COST AND WORKS

ACCOUNTING-II

B.Com
Third Year
305E

SAVITRIBAI PHULE PUNE UNIVERSITY

School of Open Learning
(Distance Education Program)
Authors:
M N Arora, Ex-Associate Professor, Department of Commerce, Hans Raj College, Delhi University
Units: (1.2, 1.3, 2, 3, 4.2-4.2.2, 5, 6, 7.2-7.2.1, 7.3, 8.2-8.4 )
Abhijit Chatterjee, Assistant Professor (MBA), Institute of Advanced Management and Research, Affiliated to Dr A.P.J Abdul
Kalam Technical University Duhai, Ghaziabad
Units: (1.3.2-1.3.3, 7.4, 8.6 )
M A Sahaf, Professor, The Business School University of Kashmir, Srinagar
Units: (4.3-4.5, 8.5)
Vikas Publishing House: (1.0-1.1, 1.3.1, 1.3.4-1.8, 4.0-4.1, 4.6-4.10, 7.0-7.1, 7.5-7.9, 8.0-8.1, 8.7-8.11)
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 SYLLABI-BOOK MAPPING TABLE
Cost and Works Accounting-II
Syllabi Mapping in Book

Unit 1: Overheads
1.1 Meaning and Definition of Overheads. Unit 1: Overheads
1.2 Classification of Overheads (Pages 1-19)
1.3 Introduction to Cost Accounting Standard, Cost Accounting Standard Board
1.4 Introduction to of CA 3, CA 11, CAS 15
1.5 Cost Accounting Standard 3: Production and Operation Overheads

Unit 2: Accounting of Overheads

2.1 Collection and Allocation of Overheads. Unit 2: Accounting of
2.2 Apportionment and Reapportionment of Overheads (Part-I) Overheads (Part I)
2.3 Simple Problem of Primary Distribution of Overhead (Pages 21-33)
2.4 Simple Problem of Secondary Distribution of Overheads (Repeated & Simultaneous
Equation Method Only)

Unit 3: Accounting of Overheads (Part-II)

3.1 Absorption - Meaning, Rate and Methods of Overhead Absorption Unit 3: Accounting of
3.2 Under and Over Absorption of Overheads - Meaning, Reasons and Accounting Overheads (Part-II)
Treatment (Pages 35-54)
3.3 Simple Problems on the Accounting Treatment of under and Over Absorption of
Overheads

Unit 4: Activity Based Costing

4.1 Definitions-Stages in Activity Based Costing Unit 4: Activity Based Costing
4.2 Purpose and Benefits of Activity Based Costing (Pages 55-73)
4.3 Cost Pools and Cost Drivers
4.4 Problems on Activity Based Costing [Simple Problems only]

Unit 5: Methods of Costing

5.1 Introduction to Methods of Costing Unit 5: Methods of Costing
5.2 Job Costing Meaning, Features, Advantages and Limitations (Simple problems (Pages 75-89)
Only)
5.3 Introduction of Batch Costing-(Theory Only)

Unit 6: Contract Costing

6.1 Meaning and Features of Contract Costing Unit 6: Contract Costing
6.2 Work-Certified and Uncertified, Escalation Clause, Retention Money, Cost Plus (Pages 91-103)
Contract, Work-In-Progress
6.3 Profit on Incomplete Contract
Unit 7: Process Costing
7.1 Meaning and Features of Process Costing Unit 7: Process Costing
7.2 Preparation of Process Accounts Including Normal and Abnormal Loss/Gain (Pages 105-136)
7.3 Joint Products and By Products (Theory and Simple Problems]
7.4 Cost Accounting Standard 19: Joint Cost

Unit 7: Service Costing

8.1 Meaning, Features and Applications of Service Costing Unit 8: Service Costing
8.2 Cost Unit-Simple and Composite (Pages 137-157)
8.3 Cost Sheet for Transportation Service
8.4 Cost Statement for Hospital and Hotel Organization
8.5 Cost Accounting Standard 13: Cost of Service Cost Center
 CONTENTS
INTRODUCTION

UNIT 1 OVERHEADS 1-19

1.0 Introduction
1.1 Objectives
1.2 Meaning and Definition of Overheads
1.2.1 Classification of Overheads
1.3 Introduction to Cost Accounting Standard and Cost Accounting Standard Board
1.3.1 Introduction to Cas 3
1.3.2 Cas 11: Cost Accounting Standard on Administrative Overheads
1.3.3 Cas 15: Cost Accounting Standard on Selling and Distribution Overheads
1.3.4 Cost Accounting Standard 3: Production and Operation Overheads
1.4 Answers to Check Your Progress Questions
1.5 Summary
1.6 Key Words
1.7 Self Assessment Questions and Exercises
1.8 Further Readings

UNIT 2 ACCOUNTING OF OVERHEADS (PART I) 21-33

2.0 Introduction
2.1 Objectives
2.2 Collection of Overheads
2.3 Allocation, Apportionment and Reapportionment of Overheads
2.3.1 Simple Problem of Primary Distribution of Overhead
2.3.2 Simple Problem of Secondary Distribution of Overheads (Repeated and Simultaneous Equation
Method Only)
2.4 Answers to Check Your Progress Questions
2.5 Summary
2.6 Key Words
2.7 Self Assessment Questions and Exercises
2.8 Further Readings

UNIT 3 ACCOUNTING OF OVERHEADS (PART-II) 35-54

3.0 Introduction
3.1 Objectives
3.2 Absorption: Meaning, Rate and Methods of Overhead Absorption
3.3 Under and Over Absorption of Overheads: Meaning, Reasons and Accounting Treatment
3.3.1 Simple Problems on the Accounting Treatment of Under And Overabsorption of Overheads
3.4 Answers to Check Your Progress Questions
3.5 Summary
3.6 Key Words
3.7 Self Assessment Questions and Exercises
 3.8 Further Readings

UNIT 4 ACTIVITY BASED COSTING 55-73

4.0 Introduction
4.1 Objectives
4.2 Definitions
4.2.1 Important Terms: Cost Drivers and Cost Pools
4.2.2 Stages in Activity Based Costing
4.3 Allocations Under ABC
4.4 Purpose and Benefits of Activity Based Costing
4.5 Problems on Activity Based Costing (Simple Problems Only)
4.6 Answers to Check Your Progress Questions
4.7 Summary
4.8 Key Words
4.9 Self Assessment Questions and Exercises
4.10 Further Readings

UNIT 5 METHODS OF COSTING 75-89

5.0 Introduction
5.1 Objectives
5.2 Introduction to Methods of Costing
5.3 Job Costing: Meaning, Features, Advantages and Limitations
(Simple Problems Only)
5.4 Introduction of Batch Costing (Theory Only)
5.5 Answers to Check Your Progress Questions
5.6 Summary
5.7 Key Words
5.8 Self Assessment Questions and Exercises
5.9 Further Readings

UNIT 6 CONTRACT COSTING 91-103

6.0 Introduction
6.1 Objectives
6.2 Meaning and Features of Contract Costing
6.2.1 Procedure
6.2.2 Work-Certified and Uncertified, Work-in-Progress and Retention Money
6.2.3 Cost–Plus Contract
6.2.4 Escalation Clause
6.3 Profit on Incomplete Contract
6.4 Answers to Check Your Progress Questions
6.5 Summary
6.6 Key Words
6.7 Self Assessment Questions and Exercises
6.8 Further Readings

UNIT 7 PROCESS COSTING 105-136

 7.0 Introduction
7.1 Objectives
7.2 Meaning and Features of Process Costing
7.2.1 Preparation of Process Accounts Including Normal and Abnormal Loss/Gain
7.3 Joint Products and By Products: Theory and Simple Problems
7.4 Cost Accounting Standard 19: Joint Cost
7.5 Answers to Check Your Progress Questions
7.6 Summary
7.7 Key Words
7.8 Self Assessment Questions and Exercises
7.9 Further Readings

UNIT 8 SERVICE COSTING 137-157

8.0 Introduction
8.1 Objectives
8.2 Meaning, Features and Applications of Service Costing
8.2.1 Cost Unit: Simple and Composite
8.3 Cost Sheet for Transportation Service
8.4 Cost Statement for Hospital
8.5 Cost Statement for Hotel Organization
8.6 Cost Accounting Standard 13: Cost of Service Cost Centre
8.7 Answers to Check Your Progress Questions
8.8 Summary
8.9 Key Words
8.10 Self Assessment Questions and Exercises
8.11 Further Readings
 INTRODUCTION

The business environment has undergone a revolutionary change due to free competition and globalization.
The whole world has become a global village where products and services are highly competitive. As a
result, cost accounting has gained special importance in all business activities. Modern industrial enterprises
now design cost accounting systems and procedures not only for providing historical data for cost
ascertainment but also for assisting the management in controlling and cost-reducing endeavours. As a
matter of fact, a cost accountant these days is now more concerned with providing relevant and significant
cost data to management for decision-making. Costing methods and techniques have also undergone a
revolutionary change in this process. New techniques and procedures are being devised by cost accountants
for better cost management.
There was a strong need to come up with guidelines that could provide guidance to organizations,
government bodies, regulatory authorities, research agencies and academic institutions to achieve uniformity
and consistency in classification, measurement and assignment of cost to product and services. The Institute
of Cost Accountants of India, therefore, introduced 24 Cost Accounting Standards.
This book, Cost and Works Accounting-II, is written with the distance learning student in mind. It
is presented in a user-friendly format using a clear, lucid language. Each unit contains an Introduction and
a list of Objectives to prepare the student for what to expect in the text. At the end of each unit are a
Summary and a list of Key Words, to aid in recollection of concepts learnt. All units contain Self-Assessment
Questions and Exercises, and strategically placed Check Your Progress questions so the student can keep
track of what has been discussed.
 Overheads

UNIT 1 OVERHEADS
Structure NOTES
1.0 Introduction
1.1 Objectives
1.2 Meaning and Definition of Overheads
1.2.1 Classification of Overheads
1.3 Introduction to Cost Accounting Standard and Cost Accounting Standard Board
1.3.1 Introduction to Cas 3
1.3.2 Cas 11: Cost Accounting Standard on Administrative Overheads
1.3.3 Cas 15: Cost Accounting Standard on Selling and Distribution Overheads
1.3.4 Cost Accounting Standard 3: Production and Operation Overheads
1.4 Answers to Check Your Progress Questions
1.5 Summary
1.6 Key Words
1.7 Self Assessment Questions and Exercises
1.8 Further Readings

1.0 INTRODUCTION

There are many different costs which are incurred by business. Not all these expenses
are directly attributable for the production of products and services. Overheads are
costs for running or operating a business. It constitutes all indirect material, labour and
administrative expenses. Interests, repairs, rent, utilities, and Overhead costing is crucial
because it has an indirect impact on the financial statements of the business. Overhead
costing is important to help companies monitor their expenses and keep them within a
reasonable level without affecting profits. It assists companies in setting prices for the
products. Overheads are also crucial for overall calculation of profits. In this unit, you
will learn about the meaning, definition of overheads and describe its classification.
Further, you will study about the Cost Accounting Standards Board and be briefly
introduced to CAS 3, 11 and 15.

1.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the meaning and definition of overheads
 Describe the classifications of overheads
 Discuss the Cost Accounting Standards and Cost Accounting Standards Board
 Describe the CAS 3, 11 and 15

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Overheads
1.2 MEANING AND DEFINITION OF OVERHEADS

Total cost may be classified into direct cost and indirect cost. The total of all direct
NOTES costs (i.e., direct material cost, direct labour cost and direct expenses) is known as
Prime cost and the total of all indirect costs (i.e., indirect material cost, indirect labour
cost and indirect expenses) is termed as Overhead cost. Various other names of
overheads are: (a) oncost; (b) supplementary cost; (c) burden; (d) non-productive
cost, etc.
Some of the authoritative definitions of overheads are reproduced below:
1. ‘Overhead is the aggregate of indirect materials, indirect wages and
indirect expenses.’
—CIMA, London
2. ‘Overhead may be defined as the cost of indirect materials, indirect
labour and such other expenses, including services as cannot
conveniently be charged direct to specific cost units. Alternatively,
overheads are all expenses other than direct expenses.’
—Wheldon
3. ‘Overheads are those costs which do not result from existence of
individual cost units.’
—Harper
4. ‘Overhead costs are the operating costs of a business enterprise which
cannot be traced directly to a particular unit of output.’
—Blocker and Weltmer
Thus, overhead cost is the total of all indirect expenditure. It comprises those
costs which the cost accountant is either unable or unwilling to allocate to particular
cost units.
Accounting and control of overhead costs is more complex than that of other
elements of cost, i.e., direct materials and direct labour. This is because overheads by
definition, are indirect costs which cannot be conveniently allocated to cost units. Hence,
there arises the knotty problem of apportioning these indirect costs to cost centres and
cost units.
1.2.1 Classification of Overheads
Overhead costs may be classified according to:
1. Functions
2. Elements
3. Behaviour
Let’s discuss each of these categorizations one by one.
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1. Classification according to Functions Overheads

The main groups of overheads on the basis of this classification are as follows:
(a) Production overheads: Also termed as factory overheads, works overheads
or manufacturing overheads, they are indirect expenditures incurred in connection NOTES
with production operations. They are the aggregate of factory indirect material
cost, indirect wages and indirect expenses. Unlike direct materials and direct
labour, production overheads are an invisible part of the finished product.
Examples of these overheads are: lubricants, consumable stores, indirect wages,
factory power and light, depreciation of plant and machinery, depreciation of
factory building, insurance of plant and factory building, storekeeping expenses,
repairs and maintenance.
(b) Administration overheads: These overheads are of general nature and consist
of all costs incurred in the direction, control and administration (including
secretarial, accounting and financial control) of an undertaking, which are not
related directly to production or selling and distribution function. Examples are:
general management salaries, audit fees, legal charges, postage and telephone,
stationery and printing, office rent and rates, office lighting and salaries of office
staff. These overheads are also known as office overheads or general overheads.
(c) Selling and distribution overheads: Selling overheads are the cost of seeking
to create and stimulate demand or of securing orders. Examples: advertising,
salaries and commission of sales personnel, showroom expenses, travelling
expenses, bad debts, catalogues and price lists.
Distribution overheads comprise all expenditures incurred from the time product
is completed in the factory till it reaches its destination or customer. It includes
packing cost, carriage outward, delivery van expenses, warehousing costs, etc.
Selling overheads and distribution overheads are both related to sales function
and thus are combined into one category of selling and distribution overheads.
These are often referred to as ‘after production costs’ because these costs are
incurred after production work is over.
2. Element-wise Classification
Under this method, the classification is done according to the nature and sources of
the expenditure. This method follows logically from the definition of overhead costs.
On this basis, expenses are classified under three main groups given below:
(a) Indirect materials: They are material costs, which cannot be allocated but
which are to be apportioned to or absorbed by cost centres or cost units.
Examples are stationery, coal, lubricants and tools for general use.
(b) Indirect wages: Indirect wages are those which cannot be allocated but which
are to be apportioned to or absorbed by cost centres or cost units. Examples
are wages of sweeper, idle time wages, maintenance and repair wages, foreman’s
pay and chowkidar’s pay.
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Overheads (c) Indirect expenses: Expenses which cannot be allocated but which are to be
apportioned to or absorbed by cost centres or cost units are indirect expenses.
For example, power, depreciation, insurance, taxes and rates and rent.

NOTES 3. Classification according to Behaviour or Variability

Different overhead costs behave in different ways when volume of production changes.
On the basis of behaviour, overheads may be classified into: (a) Fixed overheads; (b)
Variable overheads; and (c) Semi-fixed or semi-variable overheads.
(a) Fixed overheads: These overheads remain unaffected or fixed in total amount
by fluctuations in volume of output. Examples are rent and rates, managerial
salaries, building depreciation, postage, stationery and legal expenses.
(b) Variable overheads: This is the cost which, in aggregate, tends to vary in
direct proportion to changes in the volume of output. Variable overheads per
unit remain fixed. Examples are indirect materials, indirect labour, salesmen’s
commission, power, light, fuel, etc.
(c) Semi-variable overheads: These overheads are partly fixed and partly variable.
In other words, semi-variable overhead costs vary in part with the volume of
production and in part they are constant, whenever there is a change in volume
of production. Examples are supervisory salaries, depreciation, repairs and
maintenance, etc.
Importance of Classifying Costs into Fixed and Variable
The fixed-variable cost classification is of great importance in planning, decision making
and control as discussed below:
1. Preparation of budgets: This classification helps in the preparation of budgets.
For instance, when flexible budgets are prepared for different levels of activity,
the fixed cost remains constant at all levels of activity, whereas variable cost
varies according to the actual level of output.
2. Decision making: As most problems of decision making relate to changes in
volume, this classification acquires a special importance in managerial decision
making. This is so because fixed and variable costs behave in different ways
when volume of output changes.
3. Control of costs: From control point of view, cost may be controllable or
uncontrollable. The fixed costs are mostly uncontrollable and if any control can
be exercised, it can be done by the top management. Variable costs, on the
other hand, are mostly controllable. For example, rent of building (fixed) is not
easily controllable but cost of materials (variable) may be controlled by purchasing
in economical lots, seasonal purchasing, etc. Classifying costs into fixed and
variable, therefore, helps in the effective control of costs by pointing out where
management should concentrate to control costs.
4. Marginal costing and break-even analysis: This technique is totally
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dependent on segregation of cost into fixed and variable.
4 Material
 5. Absorption of overheads: By classifying costs into fixed and variable, separate Overheads

rates of absorption of overheads may be used for fixed and variable overheads.
The under/over-absorption arising out of two types of overheads are different
in nature andneed different managerial action. For example, under-absorption
of fixed overheads means the existence of surplus or idle capacity so suitable NOTES
steps may be taken to effectively utilize idle capacity.
6. Other uses: In addition to points stated above, fixed-variable cost classification
is useful in many other areas. For example, while planning capital expenditure,
effect of the proposed project on total fixed and variable costs should be studied.
Moreover, differential and comparative cost analysis are based on this
classification.
Segregation of Semi-variable Costs
The main purpose of classifying overhead costs into fixed and variable is to help the
management in decision making and control of expenditure As such, the semi-variable
costs may present some problems and thus the cost accountant must split them into
fixed and variable components. In other words, the extent to which an item of semi-
fixed or semi-variable cost is fixed or variable has to be determined. The following
methods are used for this purpose:
1. High and low points method
Under this method, semi-variable costs at various level of output are considered. The
difference between the highest and the lowest volume of output and the difference
between the corresponding costs are worked out. Then the variable element per unit
of output is calculated by applying the following formula:
Difference in sem i-variable costs ( )
Variable element per unit =
Difference in ou tpu t (u nits)
2. Method of averages
Under this method, data given is divided into two parts. Then average of output and
cost is separately computed for these two parts. Variable element in the cost is then
calculated by the following method:
Difference in the average costs
Variable element per unit =
Difference in average ou tpu t

3. Scatter diagram method

This is a graphic method. Under this method, the semi-variable costs incurred at levels
of output are plotted on a graph, the X-axis of which represents the volume of production
and Y-axis, the amount of expenditure. After plotting the points on the graph, a straight
line is drawn in such a way as to represent an average of all those points. This is known
as the line of best fit or line of regression. The point where this line of best fit
interacts the X-axis, marks the fixed cost. A line from this point is drawn which is
parallel to X-axis. This is fixed cost line. The difference between semi-variable cost
line and fixed cost line represents variable component.
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Overheads 4. Simultaneous Equations Method
In this method, overhead costs are segregated by means of an equation. This equation
for a straight line is:
NOTES Y = mX + c
where Y = Total semi-variable cost
X = Volume of output
c = Fixed cost
m = Slope of variable cost line, i.e., variable cost per unit of output.
For the purpose of separating fixed and variable components of the cost, the
overhead cost is determined at various levels of output and pairs of values of X and Y
are fitted in the above formula in order to compute the values of m and c.
Standing Order Numbers (Codification of Overheads)
After overheads are classified, it is found useful to allot a number or symbol to each
group of expenses so that each such group is easily distinguished from others. Such
numbers or symbols are codes for overheads and are called standing order numbers.
Each standing order number denotes a particular type of expenditure so that items of
expenses of similar nature, as and when they are incurred, are appropriately classified
into one of these. A schedule or manual is maintained enlisting all standing order numbers.
There cannot be a standard list of standing order numbers as the number and type
under which overheads may be sub-grouped vary with the: (a) size of the factory; (b)
type of expenses; and (c) the extent of control necessary.
Utility
Use of code numbers is preferred to lengthy names of overhead items because of the
following reasons:
 It is convenient to write a code number in place of an overhead item.
 Use of code numbers helps in maintaining secrecy because item name is not
revealed at the time of posting and processing of cost data.
 Clerical effort is reduced as length in description is minimized.
 Coding is essential in mechanized accounting.

Check Your Progress

1. What are some of the other names of overheads?
2. Why is accounting and control of overhead costs more complex than that of
other elements of cost?
3. Mention examples of administration overheads.
4. Which type of overheads include 'power, depreciation, insurance, taxes and
rates and rent'?
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 Overheads
1.3 INTRODUCTION TO COST ACCOUNTING
STANDARD AND COST ACCOUNTING
STANDARD BOARD
NOTES
The Institute of Cost Accountants of India (ICAI), recognizing the need for a structured
approach to the measurement of cost in manufacture or service sector and to provide
guidance to user organizations, government bodies, regulators, research agencies and
academic institutions to achieve uniformity and consistency in classification, measurement
and assignment of cost to product and services, has constituted Cost Accounting
Standards Board (CASB) with the objective of formulating Cost Accounting Standards.
CASB has so far issued 14 Cost Accounting Standards as given below:
Table 1.1 Cost Accounting Standards

CAS No Title Objective

CAS1 Classification of Cost For preparation of cost statements.
CAS2 Capacity Determination For determination of capacity.
CAS3 Overheads For collection, allocation, apportionment and
absorption of Overheads.
CAS3 Overheads (Revised 2011) To bring uniformity and consistency in the
principles and methods of determining the
Overheads with reasonable accuracy.
CAS4 Cost of Production To determine the Assessable Value of
Excisable
for Captive Consumption Goods used for captive consumption.
CAS5 Average (equalized) To determine averaged/equalized
Transportation
Cost of Transportation Cost
CAS6 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.
CAS7 Employee Cost To bring uniformity and consistency in the
principles and methods of determining the
Employee cost with reasonable accuracy.
CAS8 Cost of Utilities To bring uniformity and consistency in the
principles and methods of determining the
Cost of Utilities with reasonable accuracy.

CAS9 Packing Material Cost To bring uniformity and consistency in the

principles and methods of determining the
Packing Material cost with reasonable
accuracy.
CAS10 Direct Expenses To bring uniformity and consistency in the
principles and methods of determining the
Direct Expenses with reasonable accuracy.

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Overheads CAS11 Administrative Overheads To bring uniformity and consistency in the
principles and methods of determining the
Administrative Over heads with reasonable
accuracy.
CAS12 Repairs and Maintenance Cost To bring uniformity and consistency in the
NOTES principles and methods of determining the
Repairs and Maintenance Cost with reasonable
accuracy.
CAS13 Cost of Service Cost Centre To bring uniformity and consistency in the
principles and 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.
The Council of the Institute has made it mandatory to apply Cost Accounting Standards
1 to 12, w.e.f. accounting period commencing on or after 1st April 2010 for the
preparation and certification of General Purpose Cost Accounting Statements. In case
any member of the Institute in practice is of the opinion that the aforesaid cost accounting
standards have not been complied with for the preparation of the cost statement, it
shall be his duty to make a suitable disclosure / qualification in his audit report / certificate.
1.3.1 Introduction to CAS 3
In this section, you will be introduced to some of the major CAS related to overheads.
This will include an introductory section on CAS 3, 11 and 15 dealing with production
and operation overheads, administrative overheads and selling and distribution
overheads.
CAS 3: Cost Accounting Standard on “PRODUCTION AND
OPERATION OVERHEADS” (Revised in 2015)
As mentioned on ICAI’s website:
The following is the Cost Accounting Standard on PRODUCTION AND
OPERATION OVERHEADS (CAS-3) (Revised 2015) issued by the Council of the
Institute of Cost Accountants of India. This standard replaces CAS-3 (Revised 2011)
on Overheads.
1. Introduction
1.1 This standard deals with the principles and methods of determining the Production
or Operation Overheads.
1.2 This standard deals with the principles and methods of classification, measurement
and assignment of Production or Operation Overheads, for determination of
the cost of goods produced or services provided and for the presentation and
disclosure in cost statements.

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2. Objective Overheads

The objective of this standard is to bring uniformity and consistency in the principles
and methods of determining the Production or Operation Overheads with reasonable
accuracy. NOTES
3. Scope
This standard shall be applied to cost statements, which require classification,
measurement, assignment, presentation and disclosure of Production or Operation
Overheads including those requiring attestation.
You will learn more about this standard in the next section of this unit.
1.3.2 CAS 11: Cost Accounting Standard on Administrative Overheads
The following is the COST ACCOUNTING STANDARD – (CAS-11) issued by
the Council of The Institute of Cost Accountants of India on “ADMINISTRATIVE
OVERHEADS”. In this Standard, the standard portions have been set in bold italic
type. This standard should be read in the context of the background material which
has been set in normal type. Kindly note, since this is only an introduction only some
parts of the CAS 11 are being discussed here.
1. Introduction
1.1 This standard deals with the principles and methods of determining the
administrative overheads.
1.2 This standard deals with the principles and methods of classification,
measurement and assignment of administrative overheads, for
determination of the Cost of product or service, and the presentation and
disclosure in cost statements.
2. Objective
The objective of this standard is to bring uniformity and consistency in the principles
and methods of determining the administrative overheads with reasonable accuracy.
3. Scope
This standard should be applied to cost statements, which require classification,
measurement, assignment, presentation and disclosure of administrative overheads
including those requiring attestation.
5. Principles of Measurement
5.1 Administrative overheads shall be the aggregate of cost of resources
consumed in activities relating to general management and administration
of an organisation.
It usually represents the cost of shared services, cost of infrastructure and general
management costs. Administrative overheads comprise items such as employee Self-Instructional
Material 9
Overheads costs, utilities, office supplies, legal expenses and outside services. The principles
of measurement of Material Cost, Employee Costs, Utilities, Repairs and
Maintenance and Depreciation found in the respective standards will apply to
these elements included in administrative overheads.
NOTES
5.2 In case of leased assets, if the lease is an operating lease, the entire rentals
shall be included in the administrative overheads. If the lease is a financial
lease, the finance cost portion shall be segregated and treated as part of
finance costs.
5.3 The cost of software (developed in house, purchased, licensed or
customized), including up-gradation cost shall be amortised over its
estimated useful life.
When hardware requires up-gradation along with software up-gradation, it is
recommended that compatible estimated lives be used for the two sets of cost.
5.4 The cost of administrative services procured from outside shall be
determined at invoice or agreed price including duties and taxes, and other
expenditure directly attributable thereto net of discounts (other than cash
discount), taxes and duties refundable or to be credited.
5.5 Any Subsidy/Grant/Incentive or any amount of similar nature received/
receivable with respect to any Administrative overheads shall be reduced
for ascertainment of the cost of the cost object to which such amounts are
related.
5.6 Administrative overheads shall not include any abnormal administrative
cost. Example: Expense incurred in a situation of natural calamity.
5.7 Fines, penalties, damages and similar levies paid to statutory authorities
or other third parties shall not form part of the administrative overheads.
5.8 Credits/ recoveries relating to the administrative overheads including those
rendered without any consideration, material and quantifiable, shall be
deducted to arrive at the net administrative overheads.
5.9 Any change in the cost accounting principles applied for the measurement
of the administrative overheads should be made only if it is required by
law or for compliance with the requirements of a cost accounting standard
or a change would result in a more appropriate preparation or presentation
of cost statements of an organisation.
6. Assignment of Cost
6.1 While assigning administrative overheads, traceability to a cost object in
an economically feasible manner shall be the guiding principle.
6.2 Assignment of administrative overheads to the cost objects shall be based
on either of the following two principles;
(i) Cause and Effect - Cause is the process or operation or activity and effect
is the incurrence of cost.
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10 Material
 (ii) Benefits received – overheads are to be apportioned to the various cost Overheads

objects in proportion to the benefits received by them (Adapted from of

CAS 3 Para 5.1).
The costs of shared services should be assigned to user activities on the basis of
actual usage. NOTES
Where the resources by way of infrastructure are shared the cost should be
assigned on a readiness to serve basis.
General management costs should be assigned on rational basis.
For example: Number of employees, turnover, investment size etc.
1.3.3 CAS 15: Cost Accounting Standard on Selling and Distribution
Overheads
The following is the COST ACCOUNTING STANDARD-15 (CAS-15) issued by
the Council of The Institute of Cost Accountants of India on “SELLING AND
DISTRIBUTION OVERHEADS”. In this standard, the standard portions have
been set in bold italic type. These are to be read in the context of the background
material which has been set in normal type. Kindly note, since this is only an introduction
only some parts of the CAS 11 are being discussed here.
1. Introduction
This standard deals with the principles and methods of determining the Selling and
Distribution Overheads.
This standard deals with the principles and methods of classification, measurement
and assignment of Selling and Distribution Overheads, for determination of the cost of
sales of product or service, and the presentation and disclosure in cost statements.
2. Objective
The objective of this standard is to bring uniformity and consistency in the principles
and methods of determining the Selling and Distribution Overheads with reasonable
accuracy.
3. Scope
This standard should be applied to cost statements, which require classification,
measurement, assignment, presentation and disclosure of Selling and Distribution
Overheads including those requiring attestation.
5. Principles of Measurement
5.1 Selling and Distribution Overheads shall be the aggregate of the cost of
resources consumed in the selling and distribution activities of the entity.
The cost of resources procured from outside shall be determined at invoice
or agreed price including duties and taxes, and other expenditure directly
attributable there to net of discounts (other than cash discounts), taxes
and duties refundable or to be credited by the Tax Authorities. Self-Instructional
Material 11
Overheads Post sales costs such as warranty cost, product liability cost, after sales service
shall be estimated on a reasonable basis.
5.2 Selling and Distribution Overheads, the benefits of which are expected to
be derived over a long period, shall be amortised on a rational basis.
NOTES
5.3 Selling and distribution overheads shall not include imputed cost.
5.4 Cost of after Sales Service provided in terms of sale agreement for a class
of transactions, shall be determined on rational and scientific basis, net of
any recovery on the service.
5.5 Any Subsidy / Grant / Incentive or any such payment received / receivable
with respect to any Selling and Distribution Overheads shall be reduced
from the cost of the sales of the cost object.
5.6 Any abnormal cost relating to selling and distribution activity shall be
excluded from the Selling and Distribution Overheads.
5.7 Any demurrage or detention charges, or penalty levied by transportation
or other authorities in respect of distribution activity shall not form part
of the Selling and Distribution Overhead.
5.8 Penalties and damages paid to statutory authorities or other third parties
shall not form part of the Selling and Distribution Overheads.
5.9 Credits / recoveries relating to the Selling and Distribution Overheads
including those rendered without any consideration, material and
quantifiable, shall be deducted to arrive at the net Selling and Distribution
Overheads.
5.10 Any change in the cost accounting principles applied for the measurement
of the Selling and Distribution Overheads shall be made only if it is required
by law or for compliance with the requirements of a cost accounting
standard or a change would result in a more appropriate preparation or
presentation of cost statements of an entity.
6. Assignment of Cost
6.1 Selling and Distribution Overheads directly traceable shall be assigned to
the relevant product sold or services rendered.
6.2 Transportation cost relating to distribution shall be assigned as per CAS –
5, where relevant and applicable.
6.3 Assignment of Selling and Distribution Overheads to the cost objects shall
be based on either of the following two principles;
(i) Cause and Effect - Cause is the process or operation or activity and effect
is the incurrence of cost.
(ii) Benefits received – overheads are to be apportioned to the various
cost objects in proportion to the benefits received by them.

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12 Material
1.3.4 Cost Accounting Standard 3: Production and Operation Overheads Overheads

4. Definitions
The following terms are being used in this standard with the meaning specified. NOTES
4.1 Abnormal cost: An unusual or atypical cost whose occurrence is usually irregular
and unexpected or due to some abnormal situation of the production or operation.
4.2 Absorption of Production or Operation Overheads: Assigning of Production
or Operation Overheads to cost objects by means of appropriate absorption
rate.
Overhead Absorption Rate = Production or Operation Overheads of the Activity
divided by the volume of activity.
For example, the rate obtained by dividing the overheads of a Machine Shop
by machine hours.
4.3 Administrative Overheads: Cost of all activities relating to general management
and administration of an entity.
Administrative overheads shall exclude production overheads, marketing
overheads and finance cost. Production overheads includes administration cost
relating to production, factory, works or manufacturing.
4.4 Cost Centre: Any unit of an entity selected with a view to accumulating all
costs under that unit. The unit can be division, department, section, group of
plant and machinery, group of employees or combination of several units.
A cost centre includes a process, function, activity, location, item of equipment,
group of persons or any other unit in relation to which costs are accumulated.
4.5 Cost Object: An activity, contract, cost centre, customer, process, product,
project, service or any other object for which costs are ascertained.
4.6 Fixed costs: Fixed costs are costs which do not vary with the change in the
volume of activity. Fixed indirect costs are termed fixed overheads.
4.7 Imputed Cost: Notional cost, not involving cash outlay, computed for any
purpose.
4.8 Indirect Employee Cost: Employee cost, which cannot be directly attributed
to a particular cost object.
4.9 Indirect Expenses: Expenses, which cannot be directly attributed to a particular
cost object.
4.10 Indirect Material Cost: Material cost that cannot be directly attributed to a
particular cost object.
4.11 Normal capacity: Normal capacity is the volume of production or services
achieved or achievable on an average over a period under normal circumstances
taking into account the reduction in capacity resulting from planned maintenance.

