COST AND MANAGEMENT

Dr Rajesh Kumar Jha

Dr. Payal Shreepal Samdariya
Dr. Khalid Y. Ghailan
Dr. Asim Mehmood
© Copyright, 2023, Author

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 AUTHORS BIOGRPAHY

Name: Dr Rajesh Kumar Jha

Designation: Associate Professor
Department: MBA
Institute: Dr. D Y Patil Institute of Management and Entrepreneur Development
District: Pune
City: Pune
State: Maharashtra

Name: Dr. Payal Shreepal Samdariya

Designation: Associate Professor
Department: MBA
Institute: AKI Poona Institute of Management Sciences and Entrepreneurship
District: Pune
City: Pune
State: Maharashtra

Name: Dr. Khalid Y. Ghailan

Designation: Associate Professor
Department: Epidemiology
Institute: Jazan University, College of Public Health & Tropical Medicine, Jazan,
Saudi Arabia
District: Jazan
City: Jazan
State: Jazan

Name: Dr. Asim Mehmood

Designation: Lecturer
Department: Health Informatics
Institute: Jazan University, College of Public Health & Tropical Medicine, Jazan,
Saudi Arabia
District: Jazan
City: Jazan
State: Jazan

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 COST AND

MANAGEMENT

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 Table of Contents

CHAPTER 1: Introduction to Cost and Management Accounting ............................................ 8

1. Cost accounting helps in periods of trade depression and trade competition .................. 24

2. Cost accounting aids price fixation .................................................................................. 25

3. Cost accounting helps in making estimates...................................................................... 25

4. Cost accounting helps in channelizing production on the right lines ............................... 25

5. Cost accounting eliminates wastages ............................................................................... 25

6. Cost accounting makes comparisons possible ................................................................. 25

7. Cost accounting provides data for periodical profit and loss account.............................. 25

8. Cost accounting helps in determining and enhancing efficiency ..................................... 26

9. Cost accounting helps in inventory control ...................................................................... 26

CHAPTER 2: Material Cost and Labour Cost ......................................................................... 35

Objectives of the system of material control ........................................................................ 39

Requirements of material control ......................................................................................... 41

CHAPTER 3: Accounting Books and Records ....................................................................... 62

Objectives of Accounting ..................................................................................................... 65

Limitations of Accounting ................................................................................................... 66

II. Accounting Conventions ................................................................................................. 80

System of Accounting .......................................................................................................... 83

CHAPTER 4: Depreciation...................................................................................................... 86

CHAPTER 5: Financial statements analysis and Interpretation ............................................ 111

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 COMPARATIVE HORIZONTAL ANALYSIS OF BALANCE SHEETS ...................... 113

COMMON-SIZE VERTICAL ANALYSIS OF BALANCE SHEETS ............................ 116

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS .................... 118

COMPARATIVE HORIZONTAL ANALYSIS OF INCOME STATEMENTS ............. 119

COMMON-SIZE VERTICAL ANALYSIS OF INCOME STATEMENTS .................... 120

AVERAGE CHECK, COST, AND INCOME PER GUEST ............................................ 123

CHAPTER 6: Cost Methods, techniques of cost accounting, and Classification of Cost ..... 127

OBJECTIVES OF COST ACCOUNTING........................................................................ 130

1.4 COST CENTRE AND COST UNITS ......................................................................... 133

CLASSIFICATION OF COST .......................................................................................... 135

COST DRIVER .................................................................................................................. 147

COST UNIT, COST CENTRE AND PROFIT CENTRE COST UNIT ........................... 148

COST CENTRE ................................................................................................................. 149

PROFIT CENTRE.............................................................................................................. 149

CHAPTER 7: Material cost control and inventory control ................................................... 152

CHAPTER 8: Labor cost accounting and Overheads ............................................................ 173

CHAPTER 9: Activity-Based Costing (ABC) ....................................................................... 185

COST AND MANAGEMENT ACCOUNTING ............................................................... 191

REMOVING THE BLINDFOLD WITH ABC/M ............................................................ 200

STAGES OF EVOLUTION OF COST MANAGEMENT SYSTEMS ............................ 205

REMOVING THE BLINDFOLD WITH ABC/M ............................................................ 212

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CHAPTER 10: Budget, Budgeting, and Budgetary Control ................................................. 215

Chapter 11: Cost Accounting Records and Cost Audit ......................................................... 233

COST RECORD RULE 2014 ............................................................................................ 235

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CHAPTER 1: Introduction to Cost and Management Accounting

Finance and accounting have assumed much importance in today’s competitive world of

business wherein corporate organizations have to show a true and fair view of their financial

position. Thus, the application of accounting in the business sector has become an

indispensable factor. Company Secretary has to provide complete and accurate information

about the financial operations of the company to management for decision-making. This

emphasizes that the books of account are to be maintained accurately, up-to-date, and as per

the norms. The subject ‘Cost and Management Accounting’ is very important and useful for

optimum utilization of existing resources.

Figure 1: Cost and management accounting

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These are branches of accounting and had been developed due to the limitations of financial

accounting. It is an indispensable discipline for corporate management, as the information

collected and presented to management based on cost and management accounting

techniques helps management to solve not only specific problems but also guides them in

decision making. Keeping in view the importance of this subject, various topics on Cost and

Management Accounting have been prescribed in the syllabus of the CS Executive

Programme with the objective of acquainting the students with the basic concepts used in cost

accounting and management accounting having a bearing on managerial decision-making.

The entire paper has been discussed in twelve study lessons. In starting four study lessons we

discussed the basis of cost accounting, material, labor, and overhead costing. Further, we

have highlighted the concept of activity-based costing, cost records, different costing

systems. Thereafter study focuses on marginal costing, standard costing, budgeting & its

applications for decision-making in business.

Figure 2: Management accounting

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At last, we have discussed cost accounting records, cost audits and analysis & interpretation

of financial statements. In this study, every effort has been made to give comprehensive

coverage of all the topics relevant to the subject. In all study lessons the requisite theoretical

framework for understanding the practical problems in the subject has been explained and

wherever necessary practical illustrations have been given to facilitate better understanding.

At the end of each study lesson a brief about the lesson has been given under the caption

‘Lesson Round Up’ as well a good blend of theoretical and practical questions has been given

under the caption ‘Self-Test Questions’ for the practice of students to test their knowledge. In

fact, this being a practical paper, students need to have good theoretical knowledge and

practice to attain the requisite proficiency and confidence.

Figure 3: Cost and management accounting

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This study material has been published to aid the students in preparing for the Cost and

Management Accounting paper of the CS Executive Programme. It is part of the education

kit and takes the students step by step through each phase of preparation stressing key

concepts, pointers, and procedures. Company Secretaryship being a professional course, the

examination standards are set very high, with emphasis on knowledge of concepts,

applications, procedures, and case laws, for which sole reliance on the contents of this study

material may not be enough. Therefore, in order to supplement the information/contents

given in the study material, students are advised to refer to the Suggested Readings

mentioned in the study material, e-bulletin, Business Dailies, and Journals.

Figure 4: Types of accounting

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Cost is the amount of resources given up in exchange for some goods or services. The

resources given up are money or money’s equivalent expressed in monetary units. The

Chartered Institute of Management Accountants, London defines cost as “the amount of

expenditure (actual or notional) incurred on, or attributable to a specified thing or activity”.

This activity of a firm may be the manufacture of a product or the rendering of a service

which involves expenditure under various heads, e.g., materials, labor, other expenses, etc. A

manufacturing organization is interested in ascertaining the cost per unit of the product

manufactured while an organization rendering service, e.g., transport undertaking, canteen,

electricity company, municipality, etc., is interested in ascertaining the costs of the service it

renders.

In its simplest form, the cost per unit is arrived at by dividing the total expenditure incurred

by the total units produced or the quantum of service rendered. But this method is applicable

if the manufacturer produces only one product. If the manufacturer produces more than one

product, it becomes imperative to split up the total expenditure between the various products

so that the cost of each product can be ascertained separately. Even if only one product is

manufactured, it may be necessary to analyze the cost per unit of each item of expenditure

that goes to make up the total cost. The problem becomes more complicated when a

multiplicity of products is produced, and it is necessary to analyze the cost per unit of each

product into various items of expenditures that make up the total cost. For a consumer cost

means price.

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 Figure 5: Financial Accounting

For management, cost means 'expenditure incurred' for producing a particular product or

rendering a particular service. The process of ascertaining the cost is known as costing. It

consists of principles and rules governing the procedure of finding out the costs of goods/

services. It aims at ascertaining the total cost and also per unit cost. For instance, in transport

companies, the total cost for the period is ascertained and used to find out the cost per

passenger/mile. I.e. The cost of carrying one passenger for one mile. It provides for analysis

of expenditure in such a way that the management gets a complete idea about even the

smallest item of cost. It is necessary to specify the exact meaning of “cost”. When the term is

used specifically, it is modified with such terms as prime cost, fixed cost, sunk cost, etc. Each

description implies a certain characteristic which is helpful in analyzing the cost.

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 Figure 6: Fields of Accounting

It helps cost accounting in achieving its three basic objectives namely-cost ascertainment,

cost control, and cost presentation. A cost must always be studied in relation to its purpose

and conditions. Different costs may be ascertained for different purposes and under different

conditions. Work-in-progress is valued at factory cost, while the stock of finished goods may

be valued at the cost of production. Even if the purpose of the study of cost is the same,

different conditions may lead to variations in cost. The cost per unit of a product is sure to

vary with an increase in the volume of output since the number of fixed expenses to be borne

by each unit of output decreases.

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 Figure 7: Management Accounting

It is also important to note here that there is no such thing as an exact cost or true cost

because no figure of cost is true in all circumstances and for all purposes. Most of the costing

information is based on estimates; for example, the amount of overheads is generally

estimated in advance; it is distributed over cost units, again on an estimated basis using

different methods. Many items of cost of production are handled in an optional manner which

may give different costs for the same product without going against the accepted principles in

any way. Depreciation is one such item, the amount of which will vary in accordance with the

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method of depreciation being used. Thus, to arrive at an absolutely correct cost may be quite

difficult unless one waits for a long time by which time the costing information may lose all

its value.

The history of accounting is as old as civilization. It is the process of identifying, measuring,

recording, and communicating economic information, capable of being expressed in terms of

money. The utility of accounting information lies in its ability to reduce uncertainty. The

information has to be relevant, verifiable, quantifiable, and free from bias. Prior to the

industrial revolution, businesses were small and characterized by simple market exchanges

between individuals and organizations. In those times there was a need for accurate

bookkeeping though not that much cost accounting. However, the industrial revolution in the

18th century brought large-sized process industries performing single activities (e.g. Textiles,

railways, etc.).

Figure 8: Difference between financial and management accounting

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During this period, there was a lack of market for intermediary products because of this cost

information gained importance as a tool for measuring the efficiency of different processes.

But the concept of prime cost was used around 1875 by some Industrialists. The period, 1880

AD -1925 AD saw the development of complex product designs and the emergence of multi-

activity diversified corporations like Du Pont, General Motors, etc. It was during this period

that scientific management was developed which led accountants to convert physical

standards into cost standards, the latter being used for variance analysis and control. In 1913

J.L. Nicholson published the book “Cost Accounting Theory and Practice” in New York.

During World War I and II, the social importance of cost accounting grew with the growth of

each country's defense expenditure.

In the absence of competitive markets for most of the required to fight the war, the

Governments in several countries placed cost-plus contracts under which the price to be paid

was the cost of production plus an agreed rate of profit. The reliance on cost information by

the parties to defense contracts continued after World War II as well. Even today, most

government contracts are decided on a cost-plus basis.

Costing is the techniques and processes of ascertaining costs. These techniques consist of

principles and rules which govern the procedure of ascertaining the cost of products or

services. The techniques to be followed for the analysis of expenses and the processes of

different products or services differ from industry to industry. The main object of costing is

the analysis of financial records, so as to subdivide expenditure and to allocate it carefully to

selected cost centers, and hence to build up a total cost for the departments, processes or jobs,

or contracts of the undertaking.

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 Figure 9: Management Accounting functions

Cost accounting may be regarded as ``a specialized branch of accounting which involves

classification, accumulation, assignment, and control of costs. The Costing Terminology of

C.I.M.A. London defines cost accounting as ``The establishment of budgets, standard costs

and actual costs of operations, processes, activities or products, and the analysis of variances,

profitability or the social use of funds”. Determination of costs of products or services and for

the presentation of suitably arranged data for purposes of control and guidance of

management”. It is thus, a formal mechanism by means of which the costs of products or

services are ascertained and controlled.

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Cost accounting is different from costing in the sense that the former provides only the basis

and information for the ascertainment of costs. Once the information is made available,

costing can be carried out arithmetically by means of memorandum statements or by the

method of integral accounting. Cost Accountancy has been defined as “the application of

costing and cost accounting principles, methods, and techniques to the science, art, and

practice of cost control and the ascertainment of profitability. It includes the presentation of

information derived there from for the purpose of managerial decision making”.

Figure 10: Scope of Accounting

Cost accounting aims at the systematic recording of expenses and analysis of the same so as

to ascertain the cost of each product manufactured or service rendered by an organization.

Information regarding the cost of each product or service would enable the management to

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know where to economize on costs, how to fix prices, how to maximize profits and so on.

Thus, the main objects of cost accounting are the following:

● To analyze and classify all expenditures with reference to the cost of products and

operations.

● To arrive at the cost of production of every unit, job, operation, process, department,

or service and to develop cost standards.

● To indicate to the management any inefficiencies and the extent of various forms of

waste, whether of materials, time, expenses or in the use of machinery, equipment,

and tools. Analysis of the causes of unsatisfactory results may indicate remedial

measures.

Figure 11: Process of Accounting

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● To provide data for periodical profit and loss accounts and balance sheets at such

intervals, e.g., weekly, monthly, or quarterly, as may be desired by the management

during the financial year, not only for the whole business but also by departments or

individual products. Also, to explain in detail the exact reasons for profit or loss

revealed in total, in the profit and loss account.

Figure 12: Scope of Financial Accounting

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● To reveal sources of economies in production having regard to methods, types of

equipment, design, output, and layout. Daily, weekly, monthly, or quarterly

information may be necessary to ensure prompt and constructive action.

● To provide actual figures of cost for comparison with estimates and to serve as a

guide for future estimates or quotations and to assist the management in their price-

fixing policy.

● To show, where standard costs are prepared, what the cost of production ought to be,

and with which the actual costs which are eventually recorded may be compared.

● To present comparative cost data for different periods and various volumes of output.

● To provide a perpetual inventory of stores and other materials so that interim profit

and loss accounts and balance sheets can be prepared without stock-taking and checks

on stores and adjustments are made at frequent intervals. Also, it provides the basis

for production planning and for avoiding unnecessary wastages or losses of materials

and stores.

● To provide information to enable management to make short-term decisions of

various types, such as quotation of prices to special customers or during a slump,

making or buying decisions, assigning priorities to various products, etc.

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 Figure 13: Cost accounting cycle

Cost accounting provides invaluable aid to management. It provides detailed costing

information to the management to enable them to maintain effective control over stores and

inventory, increase the efficiency of the organization, and check waste and losses. It

facilitates the delegation of responsibility for important tasks and the rating of employees. For

all these, the management should be capable of using the information provided by cost

accounts in a proper way. The various advantages derived by the management from a good

system of costing are as follows:

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 Figure 14: Limitation of cost accounting

1. Cost accounting helps in periods of trade depression and trade competition

In periods of trade depression, the organization cannot afford to have losses that pass

unchecked. The management must know the areas where economies may be sought, waste

eliminated, and efficiency increased. The organization has to wage a war not only for its

survival but also continued growth. The management should know the actual cost of their

products before embarking on any scheme of price reduction. An adequate system of costing

facilitates this.

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2. Cost accounting aids price fixation

Although the law of supply and demand to a great extent determines the price of the article,

cost to the producer does play an important role. The producer can take necessary guidance

from his costing records in case he is in a position to fix or change the price charged.

3. Cost accounting helps in making estimates

Adequate costing records provide a reliable basis for making estimates and quoting tenders.

4. Cost accounting helps in channelizing production on the right lines

Proper costing information makes it possible for the management to distinguish between

profitable and non-profitable activities. Profits can be maximized by concentrating on

profitable operations and eliminating non-profitable ones.

5. Cost accounting eliminates wastages

As cost accounting is concerned with a detailed break-up of costs, it is possible to check

various forms of wastages or losses.

6. Cost accounting makes comparisons possible

Proper maintenance of costing records provides various costing data for comparisons which

in turn helps the management in the formulation of future lines of action.

7. Cost accounting provides data for periodical profit and loss account

Adequate costing records provide the management with such data as may be necessary for the

preparation of the profit and loss account and balance sheet at such intervals as may be

desired by the management.

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8. Cost accounting helps in determining and enhancing efficiency

Losses due to wastage of materials, idle time of workers, poor supervision, etc., will be

disclosed if the various operations involved in the production are studied carefully. Efficiency

can be measured, costs controlled, and various steps can be taken to increase the efficiency.

9. Cost accounting helps in inventory control

Cost accounting furnishes control which management requires in respect of stock of

materials, work-in-progress, and finished goods.

Figure 15: Element of cost

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Cost can be distinguished as direct and indirect. Direct Costs: The direct costs are those

which can be easily traceable to a product or cost unit or cost center or some specific activity,

e.g., Cost of wood for making furniture. It is also called traceable cost. Indirect Costs: The

indirect costs are difficult to trace to a single product or it is uneconomic to do so. They are

common to several products, e.g., Salary of a factory manager. It is also called common

costs. Costs may be direct or indirect with respect to a particular division or department. For

example, all the costs incurred in the Powerhouse are indirect as far as the main product is

concerned but as regards the Powerhouse itself, the fuel cost or supervisory salaries are

direct.

It is necessary to know the purpose for which cost is being ascertained and whether it is being

associated with a product, department or some activity. Direct cost can be allocated directly

to the costing unit or cost center. Whereas Indirect costs have to be apportioned to different

products if appropriate measurement techniques are not available. These may involve some

formula or base which may not be totally correct or exact. Cost can be classified as product

costs and period costs. Product Costs: Product costs are those which are traceable to the

product and included in inventory values. In a manufacturing concern, it comprises the cost

of direct materials, direct labor, and manufacturing overheads. Product cost is a full factory

cost. Product costs are used for valuing inventories which are shown in the balance sheet as

assets till they are sold. The product cost of goods sold is transferred to the cost of goods sold

account.

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 Figure 16: Elements of cost

Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc., and

include many selling and administrative costs essential to keep the business running. Though

they are necessary to generate revenue, they are not associated with production, therefore,

they cannot be assigned to a product. They are charged for the period in which they are

incurred and are treated as expenses. Selling and administrative costs are treated as period

costs for the following reasons: (i) Most of these expenses are fixed in nature. (ii) It is

difficult to apportion these costs to products equitably.

Costs can be classified as fixed, variable, and semi-variable costs. Fixed Costs: The Chartered

Institute of Management Accountants, London, defines fixed cost as “the cost which is

28
incurred for a period, and which, within certain output and turnover limits, tends to be

unaffected by fluctuations in the levels of activity (output or turnover)”. These costs are

incurred so that physical and human facilities necessary for business operations, can be

provided. These costs arise due to contractual obligations and management decisions. They

arise with the passage of time and not with production and are expressed in terms of time.

Examples are rent, property taxes, insurance, supervisors’ salaries, etc. It is wrong to say that

fixed costs never change. These costs may vary depending on the circumstances. The term

fixed refers to non-variability related to the relevant range. Fixed costs can be classified into

the following categories for the purpose of analysis:

Figure 17: Limitations of cost accounting

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(a) Committed Costs: These costs are incurred to maintain certain facilities and cannot be

quickly eliminated. The management has little or no discretion in this cost, e.g., rent,

insurance, etc.

(b) Policy and Managed Costs: Policy costs are incurred for implementing particular

management policies such as executive development, housing, etc. Such costs are often

discretionary. Managed costs are incurred to ensure the operating existence of the company

e.g., staff services.

(c) Discretionary Costs: These are not related to the operations and can be controlled by the

management. These costs result from special policy decisions, new research, etc., and can be

eliminated or reduced to a desirable level at the discretion of the management.

(d) Step Costs: Such costs are constant for a given level of output and then increase by a fixed

amount at a higher level of output.

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 Figure 18: Relevant range of production units

Variable Cost: Variable costs are those costs that vary directly and proportionately with the

output e.g., Direct materials, and direct labor. It should be kept in mind that the variable cost

per unit is constant but the total cost changes corresponding to the levels of output. It is

always expressed in terms of units, not in terms of time. Management decisions can influence

cost behavior patterns. The concept of variability is relative. If the conditions upon which

variability was determined change, the variability will have to be determined again.

Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable elements. Because

of the variable element, they fluctuate with volume and because of the fixed element; they do

not change in direct proportion to output. Semi-variable costs change in the same direction as

that of the output but not in the same proportion. Depreciation is an example; for two shifts

working the total depreciation may be only 50% more than that for single shift working. They

may change with comparatively small changes in output but not in the same proportion.

Figure 19: Production units

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A company performs a number of functions. Functional costs may be classified as follows:

(a) Manufacturing/production Costs: It is the cost of operating the manufacturing division of

an undertaking. It includes the cost of direct materials, direct labor, direct expenses, packing

(primary) cost, and all overhead expenses relating to production.

(b) Administration Costs: They are indirect and cover all expenditures incurred in

formulating the policy, directing the organization, and controlling the operation of a concern,

which is not related to research, development, production, distribution or selling functions.

(c) Selling and Distribution Cost: Selling cost is the cost of seeking to create and stimulate

demand e.g. Advertisements, market research, etc. Distribution cost is the expenditure

incurred which begins with making the package produced available for dispatch and ends

with making the reconditioned packages available for re-use e.g. Warehousing, cartage, etc. It

includes expenditure incurred in 12 EP-CMA transporting articles to central or local storage.

Expenditure incurred in moving articles to and from prospective customers as in the case of

goods on sale or return basis is also a distribution cost.

(d) Research and Development Costs: They include the cost of discovering new ideas,

processes, and products by experiment and implementing such results on a commercial basis.

(e) Pre-production Cost: When a new factory is started or when a new product is introduced,

certain expenses are incurred. There are trial runs. Such costs are termed as pre-production

costs and treated as deferred revenue expenditure. They are charged to the cost of future

production.

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 Figure 20: Cost accounting

Cost can be Controllable and Non-Controllable. Controllable Cost: The Chartered Institute of

Management Accountants defines controllable cost as “cost which can be influenced by its

budget holder”. Non-Controllable Cost: It is a cost that is not subject to control at any level of

managerial supervision. The difference between the terms is very important for the purpose

of cost accounting, cost control, and responsibility accounting. A controllable cost can be

controlled by a person at a given organizational level. Controllable costs are not totally

controllable. Some costs are partly controllable by one person and partly by another e.g.,

maintenance cost can be controlled by both the production and maintenance manager. The

term “controllable costs” is often used to mean variable costs and non-controllable costs as

fixed. Belkaoni has mentioned the following fallacies about controllable costs:

(i) All variable costs are controllable and fixed are not.

33
(ii) All direct costs are controllable and indirect costs are not.

