantity – Actual Quantity).
or Standard Cost of Revised Standard Mix – Standard Cost of Actual Mix.
D/1·16 STANDARD COSTING AND VARIANCE ANALYSIS

ILLUSTRATION 3. From the following information, calculate the materials mix variance.
Materials Standard Actual
A 200 units @ R 12 160 Units @ R 13
B 100 units @ R 10 140 units @ R 10
Due to shortage of material A, it was decided to reduce consumption of A by 15% and increase
that of material B by 30%.
SOLUTION
Revised Standard Mix is :
Material A : 200 units – 15% of 200 = 170 units
B : 100 units + 30% of 100 = 130 units
Materials Mix Variance :
Standard Unit Cost (Revised Standard Quantity – Actual Quantity)
Material A : R 12 (170 units – 160 units) = R 120 Favourable
Material B : R 10 (130 units – 140 units) = R 100 Adverse
——————————

Materials Mix Variance = R 20 Favourable

——————————

(ii) When actual weight of mix differs from the standard weight of mix. In such a case, material
mix variance is calculated as follows :

[ Total Weight of Actual Mix

Total Weight of (Revised) St. Mix
× St. Cost of (Revised) St. Mix – St. Cost of Actual Mix ]
This formula is necessitated to adjust the total weight of standard mix to the total weight of actual
mix which is more or less than the weight of standard mix.
ILLUSTRATION 4. From the data given below, calculate all materials variances.
Consumption for 100 units of product
Raw Materials Standard Actual
A 40 units @ 50 per unit
R 50 units @ 50 per unit
B 60 units @ R 40 per unit 60 units @ R 45 per unit
SOLUTION
Workings :

Raw Standard Cost Actual Cost Revised Standard Standard

Materials Cost
——————————————————————————————————————————————————————————————————————————————————————————————————
Cost of
Units Rate Total Units Rate Total Units Rate Total Actual Mix
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R R R

A 40 50 2,000 50 50 2,500 44 50 2,200 2,500

(i.e. 50 × 50)
R

B 60 40 2,400 60 45 2,700 66 40 2,640 2,400

(i.e. 60 × 40)
R
———————— ———————— ———————— ———————— ——————— ———————— ————————
100 4,400 110 5,200 110 4,840 4,900
———————— ———————— ———————— ———————— ——————— ———————— ————————

(i) Materials Cost Variance = Standard Cost of Materials – Actual Cost of Materials
= 4,400 – 5,200 = 800 ( Unfavourable)
R R R
STANDARD COSTING AND VARIANCE ANALYSIS D/1·17

(ii) Materials Price Variance

Actual Quantity (Standard Unit Price – Actual Unit Price)
Material A : 50 units ( 50 – 50)
R R = Nil
Material B : 60 units ( 40 – 45)
R R = 300 Unfavourable
R
—————————————
Materials Price Variance = R 300 Unfavourable
—————————————

(iii) Materials Usage Variance

Standard Unit Price (Standard Quantity – Actual Quantity)
Material A : 50 (40 units – 50 units)
R = 500 Unfavourable
R

Material B : 40 (60 units – 60 units)

R = Nil
—————————————
Materials Usage Variance = R 500 (Unfavourable)
—————————————
(iv) Materials Mix Variance
= Standard Cost of Revised Standard Mix – Standard Cost of Actual Mix.
= 4,840 – 4,900 = 60 Unfavourable.
R R R

Or Material Mix Variance

Total Weight of Actual Mix
= × St. Cost of St. Mix – St. Cost of Actual Mix
Total Weight of St. Mix
50 units + 60 units
= × 4,400 – 4,900 = 4,840 – 4,900 = 60 Unfavourable
R R R R
40 units + 60 units
(e) Material Yield (or Sub-usage) Variance (MYV). It is that portion of the material usage variance
which is due to the difference between the standard yield specified and the actual yield obtained.
This variance measures the abnormal loss or saving of materials. This variance is particularly important in
case of process industries where certain percentage of loss of materials is inevitable. If the actual loss
of materials differs from the standard loss of materials, yield variance will arise. Yield variance is
also known as scrap variance. This loss may result in the following two situations :
(i) When standard and actual mix do not differ. In such a case, yield variance is calculated with
the help of the following formula :
Yield Variance = Standard Rate (Actual Yield – Standard Yield)
Standard Cost of Standard Mix
Where Standard Rate =
Net St. Output (i.e‚ Gross Output – St. Loss)
(ii) When actual mix differs from standard mix. In such a case, formula for the calcula-tion of
yield variance is almost the same. But since the weight of actual mix differs from that of the standard
mix, a revised standard mix is to be calculated to adjust the standard mix in proportion to the actual
mix and the standard rate is to be calculated from the revised standard mix as follows :
Standard Cost of Revised Standard Mix
Standard Rate =
Net Standard Output
Formula for yield variance in such a case is :
Yield Variance = Standard Rate (Actual Yield – Revised Standard Yield).
ILLUSTRATION 5. From the following data, calculate materials yield variance :
Standard Mix Actual Mix
Material A 200 units @ R 12 160 units @ R 13
Material B 100 units @ R 10 140 units @ R 10
Standard loss allowed is 10% of input. Actual output is 275 units.
D/1·18 STANDARD COSTING AND VARIANCE ANALYSIS

SOLUTION
In this case standard and actual mix do not differ. So there is no need of calculating revised standard mix.
Standard Mix Actual Mix
Materials A 200 units @ 12 = 2,400
R R 160 units @ 13 = 2,080 R R

Material B 100 units @ 10 = 1,000

R R 140 units @ 10 = 1,400 R R
————————————— ——————— ————————————— ———————
300 units R 3,400 300 units R 3,480
Less : Loss 30 units (10%) — 25 units —
————————————— ——————— ————————————— ———————
Output 270 units R 3,400 275 units R 3,480
————————————— ——————— ————————————— ———————
3‚400
Standard Cost per unit = R = R 12.593
270
Yield Variance = Standard Rate (Actual Yield – Standard Yield)
= R 12.593 (275 units – 270 units) = R 12.593 × 5 = R 62.965 Favourable.
ILLUSTRATION 6. From the following data, calculate material yield variance :
Standard Mix Actual Mix
Material A 60 units costing R 3,000 300 units costing R 15,300
Material B 40 units costing R 1,200 200 units costing R 5,600
Standard loss allowed is 10% of input and standard rate of scrap realisation is R 6 per unit.
Actual output is 440 units.
SOLUTION
Standard Mix Actual Mix
———————————————————————————————————————————
Units Amount Units
Material A 60 R3,000 300
Material B 40 R 1,200 200
——————— ———————————————— ———————
100 R 4,200 500
Less : Loss 10% 10 R 60 60
(Scrap of 10 units
@ R 6 per unit)
——————— ———————————————— ———————

Output 90 R 4,140 440

——————— ———————————————— ———————

R 4‚140
Standard cost per unit = = R 46
90
Yield Variance = St. Cost per unit (Actual Yield – St. Yield)
= 46 (440 units – 450 units) = 460 Adverse
R R

Standard Yield = Actual Material Mix – 10% of Actual Material Mix

10
= (300 units of A + 200 units of B) – × 500 = 500 – 50 = 450 units.
100
(f) Material Revision Variance. Once a standard is set for a period, it is usually followed for that
period. But sometimes due to seriousness of the situation such as a sudden rise in the prices of
materials, or due to the short supply of a particular material, there may be need of revision of
standard to cope with the situation. Standards are revised with the hope that when the current
difficulties are over, original standard will continue to operate. Thus, revision of standards may be for
a short period. Material revision variance is calculated as given below :
Material Revision Variance = St. Price (St. Usage – Revised St. Usage)
STANDARD COSTING AND VARIANCE ANALYSIS D/1·19

For calculation of material usage variance, revised standard usage or quantity will be taken in
stead of standard usage or quantity. Material usage variance will be calculated as given below :
Material Usage Variance = St. Price (Revised St. Usage – Actual Usage)
Other material variances will be calculated in the same way as explained earlier. In case there is
material revision variance, material cost variance will be verified as given below :
Material Cost Variance = Material Revision Variance + Price Variance + Usage Variance

ILLUSTRATION 7.
The standard cost of a chemical
mixture is as under :
8 tons of material A at R 40 per ton. Actual cost for a period is as under :
12 tons of material B at R 60 per ton. 10 tons of material A at R 30 per ton
Standard yield is 90% of input. 20 tons of material B at R 68 per ton
Compute all materials variances. Actual Yield is 26.5 tons.

SOLUTION
Workings :
Raw Standard Cost Actual Cost Revised Standard Standard Cost of
Materials Cost Actual Mix
—————————————————————————————————————————————————————————————————————————————————————————————————————
Tons Rate Total Tons Rate Total Tons Rate Total
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (3) × (5)
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R R R R

A 8 40 320 10 30 300 12 40 480 400

B 12 60 720 20 68 1,360 18 60 1,080 1,200
———————— ———————— ———————— ———————— ——————— ————————
20 1,040 30 1,660 30 1,560
Loss 2 — 3.5 — 3 —
———————— ———————— ———————— ———————— ——————— ———————— ————————
18 1,040 26.5 1,660 27 1,560 1,600
———————— ———————— ———————— ———————— ——————— ———————— ————————

(a) Materials Cost Variance

Standard Cost of Materials – Actual Cost of Actual Materials
1‚040 R

= × 26.5 – 1,660 = 1,531 – 1,660 =

R R R R 129 (A)
18
(b) Materials Price Variance
Actual Usage (St. Price – Actual Price)
Materials A : 10 tons ( 40 – 30) R = R R 100 (F)
Materials B : 20 tons ( 60 – 68) R = R R 160 (A)
—————————————
Materials Price Variance = R 60 (A)
—————————————

(c) Materials Usage Variance

Standard Price (Standard Usage – Actual Usage)

Material A : 40 R
8
18 (
× 26.5 tonnes – 10 tons ) = R 71 (F)

Material B : 60 R
12
18 [
× 26.5 tons – 20 tons ] = R 140 (A)
—————————————

Material Usage Variance R 69 (A)

—————————————
D/1·20 STANDARD COSTING AND VARIANCE ANALYSIS

(d) Materials Mix Variance

= Standard Cost of Revised Standard Mix – Standard Cost of Actual Mix
= 1,560 – 1,600 = 40 (A)
R R R

( e) Yield Variance
Standard Rate Per Unit (Actual Yield – Standard Yield)
1‚560
= R (26.5 tons – 27 tons) = 29 (A) R
27
Verification
Materials Cost Variance = Materials Price Variance + Materials Usage Variance
129 Unfav. = – 60 – 69 = 129 Unfav.
R R R R

Materials Usage Variance = Materials Mix Variance + Materials Yield Variance

R69 Unfavourable = – 40 – 29 = 69 Unfavourable.
R R R

ILLUSTRATION 8. XYZ Company manufactures a product ABC by mixing three raw

materials. For every 100 kgs. of ABC 125 kgs raw materials are used. In April, 2024, there was an
output of 5,600 kgs. of ABC. The standard and actual particulars of April 2024 are as follows :
Raw Material Standard Actual
——————————————————————————————————— ——————————————————————————————————————
Mix Price per kg. Mix Price per kg.
% R % R

I 50 40 60 42
II 30 20 20 16
III 20 10 20 12
Calculate all variances.
SOLUTION
Standard Cost Actual Cost Standard
Material ———————————————————————————————————————————————————————————————————————————————————————————————————————— Cost of
Kgs. Price Total Kgs. Price Total Actual Mix
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R R

I 3,500 40 1,40,000 4,200 42 1,76,400 1,68,000

II 2,100 20 42,000 1,400 16 22,400 28,000
III 1,400 10 14,000 1,400 12 16,800 14,000
————————— ———————————— ————————— ———————————— —————————————
7,000 1,96,000 7,000 2,15,600 2,10,000
125
(5,600 × 100 ) —————————————

Loss 1,400 — 1,400 —

25
(7,000 × 125 )
————————— ———————————— ————————— ————————————
5,600 1,96,000 5,600 2,15,600
————————— ———————————— ————————— ————————————

MCV = SC – AC MQV = SP (SQ – AQ)

= 1,96,000 –
R R 2,15,600 = R 19,600 (A) I = 40 (3,500 – 4,200) =
R R 28,000 (A)
MPV = AQ (SP – AP) II = 20 (2,100 – 1,400) =
R R 14,000 (F)
I = 4,200 ( 40 –42)= 8,400 (A)
R R R III = 10 (1,400 – 1,400) =
R —
———————————————
II = 1,400 ( 20 –16)= 5,600 (F)
R R R R 14,000 (A)
———————————————
III = 1,400 ( 10 –12)= R 2,800 (A)
———————————————
R R

5,600 (A)
———————————————
R

MMV = SC of SM – SC of AM = 1,96,000 – R R 2,10,000 = R 14,000 (A)

MYV = Nil
STANDARD COSTING AND VARIANCE ANALYSIS D/1·21

Labour Variances
Labour variances can be analysed as follows :
(a) Labour Cost Variance (LCV) ; (b) Labour Rate (of Pay) Variance (LRV) ; (c) Total Labour
Efficiency Variance (TLEV) Or Labour Efficiency Variance Unadjusted ; (d) Labour Efficiency
Variance (LEV) ; (e) Labour Idle Time Variance (LITV) ; (f) Labour Mix Variance or Gang
Composition Variance (LMV or GCV) ; (g) Labour Yield Variance or Labour Efficiency Sub-variance.
(LYV or LESV) ; (h) Substitution Variance.
These variances are like material variances and can be defined as follows :
(a) Labour Cost Variance. It is the difference between the standard cost of labour allowed (as per
standard laid down) for the actual output achieved and the actual cost of labour employed. It is also
known as wages variance. This variance is expressed as :
Labour Cost Variance = Standard Cost of Labour – Actual Cost of Labour.
(b) Labour Rate (of Pay) Variance. It is that portion of the labour cost variance which arises due
to the difference between the standard rate specified and the actual rate paid. It is calculated as
follows :
Rate of Pay Variance = Actual Time Taken (Standard Rate – Actual Rate).
(c) Total Labour Efficiency Variance. It is that part of labour cost variance which arises due to the
difference between standard labour cost of standard time for actual output and standard cost of
actual time paid for. It is calculated as follows :
Total Labour Efficiency Variance (TLEV)
= Standard Rate (Standard Time for Actual Output – Actual Time paid for)
Total labour efficiency variance is calculated only when there is abnormal idle time.
(d) Labour Efficiency Variance. It is that portion of labour cost variance which arises due to the
difference between the standard labour hours specified for the output achieved and the actual labour
hours spent. It is expressed as :
Labour Efficiency Variance = Standard Rate (Standard Time for Actual output – Actual Time
Worked). Here standard time for actual output means time which should be allowed for the actual
output achieved.
Actual Time worked means actual labour hours spent minus abnormal idle hours.
ILLUSTRATION 9. Calculate variances from the following data :
Standard Actual
Number of men employed 100 90
Output in units 5,000 4,800
Number of working days in a month 20 18
Average wages per man per month R 200 R 198

SOLUTION
First, we calculate standard rate, actual rate, standard time and actual time which are not directly given in
the question.
Standard wages per man per month = 200R

Standard working days in a month = 20

D/1·22 STANDARD COSTING AND VARIANCE ANALYSIS

200
∴ Standard rate per day = R = 10 R
20
Actual wages per man per month = 198 R

Actual working days in a month = 18

198
∴ Actual rate per day = R = 11 R
18
Standard man days for an output of 5,000 units = 100 × 20 = 2,000 man days
2‚000
∴ Standard man days for the actual output of 4,800 units = × 4,800 = 1,920 mandays.
5‚000
Actual man days = men × working days = 90 × 18 = 1,620 man days.
(a) Labour Cost Variance
Labour Cost Variance = Standard Cost of Labour – Actual Cost of Labour.
For. 5,000 units Standard cost of labour = 100 workers @ 200 = 20,000. R R

20‚000
∴ For the actual output of 4,800 units, Standard cost of labour = × 4,800 = R 19,200.
5‚000
Actual Cost of Labour = 90 workers @ 198 = 17,820. R R

∴ Labour Cost Variance = 19,200 – 17,820 = 1,380 Favourable

R R R

(b) Rate of Pay Variance

Actual Time (Standard Rate – Actual Rate)
1,620 man days ( 10 – 11) = 1,620 Unfavourable
R R R

(c) Labour Efficiency Variance

Standard Rate (Standard Time – Actual time)
R10 (1,920 man days – 1,620 man days) = 3,000 Favourable R

(e) Labour Idle Time Variance. It is calculated only when there is abnormal idle time. It is that
portion of labour cost variance which is due to the abnormal idle time of workers. This variance is
shown separately to show the effect of abnormal causes affecting production like power failure,
breakdown of machinery, shortage of materials etc. While calculating labour efficiency variance,
abnormal idle time is deducted from actual time expended to ascertain the real efficiency of the
workers. Labour idle time variance is expressed as :
Idle Time Variance = Abnormal Idle Time × Standard Rate
Or Idle Time Variance = St. Rate (Actual Hours Worked – Actual Hours Paid)
Total Labour Cost Variance = Labour Rate of Pay Variance + Total Labour Efficiency
Variance
Total Labour Efficiency Variance = Labour Efficiency Variance + Labour Idle Time Variance
ILLUSTRATION 10. Using the following information, calculate labour variances :
Gross direct wages = R 3,000 ; Standard hours produced = 1,600 ; Standard rate per hour =
R 1.50 ; Actual hours paid 1,500 hours, out of which hours not worked (abnormal idle time) are 50.
SOLUTION
(a) Labour Cost Variance
Standard Cost of Labour – Actual Cost of Labour
or Standard Hours × Standard Rate – Actual Hours × Actual Rate
1,600 × R 1.50 – 1,500 × R 2= R 600 (Adverse)

( Actual Rate =
Gross Direct Wages
Actual Time
=
3‚000
1‚500 hours
= R R 2 per hour )
STANDARD COSTING AND VARIANCE ANALYSIS D/1·23

(b) Labour Rate of Pay Variance

Actual Time (Standard Rate – Actual Rate)
= 1,500 hours ( 1.50 –
R R 2) = R 750 (Adverse)
(c) Total Labour Efficiency Variance = SR (ST for AO – AT paid for)
= R 1.50 (1,600 Hours – 1,500 Hours) = R 150 (F)
(d) Labour Efficiency Variance
Standard Rate (Standard Time – Actual Time Worked)
R 1.50 (1,600 Hours – 1,450 Hours) = R 225 Favourable
(Actual Time = Actual Hours Paid – Idle Hours i.e. 1,500 – 50 = 1,450 Hours)
(e) Idle Time Variance
Abnormal Idle Time × Standard Rate
50 Hours × R 1.50 = R 75 Adverse
Verification
Labour Cost Variance = Rate of Pay Variance + Efficiency Variance + Idle Time Variance
R 600 Adverse = – R 750 + R 225 – R 75 = R 600 Adverse.
ILLUSTRATION 11. The standard output of ‘X’ is 25 units per hour in a manufacturing
department of a company employing 100 workers. The standard wage rate per labour hour is R 6.
In a 42 hour week, the department produced 1,040 units of X despite the loss of 5% of the time
paid due to abnormal reason. The hourly rates actually paid were R 6.20, R 6 and R 5.70 respectively
to 10, 30 and 60 workers. Compute relevant variances.
SOLUTION
Basic Calculations
Standard output of 100 workers working for one hour in a manufacturing department is 25 units.
100 hours
∴ St. time per unit = = 4 hours
25 units
St. time for actual output of 1,040 units @ 4 hours = 4,160 hours
St. labour cost of actual output cost. rate of 6 = 4,160 × 6 = 24,960 R R R

CALCULATION OF ACTUAL LABOUR COST

No. of Hours per Actual hours Idle hours paid @ Effective Rate per Actual Labour
workers week paid 5% of time paid hours hour Cost
(1) (2) (3) = (1) × (2) (4) = 5% of (3) (5) = (3) – (4) (6) (7) = (3) × (6)
10 42 420 21 399 6.20 2,604
30 42 1,260 63 1,197 6.00 7,560
60 42 2,520 126 2,394 5.70 14,364
Total 4,200 210 3,990 24,528

Calculation of Variances
Labour Rate Variance = Actual Time (St. Rate – Actual Rate)
For 10 Workers = 420 ( 6 – 6.20)
R R = R 84 Adverse
For 30 Workers = 1,260 ( 6 – 6) R R = Nil
For 60 Workers = 2,520 ( 6 – 5.70) R R = R 756 Fav.
———————————

Total Labour Rate Variance R 672 Fav.

———————————
D/1·24 STANDARD COSTING AND VARIANCE ANALYSIS

Total Labour Efficiency Variance

= St. Rate (St. Time for Actual Output – Actual Time Paid)
= 6 (4,160 hours – 4,200 hours) = 240 Adverse
R R

Labour Efficiency Variance

= St. Rate (St. Time for Actual Output – Actual Time Worked)
= 6 (4,160 hours – 3,990 hours)
R

= 1,020 Fav.
R

Idle Time Variance

= St. Rate (Actual Hours Worked – Actual Hours Paid)
= 6 (3,990 – 4,200)
R

= 1,260 Adverse
R

Labour Cost Variance = St. Labour Cost – Actual Labour Cost

= 24,960 – 24,528
R R

= 432 Fav.
R

Verification
Labour Cost Variance = Labour Rate Variance + Total Labour Efficiency Variance
432 Fav.
R = 672 Fav. + 240 Adverse = 432 Fav.
R R R

or Labour Cost Variance = Rate Variance + Efficiency Variance + Idle Time Variance
432 Fav.
R = 672 Fav. + 1,020 Fav. + 1,260 Adverse = 432 Fav.
R R R R

Labour Efficiency Variance can be split into :

(i) Labour Mix Variance or Gang Composition Variance
(ii) Labour Yield Variance or Labour Efficiency Sub-Variance.
(f) Labour Mix (or Gang Composition) Variance. It is like materials mix variance and is a part of
labour efficiency variance. This variance shows to management as to how much of the labour cost
variance is due to the change in the composition of labour force. It is calculated as follows :
(i) When there is no change in the standard composition labour force and total time expended is
equal to the total standard time, the formula is
Labour Mix Variance = Standard Cost of Standard Composition (for Actual Time Taken)
– Standard Cost of Actual Composition (for Actual Time Worked)

Or Labour Mix Variance = Labour Hours (

Total Actual Standard Rate per hour Standard Rate per Hour
of Standard Mix – of Actual Mix )
(ii) When standard composition of labour force is revised due to shortage of a particular type of
labour and the total time expended is equal to the total standard time, the formula is :
Labour Mix Variance = Standard Cost of Revised Standard Composition (for Actual Time Taken)
– Standard Cost of Actual Composition (for Actual Time Worked)
(iii) When total actual time of labour differs from the total standard time of labour, the formula
is—
Labour Mix Variance
⎛ Total Time of Actual ⎞
⎜ Labour Composition ⎟
=⎜
Time of Standard⎟
× Standard Cost of Standard Labour Composition
⎜⎝ Total
Labour Composition ⎠
⎟ – (Standard Cost of Actual Labour Composition)

(iv) When standard is revised and the total actual time of labour differs form the total standard
time of labour, then formula for the calculation of labour mix is :
STANDARD COSTING AND VARIANCE ANALYSIS D/1·25

Labour Mix Variance

⎛ Total Time of Actual ⎞
=⎜
Labour Composition ⎟
⎜ ×
Time of Revised⎟
⎜ Total ⎟
⎜⎝ Standard Labour ⎟⎠ Standard Cost of Revised Standard Labour
Composition Composition
– (Standard Cost of Actual Labour Composition)
ILLUSTRATION 12. From the following data, calculate labour variances :
The budgeted labour force for producing product A is :
20 Semi-skilled workers @ p. 75 per hour for 50 hours
10 Skilled workers @ R 1.25 per hour for 50 hours
The actual labour force employed for producing A is :
22 Semi-skilled workers @ p. 80 per hour for 50 hours.
8 Skilled workers @ R 1.20 per hour for 50 hours.
SOLUTION
Working Notes :
Standard Cost Actual Cost Standard
Workers ——————————————————————————————————————————————————————————————————————————————————————————————————————— Cost of
Hours Rate Total Hours Rate Total Actual Mix
per unit per unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R R

Semi-skilled 1,000 0.75 750 1,100 0.80 880 825

Skilled 500 1.25 625 400 1.20 480 500
————————— ———————————— ————————— ———————————— ————————————
1,500 1,375 1,500 1,360 1,325
————————— ———————————— ————————— ———————————— ————————————

(a) Labour Cost Variance

Standard Cost of Labour – Actual Cost of Labour
Labour Cost Variance = 1,375 – 1,360 = 15 (Favourable)
R R

(b) Rate of Pay Variance

Actual Time (Standard Rate – Actual Rate)
Semi-skilled Workers = 1,100 ( 0.75 – 0.80) =R R R 55 (A)
Skilled Workers = 400 ( 1.25 – 120)
R =R R 20 (F)
—————————————————
R 35 (A)
—————————————————
(c) Labour Efficiency Variance
Standard Rate (Standard Time – Actual Time)
Semi-skilled Workers = 0.75 (1,000 – 1,100)
R = R 75 (A)
Skilled Workers = 1.25 (500 – 400)
R = R 125 (F)
——————————————
Total Labour Efficiency Variance = R 50 (F)
——————————————

(d) Labour Mix Variance

Standard Cost of Standard Mix – Standard Cost of Actual Mix
∴ Labour Mix Variance = 1,375 – 1,325 = 50 (F)
R R R

Verification
Labour Cost Variance = Rate of Pay Variance + Efficiency Variance
15 Favourable = – 35 + 50 = 15 Favourable
R R R R
D/1·26 STANDARD COSTING AND VARIANCE ANALYSIS

ILLUSTRATION 13. From the following data, calculate labour mix variance or gang
composition variance.
Standard Labour
100 Skilled workers @ R 300 per month
200 Semi-skilled workers @ R 200 per month
Actual Labour
110 Skilled workers @ R 350 per month
340 Semi-skilled workers @ R 225 per month
Due to shortage of skilled workers, it was decided to reduce the number of skilled workers by
10% and increase that of semi-skilled workers @ 5%.
SOLUTION
Revised Standard Mix
10
Skilled workers = 100 – × 100 = 90
100
5
Semi-skilled workers = 200 + × 200 = 210
100
————————

300
————————

Actual Mix
Skilled workers = 110
Semi-skilled workers = 340
————————
450
————————

In this case, total number of standard workers differs from total number of actual workers. Therefore, the

( )
following formula for the calculation of labour mix variance will apply.
Total Number of Actual
Labour Mix Standard Cost of Revised
× – Standard Cost of Actual Composition
Total Number of Revised Standard Labour Mix
Standard Labour Mix
450
= × R 69,000 – R 1,01,000 = 1,03,500 –
R R 1,01,000 = R 2,500 Fav.
300
Standard Cost of Revised Standard Mix R

Skilled Workers 90 @ 300 R = 27,000

Semi-skilled workers 210 @ R 200 = 42,000
—————————————

69,000
—————————————

Standard Cost of Actual Mix R

Skilled Workers 110 @ 300 R 33,000

Semi-skilled Workers 340 @ 200 R 68,000
—————————————
1,01,000
—————————————

(g) Labour Yield Variance. It is like material yield variance and arises due to the difference
between yield that should have been obtained by actual time utilised on production and actual yield
obtained. It can be calculated as follows :
Standard Labour Cost per unit [Actual Yield in units – Standard Yield in units expected from the
actual time worked on production].
STANDARD COSTING AND VARIANCE ANALYSIS D/1·27

(h) Substitution Variance. This is a variance in labour cost which arises due to substitution of
labour when one grade of labour is substituted by another. This is denoted by difference between the
actual hours at standard rate of standard worker and the actual hours at standard rate of actual
worker. This can be denoted as under :
Substitution Variance = (Actual Hours × Std. Rate for Std. Worker) – (Actual Hours × Std.
Rate for Actual Worker)

ILLUSTRATION 14. A gang of workers usually consists of 100 men, 50 women and 50 boys
in a factory. They are paid at standard hourly rate of R 12.50, R 8.00 and R 7.00 respectively. In a
normal working week of 40 hours the gang is expected to produce 1,000 units of output.
In a certain week, the gang consisted of 130 men, 40 women and 30 boys. Actual wages were
paid at the rates of R 12.00, R 8.50 and R 6.50 respectively. Two hours were lost due to abnormal idle
time and 960 units of output were produced.
Calculate various labour variances.
SOLUTION
Working Notes :
Here M = Men, W = Women and B = Boys
(A) Standard Mix (B) Standard Hours.
4‚000
M = 100 × 40 = 4,000 hrs. M = × 960 = 3,840 hrs.
1‚000
2‚000
W = 50 × 40 = 2,000 hrs. W = × 960 = 1,920 hrs.
1‚000
2‚000
B = 50 × 40 = 2,000 hrs. B = × 960 = 192 hrs.
1‚000
————————— —————————
8,000 hrs. 7,680 hrs.
—————————
————————— —————————
—————————

(C) Actual Hours (excluding Idle Time) (D) Idle Time

M = 130 × 40 = 5,200 hrs. M = 130 × 2 = 260 hrs
W = 40 × 40 = 1,600 hrs. W = 40 × 2 = 80 hrs.
B = 30 × 40 = 1,200 hrs. B = 40 × 2 = 80 hrs.
————————— —————————

8,000 hrs. 400 hrs.

—————————
————————— —————————
—————————

(E) Actual Hours (excluding Idle Time) (F) Revised Standard Hours
100
M = 5,200 – 260 = 4,940 hrs. M = 7,600 × = 3,800 hrs.
200
50
W = 1,600 – 80 = 1,520 hrs. W = 7,600 × = 1,900 hrs.
200
50
B = 1,200 – 80 = 1,120 hrs. B = 7,600 × = 1,900 hrs.
200
———————— —————————
7,600 hrs. 7,600 hrs.
————————
———————— —————————
—————————

Standard Rate Actual Rate

M = 12.50
R M = 12.00
R

W = 8.00
R W = 8.50
R

B = 7.00
R B = 6.50
R

Labour Cost Variance = (SH × SR) – (AH × AR)

M = (3,840 × R 12.50) – (5,200 × R 12) = 14,400 (A)
D/1·28 STANDARD COSTING AND VARIANCE ANALYSIS

W = (1,920 × R 8.00) – (1,600 × R 8.50) = 1,760 (F)

B = 1,920 × R 7.00) – (1,200 × R 6.50) = 5,640 (F)
—————————

7,000 (A)
—————————
—————————

Labour Rate Variance = AT (SR – AR)

M = 5,200 ( 12.50 – R 12.00) = R R 2,600 (F)
W = 1,600 ( 8.00 – R 8.50) = R R 800 (A)
B = 1,200 ( 7.00 – R 6.50) = R R 600 (F)
—————————

R 2,400 (F)
—————————
—————————

Total Labour Efficiency Variance = SR (SH – AH)

M = 12.50
R (3,840 – 5,200) = 17,000 (A)
W = 8.00
R (1,920 – 1,600) = 2,560 (F)
B = 7.00
R (1,920 – 1,200) = 5,040 (F)
—————————

9,400 (A)
—————————
—————————

Labour Net Efficiency Variance = SR (SH – RSH)

M = 12.50
R (3,840 – 3,800) = 500 (F)
W = 8.0
R (1,920 – 1,900) = 160 (F)
B = 7.00
R (1,920 – 1,900) = 140 (F)
—————————

800 (F)
—————————
—————————

Labour Idle Time Variance = SR × IT

M= R 12.50 × 260 = 3,250 (A)
W= R 8.00 × 80 = 640 (A)
B= R 7.00 × 80 = 420 (A)
—————————

4,310 (A)
—————————
—————————

Labour Mix Variance = SR (RSH – AH)

M= R12.50 (3,800 – 4,940) = 14,250 (A)
W= R 8.00 (1,900 – 1,520) = 3,040 (F)
B= R 7.00 (1,900 – 1,140) = 5,320 (F)
—————————

5,890 (A)
—————————
—————————

Labour Yield Variance = Standard Labour Cost per unit (AY – SY)
= 80 (960 – 950) = 800 (F)
R R

1‚000
Std. Yield = × 7,600 = 950 units
8‚000
(4‚000 × R 12.50) + (2‚000 × R 8.00) + (2‚000 × R 7)
Standard Labour Cost per unit = = R 80
1‚000

ILLUSTRATION 15. The original standard rate of pay in a factory was R 4 per hour. Due to
settlement with trade unions, this rate of pay per hour is increased by 15%. During a particular
period, 5,000 actual hours were worked whereas work done was equivalent to 4,400 hours. The
actual labour cost was R 24,000. Calculate labour variances.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·29

SOLUTION
Original standard rate per hour R 4
Current standard rate per hour ( 4 + 15% of R R 4) R 4.60
(a) Rate of Pay Variance
= Actual time (Current standard rate – Actual rate)

= 5,000 hrs. [ R 4.60 – R

24‚000
5‚000 ]
= R 23,000 — R 24,000 = R 1,000 Adverse.
(b) Labour Efficiency Variance
= Current standard rate (Standard time – Actual time)
= 4.60 (4,400 hrs. – 5,000 hrs.) = 2,760 Adverse.
R R

(c) Wages Revision Variance

= Standard labour cost of actual output at original standard rate
– Standard labour cost of actual output at current standard rate
or = Time allowed × Original standard rate – Time allowed × Current standard rate
= 4,400 hrs. × R 4 – 4,400 hrs. × R 4.60 = R 2,640 Adverse.
(d) Total Labour Cost Variance
Standard time × Original st. rate – Actual cost of labour
= 4,400 hrs. R 4– R 24,000 = R 6,400 Adverse.

Materials and Labour Variances

ILLUSTRATION 16. Trishul Industries turns out only one article, the prime cost standards
for which have been established as follows :
Per Completed Piece
Material—5 lbs. @ 4.20 R R 21

Labour — 3 hours @ R 3 R 9

The production schedule for the month of July, 2023 required completion of 5,000 pieces.
However, 5,120 pieces were actually completed.
Purchases for the month of July 2023 amounted to 30,000 lbs. of material at the total invoice
price of R 1,35,000.
Production records for the month of July, 2023 showed the following actual results.
Materials requisitioned and used 25,700 lbs.
Direct labour—15,150 hours R 48,480

Calculate appropriate material and labour variances.

SOLUTION
( a) Material Cost Variance
Standard Unit Cost of Material × Actual Output—Actual Cost of Material
1‚35‚000 R
R21 × 5,120 pieces – × 25,700 lbs.
30‚000 lbs.
= 1,07,520 – 1,15,650 = 8,130 Adverse
R R R
D/1·30 STANDARD COSTING AND VARIANCE ANALYSIS

(b) Material Price Variance

Actual Usage (Standard Unit Price – Actual Unit Price)

= 25,700 lbs. [ R 4.20 –

R 1‚35‚000
30‚000 ]
= 25,700 lbs. ( 4.20 – R R 4.50) = R 7,710 Adverse
( c) Material Usage Variance
Standard Unit Price (Standard Usage – Actual Usage)
R4.20 (5,120 × 5 lbs. – 25,700 lbs.)
= 4.20 (25,600 lbs. – 25,700 lbs.) = 420 Adverse
R R

(d) Labour Cost Variance

Standard Labour Cost per unit × Actual Output – Actual Cost of Labour
R 9 × 5,120 pieces – 48,480R

= 46,080 – 48,480 =
R R R 2,400 Adverse
(e) Labour Rate of Pay Variance
Actual Time (Standard Rate – Actual Rate)

15,150 hours [ R 3–
R48‚480
15‚150
= ] R 45,450 – R 48,480 = R 3,030 Adverse

(f) Labour Efficiency Variance

Standard Rate (Standard Time – Actual Time)
R 3(5,120 × 3 hours – 15,150 hours) = R 3 (15,360 – 15,150) = R 630 Favourable.

OVERHEADVARIANCE
Overhead cost variance can be defined as the difference between the standard cost of overhead
allowed for the actual output achieved and the actual overhead cost incurred. In other words,
overhead cost variance is under or over absorption of overheads. The formula for the calculation is:

Overhead Cost Variance

Actual Output × Standard Overhead Rate per unit – Actual Overhead Cost
or Standard Hours for Actual Output × Standard Overhead Rate per hour – Actual Overhead Cost
Overhead cost variance can be classified as :
(1) Variable Overhead Variance ; (2) Fixed Overhead Variance.
1. Variable Overhead Variance. It is the difference between the standard variable overhead cost
allowed for the actual output achieved and the actual variable overhead cost. This variance is
represented by expenditure variance only because variable overhead cost will vary in proportion to
production so that only a change in expenditure can cause such variance. It is expressed as :
Actual Output × Standard Variable Overhead Rate – Actual Variable Overheads
or St. Hours for Actual Output × St. Variable Overhead Rate per hour – Actual Variable Overheads
Some accountants also find out variable overhead efficiency variance just like labour efficiency
variance. Variable overhead efficiency variance can be calculated if information relating to actual
STANDARD COSTING AND VARIANCE ANALYSIS D/1·31

time taken and time allowed is given. In such a case variable overhead variance can be divided into
two parts as given below :
(a) Variable Overhead Expenditure Variance Or Variable Overhead Budget Variance
= Actual hours worked × Standard variable overhead rate per hour – Actual variable overheads
Or Actual Hours (Standard Variable Overhead Rate per Hour – Actual Variable Overhead Rate per
Hour)
Variable overhead expenditure variance is calculated in the same way as labour rate variance is
calculated.
(b) Variable Overhead Efficiency Variance
= Standard time for actual production × Standard variable overhead rate per hour
– Actual hours worked × Standard variable overhead rate per hour
Or Standard Variable Overhead Rate per Hour (Standard Hours for Actual Production – Actual Hours)
Variable overhead efficiency variance resembles labour efficiency variance and is calculated
like labour efficiency variance.
ILLUSTRATION 17. From the following data, calculate variable overhead variances :
Budgeted Actual
Variable overhead R2,50,000 R 2,60,000
Output in units 25,000 20,000
Working hours 1,25,000 1,10,000
SOLUTION
2‚50‚000
Standard variable overhead per unit = = 10
R R
25‚000
2‚50‚000
Standard variable overhead per hour = = 2R R
1‚25‚000
1‚25‚000
Time allowed per unit of output = = 5 hours
25‚000
Variable Overhead Expenditure Variance
Actual hours worked × Standard rate per hour – Actual overhead
1,10,000 × 2 – 2,60,000 = 40,000 Adverse
R R R

Variable Overhead Efficiency Variance

Standard time for actual production × Standard variable overhead rate per hour
– Actual hours worked × Standard variable overhead rate per hour
= 1,00,000 × 2 – 1,10,000 × 2 = 20,000 Adverse
R R R

Standard time for actual production = Time allowed for 20,000 units of actual output @ 5 hours per unit i.e.,
1,00,000 hours.
Total Variable Overhead Variance
Actual output × Standard rate per unit – Actual overhead
20,000 × R 10 – R 2,60,000 = R 60,000 Adverse.
2. Fixed Overhead Variance. It is that portion of total overhead cost variance which is due to the
difference between the standard cost of fixed overhead allowed for the actual output achieved and
the actual fixed overhead cost incurred. The formula for the calculation of this variance is
Actual Output × Standard Fixed Overhead Rate per Unit – Actual Fixed Overheads.
D/1·32 STANDARD COSTING AND VARIANCE ANALYSIS

or Standard Hours Produced × Standard Fixed Overhead Rate per Hour – Actual Fixed Overheads
(Standard Hours Produced = Time which should be taken for actual output i.e., Standard Time
for Actual Output)
Or Fixed Overheads Absorbed – Actual Fixed Overheads
This variance is further analysed as under :
(a) Budget or Expenditure Variance. It is that portion of the fixed overhead variance which is due
to the difference between the budgeted fixed overheads and the actual fixed overheads incurred
during a particular period. It is expressed as :
Expenditure Variance = Budgeted Fixed Overheads – Actual Fixed Overheads
Expenditure Variance = Budgeted Hours × Standard Fixed Overhead Rate per Hour
– Actual Fixed Overheads.
(b) Volume Variance. It is that portion of the fixed overhead variance which arises due to the
difference between the standard cost of fixed overhead allowed for the actual output and the
budgeted fixed overheads for the period during which the actual output has been achieved. This
variance shows the over or under absorption of fixed overheads during a particular period. If the
actual output is more than the budgeted output, there is over-recovery of fixed overheads and
volume variance is favourable and vice versa if the actual output is less than the budgeted output.
This is so because fixed overheads are not expected to change with the change in output. This
variance is expressed as :
Volume Variance = Actual Output × Standard Rate – Budgeted Fixed Overheads
or Standard Rate (Actual Output – Budgeted Output)
or Volume Variance = Standard Rate per hour (Standard Hours Produced – Actual Hours)
Standard hours produced means number of hours which should have been taken for the actual
output as per the standard laid down.
Volume variance can be further subdivided into three variances as given below :
(i) Capacity Variance. It is that portion of the volume variance which is due to working at higher
or lower capacity than the budgeted capacity. In other words, this variance is related to the under
and over utilisation of plant and equipment and arises due to idle time, strikes and lock-out,
break-down of the machinery, power failure, shortage of materials and labour, absenteeism,
overtime, changes in number of shifts. In short, the variance arises due to more or less working
hours than the budgeted working hours. It is expressed as :
Capacity Variance = Standard Rate (Revised Budgeted Units – Budgeted Units)
or Capacity Variance = Standard Rate (Revised Budgeted Hours – Budgeted Hours)
(ii) Calendar Variance. It is that portion of the volume variance which is due to the difference
between the number of working days in the budget period and the number of actual working days in
the period to which the budget is applicable. If the actual working days are more than the standard
working days, the variance will be favourable and vice versa if the actual working days are less than
the budgeted days. It is calculated as :
Calendar Variance = Increase or decrease in production due to more or less working days at the
rate of budgeted capacity × Standard rate per unit.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·33

(iii) Efficiency Variance. It is that portion of the volume variance which is due to the difference
between the budgeted efficiency of production and the actual efficiency achieved. This variance is
related to the efficiency of workers and plant and is calculated as :
Standard Rate per unit (Actual Production (in units) – Standard Production (in units))
or Standard Rate per hour (Standard Hours Produced — Actual Hours)
Here, standard production or hours means budgeted production or hours adjusted to increase or
decrease in production due to capacity or calendar variance.
Suppose, budgeted production is 10,000 units, 5% capacity is increased and factory works for 27
days instead of 25 days during the month. Standard production in this case should be 11,340 units
calculated as follows :
10‚000 units
Revised Budgeted Production = × 27 = 10,800 units
25
5
Production increased due to 5% increase in capacity = 10,800 × = 540 units
100
Production increased due to 2 more working days is :
Within 25 days, Standard production is 10,000 units
10‚000
∴ Within 2 days, production should be × 2 = 800 units.
25
Hence, total standard output is 10,000 + 540 + 800 = 11,340 units.