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Material 13
Overheads 4.12 Production or Operation Overheads: Indirect costs involved in the production
of a product or in providing service.
The terms Production Overheads, Operation Overheads, Factory Overheads,
Works Overheads and Manufacturing Overheads denote the same meaning
NOTES
and are used interchangeably.
Production or Operation Overheads include administration cost relating to
production, factory, works or manufacturing and providing of services.
In addition, Production or Operation Overheads shall also be classified on the
basis of behaviour such as variable Production or Operation Overheads, semi-
variable
Production or Operation Overheads and fixed Production or Operation
Overheads.
• Variable Production or Operation Overheads comprise of expenses which
vary in proportion to the change of volume of production or activity or services
provided.
• Semi Variable Costs are the costs that contain both fixed and variable
elements. They partly change with the change in the level of activity.
• Fixed overhead are indirect costs which do not vary with the change in the
volume of production or activity or service provided.
4.13 Standard Cost: A predetermined cost of a product or service based on technical
specifications and efficient operating conditions.
Standard costs are used as scale of reference to compare the actual cost with
the standard cost with a view to determine the variances, if any, and analyse the
causes of variances and take proper measure to control them. Standard costs
are also used for estimation.
4.14 Variable costs: Variable costs are the cost which tends to directly vary with
the volume of activity.
5. Principles of Measurement:
5.1 Production or Operation Overheads representing procurement of resources
shall be determined at invoice or agreed price including duties and taxes, and
other expenditure directly attributable thereto net of discounts (other than cash
discounts), taxes and duties refundable or to be credited.
5.2 Production or Operation Overheads other than those referred to in paragraph
5.1 shall be determined on the basis of cost incurred in connection therewith.
In case of machinery spare fabricated internally or a repair job carried out
internally, it will include cost incurred on material, employees and expenses.
5.3 Any abnormal cost where it is material and quantifiable shall not form part of the
Production or Operation Overheads.
5.4 Production or Operation Overheads shall not include imputed cost.
Self-Instructional 5.5 Production or Operation Overhead variances attributable to normal reasons
14 Material
shall be treated as part of Production or Operation Overheads. Overhead
 variances attributable to abnormal reasons shall be excluded from Production Overheads

or Operation Overheads.
5.6 Any subsidy, Grant, Incentive or amount of similar nature received or receivable
with respect to Production or Operation Overheads shall be reduced for
ascertainment of the cost of the cost object to which such amounts are related. NOTES
5.7 Fines, penalties, damages and similar levies paidor payable to statutory
authorities or other third parties shall not form part of the Production or Operation
Overheads.
5.8 Credits or recoveries relating to the Production or Operation Overheads, material
and quantifiable, shall be deducted from the total Production or Operation
overheads to arrive at the net Production or Operation Overheads. Where the
recovery exceeds the total Production or Operation Overheads, the balance
recovery shall be treated as other income.
5.9 Any change in the cost accounting principles applied for the measurement of the
Production or Operation Overheads shall be made only if, it is required by law
or for compliance with the requirements of a cost accounting standard, or a
change would result in a more appropriate preparation or presentation of cost
statements of an entity.
6. Assignment
6.1 While assigning Production or Operation Overheads, traceability to a cost object
in an economically feasible manner shall be the guiding principle. The cost which
can be traced directly to a cost object shall be directly assigned.
6.2 Assignment of Production or Operation Overheads to the cost objects shall be
based on either of the following two principles;
i) Cause and Effect - Cause is the process or operation or activity and effect
is the incurrence of cost.
ii) Benefits received – Production Overheads are to be apportioned to the
various cost objects in proportion to the benefits received by them.
In case of facilities created on a standby or ready to serve basis, the cost shall
be assigned on the basis of expected benefits instead of actual.
6.3 Absorption of Production or Operation Overheads shall be as follows:
6.3.1 The variable Production or Operation Overheads shall be absorbed to
products or services based on actual production.
6.3.2 The fixed Production or Operation Overheads shall be absorbed based
on the normal capacity.
7. Presentation
7.1 Production or Operation Overheads shall be presented as separate cost head.
7.2 If material, element wise and behaviour wise details of the Production or
Operation Overheads shall be presented.
7.3 Any under-absorption or over-absorption of Production or Operation Overheads Self-Instructional
Material 15
shall be presented in the reconciliation statement.
Overheads 8. Disclosures
8.1 The cost statements shall disclose the following:
1. The basis of assignment of Production or Operation Overheads to the cost
NOTES objects.
2. Production or Operation Overheads incurred in foreign exchange.
3. Production or Operation Overheads relating to resources received from or
supplied to related parties.
4. Any Subsidy, Grant, Incentive or any amount of similar nature received or
receivable reduced from Production or Operation Overheads.
5. Credits or recoveries relating to the Production or Operation Overheads.
6. Any abnormal cost not forming part of the Production or Operation
Overheads.
7. Any unabsorbed Production or Operation Overheads.
8.2 Disclosures shall be made only where material, significant and quantifiable.
8.3 Disclosures shall be made in the body of the Cost Statement or as a foot note or
as a separate schedule.
8.4 Any change in the cost accounting principles and methods applied for the
measurement and assignment of the Production or Operation Overheads during
the period covered by the cost statement which has a material effect on the
Production or Operation Overheads shall be disclosed. Where the effect of
such change is not ascertainable wholly or partly the fact shall be indicated.
9. Effective date
This Cost Accounting Standard shall be effective from the period commencing on or
after 1st April 2016 for being applied for the preparation and certification of General
Purpose Cost Accounting Statement.

Check Your Progress

5. How many Cost Accounting Standards have been issued thus far in India by
CASB?
6. State the scope of CAS 3.
7. Are fines, penalties, damages and similar levies paid to statutory authorities a
part of administrative overheads as per CAS 11?
8. How are subsidies and grant with respect to selling and distribution heads
treated as per CAS 15?
9. How are abnormal costs treated with respect to production and operation
overheads as per CAS 3?

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16 Material
 Overheads
1.4 ANSWERS TO CHECK YOUR PROGRESS
QUESTIONS

1. Various other names of overheads are: (a) oncost, (b) supplementary cost, (c) NOTES
burden and (d) non-productive costs.
2. Accounting and control of overhead costs more complex than that of other
elements of cost because overheads by definition are indirect costs which cannot
be conveniently allocated to cost units, Hence, there arises the knotty problem
of apportioning these indirect costs to cost centres and cost units.
3. Examples of administration overheads include general management salaries, audit
fees, legal charges, postage and telephone, stationery and printing, office rent
and rates, office lighting and salaries of office staff, etc.
4. Indirect expenses under element-wise classification of overheads include ‘power,
depreciation, insurance, taxes and rates and rent’.
5. The Cost Accounting Standards Board has so far issued 14 Cost Accounting
Standards.
6. CAS 3 shall be applied to cost statements, which require classification,
measurement, assignment, presentation and disclosure of Production or
Operation Overheads including those requiring attestation.
7. As per CAS 11, fines, penalties, damages and similar levies paid to statutory
authorities or other third parties shall not form part of the administrative
overheads.
8. As per CAS 15, any Subsidy / Grant / Incentive or any such payment received
/ receivable with respect to any Selling and Distribution Overheads shall be
reduced from the cost of the sales of the cost object.
9. As per CAS 3, any abnormal cost where it is material and quantifiable shall not
form part of the Production or Operation Overheads.

1.5 SUMMARY

 Total cost may be classified into direct cost and indirect cost.
 The total of all direct costs is known as Prime cost and the total of all indirect
costs is termed as Overhead cost.
 Overhead costs comprise those costs which the cost accountant is either unable
or unwilling to allocate to particular cost units.
 Overhead costs may be classified according to functions, elements and behaviour.
 The main groups of overheads on the basis of functions are production overheads,
administration overheads, and selling and distribution overheads.
 The three main groups of overheads under element-wise classification are indirect
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materials, indirect wages and indirect expenses. Material 17
Overheads  On the basis of behaviour, overheads may be classified as (a) Fixed overheads,
(b) Variable overheads and (c) Semi-fixed or semi-variable overheads.
 The following points highlight the importance of classifying costs into fixed and
variable components: preparation of budgets, decision making, control of costs,
NOTES
marginal costing and break-even analysis, absorption of overheads and other
uses.
 The semi-variable costs may present some problems and thus the cost accountant
must split them into fixed and variable components. The following methods are
used for this purpose: high and low points method, method of averages, scatter
diagram method and simultaneous equations method.
 After overheads are classified, it is found useful to allot a number or symbol to
each group of expenses so that each such group is easily distinguished from
others.
 The Institute of Cost Accountants of India (ICAI), recognizing the need for a
structured approach to the measurement of cost in manufacture or service sector
and to provide guidance to user organizations, government bodies, regulators,
research agencies and academic institutions to achieve uniformity and consistency
in classification, measurement and assignment of cost to product and services,
has constituted the Cost Accounting Standards Board.
 CAS 3 deals with the principles and methods of determining the Production or
Operation Overheads. This standard deals with the principles and methods of
classification, measurement and assignment of Production or Operation
Overheads, for determination of the cost of goods produced or services provided
and for the presentation and disclosure in cost statements.
 CAS 11 deals with the principles and methods of determining the administrative
overheads. This standard deals with the principles and methods of classification,
measurement and assignment of administrative overheads, for determination of
the Cost of product or service, and the presentation and disclosure in cost
statements.
 CAS 15 deals with the principles and methods of determining the Selling and
Distribution Overheads. This standard deals with the principles and methods of
classification, measurement and assignment of Selling and Distribution
Overheads, for determination of the cost of sales of product or service, and the
presentation and disclosure in cost statements.

1.6 KEY WORDS

 Overhead cost: It is the total of all indirect expenditure. It comprises those

costs which the cost accountant is either unable or unwilling to allocate to particular
cost units.

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18 Material
  Cost centre: It refers to any unit of an entity selected with a view to accumulating Overheads

all costs under that unit. The unit can be division, department, section, group of
plant and machinery, group of employees or combination of several units.
 Cost unit: It refers to the unit of amount of product/service/time which is used
NOTES
to represent or assess costs.

1.7 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. What does the total cost include? Mention its sub-elements.
2. Why is it important to classify costs into fixed and variable components?
3. What is codification of overheads? List the points of its utility.
4. Briefly explain the principle of measurement as mentioned under CAS 11.
5. Write a short note on the applicability, principle of measurement and assignment
as per CAS 15.
Long Answer Questions
1. Explain the classification of overheads.
2. Describe the segregation of semi-variable costs.
3. Discuss the definitions, principles of measurements and disclosures as mandated
by the CAS 3.

1.8 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:

Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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Material 19
 Accounting of

UNIT 2 ACCOUNTING OF Overheads (Part I)

OVERHEADS (PART I)
NOTES
Structure
2.0 Introduction
2.1 Objectives
2.2 Collection of Overheads
2.3 Allocation, Apportionment and Reapportionment of Overheads
2.3.1 Simple Problem of Primary Distribution of Overhead
2.3.2 Simple Problem of Secondary Distribution of Overheads (Repeated and
Simultaneous Equation Method Only)
2.4 Answers to Check Your Progress Questions
2.5 Summary
2.6 Key Words
2.7 Self Assessment Questions and Exercises
2.8 Further Readings

2.0 INTRODUCTION

In the previous unit, you learnt about the concept of overheads. Proper overhead
costing is very important for business to control their expenses. Overhead costing is a
complex process since it involves indirect expenses. Following a sequence of steps
allows accountants to deal with overhead costs better. There are certain predetermined
stages in overhead costing. These involved collection, classification, codification,
allocation, apportionment, reapportionment and absorption of overheads. In this unit,
you will learn about the sources of collection of overheads and the bases of allocation
and apportionment of overheads. While collection of overheads involved recording of
costs for ascertainment, allocation consists of apportionment of costs to cost units and
centres. Apportionment of costs is allocation of proportioned costs to cost centre and
units of different departments.
In this unit, you will learn about the allocation, apportionment and absorption of
overheads.

2.1 OBJECTIVES

After going through this unit, you will be able to:

 Discuss the collection of overheads
 Describe the allocation of overheads
 Explain the apportionment and reapportionment of overheads

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Material 21
Accounting of
Overheads (Part I) 2.2 COLLECTION OF OVERHEADS

Direct costs are charged direct to the cost centres or cost units without difficulty. But
NOTES this is not possible in overhead costs. Distribution of overhead costs to cost units is
one of the most complex problems of cost accounting. This is because overhead costs
cannot be identified with individual cost units and there are no accounting means of
exact distribution. Therefore, such costs are analysed and distributed to various cost
centres and cost units on arbitrary basis. For example, it is not possible to exactly
calculate the amount of rent that should be charged to a particular cost unit and thus, it
has to be distributed on some arbitrary basis. The cost accountant is constantly searching
for equitable bases to distribute overhead costs to units and divisions of business
enterprise and quite often he needs to exercise his own judgement in this regard. For
instance, he may apportion rent to various departments of the factory on the basis of
area occupied by each such department. Similarly, labour welfare expenses may be
apportioned on the basis of number of workers in each department. The procedure of
distribution of overhead costs is discussed below.
Steps in Overheads Distribution
Unlike direct materials and direct wages, overheads cannot be charged to cost units
directly. The various steps taken for distribution of overhead costs are as follows:
1. Classification and collection of overheads
2. Allocation and apportionment of overheads to production departments and
service departments
3. Re-apportionment of service department costs to production departments
4. Absorption of overheads of each production department in cost units
You have already learnt about the classification of overheads in the previous unit.
In this section, you will learn about the collection of overheads.
Allocation, apportionment and re-apportionment will be discussed in later
sections. The topic of absorption will be taken up in Unit 3.
Collection of Overheads
The procedure of classification of production overheads and of assigning standing
order (code) numbers has already been discussed. Such classification and codification
is pre-requisite for the collection of overheads.
Production overheads should be collected under standing order numbers. The
main sources from which overhead costs are collected are as follows:
(a) Invoice—for collection of indirect expenses, like rent, insurance, etc.
(b) Stores Requisitions—for collection of indirect materials.
(c) Wages Analysis Sheet—for collection of indirect wages.
(d) Journal entries—for collection of those overhead items which do not result in
Self-Instructional current cash outlay and need some adjustment, e.g., depreciation, charge in lieu
22 Material
of rent, outstanding rent, etc.
 Accounting of
2.3 ALLOCATION, APPORTIONMENT AND Overheads (Part I)

REAPPORTIONMENT OF OVERHEADS

After overhead costs have been collected under various standing order numbers, the NOTES
next step is to allocate and apportion the overheads to production and service
departments. Such allocation and apportionment is known as departmentalization or
primary distribution of overheads.
Departmentalization of overheads is the process of allocation and apportionment
of overheads to different departments or cost centres. For smooth and efficient working,
a factory is sub-divided into a number of departments, each of which denotes a particular
activity of the factory, e.g., purchase department, stores department, time-keeping
department, personnel department, crushing department and melting shop. These
departments are mainly of two types:
(a) Production departments; and
(b) Service departments.
These are discussed in the later pages.
Objectives of Departmentalization
Departmentalization of overheads serves the following purposes:
1. Ensures greater accuracy in cost ascertainment
2. Control of overhead costs
3. Use of different methods of absorption
4. Valuation of work-in-progress
5. Cost of service of departments
6. Forecasting and estimating
Allocation
Certain items of overhead costs can be directly identified with a particular department
or cost centre as having been incurred for that cost centre. Allotment of such costs to
departments or cost centres is known as allocation. Thus, allocation may be defined
as ‘the assignment of whole items of cost directly to a cost centre.’ In other words,
allocation is charging to a cost centre those overheads that result solely from the
existence of that cost centre. A point to be clearly understood is that allocation can be
made only when exact amount of overheads incurred in a cost centre is definitely
known. For example, rent cannot normally be allocated since rent is payable for the
factory as a whole and exact amount of rent for each department cannot be known.
Indirect materials, on the other hand, can be easily allocated to various departments in
which they are incurred. Other items which are allocated include indirect wages, overtime
and idle time cost, power (when sub-metres are installed in departments), depreciation
of machinery, supervision, etc.
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Material 23
Accounting of In brief, in order that an overheads can be allocated, they should meet both of the
Overheads (Part I)
following conditions:
(a) The cost centre must have caused the overhead cost to be incurred; and
NOTES (b) The exact amount incurred in a cost centre must be known.
Apportionment

Certain overhead costs cannot be directly charged to a department or cost centre.

Such costs are common to a number of cost centres or departments and do not originate
from any specific department. Distribution of such overhead costs to various
departments is known as apportionment. Thus, apportionment may be defined as ‘the
distribution of overheads to more than one cost centre, on some equitable basis.’
In other words, it is charging a fair share of an overhead cost to a cost centre. Where
an item of overhead cost is common to various cost centres, it is allotted to different
cost centres proportionately. Again taking the cases of rent, as it cannot be allocated,
it is apportioned to various departments on some equitable basis, i.e., in the ratio of
area occupied. Similarly salary of a general manager cannot be allocated wholly to any
one department as he attends in general to all the departments. It should, therefore, be
apportioned to the required departments on some equitable basis. Other items which
generally cannot be allocated but are apportioned include fire insurance, lighting and
heating, time keeping expenses, canteen expenses, medical and other welfare expenses,
etc.
Distinction between Allocation and Apportionment

The distinction between allocation and apportionment is important to understand. As

seen above, the purpose of both cost allocation and cost apportionment is the
identification or allotment of items of cost to cost centres or cost units. However, the
main difference between the two procedures is that while allocation deals with whole
items of costs, apportionment deals with proportions of the items of cost. Allocation is
a direct process but apportionment may be made only indirectly and for which suitable
bases are to be selected. Whether an item of cost can be allocated or apportioned
does not depend upon the nature of cost but upon its relation with the cost centres or
cost units to which it is to be charged.
Overheads should always be allocated, as far as possible. If an overhead cost
cannot be allocated, it is apportioned. This involves finding some basis of apportionment
that will enable the overhead cost to be equitably distributed over various production
and service departments.
Production and Service Departments

Departments are classified into production and service departments. A production

department is one that is engaged in the actual manufacture of the product by changing
the shape, form or nature of material worked upon or by assembling the parts into
finished product. A service department, on the other hand, is one which is rendering
a service to production departments. It contributes in an indirect manner to the
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24 Material
 Accounting of
manufacture of the product but it does not itself change the shape, form or nature of Overheads (Part I)
material that is converted into the finished product.
Principles of Apportionment
NOTES
Apportionment of overheads to various production and service departments is based
on the following principles:
1. Service or use: This is the most common principle of apportionment of overhead
costs. It is based on the theory that greater the amount of service or benefit
received by a department, the larger should be the share of the cost to be borne
by that department. For example, rent is apportioned to various departments
according to the floor space occupied; telephone cost according to the number
of extension telephones in each department, and so on.
2. Survey method: This method is used for those overhead costs that are not
directly related to departments and whose remoteness necessitates an arbitrary
distribution. For example, salary of a general manager of a company may be
apportioned on the basis of the results of a survey which may reveal that 30%
of his salary should be apportioned to sales, 10% to administration and 60% to
various producing departments. Similarly, lighting expenses may be apportioned
on the basis of a survey of the number of light points, size, estimated hours of
use, etc.
3. Ability-to-pay method: This is based on the theory of taxation which holds
that those who have the largest income should bear the highest proportion of
the tax burden. In overhead cost distribution, those departments which have the
largest income may be charged with the largest amount of overheads. This method
is generally considered inequitable because it penalizes the efficient and profitable
departments to the advantage of inefficient ones.
Bases of Apportionment
The following are some of the common bases of apportionment of overheads:
Table 2.1 Bases of Apportionment

Overhead Cost Bases of Apportionment

1. (i) Rent and other building expenses
(ii) Lighting and heating Floor area, or
(iii) Fire precaution service volume of department
(iv) Air-conditioning
2. (i) Fringe benefits
(ii) Labour welfare expenses
(iii) Time keeping Number of workers
(iv) Personnel office
(v) Supervision
3. (i) Compensation to workers
(ii) Holiday pay
Direct wages
(iii) ESI and PF contribution
(iv) Fringe benefits
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cont... Material 25
Accounting of 4. General overheads Direct labour hours, or
Overheads (Part I) Direct wages, or Machine hours
5. (i) Depreciation of plant and machinery
(ii) Repairs and maintenance of
plant and machinery Capital values
NOTES (iii) Insurance of stock
6. (i) Power/steam consumption
(ii) Internal transport Technical estimates
(iii) Managerial salaries
7. Lighting expenses No. of light points, or Area
8. Electric power Horse power of machines, or
Number of machine hours, or
Value of machines
9. (i) Material handling Weight of materials, or Volume of
(ii) Stores overheads materials, or Value of materials

The choice of an appropriate basis is really a matter of judgement. For example,

welfare expenses may be apportioned on the basis of number of employees or total
wages. Similarly lighting expenses may be apportioned on the basis of number of light
points in each department or on the basis of floor area.
For allocation and apportionment of overheads, a statement called of ‘Overheads
Distribution Summary’ is prepared.
Re-apportionment of Service Department Costs (Secondary Distribution)
Once the overheads have been allocated and apportioned to production and service
departments and totalled, the next step is to re-apportion the service department costs
to production departments. This is necessary because our ultimate objective is to
charge overheads to cost units, and no cost units are produced in service departments.
Therefore, the costs of service departments must be charged to production departments
which directly come in contact with cost units. This is called secondary distribution.
The method of re-apportionment of service department costs is similar to
apportion-ment of overheads discussed earlier.
Thus, the costs of service departments are apportioned on the basis of service
rendered, i.e., the benefits received by the beneficiary departments.
Apportionment to Production Departments Only
In this case, cost of each service department is apportioned only to production
departments without apportioning it to other service departments.
Apportionment to Production as well as Service Departments
Quite often, a service department renders services not only to production department
but also to other service departments. For example, maintenance department looks
after not only the plant and machinery of production department but also the equipment
of other service departments like power house, material handling, etc. Similarly, power
house supplies electricity not only to production departments but also to service
departments like canteen, maintenance departments, etc.
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26 Material
 Accounting of
This type of inter-service department apportionment may be either on reciprocal Overheads (Part I)
basis or non-reciprocal basis.
Apportionment on non-reciprocal basis (Stepladder Method): This method
is used when a service department renders services to other service departments but NOTES
does not receive services of the other service departments, i.e., when service
departments are not inter-dependent. In this method, the service departments are
arranged in descending order of their serviceability. The cost of the most serviceable
department, i.e., the department which serves the largest number of departments is
first apportioned to other service departments. The service department which serves
the next largest number of departments is taken up next and its cost (including the
prorated cost of the first service department) is apportioned to other service and
production departments excepting the first service department. In the same way, while
apportioning the cost of the third service department in this order, the first two service
departments are ignored. This process is continued till the cost of the last service
department is apportioned. It should be noted that the cost of the last service department
is apportioned only to production departments.
Apportionment on reciprocal basis: This method is used when service departments
are mutually dependent. This means a service department not only provides its services
to other service departments but also receives services of other service departments.
For example, boiler house and pump room are the two service departments. Boiler
house has to depend upon pump room for supply of water and pump room has to
depend upon the boiler house for supply of steam power for driving the pump. Thus,
both boiler house and pump room depend upon each other for their services.
The following methods may be used for apportionment of overhead costs on a reciprocal
basis:
1. Simultaneous Equations Method
2. Repeated Distribution Method
3. Trial and Error Method
Let’s discuss their types one by one.
1. Simultaneous Equations Method: In this method, the following algebraic
equations help in finding out cost of service departments.
X = a + bY
Y = a + bX
2. Repeated Distribution Method: In this method the following steps are taken to
apportion the service departments costs:
(i) The costs of the first service department are apportioned in the normal way
according to the given percentages. This will close the account of the first
servicedepartment.
(ii) Then apply the given percentages for the apportionment of second service
department costs which include their own cost plus amount apportioned from
the first service department. This closes the account of the second service Self-Instructional
Material 27
department but reopens the account of the first service department.
Accounting of (iii) The same procedure should be followed in the case of all other service
Overheads (Part I)
departments. This completes the first cycle of apportionment.
(iv) The procedure should be repeated again starting with the first service department
whose total now consists only of amounts apportioned from other service
NOTES
departments. In this way, service department costs keep on reducing with each
cycle of distribution because each time, a substantial amount is charged to the
production departments.
(v) This process is continued until the amounts involved become insignificant.
It should be noted that unlike Simultaneous Equations Method, this method produces
approximate results. But the advantage of this method is that it can be conveniently
applied where the number of service departments is more than two.
3. Trial and Error Method: In this method the cost of first service department is
apportioned to other service departments only in the given percentage. The cost of the
second service department then is apportioned to the first and other service
departments. In this way, when the cost of all service departments has been
apportioned, the process is repeated till the service department costs are reduced to
negligible amounts. In this way, the total cost of each service department is found out
by trial and error.
It will be seen that this is a modification of repeated distribution method where
production departments are initially ignored for the purpose of redistribution. Like
Repeated Distribution Method, this method may also give approximate results.
It is important to note that all the three methods produce the same result.
2.3.1 Simple Problem of Primary Distribution of Overhead
Illustration 2.1: Mosich Co. Ltd, has three production departments A, B and C and
two service departments D and E. The following figures are extracted from the records
of the company:

Rent and rates 5,000 General lighting 600

Indirect wages 1,500 Power 1,500
Depreciation of machinery 10,000 Sundry expenses 10,000
The following further details are available:
Total A B C D E
Floor space (Sq. ft) 20,000 4,000 5,000 6,000 4,000 1,000
Light points 120 20 30 40 20 10
Direct wages ( ) 10,000 3,000 2,000 3,000 1,500 500
H.P. of machines 150 60 30 50 10 —
Value of machinery ( ) 2,50,000 60,000 80,000 1,00,000 5,000 5,000
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28 Material
Apportion the costs to various departments on the most equitable basis and prepare Accounting of
Overheads (Part I)
Overhead Distribution Summary.
Solution:
Overheads Distribution Summary
NOTES
Basis of
Item Total Producting Deptts Service Deptts
apportionment
A B C D E

Direct wages Actual 2,000 — — — 1,500 500

Rent and rates Floor space 5,000 1,000 1,250 1,500 1,000 250
General lighting Light points 600 100 150 200 100 50
Indirect wages Direct wages 1,500 450 300 450 225 75
Power H.P. of machines 1,500 600 300 500 100 —
Depreciation of Value of
machinery machines 10,000 2,400 3,200 4,000 200 200
Sundry expenses Direct wages 10,000 3,000 2,000 3,000 1,500 500
Total 30,600 7,550 7,200 9,650 4,625 1,575
Note: It should be noted that direct wages have been charged only for service departments because for
service departments, all costs are indirect.

2.3.2 Simple Problem of Secondary Distribution of Overheads

(Repeated and Simultaneous Equation Method Only)
Illustration 2.2: A company has three production departments and two service
departments. Distribution summary of overheads is as follows:
ProductionDepartments Service Departments
A 3,000 1 234
B 2,000 2 300
C 1,000
The expenses of service departments are charged on a percentage basis which
is as follows:
A B C 1 2
1. 20% 40% 30% — 10%
2. 40% 20% 20% 20% —
Find out the total overheads of production departments using the following
methods:
(a) Simultaneous Equations Method (b) Repeated Distribution Method
Solution:
(a) Simultaneous Equations Method
Let x denote total overheads of service department 1
y denote total overheads of service department 2
Therefore, x = 234 + 0.2y …(i)
Self-Instructional
y = 300 + 0.1x …(ii) Material 29
Accounting of To solve the equations, re-arrange these and multiply by 10 to eliminate decimals.
Overheads (Part I)
10x – 2y = 2,340 …(i)
– x + 10y = 3,000 …(ii)
NOTES Multiplying second equation by 10 and adding
10x – 2y = 2,340
– 10x + 100y =30,000
98y =32,340
y = 32,340 ÷ 98
y = 330; and x = 300
Secondary Distribution Summary
Total Production Departments
A B C

Total as per primary summary 6,000 3,000 2,000 1,000

Service Deptt 1 (90% of 300) 270 60 120 90
Service Deptt 2 (80% of 330) 264 132 66 66
Total 6,534 3,192 2,186 1,156

(b) Repeated Distribution Method

Items Production Deptts Service Deptts

A B C X Y

Total as per primary summary 3,000 2,000 1,000 234 300

Service Deptt 1 47 94 70 (–) 234 23
Deptt 2 129 65 65 64 (–) 323
Deptt 1 14 25 19 (–) 64 6
Deptt 2 2 2 2 — —
Total 3,192 2,186 1,156 — —

Check Your Progress

1. On what basis are overhead costs analysed and distributed?
2. What is the source for collecting costs related to indirect wages?
3. Mention the two main types of departments for departmentalization of
overheads.
4. State the conditions which are necessary for allocation of overhead costs.
5. Why is the ability-to-pay method considered inequitable?

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30 Material
 Accounting of
2.4 ANSWERS TO CHECK YOUR PROGRESS Overheads (Part I)

QUESTIONS

1. Overhead costs cannot be identified with individual cost units and there are no NOTES
accounting means of exact distribution. Therefore, such costs are analysed and
distributed to various cost centres and cost units on arbitrary basis.
2. Wages analysis sheet is used for collection of indirect wages.
3. For smooth and efficient working, a factory is sub-divided into a number of
departments, each of which denotes a particular activity of the factory. These
departments are mainly of two types: production and service departments.
4. In order that an overhead can be allocation, they should meet both the following
conditions: (a) The cost centre must have caused the overhead cost to be
incurred; and (b) The exact amount incurred in a cost centre must be known.
5. The ability-to-pay method is generally considered inequitable because it penalizes
the efficient and profitable departments to the advantage of inefficient ones.
6. Trial and error method is a modification of repeated distribution method where
production departments are initially ignored for the purpose of redistribution.
Like Repeated Distribution Method, this method may also give approximate
results.

2.5 SUMMARY

 Distribution of overhead costs to cost units is one of the most complex problems
of cost accounting. This is because overhead costs cannot be identified with
individual cost units and there are no accounting means of exact distribution.
Therefore, such costs are analysed and distributed to various cost centres and
cost units on arbitrary basis.
 The various steps taken for distribution of overhead costs are as follows:
classification and collection of overheads; allocation and apportionment of
overheads to production departments and service departments; reapportionment
of service department costs to production departments and absorption of
overheads of each production department in cost units.
 Classification and codification are pre-requisites for the collection of overheads.
The main sources from which overhead costs are collected include invoice,
store requisition, wages analysis sheet and journal entries.
 After overhead costs have been collected under various standing order numbers,
the next step is to allocate and apportion the overheads to production and
service departments. Such allocation and apportionment is known as
departmentalization or primary distribution of overheads.

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Material 31
Accounting of
Overheads (Part I)
 There are mainly two types of departments: production and service departments.
 Certain items of overhead costs can be directly identified with a particular
department or cost centre as having been incurred for that cost centre. Allotment
NOTES of such costs to departments or cost centres is known as allocation.
 Certain overhead costs cannot be directly charged to a department or cost
centre. Such costs are common to a number of cost centres or departments and
do not originate from any specific department. Distribution of such overhead
costs to various departments is known as apportionment.
 Apportionment of overheads to various production and service departments is
based on the following principles: service or used, survey method and ability-
to-pay method.
 Once the overheads have been allocated and apportioned to production and
service departments, and totaled, the next step is to re-apportion the service
department costs to production departments.
 Quite often, a service department renders services not only to production
department but also to other service departments. Inter-service department
apportionment may be either on reciprocal basis or non-reciprocal basis.
 The following methods may be used for apportionment of overhead costs on a
reciprocal basis: Simultaneous equations method, repeated distribution method
and trials and error method.

2.6 KEY WORDS

 Departmentalization of overheads: It is the process of allocation and

apportionment of overheads to different departments or cost centres.
 Allocation: It refers to the ‘assignment of whole cost directly to a cost centre.’
 Apportionment: It refers to the ‘distribution of overheads to more than one
cost centre, on some equitable basis.’