(iii) All long-term costs are controllable. Sometimes the time factor and the decision-making

authority can make a cost controllable. If the time period is long enough, all costs can be

controlled. Proper delegation helps in establishing clear responsibility and controllability. But

all costs can be controlled by one or another person. The authority and responsibility of cost

control are delegated to different levels, though the managing director is responsible for all

the costs.

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 CHAPTER 2: Material Cost and Labor Cost

We have acquired a basic knowledge of the concepts, objectives, advantages, methods, and

elements of cost. We shall now study each element of cost separately beginning with material

cost. The general meaning of the material is all commodities/ physical objects used to make

the final product. It may be direct or indirect.

(i) Direct Materials: Materials, cost of which can be directly attributable to the end product

for which it is being used, in an economically feasible way.

Figure 21: Percentage of material and labor cost

(ii) Indirect Materials: The materials which are not directly attributable to a particular final

product. Direct Materials constitute a significant part of the manufacturing and production of

goods. Being an input and a significant cost element, it requires adequate management

attention.

35
 Figure 22: Concept of the labor cost

Direct Materials constitute a significant part of the manufacturing and production of goods.

Being an input and a significant cost element, it requires adequate management attention.

Cost control starts from here, and for this purpose, it is necessary that the principle of 3Es

(Economy, Efficiency, and Effectiveness) i.e. Economy in procurement, efficiency in

handling and processing the material, and effectiveness in producing desired output as per the

standard, is also applied for this cost element. The importance of proper recording and control

of material are as follows:

(a) Quality of final product: The quality of output depends on the quality of inputs.

36
(b) Price of the final product: Material constitutes a significant part of any product and the

cost of the final product is directly related to the cost of materials used to produce the

product.

Figure 23: labor cost

(c) Production continuity: The production process should run smoothly and should not be

paused for the want of materials. To avoid production interruptions, an adequate level of

stock of materials should be maintained.

37
(d) Cost of Stock holding and stock-out: An entity has to incur stock holding costs in the

form of interest and/or opportunity cost for the fund used, stock handling losses like

evaporation, obsolescence, etc. Under-stocking causes a loss of revenue due to stock-out and

breach of commitment.

Figure 24: Cost of labor turnover

(e) Wastage and other losses: While handling and processing materials, some wastage and

loss arise. Based on the nature of the material and process, these are classified as normal and

abnormal for efficient utilization and control.

38
(f) Regular information about resources: Regular and updated information on the availability

and utilization of materials are necessary for the entity for timely and informed decision-

making.

Objectives of the system of material control

The objectives of a system of material control are the following:

(i) Minimizing interruption in the production process: Ensuring that no activity, particularly

production, suffers from interruption for want of materials and stores.

It should be noted that this requires constant availability of every item that may be needed

howsoever small its cost may be.

(ii) Optimization of Material Cost: Seeing to it that all the materials and stores are acquired at

the lowest possible price considering the quality that is required and considering other

relevant factors like reliability in respect of delivery, etc. Holding costs should also be

required to be minimized.

Figure 25: Material management

39
(iii) Reduction in Wastages: Avoidance of unnecessary losses and wastages that may arise

from deterioration in quality due to defective or long storage or from obsolescence. It may be

noted that losses and wastages in the process of manufacture, concern the production

department.

(iv) Adequate Information: Maintenance of proper records to ensure that reliable information

is available for all items of materials and stores that not only helps in detecting losses and

pilferages but also facilitates proper production planning.

(v) Completion of order in time: Proper material management is very necessary for fulfilling

orders of the firm. This adds to the goodwill of the firm.

Figure 26: Material management

40
Requirements of material control

Material control requirements can be summarized as follows:

● Proper coordination of all departments involved viz., finance, purchasing, receiving,

inspection, storage, accounting, and payment.

● Determining purchase procedure to see that purchases are made, after making suitable

inquiries, at the most favorable terms to the firm.

● Use of standard forms for placing the order, noting receipt of goods, authorizing issue

of the materials etc.

● Preparation of budgets concerning materials, supplies and equipment to ensure

economy in purchasing and use of materials.

Figure 27: Elements of cost

41
● Operation of a system of internal check so that all transactions involving materials,

supplies and equipment purchases are properly approved and automatically checked.

● Storage of all materials and supplies in a well-designated location with proper

safeguards.

● Operation of a system of perpetual inventory together with continuous stock checking

so that it is possible to determine at any time the amount and value of each kind of

material in stock.

● Operation of a system of stores control and issue so that there will be delivery of

materials upon requisition to departments in the right amount at the time they are

needed.

● Development of system of controlling accounts and subsidiary records which exhibit

summary and detailed material costs at the stage of material receipt and consumption.

● Regular reports of materials purchased, issue from stock, inventory balances, obsolete

stock, goods returned to vendors, and spoiled or defective units.

Figure 28: Elements of Material Control

42
Costs should be gathered together in their natural grouping such as Material, labor and Other

Direct expenses. Items of costs differ on the basis of their nature. The elements of cost can be

classified in the following three categories. 1. Material 2. labor 3. Expenses

Figure 29: Cost classification

Material Cost: Material cost is the cost of material of any nature used for the purpose of

production of a product or a service. It includes the cost of materials, freight inwards, taxes &

duties, insurance ...etc. directly attributable to the acquisition, but excluding the trade

discounts, duty drawbacks, and refunds on account of excise duty and vat.

Labor Cost: labor cost means the payment made to the employees, permanent or temporary

for their services. Labor cost includes salaries and wages paid to permanent employees,

temporary employees, and also the employees of the contractor. Here salaries and wages

include all the benefits like provident fund, gratuity, ESI, overtime, incentives...etc.

43
Expenses: Expenses are other than material costs or labor costs which are involved in an

activity.

Classification by Relation to Cost Centre or Cost Unit: If expenditure can be allocated to a

cost center or cost object in an economically feasible way then it is called direct otherwise the

cost component will be termed as indirect. According to this criterion for classification,

material cost is divided into direct material cost and indirect material cost, labor cost is

divided into direct labor and indirect labor cost, and expenses into direct expenses and

indirect expenses. Indirect cost is also known as overhead.

Figure 30: Cost classification by relation

Direct Material Cost: Cost of material that can be directly allocated to a cost center or a cost

object in an economically feasible way.

44
Direct labor Cost: Cost of wages of those workers who are readily identified or linked with a

cost center or cost object. Direct Expenses: Expenses other than direct material and direct

labor can be identified or linked with the cost center or cost object. Direct Material + Direct

labor + Direct Expenses = Prime Cost

Indirect Material: Cost of material that cannot be directly allocable to a particular cost center

or cost object.

Indirect labor: Cost of wages of employees which are not directly allocable to a particular

cost center.

Indirect expenses: Expenses other than of the nature of material or labor and cannot be

directly allocable to a particular cost center. Indirect Material + Indirect Labour + Indirect

Expenses = Overheads © Classification by Functions: A business enterprise performs a

number of functions like manufacturing, selling, research...etc. Costs may be required to be

determined for each of these functions and on this basis functional costs may be classified

into the following types: -

(i) Production or Manufacturing Costs

(ii) Administration Costs

(iii) Selling & Distribution costs

(iv) Research & Development costs

45
 Figure 31: Cost classification

(i) Production or Manufacturing Costs: Production cost is the cost of all items involved in the

production of a product or service. These refer to the costs of operating the manufacturing

division of an undertaking and include all costs incurred by the factory from the receipt of

raw materials and supply of labor and services until production is completed and the finished

product is packed with the primary packing. The followings are considered Production or

Manufacturing Costs: -

(1) Direct Material

(2) Direct labor

(3) Direct Expenses and

(4) Factory overhead,

I.e., the aggregate of factory indirect material, indirect labor, and indirect expenses.

Manufacturing cost can also be referred to as the aggregate of prime cost and factory

46
overhead. (ii) Administration Costs: Administration costs are expenses incurred for the

general management of an organization. These are in the nature of indirect costs and are also

termed administrative overheads. For understanding administration costs, it is necessary to

know the scope of the administrative function. Administrative function in any organization

primarily concerned with the following activities: - (1) Formulation of policy (2) Directing

the organization and (3) Controlling the operations of an organization. But the administrative

function will not include control activities concerned with production, selling and

distribution, and research and development.

Figure 32: Relevant of the cost material

47
The cost of only those control operations which are not related to production, selling and

distribution, and research and development). In most cases, administration cost includes

indirect expenses of the following types:

(1) Salaries of office staff, accountants, and directors

(2) Rent, rates, and depreciation of office building

(3) Postage, stationery, and telephone

(4) Office supplies and expenses

(5) General administration expenses.

(iii) Selling & Distribution Costs: Selling costs are indirect costs related to selling products

are services and include all indirect costs in sales management for the organization.

Distribution costs are the costs incurred in handling a product from the time it is completed in

the works until it reaches the ultimate consumer. The selling function includes activities

directed to create and stimulate demand of the company’s product and secure orders.

Distribution costs are incurred to make the saleable goods available in the hands of the

customer.

48
 Figure 33: Factors of labor cost

Following are the examples of selling and distribution costs:

(1) Salaries and commissions of salesmen and sales managers.

(2) Expenses of advertisement, and insurance.

(3) Rent, rates, depreciation, and insurance of sales office and warehouses.

(4) Cost of insurance, freight, export, duty, packing, shipping, etc.,

(5) Maintenance of Delivery vans.

49
 Figure 34: Reduction of the labor cost

(iv) Research & Development Costs: Research & development costs are the cost for

undertaking research to improve the quality of a present product or improve the process of

manufacture, develop a new product, market research...etc. And commercialization thereof.

R&D Costs comprise of the following: - (1) Development of new product. (2) Improvement

of existing products. (3) Finding new uses for known products. (4) Solving technical problem

arising in manufacture and application of products. (5) Development cost includes the costs

incurred for commercialization/implementation of research findings. Pre-Production Costs:

These are costs incurred when a new factory is in the process of establishment, a new project

50
is undertaken, or a new product line or product is taken up but there is no established or

formal production to which such costs may be charged.

Figure 35: Product cost manufacturing

Preproduction costs are normally treated as deferred revenue expenditure and charged to the

costs of future production. (d) Classification based on Behavior – Fixed, Semi-variable or

Variable Costs are classified based on behavior as a fixed cost, variable cost, and semi-

variable cost depending upon response to the changes in the activity levels.

51
Material refers to all commodities that are consumed in the process of manufacture. Material

can be defined as “anything that can be stored, stacked or stockpiled” It continues an

important part of the cost of production of commodities. They account for nearly 60% of the

cost of production of a large number of organizations. Types of Materials The materials can

be categorized into two:

(a) Direct Materials: The materials which can be identified with the individual units, are

known as direct materials. These materials form part of the finished product. All costs, which

are incurred to obtain direct material, are known as ‘direct material costs.’ The leather used in

the manufacture of shoes and the yarn required for the production of cloth are examples of

direct materials.

Figure 36: Types of the cost production

52
(b) Indirect Materials: Indirect materials do not form part of the finished products. Indirect

material cannot be accurately allocated to a particular unit of product. Examples of such

materials are consumable stores, cotton waste, and lubricating oils, required for the

maintenance of machines, etc. Objectives of Material Control The following are the main

objectives of material control.

(a) All types of raw materials should be available throughout. This ensures an uninterrupted

production schedule.

(b) There should be no under-stocking, which generally hampers the production process.

(c) There should be no overstocking, which makes the capital dearer.

Material Cost

(d) The purchaser is able to make a valuable contribution to the reduction in cost by

purchasing raw materials at the most favorable prices. (e) The purchase of material should be

of the right quality and consistent with the standards prescribed in respect of the finished

goods. (f) Proper storage conditions should be provided for different types of raw materials in

order to minimize the loss of material. (g) There should be a system to give complete and up-

to-date accounting information about the availability of material. Procedures for Materials

Procurement and Use Although production process and material requirements vary, the cycle

of procurement and use of material usually involves the following steps: (1) Engineering and

planning: Determine the design of the product, the material specification, and the

requirements at each stage of operations.

53
 Figure 37: Steps of the recruitment process

Engineering and planning not only determine the maximum and minimum quantities to run

and the bill of materials for given products and quantities but also cooperate in developing

standards where applicable. (2) The production budget: Provides the master plan from which

details concerning material requirements are eventually developed. (3) The purchase

requisition: Inform the purchasing agent concerning the quantity and type of materials

needed. (4) The purchase order: Contracts for appropriate to be delivered at specified dates to

assure uninterrupted operations. (5) The receiving report: Certifies quantities received and

may report results of inspection and testing for quality. (6) The materials requisition: Notifies

the storeroom or warehouse to deliver specified time or is the authorization for the storeroom

to issue material to departments.

(7) The materials ledger cards: Record the receipt and the issuance of each class of materials

and provide a perpetual inventory record. Purchase of supplies, services, and repairs: The

procedure followed in purchasing productive materials should apply to all departments and

54
divisions of a business. Purchase requisitions, purchase orders, and receiving reports are

appropriate for accounting department supplies and equipment, the company cafeteria, the

first aid unit, the treasurer's office, the building service department, and the public relations,

personnel, sales, and engineering department, as well as all other departments.

Figure 38: Contribution of the material cost

If for example, the accounting department needs new forms printed, a requisition should be

sent to the purchasing department in the usual manner, and a purchase order should be

prepared and sent to the printer. In the case of magazine subscriptions, trade and professional

association memberships for company officials, and similar services, the official or

department head may send in a requisition in a usual manner. A requisition, an order, and an

invoice for all goods and services purchased are necessary for properly controlling purchases.

55
 Figure 39: Impact of cost material

Repair contracts on an annual basis for typewriters, calculators, electronic data processing

(EDP) equipment, and some types of factory equipment may be requisitioned and ordered in

the usual manner. In order cases, a department head or other employee may telephone for

service and shortly thereafter may have a machine repaired and back in operation. In such

cases, the purchasing agent issues a so-called blanket purchase order that amounts to approval

of all repair and service costs of a specific type without knowing the actual amount charged.

56
When the repair bill is received, the invoice clerk checks the amount of the bill with the head

of the department where the repairs took place and then approves the invoices for payment.

Purchase Requisition Form The purchase requisition originates with

● Stores or where a house clerk who observes that quantity on hand is at a set ordering

minimum,

● A materials ledger clerk who may be responsible for notifying the purchasing agent

when to buy,

● A works manager who foresees the need for special materials or unusual quantities

● A research or engineering department employee who needs materials or supplies of a

special nature, or

● A computer that has been programmed to produce replenishment advice for the

purchasing department. For standard material, little information other than the stock

number may be needed, and the purchasing agent uses judgment concerning where to

buy and the quantity to order. For other purchase requests, it may be necessary to give

meticulous descriptions, blueprints, catalog numbers, weights, standards, brand

names, exact quantities to order, and suggested prices.

Figure 40: Components of material cost

57
The function of the receiving department is to: unload and unpack incoming materials; check

quantities received against the shipper's packing list; identify goods received with a

description on the purchase order; prepare a receiving report; notify the purchasing

department of the description discovered; arrange for inspection when necessary; notify the

traffic department and the purchasing department of any damage in transit; and route

accepted materials to the appropriate factory location. Invoice approval is an important step

in the materials control procedure since it certifies that the goods have been received as

ordered and the payment can be made. The invoice approval information is often built into a

rubber stamp and each invoice is stamped.

The voucher data are entered first in the purchases journal and are posted to the subsidiary

records. They are then entered in the cash payments journal according to the due date for

payment. The original voucher and two copies are sent to the treasurer for issuance of the

cheque. The treasurer mails the cheque with the original voucher to the vendor, files a

voucher copy and returns one voucher copy to the accounting department for the vendor's

file.

Figure 41: Cycle of cost accounting

58
Purchase transaction entered in the purchases journal affect the control accounts and the

subsidiary records as shown in the chart below:

General Ledger Control Transaction Subsidiary Records Debit Credit Materials purchased

for Materials Accounts payable Entry in the received section in stock the materials ledger

card Materials purchased for a Work in process Accounts payable Entry in the direct material

particular job or department section of the production or the job order Materials and supplies

Materials Accounts payable Entry in the received section of purchased for factory the

material ledger card overhead purposes Supplies purchased for Material Marketing Accounts

payable Entry in the received section of marketing and administrative expense control the

materials ledger card or in office the proper columns of the Administrative marketing or

administrative expenses Control expenses analysis sheets Purchase of service or Factory

Overhead Accounts payable Entry in the proper repairs Marketing expenses account columns

of the control expenses analysis sheet Administrative expenses control Purchase of

equipment Accounts payable Entry on the equipment ledger card.

Figure 42: Units of labor cost

59
When the purchase order, receiving report, and invoice are compared, various adjustments

may be needed as a result of the circumstances described below.

Cost Accounting

(1) Some of the materials ordered are not received and are not entered in the invoice. In this

case, no adjustment is necessary, and the invoice may be approved for immediate payment.

On the purchase order, the invoice clerk will make a notation of the quantity received in place

of the quantity ordered. If the vendor is out of stock or otherwise unable to deliver specified

merchandise, and immediate ordering from other sources may be necessary.

(2) Items ordered are not received but are entered in the invoice. In this situation, the shortage

is noted in the invoice and is deducted from the total before payment is approved. A letter to

the vendor explaining the shortage is usually in order.

(3) The seller ships a quantity larger than called for in the purchase order. The purchaser may

keep the entire shipment and add the excess to the invoice, if not already invoiced; or the

excess may be returned or held, pending instruction from the seller. Some companies issue a

supplementary purchase order that authorizes the invoice clerk to pay the over shipment.

(4) Materials of the wrong size and quality, defective parts, and damaged items are received.

If the items are returned, a correction in the invoice should be made before payment is

approved. It may be advantageous to keep damaged or defective shipments if the seller makes

adequate price concessions, or the items may be held subject to the seller’s instructions.

(5) It may be expedient for a purchase to pay transportation charges, even though delivered

prices are quoted and purchases are not made on the basis. The amount paid by the purchaser

is deducted from the invoice, and the paid freight bill is attached to the invoice as evidence of

payment.

60
A guiding principle in accounting for the cost of materials is that all costs incurred in entering

a unit of materials into factory production should be included. Acquisition costs: such as the

vendor’s invoice price and transportation charges are visible costs of the purchased goods.

Less obvious costs of materials entering factory operations are costs of purchasing, receiving,

unpacking, inspecting, insuring, storing, and general and cost accounting.

Applied acquisition costs: If it is decided that the materials cost should include incoming

freight charges and other acquisition costs, an applied rate might be added to each invoice

and to each item instead of charging these costs directly to factory overhead.

Stores Records The records of stores may be maintained in three forms.

(1) Bin Cards

(2) Stock Control Cards

(3) Stores Ledger

The first two forms of accounts are records of quantities received, issued and those in balance

but the third one is an account of their cost also. Usually, the account is kept in the forms, the

quantitative in the stores and quantitative cum financial in the cost department. Bin Cards and

Stock Control Cards These are essentially similar, being only quantitative records of stores.

The latter contains further information as regards stock on order. Bin cards are kept attached

to the bins or receptacles or quite near thereto so that these also assist in the identification of

the stock. The stock control cards, on the other hand, are kept in cabinets or trays or loose

binders.

61
 CHAPTER 3: Accounting Books and Records

Meaning and Scope of Accounting is the language of business. The main objective of

accounting is to safeguard the interests of the business, its proprietors, and others connected

with the business transactions. This is done by providing suitable information to the owners,

creditors, shareholders, Government, financial institutions, and other related agencies.

Figure 43: Introduction of accounting

62
Definition of Accounting the American Accounting Association defines accounting as "the

process of identifying, measuring, and communicating economic information to permit

informed judgments and decisions by the users of the information." According to AICPA

(American Institute of Certified Public Accountants) it is defined as "the art of recording,

classifying and summarizing in a significant manner and in terms of money, transactions, and

events which are in part at least of a financial character and interpreting the result thereof."

Steps of Accounting The following are the important steps to be adopted in the accounting

process:

(1) Recording: Recording all the transactions in subsidiary books for the purpose of future

records or references. It is referred to as a "Journal."

(2) Classifying: All recorded transactions in subsidiary books are classified and posted to the

main book of accounts. It is known as a "Ledger."

Figure 44: Stages of accounting

63
(3) Summarizing: All recorded transactions in the main books will be summarized for the

preparation of Trail Balance, Profit and Loss Account, and Balance Sheet.

(4) Interpreting: Interpreting refers to the explanation of the meaning and significance of the

result of financial accounts and balance sheets so that parties concerned with business can

determine the future earnings, ability to pay interest, liquidity, and profitability of a sound

dividend policy.

Functions of Accounting From the definition and analysis of the above the main functions of

accounting can be summarized:

● Keeping a systematic record of business transactions.

● Protecting properties of the business.

● Communicating the results to various parties interested in or connected with the

business. Meeting legal requirements.

Figure 45: The accounting cycle

64
Objectives of Accounting

(1) Providing suitable information with the aim of safeguarding the interest of the business

and its proprietors and others connected with it.

(2) To emphasize on the ascertainment and exhibition of profits earned or losses incurred in

the business.

(3) To ascertain the financial position of the business as a whole.

(4) To ensure accounts are prepared according to some accepted accounting concepts and

conventions.

(5) To comply with the requirements of the Companies Act, Income Tax Act, etc. Definition

of Bookkeeping Bookkeeping may be defined as "the art of recording the business

transactions in the books of accounts in a systematic manner." A person who is responsible

for and who maintains and keeps a record of business transactions is known as Bookkeeper.

His work is primarily clerical in nature. On the other hand, Accounting is primarily

concerned with recording, classifying, summarizing, interpreting financial data, and

communicating the information disclosed by the accounting records to those persons

interested in the accounting information relating to the business.

65
 Figure 46: Understanding of accounts.

Limitations of Accounting

● Accounting provides only limited information because it reveals the profitability of

the concern as a whole.

● Accounting considers only those transactions which can be measured in terms of

money or quantitatively expressed. Qualitative information is not taken into account.

● Accounting provides limited information to the management.

● Accounting is only historical in nature. It provides only a post-mortem record of

business transactions. Branches of Accounting The main function of accounting is to

provide the required information for different parties who are interested in the welfare

of the enterprise concerned. In order to serve the needs of management and outsiders

various new branches of accounting have been developed.

66
 Figure 47: Limitations of accounting

The following are the main branches of accounting: (1) Financial Accounting. (2) Cost

Accounting. (3) Management Accounting.

(1) Financial Accounting: Financial Accounting is prepared to determine the profitability

and financial position of a concern for a specific period of time.

(2) Cost Accounting: Cost Accounting is the formal accounting system setup for recording

costs. It is a systematic procedure for determining the unit cost of output produced or service

rendered.

(3) Management Accounting: Management Accounting is concerned with the presentation of

accounting information to management for effective decision-making and control.

67
 Figure 48: Functions of managerial accounting

Accounting Principles Various accounting systems and techniques are designed to meet the

needs of the management. The information should be recorded and presented in such a way

that management is able to arrive at the right conclusions. The ultimate aim of the

management is to increase profitability and losses. In order to achieve the objectives of the

concern as a whole, it is essential to prepare the accounting statements in accordance with the

generally accepted principles and procedures. The term principles refer to the rule of action

or conduct to be applied in accounting. Accounting principles may be defined as "those rules

of conduct or procedure which are adopted by the accountants universally while recording the

accounting transactions.