Suppose further that actual output is 10,600 units and standard fixed overheads rate is R 2 per
unit. In such a case, efficiency variance will be :

Standard Rate (Actual Production – Standard Production)

R 2 (10,600 units – 11,340 units) = R 1,480 Unfavourable

Total Overhead Cost Variance can be analysed as follows :

Total Overhead Cost Variance

Fixed Overheads Variance VariableOverheads

Variable Overhead Variance
Variance

Volume Variance Expenditure Variance

or Level Variance
or Budget Variance

Capacity Variance Calendar Variance Efficiency Variance

Two Variance, Three Variance and Four Variance Methods of Analysis of Overhead
Variances
Analysis of overhead variance can also be made by two variance, three variance and four
variance methods. The analysis of overhead variances by expenditure and volume is called two
D/1·34 STANDARD COSTING AND VARIANCE ANALYSIS

variance analysis. When the volume variance is further analysed to know the reasons of change in
output, it is called three variance analysis. Change in output occurs due to :

(i) Change in capacity i.e., change in working hours per day giving rise to capacity variance.
(ii) Change in number of working days giving rise to calendar variance.
(iii) Change in the level of efficiency resulting into efficiency variance.

Thus, three variance analysis includes :

(i) Expenditure variance ; (ii) Volume variance further analysed into : (a) Capacity variance,
(b) Calendar variance, and (c) Efficiency variance.
Four Variance Analysis includes :
(i) Expenditure Variance or Spending Variance ; (ii) Variable Overhead Efficiency Variance ; (iii)
Fixed Overhead Capacity Variance ; (iv) Fixed Overhead Efficiency Variance. ;
ILLUSTRATION 18. From the following data, calculate overhead variances :
Budgeted Actual
Output 15,000 units 16,000 units
Number of Working Days 25 27
Fixed Overheads R 30,000 R 30,500

Variable Overheads R 45,000 R 47,000

There was an increase of 5% in capacity.

SOLUTION
(1) Total Overhead Cost Variance
Actual units × Standard Rate – Actual Overheads Cost
16,000 units ( 2 + 3) – ( 30,500 + 47,000)
R R R R

= 80,000 – 77,500 = 2,500 Favourable

R R R

Standard Overheads
Standard Rate =
Standard Output
30‚000
∴ Standard Rate : Fixed : = 2 R R
15‚000
45‚000
– Variable : = 3
R R
15‚000
Actual Overhead Cost = Fixed Overheads + Variable Overheads
= R 30,500 + 47,000 = 77,500.
R R

(2) Variable Overhead Expenditure Variance

Actual Units × Standard Rate – Actual Variable Overhead Cost
16,000 × R 3– R 47,000 = R 1,000 Favourable.

(3) Fixed Overhead Variance

Actual Units × Standard Rate (Fixed Overheads) – Actual Fixed Overheads
16,000 × R 2– R 30,500 = R 1,500 Favourable
(4) Volume Variance
Actual Units × Standard Rate – Budgeted Fixed Overheads
16,000 × R 2– R 30,000 = R 2,000 Favourable
STANDARD COSTING AND VARIANCE ANALYSIS D/1·35

(5) Expenditure Variance

Budgeted Fixed Overheads – Actual Fixed Overheads
= 30,000 – 30,500 = 500 Unfavourable.
R R R

(6) Capacity Variance

Standard Rate (Revised Budgeted Units – Budgeted Units)
Budgeted units for 25 days = 15,000 units
15‚000
∴ Budgeted units for 27 days = × 27 = 16,200 units
25
Revised budgeted units after 5% increase in capacity
5
= 17,010 i.e., 16,200 + × 16,200
100
∴ Capacity Variance = R 2 (17,010 – 16,200) = R 1,620 Fav.
(7) Calendar Variance
Increase or decrease in production due to more or less working days × Standard rate per unit
Within 25 days, Standard production = 15,000 units
∴ Within 2 days (27 – 25), production will be increased by
15‚000 × 2
= = 1,200 Units
25
∴ Calendar Variance = 1,200 units × 2 R = 2,400 Favourable.
R

(8) Efficiency Variance

Standard Rate (Actual Production – Standard Production)

Standard Production
Budgeted Production = 15,000 units
Production increased due to increase in capacity = 810 units
Production increased due to 2 more working days = 1,200 units
——————————————————

17,010 units
——————————————————

∴ Efficiency Variance = R 2 (16,000 units – 17,010 units) = R 2 (– 1,010 units)

= R 2,020 Unfavourable

ILLUSTRATION 19. From the following data, calculate overhead variances :

Budgeted Actual
Overheads R3,75,000 R 3,77,500
Output per man hour in units 2 1.9
Number of Working days 25 27
Man hours per day 5,000 5,500
SOLUTION
Variances relate to fixed overhead variances, because overheads are to be treated as fixed when question
is silent about their nature whether fixed or variable. We proceed to find out standard output, standard rate and
actual output which are not given in the question.
Standard working days = 25
Standard man hours per day = 5,000
Standard output per man hour = 2
∴ Standard output = 25 × 5,000 × 2 = 2,50,000 units
Standard Fixed Overheads = R3,75,000
D/1·36 STANDARD COSTING AND VARIANCE ANALYSIS

∴ Standard Rate per unit = R

3‚75‚000
2‚50‚000 ( Standard Overheads
Standard Output )
= 1.50 R

Actual working days = 27

Actual man hours per day = 5,500
Actual output per man hour = 1.9
∴ Actual output = 27 × 5,500 × 1.9 = 2,82,150 units.
(1) Fixed Overhead Variance
Actual Output × Standard Rate – Actual Overheads
2,82,150 × 1.50 – 3,77,500 = 4,23,225 – 3,77,500 =
R R R R R 45,725 Favourable.
(2) Expenditure Variance
Budgeted Overheads – Actual Overheads
R3,75,000 – 3,77,500 = 2,500 Unfavourable.
R R

(3) Volume Variance

Actual Output × Standard Rate – Budgeted Overheads
2,82,150 units × 1.50 – 3,75,000
R R

= 4,23,225 – 3,75,000 = 48,225 Favourable

R R R

(4) Capacity Variance

Standard Rate (Revised Budgeted Units — Budgeted Units)

Revised Budgeted Units

Actual Working days = 27
Revised man hours due to increase in capacity = 5,500
Standard Output per man hour = 2
∴ Revised Budget Units = 27 × 5,500 × 2 = 2,97,000 units
Budgeted units = 27 × 5,000 × 2 = 2,70,000 units
∴ Capacity Variance = 1.50 (2,97,000 – 2,70,000)
R

= 40,500 Fav.
R

(5) Calendar Variance

Within 25 days, budgeted production = 2,50,000 units
Within 2 more working days, production will increase by
2‚50‚000
= × 2 = 20,000 units
25
∴ Calendar Variance= 20,000 units × 1.50 = 30,000 Fav.
R R

(6) Efficiency Variance

Standard Rate (Actual Production – Standard Production)
Standard Production, i.e., number of units which should have been produced if there had been no increase
or decrease in efficiency.
Budgeted Output = 2,50,000 units
Production increased due to increase in capacity = 27,000 units
Production increased due to 2 more working days = 20,000 units
——————————————

Standard Output 2,97,000 units

——————————————

Efficiency Variance = R 1.50 (2,82,150 units – 2,97,000 units)

= R 1.50 (–14,850 units) – 22,275 Unfav.
R
STANDARD COSTING AND VARIANCE ANALYSIS D/1·37

Efficiency variance can also be calculated as follows :

Actual working days = 27
Actual man hours per day = 5,500
∴ Actual man hours = 27 × 5,500 = 1,48,500
Standard output per man hour = 2 units
Actual output per man hour = 1.9 units
∴ Loss of output or inefficiency per man hour = 2 – 1.9 = 0.1 unit
∴ Total loss of output due to inefficiency :
Actual man hours × loss of output per hour
= 1,48,500 man hours × 0.1 unit = 14,850 units
∴ Efficiency Variance= –14,850 × Standard Rate = –14,850 × R 1.50 = R 22,275 Unfav.
Verification
Fixed Overhead Variance = Volume Variance + Expenditure Variance
R 45,725 Favourable = 48,225 (Favourable) – 2,500 (Unfavourable)
R R

R 45,725 Favourable = 45,725 Favourable

R

Volume Variance = Capacity Variance + Calendar Variance + Efficiency Variance

R 48,225 (Favourable) = 40,500 (Fav.) + 30,000 (Fav.) – 22,275 (Unfav.)
R R R

= 48,225 Favourable = 48,225 Favourable.

R R

ILLUSTRATION 20. S.V. Ltd. has furnished you the following data :
Budgeted Actual
July, 2023
Number of working days 25 27
Production in units 20,000 22,000
Fixed overheads R 30,000 R 31,000

Budgeted fixed overhead rate is R 1.00 per hour. In July 2023 the actual hours worked were
31,500.
Calculate : (i) Efficiency Variance, (ii) Capacity Variance, (iii) Calendar Variance, (iv) Volume
Variance, (v) Expenditure Variance, and (vi) Total Overhead Variance.
SOLUTION
Budgeted fixed overheads R 30,000
Budgeted fixed overhead rate per hour R 1.00

Therefore, budgeted hours ( R 30‚000

R1 ) 30,000 hours

Budgeted production in units 20,000

Therefore, standard time per unit

30‚000
20‚000 ( ) 1.50 hours

Standard rate per unit ( Budgeted overheads

Budgeted output
i.e.‚
30‚000
20‚000
R

) R 1.50

(i) Efficiency Variance

Standard overhead rate per hour (Standard hours for actual output – Actual hours worked)
R 1.00 (33,000 – 31,500) = 1,500 Favourable.
R

(Standard hours for actual output = 22,000 units @ 1.5 hours = 33,000 hours).
D/1·38 STANDARD COSTING AND VARIANCE ANALYSIS

(ii) Capacity Variance

Standard rate per hour (Actual hours worked – Budgeted hours for 27 days)
R1.00 (31,500 – 32,400) = 900 Adverse.
R

( Budgeted hours for 25 days are 30,000, therefore budgeted hours for 27 days are 32,400 i.e.,
30‚000
25 × 27 ).
(iii) Calendar Variance
Standard Overheads
(Actual working days — Standard working days)
Standard number of days
R30‚000
(27 – 25) = 2,400 Favourable.
R
25
(iv) Volume Variance
Standard rate per unit (Actual output – Standard output)
1.50 (22,000 – 20,000) = 3,000 Favourable.
R R

(v) Expenditure Variance

Budgeted overheads – Actual overheads
30,000 – 31,000 = 1,000 Adverse.
R R R

(vi) Total Overhead Variance

Standard overheads for actual output – Actual overheads
or, Standard rate per unit × Actual output – Actual overheads
R 1.50 × 22,000 – R 31,000 = R 2,000 Favourable.

An Alternative Method of Analysis of Fixed Overhead Variance

Some accountants analyse fixed overhead variance into three classifications as given below :
(a) Expenditure Variance ; (b) Efficiency Variance ; (c) Volume Variance.
(a) Expenditure Variance. It is that portion of fixed overhead variance which is due to the
difference between the budgeted fixed overhead and the actual fixed overhead incurred during a
particular period.
(b) Efficiency Variance. It is that portion of fixed overhead variance which is due to the difference
between the standard recovery of fixed overhead and the standard fixed overhead for actual hours. It
is calculated as follows :
Standard fixed overhead rate per hour (Standard hours for actual production – Actual hours).
(c) Volume Variance. It is that portion of fixed overhead variance which is due to the difference
between the standard fixed overhead for actual hours and the budgeted hours. It is calculated as
given below :
Standard fixed overhead rate per hour (Actual hours – Budgeted hours)
The operations of a firm are so inter linked that the level of performance in one area of operation
will affect the performance in other areas. Improvements in one area may lead to improvements in
other areas. A sub-standard performance in one area may be compensated by a favourable
performance in another area. A company may experience an unfavourable variance in materials
because of purchase of superior quality of materials than the budgeted quality but this may be offset
by favourable variances due to lower percentage of materials rejections, wastages and improvements
in quality of the end products leading to better prices. Because of the interdependencies among
STANDARD COSTING AND VARIANCE ANALYSIS D/1·39

activities in a firm, the managers should not jump to conclusions merely based on the type of
variances namely favourable or unfavourable. The variances thus provide only clues for more
detailed investigation. Thus the overhead variances should be viewed as interdependent rather than
independent. A better picture will be captured when overhead variances are not viewed in isolation
but in an integrated manner because there is room for a trade off between variances.
The analysis of fixed overhead variance according to the above method is made clear in the
illustration given below :
ILLUSTRATION 21. From the data given below prepare a table to include overhead
variances analysed into Efficiency, Volume and Expenditure.
Standard details Department
————————————————————————————————————————

X Y
Hours, when working at normal capacity 4,000 2,000
Overhead, hourly rate R 0.50 R 2.00

Allowed hours for actual production 4,000 1,600

Actual details—
Hours 4,150 1,550
Overhead R 2,020 R 3,750
SOLUTION
CALCULATION OF VARIANCES
Dept. X Dept. Y
——————————————————————————————————————————————————————————————

1. Budgeted hours 4,000 2,000

2. Standard overhead rate per hour R 0.50 R 2
3. Budgeted overhead (1 × 2) R 2,000 R 4,000
4. Allowed, i.e., standard hours for actual production 4,000 1,600
5. Standard recovery of overhead (4 × 2) R 2,000 R 3,200
6. Actual overhead R 2,020 R 3,750
7. Total overhead variance (5– 6) R 20 Adverse R 550 Adverse
8. Actual hours worked 4,150 1,550
9. Standard overhead for actual hours (8 × 2) R 2,075 R 3,100
10. Efficiency Variance (5 – 9) R 75 Adverse R 100 Fav.
11. Volume Variance (9 – 3) R 75 Fav. R 900 Adverse
12. Expenditure Variance (3 – 6) R 20 Adverse R 250 Fav.

SALESVARIANCES
The analysis of variances will be complete only when the difference between the actual profit and
standard profit is fully analysed. It is necessary to make an analysis of sales variances to have a
complete analysis of profit variance because profit is the difference between sales and cost. Thus, in
addition to the analysis of cost variances, i.e., materials cost variance, labour cost variance and
overheads cost variance, an analysis of sales variances should be made. Sales variances may be
calculated in two different ways. These may be computed so as to show the effect on profit or these
D/1·40 STANDARD COSTING AND VARIANCE ANALYSIS

may be calculated to show the effect on sales value. The first method of calculating sales variances is
profit method of calculating sales variances and the second is known as value method of calculating
sales variances. Sales variances showing the effect on profit are more meaningful, so these would be
considered first.
Profit Method of Calculating Sales Variances
The sales variances according to this method can be analysed as :
(1) Total Sales Margin Variance (TSMV)
Actual Profit – Budgeted Profit
or Actual Quantity of Sales × Actual Profit per unit– Budgeted Quantity of Sales
× Budgeted Profit per unit

(2) Sales Margin Variance (SMV) due to Selling Price. It is that portion of total sales margin
variance which is due to the difference between the actual price of quantity of sales effected and the
standard price of those sales. It is calculated as :
Actual Quantity of Sales (Actual Selling Price per unit – Standard Selling Price per unit).
(3) Sales Margin Variance (SMV) due to Volume. It is that portion of total sales margin variance
which arises due to the number of articles sold being more or less than the budgeted quantity of sales.
It is calculated as :
Standard Profit per unit (Actual Quantity of Sales – Budgeted Quantity of Sales)
Sales margin variance due to volume can be divided into two parts as given below :
(i) Sales margin variance due to sales mixture.
(ii) Sales margin variance due to sales quantities.

Sales Margin Variance (SMV)due to Sales Mixture (SM)

It is that portion of sales margin variance due to volume which arises because of different
proportion of actual sales mix. It is taken as the difference between the actual and budgeted
quantities of each product of which the sales mixture is composed, valuing the difference of
quantities at standard profit. It is calculated as given below :
Standard Profit per unit (Actual quantity of sales – Standard proportion for actual sales)
or Standard Profit – Revised Standard Profit.

Sales Margin Variance (SMV)due to Sales Quantities (SQ)

It is that portion of sales margin variance due to volume which arises due to the difference
between the actual and budgeted quantity sold of each product. It is calculated as :
Standard Profit per unit (Standard proportion for actual sales – Budgeted quantity of sales)
or Revised Standard Profit – Budgeted Profit.

Value Method of Calculating Sales Variances

Sales variances calculated according to value method show the effect on sales value and enable
the sales manager to know the effect of the various sales efforts on his overall sales value figures.
Sales variances according to this method may be as follows :
STANDARD COSTING AND VARIANCE ANALYSIS D/1·41

(1) Sales Value Variance (SVV) It is the difference between the standard value and the actual
value of sales effected during a period. It is calculated as :
Sales Value Variance = Actual Value of Sales – Budgeted Value of Sales.
Sales value variance arises due to one or more of the following reasons :
(i) Actual selling price may be higher or lower than the standard price. This is expressed in sales
price variance.
(ii) Actual quantity of goods sold may be more or less than the budgeted quantity of sales. This is
expressed in sales volume variance.
(iii) Actual mix of various varieties sold may differ from the standard mix. This is expressed in
sales mix variance.
(iv) Revised standard sales quantity may be more or less than the budgeted quantity of sales. This
is expressed in sales quantity variance.
(2) Sales Price Variance (SPV). It is that portion of sales value variance which arises due to the
difference between actual price and standard price specified. The formula for the calculation of this
variance is :
Sales Price Variance = Actual Quantity Sold (Actual Price – Standard Price)
(3) Sales Volume Variance (S.Vol. V). It is that portion of the sales value variance which arises
due to difference between actual quantity of sales and standard quantity of sales. The variance is
calculated as :
Sales Volume Variance = Standard Price (Actual Quantity of Sales – Budgeted Quantity of Sales)
Sales volume variance can be divided into two parts as follows :
(a) Sales Mix Variance (SMV). It is a part of sales volume variance and arises due to the
difference in the proportion in which various articles are sold and the standard proportion in which
various articles were to be sold. It is calculated as :
Sales Mix Variance = Standard Value of Actual Mix – Standard Value of Revised Standard Mix.
(b) Sales Quantity Variance (SQV). It is that part of sales volume variance which arises due to the
difference between revised standard sales quantity and budgeted sales quantity. It is calculated as :
Standard Selling Price (Revised Standard Sales Quantity – Budgeted Sales Quantity).

ILLUSTRATION 22. From the following particulars calculate all sales variances according to
(A) Profit Method and (B) Value Method.
Product Standard Actual
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Quantity Cost Price Quantity Cost Price

units per unit per unit units per unit per unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

X 3,000 R 10 R 12 3,200 R 10.50 R 13

Y 2,000 R 15 R 18 1,600 R 14.00 R 17

SOLUTION (For working table see next page)

D/1·42 STANDARD COSTING AND VARIANCE ANALYSIS
STANDARD COSTING AND VARIANCE ANALYSIS D/1·43

(A) Profit Method

1. Total Sales Margin Variance = Actual Profit – Budgeted Profit
= 12,800 – 12,000 = 800 (F)
R R R

2. Sales Margin Variance due to Selling Price

= Actual Qty. of Sales (Actual sale price per unit – Budget sales price per cent)
X = 3,200 ( 13 – 12)
R R= 3,200 (F)
R

Y = 1,600 ( 17 – 18)
R R= 1,600 (A)
R
————————————

1,600 (F)
————————————

3. Sales Margin Variances due to Volume

= Standard Profit per unit (Actual Quantity of Sales – Budgeted Quantity of Sales)
X = 2 (3,200 – 3,000) =
R 400 (F)
R

Y = 3 (1,600 – 2,000) =
R 1,200 (A)
R
————————————

800 (A)
————————————

4. Sale Margin Variance due to Sales Mix

= Standard Profit per unit (Actual Qty. of Sales – Standard Proportion for Actual Sales)
X = 2 (3,200 – 2,880) =
R 640 (F)
R

Y = 3 (1,600 – 1,920) =
R 960 (A)
R
————————————

320 (A)
————————————

5. Sales Margin Variance due to Sales Quantity

= Standard Profit per unit (Standard Proportion for Actual sales – Budgeted Quantity of Sales)
X = 2 (2,880 – 3,000) =
R 240 (A)R

Y = 3 (1,920 – 2,000) =
R 240 (A)R
————————————
R 480 (A)
————————————

(B) Value Method

1. Sales Value Variance = Actual Value of Sales – Budgeted Value of Sales)
= 68,800 – 72,000 = 3,200 (A)
R R R

2. Sales Price Variance = Actual Quantity of Sales (Actual Price – Budgeted Price)
X = 3,200 ( 13 – 12) =
R 3,200 (F)
R R

Y = 1,600 ( 17 – 18) =
R 1,600 (A)
R R
————————————

1,600 (F)
————————————

3. Sales Volume Variance = Standard Price (Actual Qty. of Sales – Budgeted Qty. Sales)
X = 12 (3,200 – 3,000) = 2,400 (F)
R R

Y = 18 (1,600 – 2,000) = 7,200 (A)

R R
—————————————

4,800 (A)
—————————————

4. Sales Mix Variance = Standard Value of Actual Mix

– Standard Value of Revised Standard Mix
= 67,200 – 69,120 = 1,920 (A)
R R R

5. Sales Quantity Variance = Standard Selling Price

(Revised Sales Qty. – Budgeted Qty. of Sales)
X = 12 (2,880 – 3,000) =
R 1,440 (A) R

Y = 18 (1,920 – 2,000) =
R 1,440 (A) R
—————————————

R 2,880 (A)
—————————————
D/1·44 STANDARD COSTING AND VARIANCE ANALYSIS

ILLUSTRATION 23. Ultra Modern Casette Ltd. had the following budgeted sales and actual
sales for March, 2024.
Budgeted Actual Cost price
—————————————————————————————————————————————————————————————————————————————————————
Cassette Units Price Units Price per unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R

A 1,100 50 1,300 55 45
B 950 100 1,000 95 85
C 1,250 80 1,200 78 70
Compute the various sales variances by following (i) Profit Method and (ii) Value Method.
SOLUTION. For Working Table, see next page
(i) According to Profit Method
TSMV = Actual Profit – Budgeted Profit
= 32,600 – 32,250 = 350 (F)
R R R

SMV due to Selling Price = AQ of Sales (Actual SP – Budgeted SP)

A = 1,300 (55 – 50) = 6,500 (F)
R R

B = 1,000 (95 – 100) = 5,000 (A)

R R

C = 1,200 (78 – 80) = 2,400 (A)

R R
——————————
R 900 (A)
——————————

SMV due to Volume = Standard Profit Per Unit (AQ of Sales – Budgeted Qty. of Sales)
A = 5 (1,300 – 1,100)
R = 1,000 (F) R

B = 15 (1,000 – 950)
R = 750 (F) R

C = 10 (1,200 – 1,250) =
R 500 (A) R
——————————
R 1,250 (F)
——————————

SMV due to Sales Mix = Standard Profit per unit (AQ of Sales – Standard Proportion for Actual Sales)
A = 5 (1,300 – 1,167) =
R 665 (F) R

B = 15 (1,000 – 1,008) =
R 120 (A) R

C = 10 (1,200 – 1,325) = 1,250 (A)

R R
——————————
R 705 (A)
——————————

SMV due to Sales Qty. = Std. Profit per unit (Std. Proportion for Actual Sales – BQ of Sales)
A = 5 (1,167 – 1,100) =
R 335 (F) R

B = 15 (1,008 – 950) =
R 870 (F) R

C = 10 (1,325 – 1,250) =
R 750 (F) R
——————————
R 1,955 (F)
——————————

PROFIT AND LOSS STATEMENT

A B C
———————————————————————————————————————————————————————————————————————————————
R R R

Budgeted Sales 55,000 95,000 1,00,000

Less : Budgeted Cost 49,500 80,750 87,500
———————————————————————————————————————————————————————————————————————————————
Budgeted Profit 5,500 14,250 12,500
Variances
SMV due to SP 6,500 (F) 5,000 (A) 2,400 (A)
SMV due to SM 665 (F) 120 (A) 1,250 (A)
SMV due to SQty. 335 (F) 870 (F) 750 (F)
———————————————————————————————————————————————————————————————————————————————
Actual Profit 13,000 10,000 9,600
STANDARD COSTING AND VARIANCE ANALYSIS D/1·45
D/1·46 STANDARD COSTING AND VARIANCE ANALYSIS

(ii) According to Value Method

SVV = Actual Value of Sales – Budgeted Value of Sales
= 2,60,100 – 2,50,000 = 10,100 (F)
R R R

SPV = AQ of Sales (AP – SP) R

A = 1,300 ( 55 – 50) = 6,500 (F)

R R

B = 1,000 ( 95 – 100) = 5,000 (A)

R R

C = 1,200 ( 78 – 80) = 2,400 (A)

R R
———————————
R 900 (A)
———————————

SVV = SP (AQ of Sales – BQ of Sales)

A = 50 (1,300 – 1,100) = 10,000 (F)
R R

B = 100 (1,000 – 950)

R = 5,000 (F) R

C = 80 (1,200 – 1,250) =
R 4,000 (A) R
—————————————
R 11,000 (F)
—————————————

SMV = Std. Value of AM – Std. Value of RSM

= 2,61,000 – 2,65,150 = 4,150 (A)
R R R

SQV = Std. Price per unit (RSQ – BSQ)

A = 50 (1,167 – 1,100) = 3,350 (F)
R R

B = 100 (1,008 – 950) = 5,800 (F)

R R

C = 80 (1,325 – 1,250) = 6,000 (F)

R R
—————————————
R 15,150 (F)
—————————————

ILLUSTRATION 24. Compute the missing data indicated by the question marks from the
following :
Product R Product S
Sales Quantity
Standard (units) ? 400
Actual (units) 500 ?
Price/unit R R

Standard 12 15
Actual 15 20
Sales Price Variance ? ?
Sales Volume Variance 1,200 F ?
Sales Value Variance ? ?
Sales mix variance for both the products together was 450 F. “F” denotes Favourable :
R

SOLUTION
Product Standard Actual
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Qty. Price Amount Qty. Price per Amount
units per unit units unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R

R ? 12 ? 500 15 7,500
S 400 15 6,000 ? 20 ?

Product R
Sales Price Variance = Actual Sales Quantity (Actual Sales Price – Std. Sales Price)
= 500 ( 15 – 12) = 1,500 (F)
R R R
STANDARD COSTING AND VARIANCE ANALYSIS D/1·47

Sales Volume Variance (Assuming std. sale quantity x)

= Std. Sales Price (Actual Sales Quantity – Std. Sales Quantity)
12 (500 – x) = 1,200 (F) (Given)
R R

6,000 – 12 x = 1,200 (F)

R R R

– 12 x = – 4,800
x = 400 units
Sales Value Variance = Sales Price Variance + Sales Volume Variance
= 1,500 (F) + 1,200 (F) = 2,700 (F)
R R R

To find out the actual sales quantity of product ‘S’

Sales Mix Variance (for products R and S together)
= Actual Sales Qty. (units) (Standard Rate of Actual Mix – Standard Rate of Std. Mix) = 450 F

= (500 + x) [ (6000 + 15x) 10‚800

(500 + x)
–
800 ]
= 450 (F)

or (6,000 + 15x) – 13.5 (500 + x) = 450 (F)

or 15x – 13.5x – 6,750 + 6,000 = 450 (F)
or 1.5 x = 1,200
x = 800 units
Product S
Sales Volume Variance = Std. Sales price (Actual Sales Qty. – Std. Sales Qty.)
= R15 (800 – 400) = 15 × 400 = 6,000 (F)
R R

Sales Price Variance = Actual Sales Qty. (Actual Sales Price – Std. Sales Price)
= 800 ( 20 – 15) = 4,000 (F)
R R R

Sales Value Variance = Sales Volume Variance + Sales Price Variance

= R6,000 (F) + 4,000 (F) = 10,000 (F).
R R

Profit and Loss Variance

Profit or loss variance is defined as the difference between the budgeted profit (or loss) and the
actual profit (or loss). This will include the total of variances appropriate to standard cost of sales, the
sales margin variances and variances due to any changes which have not been included in standard
cost of production.
ILLUSTRATION 25. Prima Ltd. has a standard costing system and prepares a monthly profit
and loss account. On its monthly output of 100 units, the profit as per standard is R 500 per unit.
During September, 2023 the actual profit was R 425 per unit, the difference being accounted for as
purchases R 2,500 ; material usage R 1,000 ; direct labour R 1,500 and overheads R 2,500. Give the
probable causes of three items of variances.
SOLUTION
R

Standard profit on 100 units @ 500 R 50,000

Actual profit on 100 units @ 425 R 42,500
——————————
Total Profit or Loss Variance (Adverse) 7,500
——————————

Profit variance is equal to the aggregate of cost variances shown below :

R

Purchase Price Variance 2,500 Adverse

Material Usage Variance 1,000 Adverse
D/1·48 STANDARD COSTING AND VARIANCE ANALYSIS

Direct Labour Cost Variance 1,500 Adverse

Overhead Variance 2,500 Adverse
——————————
Total Cost Variance 7,500 Adverse
——————————
——————————

The probable causes of cost variances are :

(1) Purchase Price Variance. Changes in market price, inefficient buying, emergency purchases, loss of
discount, non-availability of standard quality etc.
(2) Material Usage Variance. Excessive wastage, careless handling, poor quality of material, wrong
specifications, wrong mixture of materials, incorrect setting of standards etc.
(3) Direct Labour Cost Variance. Inefficient workmanship, general rise in wages, abnormal idle time,
ineffective supervision, abnormal overtime, wrong grade of labour, poor working conditions, poor quality of
materials used etc.
(4) Overhead Variance. Over expenditure of overhead, changes in production methods, under-utilisation
capacity, less working days, inefficient use of a service etc.

Variance Analysis
Analysis of variances is most important step in standard costing. It is very important tool for
exercising cost control. Analysis of variances will help us in locating the cause and person responsible
for a particular type of variance as is illustrated below :
Variance Possible Causes Person Responsible
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

1. Materials Price ( i) Changes in market price Uncontrollable

Variance (ii) Inefficient buying Purchase officer
(iii) Emergency Purchases Production/Sales Manager
(iv) Loss of discount Accounts Officer
(v) Non-availability of standard quantity Uncontrollable
2. Materials Usage ( i) Excessive wastage Foreman
Variance (ii) Careless handling Storekeeper
(iii) Poor quality of material Purchase Officer
(iv) Wrong specification Planning Engineer
(v) Wrong mixture of materials Production Manager
(vi) Incorrect setting of materials Cost Accountant
3. Rate of Pay ( i) Wrong grade of labour Foreman
Variance (ii) General rise in wages Uncontrollable
(iii) Overtime for urgent work Production/Sales Manager
4. Labour Efficiency ( i) Ineffective supervision Foreman
Variance (ii) Poor quality of materials Purchase Officer
(iii) Poor working conditions Personnel Manager
5. Idle Time Variance ( i) Shortage of materials Purchase Officer
(ii) Break-down of machinery Maintenance Engineer
(iii) Power failure Electrical Engineer
(iv) Time lost in getting instructions Production Manager
6. Expenditure ( i) Rise in general price level Uncontrollable
Variance (ii) Changes in production methods Production Manager
(iii) Ineffective control Departmental Manager
7. Volume Variance ( i) Lack of orders Sales Manager
(ii) Ineffective supervision Departmental Manager
(iii) Poor efficiency of machinery Maintenance Engineer
STANDARD COSTING AND VARIANCE ANALYSIS D/1·49

(iv) Poor efficiency of workers Foreman

(v) More or less working days Uncontrollable
8. Sales Price ( i) Unexpected competition Uncontrollable
Variance (ii) Rise in general price level Uncontrollable
(iii) Poor quality of products Production Manager
9. Sales Volume ( i) Unexpected competition Uncontrollable
Variance (ii) Ineffective sales promotion Publicity Manager
(iii) Ineffective supervision and Sales Manager
control of salesmen

The analysis of variances should be reported to the management, so that corrective action may be
taken. Corrective action cannot be taken by the cost accountant, it can only be taken by the
management. So reporting of variances to the management becomes essential. To make variances
reporting effective, it is essential that following conditions are fulfilled :
(i) The variances arising out of each factor should be correctly segregated so that there may be
correct reporting to the management. For example volume variance arising on account of change in
production should be correctly segregated into capacity variance, calendar variance and efficiency
variance.
(ii) Authority and responsibility of each employee should be clearly laid down so that
responsibility for negative variances may be fixed and corrective action may be taken. This will avoid
shirking of responsibility.
(iii) Variances should be divided into controllable and uncontrollable variances. Uncontrollable
variances are beyond the control of the organisation, so on employee can be held responsible for these
variances. But controllable variances should be reported with no loss of time so that responsibility
may be fixed and action may be taken against the individuals who are responsible for such variances.
(iv) Reporting of variances to the top management should contain broad details only whereas
reporting of variances to the lower levels of management should be a detailed one showing the
causes of each variances alongwith the persons who may be held responsible for each variance.

Accounting Entries
Following is the accounting treatment in connection with standard costs :
(i) Debit Work-in-Progress Account at standard cost.
(ii) Credit All Expenses Control Account at actual cost.
(iii) Keep all variances under separate accounts and close them by transferring to Costing Profit
and Loss Account. Favourable variances are credited under their respective accounts and
unfavourable variances (being loss) are given debit under their respective accounts.
Suppose, standard cost of material is R 500 and actual cost of material is R 600. Material price
variance is R 125 unfavourable and material usage variance is R 25 favourable. In this case the
following entry will be passed :
Work-in-Progress Account Dr. R 500
Material Price Variance Account Dr. R 125

To Material Usage Variance Account R 25

To Stores Ledger Control Account R 600
D/1·50 STANDARD COSTING AND VARIANCE ANALYSIS

Further, Materials Price Variance Account and Materials Usage Variance Account will be closed
by transferring them to Costing Profit and Loss Account.
Costing Profit and Loss Account Dr. 125
To Material Price Variance Account R 125
Material Usage Variance Account Dr. 25
To Costing Profit and Loss Account R 25

Advantages of Standard Costing

Standard costing is a very important managerial tool for cost control. The chief advantages of
standard costing are summarised as follows :
1. Standards set provide yardsticks against which actual costs are compared to ascertain efficiency or
inefficiency of actual performance. Thus, standard costing helps in exercising cost control and
provides information which is helpful in cost reduction.
2. Analysis of variances will assist to single out inefficiency and locate persons who are responsible
for unfavourable variances. Thus, analysis of variances will fix the responsibility for inefficiencies.
3. The principle of management of exception can be successfully applied by the concerns which
follow technique of standard costing. Management has got limited time and it need not burden itself
with respect to those activities of the concern which proceed according to standard performance. It is
only in case of below or above standard performance that they have to concentrate their attention.
4. Setting standards require detailed study of various operations so that they may be made
efficient. This method results in improvements of methods of production of sales, with resultant
lower costs. For example, setting of standards or labour may require the use of time and motion
study, with consequent improvement in the performance of labour.
5. Standard costing provides a valuable guidance to the management in the formulation of price and
production policies. It helps management in preparing price lists, planning production of new products
and furnishing costs estimates at higher levels.
6. Standard costs, being pre-determined costs, are useful in planning and budgeting.
7. Standard costing makes all the executives cost conscious which increases efficiency and
productivity all round. All executives are motivated to achieve the standard performance.
8. Standard costing makes the work of valuation of inventory easier because the inventory is valued
at predetermined costs.
9. An effective delegation of authority is possible because top executive may safely delegate
responsibility by telling the persons concerned what standard performance they have to achieve.
10. The Standard Costing System enables the management to perform its functions of planning,
coordination, organisation, motivation and control more efficiently.
11. Standard costing and the variance analysis provide a ready means of interpretation of
information for the management for the purpose of control and decision making. Ready reporting
enhances the value of reports.
12. Standard costing involves a great deal of preliminary work for setting standards but once
standards have been established the clerical work of costing is considerably reduced. Thus, it
provides economical means of costing.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·51

Disadvantages (or Limitations)of Standard Costing

1. The technique of standard costing may not be applicable in case of small concerns because
establishment of standards requires high degree of skill. Thus, fixation of standards may prove costly
which a small organisation may not afford. For example, fixation of standard time may need a costly
process of time and motion study.
2. For fixing responsibilities, variances should be segregated into controllable and uncontrollable
variances because executives can be made responsible for controllable variances which arise from
their action. But the division of variances into controllable and uncontrollable variances is a difficult task.
3. The technique of standard costing may not be very effective in the industries which deal with non-
standardised products and the jobs which change according to customers’ requirements. In such cases,
standards are to be frequently revised so as to render them comparable with actual results.
4. It is very difficult to establish standard costs of material, labour and overhead. So sometimes
inaccurate and out of date standards are set which do more harm than any benefit as they provide
wrong yardsticks. If the standard set is very high, its non-achievement results in frustration and a
built up of resistance from the employees. On the other hand, if the standard set is very low it will be
easily achieved without putting any extra effort.
5. To make technique of standard costing successful, co-operation of all concerned is required
which may not be there sometimes in the organisation due to inter-departmental rivalry.
Behaviour Consideration in Standard Costing
Standard costing system should be developed in such a way that individuals are encouraged to
behave in a manner which is consistent with overall goal of the organisation. There should be goal
congruence between the personnel goals and the organisational goal.
Specific quantitative targets have a strong motivational approach but careful consideration
should be given to the degree of difficulty represented by the target figures.
Performance measures should encourage goal congruence. There should be appropriate
participation of managers in preparation of budgets.
However, this may result in bias and the same can be avoided by taking a flexible attitude while
settling the standards.