2.7 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. Mention the steps involved in overheads distribution.
2. What is collection of overheads? List the sources from which overhead costs
are collected.
3. Enumerate the objectives of departmentalization.
4. Differentiate between allocation and apportionment.
Self-Instructional 5. What are production and service departments?
32 Material
Long Answer Questions Accounting of
Overheads (Part I)
1. Describe the principles and bases of apportionment.
2. Explain the methods of inter-service department apportionment.
NOTES
2.8 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:

Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

Self-Instructional
Material 33
 Accounting of

UNIT 3 ACCOUNTING OF Overheads (Part II)

OVERHEADS (PART II)

NOTES
Structure
3.0 Introduction
3.1 Objectives
3.2 Absorption: Meaning, Rate and Methods of Overhead Absorption
3.3 Under and Over Absorption of Overheads: Meaning, Reasons and Accounting
Treatment
3.3.1 Simple Problems on the Accounting Treatment of Under And Overabsorption
of Overheads
3.4 Answers to Check Your Progress Questions
3.5 Summary
3.6 Key Words
3.7 Self Assessment Questions and Exercises
3.8 Further Readings

3.0 INTRODUCTION

You have already learnt about the allocation and apportionment of overheads. In this
unit, the discussion moves forward with the overhead absorption. Absorption of
overheads is the charging of indirect costs to cost objects. In other words, it is the
distribution of allocated overheads from cost centres to the produced units. Overhead
absorptions is based on certain rates. There are also different methods for absorption
of overheads. In this unit, you will learn about the rates and methods of absorption.
Further, you will also learn about situations in which under and over absorption happens
and the manner in which they are treated in the books of accounts.

3.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the meaning, rate and methods of overhead absorption
 Describe the meaning, reasons and accounting treatment for under and over
absorption

3.2 ABSORPTION: MEANING, RATE AND METHODS

OF OVERHEAD ABSORPTION

Once departmentalization of overheads has been completed, the total cost of each
production department comprises the following:
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Material 35
Accounting of (i) Costs allocated and apportioned to production departments.
Overheads (Part II)
(ii) Costs of service departments re-apportioned to production departments.
The total overhead cost pertaining to a production department or cost centre is
NOTES then charged to or absorbed in the cost of the products or cost units passing through
that centre. This is known as absorption.
The absorption of overheads is the last step in the distribution plan of overheads.
It is defined as charging of overheads to cost units. In other words, overhead
absorption is the apportionment of overheads of the cost centres over cost units.
Absorption of overheads is also known as levy, recovery or application of overheads.
There are two steps in the absorption of overheads:
1. Computation of overheads absorption rate; and
2. Application of these rates to cost units.
Let us discuss these steps.
1. Computation of Overheads Absorption Rate: Absorption rates are computed
for the purpose of absorption of overheads in costs of the cost units. There are mainly
six methods for determining absorption rates which have been described later in this
unit. In all these methods, the overhead rate is computed by dividing the total amount
of overheads of department or cost centre by the number of units in the base, such as
number of cost units, machine hours, labour hours, direct labour cost, price cost, etc.
This is shown as follows:

Overheads absorption rate = Total overhead s of cost centre

Total u nits in base
It should be noted that only one rate is computed for any single group of
overheads.
2. Application of rates to cost units: In order to arrive at the overhead cost of each
cost unit, the overhead rate is multiplied by the number of units of base in the cost unit.
Thus:
Overhead absorbed = No. of units of base in the cost unit × Overhead rate
For example, machine hour rate is 25 and a cost units has used 12 hours of the
machine, overheads absorbed will be = 12 hours × 25 = 300.
Methods of Absorption of Production Overheads
Various methods of absorption discussed below are used to determine the overheads
absorption rate for production overheads.
1. Direct Materials Cost Percentage Rate: Under this method, the amount of
overheads to be absorbed by a cost unit is determined by the cost of direct materials
consumed in producing it. This rate is computed by dividing the total overheads by the
total cost of direct materials consumed in the department. Thus,

Overhead rate = Prod u ction o verhead s × 100

Self-Instructional Direct m aterials
36 Material
Example: Production overheads 40,000 Accounting of
Overheads (Part II)
Direct materials 200,000
40,000
Overhead rate = × 100 = 20%
200,000 NOTES
Thus, if the direct material cost of a job or cost unit is 1,200, the overheads to
be absorbed by it will be 240, i.e., 20% of 1,200.
2. Direct Labour Cost Percentage Rate: The overhead rate under this method is
computed by dividing the production overheads by the direct labour cost.

Overhead rate = Prod u ction overhead s × 100

Direct labou r cost
Example: Production overheads = 40,000
Direct labour cost = 1,00,000
40,000
Overhead rate = × 100 = 40%
1,00,000

Thus a job for which direct wages are 200 will absorb production overheads
of 80, i.e., 40% of 200.
3. Prime Cost Percentage Rate: This method is based on the premise that both
materials and labour give rise to factory overheads and thus the total of the two, i.e.,
prime cost should be taken as the base for absorption of factory overheads. In a way,
this is a combination of the material cost and labour cost methods.
Overhead rate in this method is calculated by dividing the production overheads
by prime cost.
Prod u ction overhead s
Overhead rate = × 100
Prim e cost
Example: Production overheads = 40,000
Prime cost = 2,50,000
40,000
Overhead rate = × 100 = 16%
2, 50, 000

Thus, if prime cost of a job is 500, production overheads to be absorbed by

that job should be 80, i.e., 16% of 500.
Although overheads are related more to labour cost than material costs, this
method gives equal importance to both material and labour. When the cost of materials
is predominating item of prime cost, the time factor will be ignored. This is shown
below:

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Material 37
Accounting of Job I Job II
Overheads (Part II)

Direct materials 1,000 100

NOTES Direct labour @ 5 per hour 100 1,000
Prime cost 1,100 1,100
Production overhead (40% of prime cost) 440 440
Works cost 1,540 1,540

It is seen that although Job II takes much longer time than Job I, the charge to
both the jobs for production overheads is the same. The above illustration also shows
that this method is likely to degenerate into either material cost method or labour cost
method. This is because in Job I direct material is the main constituent of prime cost
and in Job II labour cost is the main constituent but the charge to both the jobs is the
same.
4. Direct Labour Hour Rate: This is a rate per hour and not a percentage rate. It is
obtained by dividing the total production overheads by the total number of direct
labour hours for the period.
Prod u ction overhead s
Overhead rate =
Direct labou r hou rs
Example: Production overheads = 40,000
Direct labour hours = 50,000 hours
40,000
Overhead rate = = 80 paise per hour
50,000 hou rs
Thus, if a job takes 20 labour hours for production, 16 (i.e., 20 hours @ 80
paise) will be charged to that job for production overhead.
Illustration 3.1: Aggarwal and Co. has three production departments—A, B and C
and one service department S. The following particulars are available for one month of
25 working days of 8 hours each. All departments work all days with full attendance.
Total Service Production Production Production
deptt deptt deptt deptt
S A B C

Power and lighting 1,100 240 200 300 360

Supervisor’s salary 2,000 20% 30% 30% 20%
Rent 500
Welfare 600
Others 1,200 200 200 400 400
Number of workers 10 30 40 20
Floor area in sq. ft 500 600 800 600
Service rendered by service
department to production departments 50% 30% 20%
Self-Instructional Calculate the ‘Labour Hour Rate’ of each of the departments A, B and C.
38 Material
Solution: Accounting of
Overheads (Part II)
Computation of Labour Hour Rate
Service Production Production Production
deptt deptt deptt deptt
S A B C NOTES

Power and lighting 240 200 300 360

Supervisor’s salary 400 600 600 400
Rent (floor area) 100 120 160 120
Welfare (No. of workers) 60 180 240 120
Others 200 200 400 400
Total 1,000 1,300 1,700 1,400
Share of Service deptt (–) 1000 500 300 200
(A) Total overheads 1,800 2,000 1,600
(B) Labour hours
(No of days × Hrs × No. of workers) 6,000 8,000 4,000
Labour Hour Rate (A) ÷ (B) 0.30 0.25 0.40

5. Machine Hour Rate: Machine hour rate is the overhead cost of running a machine
for one hour. This rate is obtained by dividing the amount of factory overheads
apportioned to a machine by the number of machine hours for the period under
consideration.
Example: Production overheads of Machine I = 25,000
No. of machine hours = 2,000
Prod u ction overhead s 25,000
Machine hour rate = = = 12.50
N o. of m achine hou rs 2,000

If Machine I has been used for a job for 30 hours, overheads to be absorbed by
that job will amount to 375, i.e., 30 hrs × 12.50.
Computation of Machine Hour Rate: The following steps are taken for the
computation of machine hour rate:
(i) The factory overheads are first apportioned to production departments as
discussed earlier under allocation and apportionment.
(ii) Overheads of the department are further apportioned to different machines or
groups of machines. For this purpose each machine or a group of machines is
treated as a cost centre or a small department. Bases of apportionment of
different expenses are given here.
(iii) Specific overheads, like power, depreciation, etc., should be directly allocated
to the machine.
(iv) The overheads relating to the machine should be divided between (a) Fixed or
standard charges, and (b) Variable charges. Fixed charges are those which
remain constant irrespective of the use of the machine, e.g., rent, supervisor’s
salary, etc. Variable charges vary with the use of machines, e.g., power,
depreciation, etc. Self-Instructional
Material 39
Accounting of (v) The working hours of a machine are estimated for the period.
Overheads (Part II)
(vi) Overheads pertaining to the machine are totalled and divided by the number of
effective machine hours. The resultant figure will be machine hour rate. The time
required for setting the machine (unless it is treated as producing time) should
NOTES
be deducted from the total working hours to arrive at effective hours.
Treatment of depreciation: Depreciation is a semi-variable item. In the computation
of machine hour rate, some accountants treat it as a fixed cost while others treat it as
a variable cost. In fact, whether it is to be treated as fixed or variable cost, depends
upon the method of computing depreciation. In this unit, it has been mostly treated as
a variable item.
Bases of Apportionment of Different Overheads to Machines

Items of overheads Basis of apportionment

1. Rent and rates Ratio of floor area occupied by each machine

2. Insurance Insured value of each machine
3. Supervision Estimated time devoted by the supervisor to each machine
4. Lighting No. of light points used for each machine, or floor area
occupied by each machine
5 Depreciation Capital values/machine hours or multiple of both
6. Repairs and maintenance Capital values/machine hours
7. Lubricating oil and other Capital values/machine hours
consumable stores

Comprehensive (or composite) machine hour rate: When the direct wages of
machine operators are included in machine hour rate, it is known as comprehensive
machine hour rate. Thus in a comprehensive machine hour rate, overheads and direct
wages are absorbed by a single rate.
Illustration 3.2: From the following information compute the machine hour rate in
respect of machine No. 10 for the month of January:
Cost of machine 32,000
Estimated scrap value 2,000
Effective working life 10,000 hours
Repairs and maintenance over the life period of machine 2,500
Standing charges allocated to this machine for January, 400
Power consumed by the machine @ 0.30 per unit, 600
The machine consumes 10 units of power per hour.

Self-Instructional
40 Material
Solution: Accounting of
Overheads (Part II)
Computation of Machine Hour Rate

per hr
Standing charges (400 ÷ 200*) 2.00
Variable Charges: NOTES
1. Repairs and Maintenance ( 2,500 ÷ 10,000 hrs) 0.25
2. Power (10 units @ 30 Paise) 3.00
 32, 000  2,000 
3. Depreciation   3.00
 10, 000 hrs 
Machine Hour Rate 8.25

*Working Notes: No. of machine hours during the month of January is computed below:
No. of power units consumed in January = 600 ÷ 0.30 = 2,000 units
No. of machine hours = 2,000 units ÷ 10 units = 200 hours.

6. Rate per Unit of Output: It is the simplest of all the methods. This rate is determined
by dividing the total overheads of a department by the number of units produced.
Example: Production overheads = 22,000
No. of units produced = 1,000
Am ou nt of overhead s 22,000
Overheads rate = = = 22 per unit
N o. of u nits 1,000

Thus, each unit produced will absorb 22 for production overheads. Though
this method has the advantage of simplicity, but unfortunately it can be advantageously
used only when all the cost units produced are identical. Stated conversely, this method
cannot be applied where a number of products of different sizes, grades, qualities,
etc., are produced according to customer’s specifications and which consume different
amounts of time in production.
Illustration 3.3: Following particulars related to the production department of a factory
for the month of June.
Material used 80,000
Direct wages 72,000
Direct labour hours worked 20,000
Hours of machine operation 25,000
Overhead charges allocated to the department 90,000
Cost data of a particular work order carried out in the above department during
June are given below:
Material used 8,000
Direct wages 6,250
Labour hours booked 3,300
Machine hour booked 2,400 Self-Instructional
Material 41
Accounting of What would be the factory cost of the work order under the following methods of
Overheads (Part II)
charging overheads.
(i) Direct labour cost rate
NOTES (ii) Machine hour rate
(iii) Direct labour hour rate
Solution:
Computation of Factory Overheads Rates:
Overhead s 90,000
(i) Direct Labour Cost Rate: × 100 = × 100 = 125%
Direct w ages 72,000

Overh ead s 90,000

(ii) Machine Hour Rate: = = 3.60 per hour
N o. of m ach in e h ou rs 25,000 hrs
Overh ead s 90,000
(iii) Direct Labour Hour Rate: = = 4.50 per hour
N o. of labou r hou rs 20,000 hrs

Statement of Factory Cost

Direct labour cost Machine hour Direct labour

rate rate hour rate

Direct material 8,000 8,000 8,000

Direct wages 6,250 6,250 6,250
Prime Cost 14,250 14,250 14,250
Factory overheads:
(i) 125% of 6,250 7,812.50 — —
(ii) @ 3.60 for 2,400 hrs — 8,640 —
(iii) @ 4.50 for 3,300 hrs — — 14,850
Factory Cost 22,062.50 22,890 29,100

(i) Types of Overhead Rates

Overhead rates may be: (i) actual or predetermined; and (ii) blanket or multiple.
These are described below.
Actual and Predetermined Rates

Overheads absorption rate may be based on actual figures or estimated figures.

Actual Rate: It is calculated by dividing the actual overheads by actual base.
Thus:
Actu al am ou nt of overhead s
Actual overhead rate =
Actu al base
On account of certain limitations of actual rate, it is not always desirable to use it for
the absorption of overheads. These limitations are:
 Actual rate cannot be computed until the end of the accounting period. This
results in delay in computing cost.
Self-Instructional
42 Material
  When costs are used to calculate the selling prices for quotations and tenders, Accounting of
Overheads (Part II)
there is bound to be a considerable delay before the sales department can
invoice customers due to delay in information from costing department.
 Actual rate may vary from period to period due to fluctuations in the amount of
NOTES
overheads, the volume of output and efficiency of operations. This makes
comparisons difficult.
 These rates do not provide any basis for cost control.
Predetermined Rate: This rate is determined in advance of the period in which it is
to be used. It is computed by dividing the estimated or budgeted amount of overheads
by the budgeted base. Thus:
Bu d geted am ou nt of overhead s
Predetermined rate =
Bu d geted base

As compared to actual rate, a predetermined rate is of greater practical utility.

This is because a predetermined rate enables prompt preparation of tenders and
quotations and fixation of selling prices. Cost control is also facilitated by comparing
the actual overheads with the predetermined overheads recovered. The use of
predetermined rates thus, helps in deriving some of the benefits of standard costing
and budgetary control.
(ii) Blanket and Multiple Rates

A blanket overhead rate is a single overhead rate for the entire factory. It is computed
as follows.
Total overhead s for the factory
Blanket rate =
Total nu m ber of u nits of base for the factory

Blanket overhead rate should not be used except when output is uniform.
Otherwise it will result in overcosting or undercosting of certain cost units. Moreover,
when a blanket rate is used, performance of individual departments or cost centres
cannot be properly assessed and exercise of control becomes difficult. Blanket rate is
also known as Plant-wide or Plant-wise rate.
Multiple rates means a number of separate rates for each department, cost centre,
etc. For instance, separate rates may be calculated for each of the following:
(a) Production department
(b) Service department
(c) Cost centre
(d) Product
(e) Fixed overheads and variable overheads
The following formula is used to calculate the multiple rates:
Overhead s of d epartm ent or cost centre
Overhead rate = Self-Instructional
Correspond ing base Material 43
Accounting of Blanket rates have a very limited application and can be usefully employed in (i) small
Overheads (Part II)
firms, or (ii) when one single product is produced, or (iii) when a firm is producing
more than one product and all of these products pass through all the departments and
the incidence of overheads is uniform. Except in these situations, use of blanket overhead
NOTES rate may result in distortion of cost. The main disadvantages of blanket rates are as
follows:
 The use of blanket rate gives misleading and erroneous results, particularly where
a firm is producing several products and all of theses products pass through a
number of production departments or cost centres.
 When a blanket rate is used, performance of individual departments or cost
centres cannot be properly assessed and exercise of control becomes difficult.
 The use of blanket rate may produce an erroneous work-in-progress valuation
because products included in work-in-progress might not have passed through
all the departments and if a blanket rate is charged for its valuation, the work-
in-progress will be over-valued to the extent of facilities not used in it.
Multiple rates are of more practical utility and should always be preferred over blanket
rate for the sake of accuracy and control.
Requisites of a Good Method of Absorption
A satisfactory method of absorption should have the following characteristics:
 It should be simple and easy to operate.
 It should give accurate results and provide an equitable basis for overheads
absorption.
 Time factor should be given due consideration.
 The method should distinguish between work done by skilled and unskilled
workers.
 It should also make a distinction between work done by hand labour and
machines.
 It should be economical in application and should not require maintenance of
unnecessary clerical records.
 Multiple rates should be preferred to blanket rates.
Capacity Utilization and Overheads
Capacity of a factory refers to its ability to produce with the resources and facilities
available at its disposal. If, for instance, with all the resources of men, materials and
machines available at its command, a company can produce 500 units of a product
per day, the capacity of the factory is said to be 500 units of production per day. Plant
capacity may be expressed in terms of any of the following:
(a) Units of products: For example tonnes of steel, meters of cable, number of
Self-Instructional cars or scooters, number of passenger kilometres, etc.
44 Material
 (b) Production hours or machine hours: For example, if in a factory there are 40 Accounting of
Overheads (Part II)
machines and each of these machines can be operated for 8 hours per day, the
plant capacity in terms of production hours will be 40 × 8 = 320 production
hours per day.
NOTES
Capacity Levels
The various types of capacity levels are:
1. Maximum Capacity: This is the maximum production capability of a plant
which can be achieved only under perfect conditions, i.e., when there is no loss
of operating time. As some loss of time is bound to occur, this capacity can
never be achieved in practice and it is for this reason that it is known as a
theoretical capacity.
2. Practical Capacity: Also known as operating capacity, this is the maximum
capacity less output or time lost due to unavoidable factors like plant repairs
and maintenance, setting up time, holidays, etc., and other normal losses.
3. Capacity Based on Sales Expectancy: This is a capacity which is based on
expected sales and is determined after a careful study of the market conditions.
A concern may not be able to sell the entire output which it is capable of
producing. This capacity level is usually less than practical capacity because of
lack of orders from the customers.
4. Actual Capacity: This is the capacity actually achieved during a particular
period. This is known only after the period is over and may be below or above
the capacity based on sales expectancy.
5. Normal Capacity: This is the long-term average of the capacity based on
sales expectancy. In other words, the concept of normal capacity is based on
the average utilization of plant capacity over a long period. An overhead rate
based on normal capacity does not fluctuate much because the long-term average
levels out highs and lows that occur in a business. Normal capacity is thus also
known as average capacity.
Capacity Levels and Overhead Rates
The capacity level that is selected for calculating the fixed overhead rate may significantly
affect the overhead absorption rate and thus affect the product cost and selling price.
It was stated earlier that overhead rates can be actual or predetermined.
Determination of actual rates is based on the actual level of capacity and thus presents
no difficult. However, when predetermined rates are to be used, capacity level selected
will affect the overhead rate. For example, annual fixed overheads are 10 lakh and
annual capacity is 10,000 labour hours. The overhead rate for charging to the cost of
products is 100 per hour (i.e., 10 lakh ÷ 10,000 hours). Suppose there is a decline
in the demand and actual work done is only 8,000 labour hours, the revised overhead
rate will be 125 per hour (i.e., 10 lakh ÷ 8,000 hrs). If the demand falls further to
Self-Instructional
Material 45
Accounting of work only for 5,000 hours, the overhead rate will increase further to 200 per hour
Overheads (Part II)
(i.e., 10 lakh ÷ 5,000 hours). It is thus recommended that companies use normal
capacity level to calculate overhead rate so that cost of products are not distorted by
short-term changes in demand. Overhead rates based on normal capacity provide a
NOTES better approximation of long-term average costs.
Illustration 3.4: A company has a maximum capacity of working 5,000 direct labour
hours, at 100 per cent capacity. Practical capacity is 90 per cent and normal capacity
80 per cent. At 100 per cent capacity, overheads are budgeted as follows:
Fixed overheads 20,000
Variable overheads 10,000
Show the effect of various capacity levels on the overhead absorption rates.
Solution:
Effect of Various Capacity Levels on Predetermined
Overheads Absorption Rates
Maximum Practical Normal
capacity capacity capacity
Percentage of capacity utilization 100% 90% 80%
Direct labour hours 5,000 4,500 4,000
Budgeted factory overheads:
Fixed 20,000 20,000 20,000
Variable 10,000 9,000 8,000
Total 30,000 29,000 28,000

Fixed overhead rate per direct labour hour 4.00 4.44 5.00
(Fixed overheads ÷ Labour hrs)
Variable overhead rate per direct labour hour 2.00 2.00 2.00
(Variable overheads ÷ Labour hours)
Total overhead rate per direct labour hour 6.00 6.44 7.00
(Total overheads ÷ Labour hours)

In the above illustration, it should be noted that overhead rates are different at
different capacity levels due to the influence of fixed overheads. When actual capacity
utilization is lower, it results in under-absorption of overheads and vice versa; when
actual capacity utilization is higher, there is over-absorption of overheads.
Idle Capacity
This is the difference between practical capacity and capacity based on sales expectancy
or actual capacity. In other words, idle capacity is the production capacity lost due to
reasons like lack of orders from customers, absenteeism, shortage of materials, etc. It
is a temporary phenomenon and can be wiped out when difficulties causing idle capacity
are overcome.
Suppose maximum capacity of a plant = 500 units per day of 8 hrs each. Normal
loss of time is 10 per cent.

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46 Material
 Practical capacity = Maximum capacity – Normal loss of time Accounting of
Overheads (Part II)
= 100% – 10% = 90%
= 500 units – 50 units
= 450 units per day NOTES
Actual capacity is only 360 units per day or 90% × 360/450 = 72%
Idle capacity = Practical capacity – Actual capacity
= 90% – 72% = 18%
= 450 units – 360 units
= 90 units per day
Idle Capacity and Idle Time
Idle time is the loss of labour time which arises due to waiting for materials, tools, job
instructions or due to machine breakdown or power failure or due to changing from
one job to another. This may be avoidable or unavoidable. Although no work is done
during the period of idle time, wages are paid to the workers for this lost time.
Idle capacity, on the other hand, represents unused production potential and is
the difference between practical capacity and actual capacity. Idle capacity is a wide
term and the cost of idle time forms a part of the cost of idle capacity.
Cost of Idle Capacity
Idle capacity costs are represented mostly by fixed charges of owning and maintaining
plant and machinery and of employee services which are not used at their maximum
potential. This is so because fixed costs continue to be incurred even if the plant is kept
idle.
The cost of idle capacity is clearly brought out if overheads absorption rate is
calculated on practical capacity—as the base. It comes out in the form of under-
absorption of overheads.
The cost of idle capacity and the reasons due to which capacity remains unutilized
can be found out by computing overheads capacity variance and by preparing idle
time reports, plant utilization reports and idle machine time reports. These reports are
prepared periodically which clearly bring out the period for which plant remained
unutilized and the cost of such capacity that is not utilized.
Illustration 3.5: Flakt India Ltd manufactures component part XE at the rate of 2
units per hour. The factory normally operates 6 days a week on a single eight-hour
shift. During the year, it is closed for 20 working days for holidays. Normal loss of
machine time for cleaning, oiling, etc., is 160 hours per year. Fixed overhead cost per
annum is 37,128. Normal sales for the component averages 2,500 units per year.
The expected sales volume for the year 2021 was 2,400 units.
Compute the idle capacity cost when overhead rates are based on practical
capacity. Self-Instructional
Material 47
Accounting of Solution:
Overheads (Part II)
Maximum capacity
= Total days in the year × No. of hours worked per day
NOTES = 365 × 8 = 2,920 hours
Practical capacity
= Maximum capacity – Normal loss
Maximum capacity 2,920 hrs
Less:Sundays (52 days × 8 hrs) 416
Holidays (20 days × 8 hrs) 160
Loss due to cleaning, oiling, etc. 160 736 hrs
Practical capacity 2,184 hrs
Normal capacity = Normal sales ÷ Units per hour
= 2,500 units ÷ 2 units per hour = 1,250 hours
Capacity based on sales expectancy = 2,400 units ÷ 2 units per hour
= 1,200 hours
Absorption rate per hour, based on practical capacity (for fixed cost only)
Fixed overhead cost ( ) 37,128
=  = 17
Practical capacity (hou rs) 2,184 hou rs

per hour
Idle capacity = Practical capacity – Capacity based on sales
expectancy
= 2,184 – 1,200 = 984 hrs
Cost of idle capacity = Idle capacity × Overhead rate
= 984 hrs × 17 = 16,728
Note: Idle capacity has been taken as the difference between practical capacity and capacity based on
sales expectancy. It may also be taken as the difference between practical capacity and actual
capacity, if information in this respect is available.

3.3 UNDER AND OVER ABSORPTION OF

OVERHEADS: MEANING, REASONS AND
ACCOUNTING TREATMENT

Overheads may be absorbed either on the basis of actual rates or predetermined

rates. When actual rates are used, the overheads absorbed should be exactly equal to
the overheads incurred. In such a case there is no problem of under- or over-absorption
of overheads. But when a predetermined rate is employed, overheads absorbed may
not be equal to the amount of actual overheads incurred. Thus, whenever the overheads
Self-Instructional
48 Material
absorbed are not equal to the amount of actual overheads, it is a case of either under- Accounting of
Overheads (Part II)
absorption or over-absorption of overheads.
Under-absorption: When the amount of overheads absorbed is less than the amount
of overheads actually incurred, it is called under-absorption or under-recovery. This
NOTES
has the effect of under-stating the cost because the overheads incurred are not fully
recovered in the cost of jobs, processes, etc.
Over-absorption: When the amount of overheads absorbed is more than the amount
of actual overheads incurred, it is known as over-absorption or over-recovery. It has
the effect of over-stating the cost of jobs, processes, etc.
Example: Predetermined overhead rate = 5 per machine hour
Actual machine hours = 1,500
Actual overheads = 9,000
Overheads absorbed = 1,500 hrs × 5 = 7,500
Under-absorption = 9,000 – 7,500 = 1,500
In this example, if the actual machine hours worked were 1,900, then:
Overheads absorbed = 1,900 hrs × 5 = 9,500
Overhead over-absorbed = 9,500 – 9,000 = 500
Reasons of Under or Over-absorption
Under or over-absorption of overheads may arise due to one or more of the following
reasons:
1. Faulty estimation of overhead costs
2. Faulty estimation of the quantity of output
3. Seasonal fluctuation in the amount of overheads in certain industries
4. Unforseen changes in the production capacity
5. Unexpected changes in the method of production affecting changes in the amount
of overheads
Whatever be the reason, under- or over-absorption is caused mainly due to wrong
estimation either of the overhead costs or of the base such as machine hours, production
quantity, etc.
Accounting Treatment of Under and Over-absorption

Under or over-absorbed amounts of overheads are disposed of in accordance with

any of the following methods, depending upon the circumstances:
1. Use of supplementary rates: Where the amount of under or over-absorbed
overheads is significant, a supplementary overhead absorption rate is calculated to
adjust this amount in the cost. However, adjustment is made in the cost of:
(i) work-in-progress; (ii) finished stock; and (iii) cost of sales. In the case of under-
absorption, the overhead cost is adjusted by a plus rate since the amount is to be
added, whereas over-absorption is adjusted by a minus rate since the amount is to Self-Instructional
be deducted. Material 49
Accounting of Illustration 3.6: A company absorbs overheads on predetermincd rates. For the
Overheads (Part II)
year ending 31 Dec. 2021, factory overheads absorbed were 3,66,250. Actual amount
of overheads incurred totalled 4,26,890. The following figures are also derived from
the trial balance.
NOTES Finished stock 2,30,732
Cost of goods sold 8,40,588
Work-in-progress 1,41,480
How would you dispose of under/over-absorbed overheads by use of
supplementary rate method.
Solution:
Under-absorbed overheads = Actual overheads – Absorbed overheads
= 4,26,890 – 3,66,250 = 60,640
Total cost incurred = 230,732 + 840,588 + 1,41,480
= 12,12,800
Unabsorbed am ou nt 60, 640
Supplementary Rate = 
Total cost 12,12, 800

As there is under-absorption of overheads, it is a plus rate, i.e., the cost of

finished goods, work-in-progress and cost of goods sold will be increased by 5% as
shown below:
Finished goods = 2,30,732 × 5% = 11,536.60
Work-in-progress = 1,41,480 × 5% = 7,074.00
Cost of goods sold = 8,40,588 × 5% = 42,029.40
Total 60,640.00
2. Writing off to Costing Profit and Loss Account: This method is used when the
under or over-absorbed amount is quite negligible and it is not worthwhile to absorb it
by supplementary rate. Under-absorption due to abnormal factors, like idle capacity
or defective planning, is also transferred to Costing Profit and Loss Account.
This method suffers from the shortcoming that stocks of work-in-progress and
finished goods remain under or over-valued and are carried over to the next accounting
period at such values.
3. Carry over to the next year: Under this method the under or over-absorbed
amount is transferred to Overhead Reserve Account or Suspense Account for carrying
over to the next accounting year. This procedure is open to criticism on the ground that
it is not logical to carry over the overheads of one year to the subsequent years for
absorption. But, this method can be usefully employed where normal business cycle
extends over more than one year and overheads are determined on a long-term basis.

Self-Instructional
50 Material
3.3.1 Simple Problems on the Accounting Treatment of Under and Accounting of
Overheads (Part II)
Overabsorption of Overheads
Illustration 3.7: During the year ending 31 March 2021, the factory overhead costs
of three production departments of an organization are as under— NOTES
X 48,950
Y 89,200
Z 64,500
The basis of absorption of overheads is given below:
Department X 5 per machine hour for 10,000 hours
Y 75% of direct labour cost of 1,20,000
Z 4 per piece for 15,000 pieces
Calculate the department-wise under or over-absorption of overheads and
present the data in a tabular form.
Solution:
Amount of cost absorbed factory overheads is calculated as follows:

X @ 5 per machine hour for 10,000 hours 50,000

Y @ 75% of direct labour cost of 1,20,000 90,000
Z @ 4 per piece for 15,000 piece 60,000
Total overheads absorbed 2,00,000
Statement Showing Department-wise Under/Over-absorption
Department Actual Absorbed Under Over
overheads overheads absorption absorption

X 48,950 50,000 — 1,050

Y 89,200 90,000 — 800
Z 64,500 60,000 4,500 —
Total 2,02,650 2,00,000 4,500 1,850

Net under-absorption ( )= 4,500 – 1,850 = 2,650

or 2,02,650 – 2,00,000 = 2,650

Check Your Progress

1. List some of the other names of absorption of overheads.
2. What is the formula for calculating the overhead cost of each cost unit?
3. State the premise on which prime cost percentage rate is based.
4. How is predetermined rate calculated?
5. Mention the industries where blanked rates can be usefully employed.
Self-Instructional
6. State one shortcoming of writing off to costing profit and loss account. Material 51
Accounting of
Overheads (Part II) 3.4 ANSWERS TO CHECK YOUR PROGRESS
QUESTIONS

NOTES 1. Absorption of overheads is also known as levy, recovery or application of

overheads.
2. In order to arrive at the overhead cost of each cost unit, the overhead rate is
multiplied by the number of units of base in the cost unit.
3. The prime cost percentage rate is based on the premise that both materials and
labour give rise to factory overheads and thus the total of the two, i.e., prime
cost should be taken as the base for absorption of factory overheads.
4. Predetermined rate is determined in advance of the period in which it is to be
used. It is computed by dividing the estimated or budgeted amount of overheads
by the budgeted base.
5. Blanket rates have a very limited application and can be usefully employed in (i)
small firms, or (ii) when one single product is product, or (iii) when a firm is
producing more than one product and all of these products pass through all the
departments and the incidence of overheads is uniform.
6. Writing off to Costing Profit and loss account method suffers from the shortcoming
that stocks of work-in-progress and finished goods remain under or over-valued
and are carried over to the next accounting period at such values.

