Unit 4 : Costing Methods
Introduction
Costing is the process of determining the expenditure incurred in
producing a product or providing a service.
Correct costing is crucial for any business organisation as it has a
direct bearing on all its sales and marketing strategies.
Basic principles of costing do not change with the system of costing
adopted.
Costing methods are broadly classified into two categories
Some methods make part use of job costing and part use of
processing costing.
Under these broad categories, Unit or output Costing, Job Costing,
Batch costing, Contract costing, Process costing and Service costing
are amongst the widely used methods of costing, in the industry.
Unit And Single-Output Costing
This method of costing
Finding out the cost of the total output
Cost per unit = total cost / the number of units produced
Example: A company produces television sets of only one type. During one
month, its total production was 3000 sets. The total cost incurred by the
company was ₹ 3 crore = cost of one television set is ₹ 3 crore/ 3000 =
Rs.10000
Suitable: Assembly department in a factory producing a mechanical article
as also in industries like brick-making, mining, sugar, cement etc.
When using this method of costing, it may not be necessary to maintain
separate cost accounts as the required information can be derived from the
financial records maintained under financial accounting.
This method has some limitations and can be used in the following
cases:
Where a firm is producing a single article on large scale by
continuous manufacture.
Where the units produced are identical.
Where the products are homogenous.
Where a firm is producing two or more grades of one product.
Cost Sheet
The cost sheet, maintained under the single-output/ unit cost, is a
periodic statement.
It is a document which records the detailed cost of a cost centre or
cost unit.
It contains information on expenditure incurred on material, labour
and direct expenses.
The administration expenses actually incurred are also included in
the total cost.
Indirect expenses, payable at periodical intervals, are included in the
cost sheet on the basis of estimates.
Selling and distribution expenses may or may not be included in cost
sheets, depending upon the management decision.
Not recorded: Taxes/interest/dividends paid, provisions and write
offs, cash discounts, profit or loss on sale of assets, etc.
Job Costing
Job costing system is required by the industries where each unit or
batch of output of a product is different form the other units or
batches.
This is in contrast to process costing system, which is used in
industries where production units are similar and the production
takes place on a continuous basis.
When the production is not on a continuous basis and each job is
different from the other
Also known as Job Order Costing
Applications of Job Costing
Companies manufacturing products or rendering services against
specific orders or jobs use this system of costing.
Examples are: Engineering and construction companies, ship-
building/furniture making, machine manufacturing companies, repair
shops, automobile garages and such other industries where jobs or
orders can be segregated.
The aim of job costing is to record all the costs incurred for
completing a job so that it may be appropriately priced.
Features of Job Costing
Execution of a job order involves meticulous planning of resources to control
the costs. Execution of a specific job, as per the specifications of the
customer, is more difficult compared to production under continuous process,
where the systems and procedures are stable and standardised. The job
execution may not be just arranging for materials and labour but may also
involve design and innovation.
The main features of job costing system can be summarised as
under:
It is costing of a specific order for production or rendering of services
as per the requirements of the customer.
It involves recording all the costs incurred for completing a job so
that it may be appropriately priced.
Estimation of costs is difficult as very little data may be available
due to uniqueness of the job.
At the end of the job, the materials left may be difficult to value due
to uncertainties about their use in other jobs.
Job Cost Cards/Sheets
A job cost card is used for each job, which is the object of costing, to
record the costs of materials, labour and overheads pertaining to
that particular job.
Job card basically provides a record to the management for their
decision making and controlling the cost.
The job cost card also records the time spent by operators on each
job.
Any breaks or idle time taken by the operators is also recorded in
the job cost card.
The main advantages of a job cost card are as under:
It gives clear and relevant information to the management to enable
them to take appropriate decisions
It is an effective tool for cost control
It helps in reducing the idle time of labour involved in the job
Job card information can be used to check the accuracy of job
account
It acts as a link between the production control and costing
departments
Following is a specimen of a simple costing card/sheet, only for the
purpose of illustrating its concept:
Job cost card/sheet (specimen)
Customer ______________
Name of Job ______________
Job No ______________
Date of start ______________
Date of completion ______________
Collecting Direct Costs
The job costing collects the following direct costs pertaining to a
job:
Direct material costs
Direct labour costs
Direct overhead costs or production overheads
Direct material costs
On receipt of a production order, the production department submits
a requisition note to the stores to issue the requisite materials.