MISCELLANEOUS ILLUSTRATIONS
ILLUSTRATION 26. ABC Industries provides the following information from their records :
Standard mix for production of 10 kgs. of a product is :
Material Quantity (Kgs.) Rate per Kg. (R)
A 4 6
B 8 4

During April, 2024, 1,000 kgs. of the product were produced. The actual consumption of
material was as under :
Material Quantity (Kgs.) Rate per Kg. (R)
A 500 7
B 760 5
D/1·52 STANDARD COSTING AND VARIANCE ANALYSIS

You are required to calculate :

(i) Material Cost Variance (ii) Material Price Variance
(iii) Material Usage Variance (iv) Material Mix Variance
(v) Material Yield Variance
SOLUTION
Standard Cost for 1,000 kg. output Actual
Material
Quantity (kg.) Rate ( ) R Amount ( ) R Quantity (kg.) Rate ( )
R Amt. ( )
R

A 400 6 2,400 500 7 3,500

B 800 4 3,200 760 5 3,800
Total 1,200 5,600 1,260 7,300

(i) Material Cost Variance = Standard Cost – Actual Cost

= 5,600 – 7,300 = 1,700 (A)
R R R

(ii) Material Price Variance = (SP – AP) × AQ

A = R (6 – 7) × 500 = R 500 (A)
B = R (4 – 5) × 760 = R 760 (A)
——————————————————

Total R 1,260 (A)

——————————————————

(iii) Material Usage Variance = (SQ – AQ) × SP

A = (400 – 500) × R 6 = R 600 (A)
B = (800 – 760) × R 4 = R 160 (F)
——————————————————

Total R 440 (A)

——————————————————

(iv) Material Mix Variance = (RSQ – AQ) × SP

A = [( 400
1‚200 )
× 1,260 – 500 × ] R 6

= (420 – 500) × R 6 = R 480 (A)

B = [( 800
1‚200 )
× 1,260 – 760 × ] R 4

= (840 – 760) × R 4 = R 320 (F)

——————————————————

Total R 160 (A)

——————————————————

(v) Material Mix Variance = (AY – SY) × SQP

(
= 1,000 – 1,000 ×
1‚260
1‚200
× )
5‚600
1‚000

= (1,000 – 1,050) × R 5.6 = R 280 (A)

ILLUSTRATION 27. S.P. Limited produces a single product and standard costing system is
followed in the organization. The standard cost card of the product shows the following cost of
material and labour per unit :
Particulars R

Direct Materials (20 kg. @ R 2 per kg.) 40

Direct Labour (4 hours @ R 16 per hour) 64
STANDARD COSTING AND VARIANCE ANALYSIS D/1·53

Budgeted output for the third quarter of a year was 2,000 units. Actual output is 1,800 units.
Actual costs for the quarter are as follows :
Particulars Budgeted Actual
Production and Sale 2,000 units 1,800 units
Direct Materials 10,000 kg. @ R 2 per kg. 10,500 kg. at R 2.50 per kg.
Direct Labour 8,000 hours @ R 16 per hour 7,400 hours @ R 18 per hour

You are required to calculate :

(i) Material Cost Variance (ii) Material Price Variance
(iii) Material Usage Variance (iv) Labour Cost Variance
(v) Labour Rate Variance (vi) Labour Efficiency Variance
SOLUTION
10‚000 kg
Standard Quantity for actual output = × 1,800 units = 9,000 kg.
2‚000 units
8‚000 hrs.
Standard Hours for actual output = × 1,800 units = 7,200 hrs.
2‚000 units
(i) Material Cost Variance = Standard Cost – Actual Cost
= (SQ × SP) – (AQ × AP)
= (9,000 × R 2) – (10,500 × 2.5)
= 18,000 – 26,250 = R 8,250 (A)
(ii) Material Price Variance = (SP – AP) × AQ
= R (2 – 2.5) × 10,500 = R 5,250 (A)
(iii) Material Usage Variance = (SQ – AQ) × SP
= (9,000 – 10,500) × R 2= R 3,000 (A)
(iv) Labour Cost Variance = Standard Cost – Actual Cost
= (SH × SR) – (AH × AR)
= (7,200 × R 16) – (7,400 × R 18)
= R 1,15,200 – R 1,33,200 = R 18,000 (A)
(v) Labour Rate Variance = (SR – AR) × AH
= R (16 – 18) × 7,400 = R 14,800 (A)
(vi) Labour Efficiency Variance = (SH – AH) × SR
= (7,200 – 7,400) × R 16 = R 3,200 (A)

ILLUSTRATION 28. SP Limited produces a single product and standard costing system is
followed in the organisation. The standard cost card of the product shows the following cost per
unit :
Particulars R

Direct Materials (10 kgs. @ R 4 per kg.) 40

Direct Labour (8 hours @ R 8 per hour) 64
Variable Overheads (8 hours @ R 6 per hour) 48
Fixed Overheads (8 hours @ R 3 per hour) 24
D/1·54 STANDARD COSTING AND VARIANCE ANALYSIS

Budgeted and actual data for the third quarter of a year was as follows :
Particulars Budgeted Actual
Production and Sales 2,000 units 1,800 units
Direct Materials 20,000 kgs. @ R 4 per kg. 20,500 kgs. @ R 4.50 per kg.
Direct Labour 16,000 hours @ R 8 per hour 14,800 hours @ R 9 per hour
Variable Overheads R 96,000 R 88,800

Fixed Overheads R 48,000 R 42,800

You are required to calculate :

(i) Material Price Variance (ii) Material Usage Variance
(iii) Labour Rate Variance (iv) Labour Efficiency Variance
(v) Variable Overhead Cost Variance (vi) Fixed Overhead Cost Variance
SOLUTION
(i) Material Price Variance = (SP – AP) × AQ
=( 4–R R 4.50) × 20,500 kgs. = R 10,250 (A)
(ii) Material Usage Variance = (SQ – AQ) × SP

= [( 20,000 ×
1‚800
2‚000)– 20,500 × ] R 4

= (18,000 – 20,500) × 4 = R 10,000 (A)

(iii) Labour Rate Variance = (SR – AR) × AH
= (8 – 9) × 14,800 = R 14,800 (A)
(iv) Labour Efficiency Variance = (SH – AH) × SR

= [( 16,000 ×
1‚800
2‚000)– 14,800 × 8]
= (14,400 – 14,800) × 8 = R 3,200 (A)
(v) Variable Overhead Cost Variance = (SH × SR) – Actual Variable Overhead
= (14,400 × 6) – 88,800 = R 2,400 (A)
(vi) Fixed Overhead Cost Variance = (SH × SR) – Actual Fixed Overhead
= (14,400 × 3) – 42,800 = R 400 (F)
ILLUSTRATION 29. Z Ltd. uses standard costing system in manufacturing of its single
product ‘M’. The standard cost per unit M is as follows :
Direct Materials 2 metres @ R 6 per metre R 12.00

Direct Labour 1 hour @ 4.40 per hour

R R 4.40

Variable Overheads 1 hour @ R 3 per hour R 3.00

——————————————
R 19.40
——————————————

During July, 2023, 6000 units of M were produced and the related data are as under :
Direct Material acquired 19,000 metres @ R 5.70 per metre
Material Consumed 12,670 metre
Direct Labour Hours ? @ ? per hour
R R 27,950
Variable Overheads incurred R 20,475
STANDARD COSTING AND VARIANCE ANALYSIS D/1·55

The variable overheads efficiency variance is R 1,500 adverse. Variable overheads are based on
direct labour hours. There was no stock of raw material in the beginning. You are required to
compute the missing figures and work out all the relevant variances.
SOLUTION
Material Cost Variance = Standard Cost – Actual Cost
= (SQ × SP) – (AQ × AP)
= [(6,000 × 2) × R 6] – (12,670 × R 5.70)
= R (72,000 – 72,219) = R 219 (A)
Material usage Variance = (SQ – AQ) × SP = (12,000 – 12,670) × R 6= R 4,020 (A)
Material Price Variance = (SP – AP) × AQ
= R (6 – 5.70) × 12,670 = 3,801 (F)
Labour Cost Variance = (SHAO × SR) – (AH × AR)
= (6,000* × R 4.4) – (6,500** × R 4.30***)
= R (26,400 – 27,950) = R 1,550 (A)
Labour Efficiency Variance = (SHAO – AH) × SR
= (6,000* – 6,500**) × R 4.40 = R 2,200 (A)
Labour Rate Variance = (SR – AR) × AH = R (4.40 – 4.30***) × 6,500** = R 650 (F)
Variable Overheads
Expenditure Variance = (AH × SR) – Actual Cost
= (6,500** × R 3) – 20,475 = R 975 (A)
Total Variable Overheads Variance
= Efficiency Variance + Expenditure Variance
= 1,500 (A) + 975 (A) = 2,475 (A) R

Working Notes:
* For variable overheads :
Standard Hours for Actual Output (SHAO) = 6,000 units × 1 hour = 6,000 hrs.
Let Actual hours (AH) be x .
** Variable Overheads Efficiency Variance = 1,500 (Adverse)
(SH – AH) × SR = –1,500
⇒ (6,000 – x) × 3 = –1,500 ⇒ 18,000 – 3 x = –1,500
⇒ 18,000 + 1,500 = 3 x AH (x) = 19,500/3 = 6,500 hrs.
*** Actual Labour Hour Rate = R 27,950/6,500 hrs. = R 4.30

Labour Variances
ILLUSTRATION 30. In a factory 100 workers are engaged and average rate of wages is R 5
per hour. Standard working hours per week are 40 and the standard performance is 10 units per
hour. During a week in February, wages paid for 50 workers were at the rate of R 5 per hour, 10
workers at R 7 per hour and 40 workers at R 4 per hour. Actual output was 380 units. The factory
did not work for 5 hours due to breakdown of machinery.
Calculate : (i) Labour Cost Variance, (ii) Labour Rate Variance, (iii) Labour Efficiency Variance,
(iv) Idle Time Variance. Also Verify your answer.
D/1·56 STANDARD COSTING AND VARIANCE ANALYSIS

SOLUTION
Labour Cost Variance (LCV) = Standard Cost of Labour – Actual Cost of Labour
= (SH × SR) – AH × AR
(380 × 100 × 5) R

= – (50 × 40 × 5 + 10 × 40 × R R 7 + 40 × 40 × R 4)
10
= 19,000 – (10,000 + 2,800 + 6,400)
R R R

= 19,000 – 19,200 = 200 (A)

R R R

Labour Rate Variance (LRV) = Actual Hours (Standard Rate – Actual Rate)
= 10 × 40 ( 5 – 7) = 800 (A)
R R

= 40 × 40 ( 5 – R R 4) =1,600 (F)
———————————

800 (F)
Labour Efficiency Variance (LEV)= Standard Rate (Standard Hours – Actual Hours)
= R 5 (3,800 – 3,500) = R 1,500 (F)

AH = 100 × 40 – 500 = R 3,500 hours

100 × 380
SH = = 3,800 hours
10
Labour Idle Time Variance (LITV) = Idle Time × Standard Rate
= 5 × 100 × R 5= R 2,500 (A)
Verification
LCV = LRV + LEV + LITV
R 200 (A) = 800 (F) + 1,500 (F) +
R R 2,500 (A)

Overhead Variances
ILLUSTRATION 31. A company has normal capacity of 100 machines working 8 hours per
day of 25 days in a month. The budgeted fixed overheads of a month are R 1,50,000. The standard
time required to manufacture one unit of product is 4 hours. In a particular month, the company
worked for 24 days of 750 machine hours per day and produced 4,500 units of the product. The
actual fixed overheads incurred were R 1,45,000. Compute all fixed overhead variances.
SOLUTION
Working Notes :
Normal Capacity = 100 machines × 8 hours × 25 days = 20,000 machine hours.
20‚000
No. of units that can be produced(BQ) = = 5,000 units
4
Actual hours worked = 750 machines × 24 days = 18,000
18‚000
SQ = = 4,500 units (should have been produced in actual hours worked)
4
AQ = 4,500 units
24
Revised Budgeted Quantity = 5,000 × = 4,800 units
25
Budgeted Fixed Overheads = 1,50,000
R

Actual Fixed Overheads = 1,45,000

R

Budgeted Fixed Overheads 1‚50‚000 R

Standard Rate = = = 30 R
Budgeted Quantity 5‚000
Standard Fixed Overheads = 4,500 units × 30 = 1,35,000 R R

(should have been incurred on actual production)

STANDARD COSTING AND VARIANCE ANALYSIS D/1·57

Fixed Overhead Variance = Actual units × Standard Fixed Rate – Actual Fixed Overhead Cost
= 4,500 Units × 30 – 145,000
R R

= 1,35,000 – 1,45,000 = 10,000 (A)

R R R

Volume Variance = Actual units × Std. Fixed Rate – Budgeted Fixed Overheads
= 4,500 × 30 – 1,50,000R R

= 1,35,000 – 1,50,000 = 15,000 (A)

R R R

Expenditure Variance = Budgeted Fixed Overheads – Actual Fixed Overheads

= 1,50,000 – 1,45,000 = 5,000 (F)
R R R

Capacity Variance = Std. Rate (Revised Budgeted Units – Budgeted Units)

= 30 (4,500 units – 4,800 Units)= 9,000 (A) R

Calendar Variance = Increase or decrease in production due to more or less working days × Std. Rate per
Unit.
= 200 × 30 = 6,000 (A)
R R

Efficiency Variance = Std. Rate (Actual Production – Std. Production)

= R 30 (4,500 – 4,500) = Nil
Reconciliation
Fixed Overhead Variance = Volume Variance + Expenditure Variance
R 10,000 (A) = R 15,000 (A) + R 5,000 (F)
R 10,000 (A) = R 10,000 (A)
Volume Variance = Capacity Variance + Calendar Variance + Efficiency Variance
R15,000 (A) = 9,000 (A) + 6,000 (A) + Nil
R R

R15,000 (A) = 15,000 (A)

R

ILLUSTRATION 32. A company follows the system of standard costing. The records of the
company reveal the following information for the month of May :
Budget Actual
Number of Man-hours 8,000 8,600
Number of Working Days 20 22
Overheads Rate per hour R 1.00 —
Hours per unit of Output 20 —
Fixed Overheads Incurred — R 7,200
Number of units Produced 450 units —

For the month of May, calculate the following variances for fixed overheads :
(i) Overhead Cost Variance (ii) Overhead Volume Variance
(iii) Overhead Efficiency Variance (iv) Overhead Capacity Variance
(v) Overhead Budget Variance (vi) Calendar Variance
SOLUTION
(i) Fixed Overhead Cost Variance
= Absorbed Overheads – Actual Overheads
= Standard Rate × Standard Time – Actual Rate × Actual Time
7‚200 R
= (1 × 20 × 450) – × 8,600
8‚600 hrs.
= 9,600 – 7,200 = 1,800 (F) R
D/1·58 STANDARD COSTING AND VARIANCE ANALYSIS

(ii) Fixed Overhead Volume Variance

= Absorbed Overheads – Budgeted Overheads
= (Standard Rate × Standard Time) – (Standard Rate × Budgeted Time)
= (1 × 20 × 450) – (1 × 8,000)
= 9,000 – 8,000 = 1,000 (F)
R

(iii) Fixed Overhead Efficiency Variance

= Absorbed Overheads – Standard Overheads
= (Standard Rate × Standard Time) – (Standard Rate × Actual Time)
= (1 × 20 × 450) – (1 × 8,600)
= 9,000 – 8,600 = 400 (F)
R

(iv) Fixed Overhead Capacity Variance

= Standard Overheads – Budgeted Overheads
= (Standard Rate × Actual Time) – (Standard Rate × Budgeted Time for Actual Hours)

(
= (1 × 8,600) – 1 ×
8‚000
20
× 22 )
= 8,600 – 8,800 = 200 (A)
R

(v) Fixed Overhead Budget/Expenditure Variance

= Budgeted Overheads – Actual Overheads
= (Standard Rate × Budgeted Time) × (Actual Rate × Actual Time)

= (1 × 8,000) – ( 7‚200
8‚600
× 8‚600 )
= (8,000 – 7,200) = 800 (F)R

(vi) Fixed Calendar Variance

= (Actual Days – Budgeted Days) × Standard Rate per day
8‚000
= (20 – 22) × × 1 = 800 (F)
R R
20
ILLUSTRATION 33. The Summarised budget and actual working results of GEMCO LTD.
for the year 2023-24 are given below :
Budget Actual
Details Products Products
A B C A B C
R R R R R R

Selling Price per Unit 12 16 25 13 16 27

Cost per Unit 9 11 20 10 12 21
Sales (Units) 40,000 32,000 24,000 42,000 40,000 22,000
Analyse the results and calculate the following :
(i) Budgeted profit, actual profit and variance in profit.
(ii) Analysis of the variance in profit into the following :
(1) Price variance. (2) Cost variance. (3) Sales margin volume variance. (4) Sales margin
mix variance. (5) Sales margin quantity variance.
SOLUTION
(i) Budged Profit = [40,000 × 3 + 32,000 ×
R R 5 + 24,000 × R 5] R

[ 1,20,000 + 1,60,000 + 1,20,000]

R R R 4,00,000
STANDARD COSTING AND VARIANCE ANALYSIS D/1·59

Actual Profit = (42,000 × 3 + 40,000 ×

R R 4 + 22,000 × R 6)
[ 1,26,000 + 1,60,000 + 1,32,000]
R R R 4,18,000
—————————————

Variance in Profit 18,000 (F)

—————————————

(ii) Analysis of Variance in Profit

(a) Cost Variance = Actual No. of Units (Standard Cost per unit – Actual Cost per unit)
A = 42,000 ( 9 – 10)
R R = R 42,000 (A)
B = 40,000 ( 11 – 12)
R R = R 40,000 (A)
C = 22,000 ( 20 – 21)
R R = R 22,000 (A)
———————————————————

R 104,000 (A)
———————————————————
———————————————————

(b) Price Variance = Actual No. of Units (Actual Price per unit – St. Price per unit)
A = 42,000 ( 13 – 12) =
R R 42,000 (F)
R

B = 40,000 ( 16 – 16) =
R R Nil
C = 22,000 ( 27 – 25) =
R R 44,000 (F)
R

———————————————————

R 86,000 (F)
———————————————————
———————————————————

(c) Sales Margin Volume Variance = Standard Profit (Actual Volume – Standard Volume)
A = 3 (42,000 – 40,000)
R = 6,000 (F)
R

B = R 5 (40,000 – 32,000) = R 40,000 (F)

C = R 5 (22,000 – 24,000) = R 10,000 (A)
——————————————————

R 36,000 (F)
——————————————————
——————————————————

Reconciliation Profit = Cost Variance + Price Variance + Volume Variance

= 1,04,000 (A) + 86,000 (F) + 36,000 (F) = 18,000 (F)
R R R R

(d) Sales Margin Mix Variance = Std. Profit (Actual Quantity – Revised Std. Quantity)

A = 3 42,000 –
R
( 40
96
× 1,04,000 = ) 4,000 (A) R

5 ( 40,000 – × 1,04,000 )
32
B = R = R 26,667 (F)
96
5 ( 22,000 – × 1,04,000 )
24
C = R = R 20,000 (A)
96 ——————————————————
R 2,667 (F)
——————————————————
——————————————————

(e) Sales Margin Quantity Variance = Std. Profit (Revised Std. Quantity – Standard Quantity)

A = 3 R
40
96 (
× 1,04,000 – 40,000 = ) 10,000 (F) R

5 ( × 1,04,000 – 32,000 ) =
32
B = R R 13,333 (F)
96

5 ( × 1,04,000 – 24,000 ) =
24
C = R R 10,000 (F)
96 ——————————————————
R 33,333 (F)
——————————————————
——————————————————

Reconciliation : R

Sales Margin Mix Variance 2,667 (F)

Sales Margin Qty. Variance 33,333 (F)
———————————————

Sales Margin Volume Variance 36,000 (F)

———————————————
———————————————
D/1·60 STANDARD COSTING AND VARIANCE ANALYSIS

QUESTIONS
SHORT ANSWER TYPE
1. What are the limitations of historical costing ?
2. Distinguish between historical costing and standard costing.
3. Define standard cost and standard costing. State the advantages of Standard Costing.
4. What are the various points of difference between standard costs and estimated costs ?
5. “Both Standard Costs and estimated costs are predetermined costs, but their objectives are different”.
Explain briefly.
6. Define and explain the concept of ‘Standard Cost’ and ‘Standard Costing’.
7. Distinguish between the two Cost Control techniques ‘Budgetary Control’ and Standard Costing.
8. (a) What do you understand by variance analysis.
(b) What do you mean by labour efficiency variance ? How is it calculated ?
9. What do you mean by volume variance ? How is it calculated ?
10. Name the two methods of calculating sales variances.
11. What are the limitations (or shortcomings) of a standard costing ?
12. Explain the meaning of a standard hour.
13. What do you mean by a standard cost card ? Give its specimen.
14. What do you mean by management by exception ? How can the study of variances be helpful in
practising this principle of management ?
15. What is the difference between current standard and basic standard ?
16. Give a list of possible causes of material price variance and labour efficiency variance.
OR
What are the various circumstances under which material price variance are likely to arise ?
17. Give the accounting treatment of standard costs.
18. Explain efficiency variance as to material, labour and overhead and show the relation among them.

19. What do you understand by the following in the context of operating a standard cost system ?
Ideal standard ; (ii) Average standard ; (iii) Attainable standard.
20. Write note on reasons for adverse material cost variance.

LONG ANSWER TYPE

1. (a) What do you mean by Standard Costing ? What are its characteristics ? In what aspects it is
different from historical cost system ?
(b) Define standard costs. At what level should the standards be set ? Do standard costs represent a
separate type of cost system ?
(c) What are the main features of standard costing and how would you distinguish it from budgetary
control. (B.Com. Panjab Sept. 2014)
(d) Explain briefly the significance of standard costing as a technique of cost control.
2. Discuss the advantages and disadvantages of standard costs and conditions under which they may be
adopted. Also indicate the circumstances in which their use may be misleading.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·61

3. (a) Distinguish between standard cost and estimated cost.

(b) Distinguish between standard costing and budgetary control. Also explain the different types of
standards. (B.Com. Panjab April 2014)
(c) Can you set up standard costing without a budget ?
4. What is the significance of the term ‘variance’ in standard costing ? Define and explain the following
variances :
(a) Material Mixture Variance ; (b) Labour Rate of pay Variance ;
(c) Calendar Variance ; (d) Volume Variance ;
(e) Yield Variance ; (f) Efficiency Variance ; and
(g) Sales Volume Variance. (h) Substitution Variance.
(i) Fixed Overhead Cost Variance.
5. In a system of standard costing, enunciate and explain any six variances, two each under materials,
labour and overheads.
6. Distinguish between :
(a) Budgetary Control and Standard Costing ; (b) Standard Cost and Standard Costing ;
(c) Standard Costing and Estimated Costing ; and (d) Basic Standard and Current Standard.
7. Describe briefly the procedure of establishing standard costs within the divisions of material, labour
and overhead costs.
8. “The basic variances are acquisition (price) and usage variances.” Discuss this statement in relation to
material, labour and overheads.
OR
Explain the term ‘variance’ and distinguish between controllable and uncontrollable variances.
9. An industrial concern has a costing system based on historical costs. Draft a report making out a case
for introduction of Standard Costing System.
10. Explain with suitable examples :
(a) Volume Variance. (b) Expense Variation. (c) Capacity Variance.
(d) Calendar Variance. (e) Efficiency Variance. (f) Sales Mix Variance.
11. What are the advantages and limitations of standard costing ? What are the requisites for the success of
this system. (B.Com. Panjab April 2016)
12. Outline the primary objects of Standard Costing. Describe briefly its uses under each of the following
heads :
(a) As a measuring rod of performance. (b) As a basis of inventory valuation. (c) As an aid in preparing
earning budget. (d) As a guide in fixing selling price.
13. Define the term ‘cost’. Distinguish between budgeted costs and standard costs.
14. (a) What is ‘standard costing’ ? Point out clearly the distinction between standard cost and other cost
systems.
(b) Explain the meaning of ‘Variance Analysis’ and describe its significance.
OR
Discuss in detail with the help of examples how to calculate overhead variances.
(B.Com. Pb. April 2013)
D/1·62 STANDARD COSTING AND VARIANCE ANALYSIS

OR
“Variance analysis is an integral part of Standard Cost accounting.” Explain.
(B.Com. Pb. Sept. 2012)
OR
Proper interpretation of variances from standard is very important for the success of standard
costing system as a tool of cost control. Mention some important factors that must be borne in mind
while interpreting variances from standard.
OR
(c) Describe briefly the managerial uses of Variance Analysis.
OR
Proper interpretation of variances from standard is very important for the success of standard costing
system as a tool for cost control. Mention some important factors that must be borne in mind while
interpreting variances from standard.
15. Explain the possible causes for material price variance and material usage variance in standard costing.
What are the remedial measures ?
16. Distinguish between :
(a) Budgetary control and standard costing. (b) Standard costs and estimated costs. (c) Controllable and
uncontrollable variances.
17. What is two variance analysis of overheads ? Give a brief description.

PRACTICAL PROBLEMS
MATERIAL VARIANCES
1. Given that the cost standards for materials consumption are 40 kgs. at R 10 per kg., compute the
variances when actuals are 48 kgs. at 12 per kg.
R

Ans. [MCV = 176 A ; MUV = 80 A ; MPV = 96 A]

R R R

2. The standard material required to manufacture one unit of product A is 5 kgs. and the standard price
per kg. of material is 30. The cost accountant’s records, however, reveal that 16,000 kgs. of material
R

costing 5,20,000 were used for producing 3,000 units of product A. Calculate the variances.
R

Ans. [Material Cost Variance = 70,000 Adverse; Material Usage Variance

R R 30,000 Adverse; Material
Price Variance = 40,000 Adverse]
R

3. Standard material cost for manufacturing 1,000 units of output is 400 kgs. of material at 2.50 per kg.
R

When 2,000 units are produced it is found that actual cost is 825 kgs. of material at 2.70 per kg.
R

Calculate material cost variance, material price variance and material usage variance.
Ans. [MCV = 227.50 (A); MPV = 165 (A); MUV = 62.50 (A)]
R R R

4. UV Ltd. presents the following information for November, 2023 :

Budgeted production of product P = 200 units. Standard consumption of raw material = 2 kg. per unit
of P. Standard price of material A = 6 per kg.
R

Actually, 250 units of P were produced and material A was purchased at R 8 per kg. and consumed at
1.8 kg per unit of P. Calculate material variances.
Ans. [MCV = R 600 (A); MPV = R 900 (A); MUV = R 300 (F)]
5. A furniture manufacturer uses Sunmica tops for tables. From the following information, find out Price
Variance, Usage Variance and Joint Variance :
STANDARD COSTING AND VARIANCE ANALYSIS D/1·63

Standard quantity of Sunmica per table 4 sq. ft. Standard price per sq. ft. of Sunmica 5.00. Actual R

production of tables 1,000. Sunmica actually used 4,300 sq. ft. Actual purchase price of Sunmica per sq.
ft. 5.50.
R

Who is responsible for the above variances ?

Ans. [Price Variance R 2,150 Unfavourable ; Usage Variance R 1,500 Unfavourable; Joint Variance R 3,650
Unfavourable]
6. Gemini Chemical Industries provide the following information from their records :
For making 10 kgs. of Gemco, the standard material requirement is :
Material Quantity Rate per kg.
kgs. R

A 8 6.00
B 4 4.00
During April 2023, 1,000 kgs. of Gemco were produced. The actual consumption of material is as under:
Material Quantity Rate per kg.
kgs. R

A 750 7.00
B 500 5.00
Calculate : (a) Material Cost Variance (b) Material Price Variance (c) Material Usage Variance.
Ans. [(a) 1,350 Adverse ; (b) 1,250 Adverse ; (c) 100 Adverse]
R R R

7. A manufacturing concern which has adopted standard costing furnishes the following information :
Standard : Actual :
Material for 70 kg. finished Output 2,10,000 kgs.
product 100 kgs. Material used 2,80,000 kgs.
Price of material R 1 per kg. Cost of material R 2,52,000
Calculate : (a) Material Usage Variance, (b) Material Price Variance and (c) Material Cost Variance.
Ans. [Material Usage Variance = R 20,000 Fav. ; Material Price Variance R 28,000 Fav.; Material Cost
Variance 48,000 Fav.]
R

8. Calculate Material Price Variance, Material Usage Variance and Material Cost Variance from the
following information :
Quantity of material purchased 3,000 units ; Value of materials purchased 14,000 ; Standard quantityR

of material required per ton of finished product 20 units ; Standard price of material 5 per unit ; R

Opening stock of material 100 units ; Closing stock of material 600 units ; Finished product
manufactured 100 tonnes.
Ans. [Material Price Variance R 800 Fav. ; Material Usage Variance R 2,500 Adverse ; Material Cost
Variance 1,700 Adverse]
R

Hint: [Material cost variance has been calculated as given below : R

Standard price of standard usage of 2,000 units @ R 5 per unit 10,000

Less : Actual price of actual usage 100 units (opening stock) @ R 5 = R 500
Standard price of 2,400 units (out of purchases)
14‚000
@ R per unit = R 11,200
3‚000
———————————— 11,700
————————————

Adverse 1,700
————————————
D/1·64 STANDARD COSTING AND VARIANCE ANALYSIS

9. From the following information compute (a) Mix, (b) Price, and (c) Usage Variances :
Standard Actual
———————————————————————————————————————————————————————————————————————————————————————————————————————

Quantity Unit Total Quantity Unit Total

Kilos Price Kilos Price
———————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

Material A 10 2.00 20.00 5 3.00 15.00

Material B 20 3.00 60.00 10 6.00 60.00
Material C 20 6.00 120.00 15 5.00 75.00
———————————————————————————————————————————————————————————————————————————————————————————————————————

Total 50 4.00 200.00 30 5.00 150.00

Ans. [(a) R 10 (A) ; (b) R 20(A) ; (c) R 70 (F)]
10. From the following information calculate the Material Mixture Variance :
Materials Standard Actual Standard Actual
Quantity Quantity price per unit price per unit
(units) (units) R R

A 100 150 5 5.50

B 200 250 6 6.00
C 300 400 4 3.50
Due to shortage of B, it was decided to reduce consumption of B by 5% and increase that of A by 10%.
Ans. [ 3.33 Favourable]
R

11. From the following particulars, calculate all material variances.

Material Standard Actual
—————————————————————————— ——————————————————————————

Qty. Price Qty. Price

Kgs. R Kgs. R

A 10 8 10 7
B 8 6 9 7
C 4 12 5 11
—————— ——————

22 24
—————— ——————

(B.Com. Panjab)
Ans. [(MCV) 12 Adverse ; (MQV)
R R 18 Adverse ; (MPV) R 6 Fav. ; (MMV) R 2 Adverse ; (MYP) R 16
Adverse]
12. From the following particulars find out : (a) Material cost variance. (b ) Material price variance.
(c) Material usage variance and (d) Material yield variance.
Quantity of material purchased 3,000 units Standard rate of material R 2 per unit
Value of material purchased R 9,000 Opening stock of material Nil
Standard quantity of material Closing stock of material 500 units
required per tonne of finished Finished production during
product 25 units the year 80 tonnes
Also explain the possible causes of these variances.
Ans. [(a) Material Cost Variance = 3,500 Adverse ; (b) Material Price Variance = 2,500 Adverse ;
R R

(c) Material Usage Variance = 1,000 Adverse ; (d) Material Yield Variance = 1,000 (A)]
R R
STANDARD COSTING AND VARIANCE ANALYSIS D/1·65

13. The standard cost of a chemical mixture is

as under : Actual cost for a period is as under :
4 tons of materials X at 20 per ton.
R 4.5 tons of material X at 15 per ton.
R

6 tons of materials Y at 30 per ton.

R 5.5 tons of material Y as 34 per ton.
R

Standard yield is 90% of input. Actual yield is 9.1 tons.

Compute all material variances.

Ans. [MCV = R 8.39 (F), MPV = R 0.50 (F), MQV = R 7.89 (F), MMV = 5.00 (F), MYV =
R R 2.89 (F)
14. 80 kgs. of material A at a standard price of 2 per kg. and 40 kgs. of material B at a standard price of R.s
R

5 per kg. were to be used to manufacture 100 kgs. of a chemical.

During a month, 70 kgs. of material A priced at 2.10 per kg. and 50 kgs. of material B priced at
R R 4.50
per kg. were actually used and the output of the chemical was 102 kgs.
Find the material variances.
Ans. [Material Cost Variance 4.80 Adverse ; Material Price Variance 18.00 Fav.; Material Usage
R R

Variance 22.80 Adverse; Material Yield Variance 7.20 Fav. ; Material Mix Variance 30.00
R R R

Adverse]
15. The standard cost of a chemical mixture is as thus :
40% material C at R 20 per kg. ; 60% material D at R 30 per kg.
A standard loss of 10% of input is expected in production :
The cost records for a period showed the following usage :
90 kgs. material C at a cost of R 18 per kg. ; 110 kgs. material D at a cost of R 34 per kg.
The quantity produced was 182 kgs. of good product.
Calculate all possible material variances. (B.Com. Panjab April 2011 Modified)
Ans. [Total Material Cost Variance = 102.22 Adverse ; Material Price Variance = 260 Adverse ; Material
R R

Usage Variance = 157.78 Favourable ; Material Mix Variance = 100 Favourable; Material Yield
R R

Variance = 57.78 Favourable]

R

16. XY Ltd., manufacturer of Product P, uses a standard cost system. Standard product and cost
specifications for 1,000 kgs. of product P are as follows :
Ingredients Quantity kgs. Price per kg. Cost
R R

A 800 2.50 2,000

B 200 4.00 800
C 200 1.00 200
————————— —————————

Input 1,200 3,000 = R 2.50/kg.

————————— —————————

Output 1,000 3,000 = R 3/kg.

Material records indicate :
Consumption in January
A 1,57,000 kgs. @ 2.40 R

B 38,000 kgs. @ 4.20 R

C 36,000 kgs. @ 1.10 R

Actual finished production for the month of January is 2,00,000 kgs.

Calculate : Material Variances.
Ans. [MCV = 24,000(F) ; MPV = 4,500 (F) ; MUV = 19,500(F) ; MMV = 3,000 (A) ; MYV =
R R R R R 22,500 (F)]
D/1·66 STANDARD COSTING AND VARIANCE ANALYSIS

17. S.V. Ltd. manufactures a simple product, the standard mix of which is :
Material A 60% at R 20 per kg.
Material B 40% at R 10 per kg.
Normal loss in production is 20% of input. Due to shortage of Material A, the standard mix was
changed. Actual results for March, 2024 were :
Material A 105 kgs. at R 20 per kg.
Material B 95 kgs. at R 9 per kg.
——————

Input 200 kgs.

Loss 35 kgs.
——————

Output 165 kgs.

——————

Calculate : (i) Material Price Variance, (ii) Material Usage Variance and (iii) Material Mix Variance, and
(iv) Material Yield Variance.
Ans. [(i) 95 (F) ; (ii) 250 (F) ; (iii) 150 (F) ; (iv) 100 (F)]
R R R R

18. The standard set of a chemical mixture of a company is as under :

Material Standard Mix (%) Standard Price /kg
R

A 80 50
B 20 100
Standard yield in production is 75%.
The actual quantity produced was 1,800 kgs. of output from the following :
Material Quantity (kgs.) Actual Price
A 1,400 60
B 600 90
Calculate total material price, mix and yield variances, indicating whether they are favourable (F) or
adverse (A or U).
Ans. [Material Price Variance R 8,000 (A); Material Mix Variance R 10,000 (A); Material Yield Variance R

24,000 (F)]
19. From the following data, calculate the following variances : (i) Material Cost Variance; (ii) Material Price
Variance; (iii) Material Quantity Variance; (iv) Material Mix Variance; (v) Material Yield Variance.
Material Standard Actual
Qty. Unit Qty. Unit
Price Price
A 60% 20
R 88 R30
B 40% 10
R 132 R10
Standard Loss : 10%
Actual Output : 180 units.
Ans. [(i) R 760 (A); (ii) 880 (A); (iii) 120 (F); (iv)
R R R 440 (F); (v) R 320 (A)]
20. The standard cost of a certain chemical mixture is :
35% Material A at 25 per kg. ; 65% Material B at 36 per kg.
R R

A standard loss of 5% is expected in production.

During a period there is used :
125 kgs. of Material A at 27 per kg. and 275 kgs. of Material B at
R R 34 per kg.
STANDARD COSTING AND VARIANCE ANALYSIS D/1·67

The actual output was 365 kgs.

Calculate :
(i) Material Cost Variance ; (ii) Material Price Variance ; (iii) Material Mix Variance ; (iv) Material Yield
Variance.
Ans. [(i) 372.63 (A); (ii) 300 (F); (iii) 165 (A); (iv) 507.60 (A)]
R R R R

21. The Standard mix of Product X is as follows :

Kgs. Material Price per Kg. ( ) R

50 A 5.00
20 B 4.00
30 C 10.00
The Standard loss in Production is 10% of input. There is no scrap value. Actual production for a month
was 7,240 kgs. of X from 80 mixes. Actual purchases and consumption of material during the month
were :
Kgs. Material Price per Kg. ( ) R

4,160 A 5.50
1,680 B 3.75
2,560 C 9.50
Calculate the following variances :
(i) Material Cost (ii) Material Price
(ii) Material Mix (iv) Material Yield
Ans. [(i) R 2,820 (A); (ii) R 380 (A); (iii) R 200 (A); (iv) R 2,240 (A)]
22. A company is manufacturing a chemical product making use of four different types of raw materials as
follows :
Raw material Share of total input (%) Cost of raw material (R/kg)
A 40 50
B 30 80
C 20 90
D 10 100
There is an inevitable normal loss of 10% during the processing.
For April 2024, the management furnished the following information :
Raw material Quantity consumed (kgs.) Cost of raw material (R/kg)
A 42,000 48
B 31,000 80
C 18,000 92
D 9,000 110
Output obtained for the month was 92,000 kgs.
Calculate : (a) Material cost variance, (b) Material price variance, (c) Material mix variance, (d) Material
yield variance, (e) Material usage variance.
Ans. [MCV— 2,18,000 (F) ; MPV— 42,000 (A) ; MUV— 2,60,000 (F) ; MMV— 1,00,000 (F) ; MYV—
R R R R R

1,60,000 (F)].
23. Compute the missing data indicated by the Question Marks from the following :
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Particulars A B
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Standard Price/Unit R 12 R 15
Actual Price/Unit R 15 R 20
D/1·68 STANDARD COSTING AND VARIANCE ANALYSIS

Standard Input (kgs.) 50 ?

Actual Input (kgs.) ? 70
Material Price Variance ? ?
Material Usage Variance ? R 300 Adverse
Material Cost Variance ? ?
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Material mix variance for both products together was 45 adverse. R

Ans. [Standard Input of Product B 50 kgs. ; Actual Input of Product A 40 kgs. ; Material A : MPV R 120
(A) ; MUV 120 (F) ; MCV Nil ; Material B : MPV 350 (A) ; MCV 650 (A)].
R R R

24. Raw materials ‘X’ costing 100 per kilogram and ‘Y’ costing 60 per kilogram are mixed in equal
R R

proportions for making product ‘A’. The loss of materials in processing works out to 25% of the output.
The production expenses are allocated at 50% of direct material cost. The end product is priced with a
1
margin of 333 % over the total cost. Material ‘Y’ is not easily available and substitute raw material ‘Z’
has been found for ‘Y’ costing 50 per kilogram. It is required to keep the proportion of this substitute
R

material in the mixture as low as possible and at the same time maintain the selling price of the end
product at existing levels and ensure the same quantum of profit as at present.
You are required to compute what should be the ratio of mix of the raw materials X and Z.
Ans. [Ratio of Mix of Materials X and Z = 3 : 2]
25. Following details relating to product X during the month of April, 2024 are available :
Standard cost per unit of X :
Materials : 50 kg @ 40/kg. R Material price variance : 9,800 (Adverse) R

Actual production : 100 units Material usage variance : 4,000 (Favourable) R

Actual material cost : 42/kg R

Calculate the actual quantity of material used during the month April, 2024.
Ans. [4,900 kg.]

LABOUR VARIANCES
26. Data relating to a job are as thus :
Standard rate of wages per hour 10 ; Standard hours 300 ; Actual rate of wages per hour 12 ;
R R

Actual hours 200.

You are required to calculate : (i) Labour Cost Variance, (ii) Labour Rate Variance, and (iii) Labour
Efficiency Variance.
Ans. [(i) 600 Favourable ; (ii) 400 Adverse ; (iii) 1,000 Favourable]
R R R

27. Calculate labour variances from the following information :

Actual hours 5,800 Standard rate per hour 0.35 R

Actual direct wages 1,800 Standard hours

R 6,000
Ans. [LCV = 300 (F); LRV = 230 (F); LEV = 70 (F)]
R R R

28. From the following information of a company, determine—(i) Labour Cost Variance; (ii) Labour
Efficiency Variance; and (iii) Labour Rate Variance :
Standard labour cost per unit of production is 15. Time allotted per unit is 3 hours. 300 units are
R

produced in 750 hours during the month of July, 2023. Actual payment of wages for the month is
4,500.
R

Ans. [LCV = Nil; LEV = 750; LRV = 750 (A)]

R R

29. In a factory 100 workers are employed and standard average wage rate is 50 per hour. Standard R

working hours per week are 40 and the standard performance is 10 units per hour. During a week,
wages paid for 50 workers are at the rate of 50 per hour, 10 workers at 70 per hour and 40 workers
R R
STANDARD COSTING AND VARIANCE ANALYSIS D/1·69

at 40 per hour. Actual output was 380 units. The factory did not work for 5 hours due to breakdown
R

for machinery. Calculate labour variances.

Ans. [LCV : 2,000 (A); LRV : 8,000 (F); TLEV : 10,000 (A); LEV : 15,000 (F); LITV : 25,000 (A)]
R R R R R

30. Calculate variances from the standard for a particular month as disclosed from the following figures :
Standard In a particular month
Number of workers employed 600 550
Average wages per worker per month 250 R R 264
Number of working days in a month 25 24
Output in units 30,000 28,000
Ans. [Labour Cost Variance = 5,200 Adverse ; Rate of Pay Variance =
R R 13,200 Adverse : Efficiency
Variance = 8,000 Favourable]
R

Hint. Standard time for standard output of 30,000 units = 600 × 25 man days.
∴ Standard time for actual output of 28,000 units
600 × 25
= × 28‚000 = 14‚000 man days.
30‚000
31. A contract job is scheduled to be completed in 30 weeks with a labour complement of 100 skilled
operatives, 40 semi-skilled operatives and 60 unskilled operatives. The standard weekly wages of each
type of operatives are—skilled 60, semi-skilled 36 and unskilled 24. The work is actually
R R R

completed in 32 weeks with a labour force of 80 skilled, 50 semi-skilled and 70 unskilled operatives and
the actual weekly wages rates average 65 for skilled, 40 for semi-skilled and 20 for unskilled
R R R

labour. Analyse the variances in the labour cost due to various reasons.
Ans. [Rate of Pay Variance = 10,240 Adverse ; Labour Efficiency Variance =
R R 1,440 Favourable; Labour
Cost Variance = 8,800 Adverse]
R

32. The standard labour employment and the actual labour engaged in a 40 hours week for a job are as
under :

Standard Actual
Category of Workers No. of Wage Rate No. of Wage Rate
Workers per hour ( )
R Workers per hour ( )
R

Skilled 65 45 50 50
Semi-skilled 20 30 30 35
Unskilled 15 15 20 10
Standard output : 200 units; Actual output : 1800 units
Abnormal Idle time 2 hours in the week
Calculate : (i) Labour Cost Variance; (ii) Labour Efficiency Variance; (iii) Labour Idle Time Variance.
Ans. [(i) 15,000 (A); (ii) 3,900 (F); (iii) 6,900 (A)]
R R

33. The standard hours for manufacturing two products M and N are 15 hours per unit and 20 hours per
unit respectively. Both products require identical kind of labour and the standard wage rate per hour is
R5. In the year 2023, 10,000 units of M and 15,000 units of N were manufactured. The total labour hours
actually worked were 4,50,500 and the actual wage bill came to 23,00,000. This included 12,000 hours
R

paid for @ 7 per hour and 9,400 hours paid for @ 7.50 per hour, the balance having been paid at 5
R R R

per hour. You are required to compute the labour variances.