3.5 SUMMARY

 Once departmentalization of overheads has been completed, the total cost of

each production department comprises the following: costs allocated and
apportioned to production department and costs of service departments re-
apportioned to production departments.
 The absorption of overheads is the last step in the distribution plan of overheads.
It is defined as charging of overheads to cost units.
 There are two steps in the absorption of overheads: computation of overheads
absorption rate and application of these rates to cost units.
 Various methods of absorption are used to determine the overheads absorption
rate for production overheads: direct materials cost percentage rate, direct labour
cost percentage rate, prime cost percentage rate, direct labour hour rate and
rate per unit of output.
 Overhead rates may be: (i) actual or predetermined; and (ii) blanket or multiple.
 Capacity of a factory refers to its ability to produce with the resources and
facilities available at its disposal. It can be expressed as units of products or
production hours or machine hours.
Self-Instructional  There are various types of capacity levels: maximum capacity, practical capacity,
52 Material capacity based on sales expectancy, actual capacity, and normal capacity.
  The capacity level that is selected for calculating the fixed overhead rate may be Accounting of
Overheads (Part II)
significantly affect the overhead absorption rate and thus affect the product cost
and selling price.
 Whenever the overheads absorbed are not equal to the amount of actual
NOTES
overheads, it is a case of either under-absorption or over-absorption of overheads.
 Under or over-absorption amounts of overheads are disposed of in accordance
with any of the following methods, depending upon the circumstance: use of
supplementary rates, writing off to costing profit and loss account and carry
over to the next year.

3.6 KEY WORDS

 Absorption: It is the apportionment of overheads of the cost centres over cost

units.
 Capacity of a factory: It refers to its ability to produce with the resources and
facilities available at its disposal.
 Under-absorption: It refers to the situation in which the amount of overheads
absorbed is less than the amount of overheads actually incurred.
 Over-absorption: It refers to the situation in which the amount of overheads
absorbed is more than the amount of actual overheads incurred.

3.7 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. What is absorption of overheads? Mention steps involved in it.
2. Write a short note on (i) direct materials cost percentage rate and (ii) direct
labour cost percentage rate.
3. What are the limitations of rate per unit of output method?
4. List the requisites of a good method of absorption.
5. Mention the various types of capacity levels.
Long Answer Questions
1. Explain the prime cost percentage rate of overhead absorption.
2. Describe the machine hour rate method including steps involved and treatment
of depreciation.
3. Discuss the different types of overhead rates.
4. Examine the relationship between capacity levels and overhead rates.
5. Analyse the causes of under-or-over absorption and its accounting treatment. Self-Instructional
Material 53
Accounting of
Overheads (Part II) 3.8 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:

NOTES Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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54 Material
 Activity Based Costing

UNIT 4 ACTIVITY BASED COSTING

Structure NOTES
4.0 Introduction
4.1 Objectives
4.2 Definitions
4.2.1 Important Terms: Cost Drivers and Cost Pools
4.2.2 Stages in Activity Based Costing
4.3 Allocations Under ABC
4.4 Purpose and Benefits of Activity Based Costing
4.5 Problems on Activity Based Costing (Simple Problems Only)
4.6 Answers to Check Your Progress Questions
4.7 Summary
4.8 Key Words
4.9 Self Assessment Questions and Exercises
4.10 Further Readings

4.0 INTRODUCTION

Up till now you have learnt about all the steps involved in the overhead costing process.
In this unit, you will learn about a specialized technique which is used for assigning
overheads to specific products and activities: Activity-based costing. As the name
suggests, activity-based costing uses activities as base representing events, tasks and
units of work. Activities of an organization are then identified and any incurred costs
are subsequently assigned to products based on their consumption. Activity based
costing is useful for organizations which have a lot of overhead expenses. Additionally,
activity-based costing is also of great use in business with complex processes and
product lines. In this unit, you will learn about the concept of activity-based costing,
cost drivers and pools. You will study about the stages in activity-based costing and its
purpose and benefits.

4.1 OBJECTIVES

After going through this unit, you will be able to:

 Describe the concept and important terms in Activity based costing
 Explain cost drivers and cost pools
 Examine the stages in activity-based costing
 Discuss the allocations under activity-based costing
 Assess the purpose and benefits of activity-based costing

Self-Instructional
Material 55
Activity Based Costing
4.2 DEFINITIONS

Activity-based costing (ABC) is a new and scientific approach developed for assigning
NOTES overheads, i.e., indirect costs, to end products, jobs and processes. It aims to rectify
the problem of inaccurate cost apportionment under the traditional approach in which
the indirect costs are allocated and apportioned on arbitrary basis. Activity-based
costing is an upcoming and more refined approach for charging indirect costs to products
and computing more accurate product costs. In the words of Cooper and Kalpan,who
developed ABC in 1988, ‘ABC systems calculate the costs of individual activities
and assign costs to cost objects such as product and services on the basis of
activities undertaken to produce each product or service.’ In this system, overheads
are assigned to activities or grouped into cost pools before they are charged to cost
objects, i.e., jobs or products. According to CIMA, London, activity-based costing
is ‘cost attribution to cost units on the basis of benefits received from indirect
activities, i.e., ordering, setting-up, assuring quality, etc.’
ABC is thus on alternative to the traditional way of overhead accounting. It is a
modern tool of charging overhead costs in which costs are first traced to activities and
then to products or jobs. Its main focus is on activities performed in the production of
goods or services. Thus activities become the focal points for cost computation. Costs
are charged to products or services based on individual products’ consumption of
each activity. It recognizes that jobs, products, services, etc., do not directly consume
resources but consume activities, which consume resources. In brief, in activity-based
costing, overheads are first assigned to activities and then absorbed by cost objects
on the basis of activities consumed by these cost objects.
4.2.1 Important Terms: Cost Drivers and Cost pools
In order to understand ABC, one should be familiar with the following terms:
Activity: An activity may be defined as a particular task or unit of work with a specific
purpose. Examples of activities are—placing of a purchase order, setting-up of a machine
and after sales service.
Cost object: It is an item for which cost measurement is required. For example, a
product, a service, a job or a customer.
Cost pool: According to CIMA, London, “cost pool is the point of focus for the
costs relating to a particular activity in an activity based cost system”. The concept
of cost pool is similar to that of cost centre in traditional cost system. In ABC, a cost
pool is created for each activity in which all costs relating to an activity are accumulated.
Thus cost pool is the sum total of all costs assigned to activity. For example, cost pool
may be procurement of material in which all cost associated with ordering, receiving,
inspecting etc. would be included.
Cost driver: It is a factor that causes a change in the cost of an activity. Cost driver is
of two types—resource cost driver and activity cost driver as given below:
Self-Instructional (a) Resource cost driver: It is a measure of the quantity of resource consumed by
56 Material
an activity. For example, number of purchase orders placed will determine the
 cost of purchasing the materials. Similarly, the number of times machines are set Activity Based Costing

up will determine the cost of setting up of machines. Resource cost driver is

used to assign the cost of a resource to an activity or cost pool.
(b) Activity cost driver: It is a measure of the frequency and intensity of demand
NOTES
placed on the activities by cost objects. It is used for assigning activity costs to
cost objects consuming the activity.
Example of cost drivers for various business functions are as follows:
Business function Cost driver
Production — Number of machine set-ups
— Number of units
— Number of machine hours/labour hours
Purchase of materials — Number of orders placed
— Number of receipts of materials
— Number of inspections
Research and development — Number of research projects
— Personnel hours on a project
— Complexities of projects
Customer service — Number of products serviced
— Number of service calls
— Number of hours spent on servicing
4.2.2 Stages in Activity Based Costing
The following are the steps in activity based cost allocation:
1. Identification of the main activities: First of all, major activities in the
organization are identified. The number of activities in an organization should
neither be too large or too small. Too large a number will be costly and will add
to the complexity of the system while a too small number of activities will
compromise with the accuracy of the cost. Total cost involved in the activity
should be significant enough to justify to give an activity a separate treatment.
2. Creation of cost pool: Cost pool is grouping of individual cost items. A cost
pool or cost bucket should be created for each activity. Cost pool is like a cost
centre around which costs are accumulated. For example, the total cost of machine
set ups might constitute one cost pool for all set-up related costs.
3. Determination of the activity cost drivers: The factors that influence the
cost of a particular activity are known as cost drivers. In other words, cost
drivers signify the factors or events that determine the cost of activity. Example
of cost drivers, as given above, are number of machine set-ups, number of
purchase orders, number of customer orders placed, etc.
4. Calculation of the activity cost driver rate: Just as an overheads absorption
rate is calculated in traditional costing system, in ABC a cost driver rate is
calculated as follows:
Activity cost driver rate = Total cost of activity ÷ Cost drivers
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Activity Based Costing 5. Charging the costs of activities to products: The costs of activities are
traced to products on the basis of demand by products. The cost drivers are
used to measure product demand of activities. For example, the total cost
allocated to cost centre for machine set-up related costs is 50,000 and that
NOTES there were 100 set-ups during the period. Thus the rate per set up is 50,000 ¸
100 = 500. If a particular product needs 10 set-ups, charge to that product
will be 500 × 10 = 5,000. If 20 units of the product are produced, cost per
unit will be 5,000 ¸ 20 units = 250. In this way, cost of other activities also
will be charged to product.

4.3 ALLOCATIONS UNDER ABC

The designing of activity-based costing system starts with an analysis of the activities
that will form the foundation of such a system. In fact, such a study attempts to identify
all such resource-consuming activities that are responsible for the creation of a firm’s
product or service. For this purpose, a firm’s activity-based costing implementation
team has to use a framework called cost hierarchy that helps it to classify activities
according to the level at which their costs are incurred. As per this framework, activities
can be classified into the following four different categories as identified by Cooper
(1990):
 Unit-level activities refer to such primary activities that are performed for
each unit of production. In fact, the costs of such activities tend to increase in
proportion to the number of units produced. The use of indirect materials/
consumables are best examples of unit-level activities as they are strongly
correlated to the number of units produced.
 Batch-level activities involve activities performed each time a batch of products
is produced. Thus, such activities are driven by the number of batches of units
produced rather than the number of units produced. The activities like material
ordering for every batch of production or resetting of machines needed for each
different batch of production are examples of batch-level activities.
 Product-level activities are performed to support an entire product line but
are not always performed every time a new unit or batch of products is produced.
In fact, such activities are driven by the creation of a new product line and its
maintenance, for example, redesigning of installation process.
 Facility-level activities are required to support a facility’s general
manufacturing process. Such costs cover the maintenance of buildings and
facilities, for example, plant maintenance, property taxes and insurance.
The above framework suggests that the management has to be careful in grouping
together activities at the appropriate level. Every precaution must be taken to avoid
grouping of activities falling within the scope of different levels. Batch-level activities
should not be combined with unit-level activities or product-level activities with batch-
level activities and so on (Garrison and Noreen, 2000). For an effective classification,
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58 Material
grouping of activities should be driven by the correlation that exists between the activities
within a level. This grouping of activities will give birth to ‘activity cost pools’—a Activity Based Costing

collection of costs that are to be allocated to cost objects.

To address the limitations of the conventional absorption costing method, many

companies adopted activity-based costing soon after its inception in 1980s. The
NOTES
Activity-Based Costing (ABC) as a new type of costing method is now an accepted
element of the accounting and control systems of companies across the world.
Although this method of costing has received overwhelming response of companies
in developed economies like the USA, Canada, Europe Australia and Japan, yet the
method has not completed failed in receiving the attention of companies in India too.
The following findings from a few research studies conducted on activity-based
costing in India ratified the view that the method is getting popular among companies
in developing economies too.
Joshi conducted a survey of 60 large and medium-sized manufacturing companies in
India in the year 2001. The findings of the study reveal that 20 per cent of the
respondent companies had adopted activity-based costing in their costing system.
Further, the study brought into light an important observation that the size of the
company in terms of total assets has a greater impact in the adoption of these
contemporary management accounting techniques. The traditional management
accounting techniques have been emphasized more as compared to contemporary
techniques because of higher perceived benefits.
Another study was conducted in 2002 by Narasimhan and Thampy with the objective
to ascertain service cost for different customers with the help of an activity-based
costing system. The research study was carried out in two branches of a large Indian
private sector bank. The study reveals that the banks have been using activity-
based cost information in benchmarking, branch network restructuring, business
process outsourcing, and identification of value-added and non-value added activities.
The study conducted by Anand et al. in 2005 indicates that activity-based costing
system introduced in corporate India has picked up momentum as 20.75 per cent of
the respondents of the study are using it as supplementary/offline and 28.30 per cent
of the respondents have integrated the activity-based costing systems with ERP
systems. The other major findings of the study are summarized below:
• There has been a response from the Indian companies to activity-based costing
which is reflected by the fact that 49 per cent of the respondent companies had
adopted activity-based costing.
• Since the firms, vis-à-vis their non-ABC users firms analyse both value chain and
supply chain the input for which is provided by ABC cost systems through accurate
cost and profit information.
• Management of Indian firms has been induced to adopt ABC systems primarily due
to the need for cost information by activity in budgeting, product pricing decision
and customer profitability analysis.
• The will to adopt ABCM is uniform across all sectors irrespective of the nature of
the same, be it service or manufacturing and of the stages of activity-based cost
system be it supplementary or offline.
• Developing an activity dictionary and cost drivers, and the lack of review of the
ABCM implementation initiative happen to be the major impediments faced by
ABCM-user respondent firms in designing activity-based cost systems.
• The pre-eminent changes rampant in management decision areas due to the
application of activity-based costing are profitable customers, pricing strategies
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Material 59
Activity Based Costing and sourcing decisions. Yet, the degree of change shares no correlation whatsoever
with sector (manufacturing vs. service), level or stage of ABC implementation.
• The application of ABCM leaves an indelible mark on decisions not just within the
internal environment (the product mix, process simplification, and product pricing)
NOTES but also in broad as well as the task environment, thereby expanding beyond the
boundaries of the firm (profitable customers, sourcing decisions, elimination of
redundant activities, distribution channel, and strategic focus). This is proved
empirically through factor analysis and linear discriminant analysis of responses of
activity-based costing user firms. Thus, it can be inferred that ABCM in India is
practised in the value chain analytic framework.
Source: M. Anand, B. S. Sahay, S. Saha, Activity-Based Cost Management Practices
in India: An Empirical Study, Decision, Vol. 32, No.1, January–June (2005).

Fig. 3.1 ABC Management Practices in India

Since cost drivers measure the number of activities undertaken by a firm to

produce a product or generate a service, therefore, such drivers are used as the bases
to relate the overheads collected in the cost pools to the cost objects. Thus, firms need
to be careful in identifying and using such drivers for each activity of activity-based
system. Generally, it is believed that a separate cost driver is called for each such
activity that generates an indirect product cost. However, some experts are of the
opinion that the selection of cost driver shall be governed by cost hierarchy—the unit-
level, the batch-level, the product-level and the facility-level. Accordingly, the number
of units like direct labour hours or cost of raw materials is used as cost drivers for unit-
level activities. In the same way, the number of batches such as the number of purchase
orders or machine resetting time for new batches serves the cost drivers for batch-
level activities. Cost drivers for product-level activities will be like the number of design
hours or the number of hours for redesigning the installation process. The choice of
cost drivers for facility-level activities is influenced by the measures that fall within the
scope of maintenance of building and facilities and accordingly a number of machine
breakdowns and maintenance schedule are used cost drivers for facility-level activities.

4.4 PURPOSE AND BENEFITS OF ACTIVITY BASED

COSTING

Although activity-based costing does not change the amount of overhead costs yet it
helps firms to allocate those costs in a more accurate manner. In fact, activity-based
costing helps a firm to identify and eliminate non-value-added activities and thereby
reduce costs. It is against this backdrop many accounting experts believe that activity-
based costing has tremendous potential to offer a firm strategic opportunities in a
competitive market by helping it to emerge as a low-cost producer or seller (Maher,
1997). Since activity-based costing helps managers to understand where their actions
can most likely contribute maximum to their firm’s profits, such an analysis can easily
serve as profit planning tool for the firms. However, activity-based costing can be of
strategic importance particularly in pricing decisions by estimating accurate product
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costs for such organizations where manufacturing operations involve large amounts of
60 Material factor overheads. In fact the accurate tracing of indirect costs has always been a
challenge for the organization with a high percentage of indirect product costs. In Activity Based Costing

addition, the accurate estimation of indirect costs would also help firms in decisions
like make or buy a product component and product elimination.
To summarize, activity-based costing is particularly useful to organizations for
NOTES
product costing where:
 A large percentage of product costs are indirect;
 Products and services use overhead activities in different ways;
 Product lines are not only numerous but diversified as well;
 Product lines constitute multiple products; and
 Product lines vary both in volume and manufacturing complexity.
Difference between Activity-Based Costing and Traditional Costing
A study of the two costing systems shows that they differ in several ways from each
other. Some major differences between these two costing systems are summarized in
Table 4.1.
Table 4.1 Activity-Based Costing Vs Traditional Costing

Limitations of Activity-Based Costing

Despite strategic significance of activity-based costing, it suffers from the following
limitations:
 Smaller organizations cannot afford to install activity-based costing system as it
is costly to implement.
 Since activity-based costing calls for identifying multiple activities and applying
numerous cost drivers, the firms find this system of costing not only costly but
also complex. Self-Instructional
Material 61
Activity Based Costing  Most organizations find it difficult to identify the accurate and exact relationship
between the cost of the activity and the cost driver which is the prerequisite for
the success of any activity-based costing system.
 Activity-based costing fails to provide an adequate response to the problems
NOTES
associated with facility-level costs. Since such costs are fixed with respect to
the number of products, therefore, they are to be allocated by means of some
arbitrary volume-based cost driver. Thus, an arbitrary element enters into the
product cost.
When to Switch to ABC
Activity-based costing as a strategic tool provides better results under certain specific
conditions. Since the establishment of activity-based costing system involves huge
costs, firms need to know when to use activity-based costing in order to optimize their
results. Although it is difficult to devise a comprehensive framework that would help
firms to decide when to switch to activity-based costing, Cooper suggests the following
indicators that would advocate the establishment of this new costing system.
Exhibit 4.1 ABC as an aid to Customer Profitability Analysis

Traditionally, companies have been concentrating on customer acquisition and making

little effort to retain the customer. A body of recent research highlights the strategic
importance of customer retention. In fact, customer retention helps a firm to increase
its profitability on the one hand and on the other hand to develop such relations with
customers as are essential to understand their preferences and needs. Further, retained
customers create favourable word-of-mouth, pay less attention to competing brands
and advertising, and are less price sensitive. Therefore, the ultimate objective of a
company in the contemporary business has to be the retention of customers rather
than simply their acquisition. Making this happen requires not only commitment but
also an effective and efficient marketing system capable of providing the customer
superior delivered value. Creating and maintaining such a system involves different
costs. Therefore, such a system can be effective for a company as long as the costs
incurred are lower than the returns from it. Consequently, such an arrangement can
be relevant only for such customers who meet the criteria. This calls for a detailed
analysis of the costs drivers (causes) before formulating and executing any customer
retention programme.
Customer cost analysis is the study of all such costs that are associated with the
activities involved in meeting the needs and expectations of customers better than
competitors. Such an analysis helps companies to identify cost drivers related to the
process of marketing. Generally different cost drivers are used for different activities.
Therefore, the identification of the cost drivers helps the companies to work out the
cost in acquiring and retaining the customers. It is pertinent to mention here that
ABC helps the companies to identify such cost drivers which was not possible under
traditional costing. Once the total cost of acquiring and retaining the customers is
ascertained, the same is compared with the sales revenue to determine commercial
viability of the customers. This kind of attempt is technically referred to as customer
profitability analysis. Thus, customer profitability analysis is the study of the
relationship that exists between marketing activities, cost drivers and the profitability
of the customers. Such an analysis involves the following steps:
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62 Material
  Define resource pools (market segments); Activity Based Costing

 Identifying activities and their respective cost drivers;

 Map costs to activities;
 Measure customer lifetime value; and
 Measure customer impact. NOTES
The major challenge that a company faces while executing the entire process of
customer profit analysis is perhaps to determine the Return on Investment (ROI) of
the chosen market segment. The rate of return can be worked out by dividing the
lifetime value of each customer segment by the investment a company makes in the
segment. Lifetime value of the customers represents the net present value of the
estimated future profits from them. Thus, the formula for calculating ROI will be:
ROI = Lifetime value of customers in the segment ÷ Investment in the segment
Since ABC analysis provides a better understanding of the profitability of the
customers, therefore, it helps the companies to determine how to manage customer
relationships in order to increase customer retention and profitability of both individual
customers and customer segments. The ABC analysis often provides information
which leads to such improved relationships that the profitability of both the company
and its customers is increased.
 Line managers do not believe the product costs reported by the accounting
department.
 Marketing personnel are unwilling to use reported product costs in making pricing
decisions.
 Complex products that are difficult to manufacture are reported to be very profitable,
although they are not priced at a premium.
 Product-line profit margins are difficult to explain.
 Sales are increasing, but profits are declining.
 Line managers suggest that apparently profitable products be dropped.
 Marketing or production managers are using ‘bootleg costing systems’, which are
informal systems they design, often on a personal computer.
 Some products that have reported high profit margins are not sold by competitors.
 The firm seems to have captured a highly profitable product niche all for itself.
 Overhead rates are very high, and increasing over time.
 Product lines are diverse.
 Direct labour is a small percentage of total costs.
 The results of bids are difficult to explain.
 Competitors’ high-volume products seem to be priced unrealistically low.
 The accounting department spends significant amounts of time on special costing
projects to support bids or pricing decisions.

4.5 PROBLEMS ON ACTIVITY BASED COSTING

(SIMPLE PROBLEMS ONLY)

Problem 4.1: Roop Industries Limited manufacturers of machinery products, produces

two tools—‘Kajal’ and ‘Kajra’. The direct materials cost amounts to 20 for Kajal
and 40 for Kajra. The firm pays 18 per unit for each product as direct labour cost.
Since Kajal is a low volume product, therefore, the firm produces only 6,000 units
annually whereas the firm produces 18,000 units of Kajra every year as it is a high Self-Instructional
Material 63
Activity Based Costing volume product. The total direct labour hours amount to 24,000 (6,000+18,000) as
each product requires an hour of direct labour for manufacturing.
The estimated manufacturing overhead cost on various activities of the firm stands as:
NOTES Activities Estimated Overhead ( )
1. Setting up machines 60,000
2. Machinery 30,000
3. Inspection 6,000
Total 96,000
The expected use of cost drivers per activity is:
No of setup 1,200 setups
Machine hours 30,000 hours
No of inspection 6,000 inspections
Since Kajal is a low volume product in comparison to Kajra, therefore,
management of Roop Industries agrees that Kajal requires more setups and inspection.
Accordingly, the expected use of cost drivers per product has been agreed by the
management for Kajal and Kajra in the following proportion:
1. Setting up machines 1:2
2. Machining 3:2
3. Inspecting 1:3
You are required to compute unit cost of products produced by Roop Industries
under both traditional costing as well as activity-based costing.
Solution:
Computation of unit cost of Kajal and Kajra under traditional costing system:

*Calculation of overhead per unit:

Predetermined Overhead Rate** × Direct Labour Hours
= 4 × 1 hour
= 4
**Calculation of Predetermined Overhead Rate:

Self-Instructional Overhead Rate =

64 Material
 Activity Based Costing
=

= 4 per hour
NOTES

Overhead Rate Per Unit:

Kajal:

Kajra:

Working:
* Conversion of cost drivers per activity into per product:
Setting up machines:
Kajal: 1/3 × 1,200 = 400 setups
Kajra: 2/3 × 1,200 = 800 setups
Machining:
Kajal: 3/5 × 30,000 = 18,000 machine hours
Kajra: 2/5 × 30,000 = 12,000 machine hours
Inspecting:
Kajal: 1/4 × 6,000 = 1,500 inspections
Kajra: 3/4 × 6,000 = 4,500 inspections
**Calculation of cost assignment:
Cost assignment: Expected use of cost driver per product × Activity-based overhead
rate
Setting Up Machines:
Kajal: 400 setups × 50*** = 20,000
Kajra: 800 setups × 50*** = 40, 000
Machining:
Kajal: 18,000 hours × 1*** = 18,000
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Material 65
Activity Based Costing Kajra; 12,000 hours × 1*** = 12,000
Inspecting:
Kajal: 1,500 inspections × 1*** = 1,500
NOTES Kajra: 4,500 inspections × 1*** = 4,500
*** Calculation of activity-based overhead rates:

Activity based overhead rate =

Setting Machines =

Machine =

Setting Machines =

Problem 4.2: JK Industries Limited manufactures two cement tiles—Economy and

Deluxe using the same plant and process. During a period the company produced
10,000 units of economy tiles and 5,000 units of deluxe titles. The company records
provide the following details of overhead costs:

The other details related to these products are shown below:

Economy Tiles Deluxe Tiles
Direct labour hours (per unit) 5 hrs. 6 hrs.
Machine hours 8,000 12,000
Set-up in the period 600 800
Orders handled in the period 1,200 2,800
Number of inspections during the period 300 700
You are required to compute the production overheads to be absorbed by one unit of
each of the tiles under both:
I. Traditional costing method; and
II. Activity-Based costing method.
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66 Material
Solution: Activity Based Costing

I. Traditional Costing Method

Calculation of overhead to be absorbed per unit:
NOTES
Overhead A bsorption Rate =

* Calculation of Direct Labour hours: (No. of units produced × Direct labour

hour per unit)
Tile Economy: 10,000 units × 5 hrs = 50,000 hours
Tile Deluxe: 5,000 units × 6 hrs = 30,000 hours
Total 80,000 hours
II. Activity-Based Costing Method

Overhead Cost per unit =

Economy tile =

Deluxe tile =

Working:
** Computation of activity-based overhead driver rate:

Activity-Based overhead driver rate =

(i) Machine cost =

(ii) Setups =

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Material 67
Activity Based Costing
(iii) Order handling =

NOTES (iv) Inspecting =

*** Calculation of expected use of cost drivers per activity:

(i) Machine hours:
Economy tile = 8,000 hours
Deluxe tile = 12,000 hours
Total = 20,000 hours
(ii) Setups in the period:
Economy tile = 600 setups
Deluxe tile = 800 setups
Total = 1,400 setups
(iii) Order handling:
Economy tile = 1,200 hours
Deluxe tile = 2,800 hours
Total = 4,000 hours
(iv) Inspecting:
Economy tile = 300 inspections
Deluxe tile = 700 inspections
Total = 1,000 inspections
Problem 4.3: MST Limited has collected the following data for its two activities. It
calculates activity cost rates based on cost driver capacity.

The company makes three products, M, S, and T. For the year ended March
31, 2021, the following consumption of cost drivers was reported:

Required:
(i) Compute the costs allocated in each product from each activity.
Self-Instructional
68 Material (ii) Calculate the cost of unused capacity for each activity.
Solution: Activity Based Costing

NOTES

(ii) Computation of Cost of Unused Capacity for each Activity:

I. Power: (50,000 kwh – 45,0002 kwh) = 5,000 × 4 = 20,000
II. Quality Inspection: (10,000 – 9,0002) = 1,000 × 3 = 30,000
Total 50,000
Working:
1. Calculation of ABC Cost Driver Rates:
(i) Power: Total OH Cost ÷ Capacity = 2,00,000 ÷ 50,000 = 4 per kwh
(ii) Quality Inspections: Total OH Cost ÷ Capacity = 3,00,000 ÷ 10,000 =
30 per inspection
2. Calculation of cost of unused capacity for the activities:
(i) Power: (10,000 + 20,000 + 15,000) = 45,000 kwh
(ii) Quality Inspection: (3,500 + 2,500 + 3,000) = 9,000 Quality Inspection
Problem 4.4: MST A engine manufacturing company has two production departments;
(i) maintenance and (ii) factory office. Budget cost data and relevant cost drivers are
as follows:
Departmental Costs
Snow mobile engine 6,00,000
Boat engine 17,00,000
Factory office 3,00,000
Maintenance department 2,40,000
Cost drivers:
Factory office department No. of employees
Snow mobile engine department 1,080 employees
Boat engine department 270 employees
Maintenance 150 employees
1,500 employees
Maintenance department: No. of work orders
Snow mobile engine department 570 orders
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Boat engine department 190 orders Material 69
Activity Based Costing Factory office department 40 orders
800
Required:
NOTES
(i) Compute the cost driver allocation percentage and then use these percentages
to allocate the service department costs by using direct method.
(ii) Compute the cost driver allocation percentage and then use these percentages
to allocate the service department costs by using non-reciprocal method/step
method.
(CA, PE II)
Solution:

(ii)

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70 Material
 Activity Based Costing

NOTES

Check Your Progress

1. State the aim of activity-based costing.
2. Mention examples of cost drivers for research and development.
3. What should the grouping of activities be driven by for effective classification?
4. What is the difference between activity-based costing in terms of accuracy?

4.6 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. Activity-based costing aims to rectify the problem of inaccurate cost

apportionment under the traditional approach in which the indirect costs are
allocated and apportioned on arbitrary basis.
2. Examples of cost drivers for research and development include number of
research projects, personnel hours on a project and complexities of projects.
3. For an effective classification, grouping of activities should be driven by the
correlation that exists between the activities within the level. This grouping of
activities will given birth to ‘activity cost pools’- a collection of costs that are to
be allocated to cost objects.
4. The ABC system uses logic and reason for the selection of the basis for
apportionment of costs among different cost objects, therefore, it is bound to
be accurate. In traditional costing, the basis used apportionment is arbitrary
which is not based on any scientific approach, therefore, its accuracy is always
doubtful.

4.7 SUMMARY

 Activity-based costing (ABC) is a new and scientific approach developed for

assigning overheads, i.e., indirect costs, to end products, jobs and processes.
 ABC is a modern tool of charging overhead costs in which costs are first traced
to activities and then to products or jobs.

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Material 71
Activity Based Costing  The concept of cost pool is similar to that of cost centre in traditional cost
system. In ABC, a cost pool is created for each activity in which all costs relating
to an activity are accumulated.
 Cost driver is a factor that causes a change in the cost of an activity. Cost driver
NOTES
is of two types: resource cost driver and activity cost driver.
 The following are the steps in activity based cost allocation: identification of the
main activities, creation of cost pool, determination of the activity cost drivers,
calculation of the activity cost drivers, calculation of the activity cost driver rate
and charging the costs of activities in products.
 The designing of activity-based costing system starts with an analysis of the
activities that will form the foundation of such a system. For this purpose, a
firm’s activity-based costing implementing team has to use a framework called
cost hierarchy that helps it to classify activities according to the level at which
their costs are incurred.
 Although activity-based costing does not change the amount of overhead costs
yet it helps firms to allocate those costs in a more accurate manner. In fact,
activity-based costing helps a firm to identify and eliminate non-value-added
activities and thereby reduce costs.

4.8 KEY WORDS

 Activity-based costing: It is ‘cost attribution to cost units on the basis of

benefits received from indirect activities, i.e., ordering, setting-up, assuring quality,
etc.’
 Cost-driver: It is a factor that causes a change in the cost of an activity.
 Cost pools: It is the sum total of all costs assigned to activity.

4.9 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. What is the main focus of activity-based costing?
2. Write short notes on the concept of cost pool and cost drivers.
3. List the stages in activity-based costing.
4. How are activities classified as per the framework provided by Cooper?
5. What is the manner in which firms should identify and using drivers for each
activity of activity-based costing?

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72 Material
Long Answer Questions Activity Based Costing

1. Describe the purpose and benefits of activity-based costing. Discuss the

differences between activity-based costing and traditional costing.
NOTES
4.10 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:

Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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Material 73
 Methods of Costing

UNIT 5 METHODS OF COSTING

Structure NOTES
5.0 Introduction
5.1 Objectives
5.2 Introduction to Methods of Costing
5.3 Job Costing: Meaning, Features, Advantages and Limitations
(Simple Problems Only)
5.4 Introduction of Batch Costing (Theory Only)
5.5 Answers to Check Your Progress Questions
5.6 Summary
5.7 Key Words
5.8 Self Assessment Questions and Exercises
5.9 Further Readings

5.0 INTRODUCTION

There are many different methods and techniques available for accountants in
accounting. The diversity in methods of costing is based on the different types of
business and their needs. An appropriate costing method is significant for not only
proper recording and assignment of costs but also for efficient costing process in the
entire organization. In this unit, we will take up two major methods of costing including
job and batch costing. You will study the concept, application and procedure of these
two methods of costing.