68
 Figure 49: Effective content of financial accounts

" The accounting principles can be classified into two categories: I. Accounting Concepts. II.

Accounting Conventions.

I. Accounting Concepts Accounting concepts mean and include necessary assumptions or

postulates or ideas which are used to accounting practice and the preparation of financial

statements.

69
 Figure 50: Role of the chie4f finance officer

The following are the important accounting concepts:

(1) Entity Concept.

(2) Dual Aspect Concept.

(3) Accounting Period Concept.

(4) Going Concern Concept.

(5) Cost Concept.

(6) Money Measurement Concept.

70
(7) Matching Concept.

(8) Realization Concept.

(9) Accrual Concept.

(10) Rupee Value Concept.

Figure 51: Vision of CFO

II. Accounting Conventions Accounting Convention implies that those customs, methods,

and practices to be followed as a guideline for the preparation of accounting statements. The

accounting conventions can be classified as follows:

71
(1) Convention of Disclosure. (2) Convention of Conservatism. (3) Convention of

Consistency. (4) Convention of Materiality.

Accounting Principles

Accounting Concept Accounting Conventions

(1) Entity Concept (1) Convention of Disclosure

(2) Dual Aspect Concept (2) Convention of Conservatism

(3) Accounting Period Concept (3) Convention of Consistency

(4) Going Concern Concept (4) Convention of Materiality

(5) Cost Concept

(6) Money Measurement Concept

(7) Matching Concept

(8) Realization Concept

(9) Accrual Concept

(10) Rupee Value Concept

The classification of accounting concepts and conventions can be explained in the following

pages.

I. Accounting Concepts (1) Entity Concept: Separate entity concept implies that a business

unit or a company is a body corporate and has a separate legal entity distinct from its

proprietors. The proprietors or members are not liable for the acts of the company. But in the

case of the partnership business or sole trader business no separate legal entity from its

proprietors. Here proprietors or members are liable for the acts of the firm. The separate

72
entity concept of accounting it applies to all forms of business to determine the scope of what

is to be recorded or what is to be excluded from the business books.

Figure 52: Principals of accounting

For example, if the proprietor of the business invests Rs.50,000 in his business, it is deemed

that the proprietor has given that much amount to the business as a loan which will be shown

as a liability for the business. On withdrawal of any amount, it will be debited in a cash

account and credited in the proprietor's capital account. In conclusion, this separate entity

concept applies much larger in body corporate sectors than sole traders and partnership firms.

73
(2) Dual Aspect Concept: According to this concept, every business transaction involves two

aspects, namely, for every receiving of benefit and. There is a corresponding giving of

benefit. The dual aspect concept is the basis of the double-entry bookkeeping. Accordingly,

for every debit, there is an equal and corresponding credit.

The accounting equation of the dual aspect concept is:

Capital + Liabilities = Assets (or) Assets = Equities (Capital)

The term Capital refers to funds provided by the proprietor of the business concern. On the

other hand, the term liability denotes the funds provided by the creditors and debenture

holders against the assets of the business. The term assets represent the resources owned by

the business. For example, Mr.Thomas Starts a business with cash of Rs.l ,00,000 and

building of Rs.5,00,000, then this fact is recorded at two places; Assets Accounts and Capital

Account. In other words, the business acquires assets of Rs.6,00,000 which is equal to the

proprietor's capital in the form of cash of Rs. L, OO, OOO, and building worth of

Rs.5,00,000. The above relationship can be shown in the form of accounting equation:

Capital + Liabilities Rs.l, OO, OOO + Rs.5,00,000 = Assets = Rs.6, OO, OOO Accounting

Principles.

74
 Figure 53: Concepts of account perioding.

(3) Accounting Period Concept: According to this concept, income or loss of a business can

be analyzed and determined on the basis of suitable accounting period instead of waiting for a

long period, Le., until it is liquidated. Being a business in continuous affairs for an indefinite

period of time, the proprietors, the shareholders, and outsiders want to know the financial

position of the concern, periodically. Thus, the accounting period is normally adopted for one

year. At the end of each accounting period, an income statement and balance sheet are

prepared. This concept is simply intended for a periodical ascertainment and reporting of the

true and fair financial position of the concern as a whole.

75
 Figure 54: The basic accounting cycle

(4) Going Concern Concept: It is otherwise known as the Continue of Activity Concept. This

concept assumes that business concerns will continue for a long period to exit. In other

words, under this assumption, the enterprise is normally viewed as a going concern and it is

not likely to be liquidated in the near future. This assumption implies that while valuing the

assets of the business on the basis of productivity and not on the basis of their realizable

value or the present market value, at cost less depreciation till date for the purpose of balance

sheet. It is useful in the valuation of assets and liabilities, depreciation of fixed assets, and

treatment of prepaid expenses.

76
(5) Cost Concept: This concept is based on the "Going Concern Concept." The cost Concept

implies that assets acquired are recorded in the accounting books at the cost or price paid to

acquire them. And this cost is the basis for subsequent accounting for the asset. For

accounting purposes, the market value of assets is not taken into account either for valuation

or charging depreciation of such assets. The cost Concept has the advantage of bringing

objectivity in the preparation and presentation of financial statements. In the absence of a cost

concept, figures shown in accounting records would be subjective and questionable. But due

to inflationary tendencies, the preparation of financial statements on the basis of cost concept

has become irrelevant for judging the true financial position of the business.

Figure 55: Steps of the accounting cycle

77
(6) Money Measurement Concept: According to this concept, accounting transactions are

measured, expressed and recorded in terms of money. This concept excludes those

transactions or events which cannot be expressed in terms of money. For example, factors

such as the skill of the supervisor, product policies, planning, and employer-employee

relationship cannot be recorded in accounts in spite of their importance to the business. This

makes the financial statements incomplete.

(7) Matching Concept: Matching Concept is closely related to the accounting period concept.

The chief aim of the business concern is to ascertain the profit periodically. To measure the

profit for a particular period it is essential to match accurately the costs associated with the

revenue. Thus, the matching of costs and revenues related to a particular period is called a

Matching Concept.

(8) Realization Concept: Realization Concept is otherwise known as Revenue Recognition

Concept. According to this concept, revenue is the gross inflow of cash, receivables, or other

considerations arising in the course of an enterprise from the sale of goods or the rendering of

services from the holding of assets. If no sale takes place, no revenue is considered. However,

there are certain exceptions to this concept. Examples, Hire Purchase / Sale, Contract

Accounts, etc.

78
 Figure 56: Knowledge of accounting

(9) Accrual Concept: Accrual Concept is closely related to Matching Concept. According to

this concept, revenue recognition depends on its realization and not accrual receipt. Likewise,

costs are recognized when they are incurred and not when paid. The accrual concept ensures

that the profit or loss shown is on the basis of full facts relating to all expenses and incomes.

(10) Rupee Value Concept: This concept assumes that the value of the rupee is constant. In

fact, due to inflationary pressures, the value of the rupee will be declining. Under this

situation, financial statements are prepared on the basis of historical costs not considering the

declining value of the rupee. Similarly, depreciation is also charged on the basis of cost price.

Thus, this concept results in the underestimation of depreciation and overestimation of assets

in the balance sheet and hence will not reflect the true position of the business.

79
 Figure 57: Accounting convention

II. Accounting Conventions

(1) Convention of Disclosure: The disclosure of all material information is one of the

important accounting conventions. According to these conventions, all accounting statements

should be honestly prepared, and all facts and figures must be disclosed therein. The

disclosure of financial information is required for different parties who are interested in the

welfare of that enterprise. The Companies Act lays down the forms of Profit and Loss

80
Account and Balance Sheet. Thus, convention of disclosure is required to be kept as per the

requirement of the Companies Act and Income Tax Act.

Figure 58: Convention of the accounting

(2) Convention of Conservatism: This convention is closely related to the policy of playing

safe. This principle is" often described as "anticipate no profit and provide for all possible

losses." Thus, this convention emphasize that uncertainties and risks inherent in business

transactions should be given proper consideration. For example, under this convention

81
inventory is valued at cost price or market price whichever is lower. Similarly, bad and

doubtful debts is made in the books before ascertaining the profit.

(3) Convention of Consistency: The Convention of Consistency implies that accounting

policies, procedures, and methods should remain unchanged for the preparation of financial

statements from one period to another. Under this convention, alternative improved

accounting policies are also equally acceptable. In order to measure the operational efficiency

of a concern, this convention allows a meaningful comparison of the performance of different

periods.

Figure 59: Accounts convention

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(4) Convention of Materiality: According to Kohler's Dictionary of Accountants Materiality

may be defined as "the characteristic attaching to a statement fact, or item whereby its

disclosure or method of giving it expression would be likely to influence the judgment of a

reasonable person." According to this convention consideration is given to all material events,

insignificant details are ignored while preparing the profit and loss account and balance sheet.

The evaluation and decision of material or immaterial depend upon the circumstances and lie

at the discretion of the accountant.

System of Accounting

The following are the main system of accounting for recording the business transactions:

(a) Cash System of Accounting.

(b) Mercantile or Accrual System of Accounting.

(c) Mixed System of Accounting.

Figure 60: Types of accounting

83
(a) Cash System of Accounting: Under this system, only actual cash receipts and cash

payments are recorded. No credit transaction is made for a payment or receipt until cash is

actually received or paid. This system is usually adopted by the Government Organizations

and Financial Institutions. The non-trading concerns are preparing Receipts and Payment

Accounts based on the Cash Systems Accounting.

(b) Mercantile or Accrual System of Accounting: Under this system, all business

transactions are recorded in the books of accounts for a particular period inclusive of cash

receipts and cash payments or any amount having become due for payment or receipt. In

other words, both cash transactions and credit transactions are recorded in the books of

accounts.

Figure 61: Methods of accounting

(c) Mixed System of Accounting: This system is applicable only where a concern adopts the

combination of the Cash System and the Mercantile System. Under the Mixed System of

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Accounting, some records are made under the cash system whereas others are recorded under

the mercantile system.

Further, Accounting records can be prepared under any one of the following systems: 1.

Single Entry System. 2. Double Entry System. (1) Single Entry System: Under this system,

all transactions relating to a personal aspect are recorded in the books of accounts but leave

all impersonal transactions. Single Entry System is based on the Dual Aspect Concept and is

incomplete and inaccurate.

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 CHAPTER 4: Depreciation

This Standard deals with depreciation accounting and applies to all depreciable assets, except

the following items to which special considerations apply: —

I) forests, plantations, and similar regenerative natural resources.

(ii) wasting assets including expenditure on the exploration for and extraction of minerals,

oils, natural gas, and similar non-regenerative resources.

(iii) expenditure on research and development.

(iv) goodwill and other intangible assets.

(v) livestock.

This standard also does not apply to land unless it has a limited useful life for the enterprise.

Different accounting policies for depreciation are adopted by different enterprises. Disclosure

of accounting policies for depreciation followed by an enterprise is necessary to appreciate

the view presented in the financial statements of the enterprise.

Figure 62: Depreciation of the cost

86
Depreciation is a measure of the wearing out, consumption or other loss of value of a

depreciable asset arising from use, effluxion of time or obsolescence through technology and

market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable

amount in each accounting period during the expected useful life of the asset. Depreciation

includes amortization of assets whose useful life is predetermined.

Figure 63: Depreciation

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Depreciable assets are assets that.

(i) are expected to be used during more than one accounting period, and

(ii) have a limited useful life; and

(iii) are held by an enterprise for use in the production or supply of goods and services, for

rental to others, or for administrative purposes and not for the purpose of sale in the ordinary

course of business.

Figure 64: Depreciation of the cost

Useful life is either (i) the period over which a depreciable asset is expected to be used by the

enterprise; or (ii) the number of production or similar units expected to be obtained from the

use of the asset by the enterprise. 3.4 Depreciable amount of a depreciable asset is its

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historical cost or other amount substituted for historical cost1 in the financial statements, less

the estimated residual value.

Depreciation has a significant effect on determining and presenting the financial position and

results of the operations of an enterprise. Depreciation is charged in each accounting period

by reference to the extent of the depreciable amount, irrespective of an increase in the market

value of the assets. Assessment of depreciation and the amount to be charged in respect

thereof in an accounting period is usually based on the following three factors:

I) historical cost or other amount substituted for the historical cost of the depreciable asset

when the asset has been revalued.

Figure 65: Process of cost management

89
(ii) expected useful life of the depreciable asset; and

(iii) the estimated residual value of the depreciable asset. 6. Historical cost of a depreciable

asset represents its money outlay or its equivalent in connection with its acquisition,

installation, and commissioning as well as for additions to or improvement thereof. The

historical cost of a depreciable asset may undergo subsequent changes arising as a result of an

increase or decrease in long-term liability on account of exchange fluctuations, price

adjustments, changes in duties or similar factors.

Figure 66: Cost estimation

90
 ● The useful life of a depreciable asset is shorter than its physical life and is:

● Pre-determined by legal or contractual limits, such as the expiry dates of related

leases.

● Directly governed by extraction or consumption.

● Dependent on the extent of use and physical deterioration on account of wear and tear

which again depends on operational factors, such as the number of shifts for which

the asset is to be used, repair and maintenance policy of the enterprise, etc.

And

(iv) reduced by obsolescence arising from such factors as:

(a) technological changes; (b) improvement in production methods; (c) change in market

demand for the product or service output of the asset; or (d) legal or other restrictions.

Figure 67: SCM project

91
Determination of the useful life of a depreciable asset is a matter of estimation and is

normally based on various factors including experience with similar types of assets. Such

estimation is more difficult for an asset using new technology or used in the production of a

new product or in the provision of a new service but is nevertheless required on some

reasonable basis.

Any addition or extension to an existing asset that is of a capital nature 60 AS 6 and which

becomes an integral part of the existing asset is depreciated over the remaining useful life of

that asset. As a practical measure, however, depreciation is sometimes provided on such

addition or extension at the rate which is applied to an existing asset. Any addition or

extension which retains a separate identity and is capable of being used after the existing

asset is disposed of, is depreciated independently on the basis of an estimate of its own useful

life.

Figure 68: Steps of the cost management

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Determination of the residual value of an asset is normally a difficult matter. If such a value

is considered as insignificant, it is normally regarded as nil. On the contrary, if the residual

value is likely to be significant, it is estimated at the time of acquisition/installation, or at the

time of subsequent revaluation of the asset. One of the bases for determining the residual

value would be the realizable value of similar assets which have reached the end of their

useful lives and have operated under conditions similar to those in which the asset will be

used.

The quantum of depreciation to be provided in an accounting period involves the exercise of

judgment by management in the light of technical, commercial, accounting, and legal

requirements and accordingly may need periodical review. If it is considered that the original

estimate of the useful life of an asset requires any revision, the unamortized depreciable

amount of the asset is charged to revenue over the revised remaining useful life. There are

several methods of allocating depreciation over the useful life of the assets. Those most

commonly employed in industrial and commercial enterprises are the straight-line method

and the reducing balance method.

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 Figure 69: Forces of change and strategic cost management-primary Concern in the 21st
century

The management of a business selects the most appropriate method(s) based on various

important factors e.g.,

(i) type of asset,

(ii) the nature of the use of such asset and

(iii) circumstances prevailing in the business.

Figure 70: Benefits of the cost counting

94
A combination of more than one method is sometimes used. In respect of depreciable assets

which do not have material value, depreciation is often allocated fully in the accounting

period in which they are acquired. 13. The statute governing enterprise may provide the basis

for the computation of the depreciation. For example, the Companies Act, of 1956 lays down

the rates of depreciation in respect of various assets. Where the management’s estimate of the

useful life of an asset of the enterprise is shorter than that envisaged under the provisions of

the relevant statute, the depreciation provision is appropriately computed by applying a

higher rate. If the management’s estimate of the useful life of the asset is longer than that

envisaged under the Depreciation Accounting 61 statute, a depreciation rate lower than that

envisaged by the statute can be applied only in accordance with the requirements of the

statute. 14. Where depreciable assets are disposed of, discarded, demolished or destroyed, the

net surplus or deficiency, if material, is disclosed separately.

Figure 71: Change management and cost estimation

95
5. The method of depreciation is applied consistently to provide comparability of the results

of the operations of the enterprise from period to period. A change from one method of

providing depreciation to another is made only if the adoption of the new method is required

by statute or for compliance with an accounting standard or if it is considered that the change

would result in a more appropriate preparation or presentation of the financial statements of

the enterprise. When such a change in the method of depreciation is made, depreciation is

recalculated in accordance with the new method from the date of the asset coming into use.

The deficiency or surplus arising from retrospective precomputation of depreciation in

accordance with the new method is adjusted in the accounts in the year in which the method

of depreciation is changed.

Figure 72: Process of cost management

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In case the change in the method results in a deficiency in depreciation in respect of past

years, the deficiency is charged in the statement of profit and loss. In case the change in the

method results in a surplus, the surplus is credited to the statement of profit and loss. Such a

change is treated as a change in accounting policy and its effect is quantified and disclosed.

Where the historical cost of an asset has undergone a change due to circumstances specified

in para 6 above, the depreciation on the revised unamortized depreciable amount is provided

prospectively over the residual useful life of the asset. Disclosure

Figure 73: SAP central finance

97
The depreciation methods used, the total depreciation for the period for each class of assets,

the gross amount of each class of depreciable assets, and the related accumulated depreciation

are disclosed in the financial statements along with the disclosure of other accounting

policies. The depreciation rates or the useful lives of the assets are disclosed only if they are

different from the principal rates specified in the statute governing the enterprise. 18. In case

the depreciable assets are revalued, the provision for depreciation is based on the revalued

amount on the estimate of the remaining useful life of such assets. In case the revaluation has

a material effect on the 62 AS 6 amounts of depreciation, the same is disclosed separately in

the year in which the revaluation is carried out. A change in the method of depreciation is

treated as a change in an accounting policy and is disclosed accordingly.

Figure 74: Organizational change management

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The depreciation method selected should be applied consistently from period to period. A

change from one method of providing depreciation to another should be made only if the

adoption of the new method is required by statute or for compliance with an accounting

standard or if it is considered that the change would result in a more appropriate preparation

or presentation of the financial statements of the enterprise. When such a change in the

method of depreciation is made, depreciation should be recalculated in accordance with the

new method from the date of the asset coming into use.

The deficiency or surplus arising from retrospective recompilation of depreciation in

accordance with the new method should be adjusted in the accounts in the year in which the

method of depreciation is changed. In case the change in the method results in deficiency in

depreciation in respect of past years, the deficiency should be charged in the statement of

profit and loss. In case the change in the method results in surplus, the surplus should be

credited to the statement of profit and loss. Such a change should be treated as a change in

accounting policy and its effect should be quantified and disclosed. 22. The useful life of a

depreciable asset should be estimated after considering the following factors:

● Expected physical wear and tear.

● Obsolescence.

● Legal or other limits on the use of the asset.

Depreciable assets may be reviewed periodically. Where there is a revision of the estimated

useful life of an asset, the unamortized depreciable amount should be charged over the

revised remaining useful life. 24. Any addition or extension which becomes an integral part

of the existing asset should be depreciated over the remaining useful life of that asset. The

depreciation on such addition or extension may also be provided at the rate applied to the

existing asset. Where an addition or extension retains a separate identity and is capable of

99
being used after the existing asset is disposed of, depreciation should be provided

independently on the basis of an estimate of its own useful life.

Where the historical cost of a depreciable asset has undergone a change due to an increase or

decrease in long-term liability on account of exchange fluctuations, price adjustments,

changes in duties or similar factors, the depreciation on the revised unamortized depreciable

amount should be provided prospectively over the residual useful life of the asset.

Where the depreciable assets are revalued, the provision for depreciation should be based on

the revalued amount and on the estimate of the remaining useful lives of such assets. In case

the revaluation has a material effect on the amount of depreciation, the same should be

disclosed separately in the year in which revaluation is carried out. If any depreciable asset is

disposed of, discarded, demolished or destroyed, the net surplus or deficiency, if material,

should be disclosed separately.

The following information should be disclosed in the financial statements:

(i) The historical cost or other amount substituted for historical cost of each class of

depreciable assets.

(ii) Total depreciation for the period for each class of assets; and

(iii) The related accumulated depreciation.

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 Figure 75: Business process

Depreciation is a decrease in the value of an asset as a result of wear and tear. Methods of

Depreciation Straight Line Method A method of depreciation in which a fixed amount is

written off year on year, during the useful life of the asset, to reduce the value of the asset to

zero or its scrap value at the end of its useful life is a straight-line method. In this method, the

cost of the asset is uniformly spread over the lifetime of the asset. This method is also known

as the fixed installment method. Under this method, a particular asset is expected to generate

equal utility (economic benefits) during its useful life.

Written Down Value Method The depreciation method in which a fixed percentage of the

reducing balance is written off every year as depreciation, to reduce the fixed asset to its

residual value at the end of its working life. This method is also known as the reducing

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balance or diminishing balance method where the annual charge of depreciation keeps on

decreasing every year. So the depreciation charged in the initial years is higher as compared

to the subsequent years. Although, according to this method the value of the asset is not fully

extinguished. Key Differences between SLM and WDV The difference between SLM and

WDV are explained in the given below points in detail SLM is a method of depreciation in

which the cost of the asset is spread uniformly over the life years by writing off a fixed

amount every year.

Figure 76: Design of the cost change

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WDV is a method of depreciation in which a fixed rate of depreciation is charged on the book

value of the asset, over its useful life. In the straight-line method, depreciation is calculated

on the original cost. On the other hand, in the written-down value method, the calculation of

depreciation is on the basis of the written-down value of the asset. The annual depreciation

charge in SLM remains fixed during the life of the asset. In contrast, the amount of

depreciation in the WDV method diminishes every year. In the straight-line method, the book

value of the asset is completely written off i.e. The asset value is reduced to zero or its

salvage value. Conversely, the asset’s book value is not completely written off in the written-

down value method.

If a firm is using the SLM method, then the amount of depreciation is initially lower while if

the method of depreciation is WDV then in the beginning the amount of depreciation is

higher. The SLM method is best for the fixed assets with negligible repairs and maintenance

like leases. On the contrary, the WDV method is appropriate for the fixed assets whose

repairs increase, as they get older like machinery, vehicles, etc. The impact of repairs and

depreciation on the P&L account can be easily understood by an example – We all know it is

natural that as the asset gets older, the number of repairs and maintenance, increases year on

year. Now look at the given situation: SLM Cost It means the total of all expenditures

incurred on the production of an article.

Costing It is the techniques and process of ascertaining costs. It enables the management to

know the total cost and each element of cost of a product. It has been defined by Wheldon as,

“the classifying, recording and appropriate allocation of expenditure for the determination of

the costs of products or services, and the presentation of suitably arranged data for purposes

of control and guidance of management”. Cost Accounting Cost accounting is the process of

classifying, recording, allocating, and reporting the various costs incurred in the operation of

an enterprise. Difference between Costing and Cost Accounting The words costing, and cost

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accounting are used interchangeably. However, they do not mean the same thing. Costing

denotes the techniques and process of ascertaining cost. It can be carried out arithmetically.

However, cost accounting is a formal system established for recording costs in the books of

accounts.