Ans. [Total Labour Cost Variance 50,000 Adverse ; Labour Rate Variance
R R 47,500 Adverse ; Labour
Efficiency Variance 2,500 Adverse]
R
D/1·70 STANDARD COSTING AND VARIANCE ANALYSIS

34. Standard labour cost of producing 40 units of a product is 30 hours work by skilled workers at a
standard rate of 60 per hour and 90 hours work by unskilled workers at the standard rate of 20 per
R R

hour. 40 units of the product were produced for which skilled workers were paid for 20 hours at 55 R

per hour and unskilled workers were paid for 130 hours at 24 per hour. Due to a machine break-down
R

both skilled and unskilled workers lost 9 hours each. They were paid even for this time.
Calculate :
(i) Labour Cost Variance; (ii) Labour Rate Variance; (iii) Labour Efficiency Variance Unadjusted; (iv)
Labour Mix Variance; (v) Labour Yield Variance; (vi) Idle time variance.
Ans. [(i) R 620 (A); (ii) R 420 (A); (iii) R 200 (A); (iv) R 880 (F); (v) R 360 (A); (vi) R 720 (A)]
35. Calculate the labour variances from the following information :
Standard Wages
Grade x : 90,000 hours at R 2 per hour
Grade y : 60,000 hours at R 3 per hour
Actual wages
Grade x : 72,000 hours at R 2.50 per hour
Grade y : 63,000 hours at R 2.00 per hour
Budgeted Hours : 1,000
Actual Hours : 900
Production : 5,000 units :Standard Loss 20%; Actual Loss 900 units.
Ans. [LCV : R 63,000 (F); LRV : R 27,000 (F); LEV : R 36,000 (F); LMV : 9,000 (A); LYV :
R R 45,000 (F)]

MATERIAL AND LABOUR VARIANCES

36. Following details relating to the product ‘X’ during the month of March, 2023 are available. You are
required to compute the material and labour cost variances and also to reconcile the standard and the
actual cost with the help of such variances.

Standard cost per unit : Actual cost for the month :

Materials 50 kgs @ R 40 per kg. Material 4,900 kgs. @ R 42 per kg.
Labour 400 hours @ R 1.00 per hour. Labour 39,600 hours @ R 1.10 per hour.
Actual production—100 units. (B.Com. Panjab)
Ans. [Material Price Variance 9,800 Adverse ; Material Usage Variance 4,000 Fav. ; Material Cost
R R

Variance 5,800 Adverse ; Labour Rate Variance 3,960 Adverse ; Labour Efficiency Variance 400
R R R

Fav. ; Labour Cost Variance 3,560 Adverse] R

37. The standard cost on ‘Material’ and ‘Labour’ for the making of a unit of a certain product is estimated
as under :
Material 80 kg. at R 1.50 per kg.
Labour 18 hrs. at R 1.25 per hr.
On completion of the production of a unit, it was found that 75 kg. of material costing 1.75 per kg. has R

been consumed and that the time taken was 16 hours, the wage rate being 1.50 per hour. R

You are required to analyse, material and labour variances.

Ans. [MCV = R 11.25 (A); MPV = R 18.75 (A); MQV = R 7.50 (F); LCV = R 1.50 (A); LRV = R 4 LEV (A); R 2.50
(F)]
STANDARD COSTING AND VARIANCE ANALYSIS D/1·71

38. Following information is available from the cost records of CEMA Ltd. for the month of March 2024:
R

Materials purchased 20,000 units 88,000 Standard rates and pieces are as follows :
Materials consumed 19,000 units Direct material rate is R 4.00 per unit
Actual wages paid for 4,950 hours 24,750 Standard input is 10 numbers for one unit.
Units produced 1,800 units Direct labour rate is R 4.00 per hour
Standard requirement is 2.5 hours per unit.
You are required to compute all material and labour variances for the month of March, 2024.
Ans. [MCV— 11,600 (A) ; MPV— 7,600 (A) ; MQV— 4,000 (A) ; LCV— 6,750 (A) ; LRV— 4,950 (A) ;
R R R R R

LEV— 1,800 (A)].

R

39. Following standards have been set to manufacture a product :

Direct Materials : R

2 units of A at 4 per unit

R 8.00
3 units of B at 3 per unit
R 9.00
15 units of C at 1 per unit
R 15.00
——————————

32.00
Direct labour 3 hours (@ R 8 per hour) 24.00
——————————

Total Standard Prime Cost 56.00

——————————

The Company manufactured and sold 6,000 units of the product during the year. Direct Material Costs
were as follows :
12,500 units of A at R 4.40 per unit ; 18,000 units of B at R 2.80 per unit ; 88,500 units of C at R 1.20 per
unit.
The Company worked 17,500 direct labour hours during the year. For 2,500 of these hours the company
paid at 12 per hour while for the remaining the wages were paid at the standard rate. Calculate
R

Material Price and Usage Variances and Labour Rate and Efficiency Variances.
Ans. [MPV = R 19,100 (A) ; MUV = R 500 (A); LRV = R 10,000 (A) ; LEV = R 4,000 (F)]
40. From the following records of Apollo Bolt Nut Manufacturing Company, you are required to compute
material and labour variances :
An input of 100 kgs. of material yields a standard output of 10,000 units.
Standard price per kg. of material = R 20.
Actual quantity of material issued and used by production department 10,000 kgs.
Actual price per kg. of material = R 21 per kg.
Actual output = 9,00,000 units
Number of employees = 200
Standard wage rate per employee per day = R 40
Standard daily output per employee = 100 units
Total number of days worked = 50 days
(Idle time paid for and included in the above half day for each employee)
Actual wage rate per day = 45. R

Ans. [MCV = 30,000 (A) ; MPV = 10,000 (A) ; MQV =

R R R 20,000 (A), LCV = R 90,000 (A) ; LRV = R 50,000
(A), LEV = 36,000 (A) ITV = 4,000 (A)].
R R
D/1·72 STANDARD COSTING AND VARIANCE ANALYSIS

OVERHEAD VARIANCES
41. From the following information, compute Fixed Overhead Cost Variance, Expenditure Variance and
Volume Variance. Normal capacity is 5,000 hours, Budgeted fixed overhead rate is R 10 per standard
hour. Actual level of capacity utilised is 4,400 standard hours. Actual fixed overheads R 52,000. Also,
verify your result.
Ans. [Fixed Overhead Cost Variance— 8,000 (A) ; Fixed Overhead Expenditure Variance— 2,000 (A) ;
R R

Fixed Overhead Volume Variance— 6,000 (A)]. R

42. For the month of April 2023, the following information is provided about overheads expenses in an
organisation : Actual variable overheads 6,00,000; Budgeted variable overheads 8,00,000; Budgeted
R R

output 1,500 units; Actual output 1,300 units; Actual hrs. worked 1,800 hrs.; Standard time 3
hours/unit.
Calculate variances relating to overheads.
Ans. [Total Variable Overheads Variance 93,342 Fav.; Variable Overheads Expenditure Variance
R R

2,79,996 Unfav.; Variable Overheads Efficiency Variance 3,73,338 Fav.]

R

43. From the following data calculate overhead variances :

Fixed overhead 10,200 R

Variable overhead 14,250 R

Normal capacity 10,000 standard hours

Budgeted Rate—Fixed overhead 1 per hour R

—Variable overhead 1.70 per hour

R

Actual Level —8,000 standard hours.

Required : Variable overhead cost variance and fixed overhead cost, budget and volume variances.
Ans. [VOCV = 650 (A); FOCV = 2,200 (A); Exp. V = 200 (A); VV = 2,000 (A)]
R R R R

44. Calculate overhead variances from the following data :

Standard Actual
Fixed overheads ( )
R 8,000 8,500
Variable overheads ( )R 12,000 11,200
Output in units 4,000 3,800
Ans. [Overhead Cost Variance 700 Adverse ; Variable Overhead Variance 200 Fav. ; Fixed Overhead
R R

Variance 900 Adverse; Volume Variance 400 Adverse ; Fixed Overhead Expenditure Variance
R R

R 500 Adverse]
45. From the following, compute the different overhead variances :
In a factory 10,000 units are budgeted to be produced in a month with budgeted fixed expenses being
15,000 i.e. 1.50 per unit. The actual output during the month was 11,000 units and actual fixed
R R

expenses being 15,500. The increase in output was due to 5% increase in capacity. The budgeted
R

working days were 25 but factory worked for 27 days.

Ans. [Overhead Variance 1,000 Fav. ; Expenditure Variance 500 Adverse ; Volume Variance 1,500
R R R

Fav.; Calendar Variance 1,200 Fav. ; Capacity Variance 810 Fav. ; Efficiency Variance 510
R R R

Adverse]
46. XYZ Co. Ltd provides the following information :
Standard Actual
Production 4,000 units 3,800 units
Working Days 20 21
Fixed Overhead R 40,000 R 39,000
Variable Overhead R 12,000 R 12,000
STANDARD COSTING AND VARIANCE ANALYSIS D/1·73

You are required to calculate following overhead variances :

(a) Variable Overhead Variance
(b) Fixed Overhead Variances.
(i) Expenditure Variance; (ii) Volume Variance.
Ans. [(a) 600 (A); (b) (i) 1,000 (F); (ii) 2,000 (A)]
R R R

47. From the following data, calculate fixed overhead variances :

Hours, when working at normal capacity 2,000
Fixed overhead hourly rate 2
R

Hours allowed for actual production 1,600

Actual details —Hours 1,550
—Overheads R 3,750
Ans. [FOHCV = 550 (A); EV = 250 (F); VV = 800 (A) ; EV = 100 (F) ; CV = 900 (A)]
R R R R R

48. A company using standard costing system presents the following information for the budget period :
Budgeted variable overheads = 8,00,000 R

Budgeted fixed overheads = 5,00,000 R

Overheads are recovered on the basis of standard machine hours. The company had budgeted for
1,00,000 machine hours for the year.
During the budget period the company used 1,10,000 machine hours while it should have used 95,000
machine hours for actual output.
Actual Variable Overheads 8,00,000R

Actual Fixed Overheads 4,70,000

R

Calculate the following variances :

(i ) Variable Overheads Cost Variance; (ii) Variable Overheads Spending Variance; (iii) Variable
Overheads Efficiency Variance; (iv) Fixed Overheads Cost Variance; (v) Fixed Overheads Expenditure
Variance; (vi) Fixed Overheads Volume Variance; (vii) Fixed Overheads Efficiency Variance; (viii) Fixed
Overheads Capacity Variance.
Ans. [(i) 40,000 (A); (ii) 80,000 (F); (iii) 1,20,000 (A); (iv) 5,000 (F); (v) 30,000 (F); (vi) 25,000 (A);
R R R R R R

(vii) 75,000 (A); (viii) 50,000 (F)]

R R

49. From the following data, calculate :

(i) Fixed overhead Expenditure Variance; (ii) Fixed overhead Volume Variance; (iii) Fixed overhead
Cost Variance.
Budgeted Actual
Fixed Overhead for July 10,000 R 10,200
R

Units of production in July 5,000 5,200

Standard time for one unit 4 hours —
Actual hours worked — 20,100 hrs
Ans. [(i) 200 (A); (ii) 400 (F); (iii) 200 (F)]
R R R

50. Following information is available from the records of a factory :

Budget Actual
Fixed overheads for June 10,000 R 12,000
R

Production in June (units) 2,000 2,100

Standard time per unit (hours) 10
Actual hours worked in June 22,000
Compute : (i) Fixed overhead cost variance ; (ii) Expenditure variance ; (iii) Volume variance ;
(iv) Capacity variance and (v) Efficiency variance.
Ans. [(i) 1,500 Adverse ; (ii) 2,000 Adverse ; (iii) 500 Fav. (iv) 1,000 Fav. ; (v) 500 Adverse]
R R R R R
D/1·74 STANDARD COSTING AND VARIANCE ANALYSIS

51. Item Budget Actual

Number of working days 20 22
Man hours per day 8,000 8,400
Output per man hour in units 1.0 1.2
Total unit output 1,60,000 2,21,760
Standard overhead rate per-man hour R0.10 —
From the above information calculate : (i) Volume variance ; (ii) Efficiency variance and (iii) Calendar
variance.
Ans. [(i) R 6,176 Fav. ; (ii) R 3,696 Fav. ; (iii) R 1,600 Fav.]
52. PKJ Ltd. operates a standard costing system. It provides the following information for March 2023.
Actual output 850 units
Actual man-hours worked 8,600
Actual working days 22
Actual fixed overhead R 3,600
Budgeted/Standard cost data is as follows :
Budgeted man-hours 8,000
Budgeted working days 20
Standard fixed overhead rate 50 paise per man-hour
Standard man-hours required 10 per unit
Calculate the following variances for fixed overheads :
(a) Cost Variance; (b) Expenditure Variance; (c) Volume Variance; (d) Capacity Variance; (e) Efficiency
Variance; (f) Calendar Variance; (g) Revised Capacity Variance.
Ans. [(a) R 650 (F); (b) R 400 (F); (c) R 250 (F); (d) R 300 (F); (e) R 50 (A); (f) R 400 (F); (g) R 100 (A)]
53. In Department A of a plant, the following data are submitted for the week ended 31st March, 2023 :
Standard output for 40 hours Actual output 1,200 units
per week 1,400 units Actual hours worked 32 hours
Budgeted fixed overheads 1,400 Actual fixed overheads
R R 1,500
You are required to prepare a statement of variances.
Ans. [Fixed Overhead Variance 300 Adverse ; Expenditure Variance 100 Adverse ; Volume Variance
R R

R 200 Adverse ; Capacity Variance 280 Adverse ; Efficiency Variance 80 Favourable]

R R

MATERIAL, LABOUR AND OVERHEAD VARIANCES

54. SP Limited produces a product ‘Tempex’ which is sold in a 10 kg. packet. The standard cost card per
packet of ‘Tempex’ are as follows :
R

Direct Materials 10 kg. @ R 45 per kg. 450

Direct Labour 8 hours @ R 50 per hour 400
Variable Overhead 8 hours @ R 10 per hour 80
Fixed Overhead 200
——————————

1,130
——————————
——————————
STANDARD COSTING AND VARIANCE ANALYSIS D/1·75

Budgeted output for the third quarter of a year was 10,000 kg. Actual output is 9,000 kg.
Actual cost for this quarter are as follows :
R

Direct Materials 8,900 kg. @ 46 per kg. R 4,09,400

Direct Labour 7,000 hours @ 52 per hour R 3,64,000
Variable Overhead incurred 72,500
Fixed Overhead incurred 1,92,000
You are required to calculate :
(i) Material Usage Variance; (ii) Material Price Variance; (iii) Material Cost Variance; (iv) Labour
Efficiency Variance; (v) Labour Rate Variance; (vi) Labour Cost Variance; (vii) Variable Overhead Cost
Variance; (viii) Fixed Overhead Cost Variance.
Ans. [(i) 4,500 (F); (ii) 8,900 (A); (iii)
R R R 4,400 (A); (iv) R 10,000 (F); (v) R 14,000 (A); (vi) R 4,000 (A); (vii) R

500 (A); (viii) 12,000 (A)]

R

SALES VARIANCES
55. From the following data calculate :
(a) sales price variance, (b) sales volume variance, and (c) sales mix variance.
Product Standard Actual
————————————————————————————————— ———————————————————————————————————————

Units Price per Units Price per

unit unit
A 1,500 30
R 2,000 R29
B 1,000 50
R 700 R50
Ans. [(a) R 2,000 Unfav. ; (b) Nil ; and (c) R 7,600 Unfav.]
56. Greenfield Co. provides the following data for the month of March 2024 :

Budgeted Actual
Product Sales Selling Price per Sales Selling Price per unit
(in units) unit ( ) R (in units) ( ) R

A 2,160 12 2,240 11
B 1,440 5 960 6

You are required to compute :

(i) Sales Value Variance; (ii) Sales Volume Variance;
(iii) Sales Price Variance; (iv) Mis Variance.
Ans. [SVV = R 2,720 (A); SVV = R 1,440 (A); SPV = R 1,280 (A); SMV = R 2,240 (F)]
57. The budgeted and actual sales of XYZ Ltd. are as follows :
Budgeted Sales = 10,000 units at R 4 per unit
Actual Sales = 5,000 units @ R 3.50 per unit
8,000 units @ R 4 per unit
Calculate : (i) Sales Value Variance ; (ii) Sales Price Variance ; (iii) Sale Volume Variance.
Ans. [(i) R 9,500 (F); (ii) R 2,500 (A); (iii) R 12,000 (F)]
58. Following table shows the budgeted and actual sales for a certain period. Compute (a) price, (b) volume,
and (c) mix variance of sales.
D/1·76 STANDARD COSTING AND VARIANCE ANALYSIS

Budget Actual
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Product Units Price per unit Units Price per unit

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R

A 3,000 30 3,500 35
B 2,000 20 2,400 25
C 1,000 10 500 5
————————— —————————

6,000 6,400
————————— —————————

Ans. [(a) R 27,000 Fav. ; (b) R 18,000 Fav. ; (c) R 8,666.67 Fav.]
59. The budgeted and actual sales of a manufacturing concern are :
Budgeted Sales Actual Sales
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Quantity Price per unit Amount Quantity Price per unit Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

10,000 units R 3 R 30,000 5,000 units R 3 R 15,000

8,000 units R 2.50 R 20,000

Ascertain :
(i) Sales Price Variance and (ii) Sales Volume Variance.
Ans. [(a) R 4,000 Unfav. ; (ii) R 9,000 Fav.]

60. Modern Toys Ltd. had the following budgeted sales and actual sales for March, 2024.

Budgeted Actual Cost per unit

————————————————————————————————————————————————————————————————————————————————————

Toy Sales Sale price Sales Sale price per

(units) per unit (units) unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R

A 900 50 1,000 55 45
B 650 100 700 95 85
C 1,200 75 1,100 78 65

Calculate sales variances according to profit method.

Ans. [TSMV = 5,050 (F) ; SMV due to S.P. = 4,800 (F) ; SMV due to Volume =
R R R 250 (F) ; SMV due to

SM = R
2‚500
11
(A) ; SMV due to SQ = R
5‚250
11
(F) ]
61. Compute the following variances from the data given below :
(1) Total sales margin variance ; (2) Sales margin volume variance ; (3) Sales margin price variance;
(4) Sales margin quantity (Sub-volume) variance.
Product Budgeted Actual quantity Budgeted sale Actual sale Standard cost
quantity units units price per unit price per unit per unit
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R

X 240 400 50 45 30
Y 160 200 25 20 15
Ans. [(1) R 600 Fav. ; (2) R 3,600 Fav. ; (3) R 3,000 Adverse ; (4) R 3,200 Fav.]
STANDARD COSTING AND VARIANCE ANALYSIS D/1·77

62. PH Ltd. furnishes the following information relating to budgeted sales and actual sales for April, 2024:
Budgeted Sales Actual Sales
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Product Quantity Selling Quantity Selling price

(Units) price per unit ( )R (Units) per unit( ) R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

A 1,200 15 880 18
B 800 20 880 20
C 2,000 40 2,640 38

Calculate : (i) Sales quantity variance ; (ii) Sales mix variance ; (iii) Sales price variance and (iv) Total
Sales variance.
Ans. [(i) 22,400 Fav. ; (ii) 11,000 Fav., (iii) 2,640 Adverse; (iv) 19,760 Fav.]
R R R R

63. From the following information about sales, calculate :

(a) Total Sales Variance ; (b) Sales Price Variance ; (c) Sales Volume Variance ; (d) Sales Mix Variance and
(e) Sales Quantity Variance.
Standard Actual
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Product Nos. Rate in R Nos. Rate in R

per unit R per unit R

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

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

—————————— —————————— —————————— ——————————

(B.Com. Panjab Sept. 2016)

Ans. [(a) 23,000 Favourable; (b)
R R 5,000 Favourable ; (c) R 18,000 Favourable ; (d) 500 Favourable ;
R

(e) 17,500 Favourable]

R

64. The budgeted and actual sales for a period in respect of two products are given below :
Product Budgeted Quantity Price Actual Quantity Rate
R R

A 1,000 20 1,300 21
B 2,000 15 2,300 14
————————— —————————

3,000 3,600
—————————
————————— —————————
—————————

Calculate the sales variances.

Ans. [SVV = 9,500 (F) ; SPV =
R R 1,000 (A), Sales Volume Variance = 10,500 (F) ; SMV =
R R 500 (F) ; SQV =
R 10,000 (F)]
WORKING TABLE
Budgeted Actual Std. Propor- Std. Value Std. Value
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Product Qty. Price Value Cost Profit Total Qty. Price Value Cost Profit Total tion for of Actual of Revised
(Units) Profit (units) per unit Profit Actual Sales Mix Std. Mix
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R R R R R R R Units R R

X 3,000 12 36,000 10 2 6,000 3,200 13 41,600 10.50 2.50 8,000 2,880 38,400 34,560

( 4,800 ×
3
5 ) (3,200 × 12) (2,880 × R 12)

Y 2,000 18 36,000 15 3 6,000 1,600 17 27,200 14.00 3.00 4,800 1,920 28,800 34,560

( 4,800 ×
2
5 ) (1,600 × 18) (1,920 × R 18)

—————————— —————————— ————————— ————————— —————————— —————————— —————————— —————————— ——————————

5,000 72,000 12,000 4,800 68,800 12,800 4,800 67,200 69,120

——————————
—————————— ——————————
—————————— —————————
————————— —————————
————————— ——————————
—————————— ——————————
—————————— ——————————
—————————— ——————————
—————————— ——————————
——————————
2

WORKING TABLE
Budgeted Actual Std. Std. Std.
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Propor- Value of Value of
Cassette Units Price Amt. Cost Profit Total Units Price Value Cost Profit Total tion for Actual Revised
Profit Profit Actual Mix Mix
Sales (3 × 8) (3 × 14)
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R R R R R R R R R Units R R
A 1,100 50 55,000 45 5 5,500 1,300 55 71,500 45 10 13,000 1,167 65,000 58,350

B 950 100 95,000 85 15 14,250 1,000 95 95,000 85 10 10,000 1,008 1,00,000 1,00,800

C 1,250 80 1,00,000 70 10 12,500 1,200 78 93,600 70 8 9,600 1,325 96,000 1,06,000

————————— ————————— ————————————— ————————— ———————— ———————————— ————————————— ———————— ———————————— ———————— ——————— —————————— ————————— ————————————— ——————————————

3,300 2,50,000 32,250 3,500 2,60,100 32,600 3,500 2,61,000 2,65,150

————————— ————————— ————————————— ————————— ———————— ———————————— ————————————— ———————— ———————————— ———————— ——————— —————————— ————————— ————————————— ——————————————

Standard proportion for actual sales has been calculated as follows :

1‚100
A : × 3,500 = 1,167
3‚300
950
B : × 3,500 = 1,008
3‚300

1‚250
C : × 3,500 = 1,325
3‚300
BUDGETARY CONTROL D/2·1

CHAPTER

2
Budgetary Control
LEARNING OBJECTIVES
To understand the meaning, features & significance of budget and budgetary control.
To learn the role of budget manual.
To learn about the classification of budget.
To understand the preparation of different types of budgets- Functional budgets, Cash budgets
To understand the fixed and flexible budget.
To understand control ratios and performance budgeting.
To know about the ZBB and their advantages and main defects of ZBB.

Meaning and Need for Budget

Every one is familiar with the idea of a budget because it is essential in every walk of our life—
national, domestic and business. A budget is an estimate of future numbers based on information. It
is a plan in details for a specific period of time. In the present era of competition, everyone is
conversant with the term budget because it is very much essential in life and business. Without a
budget, the business owner is literally shooting in the dark when it comes to plan expenditures for
the businesses and match them to sales revenues. In the budgeting process, managers in every
department justify the resources they need to achieve their goals. They explain to their superiors
the scope and volume of their activities as well as how their tasks will be performed. The
communication between superiors and subordinates helps affirm their mutual commitment to
company goals. It estimates the profits, financial performance and cash flows of a business for a
particular period of time. It is a forecast of what will happen financially if certain strategies and
decisions are implemented. A budget is a financial planning tool that helps the business to control
and manage the spending of money. A budget is prepared to have effective utilisation of funds and
for the realisation of objectives as efficiently as possible. Budgeting is a powerful tool to the
management for performing its functions (i.e., formulating plans, coordinating activities and
D/2·2 BUDGETARY CONTROL

controlling operations etc.) efficiently. The Chartered Institute of Management Accountants, London
(CIMA), defines a budget as under :
“Quantitative expression of a plan for a defined period of time. It may include planned sales
volumes and revenues, resource quantities, costs and expenses; assets liabilities and cash flows.” It
can also be defined as “a plan quantified in monetary terms prepared and approved prior to a defined period
of time usually showing planned income to be generated and/or expenditure to be incurred during that period
and the capital to be employed to attain a given objective.”
An analysis of this definition reveals the following essentials of a budget :
● It is a plan expressed in monetary terms but it can also contain physical units.
● It is prepared prior to a defined period of time (budget period) during which it will operate.
● It is related to a definite future period.
● It is approved by the management for implementation.
● It usually shows the planned income to be generated and expenditure to be incurred.
● It also shows capital to be employed during the period and
● It is prepared for the purpose of implementing the policy formulated by the management and
the objective to be achieved during the period.
Thus, a budget fixes a target in terms of rupees or quantities against which the actual
performance is measured. A budget can, therefore, be taken as a document which is closely related to
both the management function as well as the accounting function of an organisation.
As the size of the organisation increases, the need for budgeting is correspondingly more because
a budget is an effective tool of planning and control. Budgets are helpful in coordinating the
various activities (such as production, sales, purchase, etc.) of the organisation with the result that all
the activities proceed according to the objective. Budgets are means of communication. Ideas of the
top management are given the shape of a budget and are passed on to the subordinates who are to
give them the practical shape. As the activities of various departmental heads are coordinated at the
preparation of a budget, it is helpful in developing a team work which is very much needed for the
very success of an organisation. Thus, a budget is necessary to plan for the future, to motivate the
staff associated, to coordinate the activities of different departments and to control the performance of
various persons operating at different levels.

Meaning of Estimate, Forecast and Budget

An estimate is predetermination of future events either on the basis of simple guess work or
following scientific principles. Forecast is an assessment of probable future events. Budget is based on
the implications of a forecast and related to planned events. Forecasting precedes preparation of a
budget as it is an essential part of the budgeting process. It is said that the budgetary process is more
a test of forecasting skill than anything else. To establish realistic budgets, it is necessary to forecast a
wide range of factors like sales volume, sales prices, material availabilities and prices, wage rates, the
cost of overheads etc. It is not sufficient merely to add or deduct a percentage to or from last year’s
budget ; rather a proper forecasting should be made and after that budget should be prepared. A
budget is a detailed statement of forecast resulting from joint action of a number of planned operations
conducted with normal efficiency.
BUDGETARY CONTROL D/2·3

Difference Between Budget and Forecast

Budget and forecast both refer to the anticipated actions and events in a specified future
period but still there are wide differences between the two as given below :
Basis of Budget Forecast
Distinction
1. Meaning Budget is a plan of action Forecast is a prediction.
2. Persons Only the authorised management of the Anybody can make a forecast about
Authorised for company can prepare budget of the company’s performance.
preparation company
3. Terms of Budget is expressed in terms of rupees Forecast is not always expressed in terms
Expression and quantities of rupees or quantities.
4. Events It relates to planned events i.e., the policy It is concerned with probable events likely to
and programme to be followed in a future happen under anticipated conditions during
period under planned conditions. a specified period of time.
5. Period It is usually planned separately for each It may cover a long period or years.
accounting period.
6. Coverage It (refer budget) comprises the whole It may cover a limited function or activity of
business unit. Sectional budgets are business as sales forecast.
coordinated into a logical whole.
7. Control Budget is a tool of control as it represents It does not connote any sense of control as
actions which can be shaped according to forecast is merely a statement of future
will to suit conditions which may or may events.
not happen.
8. Process The process of budget starts where The function of forecast ends with the
forecast ends and converts it into a forecast of likely events.
budget.
9. Spheres It is made in respect of those spheres It is made in several other spheres which
which are related to business or industry. may not be connected with the budgeting
process.

Budgetary Control
Budgetary control is applied to a system of management and accounting control by which all
operations and output are forecasted as far ahead as possible and actual results when known are
compared with budget estimates. CIMA, London defines budgetary control as—The establishment of
the budgets relating to the responsibilities of executives to the requirements of a policy and the
continuous comparison of actual with budgeted result either to secure by individual action the
objectives of that policy or to provide a firm basis for its revision.
Essentials features of budgetary control that are contained in this definition are :
(i) Establishment of budgets for each function and section of the organisation.
(ii) Executive responsibility in order to perform the specific tasks so that objectives of the
enterprise may be attained.
(iii) Continuous comparison of the actual performance with that of the budget so as to know the
variations from budget and placing the responsibility of executives for failure to achieve the desired
result as given in the budget.
D/2·4 BUDGETARY CONTROL

(iv) Taking suitable remedial action to achieve the desired objective if there is a variation of the
actual performance from the budgeted performance.
(v) Revision of budgets in the light of changed circumstances.
Budgetary Control is a system which uses a comprehensive framework of budgeting to aid
management in carrying out its functions of planning, coordinating and controlling operation.
Budgetary control is used in evaluation of actual performance. Performance evaluation usually
takes in the form of an analysing variances, ascertaining causes and initial corrective actions.

Budget, Budgeting and Budgetary Control

A budget is simply a forecast of future events expressed in quantitative terms. It performs three
basic functions of a firm. The are :
(i) It indicates the amount and the exact timing of the firm’s needs for future financing.
(ii) It takes corrective actions where the budgeted figures do not match with actual.
(iii) It provides a basis for performance evaluation.
Budgeting is a technique for formulating budgets. It indicates a right path for managing the
business. It helps management to anticipate the various problems of the business and to put
corrective measures to overcome the problems. It is a means of coordinating the combined
intelligence of an entire organisation into a plan of action based on past performance and governed
by rational judgement of factors that will influence the course of business in the future.
Budgetary control is a technique of managerial control through budgets. It is designed to assist
management in the allocation of various responsibilities. It is a system of achieving the firm’s
objectives with minimum cost and provides a powerful tool to the management for efficient
performance of the managerial functions.
Rowland and William in their book entitled Budgeting for Management Control has given the
difference between budget, budgeting and budgetary control as follows :
“Budgets are the individual objectives of a department, etc. whereas budgeting may be said to be
the act of building budgets. Budgetary Control embraces all this and in addition includes the science
of planning the budgets themselves and the utilisation of such budgets t o effect an overall
management tool for the business planning and control”.
Thus, a budget is a financial plan and budgetary control results from the administration of the
financial plan.

Objectives of Budgetary Control

The main objective of budgetary control is to plan, monitor, control and adapt resources to meet
agreed business objectives whilst remaining within notified limits. Budgetary Control is planned to
assist the management in the allocation of responsibilities and authority to aid in making estimates
and plans for future, to assist in analysis of variations between estimated and actual results and to
develop basis of measurement or standards with which to evaluate the efficiency of operations. The
general objectives of budgetary control are as follows :
1. Planning. The first and most important step in understanding a budget is to plan. Planning
involves figuring out what the ideal budget would accomplish. Without proper planning the budget
would be much like a map without a destination. The budget draws up detailed plans relating to
BUDGETARY CONTROL D/2·5

sales, production purchases, labour, overheads etc. With the implementation of planned performance,
a business is able to implement its policies by the collective efforts of all sections of the business. The
planning for the personal budgeting would differ with the planning for the business. Planning is
concerned with specifying the type, quantity, and quality of services that will be provided to
constituents, estimating service costs and determining how to pay for the services. In order to bring
the budget effective, it must take into account the current income sources and current expenses. The
budget will meet its goal based on the current levels of income and expenses. A budget is a plan of
the policy to be pursued during the defined period of time to attain a given objective. The budgetary
control will force management at all levels to plan in time all the activities to be done during the
future periods. A budget as a plan of action achieves the following purposes :
(a) Action is guided by well thought out plan because a budget is prepared after a careful study
and research.
(b) The budget serves as a mechanism through which management’s objectives and policies are
effected.
(c) It is a bridge through which communication is established between the top management and
the operatives who are to implement the policies of the top management.
(d) The most profitable course of action is selected from the various available alternatives.
(e) A budget is a complete formulation of the policy of the undertaking to be pursued for the
purpose of attaining a given objective.
2. Co-ordination. The budgetary control co-ordinates the various activities of the firm and
secures co-operation of all concerned so that the common objective of the firm may be successfully
achieved. It forces executives to think and think as a group. It co-ordinates the broader economic
trends and the economic position of an undertaking. It is also helpful in co-ordinating the policies,
plans and actions. An organisation without a budgetary control is like a ship sailing in a chartered
sea. A budget gives direction to the business and imparts meaning and significance to its achievement
by making comparison of actual performance and budgeted performance.
3. Control. Control consists of the action necessary to ensure that the performance of the
organisation conforms to the plans and objectives. Control of performance is possible with pre-
determined standards which are laid down in a budget. Thus, budgetary control makes control
possible by continuous comparison of actual performance with that of the budget so as to report the
variations from the budget to the management of corrective action. To excercise more effective
control, principle of ‘management by exception’ is applied.
4. Reporting and Evaluating. Evaluation is a spontaneous process or act of assessing a project’s
effectiveness, efficiency, costs, relevance and impact based on specified objectives. Budget evaluation
involves the collection and analysis of data about the budget activities. Evaluation is to improve both
an on going project and making the future projects. Budgets lay the foundation for end-of-period
reports and evaluations. When a budget tied to an organization’s objectives, it can facilitate
assessments of efficiency and effectiveness. Proper evaluation and reporting helps an organisation
facilitates the identification and resolution of various problems of the business.
Thus, budgeting system integrates key managerial functions as it links top management’s
planning function with the control function performed at all levels in the managerial hierarchy. But
the efficiency of the budget as a planning and control device depends upon the activity in which it is
being used. A more accurate budget can be developed for those activities where direct relationship
D/2·6 BUDGETARY CONTROL

exists between inputs and outputs. The relationship between inputs and outputs becomes the basis
for developing budgets and exercising control.

Process of Budgetary Control

Budgetary control involves continuos comparison of actual results with the budgets and taking
appropriate remedial action promptly. The budgetary control system involves fixing of targets (in the
form of specific tasks) collection of information regarding actual and continuos comparison of actual
with the targets with a view to reporting for action. The process of budgetary control is as follows :
(i) Definition of objectives : A budget being a plan for the achievement of certain operational
objectives, it is desirable that the same are defined precisely. The objectives should be written
out; the areas of control demarcated; and items of revenue and expenditure to be covered by
the budget stated.
(ii) Location of the key (or budget) factor : There is usually one factor (sometimes there may be
more than one) which sets a limit to the total activity. Such a factor is known as key factor.
For proper budgeting, it must be located and estimated properly.
(iii) Standard of activity or output : For preparing budgets for the future, past statistics cannot be
completely relied upon, for the past usually represents a combination of good and bad
factors. Therefore, though results of the past should be studied but these should only be
applied when there is a likelihood of similar conditions repeating in the future.
(iv) Organisation Chart : An organisational chart is prepared defining functional representatives of
executives responsible for accomplishment of organisational objectives.
(v) Budget Centre : Budget Centre is established for cost control and all the budgets should be
related to cost centres.
(vi) Budget Manual : A budget manual is prepared which sets outstanding instructions governing
the responsibilities of persons and the procedures, forms and records relating to the
preparation and use of budgets.
(vii) Budget Controller : A budget controller is appointed to line up the various functions of budget
committee and compiling information of all types for the purposes of efficient preparation of
budgets and proper reporting.
(viii) Budget Committee : The budget Committee is set up comprising of group of representatives of
various functions in an organisation.
(ix) Budget Period : The budget period is determined. It refers to the period of time covered by a
budget. It can be “Long-term budget” or “short-term budget”.
(x) Budget Reports : Finally budget reports are prepared showing the comparison between the
actual and budgeted expenditure.

Budgetary Control and Accounting

A proper system of accounting is essential for developing a satisfactory budget. The formation of
the budget depends upon information largely collected from the cost accounting system. An
important characteristics of the budgetary control is comparing actual performance with prior
estimates or targets laid down in the budget to make sure that actual performance is steering in the
right direction. This function can be discharged only on the availability of reliable and prompt
accounting information. The accounting system should provide classified information in terms of
organisation authority and responsibility so that responsibility for pitfalls may be fixed and corrective
BUDGETARY CONTROL D/2·7

action may be taken. The accounting information should be consistent with the requirements of
budgetary control so that satisfactory budgets may be developed.
We have seen that budgetary control is dependent upon accounting. Similarly a sound cost
accounting system is also dependent for its effective operation on sound budgetary procedure. Cost
accounting, specially overhead accounting, is based on careful budget of expenses in the future,
corresponding to different operating capacities. Overhead rate for absorption in jobs, orders or
processes is determined on the basis of future estimates made while preparing various budgets.
Determination of estimated costs or standard costs is made on the budgeted costs of the materials,
labour and overheads. It, therefore, follows that development of an efficient budgetary control system
is an important pre-requisite for operating a sound costing system.

Essentials of an Effective Budgetary Control System

For an effective budgetary control system, there must be certain essential prerequisites. These
are as follows :
(i) Support of Tops Management. No control system can be effective unless it gets full support
from every member of the management specially top management must be committed to the
budget idea as well as to the principles and policies underlying the system.
(ii) Reasonable Goals. The budget goals should be realistic and should represent reasonably
available goals.
(iii) Clear Objectives. The objectives to be achieved through budgets should be clearly stated.
(iv) Participation by Responsible Executives. Those who are entrusted with the performance of
the budgets should participate in the process of setting the budgets. This will ensure proper
implementation of programmes.
(v) Appropriate Accounting System. There is close relationship between budgeting and
accounting. One has to depend on accounting department for reliable historical data.
Responsibility accounting is essential for successful budgetary control.
(vi) Continuous Budget Education. There should be a system of continuous education of staff
about the objectives and techniques of budgeting.
(vii) Maximum Profit. This ultimate objective of realising the maximum profit should always be
kept uppermost.
(viii) Constant Vigilance. Constant vigilance is required so that continuous comparison between
the budgeted and actual data and variance should be reported.
(ix) Cost of the System. The cost of the system should be not more than the benefit received from
the system.
(x) Co-ordination with Standard Costing. Where standard costing system is also being used the
budget programme should be prepared in co-ordination with standard cost.

Preliminaries for the Adoption of a System of Budgetary Control

Following are the pre-requisites or steps for the successful implementation of a sound system
of budgetary control :
(i) Budget centres should be established for cost control and all budgets should be related to cost
centres. Budget centres will disclose the sections of the organisation where planned performance is
not achieved.
D/2·8 BUDGETARY CONTROL

(ii) There must be efficient system of accounting in order to record and provide necessary
accounting information to the management for successful system of budgetary control.
(iii) A concern must have an organisation chart. This is necessary in order to have a clear idea of
authority and responsibility of each executive so that there may be no conflict among functional
executives for shirking responsibilities and blaming others for poor performance.
(iv) Budget committee should be set up for the establishment and efficient execution of the plan.
(ix) The budgeted output should be stated in clear terms.
(v) There should be a budget manual to indicate charter of programme. It contains all details
regarding the plan and procedures for its execution. It should also specify the length of the budget
period.
(vi) Budget period should be determined.
(vii) The budget or key factor, if any, must be indicated before starting the preparation of budgets.
(viii) The business objectives, plans and policies should be clearly defined and stated in
unambiguous terms. The scope of budgetary control should also be clearly laid down.
(x) To make budgetary control successful, there should be a proper system of communication and
reporting between the various levels of management. A two way system of communication should be
adopted. The top management should be able to communicate the budgeted plan to the lower levels
in clear terms who in turn should feedback by reporting the deviations from the targets to the higher
levels. On the basis of feedback, the top management may again communicate instructions to the
lower management for taking corrective action.
(xi) To motivate the workers, the budget must be prepared by those who are responsible for its
performance.
(xii) The budget should cover all phases.
(xiii) Top management approval is necessary in order to get full cooperation and acceptance of the
system of budgetary control. The system may fail in future due to disagreements which may arise
later on without approval of the top management.
Components of Budgetary Control System
The policy of a business for a defined period is represented by the master budget the details of
which are given in a number of individual budgets called functional budgets.