5.1 OBJECTIVES

After going through this unit, you will be able to:

 Discuss the methods of costing
 Explain the meaning, features, advantages and limitations of job costing
 Describe the basics of batch costing

5.2 INTRODUCTION TO METHODS OF COSTING

The methods or types of costing refer to the techniques and processes employed in
the ascertainment of costs. Several methods have been designed to suit the needs of
different industries. The method of costing to be applied in a particular concern depends
upon the type and nature of manufacturing activity. Basically, there are two methods of
costing:
1. Job costing or job order costing
2. Process costing Self-Instructional
Material 75
Methods of Costing All other methods are variations of either job costing or process costing. The various
methods given here are in outline only and detailed discussion of each of these is given
in later chapters.
1. Job order costing: This method ‘applies where work is undertaken to
NOTES
customers’ special requirements.’ Cost unit in job order costing is taken to be
a job or work order for which costs are separately collected and computed. A
job, big or small, comprises a specific quantity of a product or service to be
provided as per customer’s specifications. Industries where this method is used
include printing repair shops, interior decoration and painting.
2. Contract costing or terminal costing: This is a variation of job costing and,
therefore, principles of job costing apply to this method. The difference between
job and contract is that job is small and contract is big. It is well said that a
contract is a big job and a job is a small contract. The cost unit here is a
‘contract’ which is of a long duration and may continue over more than one
financial year. Contract costing is most suited to construction of buildings, dams,
bridges and roads, shipbuilding, etc.
3. Batch costing: Like contract costing, this is also a variation of job costing. In
this method, the cost of a batch or group of identical products is ascertained
and therefore each batch of products is a cost unit for which costs are ascertained.
This method is used in companies engaged in the production of readymade
garments, toys, shoes, tyres and tubes, component parts, bakery, etc.
4. Process costing: As distinct from job costing, this method is used in mass
production industries manufacturing standardized products in continuous
processes of manufacturing. Costs are accumulated for each process or
department. Here raw material has to pass through a number of processes in a
particular sequence to the completion stage. In order to arrive at cost per unit,
the total cost of a process is divided by the number of units produced. The
finished product of one process is passed on to the next process as raw material.
Textile mills, chemical works, sugar mills, refineries, soap manufacturing, etc.,
may be cited as examples of industries which employ this method.
5. Operation costing: This is nothing but a refinement and a more detailed
application of process costing. A process may consist of a number of operations
and operation costing involves cost ascertainment for each operation instead of
a process where distinctly seperate operations are involved in a process, cost
of each operation is found for effective control mechanism.
6. Single, output or unit costing: This method of cost ascertainment is used
when production is uniform and consists of a single or two or three varieties of
the same product. Where the product is produced in different grades, costs are
ascertained grade-wise. As the units of output are identical, the cost per unit is
found by dividing the total cost by the number of units produced. This method is
applied in mines, quarries, brick kilns, steel production, flour mills, etc.
7. Operating or service costing: This method should not be confused with
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76 Material operation costing. It is used in undertakings which provide services instead of
 manufacturing products. For example, transport undertakings (road transport, Methods of Costing

railways, airlines, shipping companies), electricity companies, hotels, hospitals

and cinemas, use this method. The cost units are passenger-kilometre or tonne-
kilometre, kilowatt hours, a room per day in a hotel, a seat per show in a
cinema hall, etc. This method is a variation of process costing. NOTES
8. Multiple or composite costing: It is an application of more than one method
of cost ascertainment with respect to the same product. This method is used in
industries where a number of components are separately manufactured and
then assembled into a final product. For example, in a television set manufacturing
company, manufacture of different component parts may require different
production methods and thus different methods of costing may have to be used.
Assembly of these components into final product requires yet another method
of costing. Other examples of industries which make use of this method are air-
conditioners, refrigerators, scooters, cars and locomotives.

Ab
Costing Techniques

ry Marginal s
geta l costing co orpt
d ro sti ion
Bu cont ng

d Un
ar co ifor
tand ing st i m
S os t Cost ng
c
Data

Job Process
Costing Methods

costing costing

Factory Batch Contract Unit Operating Operation

job costing costing costing costing costing costing

Multiple
costing

Fig. 5.1 Costing Methods and Techniques

Techniques of Costing
It is the type of industry that determines which of the eight methods of costing discussed
above will be used in a particular enterprise. However, in addition to these methods,
there are certain techniques of costing which are not alternatives to the methods discussed
above. These techniques may be used for special purpose of control and policy in any
business irrespective of the method of costing being used there. These techniques
have been briefly explained below:
1. Standard costing: This is a very valuable technique of controlling cost. In
this technique, standard cost is predetermined as target of performance, and
actual performance is measured against the standard. The difference between
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Methods of Costing
standard and actual costs are analysed to know the reasons for the difference
so that corrective actions may be taken.
2. Budgetary control: Closely allied to standard costing is the technique of
NOTES budgetary control. A budget is an expression of a firm’s business plan in financial
form and budgetary control is a technique applied to the control of total
expenditure on materials, wages and overheads by comparing actual performance
with planned performance. Thus, in addition to its use in planning, the budget is
also used for control and co-ordination of business operations.
3. Marginal costing: In this technique, separation of costs into fixed and variable
(marginal) is of special interest and importance. This is so because marginal
costing regards only variable costs as the cost of the products. Fixed cost is
treated as period cost and no attempt is made to allocate or apportion this cost
to individual cost centres or cost units. It is transferred to costing profit and loss
account of the period. This technique is used to study the effect on profit of
changes in volume or type of output.
4. Total absorption costing: It is a traditional method of costing whereby total
costs (fixed and variable) are charged to products. This is in complete contrast
to marginal costing where only variable costs are charged to products. Although
until recently, this was the only technique employed by cost accountants, but
now a days it is considered to have only a limited application.
5. Uniform costing: This is not a separate technique or method of costing like
standard costing or process costing. It simply denotes a situation in which a
number of firms adopt a uniform set of costing principles. It has been defined by
CIMA, London as ‘the use by several undertakings of the same costing
principles and/or practices.’ This helps to compare the performance of one
firm with that of other firms and thus, to derive the benefit of anyone’s better
experience and performance.

Check Your Progress

1. What is the cost unit taken in job order costing?
2. Mention the types of industries in which unit costing is applied.
3. Name the costing technique which is used to study the effect on profit of changes
in volume or type of output.

5.3 JOB COSTING: MEANING, FEATURES,

ADVANTAGES AND LIMITATIONS
(SIMPLE PROBLEMS ONLY)

All industries may be broadly classified into two categories:

1. Job order industries
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78 Material
 In job order industries, production work is done against orders from customers. Methods of Costing
Each job work needs special treatment and can be clearly distinguished from other
jobs. Each job is completed as per customer’s specifications. Examples of job order
industries are printing press, construction of buildings, bridges, roads and ship building.
In mass production, firms manufacture uniform types of products. Since NOTES
production is of standard products, it is on a mass scale and on a continuous basis. No
customer order or specifications are required for production. Examples of mass
production industries are textiles, paper, sugar, chemicals and steel.
Job costing
Job costing or job order costing is a method of cost ascertainment used in job order
industries. Special features of such industries are as follows:
(a) Production is against customer’s orders and not for stocks.
(b) Each job has its own characteristics and requires special attention.
(c) The flow of production from one department to another is not uniform. It is the
nature of job which determines the department through which it is to be processed.
Objectives of Job Costing
The following are the main objectives of job costing:
1. Cost of each job/order is ascertained separately. This helps in finding out the
profit or loss on each individual job.
2. It enables the management to know those jobs which are more profitable and
those which are unprofitable.
3. It provides a basis for determining the cost of similar jobs undertaken in future.
It thus helps in future production planning.
4. It helps the management in controlling costs by comparing the actual costs with
the estimated costs.
Procedure of Job Costing
The following steps are taken in job costing:
1. Job number: When an order has been accepted, an individual job number must
be assigned to each job so that separate jobs are identifiable at all stages of production.
Assignment of job numbers also facilitates reference for costing purposes in the ledger
and is conveniently short for use on various forms and documents.
2. Production order: The production control department then makes out a Production
Order, thereby authorizing to start work on the job. Several copies of the production
order are prepared, the copies often being in different colours to distinguish between
them more easily. These copies are passed on to the following:
(i) All departmental foremen concerned with the job
(ii) Storekeeper for issuance of materials
(iii) Tool room for an advance notification of tools required
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Methods of Costing

NOTES

Fig. 5.2 Production Order for Job

The columns provided in the production order differ widely, depending largely
upon the nature of production. Sometimes orders are accompanied by the blue prints
and contain a bill of materials and detailed instructions as to which tools and machinery
are to be used.
3. Job cost sheet: The unique accounting document under job costing is the job cost
sheet. Receipt of production order is the signal for the cost accountant to prepare a
job cost sheet on which he will record the cost of materials used and the labour and
machine time taken. Each concern has to design a job cost sheet to suit its needs. A
simple pro forma of job cost sheet is given in Fig. 5.3.
Job cost sheets are not prepared for specified periods but they are made out for
each job regardless of the time taken for its completion. However, material, labour
and overhead costs are posted periodically to the relevant cost sheet.

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 Methods of Costing

NOTES

Fig. 5.3 Job Cost Sheet

The material, labour and overheads to be absorbed into jobs are collected and
recorded in the following way:
(a) Direct materials: Material requisitions or bills on materials show the quantities
of materials issued to jobs from store. When copies of these documents reach
the cost office, they are priced and entered in the stores ledger account in the
‘issues’ column. Each requisition shows the job number to which the material is
to be charged. Summaries of material requisitions are prepared at regular intervals
on Materials Abstract or Materials Issue Analysis Sheet. These summaries
facilitate debiting the job with total cost of materials rather than charging with
many small items. These totals are also used for entries in stores ledger control
account and work-in-progress control account.
(b) Direct wages: As explained earlier in the unit on labour cost, the wages payable
to workers are calculated on clock cards, job cards, time sheets, etc. The
summaries of job cards are made on Wages Abstract or Wages Analysis Sheets,
which show the direct wages chargeable to each job. The total of wages
chargeable to various jobs is debited to work-in-progress control account.
(c) Direct expenses: Direct expenses which can be identified with specific jobs
are directly charged to these jobs, the total being debited to work-in-progress
control account.
(d) Overheads: Indirect materials, indirect wages and indirect expenses which
cannot be identified with specific jobs are apportioned to cost centres. Absorption
of overheads by the jobs passing through the cost centres is based upon
percentage of direct wages or direct material cost, direct labour hours or machine
hours, etc.
The direct materials, wages and expenses and the overheads absorbed are
totalled to give the total cost.
Completion of Jobs
When jobs are completed, the cost is transferred to cost of sales account. The total
cost of jobs completed during each period is set against the sales to determine the
profit or loss for the, period.
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Methods of Costing Illustration 5.1: A factory uses job costing. The following data are obtained from its
books for the year ended 31 December 2020:

Direct materials 90,000 Selling and distribution overheads 52,500

NOTES
Direct wages 75,000 Administration overheads 42,000
Profit 60,900 Factory Overheads 45,000
(a) Prepare a Job Cost Sheet indicating the Prime cost, Works cost, Production
cost, Cost of sales and the Sales value.
(b) In 2021, the factory received an order for a number of jobs. It is estimated that
direct materials required will be 1,20,000 and direct labour will cost 75,000.
What should be the price for these jobs if factory intends to earn the same rate
of profit on sales assuming that the selling and distribution overheads have gone
up by 15%? The factory recovers factory overheads as a percentage of direct
wages and administration and selling and distribution overheads as a percentage
of works cost, based on cost rates prevailing in the previous year.(CA Inter)
Solution:
Production Statement
for the year ended 31 December 2020

Direct materials 90,000

Direct wages 75,000
Prime Cost 1,65,000
Factory overheads 45,000
Works Cost 2,10,000
Administration overheads 42,000
Cost of Production 2,52,000
Selling and distribution overheads 52,500
Cost of Sales 3,04,500
PROFIT 60,900
Sales Value 3,65,400

Calculation of Rates
45,000
1. % of factory overheads to direct wages = × 100 = 60%
75,000
42,000
2. % of administration overheads to works cost = × 100 = 20%
2,10,000
3. Selling and distribution overheads 52,500
Add 15% increase 7875
60,375
Selling and distribution overheads % to works cost
60,375
= × 100 = 28.75%
2,10,000

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 Methods of Costing
60,900
4. % of profit to sales = × 100
3,65,400
 1 1 
= 16.67%  6 of sales or 5 of total cost 
NOTES
Job Cost Sheet
(Statement showing Estimated Cost and Price of Jobs in 2021)

Direct materials 1,20,000

Direct wages 75,000
Prime Cost 1,95,000
Factory overheads (60% of direct labour) 45,000
Works Cost 2,40,000
Administration overheads (20% of works cost) 48,000
Cost of Production 2,88,000
Selling and distribution overheads (28.75% of works cost) 69,000
Total Cost 3,57,000
PROFIT (1/5 of cost) 71,400
Selling Price 4,28,400

Advantages and Limitations of Job Costing

The advantages of job costing:
 It helps companies learn about profits from each job separately.
 It helps companies control costs better since they can be computed at any stage
of job completion.
 Cost of jobs can be compared with past records to learn control excess and
make better estimates.
 Spoilage can be tracked better.
 It helps in pricing of individual jobs.
The limitations of job costing:
 It is an expensive process.
 It is very difficult to standardize.
 It demands a lot of clerical work.
 Accurate information is difficult to obtain since many small jobs are ongoing at
the same time.

Check Your Progress

4. What is the timeline for which job sheet is prepared?
5. How are direct expenses treated in job costing?

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Methods of Costing
5.4 INTRODUCTION OF BATCH COSTING
(THEORY ONLY)
NOTES Batch costing is a variation of job costing. While job costing is concerned with costing
of jobs that are made to a customer’s particular requirements, batch costing is used
when production consists of limited repetitive work and a definite number of articles
are manufactured in each batch to be held in stock for sale to customers generally.
Thus, a batch is a cost unit consisting of a group of identical items.
Application of Batch Costing
Batch costing is applied in the manufacture of shoes, toys, readymade garments,
component parts of say, cars, radios, watches, etc. In shoe industry, for example, it is
just not economical to manufacture a pair of shoes to meet the requirements of one
customer. On the other hand, batches of say 500 to 5,000 shoes of each size, style,
colour, etc., are economically made and held in stock for sale on demand.
 Shoe manufacture
 Toys
 Readymade garments
 Tyres and tubes
 Component parts, etc.
Batch Costing Procedure
Each batch is given a batch number in exactly the same way as a job is given a job
number. Direct materials, direct labour and direct expenses which can be identified
with the batch are recorded on the Batch Cost Card. The costing of materials requisitions
and time sheets follows normal job costing principles. Overheads are absorbed on
one of the bases already explained as is done is job costing. When a batch is completed,
the total cost of the batch is divided by the quantity produced in the batch to arrive at
the cost per unit or per dozen etc., as required.
Often, a major cost in producing a batch is the cost of setting up jigs and tools.
This is of the nature of fixed cost and is spread over the total number of articles in the
batch. So the larger the batch size, the lower is the setting up cost per article.
Illustration 5.2: Component 89-X is made entirely in cost centre 75. Material cost is
6 paise per component and each component takes 10 minutes to produce. The machine
operator is paid 72 paise per hour, and the machine hour rate is
1.50. The setting up of the machine to produce component 89-X takes 2 hours 20
minutes.
On the basis of this information, prepare a comparative cost sheet showing the
production and setting up cost, both in total and per component assuming a batch of
(a) 10 components, (b) 100 components and (c) 1,000 components, is produced.
(CA Inter)
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84 Material
Solution: Methods of Costing
Comparative Cost Sheet
Component 89-X

Particulars Batch size in components

10 100 1,000
NOTES

Setting-up Cost
Labour–2 hrs 20 mts at 72 paise per hour 1.68
Overheads–2 hrs 20 mts at 1.50 per
machine hour 3.50 5.18 5.18 5.18
Production Cost
Material cost @ 6 paise per component 0.60 6.00 60.00
Wages @ 72 paise per hour
For 10 components 1 hr 40 mts 1.20
For 100 components 16 hrs 40 mts 12.00
For 1,000 components 166 hrs 40 mts 120.00
Overheads @ 1.50 per machine hour
For 10 components 1 hr 40 mts 2.50
For 100 components 16 hrs 40 mts 25.00
For 1,000 components 166 hrs 40 mts 250.00

Total Cost 9.48 48.18 435.18

Cost per component (Total cost ÷ No. of Components) 0.94 0.48 0.44

Economic Batch Quantity (EBQ)

In the above Illustration 5.2, it was seen that when batch size increases, the total cost
per component decreases. It is due to the fixed nature of setting up cost which remains
unchanged with the increase or decrease in the batch size. Thus larger the number of
units in a batch, lower is the setting up cost per unit. In industries where batch costing
is employed, an important point is the determination of the optimum quantity in a batch
at which cost per unit is minimum. This is known as a Economic Batch Quantity.
While determining economic batch quantity, two type of costs are considered:
(a) Setting-up costs: This is the cost of setting the machine and the tools for
production of a particular batch. This is of a fixed nature. Therefore, when the
size of the batch is large, setting-up cost per article in the batch is lower.
(b) Carrying cost: This includes the cost of storage, interest on capital invested,
etc. Larger size of a batch leads to higher carrying costs.
In determining the economic batch quantity, there are five main considerations:
(a) The cost and time taken in setting up the tools on the machines
(b) The cost and time taken in manufacturing the parts
(c) The interest on capital invested in the parts
(d) The cost of storage
(e) The rate of consumption or sale of the parts
As the concept of economic batch quantity is similar to economic order quantity
Self-Instructional
the former can also be determined with the help of tables, mathematical formulae and Material 85
Methods of Costing graphs. A simple formula for determining the economic batch quantity is given below:
2.U.S
EBQ =
C
NOTES where EBQ = Economic Batch Quantity
U = No. of units to be produced in a year
S = Set-up costs per batch
C = Carrying cost per unit of production.
Example: U = Production per year = 12,000 units
S = Set-up costs per batch = 150
C = Carrying cost per unit = 0.20
2  12, 000  150
EBQ = = 4,243 units
0.20

Check Your Progress

6. Why does the total cost per component decreases whenever the batch size
increases?
7. What is carrying cost?

5.5 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. Cost unit in job order costing is taken to be a job or work order for which costs
are separately collected and computed.
2. Single, output or unit costing is applied in mines, quarries, brick kilns, steel
production, flour mills, etc.
3. Budgetary control is the costing technique which is used to study the effect on
profit of changes in volume or type of output.
4. Job cost sheets are not prepared for specified periods but they are made out
for each job regardless of the time taken for its completion. However, material,
labour and overhead costs are posted periodically to the relevant cost sheet.
5. Direct expenses which can be identified with specific jobs are directly charged
to these jobs, the total being debited to work-in-progress control account.
6. When batch size increases, the total cost per component decreases. It is due to
the fixed nature of setting up cost which remains unchanged with the increase or
decrease in the batch size.
7. Carrying cost includes the cost of storage, interest on capital invested, etc.

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 Methods of Costing
5.6 SUMMARY

 The methods or types of costing refer to the techniques and processes employed
in the ascertainment of costs. Several methods have been designed to suit the NOTES
needs of different industries.
 There are two methods of costing job costing and process costing. All other
methods are variations of either job costing or process costing.
 Some of the popular methods of costing include job order costing, contract
costing, batch costing, process costing, operation costing, service costing, unit
costing and composite costing.
 It is the type of industry that determines which of the eight methods of costing
discussed above will be used in a particular enterprise. However, in addition to
these methods, there are certain techniques of costing which are not alternatives
to the aforementioned methods.
 Some of the techniques of costing are standard costing, budgetary control,
marginal costing, total absorption costing and uniform costing.
 All industries may be broadly classified into two categories: 1. Job order industries
and 2. Mass production industries.
 In job order industries, production work is done against orders from customers.
Each job work needs special treatment and can be clearly distinguished from
other jobs. Each job is completed as per customer’s specifications. Examples
of job order industries are printing press, construction of buildings, bridges,
roads and ship building.
 Job costing or job order costing is a method of cost ascertainment used in job
order industries.
 Steps involved in job costing are: assigning of job numbers, preparation of
production order and preparation of job cost sheet.
 When jobs are completed, the cost is transferred to cost of sales account. The
total cost of jobs completed during each period is set against the sales to
determine the profit or loss for the, period.
 Batch costing is a variation of job costing. While job costing is concerned with
costing of jobs that are made to a customer’s particular requirements, batch
costing is used when production consists of limited repetitive work and a definite
number of articles are manufactured in each batch to be held in stock for sale to
customers generally.
 Each batch is given a batch number in exactly the same way as a job is given a
job number. Direct materials, direct labour and direct expenses which can be
identified with the batch are recorded on the Batch Cost Card. The costing of
materials requisitions and time sheets follows normal job costing principles.
Overheads are absorbed on one of the bases already explained as is done is
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Material 87
Methods of Costing job costing. When a batch is completed, the total cost of the batch is divided by
the quantity produced in the batch to arrive at the cost per unit or per dozen
etc., as required.
 While determining economic batch quantity, two type of costs are considered:
NOTES
setting-up costs and carrying cost.

5.7 KEY WORDS

 Job costing or job order costing: It is a method of cost ascertainment used in

job order industries.
 Job order industries: It refers to industries in which production work is done
against orders from customers. Each job work needs special treatment and can
be clearly distinguished from other jobs.
 Batch costing: It is a costing method used when production consists of limited
repetitive work and a definite number of articles are manufactured in each batch
to be held in stock for sale to customers generally.
 Economic Batch Quantity: It refers to the optimum quantity in a batch at
which cost per unit is minimum.

5.8 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. What is the distinction between costing methods and techniques?
2. Write a short note on the popular techniques of costing.
3. What are job order and mass production industries?
4. List the features of job order industries.
5. Enumerate the main objectives of job costing.
6. What are the types of industries in which batch costing is used?
7. Mention the five main considerations and formula for determining the economic
batch quantity.
Long Answer Questions
1. Explain the major methods of costing.
2. Describe the steps taken in job costing.

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 Methods of Costing
5.9 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:

Vikas Publishing House. NOTES
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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 Contract Costing

UNIT 6 CONTRACT COSTING

Structure NOTES
6.0 Introduction
6.1 Objectives
6.2 Meaning and Features of Contract Costing
6.2.1 Procedure
6.2.2 Work-Certified and Uncertified, Work-in-Progress and Retention Money
6.2.3 Cost–Plus Contract
6.2.4 Escalation Clause
6.3 Profit on Incomplete Contract
6.4 Answers to Check Your Progress Questions
6.5 Summary
6.6 Key Words
6.7 Self Assessment Questions and Exercises
6.8 Further Readings

6.0 INTRODUCTION

In this unit you will learn about the meaning, features and procedures of contract
costing. It is a method of costing used in industries where costs are to be tracked on
the basis of specific contracts with the clients. Contract costing is also referred to as
special order or job costing since each order or work here is based on specialized
requirements of the customers. Contract costing is often found in construction industries.
There are many special elements of contract costing including work-in-progress,
retention money, escalation clause and profits on incomplete contracts. All of these
aspects will also be discussed in this unit.

6.1 OBJECTIVES

After going through this unit, you will be able to:

 Discuss the meaning and features of contract costing
 Explain the procedure of contract costing
 Describe the concepts of work-certified and uncertified, work-in-progress and
retention money
 Examine cost plus contract and escalation clause
 Discuss profit on incomplete contract

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Contract Costing
6.2 MEANING AND FEATURES OF CONTRACT
COSTING

NOTES Contract costing, also known as terminal costing, is a variant of job costing. In this
method of costing, each contract is a cost unit and an account is opened for each
contract in the books of the contractor to ascertain profit/loss thereon.
Contract Costing and Job Costing—Distinction
Main points of distinction between contract and job costing are as follows:
1. The number of jobs undertaken at a time are usually large as compared to
number of contracts because contracts are generally much bigger in size.
2. In contract costing, most of the costs are chargeable direct to contract accounts.
Under job costing, direct allocation to such an extent is not possible.
3. Allocation and apportionment of overhead costs is simpler in contract costing
as compared to job costing.
4. Contract is generally big while job is small. It is well said, ‘a job is a small
contract and a contract is a big job.’
5. Jobs are usually carried out in factory premises while contract work is done at
site.
Features of Contract Costing
Contract costing usually shows the following features:
1. Contracts are generally of large size and, therefore, a contractor usually carries
out a small number of contracts in the course of one year.
2. A contract generally takes more than one year to complete.
3. Work on contracts is carried out at the site of contracts and not in factory
premises.
4. Each contract undertaken is treated as a cost unit.
5. A separate contract account is prepared for each contract in the books of the
contractor to ascertain profit or loss on each contract.
6. Most of the materials are specially purchased for each contract. These will,
therefore, be charged direct from the supplier’s invoices. Any materials drawn
from the store is charged to contract on the basis of material requisition notes.
7. Nearly all labour is direct.
8. Most expenses (e.g., electricity, telephone, insurance, etc.) are also direct.
9. Specialist sub-contractors may be employed for say, electrical fittings, welding
work, glass work, etc.
10. Plant and equipment may be purchased for the contract or may be hired for the
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92 Material duration of the contract.
 11. Payments by the customer (contractee) are made at various stages of completion Contract Costing

of the contract based on architect’s certificate for the completed stage. An

amount, known as retention money, is withheld by the contractee as per agreed
terms.
NOTES
12. Penalties may be incurred by the contractor for failing to complete the work
within the agreed period.
6.2.1 Procedure
The basic procedure for costing of contracts is as follows:
1. Contract account: Each contract is allotted a distinct number and a separate
account is opened for each contract.
2. Direct costs: Most of the costs of a contract can be allocated direct by to the
contract. All such direct costs are debited to the contract account.
Direct costs for contracts include: (i) Materials; (ii) Labour and supervision;
(iii) Direct expenses; (iv) Depreciation of plant and machinery; (v) Sub-contract
costs, etc.
3. Indirect costs: Contract account is also debited with overheads which tend to
be small in relation to direct costs. Such costs are often absorbed on some
arbitrary basis as a percentage on prime cost, or materials, or wages, etc.
Overheads are normally restricted to head office and storage costs.
4. Transfer of materials or plant: When materials, plant or other items are
transferred from the contract, the contract account is credited by that amount.
5. Contract price: The contract account is also credited with the contract price.
However, when a contract is not complete at the end of the financial year, the
contract account is credited with the value of work-in-progress as on that date.
6. Profit or loss on contract: The balance of contract account represents profit
or loss which is transferred to Profit and Loss Account. However, when contract
is not completed within the financial year, only a part of the profit arrived is
taken into account and the remaining profit is kept as reserve to meet any
contingent loss on the incomplete portion of the contract.
6.2.2 Work-Certified and Uncertified, Work-in-Progress and Retention
Money
Some of the important points to be considered in contract costing are now discussed:
Cost of Materials
Materials include: (i) materials specifically purchased for the contract; (ii) materials
issued from store against material requisition notes. The cost of both these types of
materials is debited to the contract account.
Materials Returned to Store: Whenever materials are issued in excess of
requirements, for instance, cement, sand, pipes and bricks, these are later returned to
the store accompanied by a Material Return Note which gives the details of the materials
returned. Such returned materials are credited to contract account. Self-Instructional
Material 93
Contract Costing Materials at Site: At the end of each accounting period, value of materials
lying unused at site is credited to contract account and is carried forward for charging
against the next period.

NOTES Cost of Labour

All wages of workers engaged on a particular contract are charged direct to the contract,
irrespective of the type of work they perform. When several contracts are running at
different locations, payroll is normally sectionalized so as to have separate payroll for
each contract. Difficulties in costing may be encountered when some workers may have to
move from one site to another if a number of small contracts are under-taken. In such
situations, it becomes necessary to provide time sheets from which allocations can be
made. In order to control labour utilization and prevent fraud in the payment of wages,
surprise visits by head-office personnel will be necessary.
Plant
There are two different methods of dealing with depreciation of plant in contract account:
(a) Contract account is debited with the cost of the plant installed. When the contract
is completed or the plant is no longer required, the plant is revalued and contract
account is credited with this revalued or depreciated figure. In case plant is sold
on the completion of the contract, the contract account is credited with its sale
proceeds. The net effect of the above debit and credit will be that the contract
account will stand debited with the amount of depreciation, which is the difference
between the value of plant debited and value of plant credited. The method is
generally used on long contracts which extend over more than one year because
depreciated value of the plant is credited to the contract account and brought
down as an opening balance in the next period.
(b) Alternatively, contract account is simply debited with the amount of depreciation.
It is usual to use this method when plant is sent to contract only for a short
period. For example, mobile crane or bulldozer used in a contract may be
charged on this basis.
However, when a plant is hired for a contract, a charge for the hire of the plant
is debited to the contract as a direct expense.
Sub-contracts
Work of specialized character, for which facilities are not internally available, is offered
to a sub-contractor. For example, steel work, glass work, painting, etc., is usually
carried out by the sub-contractors who are accountable to the main contractor. The
cost of such work is charged to the contract account.
Payment based on Architect’s Certificate
In case the contract is small, full payment is usually made on the completion of the
contract. But in case of large contracts, it may take more than one year to complete. In
such a case, if no payment is received until the completion of the contract, the financial
resources of the contractor could surely become strained. Therefore, a system of
Self-Instructional progress payments is followed. In this system, part payments of the contract amount
94 Material
are paid from time to time on the basis of certificate issued by the architects (acting for Contract Costing
the contractee), certifying the value of the work satisfactorily completed. Such payments
received by the contractor are usually credited to the personal account of the contractee.
It should be noted that such payments are not entered in the Contract Account.
NOTES
Work-in-Progress: Work Certified and Work Uncertified
When the contract is not completed till the end of the accounting year, the architect is
required to value the work-in-progress. Such work-in-progress is classified into work
certified and work uncertified.
Work Certified: This is that part of the work-in-progress which has been
approved by the contractee’s architect or engineer for payment. Work certified is
valued at contract price (i.e., selling price), and includes an element of profit.
Work Uncertified: This is that part of the work-in-progress which is not
approved by the architect or engineer. 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 assets side of the balance sheet.
Retention Money and Cash Ratio
It is a usual practice not to pay the full amount of work certified. The contractee may
pay a fixed percentage, say 80% or 90% of the work certified, depending upon the
terms of the contract. This is known as Cash Ratio. The balance amount not paid is
known as Retention Money. For example, if cash ratio is 75%, the retention money
will be the remaining 25%. This retention money is a type of security for any defective
work which may be found in the contract later on. This also works as a deterrent for
the contractor to leave the contract incomplete, if he finds the contract unprofitable.
The retention money may also be adjusted against penalties that become due if the
contract is not completed within the stipulated time as per the terms of the agreement.
Extra Work
Sometimes the contractor is required to do some extra work like additions or alterations
in the work originally done as per agreement. The contractor will charge extra money
for such extra work. The cost of such extra work is debited to the contract account
and extra price realized is credited to the contract account.
6.2.3 Cost–Plus Contract
Cost-plus contract is a contract in which the price is not fixed at the time of entering
into the contract. The contract price is determinded by adding a specified amount or
percentage of profit to the costs allowed in the contract. The contractee compensates
the contractor for all allowable costs actually incurred by him. Over and above these
costs the contractor is paid a fixed amount or a fixed percentage of cost as profit. The
items of cost to be included for the purpose of determining contract price are broadly
agreed upon in advance. The accounts of the contractor are usually subject to audit by
the contractee.
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Material 95
Contract Costing Cost-plus contracts are usually entered into for executing special types of work,
like construction of dam, power house, newly designed ship, etc., where accurate
cost estimation is difficult. Government often prefers to give contracts on ‘cost-plus’
terms.
NOTES Advantages: Cost-plus contracts offer the following advantages:
To the Contractor:
1. There is no risk of loss being incurred on such contracts.
2. It protects him from the risk of fluctuations in market prices of material, labour,
etc.
3. It simplifies the work of preparing tenders and quotations.
To the Contractee: The contractee can ensure a fair price of the contract by being
entitled to audit the accounts of the contractor.
Disadvantages
The disadvantages of cost-plus contracts are:
To the Contractor:
1. The contractor is deprived of the advantages which would have accrued due to
favourable market prices.
2. The contractor has to suffer for his own efficiency. This is because profit is
usually based as a percentage of cost and efficient working resulting in lower
cost also leads to lower profits.
To the Contractee:
1. The contractee has to pay more for the inefficiency of the contactor as the
contractor has no incentive to reduce costs.
2. The price the contractee has to pay is unknown until after the completion of
work.
6.2.4 Escalation Clause
This clause is often provided in contracts to cover any likely changes in the price or
utilization of materials and labour. Thus, a contractor is entitled to suitably enhance the
contract price if the cost rises beyond a given percentage. The object of this clause is
to safeguard the interest of the contractor against unfavourable changes in cost. The
escalation clause is of particular importance where prices of material and labour are
anticipated to increase or where quantity of material and/or labour time cannot be
accurately estimated.
Just as an escalation clause safeguards the interest of the 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 for downward revision of the contract price in
the event of cost going down beyond an agreed level.

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 Contract Costing

Check Your Progress

1. What is another name for contract costing?
2. Where is work on contracts usually carried out at? NOTES
3. Where do work certified and uncertified appear in the Contract Account and
the balance sheet?
4. Mention the situations for entering into cost-plus contracts.
5. State the object of escalation clause.