Surplus, excess or incorrect materials are returned by the
production department to the stores with materials return note.
The job cost sheet records all these issues and returns of materials.
Direct labour costs
Each day, the time spent by various types of labour on a particular
job, is recorded.
Labour summaries or wages analysis sheets are prepared for each
week or any other suitable accounting period.
This analysis also includes the amounts on account of overtime, idle
time, shift-differential etc.
Direct labour costs are posted on the respective job cost-sheets.
Direct overhead costs or production overheads
Direct overhead costs for a job are recorded for all the cost centres
through which the job passes in the course of its completion.
The amount of direct overhead costs for each job order is
summarised in an analysis sheet and is posted in the relevant cost
cards/sheet of that job
Allocation of Fixed/Non-Manufacturing Overheads
This is done on the basis of a pre-decided percentage of the total
Fixed/Non-manufacturing overhead costs.
The criteria for this percentage could be the time taken, labour
input, complexity of job or any other suitable parameter. Normally,
these overheads are added only after completion of the job.
Job Account
For each job, a Job account is maintained so that the cost of that job
is known readily.
The Job Account is different from the job cost sheet.
Job account contains only the monetary information, while the job
cost sheet records other information also.
As in the case of job sheet, depending upon the nature of the job
and the requirements of the organisation, the format of the Job
account is devised and used.
An illustrative format of a job account may be as under:
Contract Costing
Contract costing is a form of job costing applied to relatively large
jobs which take a considerable time to complete (normally, more
than one year).
Like in job costing, in contract costing also, each contract is treated
as a cost unit and its costs are separately ascertained.
Examples where contract costing is suitable include shipbuilding,
engineering projects, construction contracts, infrastructure projects
etc.
In some industries and government contracting, contract costing is
the primary task of the accounting department.
Proper contract costing is crucial to earn adequate profits, and so is
usually staffed with experienced accountants.
Features of Contract Costing
Under Contract Costing, a separate contract account is maintained
for each contract.
All the direct costs related to execution of contract, are allocated to
the contract.
The overheads for a contract are allocated in the same way as under
the job costing. A contract usually involves a lower amount of
overheads but these require appropriate allocation.
Work-in-progress is an important aspect in contract costing.
Distinction Between Job and Contract Costing
The work is usually carried out at a site different from contractor’s
workplace, in a contract. In execution of a job, the job is usually
carried out at the contractor’s workplace.
A contract and a job are differentiated on the basis of size and time
taken also. Contracts are usually larger and take longer time
compared to jobs.
In a contract, most of the costs are of direct nature, unlike in a job.
In costing a contract, each contract is treated as a cost unit while in
job costing, there can be more than one cost units.
Types of Contracts
Fixed price: Under this type of contracts, the price is not
dependent on any factor like materials, labour, time etc. but is a
fixed total amount.
Cost plus: Under this type of contracts, the contract price is based
on the costs actually incurred, plus a percentage profit or fixed
profit. This is used in those contracts whose exact cost cannot be
correctly estimated at the time of starting a work. In this type of
contracts, the customer may use the services of an auditor to
examine the contractor’s contract costs, and may not sallow
some of them.
Time and material: This is similar to the cost plus arrangement,
except that the contractor includes a profit into its billings, rather
than being given a specific profit. In this arrangement also, the
customer may verify all the costs in detail.
Progress Payments and Retention Money
When a contractor undertakes to execute a large contract for a
customer, the two parties agree on the terms of reimbursement to
the contractor. As a contract involves considerable period of time,
large amount of contractor’s working capital may get stuck up if
there is no periodic payment by the customer. Thus, it is always
suggested to have a system of progress payments. Normally, this
progressive payment is based, at least in part, on the costs incurred
by the contractor in execution of the contract. Therefore, the
contractor must keep a track of the costs associated with the
execution of that contract to justify its billings to the customer.
The progress billing is normally decided by the experts, such as
architects, engineers, and surveyors etc.
Based on this certificate, the proportionate billing is done by the
contractor.
Retention money is normally an integral part of every contract. The
customer keeps some amount of money, out of the progressive bill
payments, with himself as retention money/security deposit, to
ensure that the work is carried out as per the plan agreed to in the
contract and that there are no defects in the end work.