Organisation for Budgetary Control

It is necessary that a concern must have a definite plan of organisation for preparing, maintaining
and administering the budget. There should be an organisation chart. It may be as follows :
CHIEF EXECUTIVE

Budget Officer

Sales Manager Production Purchasing Personnel Accountant

(Sales Budget Manager Manager Manager (Cost Budgets,
including (Production (Materials (Labour Master
advertising, and Plant Budget) Budget) Budget)
selling and dis- Utilisation
tribution cost) Budget)
BUDGETARY CONTROL D/2·9

The organisation chart shows that chief executive is the head of the budgetary control system. He
delegates his authority to the budget officer who sees that all budgets are co-ordinated and drawn in
time. The other managers will prepare the budgets shown against them in the chart. Thus, budgetary
control is a concerted action in which all individuals take part and there must be coordination in
order to have proper link among them. All those who are responsible for its execution and
performance must be taken into confidence. When there is a clear cut division of responsibility and
authority, no overlapping will be there. It will create team work and a spirit of cooperation among the
staff, ultimately leading to high degree of budget consciousness.
The budget control organisation is generally headed by a top executive known as Budget
Controller or Budget Director or Budget Officer. The Chief Executive should appoint such executive
who should be given the specific duty of administering the budget. His rank should be equal to other
functional managers. As his work will deal with the preparation and co-ordination of budgets
involving figures, he will usually be a person with accountancy knowledge. He should also have a
technical knowledge of the business. He should see that the functional managers draw the budgets in
time. He is also to chase the budgets and to see that the actual performance is going in lines with the
budgeted performance and to issue timely warning when the actual performance differs
substantially. He should help in revising the budgets if there are fundamental changes in the
circumstances after the budgets have been prepared. He is to make sure that budgets are being
prepared according to the budget manual. The budget controller has a staff function. He has no line
function except over his own section. His function is to give advice to the line
managers. Development of budgets is not the direct responsibility of the budget controller, his
position is that of the supervisor and co-ordinator of all budget functions. Generally in big
organisations a full time Budget Controller is appointed but in small organisations, a top official is
made responsible for executing the budgetary control system besides attending to his own duties.
Duties of Budget Controller may be summarised as follows :
(i) To create co-ordination among the various functional managers and provide them guidance
in all matters pertaining to budgets.
(ii) To revise and amend the budget manual as and when necessity arises to do so.
(iii) To prepare budget programmes and issue instructions for proper execution of each
programme.
(iv) To revise and scrutinize the functional budgets received from various departments and
provide necessary information which has an impact on preparation of their budgets.
(v) To discuss the proposed requirements of the departments and overall budgets with the
budget committee.
(vi) To prepare summary budgets in consultation with budget committee and place all
information and budgets before the budget committee.
(vii) To revise budgets according to the directions of the budget committee and place it before Board
of Directors for final approval before sending it to different departments concerned.
(viii) To collect actual costs from cost office and compare it with budgeted figures in budget
reports, place it before the budget committee for decision and finally convey it to the
departmental managers for their compliance.
The Budget Controller is assisted by the Budget Committee. The Budget Committee will include
General Manager (or any other chief executive), Sales Manager, Works Manager, Accountant or
D/2·10 BUDGETARY CONTROL

Budget Controller, Purchase Officer, Personnel Manager and Departmental Managers. The General
Manager generally acts as Chairman of the Committee. The functional managers will prepare the
budgets and submit to the Committee for approval. It is the duty of Budget Committee to make
necessary adjustments in the budgets, co-ordinate all the budgets, and finally approve the budgets.
Budget being an administration function, the closest association of the various executives in charge of
the various functions of the business is essential ; so all functional managers are included in the
budget committee. The budget committee is an advisory committee. It examines budget reports
which make comparison of the actual performance with the budgeted performance and recommends
corrective action for discrepancies between actuals and budgets.
The budget committee is generally entrusted with the following duties :
(i) To receive, scrutinize, revise and approve functional budgets prepared by each section/
department.
(ii) To receive reports according to the prescribed schedule and compare actuals with the
budgeted figures.
(iii) To pinpoint the responsibility by analysing the deviations and suggest remedial action or
revision of budget, if necessary.
(iv) To participate in the discussion for evaluating the different projects or programmes which
have direct effect on the budgets.
The Budget Controller is made responsible to the Chief Executive Officer or Chairman or the
Chief Accounts Officer, if attached with him. He maintains a close link between the accounting
records and budget. He has access to all accounting records and thus avoids overlapping of work by
providing all information as and when needed.

Budget Manual
A budget manual lays down the details of the organisational set up, the routine procedures and
programmes to be followed for developing budgets for various items and the duties and
responsibilities of the executives regarding the operation of the budgetary control system. CIMA
London, defines a budget manual as “a document schedule or booklet which sets out, inter alia, the
responsibilities of the persons engaged in the routine of and the forms and records required for
budgetary control”. Thus, it is a written document which guides the executives in preparing various
budgets. Budgets are to be drawn keeping in view the objectives of the organisation given in the
budget manual. Responsibility and functions of each executive in regard to budgeting are written
down in the budget manual to avoid any duplication or overlapping of responsibilities. Steps and the
methods for developing various budgets and the method of reporting performance against the
budget are written down in the budget manual. In short, it is a written document which gives
everything relating to the preparation and execution of various budgets. It should be clear and there
should be no ambiguity in it. The manual is divided into separate sections so that each manager can
be issued only that section appropriate to his work and responsibilities.

Salient Features of Budget Manual

(i) budget manual contains many information which are required for effective budgetary
planning.
(ii) A budget manual is a collection of documents that contains key information for those
involved in the planning process.
BUDGETARY CONTROL D/2·11

(iii) An introductory explanation of the budgetary planning and control process, including a
statement of the budgetary objective and desired results is included in Budget Manual.
(iv) Budget Manual contains a form of organisation chart to show who is responsible for the
preparation of each functional budget and the way in which the budgets are interrelated.
(v) In contains a timetable for the preparation of each budget.
(vi) Copies of all forms to be completed by those responsible for preparing budgets, with
explanations concerning their completion is included in Budget Manual.
Following are some of the most important matters covered in a Budget Manual :
(i) Introduction and brief explanation of the objects, benefits and principles of budgetary
control.
(ii) Organisation chart giving the titles of different personnels with full explanation of the duties
of each to operating system and preparation of departmental and functional budgets.
(iii) A statement showing the responsibility and of authority given to each manager for
approval of budgets, vouchers and all other forms and documents which authorise them to
spend the money. The authority for granting approval must be clearly stated.
(iv) The entire process of budgeting programme including the time table for periodical reporting.
A schedule should be drawn for this.
(v) Purpose, specimen form and number of copies to be used for each report and statement.
Budget centres involved should also be stated clearly.
(vi) Length of budget periods and control periods should be clearly stated.
(vii) Procedure to be followed throughout the system should be explained in clear terms.
(viii) A method of accounting and control of expenditure.
(ix) Outline of main budgets and their accounting relationships.
(x) Explanation of key budgets.

Advantages of the Budget Manual

Following are the advantages to be derived from the use of a budget manual:
(a) Every one knows in writing that what is his role, what is to be done and how it is to be done in
the system of budgetary control.
(b) As every thing is in writing, ambiguity is avoided and reliance on memory is eliminated.
(c) As one of the objectives of budgeting is communication, it is important to have budget
manual so that everyone in the organisation can refer to it for guidance and information about the
budgetary process.
(d) The methods and procedures of budgetary control are standardised.
(e) It is a formal record defining the functions and responsibilities of each executive.
(f) There is synchronisation of the efforts of all which result in maximisation of the profits of the
organisation.

Budget Period
This may be defined as the period for which a budget is prepared and employed. The budget
period will depend upon two factors i.e. (i) The type of business ; and (ii) The control aspect.
D/2·12 BUDGETARY CONTROL

For example, in case of seasonal industries (i.e., food or clothing), the budget period should be a
short one and should cover one season. But in case of industries with heavy capital expenditure such
as heavy engineering works, the budget period should be long enough to meet the requirements of
the business. From control point of view, the budget period should be a short one so that the actual
results may be compared with the budget each week end or month end and discussed with the
Budget Committee. Long term budgets should be supplemented by short term budgets to make the
budgetary control successful, as short-terms budgets will help in exercising control over day-to-day
operations. In short, the budget period should not be too long so that estimates may not become
unreliable. Similarly, it should also be not too short so that there may be sufficient time before
budget implementation. For most businesses, annual budget is quite common because it compares
with the financial accounting year.
There should be a regular time plan for budget preparation. It may be on the following lines :
1. Long-term budgets for three to five years should be prepared for expansion and modernisation
of the undertaking, introduction of new products or new projects and undertaking heavy
advertisement.
2. Annual budgets coinciding with financial accounting year should be prepared for the
operational activities (i.e., sales, purchases, production etc. of the business).
3. Short-term budgets for control purposes, monthly or even weekly budgets—should be
prepared for watching progress of actual performance against targets. Short-term budgets are
prepared to see that actual performance is proceeding according to the budgets and early corrective
action may be taken if there is any pitfall.

Annual vs. Continuous (or Rolling) Budgeting System

In some organisations budgets are prepared on annual basis. But annual budgets may not help
the management to have control because variances due to rapidly changing conditions affect the sales
in quantity and prices, severe inflationary conditions exist resulting fast increase in the prices of
inputs without reflecting in sales prices immediately and wide range of products being produced
making it not feasible to have precise estimate of levels of activity for a year.
In order to remove the defects of annual budgeting system the continuous budgeting on quarterly
cycle may be adopted. The procedure in continuous budgeting will be that a year will be divided into
four quarters. Monthly budgets for the first quarter and three quarterly budgets for the next year can
be prepared. For the first quarter precise estimates can be drawn up monthly. The budget estimates
for the second quarter may be revised working out separately monthly estimates on more precise ba-
sis for control purposes before the starting of the second quarter. Similar procedure may be followed
for third and fourth quarters. This method should be followed on a continuous basis for the coming
four quarterly periods at a time which need not be in respect of or coincide with the financial year. It
will enable to evolve a precise plan of action and control of variance functions at least for the imme-
diate quarter and a broad plan/tentative one for the subsequent three quarters on a continuous basis.
Where future costs or activities could not be predicted and forecast reliably, this method is useful.
However, it is a costly exercise but matched by considerable reduction in operational variances.

Principal Budget (or Limiting)Factor (PBF)

Principal budget factor is such an important factor that it would affect all the functional budgets
to a large extent. The extent of its influence must be assessed first in order to ensure that functional
BUDGETARY CONTROL D/2·13

budgets are reasonably capable of fulfilment. This is the factor in the activities of an undertaking
which at a particular point in time or over a period will limit the volume of output. It is the governing
factor which is a major constraint on all the operational activities of the organisation, so this factor is
taken into consideration to determine whether the budgets are capable of attainment. It is essential to
locate the limiting factor before the preparation of budgets because it influences almost all budgets.
The limiting factor may be any one of the following :
● Is there sufficient demand for the product ? (customer demand)
● Will a required quality and quantity of materials be available ? (availability of raw material)
● Is the required type of labour available ? (availability of labour)
● Is the plant capacity sufficient to cope up with the expected sales ? (plant capacity)
● Is cash position sufficient to finance the expected volume of sales ? (cash position)
● Are there any Goverment restrictions (Government restrictions)
A typical list of some of the PBF can also be given as below :
(i) Sales—Consumer demand,
(ii) Materials—Availabilities of supply, restrictions on import.
(iii) Labour—Shortage of labour.
(iv) Plant—Lack of capital, bottlenecks in key processes.
(v) Management—Shortage of efficiency executives, lack of knowhow, faulty design, pricing
policy, etc.
For example, a concern has the capacity to produce 50,000 units of a particular item per year. But
only 30,000 units can be sold in the market. In this case, low demand for the product is the limiting
factor. Therefore, sales budget should be prepared first and other functional budgets such as
production budget, labour budget, plant utilisation budget, cash budget etc. should be prepared in
accordance with the sales budget. Suppose another concern has no sales problem and can sell
whatever it can produce. In this case plant capacity is limited. Therefore, production budget should
be prepared first and other budgets should follow the production budget.
Thus, the budget relating to limiting factor should be prepared first and the other budgets
should be prepared in the light of that factor. All budgets should be co-ordinated keeping in view the
principal budget factor if the budgetary control is to achieve the desired results.
Principal budget factor is not static. It may vary rapidly from time to time due to internal and
external factors. It is of temporary nature and in the long run can be overcome by suitable
management actions. Most often shortage of sales is the key factor in industry and this factor can be
overcome by taking sales promotion steps as increasing sales staff and advertising. Plant capacity can
be improved by better planning, simplification of product or extension of plant.
Different Types of Budgets
Different types of budgets have been developed keeping in view the different purposes they
serve. Budgets can be classified according to : (1) the coverage they encompass ; (2) the capacity to
which they are related ; (3) the conditions on which they are based ; and (4) the periods which they
cover.
D/2·14 BUDGETARY CONTROL

Budget

Coverage Capacity Condition Period

Func- Master Fixed Flexible Basic Current Short Medium Long

tional Budget Budgets Budgets Budgets Budgets Term Term Term
Budgets Budgets Budgets Budgets

Functional Budgets
A functional budget is a budget which relates to any of the functions of an undertaking, e.g., sales,
production, research and development, cash etc. Following functional budgets are generally
prepared :
Budget Prepared by
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

( i) Sales Budget including Selling and Distribution Cost Budget Sales Manager
(ii) Production Budget Production Manager
(iii) Materials Budget Purchase Manager
(iv) Labour and Personnel Budget Personnel Manager
(v) Manufacturing Overheads Production Manager
(vi) Administration Cost Budget Finance Manager
(vii) Plant Utilisation Budget Production Manager
(viii) Capital Expenditure Budget Chief Executive
(ix) Research and Development Cost Budget R & D Manager
(x) Cash Budget Finance Manager

( i)Sales Budget
Sales budget is the most important budget and of primary importance. It forms the basis on
which all the other budgets are built up. This budget is a forecast of quantities and values of sales to
be achieved in a budget period. Every effort should be made to ensure that its figures are as accurate
as possible because this is usually the starting budget (sales being limiting factor on which all the
other budgets are built up). The Sales Manager should be made directly responsible for the
preparation and execution of the budget. The sales budget may be prepared according to products,
sales territories, types of customers, salesmen etc. In the preparation of the sales budget, the sales
manager should take into consideration the following factors :
(1) Past Sales Figures and Trends. The complier of the sales budget should be assisted by graphs
recording sales of the previous year and the general sales trend (upward and downward) should be
noticed from the graphs. The record of previous year’s sales is the most reliable basis as to future
sales as the past performance is based on actual business conditions. But in addition to past sales,
other factors affecting future sales, e.g., seasonal fluctuations, growth of market, trade cycle etc.,
should be considered in the preparation of the sales budget.
(2) Estimates of Salesmen. In preparing the sales budget, the sales manager should consider the
estimates of sales received from salesmen because they can make more accurate estimates, being in
direct contact with the customers. However, it should be seen that estimates of salesmen should
neither be over-optimistic nor too conservative.
BUDGETARY CONTROL D/2·15

(3) Plant Capacity. The budget should be within the plant capacity available and should ensure
proper utilisation of plant facilities. Proposed plant extensions should be allowed for in the
preparation of the sales budget.
(4) Availability of Raw Material and Other Supplies. Adequate supply of raw materials and
other supplies should be ensured before preparing the sales estimates. Sales estimates should be
adjusted according to the availability of raw material if the raw materials are in short supply.
(5) General Trade Prospects. The probability of the sales going up or down depends on the
general trade prospects. In this connection valuable information may be gathered from financial
papers and magazines such as the Economic Times, the Financial Express, the Commerce, etc.
(6) Orders in Hand. In boom periods or where production is a very lengthy process the value of
orders in hand may have considerable influence on the amount of sales to be budgeted.
(7) Seasonal Fluctuations. In preparation of the sales budget, seasonal fluctuations should be
considered because sales are affected by these fluctuations. In order to have an even flow of
production, efforts should be made to minimise the effects of seasonal fluctuations on sales by giving
special concessions or added inducements during the off- season.
(8) Financial Aspect. The sales budget should be within the financial capacity of the concern.
Sales expansion usually requires an increase in capital outlay. Thus, if any big sales expansion is
planned, it must be ensured that facilities are available to finance the operations.
(9) Adequate Return on Capital Employed. The sales volume budgeted should produce an
adequate return on the capital employed.
(10) Competition. The nature and degree of competition within the industry should be
considered in the preparation of the sales budget to have a realistic sales budget capable of being
achieved in the face of competition.
(11) Miscellaneous Considerations. Other considerations such as advertising and sales
promotion efforts, government intervention, import possibility, product profitability, market research
studies, pricing policies etc. should also be kept in view.
The sales manager, after taking into consideration the above factors, should prepare the sales
budget in terms of quantities and amounts and the sales estimates must be analysed for products
periods and territories. The sales budget should include an estimate of selling and distribution costs
in addition to an estimate of the total proceeds. The specimen of the sales budget is given as under :
Biscuit Division SALES BUDGET Year 2023-24
For the year Per month
Area Production Quantity Rate Value Quantity Value
kgs. per kg. R kgs. R

Marie
North Goodday
Bourbon
Total
Marie
South Coco-cream
Orange cream
Total
D/2·16 BUDGETARY CONTROL

East Horlicks
Bourbon
Goodday
Total
Marie
West Goodday
Bourbon
Total
Marrie
Total Goodday
Horlicks
Bourbon
Orange cream
Total

Sales Forecast and Sales Budget

A sales forecast may be just a guess of sales without taking into consideration production
capacity and may lack any objective to control the actual performance. On the other hand, estimate of
the sales given in the sales budget is not mere guess, it is based on the plant capacity, availability of
material, labour and working capital and many other considerations. It is capable of being achieved,
being so it is amenable to control.

ILLUSTRATION 1. (Sales Budget) A manufacturing company submits the following figures

of product ‘X’ for the first quarter of 2023 :
Sales (in units) January 30,000 Target of 1st Quarter 2024
February 25,000 Sales quantity Increase 10%
March 35,000 Sales price increase 10%
Selling Price per unit R 20
Prepare Sales Budget for the first quarter of 2024

SOLUTION
SALES BUDGET
for the first quarter of 2024
Months Units Price per unit Value
R R

January 33,000 22 7,26,000

February 27,500 22 6,05,000
March 38,500 22 8,47,000
——————————— ———————————————
99,000 21,78,000
——————————— ———————————————

( ii)Production Budget
Production budget is a forecast of the total output of the whole organisation broken down into
estimates of output of each type of product with a scheduling of operations (by weeks and months) to
BUDGETARY CONTROL D/2·17

be performed and a forecast of the closing finished stock. This budget may be expressed in
quantitative (weight, units etc.) or financial (rupees) units or both. This budget is prepared after
taking into consideration the estimated opening stock, the estimated sales and the desired closing
finished stock of each product. Suppose, if the estimated opening stock of product X is 2,000 units and
the estimated sales is 15,000 units and the closing stock of the product is 2,500 units the estimated
production will be 15,000 + 2,500 – 2,000 (Sales + closing stock – opening stock) = 15,500 units. The
Works Manager is responsible for the total production budget and the departmental managers are
responsible for the departmental production budget. In preparing the production budget, the
following factors are considered :
(1) The time lag between the production in the factory and sales to the customer should be
considered so as to allow for the time required for the despatch of goods from the factory to
the place of the customers.
(2) The stock of goods to be maintained both at the factory’s godown and at the sales centres.
(3) The level of production needed to meet the sales programme. Monthly production targets
should be fixed and it should be seen that production is kept more or less at a uniform level
throughout the year. Planning the level of production involves the answer of four questions :
(a) What is to be produced ? (b) When is it to be produced ?
(c) How is it to be produced ? (d) Where is to be produced ?
Requirements of material, labour and plant should be ascertained to have the desired production
to meet the sales programme.
The sales budget and the production budget are inter-dependent because production budget is
governed by the sales budget and the sales budget is largely determined by the production capacity
and by production costs.
ILLUSTRATION 2. (Production Budget) Prepare a production budget for 3 months ending
March 31, 2024, for a factory producing four products, on the basis of the following information:
Type of Estimated Stock Estimated Sales Desired Closing Stock
Product on Jan. 1, 2024 during Jan-March, 2024 on March 31, 2024
A 2,000 10,000 3,000
B 3,000 15,000 5,000
C 4,000 13,000 3,000
D 3,000 12,000 2,000
SOLUTION
PRODUCTION BUDGET
for three months ending 31st March, 2024
Product
A B C D Total
Units Units Units Units Units
Estimated Sales 10,000 15,000 13,000 12,000 50,000
Add : Desired Closing Stock 3,000 5,000 3,000 2,000 13,000
13,000 20,000 16,000 14,000 63,000
Less: Estimated Opening Stock 2,000 3,000 4,000 3,000 12,000
Units to be produced 11,000 17,000 12,000 11,000 51,000
D/2·18 BUDGETARY CONTROL

ILLUSTRATION 3. Sportswear Ltd. manufactures sportswear shirts and shorts. The

production budget for these two products has to be prepared for the next three months, November,
2023, December, 2023 and January 2024.
Following information is given :
(i) Sales volume every month will be 2% more than the previous month’s volume for each
product.
(ii) The company carries stock of finished garments sufficient to meet 40% of the next
month’s sales.
(iii) Closing stock for October 2023 was 6,000 shirts and 8,000 shorts.
You are required to prepare the production budget for each product for November 2023,
December 2023 and January 2024.
SOLUTION
PRODUCTION BUDGET
Shirts Shorts
2023 2024 2023 2024
Nov. Dec. Jan. Feb. Nov. Dec. Jan. Feb.
Closing Stock 6,120 6,242 6,367 — 8,160 8,323 8,490 —
(40% of Next Montsh’s Sales)
Add : Sales (1) 15,000 15,300 15,606 15,919 20,000 20,400 20,808 21,224
Total 21,120 21,542 21,973 28,160 28,723 29,298
Less : Opening Stock 6,000 6,120 6,242 8,000 8,160 8,320
Production 15,120 15,422 15,731 20,160 20,563 20,978
Working Notes : (i) Calculation of Sales
Opening Stock Shirts = 6000 = 40% of Nov. Sales
Sale of Shirts Sale of Shorts
6‚000 8‚000
2023 Nov. = = 15,000 2023 Nov. = = 20,000
40% 40%
Dec. = 1.02 × 15,000 = 15,300 Dec. = 1.02 × 20,000 = 20,400
2024 Jan. = 1.02 × 15,300 = 15,606 2024 Jan. = 1.02 × 20,400 = 20,808
Feb. = 1.02 × 15,606 = 15,918 Feb. = 1.02 × 20,808 = 21,224

( iii)Cost of Production Budget

After determining the volume of output the cost of procuring the output must be obtained by
preparing a cost of production budget. This budget is an estimate of cost of output planned for a
budget period and may be classified into material cost budget, labour cost budget and overhead
budget because cost of production includes material, labour and overheads.

( a)Materials Budget
In drawing up the production budget, one of the first requirements to be considered is material.
As we know, materials may be direct or indirect. Thus materials budget deals with the requirement
and procurement of direct materials. Indirect materials are dealt with under the works overhead
budget. The budget should be related to the production budget and the period of the budget should
BUDGETARY CONTROL D/2·19

be of short duration because this budget has an important bearing on the cash budget. The
preparation of the materials budget includes :
(1) The preparation of estimates of different types of raw materials needed for various products.
(2) Procuring or purchasing raw materials in required quantities at the required time.
In preparing the materials budget the following factors are considered :
(i) Raw materials required for the budgeted output.
(ii) The percentage of raw materials to total cost of products should be calculated on the basis of
previous records. On the basis of this percentage a rough total value of raw materials
required for the budgeted output will be ascertained.
(iii) Consideration must be given to the company’s stocking policy. Figures related to the
anticipated raw materials stock to be held at different times should be known.
(iv) Consideration must be given to the lag between the placing of the order of the purchase of
materials and the receipt of materials.
(v) The seasonal nature in the availability of raw materials should be considered.
(vi) The price trend in the market.
Materials budget can be classified into material requirement budget and material procurement or
purchase budget. The material requirement budget gives information about the quantity of materials
required during the budget period to attain the production target. Material requirement budget takes
into consideration the inventory of materials and the materials on order at the beginning of a budget
period, and the anticipated inventory of materials and the materials to be on order on the closing date
of the budget period.
ILLUSTRATION 4. Draw up a Material Requirement Budget (quantitative) from the
following information :
Estimated sales of a product—40,000 units. Each unit of the product requires 3 units of material
A and 5 units of material B.
Estimated opening balances at the commencement of the next year : Finished product—5,000
units; Material A—12,000 units; Material B—20,000 units; Material on order—Material A—7,000
units and Material B—11,000 units. The desirable closing balances at the end of next year :
Finished product—7,000 units; Material A—15,000 units; Material B—25,000 units; Material on
order—Material A—8,000 units and Material B—10,000 units.
SOLUTION
Estimated production during the next year is not given in the question. It is calculated as follows :
Estimated Production = Expected Sales + Desired Closing Stock of Finished Goods
– Estimated Opening Stock of Finished Goods
= 40,000 units + 7,000 units – 5,000 units = 42,000 units
MATERIAL REQUIREMENT BUDGET
(Quantitative)
Material A Material B
Units Units
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Material required to meet the production target :
Material A—@ 3 units for 42,000 finished units 1,26,000
Material B—@ 5 units for 42,000 finished units 2,10,000
D/2·20 BUDGETARY CONTROL

Desired closing balances of materials at the end of the budget period 15,000 25,000
Estimated units of materials to be on order at the end of the budget period 8,000 10,000
————————————————— ——————————————

1,49,000 2,45,000
Less : Estimated opening balances of materials at the beginning of the period 12,000 20,000
————————————————— ——————————————

1,37,000 2,25,000
Less: Estimated units of materials or order at the beginning of the budget period 7,000 11,000
————————————————— ——————————————

1,30,000 2,14,000
—————————————————
————————————————— ——————————————
——————————————

Purchase Budget
Purchase Budget is mainly dependent on production budget and material requirement budget.
This budget provides information about the materials to be acquired from the market during the
budget period. This budget shows the quantity of materials to be purchased during the coming year.
If the raw material availability is the key factor, it become, the starting point. The desired closing
inventory of the raw materials is added to the requirements as per the production budget and the
opening inventory is subtracted from the gross requirements. This budget is prepared in quantity as
well as in monetary terms and helps immensely in planning of the purchases of raw materials.
Availability of storage space, financial resources, various levels of raw materials like maximum,
minimum, re-order and economic ordering quantity are taken into consideration while preparing this
budget. A separate material utilisation budget may also be prepared as a preparatory to Material
Purchase Budget.
Purchase budget should be prepared by the purchase manager by getting relevant information
about capital items, tools, general supplies and direct materials required during the budget period
from other related departments. Like other budgets, the purchase budget has to be approved by the
budget committee. After approval it becomes the responsibility of the purchase officer to see that
purchases are made as per the purchase budget. Sometimes additional purchase which are not
covered by the purchase budget are made under the following circumstances :
(a) If there is increase in production not anticipated while preparing the purchase budget and
purchase of larger quantities of materials becomes necessary.
(b) If accumulation of stock becomes necessary to avoid shortage of materials.
(c) If overstocking is desired to take advantage of lower prices and there is fear that prices will
increase in near future.
The purchase manager should get additional sanctions from the higher authorities for making the
additional purchases not covered by the purchase budget.
ILLUSTRATION 5. The Beta Ltd. has prepared the following sales budget for the first five
months of the financial year 2023-24 :
SALES BUDGET
Month Unit Month Unit
April 54,000 July 52,000
May 78,000 August 49,000
June 61,000
BUDGETARY CONTROL D/2·21

Inventory of finished goods at the end of every month is to be equal to 1/4th of sales estimate
for the next month. On 1st April, 2023 there were 13,500 units of the product on hand. There is no
work in progress at the end of any month.
Every unit of the product requires two types of materials in the following quantities :
Material A—5 kg., Material B—6 kg.
Materials equal to 50% of the requirement of the next month’s production are to be in hand at
the end of every month. This requirement was adequately met on 1st April, 2023.
Prepare the following budgets for the first Quarter of the financial year 2023-24 :
(i) Quantitative Production Budget;
(ii) Material Purchase Budget (Quantitative)
SOLUTION
(i) PRODUCTION BUDGET FOR THE FIRST QUARTER OF 2023-24
April (Units) May (Units) June (Units) July (Units)
Budgeted Sales 54,000 78,000 61,000 52,000
Add : Closing Stock 19,500 15,250 13,000 12,250
Less : Opening Stock 13,500 19,500 15,250 13,000
Production during the period 60,000 73,750 58,750 51,250

(ii) MATERIAL PURCHASE BUDGET

for the first quarter of 2023-24
April May June
Particulars A B A B A B
kg. kg. kg. kg. kg. kg.
Material for Production
@ 5 kg. per unit of A 3,00,000 3,68,750 2,93,750
@ 6 kg. per unit of B 3,60,000 4,42,500 3,52,500
Add : Closing Stock 1,84,375 2,21,250 1,46,875 1,76,250 1,28,125 1,53,750
Less : Opening Stock (1,50,000) (1,80,000) (1,84,375) (2,21,250) (1,46,875) (1,76,250)
3,34,375 4,01,250 3,31,250 3,97,500 2,75,000 3,30,000

ILLUSTRATION 6. Following details apply to an annual budget for a manufacturing

company :
Quarter 1st 2nd 3rd 4th
Working Days 65 60 55 60
Production (units per working day) 100 110 120 105
Raw Material Purchase
(% by weight of annual total) 30% 50% 20%
Budget purchase price (per kg) R 1 R 1.05 R 1.125
Quantity of raw material per unit of production 2 kgs.
Budgeted opening stock of raw material—4,000 kgs.
Budgeted closing stock of raw material—2,000 kgs.
Calculate the budgeted figures quarterly and annual purchases of raw material by weight and
value.
D/2·22 BUDGETARY CONTROL

SOLUTION RAW MATERIALS PURCHASE BUDGET

(by weight and value)
Consum- Add Less Purchases Price Amount of
Quarter ption (1) Closing Opening (2) per Purchase of
Stock Stock kg. Materials
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
kgs. kgs. kgs. kgs. R R

I 13,000 15,000 1.00 15,000

II 13,200 25,000 1.05 26,250
III 13,200 10,000 1.125 11,250
IV 12,600 — —
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Total 52,000 2,000 4,000 50,000 52,500

Working Notes :
(1) Consumption = Working days × Production (2) Purchases
× Quantity of raw material Quarter I = 30% of 50,000 = 15,000 kgs.
per unit of production II = 50% of 50,000 = 25,000 kgs.
Quarter I = 65 × 100 × 2 = 13,000 kgs. III = 20% of 50,000 = 10,000 kgs.
II = 60 × 110 × 2 = 13,200 kgs.
III = 55 × 120 × 2 = 13,200 kgs.
IV = 60 × 105 × 2 = 12,600 kgs.

( b)Direct Labour Budget

This budget gives an estimate of the requirements of direct labour essential to meet the
production target. This budget may be classified into labour requirement budget and labour
recruitment budget. The labour requirement budget is developed on the basis of requirement of the
production budget given and detailed information regarding the different classes of labour, e.g.
fitters, welders, turners, millers, grinders, drillers etc., required for each department, their scales of
pay and hours to be spent. This budget is prepared with a view to enable the personnel department to
carry out programmes of training and transfer and to find out sources of labour needed so that every
effort may be made to remove difficulties arising in production through lack of suitable personnel.
Labour recruitment budget is prepared on the basis of labour requirement budget after taking into
consideration the available workers in each department, the expected changes in the labour force
during the budget period due to the labour turnover. This budget gives information about the
personnel specifications for the jobs for which workers are to be recruited, the degree of skill and
experience required and the rates of pay. In preparing the labour cost budget, the question of
overtime should not be overlooked because workers are to get higher rates of wages if they work on
overtime. Regular overtime should be avoided by engagement of additional workers and extension of
plant. Where standard costing system is applied, the labour cost budget is developed on the basis of
standard labour cost per unit multiplied by the quantity of anticipated production determined in the
production budget. If standard costing system is not being followed in the organisation, the
information of labour cost may be obtained from past records or estimated cost.
ILLUSTRATION 7. P Ltd. manufactures two products using one grade of labour. Shown
below is an extract from the company’s working papers for the next period’s budget :

Product A Product B
——————————————————— ———————————————————

Budgeted production (units) 3,480 4,000

Standard hours allowed per product 5 4
BUDGETARY CONTROL D/2·23

Budgeted wage rate R 8 per hour.

Overtime premium is 50% and is payable, if a worker works for more than 40 hours a week.
There are 90 direct workers.
The target productivity ratio (or efficiency ratio) for the productive hours worked by the direct
workers in actually manufacturing the production is 80%; in addition the non-productive
downtime is budgeted at 20% of the productive hours worked.
There are twelve 5 days weeks in the budget period.
Prepare the wages budget for direct workers showing hours required and wages paid.

SOLUTION
DIRECT WORKERS WAGES BUDGET
(Showing hours required and wages paid)
Product A Product B Total
————————————————————————————————————————————————————————————————————————————————————————————————

Budget production in units 3,480 4,000 Hours

Standard hours for budgeted production 17,400 16,000 33,400
————————————

(3,480 units × 5 hours) (4,000 units × 4 hours)

Standard hours for budgeted production at target efficiency ratio (A)

(33,400 hours ×
100
80 )
Add : Normal productive down time (20% × 41,750 hours)
41,750
8,350
————————————

Total labour hours required 50,100

Less : Normal labour hours (90 workers × 12 weeks × 5 days × 8 hours) 43,200
————————————

Difference (overtime) 6,900

————————————

Wages for normal hours (43,200 × R 8) 3,45,600

Overtime wages (6,900 × R 12) 82,800
————————————

Total wages 4,28,400

————————————
————————————

Manpower Budget
This budget gives the requirements of direct and indirect labour necessary to meet the
programme set out in the sales, manufacturing, maintenance, research and development and capital
expenditure budgets. The labour requirements are expressed in terms of rupee value, number of
labour hours, number and grade of workers etc. This budget makes provision for shift and overtime
work and for the effective training for new workers on labour cost. The main purposes of this budget
are :
(1) It provides efficient personnel management.
(2) It helps to make provision for a suitable yardstick with which the actual labour force may be
compared and controlled.
(3) It helps in reducing labour turnover by providing favourable conditions.
D/2·24 BUDGETARY CONTROL

(4) It also helps to measure and stabilise the ratio between direct labour and indirect labour.
(5) It gives the requirements of cash for paying wages and thus facilitates the preparation of
Cash Budget.
A proforma of Manpower Budget is given as under :
MANPOWER BUDGET
Biscuit Division Year 2023-24
Present To be Recruited
Classification of Labour Grade I Grade II Grade III Total Strength
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

I. Direct Labour :
Mixing Department
Making Department
Packing Department —————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Sub Total
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————

II. Indirect Labour :

(a) Production :
Details
(b) Administration :
Details
(c) Selling and
Distribution :
Details
(d) Research and
Development :
Details
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Sub Total
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————

III. Total (I + II)

ILLUSTRATION 8. The direct labour requirements of three of the products manufactured in

a factory, each involving more than one labour operations, are estimated as follows :
Direct labour hours per unit (in minutes)
Product
———————————————————————————————————————

1 2 3
Operation
1 18 42 30
2 — 12 24
3 9 6 —
The factory works 8 hours per day, 6 days in a week. The budget quarter is taken as 13 weeks
and during a quarter lost hours due to leave and holiday and other causes are estimated to be 124
hours.
The budgeted hourly rates for the workers manning the operations 1, 2 and 3 are R 2.00, R 2.50
and R 3.00 respectively.
The budgeted sales of the product during the quarter are :
Product 1 9,000 units
2 15,000 units
3 12,000 units
BUDGETARY CONTROL D/2·25

There is a carry over of 5,000 units of product 2 and 4,000 units of product 3 and it is proposed
to build up a stock at the end of the budget quarter as follows :
Product 1 1,000 units
3 2,000 units
Prepare a man-power budget for the quarter showing for each operation, (i) direct labour
hours, (ii) direct labour cost and (iii) the number of workers.
SOLUTION
MANPOWER BUDGET FOR THE QUARTER
Rate Product I Product II Product III Total
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
per Labour Labour Labour Labour No. of
Operation Hour Hours Cost Hours Cost Hours Cost Hours Cost Workers
(3) (3) (3) (4)
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R R

1 2.00 3,000 6,000 7,000 14,000 5,000 10,000 15,000 30,000 30

2 2.50 — — 2,000 5,000 4,000 10,000 6,000 15,000 12
3 3.00 1,500 4,500 1,000 3,000 — — 2,500 7,500 5
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Total 4,500 10,500 10,000 22,000 9,000 20,000 23,500 52,500 47
———————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Working Notes :
(1) Total hours available per worker in the quarter
(8 hours × 6 days × 13 weeks) 624
Less : Hours lost because of leave and holidays 124
———————
Total hours available per worker in the quarter 500
———————
———————
(2) No. of units produced in the quarter
Product 1 Product 2 Product 3
Units Units Units
Sales 9,000 15,000 12,000
Add : Closing Stock 1,000 — 2,000
——————————— ——————————— ———————————
10,000 15,000 14,000
Less : Opening Stock — 5,000 4,000
——————————— ——————————— ———————————
Output 10,000 10,000 10,000
——————————— ——————————— ———————————

(3) Direct Labour hours required

Operation Product 1 Product 2 Product 3

————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
18 mts × 10‚000 42 × 10‚000 30 × 10‚000
1. = 3,000 hours = 7,000 hours = 5,000 hours
60 60 60
12 × 10‚000 24 × 10‚000
2. — = 2,000 hours = 4,000 hours
60 60
9 mts × 10‚000 6 × 10‚000
3. = 1,500 hours = 1,000 hours —
60 60
Total labour hours required
(4) No. of workers required =
Total available hours per worker
15‚000 6‚000 2‚500
Operation 1 = = 30 ; Operation 2 = = 12 ; Operation 3 = = 5.
500 500 500
D/2·26 BUDGETARY CONTROL

( c)Manufacturing (or Production) Overheads Budget

This budget gives an estimate of the works overhead expenses to be incurred in a budget period
to achieve the production target. The budget includes the cost of indirect materials, indirect labour
and indirect works expenses. The budget may be classified into fixed cost, variable cost and semi-
variable cost. It can be broken into departmental overhead budget to facilitate control. In preparing
the budget, fixed works overhead can be estimated on the basis of past information after taking into
consideration the expected changes which may occur during the budget period. Variable expenses
are estimated on the basis of the budgeted output because these expenses are bound to change with
the change in output.
The Cost and Management Accountant prepares this budget on the basis of figures available in
the manufacturing overhead ledger or the head of the workshop may be asked to give estimates for
the manufacturing expenses. A good method is to combine the estimates of the Cost and
Management Accountant and the shop executive.
ILLUSTRATION 9. Prepare a manufacturing overhead budget and ascertain the
manufacturing overhead rates at 50% and 70% capacities. Following particulars are given at 60%
capacity :
Variable overheads : Indirect Material R 6,000 ; Indirect Labour R 18,000.
Semi-variable overheads : Electricity (40% fixed) R 30,000 ; Repairs and Maintenance (20%
variable) R 3,000.
Fixed overheads : Depreciation R 16,500 ; Insurance R 4,500 and Salaries R 15,000.
Estimated direct labour hours 1,86,000 hrs.
SOLUTION
MANUFACTURING OVERHEAD BUDGET AND ASCERTAINMENT OF OVERHEAD RATES
Items 50% Capacity 60% Capacity 70% Capacity
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Variable overheads : R R R

Indirect Material 5,000 6,000 7,000

Indirect Labour 15,000 18,000 21,000
Semi-variable overheads :
Electricity (1) 27,000 30,000 (1) 33,000
Repairs and Maintenance (2) 2,900 3,000 (2) 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 (a) 85,900 93,000 1,00,100
Estimated direct labour hours ( b) 1,55,000
—————————————————
1,86,000
—————————————————
2,17,100
————————————————
Overhead Rate [(a) ÷ (b)] R 0.55 R0.50 R0.46
Notes :
1. Electricity. At 60% electricity cost is R 30,000 of which R 12,000 (i.e. 40% of R 30,000) is fixed and

R 18,000 variable. The variable portion of the electricity cost is R 15,000 ( i.e.
R 18‚000
60 )
× 50 at 50% capacity

and R
(
21,000 i.e.
R 18‚000
60 )
× 70 at 70% capacity. To this variable portion, the fixed portion of R 12,000 should

be added to get the elecricity cost.

BUDGETARY CONTROL D/2·27

2. Repairs and maintenance. At 60% capacity, repairs and maintenance cost is 3,000 of which 2,400 R R

(i.e. 80% of 3,000) is fixed and 600 (i.e., 20% of

R 3,000) is variable. The variable portion at 50% is 500
R R R

( i.e.‚
R 600
60
× 50 ) and R 700 ( i.e.‚
R 600
60 )
× 70 at 70% capacity. To this variable, the fixed portion of R 2,400

should be added to obtain the repairs and maintenance cost. Thus, total cost of repairs and maintenance comes
to 2,900 (i.e., 500 + 2,400) at 50% and 3,100 (i.e. 700 + 2,400) at 70%.
R R R R R

ILLUSTRATION 10. At 100% capacity (1,00,000 hours), the monthly production overhead
budget for a factory was as follows :
R Category
Salaries 40,000 C
Indirect Wages 8,000 B
Spoilage 2,000 A
Fuel and Power 15,000 A
———————————

65,000
———————————

The behaviour of various categories of expenses was as follows :

Activity as a % of Capacity Multipliers applicable to budget
A B C
80 0.85 1.00 1.00
100 1.00 1.00 1.00
120 1.12 1.00 1.00
140 1.23 1.10 1.00
There were three products and in a month the total production was expected to be :
X 10,000 units ; Y 15,000 units ; Z 5,000 units
The standard hours per unit of the three products were agreed to be :
5 for X; 4 for Y and 6 for Z.
Prepare production overhead budget for the concerned month.
SOLUTION
Production in Terms of Standard Hours during the month
Product Units Produced Standard hours per unit Standard hours produced
X 10,000 5 50,000
Y 15,000 4 60,000
Z 5,000 6 30,000
———————————

1,40,000

( )
———————————
———————————

100
Hence the activity level is 140% i.e. × 1,40,000
1‚00‚000
PRODUCTION OVERHEAD BUDGET
for the month..............
Items of Expenses Budget at 100% Category Multiplier @ 140% Amount
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

R R

Salaries 40,000 C 1.00 40,000

Indirect Wages 8,000 B 1.10 8,800
D/2·28 BUDGETARY CONTROL

Spoilage 2,000 A 1.23 2,460

Fuel and Power 15,000 A 1.23 18,450
——————————— ———————————

65,000 69,710
———————————
——————————— ———————————
———————————

( iv)Administration Expenses Budget

This budget covers the expenses incurred in framing policies, directing the organisation and
controlling the business operations. In other words, the budget provides an estimate of the expenses
of the central office and of management salaries. The budget can be prepared with the help of past
experience and anticipated changes. Budget may be prepared for each administration department so
that responsibility for increasing such expenses may be fixed and related to the different executives.
Much difficulty is not experienced in developing such budget as most of the administration expenses
are of a fixed nature. Although fixed expenses remain constant and are not related to sales volume in
the short run, they are dependent upon sales in the long run. With a small change in output, they do
not change. However, if there is a persistent fall in output, administration expenses will have to be
reduced by discharging the services of some members of the staff and taking other economy
measures. On the other hand, with persistent increase in output or business activity, administration
expenses will increase but they may lag behind business activity.