6.3 PROFIT ON INCOMPLETE CONTRACT

Contracts which are started and finished during the same financial year create no
accounting problems. But in case of those contracts which take more than one year to
complete, a problem arises whether profit on such contracts should be worked out
only on the completion of the contract or at the end of each financial year on the partly
completed work. If profit is computed only on the completion of the contract, profit
will be high in the year of completion of the contract, whereas in other years of working
on contract, profit will be nil. This would result not only in distorted profit pattern but
also higher tax liability because income tax at higher rates may have to be paid.
Therefore, when contracts extend beyond a year, it becomes necessary to take into
account the profit earned (or loss incurred) on the work performed during each year.
This helps in avoiding distortion of the year-to-year profit trend of the business.
There are two aspects of profit computation:
(a) Computation of notional profit or estimated profit.
(b) Computation of the portion of such profit that is to be transferred to Profit
and Loss Account.
Notional Profit
Notional profit is the difference between the value of work-in-progress certified and
the cost of work-in-progress certified. It is computed as follows (Figures are assumed):

Value of work certified 20,00,000

Add: Cost of work not yet certified 1,50,000
21,50,000
Less: Cost of work to date 19,00,000
Notional Profit 2,50,000
If in any year, cost of work done exceeds the value of work certified and
uncertified, the result will be a notional loss.
Estimated Profit
Estimated profit represents the excess of the contract price over the estimated total
cost of the contract. It is computed as follows (Figures are assumed):
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Material 97
Contract Costing

Contract Price 30,00,000

Less: Total cost already incurred 21,00,000
9,00,000
NOTES Less: Estimated additional costs to complete the contract 3,50,000
Estimated Profit 5,50,000

Portion of Notional Profit or Estimated Profit to be Transferred to

Profit and Loss Account
The portion of the notional or estimated profit to be transferred to P&L Account
depends upon the stage of completion of the contract, i.e., ratio of work-in-progress
certified to total contract work. For this purpose work-in-progress uncertified is not
considered. Prudence requires that the total notional profit should not be transferred
to P&L Account but a portion of it should be withheld as a reserve to meet any
unforeseen future expenses or contingencies.
Rules: There are no hard and fast rules in this regard. However, the following
general rules may be followed in this context.
1. When work certified is less than 1/4 of the contract price, no profit is transferred
to Profit and Loss Account. This is based on the principle that no profit should
be taken into account unless the contract has advanced reasonably.
2. When work-in-progress certified is 1/4 or more but less than 1/2 of the contract
price, then generally 1/3 of the profit is transferred to Profit and Loss Account.
The balance amount is treated as reserve. Thus, profit to be transferred to
Profit and Loss Account is computed by the following formula:
1
Transfer to P&L A/c = Notional Profit ×
3
Alternatively, a more common practice is to further reduce this amount by the
cash ratio.
1 Cash received
Thus: Transfer to P&L A/c = Notional profit × ×
3 Work certified
3. When work certified is 1/2 or more but less than 9/10 of the contract price, (i.e.
50% to 90%), then the profit to be transferred to P & L Account is computed
as follows:
2
Transfer to P&L A/c = Notional Profit ×
3
Here also a more common practice is to further reduce this amount by cash
ratio. This is shown below:
2 Cash received
Transfer to P&L A/c = Notional Profit × 3
×
Work certified
4. When contract is near completion, then the estimated profit should be calculated
on the whole contract. The proportion of estimated profit to be transferred to
Profit and Loss Account is computed by any one of the following formulas:
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98 Material
 Contract Costing
Work certified
(a) Estimated profit × Contract price

Work certified Cash received

(b) Estimated profit × Contract price × Work certified
NOTES
Cost of w ork to d ate
(c) Estimated profit ×
Estim ated total cost of work
Cost of w ork to d ate Cash received
(d) Estimated profit × ×
Estim ated total cost of work Work certified
5. Loss on Uncompleted 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.
It was stated earlier also that these are not hard and fast rules. The practice may
vary from firm-to-firm depending upon the nature of work involved, degree of risk in
the business, extent of work completed, etc. But whatever method is adopted, it should
be applied consistently from year-to-year so as not to disturb the trend of profits.
Illustration 6.1: Raja Construction Ltd took a contract in 2021 for road construction.
The contract price was 10,00,000 and its estimated cost of completion would be
9,20,000. At the end of 2021, the company has received 3,60,000, representing
90% of the work certified. Work not yet certified had a cost of 10,000.
Expenditure incurred on the contract during 2021 was as follows:
Materials 50,000, Labour 3,00,000, Plant 20,000.
Materials costing 5,000 were damaged and had to be disposed of for 1,000.
Plant is considered as having depreciated by 25 per cent.
(i) Prepare Contract Account for 2021 in the books of Raja Construction Ltd.
(ii) Show all possible figures that can be reasonably credited to Profit and Loss
Account in respect of the contract.
Solution:
(i) Contract A/c for the year 2021

To Materials 50,000 B y Materials damaged 5,000

To Labour 3,00,000 B y Plant at site 15,000
To Plant 20,000 B y Work-in-progress:
To Profit (Notional) 60,000 Work certified 4,00,000*
Work uncertified 10,000
4,30,000 4,30,000

* Working Note: Work certified = 3,60,000 ÷ 90% = 4,00,000.

(ii) Amount of profit that may be taken to Profit and Loss Account:
The contract price is 10,00,000
The work certified is 4,00,000, i.e., 40% of contract price.
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Material 99
Contract Costing Method I — 1/3 of the notional profit may be transferred to Profit and Loss
Account
= 60,000 × 1/3 = 20,000
NOTES Method II — The amount calculated, as above, may be reduced on cash basis:
i.e., Notional profit × 1/3 × cash ratio
= 60,000 × 1/3 × 90% = 18,000
Method III —The estimated profit is 80,000, i.e., 10,00,000 – 9,20,000
Profit to be transferred to Profit and Loss Account may be
calculated on the basis of estimated profit:
4,00,000
= Estimated profit × Work certified = 80,000 ×
Contract price 10,00,000
= 32,000
Method IV — Profit calculated in method III may be further reduced by cash
ratio as follows:
80,000 × 4,00,000 × 90 = 28,800
10,00,000 100

Check Your Progress

6. What is the issue with computing profit only on the completion of contracts?
7. What should be done with the total notional profit as per prudence?

6.4 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. Contract costing is also known as terminal costing.

2. Work on contracts is carried out at the site of contracts and not in factory
premises.
3. Both work certified and uncertified appear on the credit side of the contract
account and also on the assets side of the balance sheet.
4. Cost-plus contracts are usually entered into for executing special types of work,
like construction of dam, power house, newly designed ship, etc., where accurate
cost estimation is difficult. Government often prefers to give contracts on ‘cost-
plus’ terms.
5. The object of this clause is to safeguard the interest of the contractor against
unfavourable changes in cost.
6. If profit is computed only on the completion of the contract, profit will be high in
the year of completion of the contract, whereas in other years of working on
contract, profit will be nil. This would result not only in distorted profit pattern
but also higher tax liability because income tax at higher rates may have to be
Self-Instructional paid.
100 Material
 7. Prudence requires that the total notional profit should not be transferred to P&L Contract Costing

Account but a portion of it should be withheld as a reserve to meet any

unforeseen future expenses or contingencies.

NOTES
6.5 SUMMARY

 Contract costing, also known as terminal costing, is a variant of job costing.

 Contract costing is a method of costing in which each contract is a cost unit and
an account is opened for each contract in the books of the contractor to ascertain
profit/loss thereon.
 Contracts are generally of large size, takes more than one year to complete and
is treated as a cost unit.
 The basic procedure for costing of contracts includes the following steps: opening
of contract account, allocation of direct and indirect costs, transfer of materials
or plants, crediting of contract account with contract price and finally transfer of
the balance of contract account to the Profit and Loss Account.
 When the contract is not completed till the end of the accounting year, the
architect is required to value the work-in-progress. Such work-in-progress is
classified into work certified and work uncertified.
 It is a usual practice not to pay the full amount of work certified. The contractee
may pay a fixed percentage, say 80% or 90% of the work certified, depending
upon the terms of the contract. This is known as Cash Ratio. The balance
amount not paid is known as Retention Money.
 Cost-plus contract is a contract in which the price is not fixed at the time of
entering into the contract.
 The contract price is determined by adding a specified amount or percentage of
profit to the costs allowed in the contract. The contractee compensates the
contractor for all allowable costs actually incurred by him. Over and above
these costs the contractor is paid a fixed amount or a fixed percentage of cost
as profit. The items of cost to be included for the purpose of determining contract
price are broadly agreed upon in advance.
 Escalation clause is often provided in contracts to cover any likely changes in
the price or utilization of materials and labour.
 When contracts extend beyond a year, it becomes necessary to take into account
the profit earned (or loss incurred) on the work performed during each year.
This helps in avoiding distortion of the year-to-year profit trend of the business.
 There are two aspects of profit computation:
(a) Computation of notional profit or estimated profit.
(b) Computation of the portion of such profit that is to be transferred to Profit
and Loss Account.
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Material 101
Contract Costing
6.6 KEY WORDS

 Contract costing: It is a method of costing in which each contract is a cost unit

NOTES and an account is opened for each contract in the books of the contractor to
ascertain profit/loss thereon.
 Cost-plus contract: It is a contract in which the price is not fixed at the time of
entering into the contract.
 Escalation clause: This clause is often provided in contracts to cover any
likely changes in the price or utilization of materials and labour.
 Notional profit: It is the difference between the value of work-in-progress
certified and the cost of work-in-progress certified.
 Estimated profit: It represents the excess of the contract price over the
estimated total cost of the contract.

6.7 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. Differentiate between contract costing and job costing.
2. Enumerate the features of contract costing.
3. Write a short note on the procedure of contract costing.
4. What is retention money and cash ratio in contract costing?
5. Briefly explain the concept of escalation clause.
Long Answer Questions
1. Explain the way in which cost of materials, labour and plant are calculated in
contract costing? Also discuss the concepts of sub-contracts and Payment based
on Architect’s Certificate.
2. Explain the concept, advantages and limitations of cost-plus contract.
3. Describe the aspects and rules related observed for calculating profit on
incomplete contracts.

6.8 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:

Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
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102 Material
 Contract Costing
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites: NOTES
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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Material 103
 Process Costing

UNIT 7 PROCESS COSTING

Structure NOTES
7.0 Introduction
7.1 Objectives
7.2 Meaning and Features of Process Costing
7.2.1 Preparation of Process Accounts Including Normal and Abnormal Loss/Gain
7.3 Joint Products and By Products: Theory and Simple Problems
7.4 Cost Accounting Standard 19: Joint Cost
7.5 Answers to Check Your Progress Questions
7.6 Summary
7.7 Key Words
7.8 Self Assessment Questions and Exercises
7.9 Further Readings

7.0 INTRODUCTION

In industries where similar products are mass produced and the production process is
continuous, the method of process costing is used. In these industries, the products
and processes are standardized and an entire process is considered as a cost centre.
In this unit, you will learn about the meaning and features of process costing. This will
involve the construction of process accounts. You will also study about the methods
for accounting normal and abnormal loss and gain. The concept of process costing
also involves accounting for joint as well as by-products. Lastly, you will learn about
the important features of CAS 19.

7.1 OBJECTIVES

After going through this unit, you will be able to:

 Explain the meaning and features of process costing
 Describe the preparation of process accounts including normal and abnormal
loss/gain
 Analyse the concept of joint products and by-products
 Discuss the important points of CAS 19

7.2 MEANING AND FEATURES OF PROCESS

COSTING

In this section, you will learnt about the features of process costing, its difference from
job costing, the procedure to make process cost accounts and some important
adjustments. Self-Instructional
Material 105
Process Costing Features
1. The production is continuous and the final product is the result of a sequence of
processes.
NOTES 2. Costs are accumulated process-wise.
3. The products are standardized and homogeneous.
4. The cost per unit produced is the average cost which is calculated by dividing
the total process cost by the number of units produced.
5. The finished product of each but last process becomes the raw material for the
next process in sequence and that of the last process is transferred to the finished
goods stock.
6. The sequence of operations or processes is specific and predetermined.
7. Some loss of materials in processes (due to chemical action, evaporation, etc.)
is unavoidable.
8. Processing of a raw materials may give rise to the production of several products.
These several products produced from the same raw material may be termed
as joint products or by-products.
Job Costing vs. Process Costing
A comparison of process and job costing methods will help in the better understanding
of process costing system.
Table 7.1 Differences between Process and Job Costing
Process costing Job costing
1. Costs are compiled process-wise and cost 1. Costs are separately ascertained for each job,
per unit is the average cost, i.e., the total which is cost unit.
cost of the process divided by the number of
units produced.
2. Production is of standardized products and 2. Production is of non-standard items with
specifications and instructions from the
cost units are identical.
customers.
3. Production is for stocks. 3. Production is against orders from customers.
4. Costs are computed at the end of a specific 4. Costs are calculated when a job is completed.
period.
5. The cost of one process is transferred to the 5. Cost of a job is not transferred to another job but
next process in the sequence. to finished stock account.
6. On account of continuous nature of 6. There may or may not be work-in-progress in the
production, work-in-progress in the beginning and end of the accounting period.
beginning and end of the accounting period
is a regular feature.
7. Cost control is comparatively easier. This is 7. Cost control is comparatively more difficult
because each cost unit or job needs individual
because factory processes and products are
attention.
standardized.

7.2.1 Preparation of Process Accounts Including Normal and Abnormal

Loss/Gain
The essential stages in process costing procedure are:
1. The factory is divided into a number of processes and an account is maintained
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106 Material for each process.
 2. Each process account is debited with material cost, labour cost, direct expenses Process Costing

and overheads allocated or apportioned to the process.

3. The output of a process is transferred to the next process in the sequence. In
other words, finished output of one process becomes input of the next process.
NOTES
4. The finished output of the last process (i.e., the final product) is transferred to
the Finished Goods Account.
Illustration 7.1: A product passes through three distinct processes to completion.
These processes are numbered respectively, 1, 2 and 3. During the week ended 31
January, 1,000 units are produced. The following information is obtained:
Process 1 Process 2 Process 3

Materials 6,000 13,000 2,000

Labour 5,000 4,000 5,000
Direct expenses 1,000 200 1,000

The indirect expenses for the period were 2,800, apportioned to the processes
on the basis of labour cost.
Prepare process accounts showing total cost and cost per unit.
Solution:
Process 1 Account
Output: 1,000 units
Particulars Per unit Total Particulars Per unit Total

To Materials 6 6,000 By Output transferred

To Labour 5 5,000 to Process 2 13 13,000
To Direct expenses 1 1,000
To Indirect expenses* 1 1,000
13 13,000 13 13,000

2, 800
*Indirect expenses as a % of labour =  100
5, 000  4, 000  5,000

2,800
=  100 = 20%
1, 4000

Process 2 Account
Output: 1,000 units
Particulars Per unit Total Particulars Per unit Total

To Process I (Transfer) 13.00 13,000 By Output transferred

To Materials 3.00 3,000 to Process 3 21.00 21,000
To Labour 4.00 4,000
To Direct expenses 0.20 200
To Indirect expenses 0.80 800

21.00 21,000 21.00 21,000

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Material 107
Process Costing Process 3 Account
Output: 1,000 units
Particulars Per unit Total Particulars Per unit Total

NOTES To Process 2 21 21,000 By Output transferred

To Materials 2 2,000 to finished stock 30 30,000
To Labour 5 5,000
To Direct expenses 1 1,000
To Indirect expenses 1 1,000

30 30,000 30 30,000

Finished Stock Account

Units
To Process 3 1,000 30,000

Important Adjustments including Inter-Process Profits

There are certain accounting adjustments which are peculiar to process costing and
accordingly, this section is broadly divided into three sections:
(1) Process losses and wastages
(2) Valuation of work-in-progress—Equivalent Production
(3) Inter process profits
In this section, you will only learn about inter-process profits in detail.
(1) Process Losses and Wastages
In industries which employ process costing, a certain amount of loss occurs at various
stages of production. Such a loss may arise due to chemical reaction, evaporation,
inefficiency, etc. It is, therefore, necessary to keep accurate records of both input and
output. Where loss occurs at a late stage in manufacture, it is apparent that financial
loss is greater. This is because more and more costs are incurred in processes as
products move towards completion stage.
Process losses may by classified into (a) normal, and (b) abnormal.
Normal Process Loss
That amount of loss which cannot be avoided because of the nature of material or
process is normal process loss. Such a loss is quite expected under normal conditions.
It is caused by factors, like chemical change, evaporation, withdrawals for tests or
sampling and unavoidable spoiled quantities.
Abnormal Process Loss
This type of loss consists of loss due to carelessness, machine breakdown, accident,
use of defective materials, etc. Thus, it arises due to abnormal factors and represents
a loss which is over and above the normal loss.
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108 Material
Accounting procedure for normal and abnormal loss differs.
Accounting Treatment of Normal Loss Process Costing

It is a fundamental costing principle that the cost of normal losses should be borne by
the good production. Normal loss is generally determined as a percentage of input.
Sometimes such a loss is due to loss of weight, say, due to evaporation or chemical NOTES
action. Since such a wastage is not physically present, obviously it cannot have any
value.
However, when normal loss is physically present in the form of scrap, it may
have some value, i.e., it may be sold at some price. Whenever scrapped material has
any value, it is credited to the Process Account.
Accounting Treatment of Abnormal Process Loss
It has been stated earlier that abnormal loss is due to carelessness, accidents, machine
breakdown and other abnormal reasons. Unlike normal loss, abnormal loss is not
absorbed by good production, rather it is transferred to Costing Profit and Loss Account.
This is because if the cost of abnormal loss were to fall upon the good production, the
cost thereof will fluctuate and the information provided would be misleading. In order
to overcome this and also to disclose the cost of abnormal loss, the following procedure
may be adopted:
(a) Allow for normal loss in the manner described earlier.
(b) After considering normal loss, find out the cost per unit in that process. This is
done by the following formula:
Total cost – Valu e of norm al loss
Cost per unit =
Units introd u ced – N orm al loss u nits
(c) Multiply the cost per unit (calculated as above) by the number of units of abnormal
loss. This gives the total value of abnormal loss.
(d) Credit the relevant Process Account with the quantity and value of abnormal
loss.
(e) The balance figure in the Process Account is the cost of good units produced in
the process. This can also be found by multiplying cost per unit with the number
of good units produced.
(f) Open ‘Abnormal Loss Account’ and debit it with the quantity and value of
abnormal loss shown in the Process Account. Sale proceeds from abnormal
loss are credited to Abnormal Loss Account. Any balance left in this account is
net loss and transferred to Costing Profit and Loss Account.
Abnormal Gain or Effectiveness
The normal process loss represents the loss that would be expected under normal
conditions. It is an estimated figure. The actual loss may be greater or less than the
normal loss. If the actual loss is greater than normal loss, it is known as abnormal loss.
But if actual loss is less than normal loss, a gain is obtained which is termed as abnormal
gain or effectiveness. The value of abnormal gain is calculated in a manner similar to
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abnormal loss. It is shown on the debit side of the Process Account and credit side of Material 109
Process Costing the Abnormal Gain Account. Like abnormal loss, it is ultimately transferred to Costing
Profit and Loss Account.
It should be noted that the method of valuation of abnormal gain is the same as
that of abnormal loss.
NOTES
Illustration 7.2: A product passes through three processes A, B and C. The normal
wastage of each process is as follows: Process A – 3 per cent, Process
B – 5 per cent, and Process C – 8 per cent. Wastage of Process A was sold at 25 p.
per unit, that of Process B at 50 p. per unit and that of Process C at 1 per unit.
10,000 units were issued to Process A in the beginning of October 2017 at a
cost of 1 per unit. The other expenses were as follows:
Process A Process B Process C
Sundry materials 1,000 1,500 500
Labour 5,000 8,000 6,500
Direct expenses 1,050 1,188 2,009
Actual output 9,500 units 9,100 units 8,100 units
Prepare the Process Accounts, assuming that there were no opening or closing
stocks. Also give the Abnormal Wastage and Abnormal Gain Accounts.
Solution:
Process A Account
Particulars Units Particulars Units
To Units introduced 10,000 10,000 By Normal wastage 300 75
To Sundry materials 1,000 (3% of 10,000)
To Labour 5,000 By Abnormal wastage 200 350*
To Direct expenses 1,050 By Process B (transfer) 9,500 16,625
10,000 17,050 10,000 17,050

17,050 – 75
*Value of abnormal wastage = × 200 units = 350
10,000 – 300 u nits
Process B Account
Particulars Units Particulars Units
To Process A 9,500 16,625 By Normal wastage 475 238
To Sundry materials 1,500 (5% or 9,500)
To Labour 8,000 By Process C (transfer) 9,100 27,300
To Direct exp. 1,118
To Abnormal gain 75 225*

9,575 27,538 9,575 27,538

27, 313  238

*Abnormal gain = units = 225
9, 500  475 u nits

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110 Material
 Process C Account Process Costing
Particulars Units Particulars Units
To Process B 9,100 27,300 By Normal wastage 728 728
(transfer) 8% of 9,100)
To Sundry materials 500 By Abnormal wastage 272 1156* NOTES
To Labour 6,500 By Finished goods
To Direct expenses 2,009 (transfer) 8,100 34,425
9,100 36,309 9,100 36,309

36,309 – 728
*Abnormal wastage = × 272 units = 1,156
9,100 – 728 u nits
Abnormal Wastage Account

Particulars Units Particulars Units

To Process A 200 350 By Sales of scrap in
To Process B 272 1,156 Process A @ 0.25 200 50
Process C @ 1 272 272
By Profit and Loss
A/c (B/F) 1,184
472 1,506 472 1,506

Abnormal Gain Account

Particulars Units Particulars Units
To Normal wastage A/c 75 38 By Process B 75 225
shortfall in the sale
of normal wastage
@ 0.50 per unit)
To Profit & Loss 187
A/c (B.F.)
75 225 75 225

When the Output of a Process is Partly Sold and Partly Transferred to

the Next Process
Sometimes the output of a process may be partly sold and partly transferred to the
next process for further processing. For example, in a textile mill, part of the output of
a spinning process may be sold and the remaining output is passed on to the weaving
process for further processing. A part of the output so sold will contain an element of
profit or loss which will be revealed in the Process Account. But when a part of the
output is sent to warehouse for sale, it is at cost and does not contain an element of
profit or loss.
Illustration 7.3: XYZ Ltd manufactures and sells three chemicals produced by
consecutive processes known as X, Y and Z. In each process 2% of the total weight
put in is lost and 10% is scrap, which from processes X and Y realized 100 a tonne

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Material 111
Process Costing and from Z 200 a tonne. The products of the three processes are dealt with as
follows:
X Y Z
Sent to warehouse for sale 25% 50% 100%
NOTES
Passed on the next process 75% 50% —
The following particulars relate to the month of May:
Materials used (tonnes) 1,000 140 1,348
Cost per tonne of materials ( ) 120 200 80
Mfg. expenses ( ) 30,800 25,760 18,100
Prepare an account for each process, showing the cost per tonne of each product.
Solution:
Process X Account
Particulars Tonnes Particulars Tonnes
To Materials 1,000 1,20,000 By Loss in weight
(@ 120) (2% of 1,000) 20 —
To Mfg. exp. 30,800 By Scrap (10% of 1,000) 100 10,000
By Warehouse
(25% of 880) 220 35,200
By Process Y (transfer) 660 1,05,600

1,000 1,50,800 1,000 1,50,800

Working Notes:

1,50,800 – 10,000
1. Transfer to warehouse =  220 tonnes = 35,200.
880 tonnes
Similar calculation has been made in Process Y.
2. As the question is silent about the nature of loss, it is presumed that both weight loss and scrap are
normal.
Process Y Account
Particulars Tonnes Particulars Tonnes
To Process X (transfer) 660 1,05,600 By Loss in weight
(2% of 800) 16 —
To Materials 140 28,000 By Scrap 80 8,000
To Mfg. exp. __ 25,760 By Warehouse 352 75,680
By Process Z (transfer) 352 75,680

800 1,59,360 800 1,59,360

Process Z Account
Particulars Tonnes Particulars Tonnes
To Process Y By Loss in Weight
(transfer) 352 75,680 (2% of 1700) 34 —
To Materials 1,348 1,07,840 By Scrap 170 34,000
To Mfg. exp. — 18,100 By Warehouse
(transfer) 1,496 1,67,620

1,700 2,01,620 1,700 2,01,620

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112 Material
(2) Work-in-Progress (Equivalent Production) Process Costing

Process costing mainly deals with continuous type of production. At the end of the
accounting period, there may be some work-in-progress, i.e., semi-finished goods
may be in the pipeline. The valuation of such work-in-progress is done in terms of NOTES
equivalent or effective production.
Equivalent Production
Equivalent production represents the production of a process in terms of completed
units. Work-in-progress at the end of an accounting period are converted into equivalent
completed units. This is done by the following formula:
Equivalent Com pleted  N o. of u nits of 
× 
Degree of 
= +
prod u ction u nits  w ork in progress   com pletion in %

For example, if there are 50 units in work-in-progress and these are estimated
to be 60% complete, then their equivalent production is 50 units × 60% = 30 units.
In each process, an estimate is made of the degree of completion of work-in-
progress in terms of percentage. Such an estimate must be accurate because any error
in such estimation will lead to erroneous valuation of work-in-progress stock which
enters into final accounts.
Evaluation of Equivalent Production
After work-in-progress has been converted into equivalent completed units, the
following steps are taken to evaluate it:
(i) Find out the total cost (net) for each element of cost, i.e., material, labour and
overheads. Scrap value of normal loss is deducted from the material cost.
(ii) Ascertain the cost per unit of equivalent production separately for each element
of cost. This is done by dividing the total cost of each element by the respective
number of equivalent units.
(iii) At this rate of cost per unit, ascertain the value of finished production and work-
in-progress.
For the purpose of computation of equivalent production and its evaluation, the
following three statements are generally prepared:
(a) Statement of equivalent production
(b) Statement of cost (per unit)
(c) Statement of evaluation
These three statements may also be combined in one comprehensive statement
called ‘Statement of Production, Cost and Evaluation.’
For clear understanding, treatment on equivalent production are classified into
the following two categories.
(a) When there is no opening stock, i.e., when there is only closing stock of
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work-in-progress. In such a situation there may or may not be process losses. Material 113
Process Costing (b) When there is opening as well as closing stock—Here also, there may or
may not be process losses.
When there is no opening stock of work-in-progress but there are process
losses—as discussed earlier, losses are inherent in process operations. Normal and
NOTES
abnormal process losses are treated differently in the calculation of equivalent
production.
Normal Loss—Equivalent units of normal loss are taken as nil. In other words, normal
loss is not added in the equivalent production. However, realizable value of normal
scrap is deducted from the cost of material so as to calculate the net material cost. This
net material cost becomes the basis of calculating the material cost per unit in the
statement of cost.
Abnormal Loss—This is treated as if this were good production lost. Abnormal loss,
thus, is added to equivalent production with due consideration to its degree of
completion. Unless the degree of completion is specified, it may be assumed that
abnormal loss units are 100% complete in respect of all elements of cost.
Abnormal Gain—Units of abnormal gain are represented by good finished production.
It is therefore, always taken as 100% complete in respect of all elements of cost, i.e.,
material, labour and overheads. Abnormal gain is deducted to obtain equivalent
production.
When there is opening as well as closing stock of work-in-progress
In such a case there are two methods of calculating equivalent production:
(i) FIFO Method, and (ii) Average Cost Method.
These methods have been discussed in detail, further.
FIFO (First-in, First out) Method
This method is based on the assumption that work-in-progress moves on a first-in-
first out basis. This means that unfinished work on the opening stock is completed first,
before work on any new units is taken up. Thus no units from opening work-in-progress
will be left incomplete and none of these find a place in the closing work-in-progress.
In other words, closing stock will be calculated out of the materials introduced during
the current period and will be valued at the current cost. The costs incurred during the
current period will be distributed over opening stock of work-in-progress (for its
completion), units introduced and completed during the period and closing stock of
work-in-progress. This is done by dividing the costs incurred by the relevant equivalent
production so as to arrive at the per unit cost of equivalent production.
FIFO method gives satisfactory results when prices of materials, rates of wages
and overheads are relatively stable.
Computation of Equivalent Production under FIFO Method. The following steps
are taken in the computation of equivalent production:
(i) State the opening stock of work-in-progress in equivalent completed units. This
Self-Instructional is done by applying the percentage of work needed to complete the unfinished
114 Material
 work of the previous period. For example, if there are 200 units of opening Process Costing

work-in-progress which are 70% complete, then the equivalent units of this will
be 200 × 30% (work required to complete the incomplete portion) = 60 units.
(ii) Ascertain the number of units introduced into the process and deduct the number
NOTES
of units of closing work-in-progress. This gives the number of units started and
completed during the period. Add these units to the opening stock of work-in-
progress calculated in (i) above.
(iii) Add to the above the equivalent completed unit of closing work-in-progress.
This can be determined by applying the percentage of work done on the finished
units at the end of the period.
Average Cost Method
In this method, the cost of opening work-in-progress is not kept separately but is
averaged with the additional costs incurred during the period. This method thus combines
the cost of opening work-in-progress and new production. Information relating to
degree of completion of opening WIP is not required.
In order to find out the cost per unit of equivalent production, the cost of each
element (material, labour and overheads) applicable to the opening work-in-progress
is added to the cost incurred in the current period for that element. A single cumulative
total and unit cost is obtained. Units completed and transferred as well as closing
work-in-progress will be valued at this average unit cost.
FIFO Method vs Average Cost Method
Both FIFO and average methods have certain advantages and it cannot be said that
one method is either simpler or more accurate than the other. The main difference
between these two methods is regarding the treatment of the opening stock-in-progress.
In FIFO method, opening stock of work-in-progress is kept as a separate
figure. Costs incurred to complete this opening work-in-progress are added to the
opening work-in-progress cost and the sum of these two costs is the total cost of
completed units of opening work-in-progress at which it is transferred to the next
process. The units which are introduced in the process and finished during the same
period have their own cost per unit which may be different from the completed cost
per unit of opening work-in-progress.
In average cost method, on the other hand, the cost of opening work-in-progress
is added to material, labour and overhead costs incurred during the period. The cost
per unit is computed by dividing the total of these costs by equivalent units.
How to choose between FIFO and Average Method
Both FIFO and Average methods have advantages and disadvantages. If one were to
choose between these methods in an examination question, the following rules may be
followed:

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Material 115
Process Costing 1. Use FIFO – If the cost of the opening work-in-progress in one lump sum figure
and the stage of completion is given. For Example:
Given: Opening work-in-progress 1,000 units
Cost 18,000
NOTES Stage of completion: Materials 100%
Labour 60%
Overheads 60%
2. Use Average – If the cost of opening work-in-progress is given in terms of
materials, labour and overhead but the stage of completion is not given. For
example:
Given: Opening work-in-progress 1,000 units
Cost—Materials 10,000
Labour 4,000
Overheads 4,000
3. FIFO or Average—Your Choice – If the degree of completion and the cost in
terms of materials, labour and overheads of the opening work-in-progress are
given, then one has a choice between FIFO and Average methods.
For example:
Given: Opening work-in-progress 1,000 units
Degree of completion and cost:
Material (100% Complete) 10,000
Labour (60% Complete) 4,000
Overhead (60% Complete) 4,000
4. Where the question specifies a method to be followed, then that method must
be followed.
Illustration 7.4: The following information relates to Process X for May 2021:
Opening work-in-progress 200 units
Introduced during the month 1,600 units
Completed during the month 1,480 units
Closing work-in-progress 320 units
Degree of Completion Material Labour Overheads
Opening work-in-progress 100% 50% 50%
Closing work-in-progress 100% 25% 25%
Costs:
Opening work-in-progress 2,400 320 3,210
Costs incurred during the period 19,200 6,368 6,368

Self-Instructional
116 Material
 Assuming materials were introduced in the beginning of the process and labour Process Costing

and overhead were incurred uniformly throughout the process, prepare process account
using:
(a) FIFO Method
NOTES
(b) Average Method
Solution:
(a) FIFO Method
(i) Statement of Production

* Units introduced and completed during the month

= Units completed – Units of opening W.I.P
= 1,480 – 200 = 1,280 units.
(ii) Statement of Cost

Cost element Equivalent units Cost per unit ( )

(A) (B) (A ÷ B)
Material 19,200 1,600 12.00
Labour 6,368 1,460 4.36
Overheads 6,368 1,460 4.36
Total 20.72

(iii) Statement of Evaluation

Particulars Elements of Equivalent Per unit Cost Total
cost units cost
Opening WIP Material — — — —
Labour 100 4.36 436
Overheads 100 4.36 436 872
Finished Production Material 1,280 12.00 15,360
Labour 1,280 4.36 5,583
Overheads 1,280 4.36 5,583 26,526
Closing WIP Material 320 12.00 3,840
Labour 80 4.36 349
Overheads 80 4.36 349 4,538

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Material 117
Process Costing Process A Account
Particulars Units Particulars Units
To Opening WIP 200 3040 By Completed production
(2,400 + 320 + 320) (3,040 + 872 + 26,526) 1,480 30,438
NOTES To Material 1,600 19,200 By Closing WIP 320 4,538
To Labour 6,368
To Overheads 6,368