Cost Accountancy: Cost Accountancy is a comprehensive term. Cost accountancy is the

application of costing and cost accounting principles, methods, and techniques to the science,

art and practice of cost control and ascertainment of profitability. It includes the presentation

of information for decision-making.

Definition Costing is referred to as, “Classifying, recording and appropriate allocation of

expenditure for the determination of the costs of products or services” ICMA, London defines

Costing as, ” The technique and process of ascertaining cost” Scope of Cost Accountancy

The scope of cost accountancy is very wide and includes the following:

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 Figure 77: Application of cost management

Cost Ascertainment It deals with the collection and analysis of expenses, the measurement of

the production of the different products at the different stages of manufacture and the linking

up of production with the expenses. In fact, the varying procedures for the collection of

expenses give rise to the different systems of costing as Historical or Actual costs, estimated

costs, standard costs, etc. Again the varying procedures for the measurement of production

have resulted in different methods of costing such as specific order costing, operation costing,

105
etc. For linking up of production with the expenses the different techniques of costing such as

marginal costing, the total cost technique, and the direct cost technique have evolved.

Figure 78: Cost control technique

All the three i.e., systems, methods, and techniques can be used in one concern

simultaneously. Cost Accounting It is the process of accounting for cost, which begins with a

recording of expenditure and ends with the preparation of statistical data. Costs of products or

services are ascertained and controlled by means of a formal mechanism. Cost can be

ascertained either by following the historical or predetermined system of costing. Cost either

can be predetermined by standard costing or estimated costing. If the cost and financial

106
accounts are kept separately then their reconciliation is also to be done in order to verify the

accuracy of both the sets of accounts.

Cost Control Cost Control is the guidance and regulation by executive action of the costs of

operating an undertaking. It aims at guiding the actual towards the line of targets and

regulates the actual if they deviate or vary from the targets, this guidance and regulation is

done by an executive action. The cost can be controlled by standard costing, budgetary

control, proper presentation and reporting of cost data, and cost audit objectives of Costing

Accounting Objectives of Cost Accounting The objectives are listed below:

Figure 79: System map

107
To find out the total cost and cost per unit of various products produced. 2. To disclose the

proportion of different elements such as materials, labor, and overheads in the total cost 3. To

provide necessary data for fixing the selling price. To supply estimates of costs based on

historical data, for the preparation of tender, etc. To provide important cost data to the

management for decision-making, planning, and controlling. To adopt a suitable system of

inventory control to avoid excessive locking up of working capital in stocks To identify the

sources of wastages and losses in the business

To help in the preparation of budgets and implementation of budgetary control To compare

the actual cost with standard cost and analyze the causes of variances. To advise the

management on future expansion policies and proposed capital projects To exercise effective

control on the idle time of men and machines To supply useful data to the management to

take decisions such as the introduction of new products etc., Advantages of Cost Accounting

I. To the Management

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 Figure 80: BIM collaboration

I. Action against unprofitable activities It tells the unproductive, unprofitable, and inefficient

activities to the management which will act as a base to take correct and proper steps in time.

109
Ii. It helps in decision-making Cost accounting helps in decision-making. It provides vital

information necessary for decision-making. For example, it helps in deciding whether to

make or buy a product, or whether to accept or reject an export order.

Iii. It helps in fixing prices Cost accounting helps in fixing prices. It provides detailed cost

data for each product, which enables in fixation of selling prices.

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 CHAPTER 5: Financial statements analysis and Interpretation

Analysis and interpretation of financial statements means looking at the various parts of the

financial statements, relating the parts to each other and to the picture as a whole, and

determining if any meaningful and useful interpretation can be made out of this analysis. All

readers of financial statements, managers, owners, investors, and creditors are interested in

analyzing and interpreting the financial statements. However, what is of interest to one may

be of less interest to another. For example, managers are very concerned about the internal

operating efficiency of the organization and will look for indications that things are running

smoothly, that operating goals are being met, and that the various departments are being

managed as profitably as possible.

Figure 81: Financial statement analysis

111
Stockholders, on the other hand, are more interested in the net income and about future

earnings and dividend prospects. In many cases, they would not be concerned about or be

familiar with internal departmental results. Creditors and investors other than stockholders

might be interested in the net income but are even more interested in the debt-paying ability

of the company. A company might have good earnings but, because of a shortage of cash,

might not be able to meet its debt obligations. An exhaustive coverage of the analysis and

interpretation of financial statements is beyond the scope of this text. Therefore, this

discussion will be confined to some of the more fundamental analysis techniques that lend

themselves well to the hospitality industry. Also, comment will be confined to the two major

financial statements: the balance sheet and the income statement. The analysis techniques

illustrated are those that normally would be used by the operation’s management.

Figure 82: Analysis of financial statement

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COMPARATIVE HORIZONTAL ANALYSIS OF BALANCE SHEETS

A Basic set of financial statements includes a balance sheet at a specific date and an income

statement for the accounting period ended on that date. Some sets of financial statements may

include a balance sheet and income statement for both the previous and current accounting

periods. When prior and current period statements are provided, changes occurring between

the two consecutive years or periods can be seen. However, these changes might not be as

obvious as you would expect. It is not easy to mentally compare the differences between two

sets of figures, and it is extremely useful to have additional information available for analysis.

One method is to complete a comparative horizontal analysis of a balance sheet or an income

statement. This technique requires at least two consecutive periods of information. The

objective is to find and identify changes that have occurred over an accounting period.

Figure 83: Statement of the financial analysis

113
The difference in dollar value reported between the two statements for each line item,

subtotal, or total of the statement is calculated and identified as a positive or negative dollar

value change. The change, positive or negative, is divided by the prior period’s dollar amount

to determine the percentage change. Completing comparative horizontal analysis of any item,

subtotal, or total appearing in a financial statement is not the difficult part of a comparative

analysis. The difficult part understands what the analysis is telling you. Exhibit 3.1 shows

balance sheet information for two successive years, and the identity of each line item,

subtotals, and totals for all assets, liabilities, and stockholders’ equity is shown. In addition,

two extra columns are added for comparative analysis, one to show the dollar value change

and the other to express the percentage of change for each line item reported.

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 Figure 84: Tools of financial analysis

The latter two columns are helpful in pinpointing large changes that have occurred, either

dollar amount changes or percentage changes. As well, we are looking for percentage

changes in one account that are not of the same magnitude as the percentage changes of the

other accounts. In Exhibit 3.1, total current assets have increased by 7.1 percent and total

assets have decreased by 2.8 percent. However, consider the cash account. The change from

Year 0003 to Year 0004 is $12,500. This may or may not be a large change depending on the

size of the hotel. The change becomes obvious when expressed in percentage terms: 54.6

percent ($12,500 / $22,900).

Figure 85: Tools of analysis process

115
Why has the cash account increased by almost 55 percent in the past year? However, the

marketable securities account has decreased $13,000, or 86.7 percent. It appears that most of

the securities held have been cashed in during the year. Is this conversion for a specific

purpose? If not, perhaps we should use some of it to reduce accounts payable, which have

gone up by $7,300 (38 percent).

In comparative analysis, the terms absolute and relative change are sometimes used. An

absolute change shows the dollar change from one period to the next. A relative change is the

absolute change expressed as a percentage. An absolute change may sometimes appear large

(for example, $10,000) but when compared to its base figure (e.g., $1,000,000) represents a

relative change of only 1%. By the same token, a relative change may seem high (e.g., 50%)

but when compared to its base figure is quite small in absolute terms (for example, a $50 base

figure increasing to $75). In terms of the total income statement, this $25 change (even

though it shows a relative increase of 50%) is insignificant.

Therefore, when analyzing comparative statements, both the absolute and the relative

changes should be looked at, and only those that exceed both acceptable norms should be of

concern. For example, absolute changes of concern might be established at $10,000 and

relative changes at 5%, and only those changes that exceeded both $10,000 and 5% would be

investigated. In this situation, the following changes would not be investigated: Above

$10,000 but below 5 percent above 5 percent but below $10,000 Below $10,000 and below 5

percent.

COMMON-SIZE VERTICAL ANALYSIS OF BALANCE SHEETS

Another technique used to analyze balance sheet information is to convert the statement to a

common-size vertical analysis format. This method requires only one period of financial data.

Common size means that total assets have a value of 100 percent and the numerical value of

116
each item being converted represents a fractional part of total assets. Since Assets Liabilities

Ownership Equity and each side of the balance sheet has the same total value, every item in a

balance sheet, subtotals, and totals, can be expressed as a percentage of total assets. Exhibit

3.2 shows the common-size (vertical) conversion of the comparative balance sheet shown in

Exhibit 3.1. The common-size statement shows that the cash account in Year 0003 is 1.6

percent of total assets, which was calculated by dividing the cash balance by total assets;

$22,900 / $1,448,800. Accounts payable in Year 0003 is 1.3 percent of total assets, $19,200 /

$1,448,800. In Exhibit 3.2, each balance sheet item shown for Year 0003 is divided by total

assets of Year 0003. The addition of each item percentage shown for Year 0003 will equal

100 percent, which is the product of total assets divided by total assets.

Percent Regardless of whether you are converting a balance sheet or a subset of assets,

liabilities, or ownership equity, the conversion procedure is the same. The advantage of

common-size statements is that they show changes in proportion of individual accounts from

one period to the next. For example, the cash account in Year 0003 was 1.6 percent of total

assets. In Year 0004, it was 2.5 percent of total assets. This change in proportion would

normally attract a reader’s attention and raise questions. Attention might also be drawn to

other accounts where large changes have occurred. The common-size vertical analysis

technique is particularly useful when comparing two companies whose size]

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 Figure 86: Methods of cost

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Whether a hotel or food service operation uses comparative balance sheets or common-sized

balance sheets is a matter of choice. Normally, only one or the other would be preferred since

both draw the attention of the reader to the relevant accounts where changes have occurred.

However, sometimes one technique will identify changes that other techniques did not

indicate. Identifying changes should provoke questions, the answers to which may be helpful

in running the business more effectively. Attention should be focused on the balance sheet

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because of the need for effective control or management of a company’s assets. However, as

a management technique for controlling internal day-to-day operations, comparative income

statements are often more useful than comparative balance sheets.

COMPARATIVE HORIZONTAL ANALYSIS OF INCOME STATEMENTS

Exhibit shows two consecutive annual income statements for a food department of a hotel.

The same method that was used to analyze balance sheets is used for income statements. Line

by line, find the numerical value change and divide the change by the prior year to find the

percentage of change. For example, revenue increased. The comparative horizontal analysis

follows the same procedures to calculate the numerical change of each line item and the

percentage that change represents.

It matters not what financial information is being compared, as long as two consecutive

operating periods of information are provided. The concept remains: (Period 2 Period 1) $

Change / Period 1 % Change The other percentage change figures are calculated in the same

way. Note that within each revenue area, except banquets, the revenue has increased, but total

revenue has gone up only 2.1 percent. The reason for this relatively small increase in total

revenue is that banquet revenue was down 7.7 percent over the year. Can the reasons be

determined? Is the sales department not doing an effective job? Is there a new, competitive

operation close by? Are prices too high? Even with the small total sales revenue increase,

income has declined $37,100, or 24.2 percent. This is a drastic change. With revenue up, all

other factors being equal, income should also be up, not down.

All other things are, obviously, not equal, because analysis of costs shows that the majority of

them have increased at a greater rate than the revenue increase. To select only one example,

the laundry cost has gone up $2,900 over the year, or 18.7 percent. Are we using more linen

than before? Has our supplier increased the cost to us by this percentage? Whatever the

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reason, corrective action can be taken once the cause is known. Each expense should be

analyzed. In this particular illustration, assuming the increased costs were inevitable, perhaps

the increased costs have not yet been incorporated into the menu selling prices.

COMMON-SIZE VERTICAL ANALYSIS OF INCOME STATEMENTS

Income statements can also be converted to a common-size vertical analysis format. With the

conversion of the income statement, total sales revenue takes the value of 100 percent and all

other items on the income statement are expressed as a fraction of total sales revenue.

However, for the cost of sales, the cost of each product is divided by its respective sales

revenue. Therefore, the cost of sales–food is divided by food sales revenue and the cost of

sales–beverage is divided by beverage sales revenue. A common-size income statement is

illustrated in Exhibit 3.4. For example, in Year 0003 dining room sales revenue was 23.7

percent of total sales revenue and is calculated as follows:

Figure 87: Process of cost

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Dining sales revenue / Total sales revenue % of Total sales revenue $201,600 / $851,600 All

items except the cost of sales in Exhibit 3.4 are calculated the same way, using $851,600 as

the denominator and the individual item as the numerator. Note that the percentage given for

gross profit is a no-account subtotal and cannot be included to arrive at the 100 percent total

of the other items’ percentages. Gross profit (also called gross margin) is derived subtotal

representing sales revenue minus cost of sales and does not represent an operating cost, nor

does it represent the resulting profit or loss from operations. Expense items, except the cost of

sales, also use $851,600 as the denominator for Year 0003. For example, the cost of salaries

and wages would be calculated as follows:

Total cost of sales, 32.6 cents was for salaries and wages, 4.1 cents was for employee

benefits, and 7.6 cents was for all other operating expenses, leaving only 18.0 cents for

income. In Year 0004, this income was down to 13.3 cents out of every $1.00 of revenue.

Common-size income statements show which items, as a proportion of revenue, have

changed enough to require investigation. For example, one of the causes for the decline to

13.3 cents of departmental income from each dollar of sales revenue in Year 0004 is that the

amount spent on total cost of sales has risen from 37.9 cents to 39.3 cents out of each dollar

of sales revenue. This 1.4-cent increase might seem insignificant, but if it had not occurred,

we would have made $12,167 more income, calculated as follows:

In the interest of brevity in Exhibit 3.4, a number of expenses have been added together under

“all other operating expenses.” In Year 0003, this figure is 7.6 percent of revenue, and in

Year 0004, 8.0 percent of revenue. This is a relatively small change and might normally be

unnoticed. It is small only because several of the individual items that decreased offset many

of the individual expense items that increased, thus hiding the facts. In practice, it would be

best to detail each individual expense and express it as a percentage of revenue to have full

information. The income statement illustrated for the food operation was analyzed with both

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comparative horizontal (Exhibit 3.3) and common-size vertical methods (Exhibit 3.4).

Normally, only one or the other would be used.

They each draw attention, albeit in a different way, to problem areas requiring investigation,

and, if necessary, corrective action. However, sometimes one technique will identify

problems that should be investigated that the other technique may not indicate. Therefore,

sometimes it is a good idea to complete both a comparative and common-size vertical

analysis. Note again that the common-size vertical analysis method is the more appropriate

one to use when comparing two companies whose size or scale of operation is quite different.

There is one other method of horizontal comparative analysis particularly suited to the food

operation, and that is to calculate and compare average sales revenue per guest, average cost

per guest, and average income per guest information.

Figure 88: Production of work

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AVERAGE CHECK, COST, AND INCOME PER GUEST

Averages for sales revenue and cost functions are another useful tool to help analyze the

income statement. When using averages, understanding how to calculate averages is

essential. The question is to find the per-guest average—but of what? “What” can be

identified as total sales revenue, revenue by division, total cost, or cost by category. A per-

guest average can be determined using the following concept: sales revenue / guests, cost /

guests, or operating income.

When we analyze the information in Exhibit 3.5, we see that the number of guests served in

all sales revenue areas increased—except in banquets, where there was a decrease of 9,410

(60,190 50,780). This is a decrease of 15.6 percent (9,410 / 60,190, then multiplied by 100).

At the same time, in the banquet area the average check per guest increased from $13.02 to

$14.24. This is an increase of $1.22 per guest, or 9.4 percent ($1.22 / $13.02, then multiplied

by 100). The combination of higher average check (average revenue) but reduced numbers of

guests meant that banquet revenue was $60,300 lower in Year 0007 than in Year 0006.

In terms of total average revenue per guest for the food operation in Year 0007, we took in 12

cents more per guest ($11.97 $11.85) but we spent 66 cents more per guest ($10.38 $9.72),

and thus our income per guest declined 53 cents ($2.13 $1.60). Obviously, our costs per

guest have risen much faster than our revenue per guest. The individual items of expense, on

a per-guest basis, have all increased, some more than others. They need to be investigated to

see whether the trend can be reversed. Alternatively, sales prices might need to be increased

to compensate for uncontrollable, increasing costs.

The need to plan effective instruction is imperative for a successful distance teaching

repertoire. This is due to the fact that the instructional designer, the tutor, the author (s) and

the student are often separated by distance and may never meet in person. This is an

increasingly common scenario in distance education instruction. As much as possible,

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teaching by distance should stimulate the student's intellectual involvement and contain all

the necessary learning instructional activities that are capable of guiding the student through

the course objectives. Therefore, the course / self-instructional material are completely

equipped with everything that the syllabus prescribes.

To ensure effective instruction, a number of instructional design ideas are used and these help

students to acquire knowledge, intellectual skills, motor skills and necessary attitudinal

changes. In this respect, students' assessment and course evaluation are incorporated in the

text. The nature of instructional activities used in distance education self-instructional

materials depends on the domain of learning that they reinforce in the text, that is, the

cognitive, psychomotor and affective. These are further interpreted in the acquisition of

knowledge, intellectual skills and motor skills. Students may be encouraged to gain, apply

and communicate (orally or in writing) the knowledge acquired. Intellectual skills objectives

may be met by designing instructions that make use of students' prior knowledge and

experiences in the discourse as the foundation on which newly acquired knowledge is built.

The provision of exercises in the form of assignments, projects and tutorial feedback is

necessary. Instructional activities that teach motor skills need to be graphically demonstrated

and the correct practices provided during tutorials. Instructional activities for inculcating

change in attitude and behavior should create interest and demonstrate need and benefits

gained by adopting the required change. Information on the adoption and procedures for

practice of new attitudes may then be introduced. Teaching and learning at a distance

eliminate interactive communication cues, such as pauses, intonation and gestures, associated

with the face-to-face method of teaching.

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 Figure 89: Target costing

This is particularly so with the exclusive use of print media. Instructional activities built into

the instructional repertoire provide this missing interaction between the student and the

teacher. Therefore, the use of instructional activities to affect better distance teaching is not

optional, but mandatory. Our team of successful writers and authors has tried to reduce this.

Divide and to bring this Self-Instructional Material as the best teaching and communication

tool. Instructional activities are varied in order to assess the different facets of the domains of

learning. Distance education teaching repertoire involves extensive use of self-instructional

materials, be they print or otherwise.

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These materials are designed to achieve certain pre-determined learning outcomes, namely

goals and objectives that are contained in an instructional plan. Since the teaching process is

affected over a distance, there is need to ensure that students actively participate in their

learning by performing specific tasks that help them to understand the relevant concepts.

Therefore, a set of exercises is built into the teaching repertoire in order to link what students

and tutors do in the framework of the course outline. These could be in the form of students'

assignments, a research project or a science practical exercise. Examples of instructional

activities in distance education are too numerous to list. Instructional activities, when used in

this context, help to motivate students, guide and measure students' performance (continuous

assessment).

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 CHAPTER 6: Cost Methods, techniques of cost accounting, and
Classification of Cost

Cost Accounting is the system of accounting which is concerned with determination of costs

of doing something which can be manufacturing or rendering service or even conducting any

activity or function. The objective of Cost Accounting is to render detailed and useful

information for guidance to Management. Financial accounting is developed over the time to

record, summaries and present the financial transaction or events which can be expressed in

terms of money. This function was primarily concerned with record keeping, leading to

preparation of Profit and Loss Account and Balance Sheet. The information obtained through

financial statements is useful to the Management or Owner in several respects. However, the

information provided by financial 2 accounting is not sufficient for several purposes of

decision making in many areas such as:

Determining output level, determining product selection – addition or dropping or changing

product combination in the case of multi product company, determining or revising prices of

products, whether Profit earned is optimum as compared with competitors and in comparison

to earlier years. The need of data for such details leads to the development of Cost

Accountancy.

Cost: Institute of Cost and Works Accountants of India defines cost as “measurement, in

monetary terms, of the amount of resources used for the purpose of production of goods or

rendering services”. Thus, the term cost means the amount of expenditure, actual or notional

incurred or attributable to a given thing. It can be regarded as the price paid for attaining the

objective. For e.g., Material cost is the price of materials acquired for manufacturing a

product.

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 Figure 90: Cost techniques

Costing: The term costing has been defined as “the techniques and processes of

ascertainment of costs. Weldon has defined costing as, “the classifying recording and

appropriate allocation of expenditure for the determination of costs the relation of these costs

to sale value and the ascertainment of profitability.” Therefore, costing involves the following

steps.

1. Ascertaining and Collecting of Costs

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2. Analysis or Classification of Costs

3. Allocating total costs to a particular thing

I.e., Product, a contract or a process.

Thus, costing simply means cost finding by any process or technique.

Figure 91: Production of the work inventory

Cost Accounting: Cost Accounting is a formal system of accounting by means of which cost

of products or service, are ascertained and controlled. Whelden defines Cost Accounting as,

“Classifying, recording and appropriate allocation of expenditure for determination of costs

of products or services and for the presentation of suitably arranged data for the purpose of

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control and guidance of management.” 3 Therefore, Cost Accounting is the application of

costing principles, methods and techniques in the ascertainment of costs and analysis of

savings or / and excesses as compared with previous experience or with standards. It

provides, detailed cost information to various levels of management for efficient performance

of their functions. The information supplied by Cost Accounting as a tool of management for

making optimum use of scarce resources and ultimately add to the profitability of business.

Figure 92: Process of costing

OBJECTIVES OF COST ACCOUNTING

Objectives of Cost Accounting are as follows: 1) To Ascertain the Cost: To ascertain the cost

of product or a service reveled and enable measurement of profit by proper valuation of

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inventory. 2) To Analyze Costs: To analysis costs or to classify the expenses under different

heads of accounts viz. Material, labor, expenses etc. 3) To Allocate and Apportion the Costs:

To allocate or charge the direct expenses or specific costs such as Raw Material, labor to

particular product, contract or process and to distribute common expenses to each product,

contract or process on a suitable basis. 4) Cost Reporting: Cost Reporting or presentation

includes a) what to report i.e. What is the nature of information to be presented? B) Whom to

Report i.e. To whom the report is to be addressed.

Figure 93: Joint costing

C) When to Report i.e. When the report is to be presented i.e. Daily weekly monthly yearly

etc. D) how to Report i.e. In what format the report is to be presented. 5) To Assist the

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Management: Cost Accounting assist the management in: a) Indicating to the management

any inefficiencies and extent of various forms of waste of Raw Material, Time, Expenses etc.

B) Fixing of selling price. C) Providing information to enable management to take decision

of various types.

Figure 94: Standard cost

4 d) Controlling Inventory of Raw Material, goods in process, finished goods, spares and

consumables etc. 6) Cost Control: Cost Accounting assist the management in cost control.

Cost control includes the following stages. A) Setting up of targets of cast and production for

each period. B) Measuring the actual figures of performance relating to cost, production etc.

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For the period concerned. C) The figures of actual performance are to be compared with the

targets to find out the variation. D) Analyzing the variance, whether favorable or adverse. E)

Immediate action has to be taken in case of adverse variation.