( v)Selling and Distribution Cost Budget

This budget is the forecast of the cost of selling and distribution for budget period and is clearly
related to the sales budget. All expenses relating to selling and distribution of the various products as
indicated in the sales budget are included in it. These expenses are based on the volume of sales set in
the sales budget and budgets are prepared for each item of selling and distribution overhead. Long
term expenses as advertisement are spread over more than one period. Selling and distribution
overheads are divided into fixed and variable category with reference to volume of sales. Separate
budgets are prepared for variable and fixed items of selling and distribution overheads. Certain items
of selling and distribution costs as cost of transport department are included in the departmental
production cost budget from control point of view rather than including in selling and distribution
costs budget. The specimen of this budget is given as follows :
SELLING & DISTRIBUTION COST BUDGET
Biscuit Division
Budget for the year Monthly Average
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Cost Elements North South East West Total North South East West Total
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(A) Direct Selling
Expenses
Salesmen’s
Salaries
Commission
Salesmen’s Exp.
Conveyance
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Sub Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(B) Sales Office
Expenses
Salaries, Rent,
BUDGETARY CONTROL D/2·29

Rates etc.
Postage &
Stationery
Depreciation
General Expenses
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Sub Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(C) Distribution
Expenses
Warehouse
Wages
Driver’s Wages
Warehouse Rent
Lorry Expenses
Depreciation
General Expenses
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Sub Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(D) Advertising Exp.
Press
Cinema
T.V.
Others
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Sub Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
(E) Sales Promotion
Total
————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
A+B+C+D+E

ILLUSTRATION 11. A department of Company X attains sales of R 6,00,000 at 80% of its

normal capacity and its expenses are given below :
Administration Costs (Fixed) : Selling Costs :
Office Salaries R 90,000 Salaries 8 per cent of sales
General Expenses 2 per cent of sales Travelling Expenses 2 per cent of sales
Depreciation 7,500 Sales Office 1 per cent of sales
Rates and Taxes 8,750 General Expenses 1 per cent of sales
Distribution Costs :
Wages (fixed) R 15,000

Rent 1 per cent of sales

Other Expenses 4 per cent of sales
Draw up flexible administration, selling and distribution costs budget, operating at 90 per
cent, 100 per cent and 110 per cent of normal capacity.
SOLUTION X LTD.
Flexible Budget of Department...
Level of activity
———————————————————————————————————————————————————————————————————————

Expenses Basis 80% 90% 100% 110%

——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
—
R R R R

Sales 6,00,000 6,75,000 7,50,000 8,25,000

———————————————————————————————————————————————————————————————————————
D/2·30 BUDGETARY CONTROL

Administrative Costs :
Office Salaries Fixed 90,000 90,000 90,000 90,000
General Expenses 2% of Sales 12,000 13,500 15,000 16,500
Depreciation Fixed 7,500 7,500 7,500 7,500
Rates & Taxes Fixed 8,750 8,750 8,750 8,750
———————————————————————————————————————————————————————————————————————

Total Administrative Costs 1,18,250 1,19,750 1,21,250 1,22,750

———————————————————————————————————————————————————————————————————————

Selling Costs :
Salaries 8% of Sales 48,000 54,000 60,000 66,000
Travelling Exp. 2% ” ” 12,000 13,500 15,000 16,500
Sales Office Exp. 1% ” ” 6,000 6,750 7,500 8,250
General Expenses 1% ” ” 6,000 6,750 7,500 8,250
———————————————————————————————————————————————————————————————————————

Total Selling Costs 72,000 81,000 90,000 99,000

———————————————————————————————————————————————————————————————————————

Distribution Costs :
Wages Fixed 15,000 15,000 15,000 15,000
Rent 1% of Sales 6,000 6,750 7,500 8,250
Other Expenses 4% of Sales 24,000 27,000 30,000 33,000
———————————————————————————————————————————————————————————————————————
Total Distribution Cost 45,000 48,750 52,500 56,250
———————————————————————————————————————————————————————————————————————
Total Adm., Selling & Dist. Costs 2,35,250 2,49,500 2,63,750 2,78,000

( vi)Plant Utilisation Budget

This budget lays down the requirements of plant capacity to carry out the production as per the
production programme. This budget is expressed in terms of convenient physical units as weight or
number of products or working hours. The main functions of this budget are :
(i) It will show the machine load in each department during the budget period.
(ii) It will indicate the overloading on some departments, machine or group of machines and
alternative courses of actions as working overtime, off-loading, procurement or expansion of plants,
sub-contracting etc., can be taken.
(iii) Idle capacity in some departments may be utilised by making efforts to increase the demand
for the products by providing after sale service, conducting advertisement campaign, reducing prices,
introducing lucky prize coupons, recruiting efficient sales staff etc.

( vii)Capital Expenditure Budget

The capital expenditure budget gives an estimate of the amount of capital that may be needed for
acquiring the fixed assets required for fulfilling production requirements as specified in the
production budget. The budget is prepared after taking into consideration the available productive
capacities, probable reallocation of the existing assets and possible improvement in production
techniques. Separate budgets may be prepared for different items of fixed assets such as plant and
equipment budget, building budget etc. The capital expenditure budget is an important budget
providing for acquisition of assets, necessitated by the following factors :
(i) Replacement of existing assets.
(ii) Purchase of additional assets to meet a proposed increase in production due to increase in
demand.
BUDGETARY CONTROL D/2·31

(iii) Purchase of additional assets because of starting up of new lines of production.

(iv) Installation of an improved type of machinery so as to reduce cost of production.
Thus, the capital expenditure budget enables one to know what new fixed assets are needed and
what will be their costs and rates of return.

( viii)Research and Development Cost Budget

While developing research and development cost budget, it should be clear in mind that work
relating to research and development is different from that relating to the manufacturing function.
Manufacturing function gives quicker results than research and development which may go on for
several years. Therefore, these budgets are established on a long term basis, say for 5 to 10 years
which can be further subdivided into short-term budgets on annual basis. As a rule research workers
are less cost conscious ; so they are not susceptible to strict control. A research and development
budget is prepared taking into consideration the research projects in hand and the new research and
development projects to be taken up. Thus this budget provides an estimate of the expenditure to be
incurred on research and development during the budget period.
After fixation of the research and development cost budget, the research executive fixes priorities
for the various research and development projects and submits research and development project
authorisation forms to the budget committee. The projects are finally approved by the senior
executive. Before giving the approval, the expenditure on research and development is matched
against the benefits likely to be availed of from the new project. After the approval of the budget, a
close watch is kept on the expenditure so that it may not exceed budget provisions. It is also seen that
extent of progress made is commensurate with the expenditure incurred.

( ix)Cash (or Financial)Budget

This budget gives an estimate of the anticipated receipts and payments of cash during the budget
period. Therefore, this budget is divided into two parts, one showing the estimated cash receipts on
account of cash sales, credit collections and miscellaneous receipts and the other showing the
estimated disbursement on account of cash purchases, amount payable to creditors, wages payable to
workers, indirect expenses payable, income tax payable, dividend payable, budgeted capital
expenditure etc. In short, every factor which affects the receipts and payments of cash is taken into
account in the preparation of this budget. Its object is to ensure balance between liquidity and
profitability. In short, every factors which affects the receipt and payment of cash is taken into
account in the preparation of this budget. The cash budget should be co-ordinated with other
functional budget. Cash budget makes a provision for minimum cash balance which will be available
at all times. Sufficient cash must always be available to meet current needs and contingencies. The
cash budget are prepared for annually, quarterly or monthly.
Cash budget makes a provision for a minimum cash balance which will be available at all times.
In general, this balance should be equal to one month’s operating expenses plus some provision for
contingencies. The minimum balance of cash will help in tiding over adverse conditions of a minor
nature. Meanwhile management can make alternative arrangement for additional cash.
This budget is prepared by the Chief Accountant for the guidance of management so that
arrangements may be made for the requirements of the organisation.
D/2·32 BUDGETARY CONTROL

Advantages of Cash Budget

Following are the main advantages of preparing cash budget :
(i) It provides an opportunity to review the cash flow for future periods as realistically as
possible and make sure that cash is available for revenue and capital expenditure.
(ii) Where adequate amount of cash is not likely to be available during certain periods e.g. when
payment of bonus, dividend, tax etc. fall due the company can know in advance so that advance
action can be taken to make available the required amount on the most advantageous terms.
(iii) If large surplus of cash is likely to result during certain periods then it will be possible to
plan most profitable investment of these funds.
(iv) Preparation of a cash budget by a company will help to plan its cash position in such a way
that maximum seasonal discounts can be availed of.
(v) Even for obtaining funds from financial institutions, the system of preparing cash budget
helps to convince the bank or other financial institutions about the bonafides of the company’s
requirements.
(vi) Importance of cash budget may be more in some trades than in others e.g. in trades where
there are wide seasonal fluctuations or where long contracts are undertaken.
There are three methods of preparing cash forecasts : (i) Receipt and Payment Method ; (ii)
Balance Sheet Forecast Method ; (iii) Profit Forecast Method.
(i) Receipt and Payment Method. This method is useful for forecasting all cash receipts and
payments for a short period. Forecasts of cash receipts and payments are made on the basis of the
provisions made in the individual functional budgets including the capital expenditure budget and
research and development budget. In short, this method of cash forecasts is the same as we have
described in the beginning of the discussion on cash budget. Following illustration will make it more
clear.
ILLUSTRATION 12. Prepare a Cash Budget for the three months ending 30th June, 2023
from the information given below :
(a) Month Sales Materials Wages Overheads
R R R R

February 14,000 9,600 3,000 1,700

March 15,000 9,000 3,000 1,900
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% sales are on cash, 50% of the credit sales are collected next month and the
balance in the following month :
1 1
Creditors : Materials 2 months ; Wages 4 month ; Overheads 2 month.
(c) Cash and Bank balance on 1st April, 2023 is expected to be R 6,000.
(d) Other relevant informations are :
(i) Plant and Machinery will be installed in February, 2023 at a cost of R 96,000. The
monthly instalment of R 2,000 is payable from April onward.
BUDGETARY CONTROL D/2·33

(ii) Dividend @ 5% on Preference Share Capital of R 2,00,000 will be paid on 1st June.
(iii) Advance to be received for sale of vehicles R 9,000 in June.
(iv) Dividends from investments amounting to R 1,000 are expected to be received in June.
(v) Income-tax (advance) to be paid in June is R 2,000
SOLUTION
CASH BUDGET
(April/June 2023 )
Particulars April May June Total
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R

1. Balance 6,000 3,950 3,000 12,950

———————————————— ———————————————— ———————————————— —————————————
2. Receipts :
Sales/Debtors (1) 14,650 15,650 16,650 46,950
Dividend — — 1,000 1,000
Advance against Sale of Vehicle — — 9,000 9,000
———————————————— ———————————————— ———————————————— —————————————
14,650 15,650 26,650 56,950
———————————————— ———————————————— ———————————————— —————————————
3. Payments :
Creditors for Materials 9,600 9,000 9,200 27,800
(After 2 months)
Wages (2) 3,150 3,500 3,900 10,550
Overheads (3) 1,950 2,100 2,250 6,300
Capital Expenditure 2,000 2,000 2,000 6,000
Dividend on Pref. Shares :
5% of 2,00,000
R — — 10,000 10,000
Income Tax Advance — — 2,000 2,000
———————————————— ———————————————— ———————————————— —————————————

16,700 16,600 29,350 62,650

———————————————— ———————————————— ———————————————— —————————————

4. Surplus/(Deficit) (2 – 3) (2,050) (950) (2,700) (5,700)

Balance (1 – 4) 3,950 3,000 300 7,250

Working Note :

Collection from Sales/Debtors

—————————————————————————————————————————————————————————

(1) April May June

—————————————————————————————————————————————————————————
R R R

February ( 14,000 – 10% of

R R 14,000) × 50% 6,300 — —
March ( 15,000 – 10% of 15,000) × 50%
R R 6,750 6,750 —
April (10% of 16,000)
R 1,600
( 16,000 – 10% of 16,000) × 50%
R R — 7,200 7,200
May (10% of 17,000)R 1,700
( 17,000 – 10% of 17,000) × 50%
R R 7,650
June 10% of 18,000 R
——————————— ———————————
1,800
———————————

14,650 15,650 16,650

——————————— ——————————— ———————————

(2) Wages : 75% of the month + 25% of the previous month.

(3) Overheads : 50% of the month + 50% of the previous month.
D/2·34 BUDGETARY CONTROL

(ii) Balance Sheet Forecast Method. This method is used for long term forecasting of cash.
Forecast of cash is made on the basis of changes in the balance sheet. The opening balance of cash all
anticipated changes in the assets and liabilities are added or deducted according to the nature of the
time. Decreases in assets and increases in liabilities are added to the opening balance of cash and
increases in assets and decreases in liabilities are deducted from the opening balance of cash. The
resulting figure is the estimated cash in hand or cash required at the end of the period. This method
suffers from the following defects :
(a) This method does not take into consideration items of expenses and incomes on the
assumption that there is a regular pattern of inflow and outflow of cash.
(b) This method does not give an idea of surplus or deficiency of cash occurring within the
budget period because it shows cash in hand or cash required at the end of the budget period.
(iii) Profit Forecast Method. This method is also helpful for long term forecast of cash and is
based on the assumption that it is the profit which makes cash available to the opening balance of
cash, estimated net profit adjusted by adding back depreciation (not being outflow of cash), decrease
in amount due to stock, bills receivable, debtors, work-in-progress and fixed assets, capital receipts,
increase in liabilities and amount received on issue of shares and debentures are added. Increase in
amount due to current assets and fixed assets, decrease in liabilities, dividend payments and
prepayments are deducted and the resultant figure will be cash in hand or cash required at the end of
the budget period.
This methods also has the same drawbacks which balance sheet forecast method has. Of all the
three methods, receipt and payment method is the most popular because it shows surplus or
deficiency of cash occurring within the budget period.

Master Budget (or Summarised Budget or Finalised Profit Plan)

This budget is prepared when sales budget purchase budget, production budget and all other
departmental budgets have been prepared. All these departmental budgets are prepared into a
summary called a Master budget. The Master Budget is consolidated summary of the various
functional budgets. It has been defined as “a summary of the budget schedules in capsule form made
for the purpose of presenting, in one report, the highlights of the budget forecast”. The Chartered
Institute of Management Accountant, London defines it, is as follows :
“The summary budget incorporating its component functional budgets and which is finally approved,
adopted and employed”. Such a budget is not a detailed budget but contains basic data relating to each
of the budgets like sales budget, material purchase budget, production budget, production cost
budget, cash budget, etc.
The master budget is prepared by the budget committee on the basis of co-ordinated functional
budgets and becomes the target for the company during the budget period when it is finally
approved by the committee and put into operation. This budget summarises functional budgets to
produce a Budgeted Profit and Loss and a Budgeted Balance Sheet as at the end of the budget period
as is clear from the form given below :
BUDGETARY CONTROL D/2·35

Period MASTER BUDGET

Normal Capacity Budgeted Capacity
Product A Product B Product C Total
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Current Previ- Current Previ- Current Previ- Current Previ-

Year ous Year ous Year ous Year ous
Year Year Year Year
Sales R R R R R R R R

Less : Factory Cost of

Sales ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Gross Profit
Less : Operating
Expenses :
Administration
Selling and
Distribution
Research and
Development
Financial ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Operating Profit
Add : Other Income ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Net Profit before
Taxation
Less : Provision for
Taxation ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Net Profit
Less : Appropriations ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Balance of Profit ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Assets :
Fixed
Current ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Total Capital
Employed
Less : Outsiders’
Liabilities
Current
Long-term ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Shareholders’ Fund ——————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Ratios :
1. Profit/Turnover
2. Profit/Capital
Employed
3. Sales/Capital
Employed
4. Current Assets/
Current Liabilities
(Current Ratio)
5. Quick Assets/
Current Liabilities
(Liquid Ratio)
D/2·36 BUDGETARY CONTROL

Advantages of the Master Budget

Following are the main advantages of the master budget:
(1) A summary of all functional budgets in capsule form is available in one report.
(2) The accuracy of all the functional budgets is checked because the summarised information of
all functional budgets should agree with the information given in the master budget.
(3) It gives an overall estimated profit position of the organisation for the budget period.
(4) Information relating to forecast balance sheet is available in the master budget.

This budget is very useful the top management because it is usually interested in the summarised
meaningful information provided by this budget.

FIXEDBUDGETANDFLEXIBLEBUDGET

Fixed Budget
This budget is drawn for one level of activity and one set of conditions. It has been defined as a
budget which is designed to remain unchanged irrespective of the volume of output or turnover
attained. It is rigid budget and is drawn on the assumption that output and sales can be accurately
estimated or there will be no change in the budgeted level of activity. It does not take into
consideration any change in expenditure arising out of changes in the level of activity. Thus, it does
not provide for changes in expenditure arising out of change in the anticipated conditions and
activity. A fixed budget will, therefore, be useful only when the actual level of activity corresponds to
the budgeted level of activity. A master budget tailored to a single output level of (say) 20,000 units of
sales is a typical example of a fixed budget. But, in practice, the level of activity and set conditions
will change as a result of internal limitations and external factors like changes in demand and prices,
shortages of materials and power, acute competition etc. It is hardly of any use as a mechanism of
budgetary control because it does not make any distinction between fixed, variable and semi-
variable costs and provides for no adjustment in the budgeted figures as a result of change in cost due
to change in level of activity. It does not provide a meaningful basis for comparison and control. It is
also not helpful at all in the fixation of price and submission of tenders.

Flexible Budget
A flexible budget is a budget which, by recognizing the difference between fixed, semi-variable
and variable cost is designed to change in relation to activity attained. The Chartered Institute of
Management Accountants, London, defines a flexible budget (also called sliding scale budget) as a
budget which, by recognising the difference in behaviour between fixed and variable costs in relation
to fluctuations in output, turnover, or other variable factors such as number of employees, is
designed to change appropriately with such fluctuations. Thus, a flexible budget gives different
budgeted costs for different levels of activity. A flexible budget is prepared after making an
intelligent classification of all expenses between fixed, semi-variable and variable because the
usefulness of such a budget depends upon the accuracy with which the expenses can be classified.
Flexible budgets represent the amount of expense that is reasonably necessary to achieve each level of
output specified. In other words, the allowances given under flexible budgetary control system serve
BUDGETARY CONTROL D/2·37

as standards of what costs should be at each level of output. Such a budget is prescribed in the
following cases :
(i) Where the level of activity during the year varies from period to period, either due to the
seasonal nature of the industry or due to variation in demand.
(ii) Where the business is a new one and it is difficult to foresee the demand.
(iii) Where the undertaking is suffering from shortage of a factor of production such as
materials, labour, plant capacity etc. The level of activity depends upon the availability of
such a factor of production.
(iv) Where an industry is influenced by changes in fashion.
(v) Where there are general changes in sales.
(vi) Where the business units keep on introducing new products or make changes in the design
of its products frequently.
(vii) Where the industries are engaged in make to order business like ship-building.
(viii) Where in companies, it is extremely difficult to forecast output and sales with accuracy.

Distinction Between Fixed Budget and Flexible Budget

Following are the main differences between these budgets :
Point of Distinction Fixed Budget Flexible Budget
1. Flexibility It is inflexible and such budget figures It is flexible and can be suitably adjusted
are not changed when the actual level or recasted quickly according to the
of activity changes. level of activity attained.
2. Condition It assumes that conditions would remain It is designed to change according to
static. changed conditions.
3. Classification of Costs are not classified according to Costs are classified according to the
costs their variability i.e. fixed, variable and nature of their variability.
semi- variable
4. Comparison Comparison of actual and budgeted Comparisons are realistic as the
performance cannot be done correctly if changed plan figures are placed against
the volume of output differs. actual ones.
5. Forecasting It is difficult to forecast accurately the It clearly shows the impact of various
results in it. expenses on the operational aspect of
the business.
6. Level of Activity Only one budget at a fixed or one level Under it, series of budgets are prepared
of activity is prepared due to an unreal- for different levels of activity.
istic expectation on the part of the
management i.e., all conditions will
remain unaltered.
7. Ascertainment of It is not possible to ascertain costs Costs can be easily ascertained at
costs correctly if there is a change in cir- different levels of activity under this type
cumstances. of budget.
8. Tool for cost con- It has a limited application and is It has more applications and can be
trol ineffective as a tool for cost control. used as a tool for effective cost control
9. Fixation of prices If the budgeted and actual activity levels It helps in fixation of price and
& submission of vary, the correct ascertainment of costs submission of tenders due to correct
tenders. and fixation of prices becomes difficult. ascertainment of costs.
D/2·38 BUDGETARY CONTROL

Utility (or Importance)of Flexible Budget

The main importance of flexible budget is that it reflects the expenditure appropriate to various
levels of output. The expenditure established through a flexible budget is suitable for comparison of
the actual expenditure incurred with the budgeted level applicable for that particular level of activity
attained. Following points show the utility or importance of flexible budget :
1. Flexible budget provides a logical comparison of budgeted allowances with the actual cost
i.e., a comparison with like basis.
2. Flexible budget reckons operational realities and streamlines control function and profit
planning. It gives balanced perspective on comparison. When flexible budget is prepared,
actual cost at actual activity is compared with budgeted cost at actual activity i.e., two things
to a like basis.
3. Flexible budget recognises concept of variability and provides logical comparison of
expenditure with actual expenditure as a means of control.
4. With flexible budget, it is possible to establish budgeted cost for any range of activity.
5. A flexible budget is very useful for purposes of budgetary control because it corresponds
with changes in the level of activity.
6. It is helpful in assessing the performance of departmental heads because their performance
can be judged in relation to the level of activity attained by the organisation.
7. Cost ascertainment at different levels of activity is possible because a flexible budget is
prepared for various levels of activity.
8. It is helpful in price fixation and for sending quotations.
To conclude, a flexible budget is more useful, elastic and practical.
Preparation of Flexible Budgets. There are three methods of preparing a flexible budget i.e. (1)
Tabular Method or Multi-Activity Method. (2) Charting Method. (3) Formula Method or Ratio
Method.
(1) Tabular Method. According to this method, a flexible budget is prepared for different levels of
activity showing different activity or capacity levels in horizontal columns and budgeted figures
against different activity or capacity levels in the vertical columns. The expenses are usually recorded
under three groups, namely, variable, semi-variable and fixed. Budgeted figures for any level of
activity not specifically covered in the flexible budget can be obtained by interpolation. A specimen of
a flexible budget may be as follows :
FLEXIBLE BUDGET
for the period ending ……………
Capacity 60% 80% 100%
1. Prime Cost :
Direct Material … … …
Direct Labour … … …
Direct Expenses … … …
——————— ——————— ———————

… … …
——————— ——————— ———————

2. Variable Overheads : … … …
3. Marginal Cost (1 + 2) … … …
BUDGETARY CONTROL D/2·39

4. Sales … … …
5. Contribution (4—3) … … …
6. Fixed Overheads
Factory Overheads … … …
Administrative Overheads … … …
Selling & Distribution Overhead … … …
——————— ——————— ———————

——————— ——————— ———————

7. Profit/Loss (5 – 6) … … …
ILLUSTRATION 13. The expenses budgeted for production of 10,000 units in a factory are
furnished below :
Per unit Per unit
R R

Materials 70 Variable Expenses (Direct) 5

Labour 25 Selling Expenses (10% fixed) 13
Variable Factory Overheads 20 Distribution Expenses (20% fixed) 7
Fixed Factory Overheads Administrative Expenses
( 1,00,000)
R 10 (Fixed – R 50,000) 5

You are required to prepare a budget for the production of 6000 units and 8,000 units.
SOLUTION
FLEXIBLE BUDGET
Output 6,000 units Output 8,000 units
Particulars —————————————————————————————————————————————————————————————————————
Per Unit Amount Per Unit Amount
R R R R
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Variable or Production Expenses :

Material 70.00 4,20,000 70.00 5,60,000
Labour 25.00 1,50,000 25.00 2,00,000
Direct Variable Expenses 5.00 30,000 5.00 40,000
—————————————————————————————————————————————————————————————————————

Prime Cost 100.00 6,00,000 100.00 8,00,000

Factory Overheads :
Variable Overheads 20.00 1,20,000 20.00 1,60,000
Fixed Overheads 16.67 1,00,000 12.50 1,00,000
—————————————————————————————————————————————————————————————————————

Works Cost 136.67 8,20,000 132.50 10,60,000

Administrative Expenses Fixed 8.33 50,000 6.25 50,000
—————————————————————————————————————————————————————————————————————

Cost of Production 145.00 8,70,000 138.75 11,10,000

Selling Expenses :
Fixed 10% of 13 R 2.17 13,000 1.63 13,000
Variable—90% of 13 R 11.70 70,200 11.70 93,600
Distribution Expenses :
Fixed 20% of 7 R 2.33 14,000 1.75 14,000
Variable—80% of 7 R 5.60 33,600 5.60 44,800
—————————————————————————————————————————————————————————————————————

Total Cost of Sales 166.80 10,00,800 159.43 12,75,400

——————————————————————————————————————————————————————————————————————
——————————————————————————————————————————————————————————————————————
D/2·40 BUDGETARY CONTROL

ILLUSTRATION 14. The monthly budgets for manufacturing overhead of a concern for two
levels of activity were as follows :
Capacity 60% 100%
Budgeted Production (units) 600 1,000
—————————— ——————————

R R

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
———————————— ————————————

You are required to :

(i) indicate which of the items are fixed, variable and semi-variable;
(ii) prepare a budget for 80% capacity; and
(iii) find the total cost, both fixed and variable, per unit of output at 60%, 80% and 100%
capacity.
SOLUTION
(i) Fixed—Depreciation and insurance.
Variable—Wages at 2.00 per unit
R

Consumable Stores at 1.50 per unit R

Semi-Variable Costs :
1‚500 – 1‚100
R 400
R R
Maintenance = = = 1 per unit variable and 500 (i.e. 1,100 – 600) fixed.
R R R R
400 400
2‚000 – 1‚600
R 400
R R
Power and fuel = = = 1 per unit variable and 1,000 (i.e. 1,600 – 600) fixed.
R R R R
400 400
(ii) Budget for 80% Capacity (output 800 units)
R

Wages @ 2 per unit

R 1,600
Consumable stores @ 1.50 per unit
R 1,200
Maintenance : 500 + 1 per unit for 800 units
R R 1,300
Power and Fuel 1,000 + 1 per unit for 800 units
R R 1,800
Depreciation 4,000
Insurance 1,000
———————————

Total cost 10,900

———————————
———————————
(iii)
Capacity 60% 80% 100%
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
—
Units 600 800 1,000
Fixed Costs
Total Per unit Total Per unit Total Per unit
R R R R R R

Depreciation 4,000 4,000 4,000

BUDGETARY CONTROL D/2·41

Insurance 1,000 1,000 1,000

Maintenance 500 500 500
Power and Fuel 1,000 1,000 1,000
—————————— —————————— ————————————
6,500 10.83 6,500 8.125 6,500 6.50
—————————— —————————— ————————————
Variable Costs
Wages @ 2 per unit
R 1,200 1,600 2,000
Consumable @ 1.50 per unit
R 900 1,200 1,500
Maintenance @ 1 per unit
R 600 800 1,000
Power and Fuel @ 1 per unit
R 600 800 1,000
—————————— —————————— ————————————
3,300 5.50 4,400 5.50 5,500 5.50
—————————— ——————————— —————————— ——————————— —————————— ———————————
Total Cost 9,800 16.33 10,900 13.625 12,000 12.00
——————————
—————————— ———————————
——————————— ——————————
—————————— ———————————
——————————— ——————————
—————————— ———————————
———————————

(2) Charting Method. Under this method, an estimate of expenses is made for different levels of
activity by classifying the expenses into three categories, namely, variable, semi-variable, and fixed.
The estimated expenses are plotted on a graph paper on Y-axis and level of activity is plotted on X-
axis. The budgeted expenses corresponding to the level of activity attained can then be read out from
the chart and the performance of departmental heads can be assessed.
(3) Formula Method or Ratio Method. Under this method, a budget is prepared for the expected
normal level of activity and variable cost per unit of activity is ascertained. Expense budget allowed
for a particular level of activity attained will be as follows :
Fixed cost + (Actual units of activity × variable cost per unit of activity)
For example, the overhead expenses budget for a normal level of 80% activity is
R 90,000. Assuming that the expenses budget consists of fixed cost R 50,000 and variable

expenses R 40,000, then variable cost per 1% activity is R

(
500 i.e.,
R 40‚000
80 )
. Suppose actual level of

activity is 75%, the expense budget allowed will be :

R 50,000 (fixed) + 75 × R 500 (variable) = R 87,500.

Basic Budgets. A basic budget has been defined as a budget which is prepared for use unaltered over a
long period of time. This does not take into consideration current conditions and can be attainable
under standard conditions.
Current Budgets. A current budget can be defined as a budget which is related to the current
conditions and is prepared for use over a short period of time. This budget is more useful than a basic
budget, as a target it lays down will be corrected to current conditions.
(1) Short-term Budgets. This budget is defined as a budget which is prepared for period less than a
year and is very useful to lower levels of management for control purposes. Such budgets are prepared for
those activities, the trend in which is difficult to foresee over longer periods. Functional budgets are
normally prepared for a period of one year. Cash budget and material budget are examples of short-
term budgets.
(2) Medium-term Budgets. Budget prepared for a period of 1-3 years is Medium-term Budget.
Budget like manpower planning are prepared for Medium-term.
(3) Long-Term Budgets. A long-term budget can be defined as a budget which is prepared for periods
longer than three years. These budgets help in business forecasting and forward planning. Capital
Expenditure Budget and Research and Development Budget are examples of long-term budgets. In
D/2·42 BUDGETARY CONTROL

the modern days due to uncertainty very few budgets are prepared for long-term. Master Budget is
normally prepared for long-term.

Performance Budgeting
The Concept of performance budgeting :
Performance Budgeting is similar to responsibility Accounting which means that the
responsibilities of various levels of management is pre-determining in terms of output or result
keeping in view that authority vested with them. The prime concepts of such a system are given
below :
(i) It is based on a classification of managerial level for the purpose of establishing a budget for
each level. The official in charge of that level should be made responsible and accountable for
its performance for a given period of time.
(ii) The starting point of the performance budgeting system rests with the organisation chart in
which the areas of jurisdiction have been determined. Authority leads to the responsibility
for certain cost and expenses which are reflected in the budget with the knowledge of the
manager concerned.
(iii) The cost of each individuals or department’s budget should be limited to the cost
controllable by them.
(iv) The person concerned should have the authority to bear the responsibility.
Performance Budgeting had its origin in U.S.A. after the Second World War. It tries to rectify
some of the shortcomings in the traditional budget. In the traditional budget amounts are earmarked
for the objects of expenditures such as salaries, travel, office expenses, grant in aid etc. In such system
of budgeting the money concept was given more prominence i.e. estimating or projecting rupee value
for the various accounting heads or classification of revenue and cost. Such system of budgeting was
more popularly used in government departments and many business enterprises. But such system of
budgeting control of performance in terms of physical units or the related costs cannot be achieved.
Performance oriented budgets are established in such a manner that each item of expenditure
related to a specific responsibility centre is closely linked with the performance of that centre. The
basic issue involved in the fixation of performance budgets is that of developing work programmes
and performance expectation by assigned responsibility, necessary for the attainments of goals and
objectives of the enterprise, it involves establishment of well defined centres of responsibilities,
establishment for each responsibility centre—a programme of target performance in physical units,
forecasting the amount of expenditure required to meet the physical plan laid down and evaluation
of performance.
These days budgets are established in such a way so that item of expenditure is related to specific
responsibility centre and is closely linked with the performance of that standard. Developing work
programmes and performance expectations by assigned responsibility is the main issue involved in
fixation of performance budgets and is necessary for the achievement and objects of the enterprise.
Thus in performance budgeting classification of expenditure follows a three tier pattern viz.
Function— Programme—Activity. Programme or production goals in physical and financial terms
are established in accordance with this new classification and after the period, the actual performance
is compared. Following matters will be specified very clearly in such bud geting.
(i) Objectives of the organisation and for which funds are requested.
BUDGETARY CONTROL D/2·43

(ii) Cost of activities proposed for the achievement of these objectives.

(iii) Quantitative measures to measure the performance.
(iv) Quantum of work to be performed under each activity.
Thus performance budget follows a separate format laying down (i) objectives and the
organisation structure to achieve the same and (ii) Financial requirement table which gives details of
programme activity classification, object wise classification and sources of funding.

Steps for System of Performance Budgeting

Following steps are necessary in the establishment of a successful system of performance
budgeting :
(i) Establishment of well defined responsibility centres or action points where operations are
performed and financial transactions in terms of money take place.
(ii) Establishment of each responsibility centre and a programme of expected performance in
physical units of that centre. For example, the performance budget for a sales department may be
units of goods sold and, for production department, units of products programmed to be
manufactured and for capital works, quantum of work likely to be done during the budget period.
(iii) To forecast the amount of expenditure under the various classification heads to meet the
physical plan. Then the procedure of budgeting could follow the usual routine.
(iv) Evaluation performance is done under two stages i.e.
(a) the actual performance is compared with the physical target in order to determine the
extent of deviation and adjusting the original rupee budget into a budget allowance for
the actual physical work performed.
(b) the actual expenditure is compared with the adjusted budget (or the budget allowance) to
determine the monetary variances.
(v) Performance reporting indicating the result of analysis of the variance from the budget is
done like that of variance reporting.

Difference Between Performance Budgeting and Traditional Budgeting

Performance Budgeting Traditional Budgeting
1. In it, the flow of decision is upward. 1. In it, the flow of decision is downward.
2. It follows the function — programme — activity 2. In it, the classification of expenses is by
classification. objects.
3. It makes a prospective approach with its focus on 3. The approach is retrospective in such
future markets. budgeting.

Advantages of Performance Budgeting

Following are the main advantages of performance budgeting :
(i) It presents clearly the purposes and objectives for which funds are required.
(ii) It gives better appreciation of budgeting by legislature.
(iii) It improves budget formulation process.
(iv) It enhances accountability of the executives.
D/2·44 BUDGETARY CONTROL

The Administrative Reforms Commission of India recommended in 1967 the introduction of

performance budgeting in major spending departments in India. Although same initial efforts were
made in this direction by the centre and some of the states, but it did not get wide acceptance.
ILLUSTRATION 15. Z Ltd. had a profit plan approved for selling 5,000 units per month at an
average selling price of R 10 per unit. The budgeted variable cost of production was R 4 per unit
and the fixed costs were budgeted at R 20,000, the planned income being R 10,000 per month. Due
to shortage of raw materials, only 4,000 units could be produced and the cost of production
increased by 50 paise per unit. The selling price was raised by R 1.00 per unit. In order to improve
the production process, an expenditure of R 1,000 was incurred for research and development
activities.
You are required to prepare a Performance Budget and a Summary Report.
SOLUTION PERFORMANCE BUDGET
Original Adjusted Actual
Plan Plan Position
—————————————————————————————————————————————————————————————————————————————————
R R R

Sales 50,000 40,000 44,000

(5,000 × 10)R (4,000 × 10)R (4,000 × 11)R

Less : Variable Costs 20,000 16,000 18,000

(5,000 × 4) R (4,000 × 4) R (4,000 × 4.50)
R
—————————————————————————————————————————————————————————————————————————————————
Contribution 30,000 24,000 26,000
Less : Fixed Costs 20,000 20,000 21,000
—————————————————————————————————————————————————————————————————————————————————
Profit 10,000 4,000 5,000

SUMMARY REPORT
R

Budgeted Profit 10,000

Variances :
Selling Price Variance : 4,000 ( 11– 10)
R R 4,000 Favourable
Variable Cost Variance : 4,000 ( 4 – 4.50)
R R 2,000 Adverse
Fixed Cost Variance : 20,000 – 21,000
R R 1,000 Adverse
Profit Volume Variance : Loss of Contribution on 1,000 units
(i.e. less quantity of sales than the budgeted quantity) @ 6
R

(i.e. 10 selling price – 4 variable cost) per unit

R R 6,000 Adverse
——————————————————————————————————————————

Actual Profit 5,000

Zero Base Budgeting (ZBB)

This budget is the preparation of budget starting from Zero or from a clean state. As a new
technique it was proposed by Peter Pyher of Texas Instruments Inc., U.S.A. This technique was
introduced in the budgeting in the state of Gorgia by Mr. Jimmy Carter who was then the Governor of
that state. When Mr. Carter later on became President of the U.S.A., ZBB was tried in federal
budgeting as a means of controlling state expenditure. The use of zero-base budgeting (ZBB) as a
managerial tool has become increasingly popular since the early 1970s. It is steadily gaining
acceptance in the business world because it is proving its utility as a tool integrating the managerial
function of planning and control.
BUDGETARY CONTROL D/2·45

ZBB is a method of budgeting in which all expenses must be justified for each new period.
ZBB starts from a ‘zero base’ and every function within organisation is analysed for its needs and
costs. Budgets are then built around what is needed for the upcoming period regardless of whether
the budget is higher or lower than the previous one. ZBB allows top-level strategic goals to be
implemented into budgeting process by tying them to specific functional areas of the organisation,
where costs can be first grouped, then measured against previous results and current expectations.
Conventional Budgets are prepared mainly on past performance and actual costs. Thus a
conventional budget represents a quantification of the firm’s objectives and the efficiency of
budgeting as a planning and control device depends upon the activity in which it is being used.
Budgets are best used as a managerial control in activities which are directly related to the final
output of the organisation because the inputs used by these activities can be compared with the
output of these activities. Thus, a more accurate budget can be framed once the relationship between
inputs and outputs is established. But there are some activities which are not directly related to the
firm’s output such as the legal staff and the personnel office. A more accurate budget cannot be
developed for such activities because the tasks assigned and resources allocated to such activities are
not directly related to the firm’s output and it is difficult to develop and use standard cost for such
activities. Zero-base budgeting is most appropriate in controlling these staff and support areas, (i.e.
non-manufacturing overhead).
A conventional budget is developed mainly on the concept of incrementalism. Under this
approach cost levels of the previous year are often taken as a base to start within, and budget units
focus their attention on ascertaining what changes from the previous year are required. Thus, a
budget is developed on the basis of incremental changes from the previous year’s figures taken as
base.
An incremental approach to budgeting carries forward previous year’s inefficiencies and
extravagances because previous year’s figures are taken as a base for the development of a budget.
Thus incremental approach does not promote operational efficiency because it does not require
managers to review their past activities.
On the other hand, zero-base budgeting is not based on the incremental approach and previous
year’s figures are not adopted as a base. Rather, zero is taken as a base as the name goes. Taking zero
as a base, a budget is developed on the basis of likely activities for the future period. In ZBB, by
delinking the budget from the past, the past mistakes are not repeated. Funds required for any
activity for the next budget period should be obtained by presenting a convincing case. Funds will
not be available as a matter of course. Zero-base budgeting has been defined by its originator Peter A
Pyher as follows :
“A planning and budgeting process which requires each manager to justify his entire budget
request in detail from scratch (hence zero base) and shifts the burden of proof to each manager to
justify why he should spend any money at all. The approach requires that all activities be analysed in
‘decision packages’ which are evaluated by systematic analysis and ranked in order of importance.”
CIMA has defined it “as a method of budgeting whereby all activities are revaluated each time
a budget is set. Discrete levels of each activity are valued and a combination chosen to match
funds available”. In short an elaborate practice of having a manager justify activities from the
ground up as though they were being launched for the first time.
A unique feature of zero-base budgeting is that it tries to help management answer the question.
“Supposing we are to start our business from scratch, on what activities would be spend our money
D/2·46 BUDGETARY CONTROL

and to what activities would we give the highest priority? Thus, zero-base budgeting tries to
overcome the weaknesses of conventional budgeting, especially in those areas where it is difficult to
apply flexible budgeting. It can be successfully applied to government expenditure and, within the
business would, cover items of expenditure other than direct material, labour and overheads such as
research and development, data processing, quality control, marketing and transportation, legal staff
and personnel office. Zero base budgeting (ZBB) is defined as method of budgeting which requires
each cost element to be specifically justified, as though the activities to which the budget relates
were being undertaken for the first time. ZBB is prepared and justified from scratch (zero).
Without approval, the budget allowance is zero.

Characteristics of ZBB
(i) Manager of a decision unit has to completely justify why there should be any budget allotment
for his decision unit.
(ii) Activities are identified in decision packages.
(iii) Decision packages are ranked in order of priority.
(iv) Package are evaluated by systematic analysis.
(v) Decision packages are linked with corporate objectives, which are clearly laid down.
(vi) Available resource are directed towards alternatives in order to prioritize to ensure optimal
results.