The amount is used to compensate the customer for
any shortcomings in execution of contract by the contractor.
The retention money is given back to the contractor by the
customer after examining the quality of the work after the
contract is fully executed.
Retention money is aimed at providing inspiration to the
contractor to provide quality work.
Escalation Clause
As a contract is spread over a long period of time, the contractor
runs the risk of price escalation of input costs. Therefore, an
escalation clause is normally included in the contracts to safeguard
the contractor against any likely changes in the prices of material
and labour.
This clause provides that in case prices of materials, labour etc.
specified in the contract, change beyond a specified limit over the
prices prevailing at the time of signing the contract, during the
execution of the contract, the contract price will be suitably
adjusted.
This clause may be useful in safeguarding the interest of the
customer also in case of decline in the prices of material, labour etc.
which is highly unlikely in present inflationary environment.
Profit on Incomplete Contracts
As a contract is spread over a long period, the contract work may
not be complete during an accounting period.
Financial accounting normally recognises profit when the goods are
sold. But, it may not be fair to adopt this principle in case of
contracts, because it will result in low or no profit during the
accounting periods in which the contract is continuing and abnormal
profit in the accounting period in which the contract is finished.
It is therefore, necessary to determine the profit relating to a
contract for each accounting period during which the contract is
under execution.
AS 7 and Ind AS 115 also recognise this principle and provide
guidelines in this respect.
While precise calculation of profit on an incomplete contract is
difficult due the uncertainties involved during the time remaining for
completion of the contract, the broad principle applied can be as
under:
Profit to date = (Cost of work completed/ Total estimated contract
cost) * Estimated contract profit.
For arriving at the cost of work completed, a contract account is
maintained.
Illustration
In a factory, refining the groundnut oil, total production of refined oil during
the month was 1000 ton. The unrefined oil used in the production was 1020
ton. This loss of 20 ton was considered to be a normal process loss. If the
total cost during the month, including the cost of unrefined oil used was ₹ 10
crore, what is the cost of one ton of refined oil, assuming that no scrap is
generated?
Solution:
The total cost during the month = ₹ 10 crore
Quantity of unrefined oil consumed = 1020 ton
Quantity of refined oil produced = 1000 ton
Value of scrap = 0
Cost of one ton of refined oil = 10, 00,00,000/ (1020 – 20) = ₹ 1,00,000 per
ton
Abnormal Loss:
The normal losses are estimated assuming that the production will
take place under normal circumstances. However, in practice, the
actual losses may be more due to abnormal conditions such as
power failures, machine or plant breakdowns, inferior quality of
materials, carelessness of workers, accidents etc.
Such losses are in excess of the estimated normal losses. The
difference between the actual losses and the expected normal
losses is called Abnormal Loss.
Abnormal Gain
If the actual process loss is less than the estimated normal loss, it is
called Abnormal Gain.
Due to the increased efficiency of workers, favourable process
conditions or expected loss not materializing.
Abnormal gain does not mean that the output is more than the
input. It only means that the extent of reduction in output quantity,
compared to input quantity, which was estimated by us before
starting production, was higher than that actually achieved.
Therefore, the abnormal gain is equal to normal loss minus
the actual loss.
Calculation: Gain is not used to reduce the cost of units of
production, but is taken into the Profit and Loss A/c.
Work-In-Progress and Equivalent Units
In process industries, as the production is continuous, there is
always some Work-in-Progress at any particular point of time.
units which are not yet finished are known as Work-in-Progress.
Also, all these unfinished units may have different stages of
completion. Some may be 90% complete while some may be only
10% complete.
In such a situation, it becomes difficult to assign cost to one unit
because though the total cost incurred during the day is known, all
units cannot be assigned the same cost.
This issue is addressed through the concept of “Equivalent
units”.
If 60 units are at the stage of 50% completion, we treat them
equivalent to 30 fully finished units.
If 10 units are at the stage of 80% completion, we treat them
equivalent to 8 fully finished units, and so on.
Inter-Process Profit
Sometimes, production of a product in process industries, may
involve more than one process.
All these processes are internal, the organisation may not be
interested in knowing the cost involved in each stage as marketing
decisions are based on the cost of the finished goods only.