8) Optimum Product Mix: Advise the management in deciding optimum product mix merits

and demerits of alterative courses of action viz. Make of buy decisions, introduction or

Automation mechanization, rationalization, system of production etc. 9) Future Policies:

Advise management on future policies regarding Expansion, growth, capital investment, etc.

1.4 COST CENTRE AND COST UNITS

Cost Centre: It is a location, person or item of equipment for which cost may be ascertained

and used for the purpose of cost control. It is a convenient unit of the organization for which

the cost may be ascertained. The main purpose of ascertainment of cost is to control the cost

and fill up the responsibility of the person who is in charge of the cost center.

Figure 95: Cost center

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• Types of cost centers: I. Personal Cost Centre: It consists of a person or group of persons.

E.g., Machine operator, salesmen, etc. II. Impersonal Cost Centre: It consists of a location or

an item of equipment or group of these. E.g., Factory, Machine etc. III. Operational Cost

Centre: This consists of machines or persons carrying on similar operations. 5 IV. Process

Cost Centre: This consists of a continuous sequence of operation or specific operations. V.

Production Cost Centre:

Figure 96: Business unit tree

This is the center where actual production takes place or these include those departments that

are directly engaged in manufacturing activity and contribute to the content and form of

finished product. E.g., Cutting, Assembly and Finishing Departments etc. VI. Service Cost

Centre: This is the Centre which renders services to production centers. These contribute to

the production process in an indirect manner. E.g. Stores department, Repairs and

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Maintenance department, H.R. Department, Purchase Department etc. 1.4.2 Cost unit: It is a

unit of product, service or time in terms of which cost are ascertained or expressed. It is

basically, a unit of quantity of product or service in relation to which costs may be

ascertained or expressed.

CLASSIFICATION OF COST

Classification is the process of grouping costs according to their common characteristics. It is

a systematic placement of like items together according to their common features. There are

various ways of classifying costs, according to their common features as given below.

Figure 97: Classification of cost

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On the basis of Identification: On the basis of identification of cost with cost units or jobs or

processes, costs are classified into – 1. Direct Costs: These are the costs which are incurred

for and conveniently identified with a particular cost unit process or department. These are

the expenditures which can be directly allocated to a particular job, product or an activity.

E.g., Cost of Raw Material used, wages paid to laborers etc.

2. Indirect Costs: These are general costs and are incurred for the benefit of a number of cost

units, processes or departments. These costs cannot be conveniently identified with a

particular cost unit or cost center. Example: Depreciation of Machinery, Insurance, Lighting,

Power, Rent of Building, Managerial Salaries, etc. Manufacturing Cost Administration Cost

Selling and Distribution Cost Research and Development Cost Direct Cost Fixed Cost On the

basis of behavior of cost Variable Cost Semi-Variable Cost On the basis of Identification

Indirect Cost On the basis of Controllability Controllable Cost Uncontrollable Cost On the

basis of Time Historical Cost Predetermined Cost On the basis of function Conversion Cost

Other Basis Normal Cost Avoidable Cost Unavoidable Cost Product Cost Period Cost 7 II On

the basis of behavior of Cost Behavior means change in cost due to change in output.

Costs behave differently when the level of production rises or falls. Certain costs change in

direct proportion with production level while other costs remain unchanged. As such on the

basis of behavior of cost – costs are classified into 1) Fixed Costs: It is that portion of the

total cost which remains constant irrespective of output up to the capacity limit. It is the cost

which does not very with the change in the volume of activity in the short run. These costs

are not affected by temporary fluctuation in the activity of an enterprise. These are also

known as period costs as it is concerned with period. Rent of premises, tax and insurance,

staff salaries, are the examples of fixed cost. Characteristics of Fixed Cost are a. Large in

value b. Fixed amount within an output range c. Fixed cost per unit decreases with increased

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output d. Indirect Cost e. Lesser degree of controllability f. Influence Variable Cost and

Working Capital.

Figure 98: Behavior of the fixed cost

2) Variable Cost: It is that cost which directly very with the volume of activity. In other

words, it is a cost which changes according to the changes in the volume of output. It tends to

very in direct proportion to output. It means when the volume of output increases, total

variable cost also increases when the volume of output decreases, total variable cost also

decreases. 8 But the variable cost per unit remains same. Direct material, Direct labor, Direct

Expenses are examples of variable costs. Characteristics of Variable Cost are a. Total cost

changes in direct proportion to the change in total output. B. Cost per unit remains content. C.

It is quite divisible. D. It is identifiable with the individual cost unit. E. Such costs are

controlled by functional manager.

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 Figure 99: Behavior of the variable cost

Semi-Variable Cost: This is also referred to as semi-fixed costs. These costs include both a

fixed and a variable component. I.e., These are partly fixed and partly variable. They remain

constant up to a certain level and registers change afterwards. These costs vary in some

degree with volume but not in direct or same proportion. Such costs are fixed only in relation

to specified constant condition. For example: Repairs and maintenance of machinery,

telephone charges, maintenance of building, supervision, professional tax, compensation for

accidents, light and power etc.

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 Figure 100: Behavior of the semi-maintenance cost

On the basis of Controllability On the basis of controllability, costs are classified into two

types:

1) Controllable Cost

2) Uncontrollable Cost

1) Controllable Cost:

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These are the costs which cannot be influenced or controlled by the concerned cost center or

responsibility center. These costs may be directly regulated at a given level of management

authority. 2) Uncontrollable Cost: These are the costs, which cannot be influenced or

controlled by the action of a specific member of an enterprise. For egg. It is very difficult to

control costs like factory rent, managerial salaries etc. The important points to be noted

regarding this classification. First, controllable cost cannot be distinguished from non-

controllable costs, without specifying the level and scope of management authority. It means

cost which is uncontrollable at one level of management may be controllable at another level

of management.

Figure 101: SAP CO

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E.g., Rent and Factory Building may be beyond control for the production department but can

be controlled by the administrative department by negotiations. Secondly all costs are

controllable in the long run and at an appropriate management level. IV On the basis of

Functions An organization performs many functions. On the basis of functions costs can be

classified as follows:

1) Manufacturing Costs: It is the cost of all items involved in the manufacturing of a

product or service. It includes all direct costs and all indirect costs related to the

production. It includes cost of direct materials, direct labor, direct expenses, and

overhead expenses related to production. Overhead expenses, means all indirect costs

involved in the production process. This is termed as factory overhead or

manufacturing overheads. Eg. Salaries of staff for production department, technical

supervision, Expenses of stores department, Depreciation of Plant and Machinery,

Repairs and maintenance of Factory Building and Machineries etc.

Figure 102: Profit center

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2) Administration Cost: These are costs incurred for general management of an organization.

It is the cost, which is incurred for formulating the policy, directing the organization of

controlling the operations. These are in the nature of indirect costs and are also termed as

administrative overhead. E.g., Salaries of Administrative Stall, General Office expenses like

rent, lighting, telephone, stationery, postage etc.

3) Selling and Distribution Costs: Selling costs are the indirect costs relating to selling of

products or services. They include all indirect costs in sales management for the organization.

Selling costs include all expenses relating to regular sales and sales promotion activities.

Examples of expenses which are included in selling costs are:

1) Salaries, Commission and traveling expenses for sales personnel

2) Advertisement cost

3) Legal Expenses for debt realization

4) Market research cost

5) Show room expenses

6) Discount allowed

7) Sample and free gifts

8) Rent on Sales room

9) After sale services

Distribution costs are the costs incurred in handling a product from the time it is completed in

the works until it reaches the ultimate consumer. Distribution expenses include all these

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expenses which are incurred in connection with making the goods available to customers.

These expenses include the following.

1) Packing charges

2) Loading charges

3) Carriage on Sales

4) Rent of warehouse

5) Insurance and lighting of warehouse

6) Transportation costs

7) Salaries of go down keeper, driver, packing staff etc. 4) Research and Development Cost:

Research and development costs are incurred to discover new ideas, processes, products by

experiment. It includes the cost of the process which begins with the implementation of the

decision to produce or improved product. V On the basis of Time On the basis of time of

computation, costs is classified into historical costs and predetermined costs.

Figure 103: Responsibility center

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1) Historical Costs: These are the costs which are ascertained after these have been incurred.

Historical costs are then nothing but actual costs. They represent the costs of actual

operational performance. These costs are not available until after the completion of

manufacturing operations.

2) Predetermined Costs: These are the future costs which are ascertained in advance of

production on the basis of a specification of all the factors affecting cost and cost data.

Predetermined costs are future costs determined in advance on the basis of standards or

estimates. These costs are extensively used for the purpose of planning and control. VI Other

Basis

Figure 104: Profit center

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1) Normal Cost: Normal cost may be defined as a cost which is normally incurred on

expected lines at a given level of output, in the condition in which that level of output in

normally attained. This cost is a part of production.

2) Abnormal Cost: Abnormal cost is that cost which is not normally incurred at a given level

of output, in the condition in which that level of output is normally attained. Such cost is over

and above the normal cost and is not treated as a part of the cost of production.

3) Avoidable Cost: The cost which can be avoided under the present conditions is an

avoidable cost. These are the costs which under given conditions of performance efficiency

should not have been incurred. They are logically associated with some activity and situation

and are ascertained by the 12 differences of actual cost with the happening of the situation

and the normal cost. E.g., When spoilage occurs in manufacturing in excess of normal limit,

the resulting cost of spoilage is avoidable cost.

Figure 105: Avoidable cost

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4) Unavoidable Cost: The cost which cannot be avoidable under the present condition is an

unavoidable cost. They are inescapable costs which are essentially to be incurred within the

limits or norms provided for. It is the cost that must be incurred under a programme of

business restriction.

Despite numerous advantages, some objections are generally raised against cost accounting.

As has been discussed earlier, cost accounting is voluntary, and no specific stereotyped

formats or systems of cost accounting are applicable to all industries. Thus, there is no

uniform procedure. This leads to difference in understanding and application of concepts,

methods and techniques of cost accounting by different industries. The major objections are:

It is expensive: Installation and maintenance of cost accounting system requires resources

analysis, allocation, absorption and apportionment of overheads require considerable amount

of clerical work. Unless benefits accruing from cost accounting are more than the costs

involved, it should not be sought. Different Results from Financial Records:

The results shown by the cost accounts generally differ from those shown by the financial

accounts due to a number of reasons. Preparation of reconciliation statements frequently is

necessary to verify their accuracy. This leads to an increase in workload. It is inapplicable:

Lack of common formats and systems makes it impossible to apply cost accounting to all

industries uniformly. Consequently, the systems need to be adapted by the respective industry

on the basis of their nature or the nature of the product manufactured or service rendered. It is

unnecessary: Maintenance of cost records leads to duplication of work i.e., Preparation of

financial accounts as well as cost accounts. Moreover, costing system itself does not control

costs or improve efficiency. If the management is alert and efficient, it can control costs

without the aid of the costing system. The system is complex:

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Cost accounting requires identification, categorization and allocation of the different types of

expenses, which is generally considered as complicated. Lack of Accuracy: Use of notional

cost such as standard cost, estimated cost hampers the accuracy of the cost results. Use of

Secondary Data: Cost accounting depends largely on financial statements. The limitations

and errors in the financial information directly affect the cost results. These objections are

flawed. Most of these drawbacks can be avoided if the cost accounting system is well

designed after taking into account technical details and advice of technical personnel of the

business, setting up an integrated system of accounts and administering the same in an

atmosphere of teamwork and co-operation.

Figure 106: Cost objectives

COST DRIVER

Chartered Institute of Management Accountants defines cost driver as ―an activity which

generates cost. A cost driver triggers a change in the cost of an activity and is generally used

to assign overhead costs to the number of produced units. An activity can have more than one

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cost driver attached to it. For example, a production activity may have a machine, machine

operator(s), floor space occupied, power consumed as the associated cost-drivers.

EXAMPLES OF COST DRIVERS

• Machine Set-ups • Purchase Orders

• Quality Inspections • Production Orders

• Shipments Maintenance • Requests Power

• Consumed Kilometers • Working

• Driven Projects Hours or • Advertisements

• Sales Volume Product Hours

COST UNIT, COST CENTRE AND PROFIT CENTRE COST UNIT

The chartered Institute of Management Accountants (CIMA), London, defines a unit of cost

as ―a unit of quantity of product, service or time in relation to which costs may be

ascertained or expressed The preparation of cost accounts requires selection of a unit for

identification of expenditure. The quantity upon which cost can be conveniently allocated is

known as cost unit. For example: in case of electricity companies cost unit will be per unit of

electricity generated and in case of transport companies, it will be per passenger-km. Or per

tone-km.

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COST CENTRE

According to the Chartered Institute of Management Accountants, England, cost center

means ―a location, person or item of equipment or group of these for which costs may be

ascertained and used for the purpose of cost control. It can be a department or a sub-

department or an item of equipment or machinery or a group of persons.

PROFIT CENTRE

A profit center is a business unit or department within an organization that generates revenues

and profits or losses. Here, both the inputs and outputs are measured in monetary terms, and

accounting for both costs and revenues results in automatic computation of profit with respect

to this center, termed as profit center.

Figure 107: Elements of cost

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A brief explanation of the elements has been given below:

Material: The basic substance used for producing the product is referred to as material.

Material can be direct or indirect in nature.

Direct Material: The materials which directly contribute to the production of the product and

are easily identifiable in the finished product are called direct materials. Cloth in shirt, paper

in books, wood in furniture are examples of direct materials.

Indirect Material: Other material which is ancillary in the production of any finished

product and cannot be conveniently assigned to specific physical units is called indirect

material. For example, printing in stationery, scissors used in cutting cloth for shirt, nails in

shoes or furniture. Labour refers to the human effort needed for conversion of materials into

finished goods. Labour can be direct or indirect.

Direct Labour: Labour which takes an active and direct part in the production of a particular

commodity and can be directly co-related to any specific activity of production is termed as

direct labour. Process labour, productive labour, operating labour, manufacturing labour,

direct wages etc are used synonymously with direct labour. Indirect Labour: Employees who

do not directly take part in the manufacturing process and whose cost cannot be identified

with the individual cost centre are included under indirect labour. Such labour does not alter

the construction, composition or condition of the product.

Salary of foreman, salesmen and director are some examples of indirect labour. Expenses:

Costs incurred in the production process but not included under material or labour are

generally expenses. They can be direct or indirect. -Direct Expenses: These are expenses

which can be directly, conveniently and wholly allocated to specific cost centers or cost units.

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Direct expenses are sometimes also described as ―chargeable expenses’ Indirect Expenses:

All expenses other than direct expenses are indirect in nature.

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 CHAPTER 7: Material cost control and inventory control

Inventories occupy the most strategic position in the structure of working capital of most

business enterprises. It constitutes the largest component of current asset in most business

enterprises. In the sphere of working capital, the efficient control of inventory has passed the

most serious problem to the cement mills because about two-third of the current assets of

mills are blocked in inventories. The turnover of working capital is largely governed by the

turnover of inventory. It is therefore quite natural that inventory which helps in maximize

profit occupies the most significant place among current assets. Meaning and Definition of

Inventory In dictionary meaning of inventory is a “detailed list of goods, furniture etc.” Many

understand the word inventory, as a stock of goods, but the generally accepted meaning of the

word ‘goods’ in the accounting language, is the stock of finished goods only.

In a manufacturing organization, however, in addition to the stock of finished goods, there

will be stock of partly finished goods, raw materials and stores. The collective name of these

entire items is ‘inventory’. The term ‘inventory’ refers to the stockpile of production a firm is

offering for sale and the components that make up the production. 186 The inventory means

aggregate of those items of tangible personal property which.

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 Figure 108: Inventory control

(i) Are held for sale in ordinary course of business.

(ii) Are in process of production for such sales.

(iii) They are to be currently consumed in the production of goods or services to be

available for sale.

Inventories are expandable physical articles held for resale for use in manufacturing a

production or for consumption in carrying on business activity such as merchandise, goods

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purchased by the business which are ready for sale. It is the inventory of the trader who dies

not manufacture it.

Figure 109: Inventory control

Finished Goods: Goods being manufactured for sale by the business which are ready for sale.

Materials: Articles such as raw materials, semi-finished goods or finished parts, which the

business plans to incorporate physically into the finished production. Supplies: “Article,

which will be consumed by the business in its operation but will not physically as they are a

part of the production. The short inventory may be defined as the material, which are either

saleable in the market or usable directly or indirectly in the manufacturing process. It also

includes the 187 items which are ready for making finished goods in some other process or

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by comparing them either by the concern itself and/or by outside parties. In other words, the

term inventory means the material having any one of the following characteristics. It may be

1. Saleable in the market,

2. Directly saleable in the manufacturing process of the business,

3. Usable directly in the manufacturing process of the undertaking, and

4. Ready to send to the outside parties for making usable and saleable productions out of it.

Figure 110: Practices of inventory control

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In the present study raw materials, stores and spare parts, finished goods and work-in-process

have been included inventories. Firm also manufactures inventory to supplies. Supplies

included office and plant cleaning materials (soap, brooms etc. Oil, fuel, light bulbs and the

likes). These materials do not directly enter into the production process but are necessary for

the production process. Inventory constitutes the most significant part of current assets of a

large majority of companies in India. For example, on an average inventory are more than 57

per cent of current assets in public limited companies and about 60.5per cent in government

companies in India. Therefore, it is absolutely imperative to manage inventories efficiently

and effectively in order to avoid unnecessary investment in them.

An undertaking neglecting the management of inventories will be jeopardizing its long 188

run profitability and may fail ultimately. It is possible for a company to reduce its level of

inventories to a considerable degree e.g., 10 to 20 per cent without any adverse effect on

production and sales. Management of Inventories consist of raw materials, stores, spares,

packing materials, coal, petroleum products, works-in-progress and finished products in stock

either at the factory or deposits. It is most important component of current assets in the

cement industry and was 42 per cent of total current assets for sample companies as on March

31, 2004. In other industries too it is very important component of total investment. The

maintenance of inventory means blocking of funds and so it involves the interest and

opportunity cost to the firm. In many countries specially in Japan great emphasis is placed on

inventory management.

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 Figure 111: Inventory management techniques

Efforts are made to minimize the stock of inputs and outputs by proper planning and

forecasting of demand of various inputs and producing only that much quantity which can be

sold in the market. The inventory cost is not only interest on stocks but also cost of store

building for storage, insurance and obsolesce and movement of inputs from place of storage

to the factory where the materials have to be finally used to convert them into finished goods.

In japan industries have adopted concept of JIT (Just in Time) and components, materials are

received when required for which detailed instructions are given to suppliers. There are many

engineering companies who receive 189 components directly at assembly point and that too

only for 3-4 hours requirements at a time.

Even in case of bulk materials like iron ore, which is imported from abroad, the minimum

possible inventory is kept. As against this by and large in India the inventory of coal, raw

157
materials and packing materials is very high and many items become junk or obsolete causing

heavy loss to the enterprise. Lack of inventory planning in India has been pointed out by

various committees but due to uncertainties in supplies, problem of timely receipt of railway

wagons, lack of planning and unreliable suppliers the investment in inventories is quite high.

The fluctuation in demand affects inventory of finished product of which cement industry has

been a victim many times. The situation in cement industry has been analyzed in this chapter

after studying the principles of inventory control and relating it with cement industry.

In case of raw materials, the first requirement is to study lead time between the date of order

and receipt in the factory and same is applicable in case of coal. In the case of cement

industry, the basic raw material i.e., Limestone is not purchased from the market but form

one’s own queries which are within 10 to 15 Km distance from factory and only in few cases

distance is more up to 50 Km. It is transported to cursing mills by trucks, rail or overhead

ropeways to the factory. The only uncertainty is with regard to problem of quarrying in

quarries, which may be affected due to labor 190 problems, problem in supplies of electricity

or explosives. But in spite of these factors industry feels that 3-4 days of stock of raw

material is enough. This, from any standard is on the high side when self-produced raw

material is used. Actually, for ideal situation there should be stock for a few hours,

requirement and at the most for one day need. The industry is keeping larger stocks of

limestone because of uncertainties in quarrying and transportation.

Objectives of Inventory Management The primary objectives of inventory management are:

(i) To minimize the possibility of disruption in the production schedule of a firm for want of

raw material, stock and spares.

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(ii)To keep down capital investment in inventories. So it is essential to have necessary

inventories. Excessive inventory is an idle resource of a concern. The concern should always

avoid this situation.

Figure 112: Role of inventory management

The investment in inventories should be just sufficient in the optimum level. The major

dangers of excessive inventories are:

(i) The unnecessary tie up of the firm’s funds and loss of profit.

(ii) Excessive carrying cost, and

(iii) The risk of liquidity. The excessive level of inventories consumes the funds of

business, which cannot be used for any other purpose and thus involves an

opportunity cost.

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The carrying cost, such as the cost of shortage, handling insurance, recording and inspection,

191 are also increased in proportion to the volume of inventories. This cost will impair the

concern profitability further. On the other hand, a low level of inventories may result in

frequent interruptions in the production schedule resulting in under-utilization of capacity and

lower sales. The aim of inventory management thus should be to avoid excessive inventory

and inadequate inventory and to maintain adequate inventory for smooth running of the

business operations. Efforts should be made to place orders at the right time with the right

source to purchase the right quantity at the right price and quality. The effective inventory

management should

(i) Maintain sufficient stock of raw material in the period of short supply and

anticipate price changes.

(ii) Ensure a continuous supply of material to production department facilitating

uninterrupted production.

(iii) Minimize the carrying cost and time.

(iv) Maintain sufficient stock of finished goods for smooth sales operations.

(v) Ensure that materials are available for use in production and production services

as and when required.

(vi) Ensure that finished goods are available for delivery to customers to fulfil orders,

smooth sales operation and efficient customer service.

(vii) Minimize investment in inventories and minimize the carrying cost and time. 192

(viii) Protect the inventory against deterioration, obsolescence and unauthorized use.

160
(ix) Maintain sufficient stock of raw material in period of short supply and anticipate

price changes.

(x) Control investment in inventories and keep it at an optimum level. Problems faced

by management: (i) to maintain a large size inventories for efficient and smooth

production and sales operation. (ii) To maintain only a minimum possible

inventory because of inventory holding cost and opportunity cost of funds

invested in inventory. (iii) Control investment in inventories and keep it at the

optimum level. Inventory management, therefore, should strike a balance between

too much inventory and too little inventory. The efficient management and

effective control of inventories help in achieving better operational results and

reducing investment in working capital.

Figure 113: Weakness invention of the factors

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It has a significant influence on the profitability of a concern. Inventory Control Inventory

control is concerned with the acquisition, storage, handling and use of inventories so as to

ensure the availability of inventory whenever needed, providing adequate provision for

contingencies, deriving maximum economy and minimizing wastage and losses. 193

Hence Inventory control refers to a system, which ensures the supply of required quantity

and quality of inventory at the required time and at the same time prevent unnecessary

investment in inventories. It is one of the most vital phases of material management.

Reducing inventories without impairing operating efficiency frees working capital that

can be effectively employed elsewhere. Inventory control can make or break a company.

This explains the usual saying that “inventories” are the graveyard of a business.

Designing a sound inventory control system is in a large measure for balancing

operations.