Steps in ZBB
The important steps involved in the process of ZBB are :
(1) Determination of a set of objects is the pre-requisite and essential step in the direction of ZBB
technique.
(2) Deciding about the extent to which the technique of ZBB is to be applied whether in all areas of
organization activities or only in few selected areas on trial basis.
(3) Identify the areas where decisions are required to be taken.
(4) Developing decision packages and ranking them in order of performance.
(5) Preparation of budget that is translating decision packages into practicable units/items and
allocating financial resources.
ZBB is simply an extension of the cost-benefit analysis method to the area of corporate planning and
budgeting.

Advantages of Zero Base Budgeting

Following are the advantages of ZBB :
(1) Zero-base budgeting is not based on incremental approach, so it promotes operational efficiency
because it requires managers to review and justify their activities or the funds requested. Past
inefficiencies are not repeated and it enables the management to identify and eliminate
wasteful expenditure.
(2) Zero-base budgeting is most appropriate for the staff and support areas (i.e., non-manufacturing
overheads) of an organisation because the inputs of these areas are not directly related to the
final outputs of the organisation.
BUDGETARY CONTROL D/2·47

(3) Zero-base budgeting considers every time alternative ways of performing the same job because
zero is taken as a base every time at the preparation of a budget. Thus management has an
opportunity to get a critical appraisal of its activities after a proper cost-benefit analysis.
(4) It focuses management process on analysis and decision-making because it requires managers to
review their activities every time when a budget is developed.
(5) It is helpful to the management in making optimum allocation of scarce resources because a
unique aspect of zero-base budgeting is the evaluation of both current and proposed
expenditure and placing it in some order of priority. Funds are used on priority basis and
hence there is better allocation of resources.
(6) Coordination within the firm is improved and communication channels are strengthened
because it provides a close relationship between departmental budgets and corporate budget.
(7) Increased participation in ZBB creates a motivational impact.
(8) ZBB is particularly useful for service departments and Governments.
(9) It makes managers cost conscious and helps them in identifying priorities in the overall interest
of the organisation.
(10) It is helpful in the introduction of the system of management by objective because it assigns
that the functions undertaken are critical for the achievement of the objectives.
Thus, it provides a systematic approach to the evaluation of different activities for ranking them
for resource allocation, ensures that the activities undertaken for achievement of the company’s
objectives are performed in the best possible way, enables allocation of resources after a thorough
cost-benefit analysis, enables the management to identify and eliminate wasteful expenditure, helps
in the introduction of the system of ‘Management by Objectives’ and ensures that the departmental
budgets are linked to corporate objectives.
To conclude, ZBB is not a panacea, but it can certainly increase the usefulness of the budgeting
process because it tries to overcome the weaknesses of conventional budgeting.

Defects of ZBB
Following are defects of ZBB :
(i) The paper work will increase periodically due to large number of decision packages.
(ii) The cost of preparing the various packages may be very high in large firms involving vast number
of decision packages. Thus, ZBB is a time consuming and costly exercise.
(iii) Ranking of packages is very often subjective and may give risk to conflicts.
(iv) Bad managers may resist new ideas and changes as they feel threatened by ZBB.
(v) Some activities may have qualitative rather than quantitative benefits as it is very difficult to
quantify such activities as research and development and general administration.
(vi) It may lay more emphasis on short term benefits to the determinent of long term objectives of
the organisation.
(vii) Costs and benefits on each package must be continually up-to-dated to be relevant and new
packages are to be developed as soon as new activities emerge.
(viii) The success depends on top management support.
D/2·48 BUDGETARY CONTROL

Inspite of these defects, ZBB was adopted by several Governments all over the world to improve
their budgeting skills. It finds application in control of service department costs. But for control of
direct costs as direct materials and direct labour expenses etc. standard costing may be more useful.

Planning Programme Budgeting System (PPBS) or Programme Budgeting

This system budgeting was introduced in the department of Defence in USA in the year 1961. It is
a system to analyse expenditure with reference to a particular objective but not by functions such as
production sales, purchases, etc. This system is specially devised to effectively utilise public funds by
improved allocation of funds. PPB is widely used in the public sector and non profit organizations to
avoid excessive costs and to ensure that expenditure is focussed on programmes and activities that
generate the most beneficial results. The aim of PPBS is to enable the management of a non-profit
organization to make more informed decisions about allocation of resources to meet the overall
objectives of the organization. Generally following steps are involved in formulation and
implementation of PPBS :
(i) Specify the objectives of the various programmes.
(ii) Identification of suitable programmes to achieve the objectives.
(iii) Budget allocation of different programmes.
(iv) Systematically implement the selected alternatives and control.
PPBS allows the management to make better decision regarding strategic allocation of resources.

Difference Between Programme Budgeting and Performance Budgeting

Programme Budgeting Performance Budgeting
1. Level of It is more relevant to the problems of It is more relevant to the problems of lower
Management top level management. and middle level management.
2. Nature of work It is concerned with the purpose of It is concerned with the process of work.
work
3. Concerned with it is basically concerned with planning It is concerned with measurement of
performance.

Single Budget System

A single budget system is normally used to serve various purposes but there is a danger as it may
be conflicting in planning and motivation and performance evaluation roles as below :
(i) Planning and motivation roles. Demanding budgets that may not be achieved may be
appropriate to motivate maximum performance but they are unsuitable for planning
purpose. For these, a budget should be set based on easier targets that are expected to be
met.
(ii) Planning and performance evaluation roles. For planning purpose budgets are set in
advance of the budget period based on an anticipated set of circumstances or environment.
Performance evaluation should be based on a comparison of actual performance with an
adjusted budget to reflect the circumstances under which managers actually operated.

Budgetary Control and Reporting

Preparation of the budget is the first step in the budgetary control system. Implementation of
budgets is the second phase which needs continuous reporting of budget performance at short
BUDGETARY CONTROL D/2·49

intervals. Preparation of budgets alone will not achieve much unless a comparison is made regularly
between the actual performance and the budgeted performance. Thus, proper reporting is an
essential element in budgetary control. The daily/weekly/monthly reports depending on the nature
of operations involved in the results of various functions are regularly submitted to the management
and follow up action has to be taken immediately. In this respect, budget reports showing the
following information will prove useful :
(a) Budgeted level of activity and budgeted cost of the same. (b) Budgeted cost of actual level of
activity. (c) Actual cost of actual activity. (d) Variance between budgeted figures and actual figures.
(e) Reasons of variance.
The importance of reporting lies in the fact that it brings into light the areas which need
management attention. It will help in taking timely action for taking corrective measures. Thus,
reporting will disclose the persons who are responsible for the variance. It is also possible that
variance may not be due to employee but may be due to external factors (i.e., change in wage rates,
prices of materials, slack market etc.) which are uncontrollable for which no operator or executive can
be held responsible. Budget reports to top management should explain the difference between the
profit in the profit plan and actual profit stating the factors involved in quantitative and financial
terms, show the flow of funds and projections in this regard and provide feedback about the
achievement of goals and objectives of the firm.
Various budget reports such as sales budget report, production budget report, purchases budget
report, labour budget report, expenses budget report, cash budget report, capital expenditure budget
report, research and development budget report etc., can be prepared to highlight the activities of
various functional budgets.

Control (or Budgeted) Ratios

Following control ratios are used by the management to know whether the deviations of the
actual performance from the budgeted performance are favourable or unfavourable. If the ratio is
100% or more, the performance is considered as favourable and if the ratio is less than 100%, the
performance is considered as unsatisfactory.
Actual Hours Worked
(i) Capacity Ratio = × 100
Budgeted Hours
This ratio indicates the extent to which budgeted hours of activity is actually utilised. If the ratio
is 85%, budgeted capacity is utilised upto 85% and 15% capacity remains unutilised.
Standard Hours for Actual Production
(ii) Activity Ratio = × 100
Budgeted Hours
This ratio measures the level of activity attained during the budget period.
Standard Hours for Actual Production
(iii) Efficiency Ratio = × 100 or
Actual Hours Worked
Activity Ratio
= × 100
Capacity Ratio
This ratio is an indicator of the efficiency attained in production over a period. Efficiency has
gone up by 25% if this ratio is 125%.
Number of Actual Working Days in a Period
(iv) Calendar Ratio = × 100
Number of Working Days in the Budget Period
D/2·50 BUDGETARY CONTROL

This ratio indicates whether all the budgeted working days in a budget period have been
available in actual practice. If the ratio is more than 100%, more days have been available in actual
practice and vice versa if the ratio is less than 100%.
Standard Capacity Usage Ratio = (Budgeted hours ÷ Max. possible hours in the budgeted
period) × 100
Actual Capacity Usage Ratio = (Actual hours worked + Maximum possible working hours in a
period) × 100
Actual Usage of Budgeted Capacity Ratio = (Actual working hours + Budgeted hours) × 100
ILLUSTRATION 16. Two articles X and Y are manufactured in a department. Their
specifications show that 2 X’s or 8 Y’s can be produced in one hour. The budgeted production for
June, 2023 is 200 X’s and 400 Y’s. The actual production at the end of the month was 250 X’s and 480
Y’s and the actual hours spent on this production was 160. Find out the capacity, activity and
efficiency ratios for June 2023.
Also find out the calendar ratio if the actual working days during the month be 27
corresponding to 25 days in the budget.
SOLUTION
Standard Budgeted Hours for June 2023 :
X — 200 ÷ 2 = 100 Hours
Y — 400 ÷ 8 = 50 Hours
————————
= 150 Hours
————————

Standard Hours for Actual Production :

X — 250 ÷ 2 = 125 Hours
Y — 480 ÷ 8 = 60 Hours
—————————
= 185 Hours
—————————
—————————

Actual Hours Worked 160

Capacity Ratio = × 100 = × 100 = 106.67%
Budgeted Hours 150
Standard Hours for Actual Production 185
Activity Ratio = × 100 = × 100 = 123.33%
Budgeted Standard Hours 150
Standard Hours for Actual Production 185
Efficiency Ratio = × 100 = × 100 = 115.62%
Hours Worked 160
Number of Actual Working Days in a Period 27
Calendar Ratio = × 100 = × 100 = 108%.
Number of Working Days in the Budget Period 25

Advantages of Budgetary Control

Budgetary control has become an essential tool of management for controlling costs and
maximising profits. It may be taken as one of the supreme examples of rationality in management. It
is very useful management tool for comparing the current performance with pre-planned
performance with a view to attain equilibrium between ends and means, output and efforts. It
corrects the deviation from preplanned path through the media of research, planning, control and
decision making and thus helps in performance of future activities in an orderly way./ It uncovers
uneconomies in operation, weakness in the organisation structure and minimize wasteful spending. It
brings efficiency and economy in the working of the business enterprises. It helps in establishing
divisional and departmental responsibility. It helps in co-ordinating the various divisions of a
BUDGETARY CONTROL D/2·51

business, namely the production, marketing, financial and administrative divisions. It helps
management in obtaining the most profitable combination of different factors of production. It acts as
a safety signal for management. It guards against undue optimism leading to over-expansion because
the targets are fixed after cool and careful thought. Thus a budget is an aid to management not a
substitute for management.
Important advantages of a budgetary control can be summed up as follows :
1. The most important advantage of a budgetary control is to enable management to conduct
business in the most efficient manner because budgets are prepared to get the effective utilisation
of resources and the realisation of objectives as efficiently as possible.
2. It lays down an objective for the business as a whole. Even though a monetary reward is not
offered the budget becomes a game—a goal to achieve or a target to shoot at—and hence it is
more likely to be achieved or hit than if there was no predetermined goal or target. The
budget is an impersonal policeman that maintains ordered effort and brings about efficiency
in result.
3. Everyone working in the concern knows what exactly to do because budgetary control lay
emphasis on the staff organisation. It ensures that individual responsibilities are clearly defined
and that the required authority commensurate with the responsibility is delegated so that
buck passing may be prevented when the budgeted results are not achieved.
4. Budgetary control takes the help of different levels of management in the preparation of the
budget. Budget finally approved represents the judgement of the entire organisation and not
merely that of an individual or a group of individuals. Thus, it ensures team work.
5. Management by exception is possible because the comparison of actual and budgeted results
points out weak spots so that remedial action is taken against weak spots which are not in
conformity with the budgeted performance.
6. It ensures effective utilisation of men, materials, machines and money because production is
planned according to the availability of these items.
7. It is helpful in reviewing current trends in the business and in determining further policy of the
business because current and future trends are studied in the preparation of the budget.
8. Budget acts as a measure of efficiency of departments and persons working in the organisation
because budgets provide a yardstick against which actual performance of departments and
employees can be compared.
9. Budgetary control creates conditions for setting up a system of standard costing.
10. It helps in promoting a feeling of cost consciousness and in restricting expenditure to the minimum.
Thus, wasteful expenditure is avoided and expenditure beyond budgeted figure is not
incurred without prior approval of the higher authority.
11. It enhances the standing and credit of the undertaking with the government and the banks because
an efficient technique of cost control is used.
12. Functions of planning, co-ordination and control can be better performed with the help of the
budgetary control.
D/2·52 BUDGETARY CONTROL

Limitations of Budgetary Control

Budgetary control as a management control device suffers from the following limitations :
1. It may be impossible to achieve the budgeted targets as estimates and forecasts relating to the
future made in the budget can never be perfectly accurate for the simple reason that future is
unpredictable.
2. In rapidly changing conditions it may not be possible to achieve the budgeted targets. Budgets may
have to be revised from time to time, but frequent revisions may prove to be a costly affair.
3. Budgets may serve as constraints on managerial initiative because every executive tries to
achieve the budgeted targets. It tends to bring about rigidity in control.
4. Correlation and coordination of various budgets is expensive ; so small organisations cannot afford
the employment of budgetary control as a cost control technique.
5. Budgetary control may lead to conflicts among functional executives because every executive may
try to get a larger share of budgetary allocation, shirk responsibility and blame others for
pitfalls. The success of budgetary control depends upon the team work which may be lacking
in the organisation.
6. Budget is only a tool of the management and is not a substitute of management.
7. Badly handled budgetary control system with undue pressure and lack of regard to behavioural
aspects may cause antagonism and may lower morale of the employees.
8. Budgets may be developed keeping in view existing organisation structure which may be
inappropriate for current conditions.

MISCELLANEOUS ILLUSTRATIONS
ILLUSTRATION 17. A company manufactures two products, A and B and the budgeted data
for the year are as follows : Product A Product B
R R

Sales price per unit 100 75

Direct material per unit 20 10
Direct wages per unit 5 4
Total works overhead 10,105 9,009
Total marketing overhead 1,200 1,100
The sales manager forecasts the sales in units as follows :
Product A Product B
Units Units
January 28 10
February 28 12
March 24 16
April 20 20
May 16 24
June 16 24
July to January (next year) per month 18 20
BUDGETARY CONTROL D/2·53

It is assumed that (i) there will be no work-in-progress at the end of any month, and
(ii) finished units equal to half the sales for the following month will be kept in stock.
Prepare (a) a production budget for each month, and (b) a summarised profit and loss
statement for the year.
SOLUTION
Closing stock of finished goods is equal to half the sales for the next month ; so opening stock is half of the
budgeted sales for the same month.
( a) PRODUCTION BUDGET
(in number of units)
Product A Product B
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
Months Add Less Produc- Add Less Produc-
Sales Closing Opening tion Sales Closing Opening tion
Stock Stock Stock Stock
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

January 28 14 14 28 10 6 5 11
February 28 12 14 26 12 8 6 14
March 24 10 12 22 16 10 8 18
April 20 8 10 18 20 12 10 22
May 16 8 8 16 24 12 12 24
June 16 9 8 17 24 10 12 22
July 18 9 9 18 20 10 10 20
August 18 9 9 18 20 10 10 20
September 18 9 9 18 20 10 10 20
October 18 9 9 18 20 10 10 20
November 18 9 9 18 20 10 10 20
December 18 9 9 18 20 10 10 20
——————————— ——————————— ——————————— ———————————

240 235 226 231

(b) SUMMARISED PRODUCT COST BUDGET

Product A Product B Total
Output 235 units 231 units
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
—
R R R

Direct Material 4,700 2,310 7,010

(@ R 20) (@ R 10)
Direct Labour 1,175 924 2,099
(@ R 5) (@ R 4)
Works Overhead 10,105 9,009 19,114
—————————————————————— ———————————————————— —————————————

Total Production Cost 15,980 12,243 28,223

——————————————————————
—————————————————————— ————————————————————
———————————————————— —————————————
—————————————

68 53
Cost per Unit (15,980 ÷ 235) (12,243 ÷ 231)
D/2·54 BUDGETARY CONTROL

SUMMARISED PROFIT AND LOSS STATEMENT

for the year...............
Product Product Total
A B
————————————————————————————————————————————
R R R

Sales : R

Product A : 240 units @ R 100 = 24,000 24,000

Product B : 226 units @ R 75 = 16,950
—————————————
16,950
40,950
—————————————
40,950
Closing Stock :
Product A : 9 units @ 68
R 612 612
Product B : 10 units @ 53
R 530 530
—————————————

Total Closing Stock 1,142 1,142

————————————— ———————————————————————————————————————————

24,612 17,480 42,092

———————————————————————————————————————————
———————————————————————————————————————————

Opening Stock : R

Product A : 14 units @ 68
R 952 952
Product B : 5 units @ 53
R 265 265
—————————————
1,217 1,217
—————————————

Production Cost :
As shown in (b) Production Cost Budget 15,980 12,243 28,223
Marketing Overhead 1,200 1,100 2,300
———————————————————————————————————————————

Cost of Sales 18,132 13,608 31,740

Profit 6,480 3,872 10,352
———————————————————————————————————————————

24,612 17,480 42,092

———————————————————————————————————————————
———————————————————————————————————————————

ILLUSTRATION 18. The following are the details of the budgeted and the actual cost of X
Production Ltd. for six months from January to June, 2022. From the figures given below, you are
required to prepare the Production Cost Budget from January to June, 2023.
JANUARY—JUNE 2022
Budget Actual
——————————————————————————————————————————————————————

Material Cost R40,00,000 R 39,90,000

(2,000 MT @ (@ R 2,100)
R 2,000)

Labour Cost R 8,00,000 799,920

R

( 20 per hour)
R ( 22 per hour)
R

Variable Overheads R 2,40,000 R 2,16,000

Fixed Overheads R 4,00,000 R 4,20,000

The budgeted production for first half of 2022 was 20,000 units, whereas the company
produced only 18,000 units during the period.
In the first half of 2023, production is budgeted for 25,000 units. Material cost per tonne will
increase from last year’s actual by R 100 but it is proposed to maintain the consumption efficiency
BUDGETARY CONTROL D/2·55

of 2022 as budgeted labour efficiency will be lower by another 1% and labour rates will be R 22 per
hour. Variable and Fixed overheads will go up by 20% over 2022 actual.
SOLUTION PRODUCTION COST BUDGET
for the six months ending 30th June, 2023
25,000 Units
————————————————————————————————————

Total Cost Per Unit Cost

————————————————————————————————————

R R

Material Cost 55,00,000 220.00

Labor Cost (2) 11,22,000 44.88
Variable Overheads (3) 3,60,000 14.40
Fixed Overheads (4) 5,04,000 20.16
————————————————————————————————————

74,86,000 299.44
————————————————————————————————————
————————————————————————————————————

Working Notes :
(1) Material Cost
2‚000 MT
Consumption per unit = = 0.10 MT
20‚000
Consumption for 25,000 units = 2,500 mt.
Cost of 2,500 mts @ R 2,200 per mt = R 55,00,000
(2) Labour Cost (3) Variable Overheads
2022 R2‚40‚000
Rate per unit in 2022 =
8‚00‚000
R 20‚000
Total budgeted Labour hrs. = = 40‚000 hrs.
20 R = 12R

40‚000 R
Labour hours budgeted for each unit = =2
20‚000 Cost for 25,000
7‚99‚920
R
@ 2022 rates 3,00,000
Actual time paid for = 36,360
22 R
Add : 20% 60,000
Less : Standard Labour hours for ————————————

18,000 units = 36,000 3,60,000

————————————
————————————
——————————
Extra time taken ( i.e. 1% extra) 360 (4) Fixed Overheads R

2023 Actual in 2022 4,20,000

Time required for 25,000 units = 50,000 Add : 20% 84,000
————————————
Add : 2% for labour efficiency 1,000
———————————— 5,04,000
51,000 ————————————
————————————
————————————
————————————
51,000 hrs at R 22 per hour = 11,22,000
————————————
————————————

ILLUSTRATION 19. Lookahead Ltd. produces and sells a single product. Sales budget for
the calendar year 2024 by quarters is as under :
Quarter No. of units to be sold Quarter No. of units to be sold
I 12,000 III 16,500
II 15,000 IV 18,000
The year 2024 is expected to open with an inventory of 4,000 units of finished product and
close with an inventory of 6,500 units.
D/2·56 BUDGETARY CONTROL

Production is customarily scheduled to provide for two-thirds 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 follows :
Direct materials 10 lbs. @ 50 paise per lb.
Direct labour 1 hour 30 minutes @ R 4 per hour.
Variable overheads 1 hour 30 minutes @ R 1 per hour.
Fixed overheads 1 hour 30 minutes @ R 2 per hour based on a budgeted production volume of
90,000 direct labour hours for the year.
(i) Prepare a Production Budget for 2024, by quarters, showing the number of units to be
produced, and the total costs of direct material, direct labour, variable overheads and fixed
overheads.
(ii) If the budgeted selling price per unit is R 17, what would be the budgeted profit for the
year as a whole ?
SOLUTION
Some Basic Calculations
(1) Variable Cost per unit R

Direct Material : 10 lbs. @ 50 paise per lb. 5.00

1
Direct Labour : 1 2 hours @ R 4 per hour 6.00
1
Variable overheads : 1 hours @2 R 1 per hour 1.50
—————————————

12.50
—————————————

(2) Fixed Overheads per annum : 90,000 hrs. @ R 2 1,80,000

—————————————

∴ Fixed overheads per quarter to be divided equally

over four quarters according to time ( R 1‚80‚000

4 ) 45,000
—————————————

(3) Number of units to be sold during the year 2024

Quarter I 12,000 units
Quarter II 15,000 units
Quarter III 16,500 units
Quarter IV 18,000 units
———————————————————

Sales during the year 61,500 units

(i) (A) PRODUCTION BUDGET

for the year 2024 by quarters
Units to be produced Quarter I Quarter II Quarter III Quarter IV Total
in each quarter
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Units Units Units Units Units

2/3rd of the current quarter’s
sales demand 8,000 10,000 11,000 12,000 41,000

( 2
3 × 12‚000 ) ( 2
3 × 15‚000 ) ( 2
3 × 16‚500 ) ( 2
3 × 18‚000 )
BUDGETARY CONTROL D/2·57

Add: 1/3rd of the following

quarter’s sales demand in
first 3 quarters and closing
inventory in the 4th quarter 5,000 5,500 6,000 6,500 23,000

( 1
3 × 15‚000 ) ( 1
3 × 16‚500 ) ( 1
3 × 18‚000 )
————————————————————————————————————————————————————————————————————————————————————————————————————————

13,000 15,500 17,000 18,500 64,000

————————————————————————————————————————————————————————————————————————————————————————————————————————
————————————————————————————————————————————————————————————————————————————————————————————————————————

(B) STATEMENT SHOWING TOTAL COST OF DIRECT MATERIAL,

DIRECT LABOUR, VARIABLE OVERHEADS AND FIXED OVERHEADS
Quarter I Quarter II Quarter III Quarter IV Total
———————————————————————————————————————————————————————————————————————————————————————————
Units to be produced as per (a) 13,000 15,500 17,000 18,500 64,000
———————————————————————————————————————————————————————————————————————————————————————————
R R R R R

Direct Material @ 5 per unit

R 65,000 77,500 85,000 92,500 3,20,000
Direct Labour @ 6 per unit
R 78,000 93,000 1,02,000 1,11,000 3,84,000
Variable Overheads @ 1.50 per unit
R 19,500 23,250 25,500 27,750 96,000
Fixed Overheads 45,000 45,000 45,000 45,000 1,80,000
———————————————————————————————————————————————————————————————————————————————————————————
Total Cost 2,07,500 2,38,750 2,57,500 2,76,250 9,80,000
———————————————————————————————————————————————————————————————————————————————————————————
———————————————————————————————————————————————————————————————————————————————————————————

(ii) STATEMENT OF BUDGETED PROFIT

for the year (as a whole)
R

Total Sales : 61,500 units @ 17 per unit

R 10,45,500
Less : Total Variable Cost : 61,500 units @ R 12.50 per unit 7,68,750
——————————————————

Contribution 2,76,750
Less : Fixed Cost for the year 1,80,000
——————————————————

Profit for the year 2024 as a whole 96,750

——————————————————

Note. Marginal costing approach has been followed for the ascertainment of profit i.e. all fixed expenses
R 1,80,000 for the year have been deducted from the contribution.
ILLUSTRATION 20. ABC Ltd. a newly started company wishes to prepare cash budget from
January. Prepare a cash budget for the first six months from the following estimated revenue and
expenses.
Month Total Sales (R) Materials (R) Wages (R) Production Selling &
Overheads ( R) Distribution
Overheads ( R)
January 20,000 20,000 4,000 3,200 800
February 22,000 14,000 4,400 3,300 900
March 28,000 14,000 4,600 3,400 900
April 36,000 22,000 4,600 3,500 1,000
May 30,000 20,000 4,000 3,200 900
June 40,000 25,000 5,000 3,600 1,200
(i) Cash balance on January, 1 was R 10,000.
D/2·58 BUDGETARY CONTROL

(ii) New machinery is to be installed at R 20,000 on credit, to be repaid by two equal

instalments in March and April.
(iii) Sales commission @ 5% on total sales is to be paid within a month following actual sales.
(iv) R 10,000 being the amount of 2nd call may be received in March.
(v) Share premium amounting to R 2,000 is also obtainable with the 2nd call.
(vi) Period of credit allowed by suppliers—2 months
(vii) Period of credit allowed to customers—1 month
(viii) Delay in payment of overheads—1 month
(ix) Delay in payment of wages—1/2 month
(x) Assume cash sales to be 50% of total sales.
SOLUTION CASH BUDGET FOR SIX MONTHS
for the year ended June ……
Particulars Jan. ( ) Feb. ( ) Mar. ( )
R R R Apr. ( ) May ( )
R R Jun. ( )
R

Opening Balance 10,000 18,000 29,800 27,000 24,700 33,100

Receipts :
Cash Sales 10,000 11,000 14,000 18,000 15,000 20,000
Receipts from Debtors — 10,000 11,000 14,000 18,000 15,000
2nd Call Money — — 10,000 — — —
Share Premium — — 2,000 — — —
Total Cash Available (A) 20,000 39,000 66,800 59,000 57,700 68,100
Cash Payments :
Machinery Purchased (Instalments) — — 10,000 10,000 — —
Sales Commission — 1,000 1,100 1,400 1,800 1,500
Creditors Payment (Suppliers) — — 20,000 14,000 14,000 22,000
Wages 2,000 4,200 4,500 4,600 4,300 4,500
Production Overheads — 3,200 3,300 3,400 3,500 3,200
Selling & Distribution Overheads — 800 900 900 1,000 900
Total Payments (B) 2,000 9,200 39,800 34,300 24,600 32,100
Closing Balance (A – B) 18,000 29,800 27,000 24,700 33,100 36,000

ILLUSTRATION 21. Prepare a cash budget for four months ending on 31st December, 2023
on the basis of the following information :
(1) Income and expenditure forecasts :
Months Sales (R) Purchase (R) Wages (R) Other Expenses (R)
July 60,000 40,000 8,000 9,000
August 90,000 60,000 10,500 8,850
September 75,000 50,000 17,500 8,000
October 90,000 60,000 17,100 7,850
November 1,05,000 70,000 12,000 7,300
December 1,20,000 80,000 12,000 7,050

(2) Cash balance on 1st September R 47,000.

BUDGETARY CONTROL D/2·59

(3)It is expected that 50% of the sales will be in cash and 25% of the purchase will be made
on credit.
(4) 75% of the credit sales is realised one month after the sales, 20% of the credit sales is
realised two months after the sales, and the balance is bad debt.
(5) 70% of the credit purchases is paid after one month and remaining 30% is paid after two
months of purchase.
(6) Wages are paid on 3rd day of every month.
(7) Other expenses include a depreciation of R 2,000 p.m.
(8) Commission @ 5% on the total sales payable after one month is not included in the other
expenses.
(9) Machinery is purchased @ R 60,000 and payment is to be made in September.
(10) A dividend on investments of R 10,250 to be received in November.
(11) The company has 10% Debentures of R 1,00,000. The interest is payable quarterly in
March, June, September and December.
(12) In case of deficit in cash in any month, the company can arrange an overdraft from the
bank for that month and such overdraft is to be repaid as early as possible out of the
surplus cash of the subsequent month. Ignore the interest on the overdraft.
SOLUTION CASH BUDGET
For four months ending on 31st Dec., 2023
Capacity Operated Sept. ( )
R Oct. ( )
R Nov. ( )
R Dec. ( )
R

Opening Cash Balance : 47,000 — — —

Cash Receipts* : Sales ( i) 37,500 45,000 52,500 60,000
(ii) 33,750 28,125 33,750 39,375
(iii) 6,000 9,000 7,500 9,000
Dividend — — 10,250 —
Total Cash Available (A) 1,24,250 82,125 1,04,000 1,08,375
Cash Payments** : Purchase ( i) 37,500 45,000 52,500 60,000
(ii) 10,500 8,750 10,500 12,250
(iii) 3,000 4,500 3,750 4,500
Wages 17,500 17,100 12,000 12,000
Other Expenses (Excluding Dep.***) 6,000 5,850 5,300 5,.050
Sales Commission @ 5% 4,500 3,750 4,500 5,250
Machinery Purchased 60,000 — — —

Debenture Interest ( R 1,00,000 ×

10
×
3
100 12 ) 2,500 — — 2,500

Total Cash Payments (B) 1,41,500 84,950 88,550 1,01,550

Cash Shortage/Surplus (A – B) (17,250) (2,825) 15,450 6,825
Bank Overdraft taken/repaid 17,250 2,825 (15,450) (4,625)
Bank Overdraft Balance 17,250 20,075 4,625 Nil
Cash Balance — — — 2,200
D/2·60 BUDGETARY CONTROL

Working Notes :
* Calculation of Receipt of Cash from Sales :
For September : 50% of 75,000
R 37,500
75% of (50% of 90,000)
R 33,750
20% of (50% of 60,000)
R 6,000
Similar Calculations for other months
** Calculation of Payment of Cash for Purchases :
For September : 75% of 50,000
R 37,500
70% of (25% of 60,000)
R 10,500
30% of (25% of 40,000)
R 3,000
Similar Calculations for other Months
*** Depreciation being non-cash item has been deducted from other expenses.
ILLUSTRATION 22. Following figures are available for sales and pre-estimated cost of XYZ
Ltd. for the year ended 31st March, 2024 at 50% (5,000 units) capacity utilisation.
(i) Fixed expenses remain constant for all levels of production and sales.
(ii) Selling price between 50% to 75% capacity is R 25 per unit.
(iii) Semi-variable expenses will remain unchanged at 50% to 65% capacity, but will increase
by 10% between 65% to 80% capacity and 30% between 80% to 100% capacity.
(iv) At 90% level material cost increases by 5% and selling price is reduced by 5%.
(v) At 100% level both material and labour cost increase by 10%, and selling price is reduced
by 8%.
(vi) Semi-variable Expenses are R 50,000.
(vii) Fixed Expenses are R 58,000.
(viii) Variable Expenses are : Material R 5 per unit, Labour R 2 per unit and Direct Expenses R 1
per unit.
Prepare a flexible budget at 60%, 75%, 90% and 100% capacity and forecast profit.
SOLUTION
FLEXIBLE BUDGET
60% 75% 90% 100%
(6,000 units) (7,500 units) (9,000 units) (10,000 units)
R R R R

Material @ 5 per unit

R 30,000 37,500 47,250 55,000
Labour @ 2 per unit
R 12,000 15,000 18,000 22,000
Direct Expenses @ 1 per unit
R 6,000 7,500 9,000 10,000
Semi-Variable Expenses 50,000 55,000 65,000 65,000
Fixed Expenses 58,000 58,000 58,000 58,000
Total Cost 1,56,000 1,73,000 1,97,250 2,10,000
Profit (Loss) (6,000) 14,500 16,500 20,000
Sales 1,50,000 1,87,500 2,13,750 2,30,000
Working Notes
(i) Semi Variable Expenses ⎡ 50% to 65% 65% to 80% 80% to 100% Same as
⎢ No change
⎣ Add 10% Add 30% 90%
BUDGETARY CONTROL D/2·61

(ii) Selling Price per unit R 25 R 25 ⎡ Less 5% ⎡ Less 8%

⎢ 23.75 ⎢ 23.00
⎣ R
⎣ R

(iii) Material No change No change ⎡ Add 5% ⎡ Add 10%

⎢ 5.25 ⎢ 5.50
⎣ R
⎣ R

(iv) Labour No change No change No change ⎡ Add 10%

⎢ 2.20
⎣ R

ILLUSTRATION 23. BMS LTD. has prepared annual budget for the year ending 31-3-2024
on the basis of 60% capacity utilisation. Summarised budget is given below :
Particular Amount Amount
( in lakh)
R ( in lakh)
R

I. Sales 150.00 IV. Fixed Expenses :

II. Direct Materials 36.50 Salaries—Managerial 9.50
Direct Labour 22.82 Rent, Rates & Taxes 6.60
Direct Expenses 8.68 Depreciation 7.40
III. Semi-Variable Expenses : Audit Fees 6.50
Repairs & Maintenance 5.30 V. Total Cost of Sales 120.00
Indirect Labour 7.70 VI. Budgeted Profit 30.00
Supervision 6.00
Heating & Lighting 3.00
Construct a Flexible Budget for 50%, 75% and 90% capacity utilization, showing (a) Variable
and Semi-Variable Cost (b) Cost of Sales and (c) Profit—with the help of the following
assumptions:
(i) Fixed expenses remain constant at all levels of activity.
(ii) Semi-variable expenses remain constant between 45% and 64% capacity, increasing by 10%
between 65% and 80% capacity, and by 20% above 80% capacity.
SOLUTION
BMS Ltd.
Flexible Budget for the year ended 31-3-2024
( in lakhs)
R

Activity Level 60% 50% 75% 90%

I. Sales 150.00 125.00 187.50 225.00
II. Direct Cost :
Material 36.50 30.42 45.62 54.75
Labour 22.82 19.02 28.53 34.23
Expenses 8.68 7.23 10.85 13.02
Sub-Total 68.00 56.67 85.00 102.00
III. Semi Variable Cost
Repairs & Maintenance 5.30 5.30 5.83 6.36
Indirect Labour 7.70 7.70 8.47 9.24
Supervision 6.00 6.00 6.60 7.20
Heating & Lighting 3.00 3.00 3.30 3.60
22.00 22.00 24.20 26.40
IV. Total of II & III 90.00 78.67 109.20 128.40
D/2·62 BUDGETARY CONTROL

V. Fixed Expenses :
Salaries & Managerial 9.50 9.50 9.50 9.50
Rent, Rates & Taxes 6.60 6.60 6.60 6.60
Depreciation 7.40 7.40 7.40 7.40
Audit Fees 6.50 6.50 6.50 6.50
Sub-Total 30.00 30.00 30.00 30.00
VI. Total Cost of Sales IV & V 120.00 108.67 139.20 158.40
V. Profit (I – VI) 30.00 16.33 48.30 66.60

PROBLEM 24. (Flexible Budget). Following are the figures of sales, costs and profit relating
to a manufacturing unit working at 50% of its capacity :
R

Sales 20,00,000
——————————————

Direct cost 8,00,000

Factory overheads 4,00,000
Office overheads 2,00,000
Selling overheads 3,00,000
——————————————

Profit 3,00,000
——————————————

Every 10% increase in sales beyond 50% of capacity is possible only after reducing the price by
1% on the base level of 50% capacity sales. Material cost included in Direct cost at this level is 25%.
With every 10% increase in capacity above this level the price of direct material comes down by
2%. Factory overheads at this level are fixed to the extent of 50% and rest are variable. Every 10%
increase in output over the present level results in 2% increase in the office overheads. Selling
overheads as a per cent of sales remain constant.
Prepare a budget at 80% capacity level considering the above information. Show workings
clearly.

SOLUTION
Budgeted Working Capacity 80%
Present Working Capacity 50%
Increase in Capacity % = 80% – 50%= 30%
30
% Increase in Sales and Output = × 100 = 60%
50
BUDGET AT 80% CAPACITY
Amount
R

Sales ( R 20,00,000 ×
160 97
×
100 100 ) 31,04,000
——————————————

Variable Cost of Sales :

Direct Materials ( R 2,00,000 ×

160 94
×
100 100 ) 3,00,800

Other Direct Costs ( R 6,00,000 ×

160
100 ) 9,60,000
BUDGETARY CONTROL D/2·63

Variable Factory Overheads ( R 2,00,000 ×

160
100 ) 3,20,000

Variable Selling Overheads (15% of R 31,04,000) 4,65,600

( % of Selling Overheads to Sales at Present Level :

R

R
3‚00‚000
20‚00‚000
× 100 = 15% ) ——————————————

Total Variable Cost of Sales 20,46,400

——————————————

Contribution (Sales – Variable Cost of Sales) 10,57,600

Less : Fixed Cost :
Factory Overheads R 2,00,000

Office Overheads ( R 2,00,000 ×

106
100 ) R 2,12,000
———————————————
4,12,000
——————————————

Profit 6,45,600
——————————————
——————————————

ILLUSTRATION 25. The budget manager of Jupiter Electricals Limited is preparing a

flexible budget for the accounting year starting from 1st July, 2022.
The company produces one product—DETX II. Direct material costs R 7 per unit. Direct labour
averages R 2.50 per hour and requires 1.6 hours to produce one unit of DETX II. Salesmen are paid
a commission of R 1 per unit sold. Fixed selling and administrative expenses amount to R 85,000
per year.
Manufacturing overhead is estimated in the following amounts under specified conditions of
volume :

Volume of Production (in units) 1,20,000 1,50,000

—————————————— ——————————————

Expenses : R R

Indirect Material 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—Plant and Equipment 90,000 90,000
Engineering Services 94,000 94,000
——————————————— ———————————————

Total Manufacturing Overhead 9,70,000 11,50,000

——————————————— ———————————————

Normal capacity is 1,25,000 units.

Prepare a budget of total cost at 1,40,000 units of production for the year ending 30th June,
2023.
SOLUTION (For Flexible Budget see next page)
D/2·64 BUDGETARY CONTROL
BUDGETARY CONTROL D/2·65

ILLUSTRATION 26. Viveka Elementary School has a total of 150 students consisting of 5
sections with 30 students per section. The school plans for a picnic around the city during the
weekend to places such as the zoo, the amusement park, the planetarium etc. A private transport
operator has come forward to lease out the buses for taking the students. Each bus will have a
maximum capacity of 50 (excluding 2 seats reserved for the teachers accompanying the students).
The school will employ two teachers for each bus, paying them an allowance of R 50 per teacher. It
will also lease out the required number of buses. Following are the other cost estimates :
Cost per student
R

Break fast 5 Rent R 650 per bus.