1,800 34,976 1,800 34,976

(b) Average Method

(i) Statement of Production

(ii) Statement of Cost

Equivalent Cost per

Opening W.I.P. + Cost incurred = Total units unit

Material 2,400 + 19,200 = 21,600 ÷ 1,800 = 12.00

Labour 320 + 6,368 = 6,688 ÷ 1,560 = 4.29
Overheads 320 + 6,368 = 6,688 ÷ 1,560 = 4.29
Total 20.58

(iii) Statement of Evaluation

Particulars Element of Equivalent Per unit Cost Total
cost units cost
Finished units Material 1,480 12.00 17,760
Labour 1,480 4.29 6,345
Overheads 1,480 4.29 6,345 30,450
Closing WIP Material 320 12.00 3,840
Labour 80 4.29 343
Overheads 80 4.29 343 4,526

Process Account
Particulars Units Particulars Units
To Opening WIP 200 3,040 By Finished output 1,480 30,450
To Material 1,600 19,200
To Labour — 6,368 By Closing WIP 320 4,526
To Overheads — 6,368

1,800 34,976 1,800 34,976

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118 Material
(3) Internal Process Profits Process Costing

In some businesses, it is a practice to charge the output of each process to the next
process not at cost but at a price showing profit to the transferor process. The transfer
price may be either the current market price or cost plus a fixed percentage. Thus NOTES
each process is charged with its input at current price and no process obtains the
benefits of saving or has to bear the losses caused by the efficiency or inefficiency of
the earlier processes. In brief, the objects of such internal process profit are:
(a) To show whether the cost in each process competes with the market prices.
(b) To make each process stand on its own efficiency and economy.
(c) To assist in making decisions, such as to buy a partly-processed material rather
than to process work internally or to sell a partly-processed product or to
process it further.
Internal process profits have the disadvantage of complicating the costing records.
The complications brought into the accounts arise from the fact that inter-process
profit, so introduced, remains included in the price of process stocks, finished stocks
and work-in-progress. For balance sheet purposes, such stocks have to be reduced
to actual cost because a firm cannot make profits by trading with itself.
The inclusion of inter-process profits should be best avoided unless the benefits
outweigh the added complications. However, the object of internal process profits
can also be achieved by making separate cost analysis and reports outside the costing
records or by adopting a standard costing system where standard should be set for
each process.
The procedure involved in inter-process profits is demonstrated in the following
illustration.
Illustration 7.5: A Ltd produces product ‘AXE’ which passes through two processes
before it is completed and transferred to finished stock. The following data relate to
October 2021:
Processes Finished Stock
Particulars I II
Opening stock 7500 9000 22,500
Direct materials 15,000 15,750 —
Direct wages 11,200 11,250 —
Factory overheads 10,500 4,500 —
Closing Stock 3,700 4,500 11,250
Inter-process profit included in
opening stock 1,500 8,250

Output of Process I is transferred to Process II at 25% profit on the transfer

price.
Output of Process II is transferred to finished stock at 20% profit on the transfer
price. Stocks in processes are valued at prime cost. Finished stock is valued at the
price at which it is received from Process II. Sales during the period is 1,40,000. Self-Instructional
Material 119
Process Costing Required: Process Cost Accounts and Finished Stock Account showing the
profit element at each stage. (CA Inter)
Solution:
Process I Account
NOTES
Cost Profit Total Cost Profit Total

To Opening By Process II 40,500 13,500 54,000

stock 7,500 — 7,500
To Direct
material 15,000 — 15,000
To Direct
wages 11,200 — 11,200
33,700 33,700
Less: Closing
stock 3,700 3,700
30,000 — 30,000
To Factory
overheads 10,500 — 10,500
40,500 — 40,500
To Profit — 13,500 13,500
40,500 13,500 54,000 40,500 13,500 54,000

Process II Account

Cost Profit Total Cost Profit Total

To Opening By Finished
stock 7,500 1,500 9,000 stock a/c 75,750 36,750 1,12,500
To Process I 40,500 13,500 54,000
To Direct
material 15,750 — 15,750
To Direct
wages 11,250 — 11,250
75,000 15,000 90,000
Less: Closing
stock 3,750 750 4,500
71,250 14,250 85,500
To Factory
overheads 4,500 — 4,500
75,750 14,250 90,000
To Profit — 22,500 22,500
75,750 36,750 1,12,500 75,750 36,750 1,12,500

Finished Stock Account

Cost Profit Total Cost Profit Total

To Opening By Sales 82,500 57,500 1,40,000

stock 14,250 8,250 22,500
To Process II 75,750 36,750 1,12,500
90,000 45,000 1,35,000
Self-Instructional
120 Material
 Less: Closing Process Costing
stock 7,500 3,750 11,250
82,500 41,250 1,23,750
To Profit – 16,250 16,250
82,500 57,500 1,40,000 82,500 57,500 1,40,000
NOTES
Working Notes:
1. Reserve for unrealized profit in closing stock
Process I: Nil
Process II:

Cost 75,000
Cost of stock = Total  Closing stock = 90,000  4,500 = 3,750

Profit = Total – Cost = 4,500 – 3,750 = 750

Finished Stock

Cost 90,000
Cost of stock =  Closing stock =  11, 250  7, 500
Total 1,35,000
Profit = Total – Cost = 11,250 – 7,500 = 3,750
2. Profit for the month

Process I: ... ... ... ... 13,500

Process II: ... ... 22,500
Add: Unrealized profit in opening stock ... ... ... 1,500
24,000
Less: Unrealized profit in closing stock ... ... 750 23,250
Finished stock ... ... 16,250
Add: Unrealized profit in opening stock ... ... 8,250
24,500
Less: Unrealized profit in closing stock ... ... 3,750 20,750
Total profit 57,500

Check Your Progress

1. What is the requirement in terms of production and products in process and
job costing?
2. Where is the finished output of the last process transferred in process costing?
3. Mention some of the factors which result into normal process loss.
4. Which method is suitable in case cost of opening work-in-progress is given in
terms of materials, labour and overhead, but the stage of completion is not
given?
5. State the disadvantage of internal process profits.

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Material 121
Process Costing
7.3 JOINT PRODUCTS AND BY PRODUCTS:
THEORY AND SIMPLE PROBLEMS
NOTES The term joint products is used for two or more products of almost equal economic
value, which are simultaneously produced from the same manufacturing process and
the same raw material. Joint products thus represent two or more products separated
in the course of processing, each product being in such proportion and of such economic
significance that no single one of them can be regarded as the main product.
Characteristics of joint products are:
(a) Joint products are produced from the same raw material in natural
proportions
(b) They are produced simultaneously by a common process
(c) They are comparatively of almost equal value
(d) Joint products may be saleable after separation or may be further processed
by incurring additional costs to make them saleable or an improved product
A classic example of joint products, as given above, is found in oil refining,
where items like petrol, diesel, naptha and kerosene are produced from the crude oil.
Other examples are in flour mill, where joint products are white flour, brown flour,
animal feeding stuff; in meat canning where joint products are hides, canned meat,
fertilizers, etc. The term joint product is also used to describe various qualities of the
same product, as for example, many grades of coal which may be produced in coal
mining.
Accounting for Joint Products
Accounting for joint products means the apportionment of joint cost to each of the
joint product. Such apportionment serves the following objectives:
(a) To determine the cost per unit of products
(b) To help in inventory valuation
(c) To determine the profit or loss on each line of product
(d) To determine the price of each product
The various methods of apportionment of joint costs (discussed below) are
based mainly on individual opinion and tend to produce only approximate results. This
is because no perfectly logical basis exists for the apportionment of joint costs to
products and most of the methods are arbitrary. Therefore, while selecting a particular
methods it should be kept in mind that the method should be logical, appropriate and
reliable and should be consistently followed. Following are the main methods of
apportionment of joint costs over joint products:
1. Sales Value Method: Under this method, joint costs are apportioned to various
joint products on the basis of sales value of each such product. The sale value method
has the following variants:
Self-Instructional (a) On the basis of unit prices: In this method, the selling prices per unit of
122 Material various joint products is taken as the basis for apportionment of joint costs. In other
words, joint cost is apportioned to various joint products in the ratio of selling prices Process Costing

of individual joint products without any regard to the quantities. It is thus suitable when
the number of units of production of all the products are equal. It is illustrated below
with assumed figures.
Example: Joint cost 9,000 NOTES
Products Selling price Apportioned cost
per unit (Ratio 12 : 8 : 4)

A 12 4,500
B 8 3,000
C 4 1,500
Joint cost 9,000

(b) On the basis of sales value: In this method, the apportionment is done on
the basis of weighted sales value, i.e., number of units produced and sold × selling
price per unit. This method thus gives due consideration to the quantities of various
joint products produced. The difference between the method based on unit selling
prices discussed earlier and this method is that while the former gives no consideration
to the quantities of joint products produced, the latter gives due importance to the
quantities. This method will give satisfactory results even when number of units of
different joint products are widely different. The method is illustrated below with assumed
figures:
Example: Joint cost 9,000
Products Selling price Production quantities Sales value Apportioned
per unit units (a) × (b) joint cost
(24 : 48 : 28) (a) (b) (c) (d)

A 12 200 2,400 2,160

B 8 600 4,800 4,320
C 4 700 2,800 2,520
Total 10,000 9,000

2. Reverse Cost Method (Net realisable value method): In this method, the joint
cost is apportioned on the basis of net value of each product. The net realisable value
is calculated by deducting the following from the sales value.
(a) Estimated profit margin
(b) Selling and distribution costs, if any
(c) After split off processing costs
The net realisable values of individual products so obtained are taken as the
basis for apportioning joint costs. This is known as reverse cost method because net
realisable values are calculated by working backwards from sales values. This method
is particularly used when products are not sold at their stage at split off point but
require further processing. Operation of this method is illustrated below. Self-Instructional
Material 123
Process Costing Illustration 7.6: In processing a basic raw material, three joint products ‘X’, ‘Y’ and
‘Z’ are produced. The joint expenses of manufacturing are: Materials 10,000; Labour
8,000; Overheads 9,000 (Total 27,000). Subsequent expenses are as follows:
X Y Z
NOTES
Material 2,000 1,600 1,800
Labour 2,500 1,400 1,700
Overheads 2,500 1,000 1,500
Total 7,000 4,000 5,000
Sales Value 42,000 20,000 18,000
Estimated profit on sales 50% 50% 331/3%
Show how you would apportion the joint costs of manufacture by Reverse
Cost Method.
Solution:
Statement of Apportionment of Joint Costs
X Y Z

Sales value 42,000 20,000 18,000

Less: Estimated profit on sales 21,000 10,000 6,000
Estimate total cost 21,000 10,000 12,000
Less: Subsequent costs (total) 7,000 4,000 5,000
Joint costs ( 27,000) apportioned 14,000 6,000 7,000

3. Physical Units Method: Under this method, the joint cost is apportioned on the
basis of relative weight, volume or quantity, etc., of each product, obtained at the point
where the split-off occurs. For the method to be suitable, the unit of measurement
should be applicable for all products, e.g., usually gases, liquids and solids cannot be
taken together. However, where joint products cannot be measured by the same
measurement unit, the joint products must be converted to a denominator common to
all the units produced. For instance in the manufacture of coke, products such as
coke, coal tar, benzol, sulphate of ammonia, gas, etc., are measured in different units.
The yield of these recovered units is measured on the basis of quantity of product
extracted per tonne of coal. This is illustrated as follows:
Illustration 7.7: The following data have been extracted from the books of Coke
Co. Ltd:
Joint products Yield (in lbs) of recovered
products per tonne of coal
Coke 1,420
Coal tar 120
Benzol 22
Sulphate of ammonia 26
Self-Instructional Gas 412
124 Material
2,000
 The price of coal is 80 per tonne. The direct labour and overhead costs to the Process Costing

point of split-off are 40 and 60, respectively, per tonne of coal.

Calculate the material, labour and total cost of each product on the basis of
weight.
NOTES
Solution:
Statement of Apportionment of Joint Cost
Apportionment of Cost
Yield % of Coal Direct Overheads Total
in lbs total labour

Coke 1,420 71.0 56.80 28.40 42.60 127.80

Coal tar 120 6.0 4.80 2.40 3.60 10.80
Benzol 22 1.1 0.88 0.44 0.66 1.98
Sulphate of ammonia 26 1.3 1.04 0.52 0.78 2.34
Gas 412 20.6 16.48 8.24 12.36 37.08
Total 2,000 100 80.00 40.00 60.00 180.00

4. Average Unit Cost Method: In this method, the joint cost is apportioned by
using the average unit cost which is obtained by dividing the total joint cost by the total
number of units produced of all the products. The average cost per unit of each product
is the same. The procedure is illustrated as follows.
Illustration 7.8: From the following particulars, find out the cost of joint products A,
B and C under the average unit cost method.
(a) Pre-separation point cost 30,000
(b) Other production data:
Product Units produced
X 1,000
Y 400
Z 600
2,000
Solution:
joint cost 30,000
Average unit cost =   15 per unit
Total no. of units produced 2,000units
Statement of Apportionment of Joint Cost
Product Units produced Average cost Apportioned cost
(A) (B) ( )A× B = C
X 1,000 15 15,000
Y 400 15 6,000
Z 600 15 9,000
Self-Instructional
Total 2,000 30,000 Material 125
Process Costing 5. Survey Method: This method apportions the joint cost to various products, on
the basis of the results of a survey or technical evaluation. In this survey, various factors,
like volume, selling price, marketing process, etc., are studied and points or weights
are assigned to each product. Costs are apportioned on the basis of such weights or
NOTES points.
Illustration 7.9: X, Y and Z are the three joint products in a factory. Their joint cost is
30,000. Quantities produced are as follows:
X 1,000
Y 400
Z 600
On the basis of technical evaluation, points allotted to X, Y and Z products are
3.2, 5 and 8 per unit, respectively. Apportion the joint cost.
Solution:
Statement of Apportionment of Joint Cost
Product Units Points Weighted *Cost per Apportined
produced assigned units weighted cost
unit (32 : 20 : 48)
(a) (b) (c) = (a) × (b) (d) (e)

X 1,000 3.2 3,200 3.00 9,600

Y 400 5.0 2,000 3.00 6,000
Z 600 8.0 4,800 3.00 14,400
Total 10,000 3.00 30,000

Joint cost 30,000

*   3 per unit.
Total no. of weighted units 10,000

By-Products
By-products are products of relatively small value which are incidentally and unavoidably
produced in the course of manufacturing the main product. For example, in sugar
mills, the main product is sugar. But baggasse and molasses of comparatively smaller
value are incidentally produced and thus are by-products. Other examples of by-
products are oil cake produced in the extraction of edible oil; cotton seed produced in
cotton textile industry, etc. These by-products are unavoidably produced and are of
secondary value. The sales value of these by-products is much less as compared to
the main product. For example, sales value of by-products bagasse and molasses is
much less than that of the main product sugar.
By-products may be:
(a) Those sold in their original form without further processing
(b) Those which require further processing in order to be saleable
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126 Material
 Examples of By-products Process Costing

Industry By-products
1. Sugar Bagasse, Molasses
2. Cotton textile Cotton seed NOTES
3. Edible oil Oil cake
4. Meat Bones
5. Rice mills Husk

Distinction between Joint Products and By-products

There are no hard and fast rules to distinguish between joint products and by-products.
A product may be treated as a joint product in one business and the same product
may be treated as a by-product in another business. However, the following factors
should be considered to determine if a product is a joint product or a by-product.
(a) Relative sales value: If the sales value of all the products are more or less
equal, they are treated as joint products. If, however, there are wide differences
in the relative sales values of products, the product with the greater sales value
is treated as the main product and the products of lower value are treated as
by-products.
(b) Objective of manufacture: If the objective of manufacturing is product A,
then unwanted products B and C be treated as by-products.
(c) Policy of management: The management may decide to treat a particular
product as the main product and the other products as by-products. Alternatively,
it may choose to treat all products as joint products.
By-products, Scrap and Waste
By-products should not be confused with waste or scrap. Waste is used to describe a
material which has no value or even negative value, if it has to be disposed of at some
cost. Examples of waste are gases, smoke and other unsaleable residues from the
manufacturing process.
Scrap is also different from by-products in the sense that it is the leftover part of
the raw materials whereas by-products are different from the material which went into
the production process. Small pieces of wood left in furniture manufacture or metal
sheet pieces left in utensil manufacture are examples of scrap, whereas minor chemicals,
having some value, emerging from a chemical process are classified as by-products.
Sale value of scrap is relatively less than that of by-products. However accounting
treatment for scrap and by-products is quite similar.
Accounting for By-products
Various methods of accounting for by-products are as follows:
1. Where by-products are of small total value: In such a case it is not
considered practicable to apportion any part of the joint cost to by-products.
The net income realized by the sale of by-products may be treated in any one of Self-Instructional
the following two ways: Material 127
Process Costing (i) It may be treated as ‘miscellaneous income’ and credited to the Costing
Profit and Loss Account.
(ii) It may be credited to the process account in which the by-product has
arisen.
NOTES
In determining the net income from by-products, the following should be deducted
from the sales value of by-products: (i) any selling and distribution expenses incurred
in the sale of by-products; and (ii) any costs incurred in further processing of by-
products to make them saleable.
2. Where by-products are of considerable total value: Where by-products are
of considerable sales value, it is proper to apportion a part of the joint cost to by-
products. Such apportioned cost of by-products is debited to by-product account
and credited to the main product account or the relevant process account. Any cost
incurred in further processing of the by-product is debited to by-product account. The
by-product account is credited with its sales value and any profit/loss arising out of this
account is transferred to costing Profit and Loss Account.
The apportionment of joint cost to by-products can be done by any of the four
methods discussed earlier in costing of joint products. These methods are:
(i) Sales value method; (ii) Physical units method; (iii) Average cost method; and (iv)
Points value or survey method.
3. Where by-products require further processing: In such situations, the share of
by-product in joint-cost at the split-off point may be arrived at by subtracting the
profit and the further processing cost from the realizable value of the products, i.e., by
using Reverse Cost Method. In case the cost of the by-products at the split-off point
is small or negligible, it may be treated as per the method (a) discussed above. On the
contrary, if it is of considerable amount, it is treated as per method (b) discussed
above, i.e., joint cost is apportioned to by-products.
Illustration 7.10: Product Z yields two by-products A and B. The joint cost of
manufacture is 65,800. From the following information, show how would you
apportion the joint cost of manufacture:
Z A B
(i) Sales 1,00,000 40,000 25,000
(ii) Manufacturing costs after separation 5,000 4,000
(iii) Estimated selling expenses on sales 20% 20%
(iv) Estimated profit on sales 25% 30%

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128 Material
Solution: Process Costing

Statement of Cost of By-products—A and B

A B
NOTES
Sales 40,000 25,000
Less: Profit 10,000 7,500
30,000 17,500
Less: After separation costs 5,000 4,000
Selling expenses 8,000 5,000
Share in joint cost 17,000 8,500

Statement of Cost of Product Z

Total joint cost 65,800

Less: Joint cost apportioned to A 17,000
B 8,500 25,500
Cost of Product Z 40,300

4. Where by-product is utilized in the undertaking itself: In those cases where

by-products are used by the company itself as a raw material for some other process,
such by-products may be priced at the opportunity cost. The opportunity cost is that
cost which would have been incurred had the by-product been purchased from an
outside firm. For example, a company is running a sugar plant as well as a paper plant.
The bagasse, a by-product of sugar plant, may be utilized in manufacture of paper as
raw material. So credit for the cost of the bagasse would be given to the sugar cost at
the price which the company would have otherwise paid to buy it from an outside firm
for the manufacture of paper.
Decision regarding Further Processing of Joint and By-products
Apportionment of joint costs is not relevant in decision making regarding further
processing of joint or by-products. Whenever management has to take a decision
whether or not to further process a joint product or by-product after split-off, decision
will be taken by comparing the incremental revenue after split-off point with the
incremental cost after split-off point. So long as the incremental revenue is more than
the incremental cost on further processing of a joint or a by-product, it is profitable to
further process the product, not otherwise.
Illustration 7.11: A company produces two joint products P and Q, their cost upto
separation point being 47,000. These products can be sold at the split-off point at
150 and 350 per unit, respectively. Alternatively, the two products can be further
processed at a cost of 15,000 and 12,000, respectively. After further processing
these can be sold at 320 and 500 per unit, respectively. The output of P is 150
units and of Q is 60 units.
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Material 129
Process Costing Advise whether these products should be sold at split-off point or these should be
processed further.
Solution:
NOTES Statement Showing Incremental Profit/Loss
Product P Product Q
Output 150 units 60 units
Incremental revenue from further processing
P ( 320 – 150) × 150 units 25,500
Q ( 500 – 350) × 60 units 9,000
Less: Incremental cost 15,000 12,000
Incremental Profit/loss (–) 10,500 (–) 3,000
Conclusion: Product P should be processed further because it gives an
incremental profit of 10,500 whereas product Q should be sold at split-off point
because it results in incremental loss of 3,000.

Check Your Progress

6. List the objectives of apportionment of joint cost to joint product.
7. When is the reverse cost method particularly used?
8. State the difference between scrap and by-product.

7.4 COST ACCOUNTING STANDARD 19: JOINT

COST

The following is the Cost Accounting Standard – 19 (CAS - 19) issued by the Council
of The Institute of Cost Accountants of India for determination of “JOINT COSTS”.
In this standard, the standard portions have been set in bold Italic type. This standard
should be read in the context of the background material which has been set in normal
type.
1. Introduction
The standard deals with the principles and methods of measurement and assignment
of Joint Costs and the presentation and disclosure in cost statement.
2. Objective
The objective of this standard is to bring uniformity, consistency in the principles,
methods of determining and assigning Joint Costs with reasonable accuracy.
3. Scope
The standard shall be applied to cost statements which require classification,
Self-Instructional measurement, assignment, presentation and disclosure of Joint Costs including those
130 Material
requiring attestation.
4. Definitions Process Costing

The following terms are being used in this standard within the meaning specified.
4.1 By-Product: Product with relatively low value produced incidentally in the
manufacturing of the product or service. NOTES
4.2 Cost Object: An activity, contract, cost centre, customer, process, product,
project, service or any other object for which costs are ascertained.
4.3 Imputed Cost: Notional cost, not involving cash outlay, computed for any
purpose
4.4 Joint Costs: Joint costs are the cost of common resources used to produce
two or more products or services simultaneously.
4.5 Joint product: Products or services that are produced simultaneously, by
the same process, identifiable at the end of the process and recognised as
main products or services having sufficient value.
4.6 Scrap: Discarded material having no or insignificant value and which is
usually either disposed off without further treatment (other than
reclamation and handling) or reintroduced into the process in place of raw
material.
4.7 Split off point: The point in the production process at which joint products
become separately identifiable.
The terms split off point and separation point are used interchangeably.
4.8 Waste: Material lost during production or storage and discarded material which
may or may not have any value.
5. Principles of Measurement
5.1 The principles and methods for measuring Joint costs up to the split off
point will be the same as stipulated in other cost accounting standards.
5.2 Cost incurred after split-off point on product separately identifiable shall
be measured for the resources consumed for each Joint/By-Product.
5.3 Cost incurred after split- off point for further processing of joint product/
By-Product shall be the aggregate of direct and indirect costs.
5.4 Cost of further processing of joint product/By-Product carried out by
outside parties shall be determined at invoice or agreed price including
duties and taxes, net of discounts (other than cash discount) taxes and
duties refundable or to be credited and other expenditure directly
attributable to such processing. This cost shall also include the cost of
resources provided to outside parties.
5.5 In case the production process generates scrap or waste, realized or
realizable value, net of disposal cost, of scrap and waste shall be deducted
from the cost of Joint Product.
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Material 131
Process Costing 5.6 Any Subsidy / Grant / Incentive or any such payment received / receivable
with respect to any joint product /By-Product shall be reduced for
ascertainment of the cost to which such amounts are related.
5.7 Penalties, damages paid to statutory authorities or other third parties shall not
NOTES
form part of the cost of the joint product /By-Product.
6. Assignment
6.1 Joint cost incurred shall be assigned to joint products based on benefits
received, which is measured using any of the following methods:
(a) Physical Units Method.
(b) Net Realisable Value at split-off point.
Net realisable value for this purpose means the net selling price per unit multiplied
by quantity (Quantity sold). Net realizable value is to be adjusted for the post-
split off costs.
(c) Technical estimates
6.2 The value of By-Product shall be estimated using any of the following
methods for adjusting joint costs:
a. Net realizable value
Net realizable value for this purpose means the net selling price per unit
multiplied by quantity (Quantity sold). Net realizable value is to be adjusted
for the post- split off costs.
b. Technical Estimates
This method may be adopted where the By-Product is not saleable in the
condition in which it emerges or comparative prices of similar products
are not available.
7. Presentation
The Cost Statement shall present the element wise cost of individual products produced
jointly and the value assigned to By-Products.
8. Disclosures
8.1 The Cost statement shall disclose the basis of allocation of Joint costs to
individual products and the value assigned to the By-Products.
8.2 The Cost statement shall also disclose:
8.3 The disclosure should be made only where material, significant &
quantifiable.
8.4 Disclosures shall be made in the body of Cost Statements or as a foot note
or as a separate schedule.
8.5 Any change in the cost accounting principles and methods applied for the
measurement and assignment of the Joint costs and the value assigned to
Self-Instructional
132 Material
 byproduct during the period covered by the cost statement which has a Process Costing

material effect on the Joint/ By-Products shall be disclosed. Where the

effect of such change is not ascertainable wholly or partly the fact shall be
indicated.
NOTES
9. Effective date:
This Cost Accounting Standard shall be effective from the period commencing on or
after ….. for being applied for the preparation and certification of General Purpose
Cost Accounting Statements.

Check Your Progress

9. What is split off point as per CAS 19?
10. How is the cost of further processing of joint products/by-products carried out
by outside parties to be determined?
11. When is the technical estimate method for by-products to be used as per
CAS 19?

7.5 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. In process costing, production is of standardized products and cost units are

identical whereas in job costing, production is of non-standardized items with
specifications and instructions from the customers.
2. The finished output of the last process (i.e., the final product) is transferred to
the Finished Goods Account.
3. Normal process loss is caused by factors like chemical change, evaporation,
withdrawals for tests or sampling and unavoidable spoiled quantities.
4. If the cost of opening work-in-progress is given in terms of materials, labour
and overhead, but the stage of completion is not given, the average cost method
of equivalent production should be used.
5. Internal process profits have the disadvantage of complicating the costing records.
The complications brought into the accounts arise from the fat that inter-process
profit, so introduced, remains included in the price of process stocks, finished
stocks and work-in-progress.
6. The apportionment of joint cost to each joint product has the following objectives:
To determine the cost per unit of products, to help in inventory valuation, to
determine the profit or loss on each line of product and to determine the price of
each product.
7. The reverse cost method is particularly used when products are not sold at their
stage at split off point but require further processing.
Self-Instructional
Material 133
Process Costing 8. Scrap is different from by-products in the sense that it is the leftover part of the
raw materials whereas by-products are different from the material which went
into the production process.
9. As per CAS 19, split off point is the point in the production process at which
NOTES
joint products become separately identifiable.
10. Cost of further processing of joint product/By-Product carried out by outside
parties shall be determined at invoice or agreed price including duties and taxes,
net of discounts (other than cash discount) taxes and duties refundable or to be
credited and other expenditure directly attributable to such processing. This
cost shall also include the cost of resources provided to outside parties.
11. According to CAS 19, the Technical Estimates method may be adopted where
the By-Product is not saleable in the condition in which it emerges or comparative
prices of similar products are not available.

7.6 SUMMARY

 In process costing, the production is continuous and the final product is the
result of a sequence of processes and costs are accumulated process wise.
 The essential stages in process costing procedure are division of factor into a
number of processes and the maintenance of separate accounts for every
process, debiting of each process account, transfer of output of a process to
the next process in the sequence and transfer of finished output of last process
to the Finished Goods Account.
 There are certain accounting adjustments which are peculiar to process costing
including process losses and wastages, valuation of work-in-progress and inter-
process profits.
 In industries which employ process costing, a certain amount of loss occurs at
various stages of production. Process losses may be classified into (a) normal,
and (b) abnormal.
 It is a fundamental costing principle that the cost of normal losses should be
borne by the good production. Since normal loss is determined as a percentage
of input. Since such a wastage is not physically present, obviously it cannot
have any value. However, when normal loss is physically present in the form of
scrap, it may have some value and is credited to the Process Account.
 Unlike normal loss, abnormal loss is not absorbed by good production, rather it
is transferred to Costing Profit and Loss Account.
 If actual loss is less than normal loss, a gain is obtained which is termed as
abnormal gain. The value of abnormal gain is calculated in a manner similar to
abnormal loss. It is shown on the debit side of the Process Account and credit
side of Abnormal Gain Account. Like abnormal loss, it is ultimately transferred
to Costing Profit and Loss Account.
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134 Material
  At the end of the accounting, there may be some work-in-progress, i.e., semi- Process Costing

finished goods may be in the pipeline. The valuation of such work-in-progress

is done in terms of equivalent or effective production.
 For the purpose of computation of equivalent production and its evaluation, the
following three statements are generally prepared: Statement of equivalent NOTES
production, Statement of cost (per unit) and Statement of evaluation.
 For clear understanding, treatment on equivalent production are classified into
the following two categories: when there is no opening stock and when there is
opening as well as closing stock.
 In some businesses, it is a practice to charge the output of each process to the
next process not at cost but at a price showing profit to the transferor process.
The transfer price may be either the current market price or cost plus a fixed
percentage.
 Joint products represent two or more products separated in the course or
processing, each product being in such proportion and of such economic
significance that no single one of them can be regarded as the main product.
 Accounting for joint products means the apportionment of joint cost to each of
the joint product.
 The main methods of apportionment of joint costs over joint products are sales
value method, reverse cost method, physical units method, average unit cost
method and survey method.
 By-products are products of relatively small value which are incidentally and
unavoidably produced in the course of manufacturing the main product.
 Various methods of accounting for by-products are categorized as where by-
products are of small total value, where by-products are of considerable total
value, where by-products require further processing, and where by-product is
utilized in the undertaking itself.
 Whenever the management has to take a decision whether or not to further
process a joint product or by-product after split-off, decision will be taken by
comparing the incremental revenue after split-off point with the incremental cost
after split-off point.
 CAS 19 deals with the principles and methods of measurement and assignment
of Joint Costs and the presentation and disclosure in cost statement. The objective
of this standard is to bring uniformity, consistency in the principles, methods of
determining and assigning Joint Costs with reasonable accuracy.

7.7 KEY WORDS

 Equivalent production: It represents the production in terms of completed

units.
 Joint products: It is used for two or more products of almost equal economic
value, which are simultaneously produced from the same manufacturing process Self-Instructional
and the same raw material. Material 135
Process Costing  By-products: It refers to products of relatively small value which are incidentally
and unavoidably produced in the course of manufacturing the main product.

NOTES
7.8 SELF ASSESSMENT QUESTIONS AND
EXERCISES

Short Answer Questions

1. List the features of process costing.
2. Differentiate between job and process costing.
3. What are the essential stages in process costing procedure?
4. Enumerate the steps involved in the evaluation of equivalent production.
5. What are the objects of internal process profit?
6. Mention some of the characteristics of joint products. Also give examples.
7. Which factors are considered to determine if a product is a joint product or a
by-product?
8. How does the management decide whether to the further processing of joint
and by-products?
Long Answer Questions
1. Describe the accounting adjustment of process losses and wastages.
2. Explain the methods for equivalent production in case of opening as well as
closing stock of work-in-progress.
3. What are the main methods of apportionment of joint costs over joint products?
4. Explain the methods of accounting for by-products.
5. Discuss the important definitions, principles of measurement and disclosure
requirements as mentioned in CAS 19.

7.9 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:
Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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136 Material
 Service Costing

UNIT 8 SERVICE COSTING

Structure NOTES
8.0 Introduction
8.1 Objectives
8.2 Meaning, Features and Applications of Service Costing
8.2.1 Cost Unit: Simple and Composite
8.3 Cost Sheet for Transportation Service
8.4 Cost Statement for Hospital
8.5 Cost Statement for Hotel Organization
8.6 Cost Accounting Standard 13: Cost of Service Cost Centre
8.7 Answers to Check Your Progress Questions
8.8 Summary
8.9 Key Words
8.10 Self Assessment Questions and Exercises
8.11 Further Readings

8.0 INTRODUCTION

Service or operating costing is a method of costing used by industries producing services

rather than products. The cost centres in these businesses are units of service. These
service industries include transport service companies, canteens, boiler houses, hospitals
as well as hotels. Since the nature of all these services are different, the cost centres
and units too differ in these industries. In this unit, you will learn about the meaning,
features and applications of service costing, the concept of simple and composite
costing. You will study service costing in transport businesses, hospitals and hotels.
Lastly, you will learn about CAS 13 related to service costing.