It is the focal point of many seemingly conflicting interests and considerations both short

range and long range. The aim of a sound inventory control system is to secure the best

balance between “too much and too little.” Too much inventory carries financial rises and

too little reacts adversely on continuity of productions and competitive dynamics. The

real problem is not the reduction of the size of the inventory as a whole but to secure a

scientifically determined balance between several items that make up the inventory. The

efficiency of inventory control affects the flexibility of the firm. Insufficient procedures

may result in an unbalanced inventory.

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 Figure 114: Inventory control

Some items out of stock, other overstocked, necessitating excessive investment. These

inefficiencies ultimately will have adverse effects upon profits. Turning the situation

round, difference in the efficiency of the inventory 194 control for a given level of

flexibility affects the level of investment required in inventory. The less efficient is the

inventory control, the greater is the investment required. Excessive investment in

inventories increase cost and reduce profits, thus, the effects of inventory control of

flexibility and on level of investment required in inventories represent two sides of the

same coin. Control of inventory is exercised by introducing various measures of

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inventory control, such as ABC analysis fixation of norms of inventory holdings and

reorder point and a close watch on the movements of inventories.

Figure 115: Inventory analysis

Inventories Control Techniques ABC Analysis of Inventories

The ABC inventory control technique is based on the principle that a small portion of the

items may typically represent the bulk of money value of the total inventory used in the

production process, while a relatively large number of items may from a small part of the

money value of stores. The money value is ascertained by multiplying the quantity of

material of each item by its unit price. According to this approach to inventory control

high value items are more closely controlled than low value items. Each item of inventory

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is given A, B or C denomination depending upon the amount spent for that particular

item. “A” 195 or the highest value items should be under the tight control and under

responsibility of the most experienced personnel, while “C” or the lowest value may be

under simple physical control.

It may also be clear with the help of the following examples: “A” Category – 5% to 10%

of the items represent 70% to 75% of the money value. “B” Category – 15% to 20% of

the items represent 15% to 20% of the money. “C” Category – The remaining number of

the items represent 5% to 10% of the money value. The relative position of these items

show that items of category A should be under the maximum control, items of category B

may not be given that much attention and item C may be under a loose control.

Particulars A item B item C item

Control Tight Moderate Loose

Requirement Exact Exact Estimated

Check Close Some Little

Regular
Expenditure Some No

Industrial
Posting Individual Group/none

Low
Safety Medium Lare

Stock

After classification, the items are ranked by their value and then the cumulative

percentage of total value against the percentage of item is noted. A detailed analysis of

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inventory may indicate above figure that only 10 per cent of item may account for 75 per

cent of the value, another 10 per cent of item may account for 15 per cent of the value and

remaining percentage items may account for 10 per cent of the value. The importance of

this tool lies in the fact that it directs attention to the key items.

Advantages of ABC Analysis

1. It ensures a closer and a stricter control over such items, which are having a sizable

investment in there.

2. It releases working capital, which would otherwise have been locked up for a more

profitable channel of investment.

3. It reduces inventory-carrying cost.

4. It enables the relaxation of control for the ‘C’ items and thus makes it possible for a

sufficient buffer stock to be created. 197

5. It enables the maintenance of high inventory turnover rate. Fixation of Norms of

Inventory Holdings Either by the top management or by the materials department could

set the norms for inventories.

The top management usually sets monitory limits for investment in inventories. The

materials department has to allocate this investment to the various items and ensure the

smooth operation of the concern. It would be worthwhile if norms of inventories were set

by the management by objectives, concept. This concept expects the top management to

set the inventory norms (limit) after consultation with the materials department. A

number of factors enter into consideration in the determination of stock levels for

individual items for the purpose of control and economy.

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Some of them are: 1. Lead time for deliveries. 2. The rate of consumption. 3.

Requirements of funds. 4. Keeping qualities, deterioration, evaporation etc. 5. Storage

cost. 6. Availability of space. 7. Price fluctuations. 8. Insurance cost. 9. Obsolescence

price. 10. Seasonal consideration of price and availability. 11. EOQ (Economic Order

Quantity), and 12. Government and other statuary restriction 198 Any decision involving

procurement storage and uses of item will have to be based on an overall appreciation of

the influence of the critical ones among them. Material control necessitates the

maintenance of inventory of every item of material as low as possible ensuring at the

same time, its availability as and when required for production.

These twin objectives are achieved only by a proper planning of inventory levels. It the

level of inventory is not properly planned, the results may either be overstocking or

understocking. If a large stock of any item is carried it will unnecessarily lock up a huge

amount of working capital and consequently there is a loss of interest. Further, a higher

quantity than what is legitimate would also result in deterioration. Besides there is also

the risk of obsolescence if the end product for which the inventory is required goes out of

fashion. Again, a large stock necessarily involves an increased cost of carrying such as

insurance, rent handling charges.

Under stocking, which is another extreme, is equally undesirable as it results in stock outs

and the consequent production holds ups. Stoppage of production in turn, cause idle

facility cost. Further, failure to keep up delivery schedules results in the loss of customers

and goodwill. These two extremes can be avoided by a proper fixation of two important

inventory level viz, the maximum level and the minimum level. The fixation of inventory

levels is also known as the demand and supply method of inventory control. 199 Carrying

too much or too little of the inventories is detrimental to the company. If too little

167
inventories are maintained, company will have to encounter frequent stock outs and incur

heavy ordering costs.

Very large inventories subject the company to heavy inventory carrying cost in addition

to unnecessary ties up of capital. An efficient inventory management, therefore, requires

the company to maintain inventories at an optimum level where inventory costs are

minimum and at the same time there is no stock out which may result in loss of sale or

stoppage of production. This necessitates the determination of the minimum and

maximum level of inventories. Minimum Level The minimum level of inventories of

their reorder point may be determined on the following bases:

1 Consumption during lead-time.

2 Consumption during lead-time plus safety stock.

3 Stock out costs.

4 Customers irritation and loss of goodwill and production hold costs.

To continue production during Lead Time it is essential to maintain some inventories.

Lead Time has been defined as the interval between the placing of an order (with a

supplier) and the time at which the goods are available to meet the consumer needs. There

are sometimes fluctuations in the lead-time and/ or in the consumption rate. If no

provision is made for these 200 variations, stock out may take place-causing disruption in

the production schedule of the company. The stock, which takes care to the fluctuation in

demand, varies in lead-time and consumption rate is known as safety stock. Safety stock

may be defined as the minimum additional inventory, which serves as a safety margin or

buffer or cushion to meet an unanticipated increase in usage resulting from an unusually

high demand and or an uncontrollable late receipt of incoming inventory.

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It can be determined on the basis of the consumption rate, plus other relevant factor such

as transport bottleneck, strikes or shutdowns. In the case of uncertainly, the probabilistic

approach may be applied to determine the safety margin. To avoid stock out arising out of

such eventualities, companies always carry some minimum level of inventories including

safety stock. Safety stock may not be static for all the times. A change in the

circumstances and in the nature of industry demand, necessitates are adjusted in its level.

In this study an effort has been made to examine how the current companies determine

their minimum level for re-order inventories, safety stock, whether a level of study is

maintained throughout the year or not. For each type of inventory, a maximum level is set

that demand presumably will not exceed as well as a minimum level representative a

margin of safety required to prevent out of stock condition.

The minimum level also governs the ordering point. An order to sufficient size is placed

to bring 201 inventories to the maximum point when the minimum level is reached.

Maximum Level The upper limit beyond which the quantity of any item is not normally

allowed to rise is known as the “Maximum Level”. It is the sum total of the minimum

quantity, and ECQ. The fixation of the maximum level depends upon a number of factors,

such as, the storage space available, the nature of the material i.e. Chances of

deterioration and obsolescence, capital outlay, the time necessary to obtain fresh supplies,

the ECQ, the cost of storage and government restriction.

Re-Order Level Also known as the ‘ordering level’ the reorder level is that level of stock

at which a purchase requisition is initiated by the storekeeper for replenishing the stock.

This level is set between the maximum and the minimum level in such a way that before

the material ordered for are received into the stores, there is sufficient quantity on hand to

cover both normal and abnormal circumstances. The fixation of ordering level depends

upon two important factors viz, the maximum delivery period and the maximum rate of

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consumption. Re-Order Quantity The quantity, which is ordered when the stock of an

item falls to the reorder level, is known as the reorder quantity or the EOQ or the

economic lot size.

Although it is not a stock level as such, the reorder quantity has a direct bearing upon the

stock level in as much as it is necessary to consider the maximum 202 and minimum

stock level in determining the quantity to be ordered. The re-order quantity should be

such that, when it is added to the minimum quantity, the maximum level is not exceeded.

The re-order quantity depends upon two important factors viz, order costs and inventory

carrying costs. It is, however, necessary to remember that the ordering cost and inventory

carrying cost are opposed to each other. Frequent purchases in small quantities, no doubt

reduce carrying cost, but the ordering costs such as the cost inviting tenders of placing

order and of receiving and inspection, goes up. If on the other hand purchases are made in

large quantities, carrying costs, such as, the interest on capital, rent, insurance, handling

charges and losses and wastage, will be more than the ordering costs. The EOQ is

therefore determined by balancing these opposing costs.

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 Figure 116: Units per order

Economy Order Quantity the EOQ refers to the order size that will result in the lowest

total of order and carrying costs for an item of 203 inventory. If a firm place unnecessary

orders, it will incur unneeded order costs. If a firm places too few orders, it must maintain

large stocks of goods and will have excessive carrying cost. By calculating an economic

order quantity, the firm identifies the number of units to order that result in the lowest

total of these two costs. The constraints and assumption followed:

1. Demand is known-- Using past data and future plans a reasonably accurate prediction

of demand can often be made. This is expressed in unit sold in a year.

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 2. Sales occur at a constant rate-- This model may be used for goods that are sold in

relatively constant amount throughout the year. A more complicated model is needed for

firms whose sales fluctuate in response to their seasonal cyclical factors.

3. Cost of running of goods is ignored-- Cost associated with storage, delays or lost sales

are not considered. These costs are considered in the determination of safety level in the

re-order point subsystem.

4. Safety stock level is not considered-- The safety stock level is the minimum level of

inventory that the firm wishes to hold as a protection against running out. Since the firm

must always be above this level the EOQ need not be considered the safety stock level.

Trial and error approach Select a number of possible lot (Order) sizes to purchase, then

determine the total cost for each lot size chosen, now select the ordering quantity that

minimizes the total cost. Quantity Discount and Order Quantity The standard EOQ analysis is

based on the assumption that the price per unit remains constant irrespective of the order size.

When quantity discount are available which is often the case, price per unit is influenced by

the ordered quantity. This violates the applicability of the EOQ formulas. However, 205 the

EOQ framework can still be used as a starting point for analyzing the problem. To determine

the optimal order size when quantity discount is available, the following procedures may be

followed:

1. Determine the order quantity using the standard EOQ formula assuming no quantity

discount.

2. If Q enables the firm to get quantity discount, then it represents the optimal order size.

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 CHAPTER 8: Labor cost accounting and Overheads

The following is the text of the COST ACCOUNTING STANDARD 3 (CAS- 3) issued by

the Council of the Institute of Cost and Works Accountants of India on “Overheads”. The

standard deals with the method of collection, allocation, apportionment and absorption of

overheads” In this Standard, the standard portions have been set in bold italic type. These

should be read in the context of the background material which has been set in normal type.

1. Introduction

In Cost Accounting the analysis and collection of overheads, their allocation and

apportionment to different cost centers and absorption to products or services plays an

important role in determination of cost as well as control purposes. A system of better

distribution of overheads can only ensure greater accuracy in determination of cost of

products or services. It is, therefore, necessary to follow standard practices for allocation,

apportionment and absorption of overheads for preparation of cost statements.

Figure 117: Types of overhead cost

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2. Objective

The standard is to prescribe the methods of collection, allocation, apportionment of overheads

to different cost centers and absorption thereof to products or services on a consistent and

uniform basis in the preparation of cost statements and to facilitate inter-firm and intra-firm

comparison. The standardization of collection, allocation, apportionment and absorption of

overheads is to provide a scientific basis for determination of cost of different activities,

products, services, assets, etc. The standard is to facilitate in taking commercial and strategic

management ` decisions such as resource allocation, product mix optimization, make or buy

decisions, price fixation etc. The standard aims at ensuring better disclosure requirement and

transparency in the cost statement.

Figure 118: Allocated overhead

3. Scope

The standard should be followed for treatment of overheads by all enterprises including

companies covered under Cost Accounting Records Rules issued in pursuant to Sec 209(1)(d)

174
of the Companies Act, 1956 or under the provisions of any other Act, Rules and Regulations.

The standard shall be applied in Cost and Management Accounting practices relating to (a)

Cost of products, services or activities (b) Valuation of stock (c) Transfer pricing (d) Segment

Performance (e) Excise / Custom duty, VAT, Income Tax, Service Tax and other levies,

duties and abatement fixation (f) Cost statements for any other purpose.

Figure 119: Flows of cost

4. Definitions:

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Overheads – Overheads comprise of indirect materials, indirect employee costs and indirect

expenses which are not directly identifiable or allocable to a cost object in an economically

feasible way. Overheads are to be classified on the basis of functions to which the overheads

are related (Refer to ‘ Classification of cost’ – CAS-1), viz - Production overheads -

Administrative overheads - Selling overheads - Distribution overheads may also be classified

on the basis of behavior such as variable overheads, semi-variable overheads and fixed

overheads. Variable overheads comprise of expenses which vary in proportion to the change

of volume of production. For example, cost of utilities etc. Fixed overheads comprise of

expenses whose value do not change with the change in volume of production such as

salaries, rent etc. Semi-variable overheads are partly affected by change in the production

volume.

Figure 120: Accounting for the labour cost

176
They are further segregated into variable overheads and fixed overheads Any items of

overheads arising out of abnormal situation in business activity should not be treated as

overheads. They are charged to Costing Profit and Loss Account. Items not related to

business activities such as donation, loss / profit on sale of assets etc. are also not to be

treated as overheads. Borrowing cost and other financial charges including foreign exchange

fluctuations will not form the part of overheads.

Collection of Overheads - Collection of overheads means the pooling of indirect items of

expenses from books of account and supportive/ corroborative records in logical groups

having regards to their nature and purpose. Overheads are collected on the basis of pre-

planned groupings, called cost pools. Homogeneity of the cost components in respect of their

behavior and character is to be considered in developing the cost pool. Variable and fixed

overheads should be collected in separate cost pools under a cost center. A great degree of

homogeneity in the cost pools are to be maintained to make the apportionment of overheads

more rational and scientific.

177
 Figure 121: Stages of labor cost

A cost pool for maintenance expenses will help in apportioning them to different cost centers

which use the maintenance service. 4.3 Allocation of overheads – Allocation of overheads is

assigning a whole item of cost directly to a cost center. An item of expense which can be

directly related to a cost center is to be allocated to the cost center. For example, depreciation

of a particular machine should be allocated to a particular cost center if the machine is

directly attached to the cost center. 4.4 Apportionment of overhead - Apportionment of

overhead is distribution of overheads to more than one cost center on some equitable basis.

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When the indirect costs are common to different cost centers, these are to be apportioned to

the cost centers on an equitable basis.

For example, the expenditure on general repair and maintenance pertaining to a department

can be allocated to that department but has to be apportioned to various machines (Cost

Centers) in the department. If the department is involved in the production of a single

product, the whole repair & maintenance of the department may be allocated to the product.

4.5 Primary and Secondary Distribution of Overheads: In case of multi-product environment,

there are common service cost centers which are providing services to the various production

cost centers and other service cost centers.

Figure 122: Labor cost

The costs of services are required to be apportioned to the relevant cost centers. First step to

be followed is to apportion the overheads to different cost centers and then second step is to

179
apportion the costs of service cost centers to production cost centers on an equitable basis.

The first step is termed as primary distribution and the second step is termed as secondary

distribution of overheads.

Figure 123: Process of the distribution cost

5. Apportionment and absorption of Production Overheads

Overheads are to be apportioned to different cost centers based on following two principles:

i) Cause and Effect - Cause is the process or operation or activity and effect is the incurrence

of cost. Apportionment of overheads based on this criterion ensures better rationality as it is

guided by the relationship between cost object and cost. Ii) Benefits received – overheads are

to be apportioned to the various cost centers in proportion to the benefits received by them.

Primary Distribution of overheads: Basis of primary apportionment of items of production

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overheads is to be selected to distribute them among the cost centers following the above two

principles as given above.

Basis of apportionment must be rational to distribute overheads. Once the base is selected, the

same is to be followed consistently and uniformly. However, change in basis for

apportionment can be adopted only when it is considered necessary due to change in

circumstances like change in technology, degree of mechanization, product mix, etc. In case

of such changes, proper disclosure in cost records is essential.

Item of Cost Basis of Apportionment

Power Consumption rate x hour Machine hours or

Fuel Man hours.

Jigs, tools & fixtures Crane hours or weight of materials handled.

Crane Number of employees

Hire charges. Number of employees

Supervisors’ salary & fringe benefits Floor or Space area

Labor welfare cost Value of fixed asset

Rent & rates. Value of fixed asset

Insurance Depreciation

Secondary Distribution of Overheads:

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Secondary distribution of overheads may be done by following either Reciprocal basis or

Non-Reciprocal Basis. While reciprocal basis considers the exchange of service among the

service departments, non-reciprocal basis considers only one directional service flow from a

service cost center to other production cost center(s).

Figure 124: Secondary distribution of cost

Secondary Apportionment of Overheads on Reciprocal Basis the services rendered by certain

service cost centers are also utilized by other service cost centers. In reciprocal secondary

distribution, the cost-of-service cost centers are apportioned to production cost center’s as

well as other service cost centers. In such case, any one of the following three methods may

be followed: I. Repeated Distribution Method II. Trial & Error Method III. Simultaneous

Equation Method

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Repeated Distribution Method Steps to be followed under this method are: i) The proportion

at which the costs of a service cost centre’s are to be distributed to production cost centre’s

and other service cost centre’s are determined. Ii) Costs of first service cost centres are to be

apportioned to production cost centre have and service cost centres in the proportion as

determined in step (i). Iii) Similarly, the cost of other service cost centres is to be

apportioned. Iv) This process as stated in (ii) and (iii) are to be continued till the figures

remaining undistributed in the service cost centre’s are negligibly small.

Figure 125: Cost overhead

The negligible small amount left with service centre may be distributed to production cost

centres. For example, refer to Exhibit 1 5.4.2 Trial and Error Method This method is to be

followed when the question of distribution of costs of service cost centres which are

183
interlocked among themselves arises. In the first stage, gross costs of services of service cost

centres are determined and then in the second stage, costs of service centre’s are apportioned

to production cost centres. Steps to be followed: i) the proportion at which the costs of a

service cost centre to be distributed to production cost centre’s and other service cost centre’s

is determined. Ii) Cost of first service cost centre is distributed to the other service centre’s in

the proportion of service they received from the first as assessed in step (i). Iii) In the next

step, total cost of second service cost centre so arrived has to be distributed to the other

service centers in the proportion of service they received from the second as assessed in step

(i). Iv) Similarly, the cost of other service cost centers are to be apportioned to the service

cost centers. V) This process as described in (iii) and (iv) is to be continued till the figures

remaining undistributed in the service cost centers are negligibly small. Vi) At the last, total

cost of service cost centers to be distributed to production cost centers.

For example, refer to Exhibit 2 5.4.3 Simultaneous Equation Method The simultaneous

equation method is to be adopted to take care of secondary distribution of cost-of-service cost

centers to production cost centres with the help of mathematical formulation and solution.

Steps to be followed: i) Proportion of service benefits received by different cost centres from

a cost centre are assessed on the basis of records ii) The same ratios are used as coefficients

in the equations framed for apportionment of cost-of-service cost centers to production cost

centres. Iii) Solution of the equations gives the cost-of-service cost centers. Iv) Cost of

service cost centres to be distributed to production cost centers.

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 CHAPTER 9: Activity-Based Costing (ABC)

As discussed in chapter 4 i.e., Overhead, in the traditional costing system, overhead costs are

grouped together under cost center and then absorbed into product costs on one of the basics

such as direct labor hours, machine hours, volume etc. In certain cases, this traditional costing

system gives inaccurate cost information. Though, it should not be assumed that all

traditional absorption costing systems are not accurate enough to give adequate information

for pricing purposes or other long-run management decision purposes. Some traditional

systems treat overheads in a detailed way and relate them to service cost centers as well as

production cost centers.

Figure 126: Activity based cost formula.

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The service center overheads are then spread over the production cost centers before

absorption rates are calculated. The main cause of inaccuracy is in the calculation of the

overhead rate itself, which is usually based on direct labor hours or machine hours. These

rates assume that products that take longer to make, generate more overheads and so on.

Organizations who do not wish to know how much it costs to make a product with precise

accuracy, may be happy with a traditional costing system. Others however fix their price on

cost and need to be able to determine it with reasonable accuracy.

The latter organizations have greatly benefitted from the development of activity-based

costing (ABC), which is more a modern absorption costing method, and was evolved to give

more accurate product costs.

Figure 127: Activities of cost

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Factors prompting the development of ABC Various factors lead to the development of

ABC include:

1. Growing overhead costs because of increasingly automated production

2. Increasing market competition which necessitated more accurate product costs.

3. Increasing product diversity to secure economies of scope & increased market share.

4. Decreasing costs of information processing because of continual improvements and

increasing application of information technology.

Figure 128: Cost activities

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Usefulness/Suitability of ABC ABC is particularly needed by organizations for product

costing in the following situation: 1. High amount of Overhead: When Production overheads

are high and significant cost, ABC will be very much useful instead of traditional costing

system.

Figure 129: Process of cost activities

Wide range of products: ABC is most suitable, when, there is a diversity in the product range

or there are multiple products. 3. Presence of Non-volume related activities: When non-

volume related activities e.g. Material handling, inspection set-up, are present significantly

and traditional system cannot be applied, ABC is a superior and better option. ABC will

identify non-value-adding activities in the production process that might be a suitable focus

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for attention or elimination. 4. Stiff competition: When the organization is facing stiff

competition and there is an urgent requirement to compute cost accurately and to fix the

selling price according to the market situation, ABC is very useful. ABC also can facilitate in

reducing cost by identifying non-value-adding activities in the production process that might

be a suitable focus for attention or elimination.

Figure 130: Process of ABC costing

Activity Based Costing is an accounting methodology that assigns costs to activities rather

than products or services. This enables resources & overhead costs to be more accurately

assigned to products & services that consume them. ABC is a technique which involves

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identification of cost with each cost driving activity and making it as the basis for

apportionment of costs over different cost objects/ jobs/ products/ customers or services.

ABC assigns cost to activities based on their use of resources. It then assigns cost to cost

objects, such as products or customers, based on their use of activities. ABC can track the

flow of activities in organization by creating a link between the activity (resource

consumption) and the cost object.

CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of

activities which involves tracing resource consumption and costing final outputs. Resources

are assigned to activities, and activities to cost objects based on consumption estimates. The

latter utilise cost drivers to attach activity costs to outputs.” 5.3 MEANING OF TERMS

USED IN ABC (i) Activity – Activity, here, refers to an event that incurs cost. (ii) A Cost

Object–It is an item for which cost measurement is required e.g. A product or a customer. 5

© The Institute of Chartered Accountants of India

Figure 131: Cost Allocation under Traditional and Activity Based Costing system.