Lunch 10 Special permit fee R 50 per bus.
Tea 3 Block entrance fee at the planetarium R 250.
Entrance fee at zoo 2 Prizes to students for games R 250.
No costs are incurred in respect of the accompanying teachers (except the allowance of R 50 per
teacher).
You are required to prepare :
(i) A flexible budget estimating the total cost for the levels of 30, 60, 90, 120 and 150 students.
Each item of cost is to be indicated separately.
(ii) Compare the average cost per student at these levels.
SOLUTION
(i) Flexible Budget for different levels
Level of students 30 60 90 120 150
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
No. of Buses required 1 2 2 3 3
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
R R R R R

(A) Variable costs ( ) R

Break fast @ 5 R 150 300 450 600 750

Lunch @ 10 R 300 600 900 1,200 1,500
Tea @ 3 R 90 180 270 360 450
Entrance fee in zoo @ R 2. 60 120 180 240 300
————————————————————————————————————————————————————————————————————

Total (A) 600 1,200 1,800 2,400 3,000

————————————————————————————————————————————————————————————————————
(B) Semi-variable costs
Rent of bus 650 1,300 1,300 1,950 1,950
Special permit fee 50 100 100 150 150
Allowance to teachers 100 200 200 300 300
————————————————————————————————————————————————————————————————————

Total (B) 800 1,600 1,600 2,400 2,400

————————————————————————————————————————————————————————————————————

(C) Fixed costs

Block entrance fee 250 250 250 250 250
Prizes to students for games 250 250 250 250 250
————————————————————————————————————————————————————————————————————

Total (C) 500 500 500 500 500

————————————————————————————————————————————————————————————————————

(D) Total cost (A) + (B) + (C) 1,900 3,300 3,900 5,300 5,900
————————————————————————————————————————————————————————————————————

(E) No. of students 30 60 90 120 150

(ii) Average Cost per Student (D ÷ E) 63·33 55 43·33 44·17 39·33
D/2·66 BUDGETARY CONTROL

ILLUSTRATION 27. AB Ltd. has prepared the following budget for 2023-24 :
%
Raw materials 40
Direct wages 25
Factory overheads (variable) 10
Factory overheads (fixed) 5
Administration and selling overheads (variable) 6
Administration and selling overheads (fixed) 12
Profit 2
————————

Total sales value 100

————————
————————

After considering the half yearly performance it was felt that the budgeted volume of sales
would not be obtained but the company expected to achieve 80% equivalent to a sales value of R
160 lacs.
You are required to : present the original budget and the revised budget based on 80%
achievement showing the quantum of profit or loss.
SOLUTION
(i) Expected achievement is 80% of budget which is equivalent to a sale value of R 160 lacs. Therefore,

budgeted sales at 100% level is R

(
200 lacs i.e., R 160 lacs ×
100
80 )
AB Ltd.
ORIGINAL AND REVISED BUDGETS
for 2023-24
Original Budget Revised Budget
% lacs
R % lacs R

Raw materials 40 80 40.00 64.00

Direct wages 25 50 25.00 40.00
Factory overheads (variable) 10 20 10.00 16.00
Factory overheads (fixed) 5 10 6.25 * 10.00
Adm. and selling overheads (variable) 6 12 6.00 9.60
Admn. and selling overheads (fixed) 12 24 15.00 * 24.00
Profit (Loss) 2 4
————————— —————————————
(2.25)* (3.60)
—————————————————————————————
Sales 100 200 100.00 160.00
————————— ————————————— —————————————————————————————

Working Note : Fixed overheads relate to original budget. Therefore, there will be no change in these
overheads relating to the revised budget. However, the percentage of fixed overheads of sales will change.
10
Factory Overheads i.e. × 100 = 6.25%
160
24
Administration and Selling Overheads × 100 = 15.00%
160
Loss is balancing figure.
ILLUSTRATION 28. Production costs of a factory for a year are as follows :
R R

Direct wages 90,000 Production overheads —fixed 40,000

Direct materials 1,20,000 —variable 60,000
BUDGETARY CONTROL D/2·67

During the forthcoming year it is anticipated that :

(a) Average rate for direct labour remuneration will fall from R 0.90 per hour to R 0.75 per hour;
(b) Production efficiency will be reduced by 5%;
(c) Price per unit for direct material and of other materials and services which comprise
overheads will remain unchanged ; and
1
(d) Direct labour hours will increase by 33 3 %.
Draw up a budget and compute a factory overhead rate, the overhead rate being absorbed on a
direct wage basis.
SOLUTION
Output in the forthcoming year will increase by 26 23 %. It is calculated as follows :
Output last year 100%
1 1
Increase due to 33 3 % increase in labour hours 333 %
———————————
1
1333 %

Less : 5% decline in production efficiency 1333% × ( 1 5

100 ) 632 %
———————————
2
1263 %
———————————
So output will increase by 26 23 %
Labour hours worked last year were :
Wages 90,000 R

Rate per hour 90 Paise

90‚000 R 100
∴ Number of labour hours last year = 90,000 × = 1,00,000 hrs.
90 Paise 90

BUDGET FOR THE FORTHCOMING YEAR

R R

Direct Material last year 1,20,000

2
Add: 263 % increase in materials due to 2632 % increase

in output ( R 1‚20‚000 ×
80
3 × 100 ) 32,000
————————————————

1,52,000
Direct Wages :
Labour hours last year 1,00,000
1
Add : Increase in labour hours, 333% 1,00,000/3
————————————————
Total labour hours in the forthcoming year 4,00,000
————————————————
3
Rate per hour 75 paise

∴ Wages for
4‚00‚000
3
hours @ R
(
0.75 i.e.,
4‚00‚000 75
3
×
100 ) 1,00,000
———————————————

Prime Cost 2,52,000

Production Overheads :
Fixed 40,000
Variable last year R 60,000
D/2·68 BUDGETARY CONTROL

2
Add: 263 % increase due to increase

in output ( R 60‚000 ×
80
3 × 100 ) R 16,000
———————————————
76,000 1,16,000
———————————————— ———————————————

Estimated Works Cost 3,68,000

———————————————
Factory Overhead Rate Based on Direct Wages is
R

R
1‚16‚000
1‚00‚000 ( Production Overheads
Wages )
× 100 = 116 %

ILLUSTRATION 29. From the following information relating to 2023 and conditions
expected to prevail in 2024, prepare a budget for 2024. Assume the rate of depreciation as 10%.
2023 Actuals : R

Sales 1,00,000 (40,000 units) Variable Overheads 16,000

Raw Materials 53,000 Fixed Overheads 10,000
Wages 11,000
2024 Prospects :
Sales 1,50,000 (60,000 units) Additional Plant One lathe R 25,000
Raw Materials 5% price increase One drill R 12,000
Wages 10% increase in wage rates
5% increase in productivity
SOLUTION
In the year 2024, additional plant worth 37,000 (i.e. R R 25,000 + R 12,000) will be used and the rate of
depreciation is 10% p.a. Therefore, fixed overheads are :
R

Fixed overheads (as given) 10,000

Depreciation (10% on 37,000) R 3,700
—————————————
Total Fixed Overheads 13,700
—————————————

Output in 2023 40,000 units

Expected Output in 2024 60,000 units
Increase in Output = 60,000 – 40,000 = 20,000 units
20‚000
% Increase in Output = × 100 = 50%.
40‚000
Budgeted Raw Materials for 2024 R

Consumption of Materials in 2023 53,000

Add : 50% increase in output 26,500
—————————————
79,500

Add : 5% increase due to increase in prices of materials ( R 79‚500 ×

5
100 ) 3,975
—————————————
83,475
—————————————
Budgeted Wages for 2024
R

Wages in 2023 11,000

Add : 50% increase in output 5,500
—————————————

16,500
BUDGETARY CONTROL D/2·69

Add : 10% increase due to increase in wage-rates 1,650

—————————————

18,150

Less: Saving due to increase in productivity ( R 18‚150 ×

5
105 ) 864
—————————————

17,286
—————————————

BUDGET
for the year 2024
Actual for Budgeted
2023 for 2024
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————
—
Sales and Output (Units) 40,000 60,000
R R

1. Sales 1,00,000 1,50,000

—————————————————— ————————————————
Raw Materials 53,000 83,475
Wages 11,000 17,286
Variable Overheads @ 40 P. per unit 16,000 24,000
Fixed Overheads 10,000 13,700
———————————————————————————————————

2. Total Cost 90,000 1,38,461

———————————————————————————————————

3. Profit (1 – 2) 10,000 11,539

QUESTIONS
SHORT ANSWER TYPE

1. Define a budget and give its four essentials.

OR
Describe the salient features of budget manual.
2. (a) Define budgetary control and give its essentials.
(b) Enumerate the steps involved in budgetary control.
(c) Briefly describe any five objectives of Budgetary Control.
3. What are the advantages of budgetary control ?
4. What is ‘Budget Manual’ What matters are included in it ?
5. (a) State the importance of budget key factor in budgeting ?
(b) “Budget is an aid to management and not a substitute for management.” Comment.
6. List important functional budgets prepared by a business.
OR
Define and explain briefly what do you understand by (a) Sales Budget, (b) Cash Budget and (c)
Overhead Budget. (B.Com. Pb. Sept. 2010)
OR
Budgets are classified according to time. State how they are classified.
7. (a) What do you understand by Master Budget ?
(b) Discuss the components of budgetary control system.
D/2·70 BUDGETARY CONTROL

8. (a) Explain briefly the concept of flexible budget.

(b) What are the cases where a flexible budget is found suitable ?
(c) Flexible budgets are more realistic and useful than fixed budgets. Do you agree ? Explain.
9. Distinguish between fixed budget and flexible budget.
10. Explain three control Ratios used for performance evaluation.
OR
Explain the Efficiency ratio and Capacity Ratio.
OR
Explain important control ratios.
11. Write a note on performance budgeting.
12. Explain the concept and important features of zero base budgeting.
OR
Discuss the characteristics of zero base budgeting.
OR
Write a note on Zero Based Budgeting.
13. Write notes on (i) Budget Manual (ii) Principal Budget Factor (iii) Rolling Budgets (iv) Limitations of
Budget.
14. Write explanatory notes on : (i) Functions of Budgeting (ii) Key Factor & its Significance (iii) Zero Base
Budgeting (iv) Fixed Budget.
OR
Discuss in detail with the help of examples various types of budgets. (B.Com. Pb. April 2013)
OR
What do you understand by a Budgeting ? Mention the types of budgets that management of a big
industrial concern could normally prepare. (B.Com. Pb. April 2011)
15. What is Sales Budget ? How is it prepared ?
16. State four limitations of the Budgetary Control System.
17. What is plant utilisation budget ? What are the main purposes of this budget ?
18. Distinguish between Conventional budgeting and Zero base budgeting.
19. If the ‘activity ratio’ and ‘capacity ratio’ of a company are 104% and 96% respectively, find out its
efficiency ratio.
Ans. [108.33%]
Activity Ratio
Hint : Efficiency Ratio in % = × 100.
Capacity Ratio
20. The activity ratio of a concern is 95.6% whereas the capacity ratio is 105% . What is the efficiency ratio ?

Ans. [91.047%]
21. Calculate (i) Efficiency Ratio, (ii) Activity Ratio and (iii) Capacity Ratio from the following figures:
Budgeted Production—880 units ; Standard Hours per unit—10; Actual Production—750 units and
Actual Working Hours—6,000.
Ans. [(i) 125% (ii) 85.23% (iii) 68.18%].
22. Calculate (i) Efficiency; and (ii) Capacity Ratio from the following figures :
Budget production—80 units; Actual production—60 units; Standard time per unit—8 hours; Actual
hours worked—500.
Ans. [(i) 96%; (ii) 78.125%]
BUDGETARY CONTROL D/2·71

23. A factory produces two products P and Q. P takes 10 hours to produce and Q requires 16 hours as per
the budget. A month has 25 budgeted days of 8 hours each. During the month 500 units of P and 400
units of Q were produced. The factory employs 50 workers. They actually worked for 9 hours daily for
24 days.
Calculate : (i) Efficiency Ratio; (ii) Capacity Ratio; (iii) Calendar Ratio.
Ans. [(i) 105.55%; (ii) 108%; (iii) 96%]
24. Two articles A and B are produced in a factory. Their specifications show that 4 A’s or 2 B’s can be
produced in one hour. The budgeted production for January, 2024 is 800 A’s and 200 B’s. The actual
production at the end of the month was 900 A’s and 180 B’s. Actual labour hours spent were 350. Find
out the capacity, activity and efficiency ratios for January, 2024 :
Ans. [Capacity Ratio = 116.67% ; Activity Ratio = 105% and Efficiency Ratio = 90%]

25. An Airline Company’s budget and actuals for the quarter January to March 2024 are as under :
R in ’000
Budget Actuals
Income 2,000 2,090
Variable Cost 1,200 1,452
Contribution 800 638
Fixed Cost 700 680
Operating Profit/(Loss) 100 (42)
Following further details are available :
(i) There was a 9% decrease in air-fare resulting in a 5% decrease in the income for the quarter.
(ii) Variable cost like fuel, wages, catering etc. are increased by 10% over the budget.
Prepare an analysis reconciling the budgeted and actual profits for the quarter.
Ans. [Increase in Profit due to : Increase in Volume 80,000 and Decrease in Fixed Costs
R 20,000; R

Reduction in Profit due to Decrease in Fare 1,10,000 and Increase in Variable Cost 1,32,000]
R R

26. Prepare a flexible budget for the production at 80% and 100% activity on the basis of the following
information :
Product at 50% capacity—5,000 units Raw Materials 80 per unit; Direct labour 50 per unit; Direct
R R

Expenses 15 per unit; Factory expenses 50,000 (50% fixed); Administration expenses 60,000 (50%
R R R

variable). (B.Com. Panjab)

Ans. [At 80% Capacity—Total cost R 13,06,600; Per unit R 163.33; At 100% Capacity—Total cost R 16,21,000;
Per unit 162.10]
R

LONG ANSWER TYPE

1. What do you mean by functional budgets ? Discuss any two such budgets.
2. What is budgetary control ? State the main objectives of budgetary control. What are the main steps in
budgetary control ? (B.Com. Panjab April, 2009)
3. In relation to cost accounting :
(a) What is a budget ? (b) What is a flexible budget ? (c) What advantages, if any, has a flexible budget
over a fixed budget ?
4. Explain the meaning of Business Budget. How does it serve as an instrument of control ?
5. “Flexibility in a budget is an aid to co-ordination, while the budgetary control is an instrument of co-
ordination.” Explain.
D/2·72 BUDGETARY CONTROL

6. Distinguish between a forecast and a budget. Give examples to illustrate the difference between the
two.
7. Explain different types of budgets. What is the purpose of classifying budgets in different types ? How
does it help to operate budgetary control technique efficiently and effectively?
OR
Describe the process of budgeting and discuss the advantages and limitations of budgetary control.
OR
Define budgetary control, budgeting and Budget. Give the advantages of budgetary control in a large
manufacturing organisation. (B.Com. Panjab Sept. 2011)
8. What is Cash Budget ? What are its advantages ? How is it prepared ? (B.Com., Punjab)
OR
What is cash budget ? What are its uses (or objectives) ?
9. What do you mean by ‘principal budget factor’ ? Explain with illustrations.
OR
Principal budget factor is of vital importance to management in profit planning”. Comment.
10. What do you understand by the term ‘flexible budget’ ? How is it drawn up and what difficulties
would you expect to face in its compilation ? Is flexible budget useful to the management ?
11. Define the term ‘budget’ as used in cost accounting, and explain what is meant by ‘budgetary control’
12. Discuss briefly the objectives and limitations of budgetary control.
OR
Budget is an aid to management not a substitute for management. Comment.
OR
What is budgeting ? Explain its advantages and limitations.
OR
Describe briefly the purpose and use of a system of budgetary control and explain its relation to
financial accounts of company. (B.Com., Punjab)
13. Explain the relationship between budget and budgetary control.
14. Explain with examples the three control ratios used for performance evaluation.
OR
Write note on control ratios as used in Budgetary Control system.
15. Define “Flexible Budget” and explain its importance as a budgeting technique and tool of control.
OR
Distinguish between fixed budget and flexible budget. (B.Com., Punjab)
OR
“Flexible budgets are more realistic and useful than fixed budgets.” Do you agree ? Explain.
16. “The concept of performance budgeting relates to greater management efficiency especially in
government organisation.” Explain.
OR
What are the essential requirements for installing an efficient system of budgetary control ?
17. Briefly explain the essentials of an effective budgetary control system.
OR
Discuss the steps necessary for the success of Budgetary Control system in an organisation.
18. State the advantages and limitations of Zero Based Budgeting.
19. What is meant by Zero Based Budgeting ? What are the essentials of introducing a system of zero based
budgeting ? Explain in brief about the drawbacks of this system.
BUDGETARY CONTROL D/2·73

PRACTICAL PROBLEMS
FUNCTIONAL BUDGETS
1. (Sales Budget) A manufacturing company submits the following figures of product ‘X’ for the first
quarter of 2023 :
Sales (in units) January 50,000 Target of 1st Quarter 2024
February 40,000 Sales quantity increase 20%
March 60,000 Sales price increase 10%
Selling price per unit 100
R

Prepare Sales Budget for the first quarter of 2024.

Ans. [Total Sale Value of First Quarter : R 1,98,00,000]
2. (Production Budget) A manufacturing company submits the following figures relating to Product X for
the first quarter of 2024 :
Sales Targets : Stock position :
January 60,000 units 1st January 2024 (% of January 2024 sales) — 50%
February 48,000 units Stock position : 31st March, 2024 — 40,000 units
March 72,000 units Stock position : End January & February — 50%
(% of subsequent Month’s Sales)
You are required to prepare production budget for the first quarter of 2024.
Ans. [Production (in units) of First Quarter : 1,90,000]
3. (Material Requirement Budget) The sales director of a manufacturing company reports that next year
he expects to sell 50,000 units of a certain product.
The production manager consults the storekeeper and costs his figures as follows :
Two kinds of raw materials, A and B, are required for manufacturing the product. Each unit of the
product requires 2 units of A and 3 units of B. The estimated opening balances at the commencement of
the year are :
Finished product—10,000 units ; A—12,000 units ; B—15,000 units.
The desirable closing balances at the end of next year are :
Finished product—14,000 units ; A—13,000 units ; B—16,000 units. Draw up the quantitative chart
showing the Material Requirement Budget for the next year.
Ans. [Material required : Material A 1,09,000 units ; Material B 1,63,000 units]
4. (Material Purchase Budget) From the following figures, prepare Raw Material Purchase Budget for
January, 2024 :
Materials Units
——————————————————————————————————————————————————————

A B C
——————————————————————————————————————————————————————

Estimated Opening Stock 16,000 6,000 24,000

Estimated Closing Stock 20,000 8,000 28,000
Estimated Consumption 1,20,000 44,000 1,32,000
Standard Price per unit R1 R 1.50 R2.00
Ans. [A— 1,24,000; B— 69,000 ; C— 2,72,000 and Total Amount
R R R R 4,65,000].
5. (Manufacturing Overhead Budget) From the following average figures of previous quarters, prepare a
manufacturing overhead budget for the quarter ending on March 31, 2024. The budgeted output during
this quarter is 6,000 units.
D/2·74 BUDGETARY CONTROL

Fixed Overheads 30,000

Variable Overheads 15,000 (varying @ R 5 per unit)
Semi-variable overheads 15,000 (40% fixed and 60% varying @ R 3 per unit)
Ans. [ 84,000]
R

6. (Material Purchase Budget) P Ltd. manufactures two products using one type of material. Shown
below is an extract from the company’s working papers for the next period budget.
Product A Product B
Budgeted sales (in units) 3,600 4,800
Budgeted material consumption per product (kgs.) 5 3
Budgeted material cost 12 per kg.
R

There are twelve 5-day weeks in the budget period and it is anticipated that sales and production will
occur evenly throughout the whole period.
It is anticipated that stock at the beginning of the period will be : Product A 1,020 units ; Product B 2,400
units ; Raw material 4,300 kgs.
The target closing stocks, expressed in terms of anticipated activity during the budget period are :
Product A 15 days sales ; Product B 20 days sales ; Raw material 10 days consumption.
Prepare Material Purchase Budget showing the quantities and values for the next period.
Ans. [Material to be purchased—30,000 kgs. × 12 = 3,60,000] R

7. (Sales Overhead Budget) Prepare a Sales Overhead Budget from the estimates given below :
Advertisement 2,500 ; Salaries of the Sales Department 5,000; Expenses of Sales Department 1,500.
R R R

Counter Salesmen’s Salaries and Dearness Allowance 6,000 and Commission to Counter Salesmen at
R

1% on their Sales.
Travelling salesmen’s commission at 10% on their sales and expenses at 5% on their sales.
The sales during the period were estimated as follows :
Counter Sales Travelling Salesmen’s Sales
R R

January 80,000 10,000

February 1,20,000 15,000
March 1,40,000 20,000
Ans. [January— R 17,300 ; February — R 18,450 ; and March — R 19,400]
8. (Production/Production Cost Budget) Following are the estimated sales of a company for eight months
ending 30-11-2023 :
Months Estimated Sales (Units) Estimated Sales (Units)
April 2023 12,000 August 2023 10,000
May 2023 13,000 September 2023 12,000
June 2023 9,000 October 2023 14,000
July 2023 8,000 November 2023 12,000
As a matter of policy, the company maintains the closing balance of finished goods and raw materials
as follows :
Stock item Closing balance of a month
Finished goods 50% of the estimated sales for the next month.
Raw Materials Estimated consumption for the next month.
BUDGETARY CONTROL D/2·75

Every unit of production requires 2 kg. of raw mateiral costing R 5 per kg.
Prepare (a) Production Budget (in units) and (b) Raw material Purchase Budget (in units and cost) of the
company for the half year ending 30 September, 2023
Ans. [(a) 65,000 units, (b) Purchase of Raw Materials 1,31,000 kgs. and cost will be R 6,55,000]
9. (Production Budget & Production Cost Budget) Following information has been made available from
the records of Incharge, Precision Tools Limited for the last six months of 2023 (and of only the sales of
January, 2024) in respect of Product ‘X’ :
(i) The units to be sold in different months are :
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

July 2023 1,100 November 2,500

August 1,100 December, 2023 2,300
September 1,700 January, 2024 2,000
October 1,900
——————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

(ii) There will be no work-in-progress at the end of any month.

(iii) Finished units equal to half the sales for the next month will be in stock at the end of every month
(including June, 2023).
(iv) Budgeted production and production cost for the year ending 31st December, 2023 are as thus:
Production (units) 22,000
Direct Materials per unit R 10.00
Direct Wages per unit R 4.00
Total Factory Overheads apportioned to Product R 88,000
It is required to prepare :
(a) A Production Budget for each of the last six months of 2023, and
(b) A Summarized Production Cost Budget for the same period.
Ans. [Production (units)—July 1,100; August—1,400; September—1,800; October—2,200; November—
2,400; December—2,150; Total Production Cost = 1,98,900] R

10. (Cost of Goods Sold Budget). Following data pertains to Mr. Y for the month budget of November,
2023 :
R R

Direct Materials used 847 Manufacturing Overheads ?

Beginning finished goods inventory ? Cost of goods manufactured 1,878
Ending finished goods inventory 94 Cost of goods sold ?
Direct manufacturing labour 389 Cost of goods available for sale 1,949
Prepare the cost of goods sold budget for the month of November, 2023 by filling the missing figures.
Ans. [Manufacturing Overheads R 642, Opening Inventory of Finished Goods R 71 ; Cost of Goods Sold
R1,855].
11. (Sales Overhead Budget). The selling expenses of a business for a particular budget period are :
R R

Sales office salaries 4,000 Fixed salaries and car allowance 12,000
Fixed expenses of sales office 3,000 Traveller’s Commission 1% on sales
Amount allocated for effected by agents
1
advertisement 4,000 Agent’s commission 7 2 % on sales.
D/2·76 BUDGETARY CONTROL

Traveller’s remuneration :
Prepare a selling overhead budget for following level of sales for the period :
R 2,80,000 including agent’s sales R 30,000
R 3,20,000 including agent’s sales R 35,000
R 3,60,000 including agent’s sales R 35,000
Ans. [ For R 2,80,000 For R 3,20,000 For R 3,60,000
Sales Sales Sales
R R R

Selling Overhead
Budget 27,750 28,475 28,875]

CASH BUDGET
12. Based on the following information prepare a Cash Budget for ABC Ltd.
1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
( )R ( )R ( )R ( )
R

Opening cash balance 10,000

Collection from customers 1,25,000 1,50,000 1,60,000 2,21,000
Payments
Purchase of materials 20,000 35,000 35,000 54,200
Other expenses 25,000 20,000 20,000 17,000
Salary and wages 90,000 95,000 95,000 1,09,200
Income tax 5,000 — — —
Purchase of machinery — — —20,000
The company desires to maintain a cash balance of 15,000 at the end of each quarter. Cash can be
R

borrowed or repaid in multiples of 500 at an interest of 10% per annum. Management does not want
R

to borrow cash more than what is necessary and wants to repay as early as possible. In any event, loans
cannot be extended beyond four quarte Interest is computed and paid when the principal is repaid.
R

Assume that borrowings take place at the beginning and repayments are made at the end of the
quarters.
Ans. [ 1st 2nd 3rd 4th
Quarter Quarter Quarter Quarter
( ) ( )
R ( )
R ( ) R R

Borrowings 20,000 — — —
Repayment — — 9,000 11,000
Interest Payment — — 675 1,100
Cash Balance at the end of the quarter 15,000 15,000 15,325 23,825]
Hint. Interest is calculated only when principal is repaid. Therefore, interest will be calculated at the end of
3rd quarter and 4th quarter when principal is repaid.
Interest paid in 3rd quarter on R 9,000 for 9 months @ 10 p.a.
10 9
= R 9,000 × × = 675 R
100 12
Interest paid in 4th quarter on R11,000 for one year @ 10%
10
= R 11,000 × = 1,100. R
100
BUDGETARY CONTROL D/2·77

13. ABC Company Ltd. has given the following particula You are required to prepare a cash budget for
R

the three months ending 31st December, 2023 :

(a) Months Sales Materials Wages Overheads
R R R R

August 20,000 10,200 3,800 1,900

September 21,000 10,000 3,800 2,100
October 23,000 9,800 4,000 2,300
November 25,000 10,000 4,200 2,400
December 30,000 10,800 4,500 2,500
(b)
Credit terms are :
Sales/Debtors—10% sales are on cash basis, 50% of the credit sales are collected next month and
the balance in the following month :
Creditors — Materials 2 months
— Wages 1/5 month
— Overheads 1/2 month
(c) Cash balance on 1st October, 2023 is expected to be 8,000. R

(d) A machinery will be installed in August, 2023 at a cost of 1,00,000. The monthly instalment of
R

5,000 is payable from October onwards.

R

(e) Dividend at 10% on preference share capital of 3,00,000 will be paid on 1st December, 2023.
R

(f) Advance to be received for sale of vehicle 20,000 in December.

R

(g) Income-tax (advance) to be paid in December 5,000. R

Ans. [October Closing Balance 7,390; November Closing Balance 8,180 ; December Bank Overdraft
R R

3,910]
R

Hint. Collection from Debtors : October 18,450, November 19,800 and December 21,600.
R R R

14. A company expects to have 37,500 cash in hand on 1st April, 2023 and requires you to prepare an
R

estimate of cash position during the three months, April to June, 2023. Following information is
supplied to you :
Sales Purchases Wages Factory Office Selling
Expenses Expenses Expenses
R R R R R R

February 75,000 45,000 9,000 7,500 6,000 4,500

March 84,000 48,000 9,750 8,250 6,000 4,500
April 90,000 52,500 10,500 9,000 6,000 5,250
May 1,20,000 60,000 13,500 11,250 6,000 6,570
June 1,35,000 60,000 14,250 14,000 7,000 7,000
Other Information :
(1) Period of credit allowed by suppliers—2 months.
(2) 20% of sales is for cash and period of credit allowed to customers for credit sales is one month.
(3) Delay in payment of all expenses—1 month.
(4) Income tax of 57,500 is due to be paid on June 15, 2023.
R

(5) The company is to pay dividends to shareholders and bonus to workers of 15,000 and 22,500
R R

respectively in the month of April.

(6) Plant has been ordered and is expected to be received and paid in May. It will cost 1,20,000.
R

Ans. [The company will need overdraft facilities in May and June to the extent of R 91,050 and R 1,15,370
respectively]
D/2·78 BUDGETARY CONTROL

FLEXIBLE BUDGET
15. (Flexible Budget) The statement given below gives the flexible budget at 60% capacity. Prepare a
tabulated statement giving the budget figures at 75% capacity.
When no indication is being given make your own classification of expenses between fixed and variable
overheads.
Expenses At 60% capacity
( )
R

Direct Material 1,60,000

Direct Labour 40,000
Indirect Material and Spares (50% Fixed) 48,000
Depreciation (50% fixed) 60,000
Indirect Labour 40,000
Rent 12,000
Electric Power (40% fixed) 8,000
Repairs and Maintenance (40% variable) 20,000
Insurance on Machinery 12,000
Ans. [
R 4,76,700]
16. ABC Ltd. has prepared the budget for the production of one lakh units of the only commodity
manufactured by it for a costing period as follows :
(Lakh)
R (Lakh) R

(i) Raw Material 2.52 (iv) Works Overheads (60% fixed) 2.25
(ii) Direct Labour 0.75 (v) Administrative Overheads (80% fixed) 0.40
(iii) Direct Expenses 0.10 (vi) Selling Overheads (50% fixed) 0.20
The actual production during the period was only 60,000 units. Calculate the revised budget cost per
unit.
Ans. [ 7.40]
R

17. Pentax Limited has prepared its expense budget for 20,000 units in its factory for the year 2024 as
detailed below :
per unit
R

Direct Materials 50
Direct Labour 20
Variable Overhead 15
Direct Expenses 6
Selling Expenses (20% fixed) 15
Factory Expenses (100% fixed) 7
Administration Expenses (100% fixed) 4
Distribution Expenses (85% variable) 12
——————

Total 129
——————
——————

Prepare an expense budget for the production of 15,000 units and 18,000 units.
Ans. [Total Cost—20,000 units— 25,80,000; 15,000 units— 20,14,000; 18,000 units— 23,53,600]
R R R

18. A factory is currently running at 50% capacity and produces 5,000 units at a cost of 90 per unit as per
R

details given below :

BUDGETARY CONTROL D/2·79

R R

Material 50 Factory overheads 15 ( 6 fixed) R

Labour 15 Administrative overheads 10 ( 5 fixed) R

The current selling price is 100 per unit. At 60% working material cost per unit increases by 2% and
R

selling price per unit falls by 2%.

At 80% working, material cost per unit increases by 5% and selling price per unit falls by 2.5%.
Prepare a flexible budget showing profits of the factory at 60% and 80% working and offer your
comments.
Ans. [Profit 60%— 53,000; 80%— 73,000]
R R

19. For production of 10,000 Electrical Automatic Irons, the following are budgeted expenses :
R per unit per unit R

Direct materials 60 Selling expenses (10% fixed) 15

Direct labour 30 Administration expenses ( 50,000 fixed
R

Variable overheads 25 for all levels of Production) 5

Fixed overheads ( 1,50,000)
R 15 Distribution expenses (20% fixed) 5
Variable expenses (Direct) 5
Prepare a budget for production of 6,000, 7,000 and 8,000 Irons, showing distinctly marginal cost and
total cost. (B.Com. Punjab)
Ans. [ For 6,000 For 7,000 For 8,000
units units units
R R R

Marginal Cost per unit 137.50 137.50 137.50

Total Marginal Cost 8,25,000 9,62,500 11,00,000
Cost per unit 175 169.64 165.63
Total Cost 10,50,000 11,87,500 13,25,000]
20. ABC Ltd. manufactures a single product for which market demand exists for additional quantity.
Present sales of 60,000 per month utilizes only 60% capacity of the plant. Marketing manager assures
R

that with the reduction of 10% in the price he would be in a position to increase the sale by about 25%
to 30%. Following data are available :
(i) Selling price R 10 per unit
(ii) Variable cost R 3 per unit
(iii) Semi-variable cost R 6,000 fixed + 50 paise per unit
(iv) Fixed cost R 20,000 at present level estimated to be R 24,000
at 80% output.
You are required to prepare the following statements :
(1) The operating profits at 60’%, 70% and 80% levels at current selling price and
(2) The operating profits at proposed selling price at the above levels.

Ans.
[ (i) Profit ( )
(ii) Profit ) R
R
60%
13,000
7,000
70%
19,500
12,500
80%
22,000
14,000
]
21. RST Limited is presently operating at 50% capacity and producing 30,000 units. The entire output is
sold at a price of 200 per unit. The cost structure at the 50% level of activity is as under :
R

Direct Material 75 per unit

Direct Wages 25 per unit
D/2·80 BUDGETARY CONTROL

Variable Overheads 25 per unit

Direct Expenses 15 per unit
Factory Expenses (25% fixed) 20 per unit
Selling and Distribution Exp. (80% variable) 10 per unit
Office and Administrative Exp. (100% fixed) 5 per unit
The company anticipates that the variable costs will go up by 10% and fixed costs will go up by 15%.
You are required to prepare an Expense budget, on the basis of marginal cost for the company at 50%
and 60% level of activity and find out the profits at respective levels.
Ans. [ 30,000 units 36,000 units
Contribution ( ) R 6,21,000 7,45,200
Profit ( ) R 2,07,000 3,31,200]
22. Appex Co. can produce 4,000 units of a product at 100% capacity. Following information is available
from its records :
April May
Units produced 2,800 3,600
R R

Power 1,800 2,000

Repairs and Maintenance 500 560
Indirect Labour 700 900
Consumable Stores 1,400 1,800
Inspection 200 240
Depreciation 1,400 1,400
Salaries 1,000 1,000
Direct material cost per unit is R 1 and direct wages per hour is 4. Rate of production
R per hour is 10
units.
You are required to :
(i) Compute the cost of production at 100%, 80% and 60% capacity levels showing variable, fixed
and semi-variable items under the flexible budget.
(ii) Compute overhead absorption rate at 80% capacity.
Ans. [ (i) 60% 80% 100%
Variable Cost 5,160 6,880 8,600
Semi-variable Cost 2,350 2,650 2,950
Fixed Cost 2,400 2,400 2,400
(ii) Overhead rate per unit = 2.33]
R

23. The cost of an article at a capacity level of 5,000 units is given under A below. For a variation of 20% in
capacity above or below this level, the individual items vary as indicated under B below :
A B A B
R R

Material Cost 25,000 (100% Varying) Stores 1,000 (100% Varying)

Labour Cost 15,000 (100% Varying) Inspection 500 (20% Varying)
Power 1,250 (80% Varying) Depreciation 10,000 (100% Varying)
Repairs and Admn. Overheads 5,000 (25% Varying)
Maintenance 2,000 (75% Varying) Selling Overheads 3,000 (25% Varying)
Find the unit cost of the product at production levels of 4,000 units and 6,000 units. (B.Com. Panjab)
Ans. [Unit Cost at Production Level of 4,000 units = 12.91; Unit Cost at Production Level of 6,000 units =
R

R 12.32]
BUDGETARY CONTROL D/2·81

24. East and West enterprises is currently working at 50% capacity and produces 10,000 units. Estimate the
profits of the company when it works at 60% and 70% capacity.
At 60% capacity the raw material cost increases by 2% and the selling price falls by 3%. At 70% capacity
the raw material cost increases by 4% and the selling price falls by 5%.
At 50% capacity working the product costs 180 per unit and is sold at 200 per unit.
R R

The unit cost of 180 is made up as follows :

R

Material R 100 Factory Overheads R 20 (40% fixed)

Wages R 30 Administration Overheads R 30 (50% fixed)
(B.Com., Panjab)
Ans. [Profit at 60% Capacity R 1,90,000 ; Profit at 70% Capacity R 1,76,000]
25. Following overhead expenses relate to a cost centre operating at 50% of normal activity. Draw up a
flexible budget for the cost centre for operating at 75%, 100% and 125% of normal capacity. Indicate the
basis upon which you have estimated each item of expenses for the different operating levels :
R R

Foreman 60 Defective Work 25

Assistant Foreman 40 Consumable Stores 20
Inspectors 65 Overtime Bonus Nil
Shop Labourers 40 Machine Depreciation 110
Machinery Repairs 100
Ans. [Fixed Basis : Foreman ; Machine Depreciation. Variable Basis : Inspectors ; Defective Work. Semi-
variable Basis : Assistant Foreman ; Shop Labourers ; Machinery Repairs ; Overtime Bonus]
26.. G Ltd. is currently operating at 75% of its capacity. In the past two years the level of operations were
55% and 65% respectively. Presently, the production is 75,000 units. The company is planning for 85%
capacity level during 2023-24. The cost details are as follows:
55% 65% 75%
—————————————————————————————————————————————————————————

Particulars : R R R

Direct Material 11,00,000 13,00,000 15,00,000

Direct Labour 5,50,000 6,50,000 7,50,000
Factory Overheads 3,10,000 3,30,000 3,50,000
Selling Overheads 3,20,000 3,60,000 4,00,000
Administrative Overheads 1,60,000 1,60,000 1,60,000
——————————————— ———————————————— ————————————————

24,40,000
———————————————
28,00,000
————————————————
31,60,000
————————————————
——————————————— ———————————————— ————————————————

Profit is estimated @ 20% on sales. The following increases in costs are expected during the year :
Direct Material 8% Fixed Factory Overheads10%
Direct Labour 5% Fixed Selling Overheads15%
Variable Factory Overheads 5% Administrative Overheads 10%
Variable Selling Overheads 8%
Prepare a flexible budget for the period 2023-24 at 85% level of capacity and ascertain the profit on
sales.
Ans. [At 85% Capacity : Total Cost 37,85,200 and Profit 9,46,300]
R R

27. Following data are available in a manufacturing company for a year period :
Fixed Expenses R (lakhs) R (lakhs)
Wages and salaries 9.5 Sales department salaries etc. 3.8
Rent, rates and taxes 6.6 Sundry administrative expenses 2.8
D/2·82 BUDGETARY CONTROL

Depreciation 7.4 Variable Expenses (at 50% of capacity)

Sundry administrative expenses 6.5 Materials 21.7
Semi-variable Expenses (at 50% capacity) Labour 20.4
Maintenance and repairs 3.5 Other expenses 7.9
Indirect labour 7.9
Assume that the fixed expenses remain constant for all levels of production, semi-variable expenses
remain constant between 45% and 65% of capacity increasing by 10% between 65% and 80% capacity
and by 20% between 80% and 100% capacity.
Sales at various levels are :
R (lakhs) R (lakhs)
50% capacity 100 90% capacity 180
60% capacity 120 100% capacity 200
75% capacity 150
Prepare a flexible budget for the year and forecast the profits at 60%, 75%, 90% and 100% of capacity.
Ans. [Profit 50% 60% 75% 90% 100%
R (lakhs) 2.00 12.00 25.20 38.40 48.40]
28.. The following information pertains to a production department of a manufacturing company :
Particulars R R per hour
—————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————————

Indirect Wages 40
Repairs : Upto 2,000 hours 10,000
For each additional 500 hours up to a total of 4,000 hours 3,500
Additional amount for 4,001 to 5,000 hours 6,000
Additional amount beyond 5,000 hours 7,000
Rent and Rates 35,000
Power : Upto 3,600 hours 25
Above 3,600 hours 30
Consumable supplies 24
Depreciation upto 100% of budgeted activity. Beyond this level,
10% increase for every 10% increase in activity or part thereof. 65,000
Cleaning and Lighting
Upto 4,000 hours 18,000
Above 4,000 hours 23,000
The budgeted level of activity is 5,000 hours in a production period.
Prepare the overhead budget with the break-up of each item of cost given above for activity levels at
70% and 110% of the budgeted volume. Compare the budgeted overhead rate per hour and the
overhead rates per hour at the above levels. Comment on these rates.
Ans. 5,000 hrs. 3,500 hrs. 5,500 hrs.
(70% level) (110 days)
Overhead Rate per hour ( ) R 121 128.57 121
Comment : There is not likely to be any significant under or over absorption to have a
supplementary rate as overhead rates are fixed at a reasonable cost.
BUDGETARY CONTROL D/2·83

CONTROL RATIOS
29. Calculate :
(i) Efficiency Ratio; (ii) Activity Ratio; (iii) Capacity Ratio
from the following information :
Budgeted Production 880 units
Budgeted Hours per unit 10
Actual Production 750 units
Actual Hours taken 6,000
Ans. [(i) 125%; (ii) 85.23%; (iii) 68.18%]
30. In a manufacturing shop Product X requires 2.5 man hours and Product Y requires 6 man hours. In a
month of 25 working days of 8 hours a day, 2,000 units of X and 1,000 units of Y were produced. The
company employs 50 workers in the shop and the budgeted man hours are 1,08,000 for the year. You
are required to work out the capacity ratio, activity ratio and efficiency ratio.
Ans. [Capacity Ratio = 111.11% ; Activity Ratio = 122.22% ; Efficiency Ratio = 110%]
31. From the following data, calculate Activity Ratio, Capacity Ratio and Efficiency Ratio :
A factory manufactures two products ‘A’ and ‘B’. Standard time to manufacture product ‘A’ is 2 hours
and product ‘B’ 10 hours. The budgeted and actual production in December, 2023 were as follows :
Budgeted Production Actual Production
Product ‘A’ 125 units 100 units
Product ‘B’ 30 units 24 units
Total actual hours worked were 660.
2
Ans. [80% ; 120% ; 663 %]
32. (Master Budget) GMR Ltd. has supplied the following summary of its operating results for the year
ending 31st March 2023 :
lakhs R

Sales (40,000 units) 48.00

Less : Trade Discount 2.40
—————————

Net Sales 45.60

—————————

Cost of Sales : R lakhs lakhs

R

Direct Materials 14.40 Administration Overheads 3.60

Direct Wages 12.60 Selling and Distribution Overheads 4.50
Factory Overheads 6.30
Following changes are to be incorporated in the budget for the year ending 31st March, 2024 :
(i) Sales quantity to be increased by 25%.
(ii) Material prices to increase by 15%.
(iii) Direct wage rates to go up by 12%.
(iv) Factory overheads will increase by 15%. In addition, a new facility will be added to the factory
laboratory at a recurring cost of 12,500 per annum.
R

(v) Administration and selling and distribution overheads are estimated to go up by 10% and 14%
respectively.
(vi) There will be no change in the rate of trade discount.
(vii) There will be no change in inventory.
You are required to present the budget for the year ending 31st March, 2024 showing the details of total
cost, sales and profit.
Ans. [Profit 2.20 lakhs]
R
1

FLEXIBLE BUDGET
for the year ending 30th June, 2023
Volume of Production Volume of Production Volume of Production
1,20,000 units 1,50,000 units 1,40,000 units
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Per unit Total Per unit Total Per unit Total
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R R R R R R
Direct Material 7.00 8,40,000 7.00 10,50,000 7.00 9,80,000
Direct Labour (1.6 hrs. @ R 2.50) 4.00 4,80,000 4.00 6,00,000 4.00 5,60,000
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Prime Cost 11.00 13,20,000 11.00 16,50,000 11.00 15,40,000

Manufacturing Overhead :
Variable :
Indirect Material 2.20 2,64,000 2.20 3,30,000 2.20 3,08,000
Indirect Labour 1.25 1,50,000 1.25 1,87,500 1.25 1,75,000
Inspection 0.75 90,000 0.75 1,12,500 0.75 1,05,000
Semi-Variable :
Maintenance 0.70 84,000 0.68 1,02,000 0.69 96,000
Supervision 1.65 1,98,000 1.56 2,34,000 1.59 2,22,000
Fixed :
Depreciation—Plant and Equipment 0.75 90,000 0.60 90,000 0.64 90,000
Engineering Services 0.78 94,000 0.63 94,000 0.67 94,000
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Works Cost 19.08 22,90,000 18.67 28,00,000 18.79 26,30,000

Fixed Selling & Admn. Expenses 0.71 85,000 0.57 85,000 0.61 85,000
Selling Commission (Variable) 1.00 1,20,000 1.00 1,50,000 1.00 1,40,000
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Total Cost 20.79 24,95,000 20.24 30,35,000 20.40 28,55,000

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