8.1 OBJECTIVES
After going through this unit, you will be able to:
 Describe the meaning, features and applications of service costing
 Examine the concept of simple and composite cost unit
 Assess the cost sheet and statements for transport service, hospital and hotel
organization
 Discuss the Cost Accounting Standard 13

8.2 MEANING, FEATURES AND APPLICATIONS OF

SERVICE COSTING

Operating costing service costing is a method of cost ascertainment used in those

undertakings which are engaged in providing services, such as transport, electricity, Self-Instructional
etc. These undertakings do not manufacture tangible products. Material 137
Service Costing The cost of providing a service is termed as ‘operating cost’. In many
manufacturing companies, operating costing is used in certain departments which render
services, within the organization, e.g., internal transport and personnel department.
Operating costing is also known as service costing.
NOTES
According to CIMA London, Operating costing is that form of operation
costing which applies where standardized services are rendered either by an under-
taking or by a service cost centre within an undertaking.
Operating costing should not be confused with operation costing. While operating
costing is applied to determine the cost of providing a service, operation costing is a
refinement and more detailed application of process costing.
Operating Costing is applicable in:
• Road transport companies
• Railways
• Airways
• Shipping companies
• Electricity companies
• Water supply companies
• Gas supply companies
• Hospitals and nursing homes
• Cinemas
• Canteens and hotels
• Computer centres
• Schools and colleges
• Local authority
• Power house in a factory
Features
The following characteristics are usually found in industries where operating costing
is used:
(a) Services rendered to customers are of unique and standardized type.
(b) A large proportion of the total capital is invested in fixed assets and comparatively
less working capital is required.
(c) The distinction between fixed cost and variable cost is of particular importance.
This is because the economics and scale of operations considerably affect the
cost per unit of service rendered. For example, fixed cost like insurance per
passenger will be lower if buses in transport company run capacity packed.

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138 Material
8.2.1 Cost Unit: Simple and Composite Service Costing

The selection of a suitable cost unit (unit of service) is very important. The cost units may
be of the following two types:
(1) Simple cost unit: A few examples are given below: NOTES
Undertaking Cost unit
1. Transport Per kilometre or per mile
2. Water works Per 1,000 litres
3. Municipality Per km of road maintained
4. Canteen Per meal or per dish
(2) Composite cost unit: In service undertakings, generally a composite cost unit is
used. In this type, two units are rolled into one. For example, in a transport company,
weight of goods as well as distance covered should be taken into account in evolving
a cost unit, i.e., a tonne-kilometre, which means 1 tonne of goods transported to 1
km. Other examples are:
Undertaking Cost unit
1. Transport Per passenger-km or Per tonne-km
2. Hospital Per bed per day
3. Hotel Per room per day
4. Cinema Per seat per show (or per man show)
5. Electricity Per kilowatt hour (kWh)
Operating costing procedure in some of the undertakings is explained in the
suceeding sections.

8.3 COST SHEET FOR TRANSPORTATION SERVICE

Let us discuss the objectives of transport costing.

Objectives: The main objectives of transport costing are:
1. To fix the rates of carriage of goods or passengers on the basis of operating
costs.
2. To decide the hire charges where vehicles are given on hire.
3. To determine what should be charged to departments or others using the service.
4. To compare the cost of using own motor vehicles and that of using alternate
forms of transport.
5. To compare the cost of maintaining one vehicle with another or one group of
vehicles with another group.

Self-Instructional
Material 139
Service Costing Determination of Number of Cost Units

The cost unit in passenger transport is usually a passenger kilometre and in goods
transport it is a tonne-kilometre. The calculation of the total number of cost units is
NOTES illustrated:
Illustration 8.1
A Delhi-Jaipur Transport Co. runs four buses between two towns which are 50 kms
apart. The seating capacity of each bus is 50 passengers and actual passengers carried
are 80% of the seating capacity. All the 4 buses run on 25 days in a month and each
bus makes one round trip per day. Calculate passenger-kms.
Solution:

Passenger- N o. of Capacity of Capacity Rou nd No. of

km s = bu ses  Distance  each bu s  u tilized  trip  d ays

= 4 × 50 × 50 × 80% × 2 × 25
= 4,00,000 passenger kilometres per month
Absolute tonne-km and Commercial tonne-km
In transport costing, composite cost units may be computed in two ways—
(a) absolute tonne-km, and
(b) commercial tonne-km
In absolute tonne-km, cost units between each two stations is calculated
separately in tonne-kms and then totalled up. But in commercial tonne-km, the trip is
considered as a whole and it is arrived at by multiplying the total distance in kms by
average load quantity.
Illustration 8.2
A truck starts with a load of 10 tonnes of goods from station P. It unloads 4 tonnes at
station Q and rest of the goods at station R. It reaches back directly to station P after
getting reloaded with 8 tonnes of goods at station R. The distances between P to Q, Q
to R and then from R to P are 40 kms, 60 kms and 80 kms, respectively. Compute
absolute tonne-kms and commercial tonne-kms.
Solution:
Absolute tonne-km = (40 kms × 10 tonnes) + (60 kms × 6 tonnes)
+ (80 kms × 8 tonnes)
= 400 + 360 + 640 = 1,400 tonne-kms
Commercial tonne-km = Average load × total km
10  6  8 
=   tonnes × 180 kms
 3 
= 8 tonnes × 180 km = 1,440 tonne-kms
Self-Instructional
140 Material
Log Sheet Service Costing

Most of the details required for transport costing are obtained from log sheet. A log
sheet is maintained for each vehicle to record details of trips, running time, capacity,
mileage, etc., on daily basis. These details also enable the management to avoid idleness NOTES
of vehicles, to prevent waste of capacity and to guard against unnecessary duplication
of trips. A specimen of a log sheet is given in Fig. 8.1.

Fig. 8.1 Daily Log Sheet in Transport Costing

Transport Costing Procedure

Costs are classified and accumulated under the following heads:

1. Standing or fixed charges: These are constant costs and are incurred
irrespective of the mileage run. Such costs, therefore, should not be allocated to
specific journeys on the basis of mileage. Some of these are direct or traceable
fixed costs and can be allocated to specific vehicles, other such costs are suitably
apportioned to each vehicle. Opinions differ as to whether depreciation is to be
regarded as a fixed cost or a variable cost. It is thus sometimes regarded as a
variable cost and sometimes as a fixed cost. Interest on capital may also be
included in fixed charges.
2. Running or variable charges: These costs are those which vary in direct
proportion to mileage run and so variable cost per unit may be computed
straightaway. Wages of drivers, conductors and cleaners are sometimes regarded Self-Instructional
Material 141
as variable costs if payment is made according to distance or trips.
Service Costing These two types of costs are compiled periodically in an operating cost sheet as
shown in the proforma given in Fig. 8.2.

NOTES

Fig. 8.2 Operating Cost Sheet in Transport Costing

Illustration 8.3
From the following data relating to two different vehicles A and B, compute the cost
per running mile:
Vehicle A Vehicle B
Mileage run (annual) 15,000 6,000
Cost of vehicle 25,000 15,000
Road licence (annual) 750 750
Insurance (annual) 700 400
Garage rent (annual) 600 500
Supervision and salaries 1,200 1,200
Driver’s wages per hour 3 3
Cost of fuel per gallon 3 3
Miles run per gallon 20 miles 15 miles
Repairs and maintenance per mile 1.65 2.00
Tyre allocation per mile 0.80 0.60
Self-Instructional Estimated life of vehicles 1,00,000 miles 75,000 miles
142 Material
 Charge interest at 5% per annum on cost of vehicles. The vehicles run 20 miles Service Costing

per hour on an average.

Solution:
Operating Cost Sheet NOTES
for the year ending.........
No. of cost units A: 15,000
B: 6,000
Cost unit: One mile
Particulars Vehicle A Vehicle B

Fixed cost per annum:

Road licence 750 750
Insurance 700 400
Garage rent 600 500
Supervisory salaries 1,200 1,200
Interest 5% on cost of vehicle 1,250 750
Total 4,500 3,600
Fixed cost per mile (A) 0.30 0.60
Variable cost per mile:
Driver’s wages ( 3 per hour for 20 miles) 0.15 0.15
Fuel cost per mile 0.15 0.20
Repairs and maintenance 1.65 2.00
Tyre allocation 0.80 0.60
Depreciation (cost ÷ estimated life) 0.25 0.20
Variable cost per mile (B) 3.00 3.15
Total Cost Per Running Mile (A + B) 3.30 3.75

Price Quotations
Transport companies may have to quote prices for specific trips on contract basis or
mileage basis. The method of preparing price quotations is usually based on cost plus
desired profit. A Statement of Quotation is thus prepared to determine the Quotation
Price as shown in the following Illustration.
Illustration 8.4
Union Transport Company supplies the following details in respect of a truck of 5-
tonne capacity:
Cost of truck 90,000
Estimated life 10 years
Diesel, oil, grease 15 per trip each way
Repairs and maintenance 500 per month
Cleaner’s wages 250 per month
Driver’s wages 500 per month
Insurance 4,800 per year
Tax 2,400 per year
General supervision charges 4,800 per year
Self-Instructional
The truck carries goods to and from city covering a distance of 50 miles each way. Material 143
Service Costing While going to the city, freight is available to the extent of full capacity and on
return 20% of capacity.
Assuming that the truck runs on an average 25 days a month, work out—
(i) Operating cost per tonne-mile, and
NOTES
(ii) Rate per trip that the company should charge if profit of 50% on freightage
is to be earned.
Solution:
(i) Operating Cost Statement
for the month ending......
Tonne-miles = 7,500*
Per month Per tonne-mile

1. Fixed Costs
Driver’s wage 500
Cleaner’s wage 250
Insurance 400
Taxes 200
General supervision 400 1,750 0.233
2. Running (or Variable) Costs
Diesel, oil, etc. (15 × 2 × 25) 750
Repairs and maintenance 500
1 1
Depreciation  90,000    750 2,000 0.267
 10 12 
Total 3,750 0.500

*Note: Tonne-miles are computed as under:

[(50 × 5) + (50 × 1)] × 25 days = 7,500 tonne-miles
(ii) Calculation of Freight Rate and Quotation
Cost per tonne-mile 0.50
Profit per tonne-mile (50% on freightage is 100% on cost) 0.50
Freight rate per tonne-mile 1.00
Freight rate per trip both ways = 1 × 300 tonne-miles = 300.
Note: In one trip (both ways) there are 300 tonne-miles, i.e., (50 × 5) + (50 × 1) = 300.

Check Your Progress

1. State the difference between operating and operation costing.
2. What is the use of log sheet for the management in transportation service?
3. Mention the basis on which price quotations are prepared in transport costing.

8.4 COST STATEMENT FOR HOSPITAL

Hospital costing is a specially designed costing method that meets the demands of
Self-Instructional hospitals. The basic objective of hospital costing is to ascertain the cost of providing
144 Material medical facilities to the patients. However, it essential to divide medical services into
cost centres before making any attempt to ascertain cost for such services. For this Service Costing
purpose, services can be categorized into the following cost centres:
• Outpatients departments
• Wards NOTES
• Operation theater
• Support service departments such as radiotherapy, diagnostic x-ray, pathology,
etc.
• General services such as boiler house, power, heating, lighting, medical records,
etc.
• Catering
• Laundry
• Transport
• Cleaning
Costs that are attributed to cost centres are directly allocated to specific cost
centres. However, common costs are apportioned to various cost centres on suitable
basis. Both fixed cost and variable cost are depicted separately in the cost sheet.
Cost Unit
The selection of cost unit in hospital service is a difficult task. Table 8.1 shows the
cost units of health that are generally used in practice:
Table 8.1 Cost Centres and Cost Units for Medical Services

Cost Centre Cost Unit

• Out-patient department • Per out-patient attended
• Wards • Per new out-patient attended or per case
• Operation theater • Per operation
• Radiotherapy • Per course of treatment per day
• Diagnostic X-ray • Per 100 units
• Pathology • Per 100 requests
• Boiler house • Per 1,000 lbs. stam raised
• Power, heating, & lighting • Per 1,000 cubic feet
• Medical records • Per weighted unit
• Catering • Per person fed per week
• Laundry • Per 100 items laundered
• Transport • Per patient-kilometre
• Cleaning • Per 1,000 cubic feet

Cost Statement
The hospital prepares a cost statement in order to arrive at the cost per unit of a specific
service. The statement consists of two major costs, viz., capital expenditure and
maintenance expenses. The former includes the expenditure like cost of building and
mechanical equipments, whereas the latter refers to expenses that are incurred by the
hospital on purchase of surgical appliances, fuel, lighting, laundry, staff uniform and
patient clothing. It also includes salary and wages of the staff. Self-Instructional
Material 145
Service Costing Illustration 8.5: Public Health Centre runs an Intensive Care Unit. For this purpose,
it has hired a building at a rent of 5,000 p.m. with the understanding that it would
bear the repairs and maintenance charges also.
The unit consists of 25 beds and 5 more beds can be comfortably accommodated
NOTES
when the occasion demands. The permanent staff members attached to the unit are as
follows:
2 supervisors, each at a salary of 500 per month
4 nurses, each at a salary of 300 per month
2 ward boys, each at a salary of 150 per month
Though the unit was open for the patients all 365 days a year, a scrutiny of
accounts of 2012 revealed that only for 120 days in a year, the unit had the full capacity
of 25 patients per day, and for another 80 days, it had only an average occupancy rate
of 20 beds per day. But there were occasions when the beds were full, extra beds
were hired from outside at a charge of 5 per bed per day and this did not come to
more than 5 beds extra above the normal capacity on any one day. The total hire
charge for extra beds incurred for the whole year amount to 2,000.
The unit engaged expert doctors from outside to attend the patients and fees
were paid on the basis of the number of patients attended and time spent by them,
which on an average worked out to be 10,000 per month in 2012. The other expenses
for the year were as under:

Repairs and maintenance 3,600

Food supplied to patients 44,000
Janitor and other services for them 12,500
Laundry charges for their bed linens 28,000
Medicines supplied 35,000
Cost of oxygen, X-ray, etc., other than directly borne for treatment of patients 54,000
General administration charges allocated to the unit 49,550
(i) If the units recovered an overall amount of 100 per day on an average
from each patient, what is the profit per patient day made by the unit in
2012.
(ii) The unit wants to work on a budget for 2013, but the number of patients
requiring intensive care is a very uncertain factor. Assuming that the same
revenue and expenses prevail in 2013, in the first instance, work out the
number of patient days required by the unit to break even.
(Adapted from ICWA, Final)

Self-Instructional
146 Material
 Service Costing
Solution
Statement of Profit
Particulars Amount
( ) NOTES
Income received from patients (5,000 patents1 × 100) 5,00,000
Less: Variable Cost:
Food 44,000
Janitor and other services 12,500
Laundry charges for bed linens 28,000
Medicine supplied 35,000
Doctors’ fee ( 10,000 × 12) 1,20,000
Hire charges for extra beds 2,000
2,41,500
Contribution 2,58,500
Less: Fixed Cost:
Salaries:
Supervisor (2 × 500) = 1,000 p.m.
Nurses (4 × 300) = 1,200 p.m.
Wards (2 × 150) = 300 p.m.
( 2,500 × 12) 2,500 p.m. 30,000
Rent ( 5,000 × 12) 60,000
Repairs and maintenance 3,600
General administration 49,550
Cost of oxygen, x-ray, etc. 54,000
1,97,350
Profit 61,350

Calculation of Profit Per Patient Day

Profit 61,350
Profit per patient day =   12.27
No. of patent days 5,000
Calculation of Break-even Point

Fixed Cost Fixed Cost

Break-even Point = 
P / V ratio Contribution  Sales
5,00, 000
 1,97,150   3,81,335
2,58,000

Working:
1. Calculation of Number of Patient Days in 2012:
25 beds × 120 days = 3,000
20 beds × 80 days = 1,600
Extra bed days ( 2000 ÷ 5) = 400
= 5,000 patient days

Self-Instructional
Material 147
Service Costing
8.5 COST STATEMENT FOR HOTEL
ORGANIZATION

NOTES Hotel business is highly diversified in terms of activities which range from
accommodation to food and entertainment. The basic aim of hotel costing is to ascertain
the cost per unit of output. For the purpose of cost control, the operations of a hotel
need to be distributed among cost centres for which cost details can be collected and
cost per unit can be worked out. Usually, the cost centres for a hotel can be
housekeeping, restaurant and laundry. Once the cost centres are determined, the cost
unit can be decided. For example, in case of housekeeping, the appropriate cost unit
could be per room, per day, or per night whereas for a restaurant, it could be per meal
or per dish. Costs incurred on various operations could be both fixed and variable. The
costs that are incurred specifically for a centre shall be allocated/directed to the centre.
However, the common costs are to be apportioned to the various centres on some
equitable basis.
Illustration 8.6: A lodging home is being run in a small hill station with 50 single rooms.
The home offers concessional rates during the six off-season months in a year. During
this period, half of the full room rent is charged. The management’s profit margin is
targeted at 20 per cent of the room rent. The following are the cost estimates and
other details for the year ending on 31 March 2012. (Assume a month to be of 30
days.)
i. Occupancy during the season is 80 per cent while in the off-season it is 40 per
cent only.
ii. Expenses:
• Staff salary (excluding room attendants) 2,75,000
• Repairs to building 1,30,500
• Laundry and linen 40,000
• Interior and tapestry 87,500
• Sundry expenses 95,400
iii. Annual depreciation is to be provided for buildings @ 5 per cent and on furniture
and equipments @ 15 per cent on straight-line basis.
iv. Room attendants are paid 5 per room day on the basis of occupancy of the
rooms in a month. Monthly lighting charges are 120 per room, except in four
months in winter when it is 30 per room and this cost is on the basis of full
occupancy for a month.
v. Total investment in the home is 100 lakh of which 80 lakh relate to buildings
and balance for furniture and equipments.
You are required to work out the room rent chargeable per day both during the season
and the off-season months on the basis of the foregoing information.

Self-Instructional
148 Material
Solution Service Costing

NOTES

*Calculation of Attendant’s Salary:

Number of Room days × Wages per Room day
= 10,800A × 5 per day = 54,000
A. Calculation of Room Days in a Year:
7,2001 room days + 3,6002 room days = 10,800 Room Days
** Calculation of Lighting Charges:
The lighting charges need to be calculated for two periods, i.e., season and non-
season separately as the two diff erent rates are applicable to the different periods.
Accordingly, the lighting charges have been worked out as under:
7,200 room days (seasonal) @ 4 per day3 = 28,800
1,200 room days (off -season) @ 4 per day3 = 4,800
2,400 room days (off -season) @ 1 per day4 = 2,400
Total lighting charges 36,000

During the season 197 will be charged as room rent whereas during non-season
98.50 will be charged as room rent.
Working:
1. Calculation of season’s occupancy for 6 months:
Season’s occupancy for 6 months @ 80% = 50 × (80 ÷ 100) × 6 × 30 = (50
× 0.8 × 6 × 30)
= 7,200 room days Self-Instructional
Material 149
Service Costing 2. Calculation of off-season’s occupancy for 6 months:
Season’s occupancy for 6 months @ 40% = 50 × (40 ÷ 100) × 6 × 30 = (50
× 0.4 × 6 × 30)
NOTES = 3,600 room days
3. Calculation of lighting per room day during the season:
120 per month = 120 ÷ 30 = 4 per room day
4. Calculation of lighting per room day during off-season:
30 per month = 30 ÷ 30 = 1 per room day

Check Your Progress

4. State the objective of hospital costing.
5. What are the categories of major costs in hospital cost statement?
6. Mention examples of cost unit for housekeeping and restaurant.

8.6 COST ACCOUNTING STANDARD 13: COST OF

SERVICE COST CENTRE

The following is the COST ACCOUNTING STANDARD – 13 (CAS - 13) issued

by the Council of The Institute of Cost Accountants of India on “Cost of Service Cost
Centre”. In this Standard, the standard portions have been set in bold italic type.
These are to be read in the context of the background material which has been set in
normal type.
1. Introduction
1.1 This standard deals with the principles and methods of determining the cost of
Service Cost Centre.
1.2 This standard covers the Service Cost Centre as defined in paragraph 4.11 of
this standard. It excludes Utilities and Repairs & Maintenance Services dealt
with in CAS-8 and CAS-12 respectively.
1.3 This standard deals with the principles and methods of classification, measurement
and assignment of Cost of Service Cost Centre, for determination of the Cost
of product or service, and the presentation and disclosure in cost statements.
2. Objective
The objective of this standard is to bring uniformity and consistency in the principles
and methods of determining the Cost of Service Cost Centre with reasonable accuracy.
3. Scope
This standard should be applied to the preparation and presentation of cost statements,
Self-Instructional which require classification, measurement and assignment of Cost of Service Cost
150 Material Centre, including those requiring attestation.
4. Definitions Service Costing

The following terms are being used in this standard with the meaning specified.
4.1 Abnormal cost: An unusual or atypical cost whose occurrence is usually
irregular and unexpected and/ or due to some abnormal situation of the NOTES
production or operation (Adapted from CAS 1 paragraph 6.5.19).
4.2 Administrative Overheads: Cost of all activities relating to general
management and administration of an entity.
Administrative overheads shall exclude production overheads (Paragraph
reference 4.13 CAS -9), marketing overheads (Paragraph reference 4.11 CAS
-7) and finance cost. Production overheads includes administration cost relating
to production, factory, works or manufacturing.
4.3 Cost Object: An activity, contract, cost centre, customer, process, product,
project, service or any other object for which costs are ascertained.
4.4 Distribution Overheads: Distribution overheads, also known as distribution
costs, are the costs incurred in handling a product or service from the time
it is ready for dispatch or delivery until it reaches the ultimate consumer
including the units receiving the product or service in an inter-unit transfer.
The cost of any non-manufacturing operations such as packing, repacking,
labelling, etc. at an intermediate storage location will be part of distribution cost.
4.5 Imputed Cost: Notional cost, not involving cash outlay, computed for any
purpose.
4.6 Interest and Finance charges: Interest, including any payment in the nature
of interest for use of non-equity funds and incidental cost that an entity
incurs in arranging those funds.
This will include interest and commitment charges on bank borrowings, other
short term and long term borrowings, amortisation of discounts or premium
related to borrowings, amortisation of ancillary cost incurred in connection with
the arrangements of borrowings, finance charges in respect of finance leases,
other similar arrangements and exchange differences arising from foreign currency
borrowings to the extent they are regarded as an adjustment to the interest
costs (Adapted from CIMA Terminology). The terms Finance costs and
Borrowing costs are used interchangeably.
4.7 Marketing overheads: Marketing overheads comprise of selling overheads
and distribution overheads.
4.8 Normal capacity: Normal Capacity is the production achieved or
achievable on an average over a number of periods or seasons under normal
circumstances taking into account the loss of capacity resulting from
planned maintenance (Adapted from CAS 2 paragraph 4.4).
4.9 Production Overheads: Indirect costs involved in the production of a product
or in rendering service.
Self-Instructional
Material 151
Service Costing The terms Production Overheads, Factory Overheads, Works Overheads and
Manufacturing Overheads denote the same meaning and are used
interchangeably.
4.10 Selling Overheads: Selling overheads are the expenses related to sale of
NOTES
products or services and include all indirect expenses incurred in selling
the products or services.
4.11 Standard Cost: A predetermined cost of a product or service based on
technical specifications and efficient operating conditions.
Standard costs are used as scale of reference to compare the actual costs with
the standard cost with a view to determine the variances, if any, and analyse the
causes of variances and take proper measure to control them. Standard costs
are also used for estimation.
4.12 Stand-by service: Any facility created as backup against any failure of the
main source of service.
4.13 Support-Service Cost Centre: The cost centre which primarily provides
auxiliary services across the entity.
The cost centre which provides services to Production, Operation or other
Service Cost Centre but not directly engaged in manufacturing process or
operation is a service cost centre. A service cost centre renders services to
other cost centres / other units and in some cases to outside parties.
Examples of service cost centres are engineering, workshop, research &
development, quality control, quality assurance, designing, laboratory, welfare
services, safety, transport, Component, Tool stores, Pollution Control, Computer
Cell, dispensary, school, crèche, township, Security etc.
Administrative Overheads include cost of administrative Service Cost Centre.
5. Principles of Measurement
5.1 Each identifiable service cost centre shall be treated as a distinct cost
object for measurement of the cost of services subject to the principle of
materiality.
5.2.1 Cost of service cost centre shall be the aggregate of direct and indirect
cost attributable to services being rendered by such cost centre.
5.2.2 Cost of in-house services shall include cost of materials, consumable
stores, spares, manpower, equipment usage, utilities, and other
resources used in such service.
Cost of other resources includes related overheads.
5.2.3 Cost of services rendered by contractors within the facilities of the
entity shall include charges payable to the contractor and cost of
materials, consumable stores, spares, manpower, equipment usage,
utilities, and other resources provided to the contractors for such
Self-Instructional services.
152 Material
 5.2.4 Cost of services rendered by contractors at their premises shall be Service Costing

determined at invoice or agreed price including duties and taxes,

and other expenditure directly attributable thereto net of discounts
(other than cash discount), taxes and duties refundable or to be
credited. This cost shall also include the cost of resources provided to NOTES
the contractors.
5.2.5 Cost of services for the purpose of inter unit transfers shall also
include distribution costs incurred for such transfers.
5.2.6 Cost of services for the purpose of inter-company transfers shall also
include distribution cost incurred for such transfers and administrative
overheads.
5.2.7 Cost of services rendered to outside parties shall also include
distribution cost incurred for such transfers, administrative overheads
and marketing overheads.
5.3 Finance costs incurred in connection with the Service Cost Centre shall
not form part of the cost of Service Cost Centre.
5.4 The cost of service cost centre shall not include imputed costs.
5.5 Where the cost of service cost centre is accounted at standard cost, the
price and usage variances related to the services cost Centre shall be treated
as part of cost of services. Usage variances due to abnormal reasons shall
be treated as part of abnormal cost.
5.6 Any Subsidy / Grant / Incentive or any such payment received / receivable
with respect to any service cost centre shall be reduced for ascertainment
of the cost to which such amounts are related.
5.7 The cost of production and distribution of the service shall be determined
based on the normal capacity or actual capacity utilization whichever is
higher and unabsorbed cost, if any, shall be treated as abnormal cost
(Adapted from Paragraph 5.7 of CAS 3). Cost of a Stand-by service shall
include the committed costs of maintaining such a facility for the service.
5.8 Any abnormal cost where it is material and quantifiable shall not form
part of the cost of the service cost centre.
5.9 Penalties, damages paid to statutory authorities or other third parties shall
not form part of the cost of the service cost centre.
5.10 Credits/recoveries relating to the service cost centre including charges for
services rendered to outside parties, material and quantifiable, shall be
reduced from the total cost of that service cost centre.
5.11 Any change in the cost accounting principles applied for the measurement
of the cost of Service Cost Centre shall be made, only if it is required by
law or for compliance with the requirements of a cost accounting standard,
or a change would result in a more appropriate preparation or presentation
of cost statements of an enterprise. Self-Instructional
Material 153
Service Costing 6. Assignment of Cost
6.1 While assigning cost of services, traceability to a cost object in an
economically feasible manner shall be the guiding principle.
NOTES 6.2 Where the cost of services rendered by a service cost centre is not directly
traceable to a cost object, it shall be assigned on the most appropriate
basis.
6.3 The most appropriate basis of distribution of cost of a service cost centre
to the cost centres consuming services is to be derived from logical
parameters which could be related to the usage of the service rendered.
The parameter shall be equitable, reasonable and consistent.
7. Presentation
7.1 Cost of service cost centre shall be presented as a separate cost head for each
type of service in the cost statement, if material.
8. Disclosures
8.1 The cost statements shall disclose the following:
1. The basis of distribution of cost of each service cost centre to the
consuming centres.
2. The cost of purchase, production, distribution, marketing and price of
services with reference to sales to outside parties.
3. Where the cost of service cost centre is disclosed at standard cost, the
price and usage variances.
4. The cost of services received from / rendered to related parties (Related
party as per the applicable legal requirements relating to the cost
statement as on the date of the statement).
5. Cost of service cost centre incurred in foreign exchange.
6. Any Subsidy/Grant/Incentive and any such payment reduced from cost
of Service Cost Centre.
7. Credits/ recoveries relating to the cost of Service Cost Centre
8. Any abnormal cost excluded from cost of Service Cost Centre.
9. Penalties and damages paid excluded from cost of Service Cost Centre.
8.2 Any change in the cost accounting principles and methods applied for the
measurement and assignment of the cost of service cost centre during the
period covered by the cost statement which has a material effect on the
cost of service cost centre shall be disclosed. Where the effect of such
change is not ascertainable wholly or partly the fact shall be disclosed.
8.3 Disclosures shall be made only where material and significant.
8.4 Disclosures shall be made in the body of the Cost Statement or as a foot
Self-Instructional note or as a separate schedule prominently.
154 Material
 Service Costing

Check Your Progress

7. Which type of cost includes 'cost of any non-manufacturing operations such as
packing and labelling'? NOTES
8. Are finance costs incurred in connection with the service cost centre a part of
cost of service cost centre?

8.7 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS

1. While operating costing is applied to determine the cost of providing a service.

Operation costing is a refinement and more detailed application of process
costing.
2. A log sheet is maintained for each vehicle to record details of trips, running time,
capacity, mileage, etc., on a daily basis. These details also enable the management
to avoid idleness of vehicles, to prevent waste of capacity and to guard against
unnecessary duplication of trips.
3. The method of preparing price quotations is usually based on cost plus desired
profit.
4. The basic objective of hospital costing is to ascertain the cost of providing
medical facilities to the patients.
5. The hospital cost statement consists of two major costs, viz., capital expenditure
and maintenance expenses.
6. In case of housekeeping, the appropriate cost unit could be per unit, per day, or
per night whereas for a restaurant, it could be per meal or per dish.
7. The cost of any non-manufacturing operations such as packing, repacking,
labelling, etc. at an intermediate storage location will be part of distribution cost.
8. Finance costs incurred in connection with the Service Cost Centre shall not
form part of the cost of Service Cost Centre.

8.8 SUMMARY

 Operating cost is a method of cost ascertainment used in those undertaking

which are engaged in providing services, such as transport, electricity, etc.
 In many manufacturing companies, operating costing is used in certain
departments which render services, within the organization, e.g., internal transport
and personnel department. Operating costing is also known as service costing.
 The selection of a suitable cost unit is very important in operating costing. The
cost units may be of the following two types: simple cost unit and composite
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Service Costing  There are a number of objectives of transport costing including fixation of rates
of carriage on the basis of operating costs, decisions regarding hire charges,
charges for departments, comparison of costs vis a vis alternatives and
comparison of maintenance of one vehicle to another group, among other
NOTES objectives.
 Most of the details required for transport costing are obtained from log sheet.
 Costs are classified and accumulated under standing or fixed charges or running
or variable charges. These two types of costs are compiled periodically in an
operating cost sheet.
 Transport companies may have to quote prices for specific trips on contract
basis or mileage basis.
 Hospital costing is specifically designed costing method that meets the demands
of hospitals.
 It is essential to divide medical services into cost centres begore making any
attempt to ascertain cost for medical facilities. The selection of cost unit in hospital
service is a difficult task.
 The hospital prepares a cost statement in order to arrive at the cost per unit of
a specific service.
 Hotel business is highly diversified in terms of activities which range from
accommodation to food and entertainment. The basic aim of hotel costing is to
ascertain the cost per unit of output.
 Once cost centres for a hotel are determined, the cost unit can be decided.
 CAS 13 standard deals with the principles and methods of determining the cost
of Service Cost Centre. This standard deals with the principles and methods of
classification, measurement and assignment of Cost of Service Cost Centre, for
determination of the Cost of product or service, and the presentation and
disclosure in cost statements.

8.9 KEY WORDS

 Operating costing: It is a method of cost ascertainment used in those undertaking

which are engaged in providing services, such as transport, electricity, etc.
 Operating cost: It is the cost of providing a service.

8.10 SELF ASSESSMENT QUESTIONS AND

EXERCISES

Short Answer Questions

1. List the industries in which operating costing is applicable.
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 2. Mention the characteristics usually found in industries where operating costing Service Costing

is used.
3. What are simple and composite cost units?
4. List some of the cost centres and cost units in hospital costing. NOTES
5. Write a short note on hospital costing.
6. What is the objective and scope of CAS 13?
Long Answer Questions
1. Examine the objectives and procedure for preparation of cost sheet for
transportation service.
2. Discuss the principles of measurement, assignment of cost and disclosure
requirements under CAS 13.

8.11 FURTHER READINGS

Arora, M N. 2012. A Textbook of Cost and Management Accounting. New Delhi:
Vikas Publishing House.
Prof Bhirud, S. 2010. Cost and Works Accounting (Overheads and Methods of
Costing (Paper II). India: Diamond Publications.
Bhalla, Kapileshwar and Parveen Sharma. 2020. Problems and Solutions in Cost
and Management Accounting for CA Intermediate | For Group 1 - Paper
3 (CA Examination Series). New Delhi: McGraw-Hill Education.
Websites:
ICAI website for CAS 3 < https://icmai.in/upload/CASB/2017/CAS_3_Revised_2015_Final.pdf>

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