However, sometimes the management may be interested in
knowing the cost involved in each stage and the notional profit
involved in it.
The notional profit at each processing stage may be based on
current market price or at cost plus an agreed percentage.
This may be useful in taking a make or buy decision regarding
intermediate products.
Joint- Products
If we examine the working of a petroleum refinery, we will see that
while the input is crude oil, the finished goods produced include
petrol, diesel, LPG, kerosene and aviation fuel, apart from some
minor products called by products) like coal tar, lubricating oils etc.
There are many such process industries where more than one
products of significant proportion and value are simultaneously
produced.
Such products are called joint products.
As per the definition of CIMA, London, joint products are “two or
more products separated in processing, each having a sufficiently
high saleable value to merit recognition as a main product.”
By-Products
When the quantity and sales value of a product, compulsorily
produced in a process, is much lower compared to the main
products, manufactured in the process, that product is classified as
“by-product”. These are the products incidental to the production
of the main products.
Taking the same example of petroleum refinery, as above, products
like coal tar, lubricating oils are also produced in the refining process
of the crude oil.
But the value and quantity of these products is very small in
comparison
To the value of joint products which are petrol, diesel and LPG.
By-products usually do not influence the decision regarding
manufacture of main products.
A by-product is different from scrap/waste which is a material of
insignificant value.
Accounting for Joint Products
Split point : In the production process, joint products are
identifiable only after a stage of common raw material processing is
achieved.
After the split point a joint product may or may not require further
processing.
After the split point, the processing cost of each product is separate
and is allocated to that product only
Batch Costing
The cost accumulation system may not, always, be classified into job
costing and process costing.
If the products have some common characteristics and also some
individual characteristics, we may have to use a combination of both
the systems.
For example; a company manufacturing tables manufactures same
type of tables except that some tables are given extra polishing.
In such a case, the costs of common processes through which all the
tables pass are calculated by applying the job costing system, while
the cost of extra work done on some items is calculated by applying
the process costing system in which a product goes to another
process centre after completion of previous process.
Features and Applications
Important features of batch costing system that costing is done not
for an individual unit but for a batch of identical units.
The cost of one unit = Batch cost / number of units in the batch.
Illustration
A furniture manufacturer has received order for supplying 100 identical
wooden chairs. The company estimates the requirements of materials at ₹
1,00,000, labour at ₹ 50,000, and manufacturing overheads at ₹ 20,000. As
per company’s policy, the fixed/non-manufacturing overheads are allocated
at 20% of material cost. What will be cost of one table, applying the batch
costing system?
Answer
The total variable cost of the batch of 100 tables is 1,00,000 + 50,000 +
20,000 = ₹ 1,70,000.
The fixed cost allocated to the batch is 20% of ₹ 1,00,000 = ₹ 20,000. Total
cost for the batch is ₹ 1,90,000.
So, cost of one table is 1,90,000/100 = ₹ 1,900.
Batch costing is useful in industries like pharmaceuticals, readymade
garments, toys, tyres and tubes etc.
Service Costing
Service Costing is also known as operating costing. Service costing
is a method of costing used by the organisations which provide
service rather than produce commodities.
It is used for establishing costs of services rendered. CIMA London,
defines Service Costing as “that form of operation costing which
applies where standardized services are rendered either by an
undertaking or by a service cost renter with in an undertaking”.
Service costing is used in service organizations like transport
companies, utility companies like electricity and water supply,
hotels, hospitals, education institutions etc.
An example of internal services is canteen services.
When services are provided to outside parties, these are termed as
external. For example, hospitals, transport companies, water and
electricity supply companies.
Application of Service Costing
Service costing provides the basis for pricing the services rendered.
It helps service sector organisations like hospitals, hotels, transport
companies, utility companies etc. Service costing helps an
organisation in not only pricing its services but also in tracking and
controlling the costs by benchmarking them against standard costs
of the industry.
Unit Costing And Multiple Costing
Unit Costing is used to where the production consists of units which
are identical and are normally mass produced.
Examples are mining, brick making, cement production etc
Multiple Costing refers to the costing method used in cases where a
large variety of articles are produced.
The difference may be in regard to material required and/or the
process involved in manufacturing.
In such cases, one costing method may not be sufficient.
Therefore, more than one method of costing may be used to
compute the cost of each unit separately.