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COST AND MANAGEMENT ACCOUNTING

A Cost Driver–It is a factor that causes a change in the cost of an activity. There are two

categories of cost driver. Example Production runs • A Resource Cost Driver– It is a measure

of the quantity of resources consumed by an activity. It is used to assign the cost of a resource

to an activity or cost pool.

• An Activity Cost Driver–It is a measure of the frequency and intensity of demand, placed

on activities by cost objects. It is used to assign activity costs to cost objects. (iv) Cost Pool-It

represents a group of various individual cost items. It consists of costs that have same cause

effect relationship. Example Machine set-up.

Cost Allocation under Traditional and Activity Based Costing system In traditional

absorption costing overheads are first related to cost centres (Production & Service Centres)

and then to cost objects, i.e., products. In ABC overheads are related to activities or grouped

into cost pools. Then they are related to the cost objects, e.g., products. The two processes

are, therefore, very similar, but the first stage is different as ABC uses activities instead of

functional departments (cost centres). The problem with functional departments is that they

tend to include a series of different activities, which incur a number of different costs that

behave in different ways.

Activities also tend to run across functions; for instance, procurement of materials often

includes raising a requisition note in a manufacturing department or stores. It is not raised in

the purchasing department where most procurement costs are incurred. Activity costs tend to

behave in a similar way to each other i.e., they have the same cost driver.

Activity Based Costing Traditional Absorption Costing

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 • Overheads are related to activities and • Overheads are related to cost

grouped into activity cost pools centers/departments.

• Costs are related to activities and • Costs are related to cost centers and

hence are more realistic. hence not realistic of cost behavior

• Activity–wise cost drivers are • Time (Hours) are assumed to be the

determined. only cost driver governing costs in all

departments.
• Activity–wise recovery rates are

determined and there is no concept of • Either multiple overhead recovery

a single overhead recovery rate. rate (for each department) or a single

overhead recovery rate may be

• Cost are assigned to cost objects, e.g.
determined for absorbing overheads.
Customers, products, services,

departments, etc • Costs are assigned to Cost Units i.e.

To products, or jobs or hours.

• Essential activities can be simplified

and unnecessary activities can be • Cost Centers/ departments cannot be

eliminated. Thus the corresponding eliminated. Hence not suitable for

costs are also reduced/ minimized. cost control.

Hence ABC aids cost control.

Identify the different activities within the organisation: Usually the number of cost centres

that a traditional overhead system uses are quite small, say up to fifteen. In ABC the number

of activities will be much more, say 200; the exact number will depend on how the

management subdivides the organisation’s activities. It is possible to break the organisation

down into many very small activities. But if ABC is to be acceptable as practical system it is

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necessary to use larger groupings, so that, say, 40 activities may be used in practice. The

additional number of activities over cost centres means that ABC should be more accurate

than the traditional method regardless of anything else. Some activities may be listed as

follows:-

• Production schedule changes

• Customer liaison

• Purchasing

• Production process set up

• Quality control

• Material handling

• Maintenance

(2) Relate the overheads to the activities, both support and primary, that caused them. This

creates ‘cost pools’ or ‘cost buckets’. This will be done using resource cost drivers that reflect

causality. (3) Support activities are then spread across the primary activities on some suitable

base, which reflects the use of the support activity. The base is the cost driver that is the

measure of how the support activities are used. (4) Determine the activity cost drivers that

will be used to relate the overheads collected in the cost pools to the cost objects/products.

This is based on the factor that drives the consumption of the activity. In production

scheduling, for example, the driver will probably be the number of batches ordered. (5)

Calculate activity cost driver rates for each activity, just as an overhead absorption rate would

be calculated in the traditional system.

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 Figure 132: Gender ledger

The activity driver rate can be used to cost products, as in traditional absorption costing, but it

can also cost other cost objects such as customers/customer segments and distribution

channels. The possibility of costing objects other than products is part of the benefit of ABC.

The activity cost driver rates will be multiplied by the different amounts of each activity that

each product/other cost object consumes.

Cost allocation under ABC Let us take a small example to understand the steps stated above:

Assume that a company makes widgets and the management decides to install an ABC

system. The management decides that all overhead costs will have only three cost drivers viz.

Direct labour hours, Machine hours and number of purchase orders and the general ledger of

the company shows the following overhead costs –

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 Figure 133: Activity cost pools

Generally, in the traditional costing method, overheads are applied on the basis of direct

labour hours (total 1,000 labour hours in the given case). So, in that case the overhead

absorption rate would be – ` 11,250/ 1000 = ` 11.25 per hour and the total overheads applied

to Widget A would have been = 400 × 11.25 = ` 4,500 and to Widget B = 600 ×11.25 = `

6,750. Hence Widget A would have been undervalued and Widget B overvalued by ` 425.

Example of cost drivers for different activity pools in a production department can be

explained below:

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 Figure 134: Formula of the Unit cost

Businesses like the Coca-Cola Company, deluxe Check, Navistar, and Allied Signal

Corporation have been performing ABC/M for many years. They are advanced and mature

ABC/M users who are interested in two goals: to institutionalize ABC/M company-wide into

a permanent, repeatable, and reliable production reporting system and to establish the

ABC/M output data to serve as an enabler to their ongoing improvement programs, such as

TQM, change management, cycle-time compression, core competency, BPR, product

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rationalization, target costing, and channel/customer profitability. More recently, new issues

for the advanced and mature ABC/M users are emerging; they include the following: •

Integrating the ABC/M output data with their decision-support systems, such as their cost

estimating, predictive planning, activity-based budgeting (ABB) systems, customer

relationship management (CRM), and balanced scorecard performance measurement systems.

• Learning the skills and rules for resizing, reshaping, releveling, and otherwise readjusting

their ABC/M system’s structure in response to solving new business problems with the

ABC/M data.

• Collecting and automatically importing data into the ABC/M system.

• Automatically exporting the calculated data out of their ABC/M system. It is evident that

among experienced ABC/M users, ABC/M eventually becomes part of their core information

technologies. More specifically, the output data of an ABC/M system is frequently the input

to another system, such as a customer order quotation system. ABC/M data also complement

other productivity or logistics management tools such as simulation software, process

modelers, business process flow charters, executive information systems (EIS), and online

analytical programs (OLAP).

In the next several years, there will be a convergence of tools as these now somewhat

separate software applications become part of the manager’s and analyst’s tool suite.

Advanced, mature users are also masters at employing ABC/M “attributes,” which are scored

and graded against the activities. ABC/M attributes allow managers to differentiate among

activities. A popular attribute involves scoring If ABC Is the Answer.

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 Figure 136: Cost management

Activities along their “high- versus low-value-adding” scale so that teams can focus on the

work that is more important. Multiple activities can be simultaneously tagged with these

attribute grades, and of course the amount of money trails along as part of the activity data.

As an option, activities can be summarized into the processes. Another option is to score or

grade each activity by how well the organization performs its work. Two or more attributes

can be combined to gain further insights. A popular combination is the level of importance

and the level of performance. With these two independently judged scores for each activity,

organizations can see, for example, that they are spending a lot of money doing things they

are good at but that they have judged to be unimportant. Some attributes are subjectively

198
scored or graded by managers and employees, and they introduce emotionally compelling

business issues.

Figure 137: Project management

I have often said that, “ABC/M adds the air-conditioning to the ABC/M data.” Organizational

Structure, Behavior, and Value Creation Organizations are discovering that the business

process performance levels necessary for their organization to remain competitive (or to

continue to be adequately funded) exceed what is possible from conventional, highly vertical,

functional organization forms. The traditional organizational model is becoming less valid as

business processes transcend old departmental boundaries. Future cost avoidance and

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performance improvement can be achieved only through reconfiguring work activities into

fewer, more integrated jobs.

Optimizing a stove-piped functional department can be a poor choice for the total

organization. On occasions there are competing performance measures: “As I do good, you

are adversely affected.” With this new way of thinking, traditional managerial accounting

comes up short. It fails to provide data for decision support, and it prevents producing the

kind of metrics to serve as inputs into balanced scorecard and performance measurement

systems, including shareholder value added (SVA) methods. One important way to answer

these questions is to provide managers and teams with fact-based data in place of assertions

and intuitive guesses. In addition, managers can benefit from visual aids that are supported

with real and tangible metrics.

Organizations will increasingly use diagrams and pictures, not just racked-and-stacked cost

tables, to help employees truly visualize, discover, internalize, and learn. The rate of

organizational learning is considered by many as today’s primary differentiator between

gaining and losing organizations. If the rate

REMOVING THE BLINDFOLD WITH ABC/M

Organizational learning is slow, that can be considered a major impediment to an

organization’s growth and sustaining power. ABC/M project managers have been slow to

recognize the behavioral change management aspects of the ABC/M data. ABC/M is a socio-

technical tool, and the emphasis should be on the social side. Many managers and ABC/M

project teams see ABC/M as simply a better measuring scheme or cost allocation method.

However, its real value lies in introducing undebatable fact-based data that can be used by

employees to build business cases, quickly recognize business problems or opportunities, and

test hypotheses.

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 Figure 138: Step of cost management

ABC/M has many of the characteristics of an organizational methodology. Many managers

are frustrated by the difficulties in bringing about change within their organizations.

Behavioral change management is receiving wider attention, and ABC/M data are playing an

important role in change.

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 Figure 139: Process of cost management

I encourage you to be part of this change. One description of old age is that it starts as soon

as your attachment to the past exceeds your excitement about the future. Since you will live

the rest of your life in the future, think young and be progressive. One technique to consider

comes from the great movie director, Alfred Hitchcock. He referred to this method as using

the superiority of suspense over shock. Make the audience squirm. Hitchcock would not

simply film two men conversing at a table, and—boom—a bomb would go off.

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 Figure 140: Primary phase of management

He would let the audience know that a time bomb is planted and timed to go off as the two

men are conversing. With ABC/M data, I encourage project teams to first have users

speculate on the results before they see the real data. For example, have them list who they

think might be the unprofitable customers. Whether they guess right or wrong, the users will

already have begun to think through many of the cost-and effect relationships. Either their

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intuition will be validated, or they will be surprised, but either reaction prepares them to

better understand how ABC/M supports the correct answer.

A Business Is Multidimensional ABC/M contends that many important cost categories vary

not with short-term changes in output but with changes in the design, mix, and range of a

company’s products, services, and customers. Once product and service-line costs are

identified, employees and managers begin to see the value of understanding the activities and

their associated costs. The primary use of ABC/M shifts from an accounting tool to a

management decision support system for operational streamlining and strategic thinking—

ABC/M is business intelligence. Information technology gathers and manages this ABC/M

information, combining not just cost but also nonfinancial information and performance

measures.

This enterprise-wide technology is called an activity-based information system. As more

managers have become aware of the activity and of the information that is available,

additional applications for ABC/M have emerged, If ABC Is the Answer, What Is the

Question? 25 including unused capacity management. ABC/M provides the lens that focuses

on an organization’s efforts. ABC/M and the Future An overarching issue in ABC/M is the

perception of it as just another way to spin financial data rather than as mission-critical

managerial information.

The Information Age can be mind-boggling. In our future, as technology advances, so will

the demand to access massive amounts of relevant information. The companies that survive

will be those that can answer the following questions: Clearly, as information technology

evolves, organizations will increase their effectiveness. Further, as markets change,

companies and organizations will run into global competitors that increasingly look to

information and information technology for competitive advantage. ABC/M is involved in

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this broad arena of “outsmart Manship.” ABC/M puts the “management” back into

management reporting.

For those who are involved with ABC/M projects, the key is to create and orchestrate change

rather than merely react to it and attempt to make the best of a poor situation. It will be fun

watching organizations move from their learning stages into mastery of building and using

ABC/M systems.

STAGES OF EVOLUTION OF COST MANAGEMENT SYSTEMS

In the early 1990s Professor Robert S. Kaplan of the Harvard Business School described four

stages of cost management systems. Figure 1.10 extends his stages of evolution with a fifth

stage beyond Kaplan’s fourth stage, “integrated” cost management systems. The fifth stage

that I propose focuses exclusively on decision support. Following is a review of the standard

four stages.

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 Figure 141: Stages of Evolution of Cost Management Systems

St-plus markup of its purchases to cover operating expenses. A step above that is the small

manufacturer or distributor. Because these organizations may not be able to justify the extra

expense to maintain a formal record-keeping system, the quality of their data will likely be

inadequate for making decisions.

Stage 2: Financial Reporting Driven Stage 2 cost management systems are used to comply

with external reporting for bankers or owners or to government agencies, such as for tax

reporting. The financial data may minimally meet the reporting requirements, but they may

distort the true costs and profit margins of the specific products or service lines being sold.

This information may be reported weeks or months after the period in which the business was

206
conducted. It also may be too aggregated to draw any insights about where to focus or what

to better control.

Manufacturers and distributors tend to focus on the direct material and labor expenses that

can be logically associated with products and service lines. The remaining support,

distribution, sales, and administrative expenses are either Stages of Evolution of Cost

Management Systems 27

• Many errors

• Large variances

• Inadequate

• Inadequate

• Inadequate

• No surprise

• Meets audit standards

• Tailored to financial reporting need

• Inaccurate

• Hidden costs and profits

• Financial feedback only

• Delayed/ aggregated

• Shared databases

• Stand-alone systems

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• Informal linkages

• Stage 2 system for financial transactions and periodic reporting • PC-based ABC models •

Product-focused • Kaizan costing; pseudo profit centers, timely nonfinancial data • Fully

linked databases and systems • Financial reporting systems • Integrated ABC/M systems •

Full absorption • Operational and strategic performance measurement systems • Fully linked

databases and systems • Financial reporting systems • Integrated ABC/M systems • Predictive

costing • Operational and strategic predictive scenario • Links to scorecards • Reflects

economics Stage 2 Financial reporting driven.

Stage 1 System Broken Aspects Data Quality External Financial Reporting Product/

Customer Costs Operational/ Strategic Control Stage 3 Customized/ stand-alone Stage 4

Integrated Stage 5 Decision support FIGURE 1.10 Stages of Evolution of Cost Management

Systems Source: Stages 1–4, R. S. Kaplan and R. Cooper, Cost & Effect (Boston: Harvard

Business School Press, 1998).

Reproduced with permission from Management Accounting, published by the Institute of

Management Accountants (IMA), Montvale, NJ, www.imanet.org. Ignored or loosely linked

to the costs of outputs. Simplistic overhead expense allocations introduce distortions that can

be large relative to the true costs. Stage 3: Customized/Stand-Alone Stage 3 cost management

systems are designed to provide reasonable accuracy and visibility for decision making. This

is the stage at which activity-based costing begins to emerge. The variety and diversity of the

products and service lines of these organizations will have expanded so much that indirect

and support overhead expenses will have become a significant portion of the cost structure.

Simplistic cost allocations, usually volume-based, are no longer sufficient to reflect how

much the individual outputs consume those expenses.

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Whether the expenses are direct or indirect, the cost assignments are computed in a parallel or

off-line model, not necessarily in a repeatable system. The operational data, such as the basis

for tracing the indirect expenses to costs, is usually input as a separate step. For

manufacturers, the assignment of overhead for inventory costing may be based on simplistic

assumptions, whereas the activity-based costs will be more reflective of use. The two

methods produce different results for different purposes. The inventory costing is used for

external reporting and the activity-based costing for strategic decision making or pricing.

Figure 142: Cost management experienced

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Stage 4: Integrated Stage 4 cost management systems are what many organizations aspire to.

The databases are linked to the calculation logic that traces the expenses to processes and to

outputs. The resulting information can be reported for monitoring performance or simply to

more accurately report spending for control or for profit margin performance. The

administrative effort to refresh the input data and update the results is much less than in Stage

3. The reporting is highly automated and supported by powerful query and analysis tools. The

distribution of the calculated results is more widely accessible to various users throughout the

organization. Fifth-Stage Cost Management System

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 Figure 143: Cost control

Stage 5: Decision Support Stage 5 is my extension of the first four. It represents more of a

profit management and value management system. It goes well beyond simply calculating

and distributing accurate and relevant cost information, providing information, and the

flexibility to configure assumptions, for decision making. All decisions affect the future, not

the past. The past reflects past decisions, good or bad. The Stages 3 and 4 cost management

systems originate in historical revenue and expense data. They are descriptive rather than

prescriptive. It is too late to do anything about what already happened.

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 Figure 144: Cost control

REMOVING THE BLINDFOLD WITH ABC/M

Logical and defensible tracing of expenses so that managers and employee teams can gain

insights into and make inferences about where to focus and what to change. The formal step

of actually taking actions based on inferences from past information leads us into the broad

realm of predictive costing, planning, and rebudgeting (during and after cost overruns). This

will be the focus of Stage 5 systems. Today this area resides in diverse pockets of an

organization where cost estimating, planning, and budgeting take place. Cost estimating is

usually performed as an ad hoc analysis aimed at a single decision, such as a capital

investment justification or a make-versus-purchase outsource decision. Another application

of cost estimating may be to determine a price quotation to offer to secure a customer order.

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 Figure 145: Control of the cost

In price quoting, there are implicit assumptions about cost rates and whether expenses are

fixed or variable. In some cases those assumptions may not be completely valid. A more

powerful predictive costing calculation engine and system will allow for more formal and

flexible configuring of assumptions of the consequences of decisions, in addition to the

specific inputs and outputs of a decision. These assumptions will recognize the impact on

capacities, specifically the adjustability of capacity and the resulting increases or decreases in

specific expenses during the time periods affected by the decision. As the Internet continues

to shift power to buyers and away from suppliers, a defense for suppliers will be to induce the

customers’ demands through a variety of option offerings.

Figure 146: Project management

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The various options will be combinations of various products, promotions, and alternative

service levels offered at appropriate pricing to stimulate the customer to order and purchase.

Much of this will be Web-based and automated. Stage 5 systems will recognize the existing

capability and capacity of an organization and take that into account as they support

predictive costing. Stage 5 systems will be rule-based. (Chapter 4 discusses the new

requirements of twenty-first-century e-commerce that will rely on Stage 5 and ABC/M

systems.).

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 CHAPTER 10: Budget, Budgeting, and Budgetary Control

The cost management plan guides these four processes. Created during the project planning

phase, the cost management plan is a document that defines how you manage, control, and

communicate a project’s costs in order to complete the project on budget.

Figure 147: Budget control

Among other things, a cost management plan identifies the individual or group responsible

for cost management, details how you will assess a project’s cost performance, and sets rules

for how to communicate cost performance to project shareholders. It also establishes the

methodologies by which you will control project cost variations.

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While you can customize a cost management plan to fit your organization’s needs, they

generally follow a standard format. Sections often include the cost variance plan, the cost

management approach, information on cost estimation, the cost baseline, cost control, and

reporting processes, the change control process, the project budget, and approvals. You may

also want to include the spending authority levels for key project personnel, specifying which

roles can approve costs up to specific thresholds.

Figure 148: Budgeting process

Let’s look at the sections in greater depth:

• Cost Variance Plan: Cost variance is when the actual amount differs from the

budgeted amount. In your cost management plan, you’ll need a section that details the

216
 actions you should take, including who is held responsible in the case of a cost

variance. The size of the variance usually necessitates different action: a cost variance

of less than five percent might result in an explanation of that variance, while a 95-

percent-or-greater variance could force the project to be abandoned. To learn how to

calculate cost variance, read Hacking the PMP: Studying Cost Variance. For a more

detailed template on tracking schedule and budget variances, see this template:

Figure 149: Tools of budget control

• Cost Management Approach: This section outlines the approach a manager uses for

cost management. The level of rigor can vary, but this describes how to establish a

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 cost baseline and how to compare actual costs. You usually track and report costs

through control accounts, where you roll up costs of subtasks. This often occurs at the

third level of the work breakdown structure, a tool that breaks a project into small

components or chunks of work to determine the resources needed to complete a job or

project. However, the point at which you track, and report depends on the scope of the

project.

Figure 150: budget control plan

• Cost Estimation: Here you will define the methods used for estimating project costs,

the levels of variation, and the expected precision, accuracy, and risk.

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• Cost Baseline: This has a specialized meaning in project management and represents

the authorized, time-phased spending plan against which you measure cost

performance. It’s the sum of the estimated project cost and contingency reserves.

Figure 151: Budgetary control

• Cost Control and Reporting Process: This section establishes how you measure

costs and their key metrics during the project. We’ll provide greater detail on this

later.

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 • Change Control Process: This describes the process for making changes to the cost

baseline and how to approve those proposed changes.

• Project Budget: The budget builds on the cost baseline by totaling the cost of

executing the project (including contingencies for possible risks). It also adds in

management reserves, which is an amount to cover unanticipated risks or unidentified

events that may arise. An organization will usually set a policy for this, and the

amount is often five to 15 percent of the total budget.

Cost Management Activities: Essential Functions at Each Phase

Cost management includes a number of activities conducted at different phases during the

project life cycle. It’s important to include the cost management function while developing

project plans so that you build solid financial controls into the project structure. Here are

some key terms and stages relevant to cost management:

Planning: Using the work breakdown structure to determine the resources needed to

complete a job or project.

Estimating: The act of calculating or predicting the expected total cost of completing a

project.

Budgeting: The authorization of a budget based on a cost estimate to complete the project.

You typically authorize budgets in tandem with schedules, so you can assess cost

performance at specific points.

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 Figure 152: budgetary control

Financing and Funding: The process of requesting, authorizing, and receiving money for a

project.

Cost Management: The general practice of overseeing project expenditures and making

cost-related decisions throughout the project life cycle.

Controlling: Addressing cost variations to avoid cost overruns

Job Control: Controlling project expenditure by comparing costs predicted by the cost

estimate and costs actually being incurred.

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Scheduling: You can determine a project’s cost performance by using a schedule that

compares the expected expenditure to the actual costs the project is incurring at any point in

time.

Accounting: The practice of recording expenditures and reconciling transactions.

How Accurate Project Cost Estimating Aids Cost Management Efforts

The first step towards robust cost management is having a clear idea of your project’s likely

costs. However, it’s futile to track and control costs if you base your spending on unrealistic

estimates.

Project estimating considers several variables, including the method you use to create the

estimate, the stage at which you build your estimate, and the types of cost you include.

The first variable is the method you employ. You can produce cost estimates using a variety

of estimating techniques, depending on the extent to which you define a project and the type

of information you have access to. Here are some common estimation techniques:

Analogous Estimating: This uses historical data from similar past projects to create

estimates for new projects. This method works if you have experience with projects of the

same type.

Parametric Estimating: This method estimates time and cost by multiplying per unit or per

task amounts by the total number expected in the project. The rates are often standard or

publicly published rates and can be expressed in hours of work, amount of data entered, or

the number of units of a product manufactured. This technique has a reputation for good

reliability, but it’s less relevant when output isn’t uniform, such as when writing computer

code. Some projects have widely varied or unprecedented tasks, so they do not lend

themselves to this method.

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Bottom-Up Estimating: This is a determinative estimating technique that estimates costs for

work breakdown structure components and adds them together to create a cost estimate for an

entire project. The project teams members help create the estimate. Since the people who are

going to be doing the work are engaged in estimating, professionals consider this method

highly accurate, as well as a team commitment builder.

Figure 153: Process of budgetary control

Three-Point Estimating: This is a PERT-related statistical method that uses the optimistic

(lowest), pessimistic (highest), and most likely cost estimates to create expected values and

standard deviations for project expenditures.

Software-Based Estimating: You can use software-based estimating techniques, such as

Monte Carlo simulation, to model the effects of risk events on project costs.

Another factor influencing the cost estimating is the stage at which you build your cost

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estimate. As a project progresses, you discover more variables and actual costs, so project

estimates become more refined. You can classify cost estimates based on how well you

define the project scope at the time of estimation and on the type of estimation technique you

use - the latter generally determines the accuracy of an estimate. In order of accuracy, the

main classes of cost estimates are:

Order of Magnitude Estimates: These are very rough cost estimates based on expert

judgment and on adjusting the costs of the current project to reflect the costs of similar, past

projects. Created before fully defining projects, they are only used in high-level project

screening.

Preliminary Estimates: A preliminary estimate uses somewhat-detailed scope information

to form estimates based on unit costs. These estimates are accurate enough to use as the basis

for budgeting.

Definitive Estimates: Created when you’ve fully defined a project’s scope, a definitive

estimate uses deterministic estimating techniques, such as bottom-up estimating. Experts

agree that definitive estimates are the most accurate and reliable.

The final variable affecting project estimation is the type of cost included. Of course, your

project budget must include all the relevant costs for labor and materials, but whether you

include a portion of your organization’s indirect costs depends on the policies of your

organization and the type of project. Here are the terms experts use to distinguish between

various types of costs:

Direct Costs: Direct costs are those which you can directly associate with a specific cost

object. They are billable to specific projects.

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Indirect Costs: You cannot associate indirect costs with a specific cost object, and you

typically incur indirect costs by a number of projects at the same time. They are not billable

to specific projects.

Fixed Costs: Fixed costs are costs you incur during manufacturing that are not associated

with the volume of produced output.

Variable Costs: Variable costs are costs you incur during manufacturing that are directly

associated with the volume of produced output.

Sunk Cost: A sunk cost is an expense you cannot recoup once it is incurred.

Opportunity Cost: When selecting a course of action, its opportunity cost is the loss of

potential benefits from all alternative courses of action.

Costing Techniques Determine How to Account for Project Costs

A costing technique is the way in which you compute the total cost of producing a product or

performing a task. Depending on the activity or activities being costed, you may use a variety

of techniques. Here are some commons ones:

Job Costing: Managers use job costing, also called job-order costing, to determine the cost

of a product that is unique or dissimilar to other products. In industries such as construction,

it’s extremely rare for two jobs to be identical. Job-order costing uses a unique job-cost

record that compiles total labor and resource costs, as well as applicable overheads, for each

task or activity completed as part of a task to determine total expenditures for the job. The

job-cost record includes both direct and indirect costs.

Process Costing: You use process costing to determine costs for products or tasks that are

identical. Unlike job costing, it does not compute the total cost of a product by summing up

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the costs of all tasks and activities that go into creating the product. Instead, process costing

looks at the processes included in the mass production that creates products. By dividing the

total cost of a process by the number of units output, it is possible to determine the cost per

unit of each process. After this, you may total the costs per unit of every process involved in

the eventual manufacturing of the product. In this way, you compute the cost per unit of each

product on a process-by-process basis.

Activity-Based Costing: Activity-based costing (ABC) is an approach to assigning overhead

costs to products. Since overhead cost allocation based simply on the number of machine

hours needed may be misleading, this costing technique looks at the activities focused on

creating a product — testing, machine setup, etc. — and then assigns portions of their costs to

all products created using these activities. Products that were not created via these activities

do not have shares of these activities’ costs added on.

Direct Costing: Direct costing, also called contribution costing or variable costing, is a

technique that only assigns variable manufacturing costs to the cost of a product. You do not

add fixed manufacturing costs to the cost of creating a product but instead associate those

costs with the time period during which you incur them.

Life-Cycle Costing: Life-cycle costing is a comparative analysis technique that involves

summing the total costs incurred during the life cycles of project options in order to choose

the best option. Since starting capital costs may not be an accurate representation of how

much a project will eventually cost, life-cycle costing includes all costs associated with

ownership — including maintenance and disposal costs — to enable better decision making.

Measuring Project Performance with Cost Management kips

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Once your budget is approved and your project is under way, you’ll want to benchmark your

progress relative to your cost management plan. First, there are some key metrics and

performance indicators to understand:

Project Cost Performance: A project’s cost performance is an assessment of how actual

expenditure on a project compares with planned expenditure as detailed in the project budget.

The project manager communicates a project’s cost performance to the project stakeholders,

and it may serve as the basis for preventative or corrective actions to avoid cost overruns.

Earned Value: Earned value is a method of measuring project cost performance. It is based

on the use of planned value (where you allot specific portions of a project’s budget to the

project tasks) and earned value (where you measure progress in terms of the planned value

that is earned upon completion of tasks). You may contrast the earned value with the actual

cost - the expenditure you actually incur up to a certain point in the project schedule - to see

how actual project costs compare to expected project costs.

Cost Performance Index (CPI): This is a measurement of how earned value compares to

actual cost. This ratio measures a project’s cost efficiency at a given point in time by

expressing earned value in proportion to actual cost. To calculate CPI, divide earned value by

actual cost. A result of 1 means the project is exactly on budget; a number above 1 means it is

under budget.

To learn more about kpis in project management, read All About KPI Dashboards.

How to Control Costs

Effective cost control means performing a number of related activities that all begin by

monitoring costs — since you can’t know if costs are greater than planned unless you are

tracking actual expenses. Then, project managers need to decide how to respond to cost

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variances. Here are some key steps and concepts that inform the cost control process:

Monitoring Cost Performance: A project manager routinely monitors a project’s cost

performance by creating performance reports that summarize current performance and

forecast whether you will complete the project on budget. You provide project stakeholders

with information about a project’s cost performance.

Reviewing Changes: You must amend the cost baseline to reflect all cost-related changes,

and you should inform the project shareholders about all changes.

Actual Costs versus Budgeted Costs: Upon milestone and entire project completion, you

examine the variances between actual costs and budgeted costs. Responses to the cost

management plan will depend on the magnitude of the variance and the stage of the plan -

this could range from a discussion to changes in the project scope that reduce costs.

Reserve Analysis: Use reserve analyses to allocate contingency reserves to projects based

on the likelihoods and magnitudes of risk.

Cash-Flow Analysis: Used in financial reporting, cash-flow analyses detail cash inflows and

outflows over a given period of time and provide starting and ending balances.

Learning-Curve Theory: The learning-curve theory applies to the relationship between the

time spent producing a unit and the number of units produced. According to the theory, the

time spent on each unit should decrease as workers gain experience and therefore produce

units faster.

Cost Management vs. Strategic Cost Management

While cost management reduces expenses regardless of their cause or purpose, strategic cost

management is a sub-discipline that strives to manage cost while also making the

organization stronger.

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Robin Cooper, Professor of Management at Claremont’s Peter F. Drucker Graduate

Management Center and Regine Slagmulder, Professor of Management Accounting at

Tilberg University in the Netherlands, define strategic cost management as the “application

of cost management techniques so that they simultaneously improve the strategic position of

a firm and reduce costs.”

Strategic cost management centers on the idea that cost reduction initiatives can affect an

organization’s strategic position. Strategic cost management emphasizes considering the

strategic and financial impact of cost management techniques.

Cooper and Slagmulder classify cost management initiatives as one of three types based on

how the initiative affects the organization:

Strengthen: An example of an initiative that strengthens competitive positioning is a taxi

service that replaces its phone booking system and team of booking agents with an app that

allows people to book taxis using their mobile devices. An initiative like this both reduces

costs and gives a company a strategic advantage, as it makes it easier to book taxis on short

notice.

No effect: An initiative that has no effect on competitiveness might concern a publishing

house that outsources proofreading tasks to international freelancers who accept lower wages.

While this increases the company’s profitability, it does not affect its strategic positioning.

Weaken: Finally, an initiative that actively harms competitive positioning might involve the

taxi company decreasing the frequency of regular vehicle maintenance, a move which, while

saving costs initially, will result in cars breaking down more often.

Strategic cost management also comprises a number of important strategies:

Relevant Cost Strategies: Use relevant cost strategies to compare and decide between

alternative courses of action. Relevant costs are costs you can reduce by adopting a particular

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course of action. They are different from sunk costs (which you cannot recoup once spent)

and fixed overhead costs (which are the same for all potential courses of action). When you

make decisions, a relevant costs strategy focuses only on costs that vary among options.

Evaluating Opportunity Costs: Evaluating opportunity costs is a more holistic approach to

decision making that considers not only all the monetary aspects of alternative courses of

action, but also all the intangible aspects.

Balanced Scorecard Strategy: A balanced scorecard strategy allows businesses to assess the

impact of cost management initiatives across four key areas: financial results, customer

impact, internal business processes, and employee growth and development. It provides a

framework for thorough consideration of the impacts of cost management initiatives.

Getting Into the Details: Cost Accounting in Project Cost Management

Cost accounting involves the recording and classification of costs associated with a project. It

is an internal practice that supports managerial decision making and is a primary discipline

concerning cost management.

Cost accounting is different than general financial accounting. Financial accounting concerns

reporting an organization’s past financial performance and does not delve into extensive

detail. Since you carry out cost accounting for a specific area of activity within a company —

Cost accounting involves preparing reports for an organization’s management (these reports

are not distributed externally). By contrast, financial accounting deals with standardized

reports that may be distributed to a variety of stakeholders and regulators.

Standard Cost Accounting: This is based on the concept of efficiencies, or ratios that

compare the time and resource costs of actually completing an activity with the costs of

completing the activity under standard conditions.

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Variance analysis is a core element of standard cost accounting.

Resource Consumption Accounting (RCA): This approach emerged around 2000, and

assigns costs based on the consumption of resources. It uses a German cost management

system known as GPK and activity-based costing, a cost allocation method.

Throughput Accounting: This is an accounting approach that aims to maximize profitability

by increasing the rate of production of goal units and minimizing operating expenses and

investment costs.

Target Costing: This uses a predetermined market price and preferred profit margin to

determine how much money can be used to create a product or service. The target cost is the

maximum amount you can spend on production without affecting the profit margin.

Cost Coding: To make cost accounting easier, most organizations have adopted a method of

identifying costs with a code, usually a number. The root of the code usually represents the

type of expense, cost center, or business unit involved. This makes it easier to group and find

related expenses in financial reports. Individual projects may be assigned their own code.

A common structure in an enterprise or very large organization is a top-level, four-digit code

that relates to the accounting entity (for example, a subsidiary company). The next numbers

pertain to department, followed by a number for the cost, which can be a cost center, profit

center, work-breakdown-structure element, fund, or internal order.

• Traceability: Direct and indirect costs

• Behavior: Fixed or variable costs

• Controllability: Controllable or uncontrollable costs

• Time Incurred: Historical or predetermined costs

• Normality: Normal or abnormal costs

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 • Functions: The organizational function by which you incur a cost

Cost accounts make it easy to identify cost overruns in specific sectors that might otherwise

be lost in a budget overview. However, managing a large number of cost accounts — up to

several hundred accounts and sub-accounts on larger projects — comes with its own

challenges. It demands a higher degree of organization in accounting, for one, and classifying

costs becomes more time consuming.

In addition, the system of categorization you use for a project’s cost accounts may not match

up with the system of categorization you use for an organization’s cost accounts. This

complicates the creation of a project budget from a final cost estimate and is likely to happen

when you create cost accounts using a system of categorization different than the performing

organization uses.

Aside from recording historical expenditure, project managers must also forecast expected

activity costs to ensure that they remain under control. Managers can do this through the use

of tables that classify costs for individual cost accounts and cost modeling techniques that

indicate whether work associated with a particular activity is due to be completed on budget.

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 Chapter 11: Cost Accounting Records and Cost Audit

The Institute of Cost Accountants of India (ICAI) was established in the year 1959 by an Act

of Parliament. • It is the only National Institute in India specializing in the field of Cost and

Management Accounting. • Members of the Institute are known as Cost And Management

Accountants simply abbreviated as CMA’s. • ICAI is headquartered in Kolkata with four

Regional Head Quarters, each in Delhi, Mumbai, Chennai and Kolkata, 96 Chapters spread

across India with many extension centers controlled by the local chapter catering to remote

locations of the locality and 8 Overseas Centers. • The Institute has 65,000 Members and

more than 5,00,000 students. Mechanism of Cost Record Maintenance and Cost Audit • This

mechanism was first introduced in 1965. • This unique mechanism is very less publicized. • It

involves calculating & certifying the true cost & margin of various products & services. •

This mechanism was revamped by Government in 2011 based on a detailed report of Expert

Group appointed by Government.

• Under 2011 Mechanism - Cost Record Maintenance and Cost Audit became applicable to

All companies in India engaged in Manufacturing / Processing / Mining Operations.

• Cost of Production of all the companies in India is reported to the GOI, which may be used

by the GOI for controlling / regulating Profiteering by capitalist sections of the society to

benefit “Common Man”. Expert Group on Cost Records & Cost Audit

• Expert Group (EG) was formed by Government in 2008.

• EG and its sub committees consisted of 44 experts from various segments across country

like MCA, CII, FICCI, ASSOCHAM, ICSI, Institute of Chartered Accountants, Institute of

Cost Accountants, Industry, Academicians, Consumer / Investor Forums, etc.

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• The EG also studied International Practices in field of Cost Audit in Developed and

Developing Countries.

• 600 plus page report was submitted to Government giving 39 recommendations and detailed

basis for the recommendation.

• Based on the recommendation of EG only the Government has issued Cost Accounting

Records Rules 2011 and Cost Audit Report Rules 2011.

Cost audit and cost record rules 2014 • companies act 2013 came into effect • this

necessitated the new rules and regulations for cost audit and cost records • the rule first came

in june 2014 • further clarity given to this rule by amendment in jan2015 (cost records and

cost audit (amendment )rule 2014) cost record rule 2014 a) what is cost records 1.cost records

is instrumental in enabling one to transform the process of manufacture/production/service

into financial values so as to arrive at the value addition at each level of production activity

and finally to arrive at the cost of production, cost of sales and margin earned product wise.

2.cost records intersect in the production, statistical and financial records. Utility of cost

record and cost audit emphasis on modern concept of “activity-based costing system”:

A methodology that measures the cost and performance of cost objects, activities and

resources. Cost objects consume activities and activities consume resources. Resource costs

are assigned to activities based on their use of those resources, and activity costs are

reassigned to cost objects (outputs) based on the cost objects' proportional use of those

activities. Activity-based costing incorporates causal relationships between cost objects and

activities and between activities and resources.

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COST RECORD RULE 2014

Utility of Cost Record and Cost Audit • Consumer Forums – Fair Pricing & Curtailing

Profiteering • Investor Forums - Corporate Performance and Economic Efficiency • National

Economy (Social Cost Benefits) – Optimum Utilization of Scarce Resources.

• Regulators – Control Price Mechanism

• Banks and Financial Institutions – Early Detection of NPA & Prevention of Sickness

• Government - Policy on Taxation, Policy on Subsidies for various sectors, Fight cases of

Dumping, Detect Revenue Leakages & Tax Evasion

• Industry - Create Cost Consciousness, Specific benefit to SME segment, Analyze Resource

Utilization, Improve Productivity and Cost Optimization, Decision Making. Utility of Cost

Record and Cost Audit COST AUDIT ENSURES RESOURCE RECONCILIATION AND

RESOURCE OPTIMIZATION:

Cost Audit and Cost Records are not only reconciliation statement in figures but it is a

“Statement of Resource Cost and Resource Utilization” and is summary chain of following

reconciliation statements – a) BOM Consumption V/S. R.M. Consumed (Stores Ledger)

b)Direct Manpower and Indirect Manpower paid for and utilized. C) Utilities Consumption –

Standard V/S Actual d) Normal Overheads V/S Abnormal e) Assets Management &

Utilization f) Quantum of work outsourced and job work charges paid f) Standard Loss /

Rejection Percentage V/S Actual g) Finally Profit Reconciliation in Figures to be reported

cost records vs financial records

• vouchers, journals and day books

• ledger posting

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• trial balance extract

• statistic records on resource utilization

• accumulating the data for a given period activity/wise

• allocation and appropriation of cost elements activity/product wise cost records vs financial

records • p&l account and balance sheet • fund flow and ratio analysis • product wise cost

sheet • analytical tables for cost control Companies (cost records and audit) Rules, 2014 (cost

records) i. Input materials/services

A. Raw materials/direct materials

B. Intermediate materials

C. Captive consumed.

D. Bought out/sub-assemblies and accessories e. Consumable stores (cost Centre wise) f.

Tools, jigs and moulds g. Materials through outsource production Companies (cost records

and audit) Rules, 2014 (cost records) i. Input materials/services a. In the case of consumable

stores and small tools, indirect services, the cost of which are insignificant (less than 5% of

the cost of material consumed), the company may, if it so desires, maintain such records for

the group of such consumable stores, tools and indirect services. B. Proper records shall be

maintained showing the quantity and value of wastage, spoilage, rejections and losses. The

method followed for adjusting the above losses as well as the income derived from the

disposal of rejected and waste C. Details of non-moving materials for more than 12 months.

Companies (cost records and audit) Rules, 2014 (COST RECORDS) 2. SALARY AND

WAGES •

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(a) piece rate wages (wherever applicable); • (b) incentive wages, either individually or

collectively as production bonus or under any other scheme based on output; • (c) overtime

wages;(d) earnings of casual or contractual labour;(e) bonus or gratuity, statutory as well as

other; • (f) contribution to superannuating scheme;(g) cost of employees stock option; • (h)

leave travel concession; (i) paid holidays;(j) leave with pay; • (k) Training, workshop,

seminar expenses; • (l) Medical/health, safety, education expenses; • (m) any other statutory

provision for labour welfare; • (n) any other free or subsidized facility. Companies (cost

records and audit) Rules, 2014 (COST RECORDS) 2.SALARY AND WAGES • Where the

employees work in such a manner that it is not possible to identify them with any specific

cost centre/service centre or department, the employees cost shall be apportioned to the cost

centre/service centres or departments on equitable and reasonable basis and applied

consistently.

• The idle labour cost shall be separately recorded under classified headings indicating the

reasons therefor. The method followed for accounting of idle time payments shall be

disclosed in the cost records. • Labour cost on capial expenses to be indicated separately and

the method followed consistently • Retirement benefit and such as benefits under voluntary

retirement scheme, expenses treated as abnormal and not forming part of salaries and wages

and cost of production of goods/rendering of services. Companies (cost records and audit)

Rules, 2014 (COST RECORDS)

3.UTILITIES • Proper records shall be maintained showing the quantity and cost of each

major utility such as power, water, steam, effluent treatment, etc. Produced and consumed by

the different cost centres in such detail as to have particulars for each utility separately. • The

cost of utility allocated/apportioned to the cost centers and further to the individual

goods/services shall be on equitable and reasonable basis and applied consistently.

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Companies (cost records and audit) Rules, 2014 (COST RECORDS) 4. SERVICE

DEPARTMENT EXPENSES

• Proper records shall be maintained to indicate expenses incurred in respect of each service

cost centre like engineering, work shop, designing, laboratory, safety, transport, computer

cell, welfare etc. These expenses shall be apportioned to other services and production

departments on equitable and reasonable basis and applied consistently. • Where these

services are utilized for other goods/services of the company also, the basis of apportionment

of such expenses to goods/services under reference and to the other goods/services shall be

on equitable and reasonable basis and applied consistently. Companies (cost records and

audit) Rules, 2014 (COST RECORDS)

5.REPAIRS AND MAINTENANCE XPENSES

• Proper records showing the expenditure incurred by the workshop, tool room and on repairs

and maintenance in the various cost centres or departments shall be maintained under

different heads. The records shall also indicate the basis of charging such expenses to

different cost centres or departments. • In addition to the above, records shall indicate the

amount and also the proportion of closing inventory of stores and spare parts representing

items which have not moved for over twenty four months. Companies (cost records and

audit) Rules, 2014 (COST RECORDS) 5.REPAIRS AND MAINTENANCE XPENSES •

The expenditure on major repair works from which benefit is likely to accrue for more than

one financial year shall be shown separately and absorbed in the cost over the period for

which such benefits are expected to accrue on equitable and reasonable basis and applied

consistently. Method of accounting along with the basis of allocation of such costs shall also

be clearly indicated in cost Records. Companies (cost records and audit) Rules, 2014 (COST

RECORDS) 6.DEPRECIATION AND LEASE CHARGES

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• Proper and adequate records shall be maintained for assets used for production of

goods/rendering of services under reference in respect of which depreciation has to be

provided for.These records shall, interalia, indicate grouping of assets under each

good/service, the cost of acquisition of each item of asset including installation charges, date

of acquisition and rate of Depreciation. Companies (cost records and audit) Rules, 2014

(COST RECORDS) 6.DEPRECIATION AND LEASE CHARGES

• Those records which enable to identify and/or allocate gross fixed assets, accumulated

depreciation up to the year and net fixed assets under the heads; land and building, plant and

machinery, furniture and fixtures etc. Employed for goods/services under reference shall be

maintained. The basis of apportionment of common assets to the goods/services under

reference shall be on equitable and reasonable basis and applied consistently. In case of

revaluation of assets, the same shall be indicated separately and depreciation on revaluation

shall also be indicated Separately. Companies (cost records and audit) Rules, 2014 (COST

RECORDS) 6.DEPRECIATION AND LEASE CHARGES

• The basis on which depreciation is calculated and allocated or apportioned to various cost

centre/service centres or departments and absorbed on all goods/services shall be clearly

indicated in the cost records. • Proper records shall be maintained giving details of assets

taken or given on lease. The breakup of lease rental in terms of financial charges,

depreciation etc. Paid or received shall be maintained separately. The details shall be

maintained separately for assets taken from or given to related party. Companies (cost records

and audit) Rules, 2014 (COST RECORDS) 7.OVERHEADS

• Proper records shall be maintained for various items of indirect expenses comprising

overheads pertaining to goods/services under reference. These expenses shall be analyzed,

classified and grouped according to functions, namely, works, administration, selling and

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distribution, Head Office expenses. Companies (cost records and audit) Rules, 2014 (COST

RECORDS) 8. DIRECT EXPENSES

Figure 154: Cost management process

• Direct expenses are such expenses that are directly identiofyable with a product/service or a

production/service centre.

• Proper records shall be maintained in respect of direct expenses in such a manner as to

enable the company to book these expenses cost centre wise or cost object or department

wise with reference to goods or services under reference and to furnish necessary particulars.

9.Administrative overheads 10.Transportation Cost Companies (cost records and audit)

Rules, 2014 (cost records) 11. Royalty and technical knowhow fee 12. Research and

development expenses 13.quality contrl expenses 14.pollution control expenses 15.packing

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expenses 16. Interest and financing charges 17.any other item of cost 18.capacity

determination

• (a) Capacity shall be determined in terms of units of production or equivalent machine or

man hours. • (b) Installed capacity is determined based on • ((ii) capacities of individual or

interrelated production centres; • (iii) operational constraints or capacity of critical machines;

or • (iv) number of shifts • (v) manufacturers’ Technical specifications.

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